Path Toward Prosperity – June 2018

FED HIKES RATES
What does it mean for you?


HOW HIGHER RATES AFFECT YOUR DEBT
Fixed and Variable rates respond differently


WHAT ABOUT SMALL-CAP STOCKS?
A check on small-cap valuations


SUMMARY OF INVESTMENT THEMES

FED HIKES RATES - WHAT DOES IT MEAN FOR YOU?

When it comes to low interest rates we have been spoiled for the better part of a decade.  In fact, according to David Rosenberg of Gluskin Sheff, 13.4 million people have been hired into the financial services industry since 2009.  Many of them have never worked during a major economic downturn.  Their only experience has been with mortgage rates below 5% and savings rates hovering near zero.

Paying an 18% mortgage was normal for those buying homes in the 1970s and early 80s.  That is hard to grasp for many people.  6.75% on your savings account?  That's what Morgan Stanley was paying back in 2000 when I was hired.

The Federal Reserve just lifted its benchmark rate by a quarter of a percentage point this month, the second hike this year.  Further, the majority of policy makers said they now expect a total of four interest rate increases this year.  Economists, investors and even President Trump now see rates continuing to rise in the coming years.

The decision reflected an economy that on the surface appears strong.  Unemployment is 3.8%, the lowest since 2000.  However, inflation is creeping higher even as the U.S. Dollar continues to strengthen.  Numerous companies are reporting the sting from the rising dollar and rising input costs.  The Fed is still raising rates gradually but in my opinion, has had a history of continuing to tighten until they create a problem.

"The main takeaway is that the economy is doing very well," Fed Chairman Jerome Powell said at a news conference. "Most people who want to find jobs are finding them, and unemployment and inflation are low."

The Fed lifted the federal funds rate, which helps determine rates for mortgages, credit cards, and other borrowing, to a range of 1.75% to 2%.  Additionally, mortgage rates have been climbing. The average rate on a 30-year fixed rate mortgage climbed to 4.66% in May, the highest in seven years.  Obviously, this makes it more expensive for potential homebuyers to make a purchase.

 

HOW HIGHER INTEREST RATES AFFECT YOUR DEBT

Simplistically, loans with fixed rates, such as Federal student loans or fixed rate mortgages, remain unchanged.

But Variable rate debt will be affected in various ways.

Many people with credit card debt will see a small, but an immediate increase in their interest rate.  That's because it is directly tied to the Federal Reserve’s prime rate.

Home Equity Lines of Credit are generally variable if you are past the fixed "teaser" rate.  Those rates should increase resulting in higher interest payments on balances outstanding.

Home Equity Loans, however, are generally fixed rates with fixed terms.  You shouldn't see any change in those.

Most private student loans are offered at a variable rate, and interest rates should continue to increase gradually.

Auto loans generally have fixed rates.  Those will remain unchanged.  But if you have an auto loan with a variable rate, that may rise.

HOW CAN YOU IMPROVE YOUR LOANS?

  1. It is extremely important to monitor and work to improve your credit score.  Your FICO score is an important barometer of your financial health to your lenders.  There are many components that go into your credit score including, payment history, length of history,ratio of balance to available credit and many other factors.  It's been shown that scores north of 720 give the best possible interest rates.  As rates rise that becomes even more important.  Try to keep your balance to available credit below 30%.

  2. Prepare yourself now.  Lines of credit, personal loans and business lines of credit should ideally be obtained when you DON'T need them.  A great way to set yourself to have cash available to manage cash flow or emergencies is to apply and secure these lines when times are good.

  3. Look around for lower interest rates.  This may sound easy, but very few people actually look around.  Additionally, you could call lenders you have worked with for a long time and potentially negotiate a lower rate to keep your business.  I amazed how often this tact works.  If you don't ask, you will not receive.

  4. Potentially restructure your revolving loans to a fixed rate loan.  This can potentially provide peace of mind knowing that your rate can no longer increase, but it most likely will come with stricter terms.

WHAT ABOUT SMALL CAP U.S. STOCKS?

As we continue to think about global market valuations, I keep coming back to small-cap U.S. stocks.  On the surface, they seem like a great place to invest right now.  With protectionism on the rise during the current administration, they seem to be focused on helping U.S. based companies.  Further, the smaller you are, the bigger the potential impact.

Small-cap companies are an interesting breed.  They offer tremendous potential growth as every large company started small. But, mature businesses are much easier to value.  If there is a long operating history to observe, it is much easier to tell if a company is over or undervalued.  If a company has survived for many, many years and has been successful through multiple booms and busts there often is something that is high quality about the business.

Interestingly, a discovery process that many individual and even professional investors previously used was to look at the major holders of a given stock.  If someone or some firm held in high esteem became a purchaser of a stock, it was assumed they knew something.  But, over the past 20 years, that process has become moot.  The major holders of most small-cap stocks today are the large indexing names.

Typical value-oriented investment managers wouldn't invest in a small-cap company unless valuations (P/Es) were in the 10-15x area.  Currently, valuations in the space are in the 20-35x range.  Those investing in these companies at this moment are the firms that are price agnostic.  They automatically invest, regardless of price.  As you can see from the above chart. Valuations are much, much higher than back in 2000 in the small-cap asset class.

Warren Buffet said, "Price is what you pay, value is what you get."

Mature, small-cap businesses growing 2-3% annually should not trade at valuations similar to high-growth companies.  I understand why premiums are being paid at the moment for companies that are growing fast.  There just isn't a lot of organic growth in the global economy at the moment.  But, for companies with slow or no growth, you may be paying for peak earnings and peak margins.  Extrapolating current growth in a linear fashion is an error made by many.  Extrapolating linear growth from a high valuation level is potentially faulty.

I believe one of the potential reasons for the higher than normal valuations in the small-cap space is the flows of indexing.  Market Cap weighted indexing doesn't care about earnings yields, risk premium, a margin of safety, cash flow or any other fundamental metric.  When an index receives an inflow, it buys, end of story.  When it receives an outflow it sells.

While overvaluation and price insensitive investing are almost always present in every cycle this one may be extreme. Maybe.....

INVESTMENT IDEAS

  • Rather than trying to “beat the market”, focus on beating inflation and the rate on cash.  Plan for safety and liquidity while seeking positive returns.

 

  • Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.

 

  • Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

 

  • A potential U.S. infrastructure upgrade cycle may be around the corner. Moving from our current grade of D+ to B would require an investment of $3.6 trillion by 2020.

 

  • Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.

 

  • Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

 

  • The rise of E-Commerce has coincided with an increased desire for efficient warehouse distribution real estate. As e-commerce moves toward even faster delivery, positioning of distribution becomes even more important.

 

  • Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.

 

No strategy ensures success or protects against a loss.

Regards,

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Colin B. Exelby
President
Celestial Wealth Management


Important Disclosures
  • The information herein was obtained from various sources and we do not guarantee their accuracy.
  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
  • The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
  • The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
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  • The fast pricing swings in commodities and currencies may result in significant volatility in an investor's holdings.
  • There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.  Diversification does not protect against market risk.
  • Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
  • The prices of small and mid-cap stocks are generally more volatile than large-cap stocks.
  • An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
  • High yield/junk bonds (grade BB or below) are not investment grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

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