A Strategy Change
David R. Kotok,
For Cumberland Advisors, August 11, 2013
It has been a busy two weeks. The Leen’s Lodge gathering added an intense interlude of high-powered conversation and analysis. The Yellen-Summers headlines now have two added mystery names per President Obama. The Fed (Federal Reserve) tapering talk adds the question “What is the policy?” to the question “Who will be making the policy?” Markets are going through gyrations in both bonds and stocks. And we see surprising reactions in foreign currencies, with the Japanese yen strengthening while changes in policy at the Bank of England have resulted in a market reaction opposite to what the BOE expected.
At Cumberland, there have been a number of strategy changes. Clients are aware of these changes by observing the activity in their accounts. We will summarize here the strategy changes and the reasons for them. Expect further commentaries on these matters as we keep you apprised of factors affecting the market and our timely responses to changing conditions.
We have raised cash in both US and international equity accounts. The bottom line is that the risk profile in stock markets is up. There are questions about the pace of economic recovery, some of the sectors such as energy or housing, and the impact of the Fed’s talk of tapering and what it is doing to risk premia and re-pricing in the market. The possibility of a Summers Fed chairmanship, coupled with Elizabeth Duke’s departing, Jerome Powell’s term ending next year, Sarah Bloom Raskin’s leaving for the Treasury, and Janet Yellen’s departing (If she is not appointed chair?) , leads market agents to conclude that an entirely different configuration of the Fed board may soon be at hand.
Add to that the retirements of some of the seasoned presidents (Cleveland Fed president Sandra Pianalto has announced), and the structure of the US central bank may reach a point where the remaining experienced and historically seasoned members of the FOMC (Federal Open Market Committee) are few. New observers and appointees may have seen the financial crisis from the outside; however, they will not have acquired firsthand the knowledge and experience gained only through making decisions under fire. Markets are aware that they face the biggest US central bank transition in many years.
Bond markets have backed up in yields. This is true in the Treasury, municipal and taxable bond markets. We have written about how yields have been distorted and yield spreads have widened enormously. Our example was a trading day in which the 30-year US Treasury obligation (federally taxable) traded at 3.62% yield. In the same 24-hour period, the tax-free New Jersey Turnpike traded at 4.73% yield, and the taxable New Jersey Turnpike traded at 5.15%. In our view, the tax-free turnpike bonds are screaming bargains in the present climate. In fact, Cumberland owns them in clients’ accounts.
Risk management issues loom larger than usual. What do you do when the stock market has reached your next year’s target? Our target was the S&P 500 at 1700 by the end of 2014. We are there. What do you do when the outlook for earnings is starting to deteriorate? We have ratcheted back our S&P 500 estimates for this year by a couple of dollars. We still think that earnings will come in around $110, give or take $2. The picture is trending toward more softness in earnings growth.
What do you do when the outlook for the future earnings growth rate is also deteriorating? We base that assessment on the fact that the profit share of the GDP in the US is at the highest level it has seen in decades and the labor share is at the lowest level. That means productivity seems high and earnings that come from that profit share seem to be strong. Could the profit share go higher? Yes it could. Is that likely now? We think not. Furthermore, the ratio of the value of the entire S&P 500 index to the GDP has reached 100%. History (Ned Davis database) suggests that this is a dangerous level.
We think the profit share of the GDP is rolling over, peaking, and tipping into what might be a long-term decline from this very high level. And the labor share may be bottoming and is positioned now to start a gradual rise over time from this very low level. If this view is correct, then American companies begin to face headwinds that will slow the earnings growth rate. This is not just a day-to-day, week-to-week or month-to-month rate of change. This is strategic. What lies before us is a longer-term stretch in which the tremendous benefit to American business from central bank policy in the post-crisis period will come to an end.
Lastly, there is the issue of demographic headwinds. Rob Arnott, a guest at Leen’s Lodge this year, has offered thoughtful analysis on demographics. He notes, in his serious research, how strongly demographics have contributed, in the past, to accelerating growth rates, and he forecasts significant headwinds that demographic change may introduce into our strategic future.
Put that package together and there emerges a set of circumstances in which stocks, having risen terrifically, now look less appealing at the current price level. Certain sectors of the bond market, by contrast, look more appealing.
Consider that New Jersey Turnpike 4.73% tax-free yield. We sat in a meeting with one of our New Jersey clients and reviewed his portfolio. The client is a successful businessman. He was joined in the meeting by his financial professional. We dissected his New Jersey tax bracket. He is somewhere in the 51%-52% marginal tax bracket. He is a New Jersey resident paying federal income taxes and New Jersey taxes at the top rates. He bumps up against levels which limit his deductions and expenses when he completes his tax return. And we must add the Obamacare tax he pays. That is how his marginal tax rates reach 52%.
Sitting in that meeting, we took apart 4.73% as a yield that he can obtain by investing in a long-term debt instrument with a senior claim on the revenues of the New Jersey Turnpike. The compounding taxable equivalent yield for him is approximately 9.5%. He can get that yield year after year.
What that means is that, to scrape up a viable and comparable investment alternative, he would have to find an investment somewhere else deriving a taxable income of 9.5% and pay all of his taxes on that percentage. The residual would equal the return generated by the New Jersey Turnpike instrument. Where are you going to find such a low credit risk, high quality, and liquid investment in New Jersey to compound at a 9% or 9.5% rate pretax so that you can derive a match against the New Jersey Turnpike? I cannot see any, and neither can he. That is why we allocated in favor of his tax-free bond portfolio. Do the same math with some long-term holding and use the 20% capital gains rate. Add Obamacare tax and add NJ taxes. The case for the New Jersey Turnpike tax-free bond is still very compelling.
We have changed our internal asset-allocation mix at Cumberland Advisors. In the beginning of this cycle, we were as high as 80% stocks in balanced accounts. That allocation has been reduced to 60%. We have taken the bond piece up to 40%. Furthermore, we have extended duration in individually managed accounts. The entire hubbub over Detroit, San Bernardino, and other specific tax-free municipal bond credit issues has provided an entry opportunity in the tax-free municipal bond market that is unparalleled except for one other time. I would characterize that other time as the “Whitney moment,” when Meredith Whitney went on 60 Minutes and predicted the end of the municipal bond world. Let’s call this current time the Whitney-esque moment.
We are buyers of tax-free bonds. We have a cash reserve in our US equity and international ETF accounts. That cash reserve is higher than it has been in our accounts in quite some time. And we are going to hold that cash reserve on the sidelines for a time. We cannot say how long and we do not know when or how much will be redeployed.
We are now facing the transitional period for the central bank. We do not know who the next chairman is going to be or what the composition of the board will be. But we do know that the current wave of uncertainty will soon be cresting into decisions sure to have cascading consequences in churning markets. We have seen a lineup of commentary coming from FOMC members that suggests a form of tapering is coming.
We are not afraid of tapering. Tapering by itself is not an issue if it is coupled with an extension of the short-term interest-rate commitment. In other words, the Fed can cut the rate of additional purchases and use guidance to extend the period before and until the Fed Funds rate will be elevated from its present 0.0%-0.25% range. Some members of the FOMC are thinking that tapering means reducing the amount of stimulus but extending the time period in which it is applied. If the market grasps that concept, bonds will rally, and tax-free bonds even more so.
Think about it. If the inflation rate in the US is roughly 1% and there is a possible downward trend, then a 4.73% tax-free New Jersey bond is delivering a real return of 3.73% after taxes to a New Jersey resident. That is a phenomenally high return on an investment for someone living in New Jersey. The real return is still quite high if the inflation rate heads up to 2%. This is now a win-win for an individual investor. There are similar opportunities in jurisdictions throughout the US.
To sum this up, carefully selected bonds now offer an entry opportunity and long duration. It is critical to check the quality of credits, particularly in the municipal bond market.
Stocks require selectivity as to sector activity and many other characteristics. We have had terrific success in our US ETF portfolios this year. We do not want to give those strategically achieved profits back. So we now have a cash reserve until we get through this difficult period.
David R. Kotok,
Chairman and Chief Investment Officer, Cumberland Advisors
Category: Think Tank
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