The Markets

Lack of imagination on the part of investors is fueling stock markets to grind quietly higher with U.S. indexes reaching record levels on their seemingly unstoppable march to new ever highs. The S&P rose 4% during the third quarter and is up 12.5% year to date. Technology stocks such as the Big Four: Facebook, Apple, Google, and Amazon drove the NASDAQ composite to a 20.67% gain so far this year. The Dow Jones Industrial Average was up 4.9% during the third quarter, its eighth consecutive quarterly advance, an achievement not seen since the late 1990s. Energy stocks rose as U.S. crude oil gained 12% during the third quarter with diesel fuel being the most highly appreciating asset so far in 2017, up 22%. This despite diminished demand for diesel in Europe due to various emissions scandals.

Real estate in the U.S. has been relatively flat while the benchmark 10-year bonds issued by the U.S.  government rose 1.4% now yielding 1.7% which means they had a price decline.  Tax-free bonds gained 1.1%, while U.S. corporate bonds gained 3.75%, yielding 2.68%, which means their price went up slightly. Interest rates have been rising in the U.S. due to the Federal Reserve’s movement to tighten up rates.  Bank stocks rallied at the end of the third quarter, due to President Trump’s tax proposal, but for the life of me, I can’t understand why their lending volume continues to diminish, down 0.1% over the last three months.

Brazil was the best performing international market and Pakistan the worst. China’s markets advanced 13.1% during the third quarter, even though their economy looks to be slowing down. China’s factory output, retail sales and capital investment all point to a cooling economy as opposed to Europe and the U.S. where rising business confidence and consumer sentiment point to increasing gross domestic product. Emerging markets look to be the best performer this year.   They rose 6.6% during the third quarter, with a year-to-date gain of close to 25%. Justification for the emerging market rally is a weaker dollar and easy global monetary policy, none of which adds up because these factors have been in place for a number of years.

With positive economic growth in most countries around the world, investors are relatively blasé about the dangers posed by a potential conflict in the Korean Peninsula or around Iran’s possible rollback of the “nuclear treaty.”  The fact that Republicans seem to be moving forward with their tax cut proposal for corporations is a positive, for holders of financial assets. There are few specifics on the tax proposals and since much is likely to be reversed, we should see more volatility in the markets as it becomes clearer as to what the Republicans can and cannot accomplish in Congress.

So far in 2017, he European stock markets are outperforming the U.S. European indexes climbed 2.3% during the third quarter, up 7.4% this year.  The best performing country was Austria, up 26.6%, with Russia performing the worst at -1.4%.  European businesses and households are upbeat for the first time in a decade as German unemployment is at a record low.  Uncertainty regarding immigration, the British exit from the European Union, rising secessionist movements in Spain and on Turkey’s southern border, are all factors which have been shrugged off by investors. The Asia central banks continue to stimulate as though it was still 2008.  The only economies where stock markets are lagging is in natural resource rich countries such as Canada and Australia.

Gold has risen 11.43% this year with natural gas tanking, down almost 19.25%. Commodities including wheat and pork have been some of the worst performing assets. Even with the price of oil going up, oil service companies stock prices have not recovered as the outlook remains uncertain for U.S. production. OPEC nations, Russia as well as some South American producers, continue to try and exert their influence on world markets by curtailing production. U.S. output has not increased as much as expected because independent large companies are not rushing to drill wells at this time.

The markets for Bitcoin and other digital currencies has been crazy. A section of this newsletter is devoted to the conceptual and practical aspects of these electronic currencies below. Investors in these new technological trading systems have been rewarded by a doubling in price (and then a one-third plunge) within the last three months.  Interest in them is growing in Asia, as well as Africa, because as smaller countries’ currencies come under attack, these anonymous and cross-border stores of value offer a haven to people with money. China outlawed crypto currencies in September while Bitcoin and other digital money providers have created considerable wealth for people in the industry. There remain many bridges to cross in this highly untested realm.

How can the U.S. stock markets continue to go up? Despite deep concerns over price valuations and rising interest rates, along with uneven strength in the U.S. economy, investors are heartened by the news out of Washington that any action will likely benefit stock and bond investors. If tax reform does take place, analysts predict a move out of emerging market stocks, which are overheated, back into U.S. equities. None of this will help bond investors because rising interest rates and a shrinking Fed balance sheet will put pressure on the prices of all bonds, especially government ones.  High dividend paying companies, such as utilities, have lagged the general market due to competition from higher earning bonds. Investors continue to pour money into the technology laden indexes over traditional stocks.

It would be hard to characterize today’s stock market environment as a “bubble.” Many people remember the bursting of the tech market bubble in 1999 and the financial crash of 2007-2008. Both of those trading environments were characterized by unwarranted enthusiasm on the part of the general public, which greatly contrasts with the uncertainty and anxiety many investors feel today. It is said that “the market climbs a wall of worry” and this has been the case over the last five years.  The U.S. economy is overdue statistically for some kind of cyclical recession, and in much the same way the stock market is due for a major technical pullback, based on valuations returning to historical norms. Of course, no one knows the timing of such a correction but there are cautionary lessons to take away. The risk-free rate of return of investing is measured by the U.S. treasury bill which is near zero. Consequently, the expected returns on all other investments should be scaled back accordingly. No one likes to make less money than they have in the past and so accepting this is difficult, especially for beleaguered pension funds of public employees which face many other challenges.

Reducing risk in publicly traded securities makes sense at this point in time. If interest rates do move up, future investments will require higher returns and the only way this happens is by a lowering of current prices. If you believe, as we do, that a correction is coming, reducing one’s risk now makes sense. The next logical question is what to do with liquid funds from sales. Staying in cash and earning nothing is not acceptable to most people so looking for alternative assets that are managed by niche players can, if identified and purchased at the right price, raise the return on a portfolio without taking on substantially more risk. Diversification outside the public markets means finding a way to put money in metals, alternative currencies and partially or fully illiquid investments such as private equity/debt.  Direct investment in real estate (though this asset class seems to be forming its own special bubble) and real estate lending through reliable and experienced managers can assist investors to diversify.  Taking profits is never a crime though most people wince at paying capital gains taxes.

The European Union’s recent economic results look encouraging as business activity and consumer confidence firms up, especially across Northern and Central Europe. Manufacturing and service jobs were created at the fastest rate in the last 10 years and the outlook for European economic growth is positive. This is also true for Emerging Markets, whose valuation levels continue to attract investor attention due to the lofty levels of U.S. stocks.

Complacency is the new watchword of the investing public. The lack of market “volatility,” the normal ups and downs created by active participants with various opinions, has been replaced by financial engineering and government intervention through the injection of massive artificial liquidity.  Ratios of relative valuations indicate a level of investor complacency which is off the charts. Translated into simpler language – people don’t believe that the market can go down and if it does, they think they won’t be affected. The protection afforded to investors with financial assets by the government over the last decade is now considered the norm, and not a temporary measure to prevent a collapse in the confidence in the financial system. We know that the rich are getting richer while everyone else is sliding backwards. It looks to us like productivity growth is going down to zero and real rates of return will go lower and lower.  We no longer operate in a real competitive economy but one in which the markets are dominated by a few enormous companies like Amazon and Google.

Investor complacency produces unconscious risk-taking. The more the government impacts the markets, the more risk is hidden because the illusion of a downside safety net is just that – a mirage.  When most of us get to the point where we believe that nothing can go wrong, which I think is the attitude of many investors who rely primarily on index funds, the system is being set up for a fall. No one talks about an asset bubble in the market today because there are always well-meaning justifications and good reasons for it to go higher.

With market valuations at current levels, The Fed is rightly talking about raising rates and reducing the size of its balance sheet.  The “passive” index industry has been one of the major beneficiaries of investor inflows over the last five years.  It looks to me to be the most exposed to downside risk. Many younger investors have never been through a sustained stock market downturn, the last one having occurred in the late 1990s when Millennials were in junior high school.  They may live under the illusion that because they are all invested together, albeit in low-cost and tax efficient vehicles run by computers, that they cannot really get hurt. Many actively managed mutual funds and money managers now mimic index funds, so everyone is buying the same stocks. Eighty-five percent of the Standard & Poor’s 500 is owned by the three major index funds providers.

Alongside the ascendance of the use of passive market indexes, there is a decline in the number of companies going public.  There is less competition amongst those already existing to compete with each other on price and valuations since few care about these old-fashioned metrics.  This has helped a few of the Standard & Poor’s 500 companies and allowed their price-earnings ratios to go to outrageous levels.  But the market as a whole, by some metrics, does not look like it is tremendously overvalued.

The Economy

The economic growth of a nation or region is primarily based on demographics –the study of the size, structure and distribution of human beings in a society. Births, deaths, and migration as well as cultural changes within subgroups due to education, nationality, religion and ethnicity all drive consumer patterns.  Businesses attempt to proactively change their activities in order to make money from the activities driven by the above characteristics. A great deal of effort is spent to try to predict these factors.  One of the preeminent observers of the impact of demographics on economic activity is Neil Howe, one of the authors of “The Fourth Turning,” a book based on generational changes in observed attitudes and activities. I’ve had the opportunity to talk with Neil on the phone and meet him in person.   We share a general outlook on the challenges which face the U.S. and global economies as a result of shifting demographic factors which Neil frequently comments upon in various publications.

The rise in the number and influence of the Millennial generation on the economy is well documented. As baby boomers move into retirement, their spending and voting patterns are changing. We live in a world where democratic institutions no longer seem to function primarily because the ability of elected officials to face real-world problems seems to have disappeared. Issues such as health care, immigration, education, infrastructure, and the environment all require concentrated focus and action based on a sound long-term plan, none of which seem to be forthcoming from our “leaders.”  While individual politicians may be intelligent, well-meaning and hard-working, few of them talk about a long-range vision and no bold and comprehensive programs are being offered in any way, shape or form.  As a result, most Westerners have little feeling of optimism about the future. This has a real impact on the economy, which responds quickly to people’s states of confidence and outlook for the future.

One of the most important demographic impacts of waning confidence is declining fertility rates. The economic crunch that most people in the West feel, those who are not part of the upper 1%, can be seen in the rate of new household formation and the incidence of home ownership, both of which have declined precipitously over the last 15 years. There is an increasing level of multi-generations living together, partly because the job prospects for young people without higher education is bleak and also because people need whatever support they can get from the younger generations. This is not necessarily a terrible thing, as traditional societies, those living near subsistence level, always shared their homes and lifestyles.

On the political front, we live in a world in which there is growing dissatisfaction with political leadership of all kinds. There is a whole generation of young people who cannot get ahead and they have found that their governments have colluded to over inflate the value of the elder generations financial assets. Most older people want to believe that things will be okay, at least for a little longer, but after that, look out. Along with the rise of populism and cultural nationalism, there seems to be a growing belief that authoritarian leadership is necessary to deal with the challenges facing the world. We as Americans may not be aware of this but the leaders of China, India and Russia are extremely popular among their domestic populations.  They are ready, willing and able to take bold action whereas legislative bodies in Japan, Europe, and the United States are not.

People under the age of 40, and that is the majority of the population in Asia, are tired of political gridlock. The Millennials in China are much more confident in the future than their counterparts in the Western world because China is looking forward into the future and taking action.  Even if it’s misguided and repressive, it is inspiring to those looking for a brighter future. Westerners have lost trust in institutions of all types, the media, legislators, executives, judges, etc.

One of the most formidable obstacles facing investors is the need of a growing population of retirees for steady cash flow. Managers of public pension funds realize that just meeting retiree pension costs, which now consumes more than 15% of the annual budget of many large U.S. cities, is going to be growing inexorably.  Meeting the liabilities facing local and state government will require continued cuts in infrastructure and basic services. If they could afford to, many civic leaders would raise taxes and impose special fees but the substantial majority of Americans are already stretched to the max. The quality and quantity of government services in urban areas has to and will suffer.  The subway system in New York City is a good example. Due to delays in maintenance and shortages of personnel, there has been an increase in the number of delays from 28,000 per month in 2012 up to 70,000 delays every month in 2017. Since 2014, New York City spent more money on funding its retirees’ pension payments than it has spent on its school system, parks, bridges and subways combined. The pressing need for cash will force governments to issue more and more debt, some of which they know there is no possibility to repay. This implicit but unseen devaluation in the value of government-issued money is one reason why alternative currencies like Bitcoin, are gaining popularity.

The U.S. bond market is expected to be buffeted by the Federal Reserve’s plan to unwind its balance sheet and raise interest rates through the end of 2018. Unwinding its balance sheet means that the government is going to be selling bonds or at least not renewing them, both of which will cut down the central banks influence on the market. Theoretically, when interest rates go up, stock prices should fall but the markets often confound the “experts.” The last seven years have seen unprecedented coordination between the U.S., Japan and European central banks in terms of flooding the market with new bonds to provide liquidity. It’s possible that any sustained decline in U.S. stock and bond prices may not occur until those other two institutions follow the same playbook as the U.S. Fed.

Electronic Currencies and Cash – Alternative Assets

Notwithstanding the publicity, both good and bad, that Bitcoin, the largest and most well-known of digital currencies, has received over the last several months, and the fact that it has gone up tenfold in 2017, I believe it’s worth knowing about if only for thinking through the possible use of alternative stores of value as opposed to traditional assets. I’ll describe what Bitcoin is and then briefly explain how it works.

The Bitcoin community is committed to only growing the supply of Bitcoin to a certain size and then no more will be created. This immediately contrasts it to the U.S. dollar, Euro and every other government issued currency. If enough people believe that Bitcoin has value, and act on that belief that by accepting Bitcoin payments in exchange for regular goods and services, there is the real possibility that Bitcoin and other electronic currencies represent a viable alternative to stocks, bonds, and cash. Government issued currencies are no longer backed by gold or silver.  It is only the “full faith and credit” of the issuing government that makes people feel comfortable holding and trading real items for regular government “fiat” currencies.

Governments can change the rules for their currencies. That recently happened in India where they outlawed the use of certain cash notes. Governments can devalue their currencies by printing more of it, as happened between World War I and World War II.  People can steal government issued money from banks or even counterfeit it. Bitcoin is not subject to government activities because it’s accounting, production, disposal and transportation is outside of the system. The ways that Bitcoin is created and recorded are technical, but the basic point is that if enough people accept it having value, it will have value and this certainly seems to be the case today.

Digital currencies like Bitcoin are created by what are called blockchains which are data structures that are limited by intent and agreement across a vast number of people. The decentralized nature of the record-keeping of the Bitcoin blockchain records and constant cross-referencing means that no one can counterfeit it or use it unless they have proper access codes. By decentralizing the production of Bitcoins and paying people for successfully tracking them, there is a self-reinforcing honesty mechanism which is lacking in government issued currencies.

The extreme volatility in Bitcoin’s value is due to the relative newness of its unique market and the fact that there is no one person ultimately responsible for setting prices and maintaining them in an orderly fashion.  Bitcoin, and other digital currencies, follow the kind of law and order administered during the Old West gold-mining days depicted in the TV series “Deadwood.” Bitcoin can be exchanged for regular money and there is beginning to be a wider opportunity for consumers across the globe to participate in Bitcoin or some other blockchain-based currency because it is not subject to controls on portability that are imposed by authorities.

The Chinese government recently clamped down on Bitcoin in China, which is where most of Bitcoin’s “minors” operate. Obviously, the Chinese government is trying to control its citizens’ wealth and they do not want it moving outside of the Chinese government’s control. The Chinese government employs hundreds of thousands of programmers to monitor the social content of the Internet and one would expect them to do the same for the blockchain currency environment as it develops and grows. It looks like the Chinese government wants to co-opt blockchain technology and create their own electronic currency. These are exciting times.  Lessons learned by Chinese citizens on how to deal with their government’s effort to control electronic money, may be relevant for U.S. citizens at some point in time.

The world’s three most populous nations are run by strong autocrats.  Chairman Xi and his China’s Communist Party, Vladimir Putin and his associates, and the strong armed Prime Minister of India are all proponents of greater government control over the financial system. Whether this is overt as is the case in China or covert, as in the case of Russia, the movement of power towards centralized control is well underway. We think of India as the world’s largest democracy and in some ways, it is.  The implementation of a prohibition against cash, by Prime Minister Modi, has forced hundreds of millions of people into using government issued debit cards. While there are ample rationalizations, reasonable and logical justifications for this move, mostly based on the need to clamp down on tax evasion and to more efficiently disperse state benefits to the lower classes, the net result is a loss of privacy, autonomy, and flexibility on the part of individual citizens.

The debate about getting rid of cash in the U.S. has begun.  Academics are already talking about making it illegal to hold large denominations such as the $50 and $100 bill. The same reasoning is being trotted out as in India: to clamp down on tax evasion, make it harder for off the books business activities, and to fight organized crime. In the U.S., some want to give the Federal Reserve more power to stimulate the financial economy by driving interest rates down below zero and outlawing cash ostensibly will help. The fear that government interventionists have is that not only will individuals but also institutions as well will go to cash if interest rates go negative.

These arguments make some sense because illicit activity everywhere on the planet does take place using U.S. cash.  American greenbacks are the one common currency in which most people trust. What theoreticians forget is that many legitimate business people outside the United States have no local currency in which they can reliably trade and so they use U.S. bills. I suspect that most of the paper currency in circulation is outside the United States.

It is generally the neediest people who bear the brunt of changes in government policy. Slightly under 10% of U.S. households do not have bank accounts and life would be exceedingly difficult for them to not use cash.  Fees and paper requirements that banks have in order to open up accounts are inhibitory. Privacy is another key topic when it comes to outlawing cash. The government wants to know about everything and forcing people to use electronic money would go a long way towards giving them this power. It is as if every person in the United States would be required to have a chip implanted in their ear lobe with the justification that it will help authorities find people who are lost or identify them if they’re in an accident.

Do you want someone to know where you are all the time? Your cell phone gives out that information, which is the start of national surveillance capabilities that technology will enable governments and their agencies to wield.  Outlawing currency would allow the government to track everything that its citizens do in the financial arena, all under the guise of fighting crime and allowing the central bank to further influence the real economy by lowering interest rates under zero. People and companies are justifiably wary of the government’s record-keeping abilities as well as their ability to look ahead and see the eventual consequences of their policies.

There is a very real possibility that large governments worldwide will march over the common person’s rights – to do what they see fit with their own money.  Digital currency mechanisms such as Bitcoin and its rival, Ethereum, have come front and center in the debate over who will control the future of money in the global society. Because of the importance of these decentralized electronic currencies, we at the Rikoon Group are starting to buy some Bitcoin.

Personnel News

Rob: Summer is my favorite time of year to travel, though it seems as if almost every month I am on the road for at least a week. This summer I was in Colorado, California, Oregon, Washington as well as my regular trips to North Carolina and New York City. The same travel schedule pretty much holds true for this Fall so I hope to spend the holidays here at home. In the studio, I am working on a diptych which will go into the Sky Lanes bowling center in Asheville. People ask why a bowling alley and my reply is why not put fine arts into unexpected places! The large egg tempura “Chapel” piece that I spent 18 years on may soon find a home in a Methodist church, that is a refuge for the homeless, mentally ill, and indigent people.  It’s about as far from a typical art museum as one could imagine. Hannah has started back into her second year of naturopathic medical school in Portland, Oregon, and Robyn is settling into the Washington DC area on her fellowship at the Kennedy Center for the Arts in stage directing.

Jeff:  I have started to play pickleball on Sunday mornings at the community college. If you are not familiar with pickleball, it is a racquet sport that sort of combines elements of badminton, tennis and ping pong and the ball that is used is a perforated Wiffle ball. After you learn the basics, there is a lot of strategy that gets involved. It’s a lot of fun. I am continuing to sing with my jazz quartet a couple times a month and am enjoying that a lot.

Kyle:  In July, I took a trip to New York City for an intensive course on Mergers and Acquisitions. Although the class kept me busy, I was able to sneak away for a visit to the Museum of Modern Art. It was my first visit to the museum since I was a teenager and it brought back some great memories. The end of the summer has brought another school year for my two sons who started second grade. Their reading has really advanced over the past year and it is fun to watch their interest in stories and graphic novels evolve. My wife just started her second semester of a nurse practitioner program, which means I am frequently the subject of medical exams to help her with assignments.

Anthony: My family and I finally finished our big backyard project. It’s been great to watch our daughter have her own place to run around and play outside. We were even able to cap off the summer with a big housewarming party, celebrating with family and friends.  Now with the arrival of Fall, we look forward to driving up to the mountains to see the foliage change, as well as plan our annual trip out to McCall’s Pumpkin Patch in Moriarty. If you have never been I highly recommend it, kids or no kids. Our daughter is already working on perfecting her Halloween “trick or treat” line. Happy Fall everyone!

Contessa: The past four months have been quite the adventure for me!  In addition to joining The Rikoon Group, my husband and I purchased a new home. We are finally feeling settled in and getting used to the extra space.  The kids are enjoying their new backyard and are looking forward to decorating the house for the holidays.  Fortunately, we were still able to get away a few times to go camping before the end of the summer and school started.  Ayden started the first grade this year and Samuel is now in Pre-K.  It amazes me how quickly they are growing.

Patrick: I have really been enjoying the end of summer here in Santa Fe and feel grateful that I live in such a magical place.  The rain and dramatic cloud formations make my weekly hiking and mountain biking adventures much more enjoyable.  I continue to bring my camera with me everywhere and have taken a lot of beautiful pictures of rainbows and the stunning New Mexico landscapes.  My girlfriend and I attended our friend’s wedding out at La Mesita Ranch and had a really good time.  We also enjoyed ourselves at Zozobra, Indian Market, and Music on the Hill.  I was able to make it down to my intentional community in the Gila for the Equinox Meeting where we discussed the future of our unique hot springs paradise.  It has been a busy summer but very rewarding.  I am trying to take advantage of the remaining light after work before it starts getting darker.  The aspens are starting to change color on the mountain and I need to get up there to take some pictures of the transition.  I bought my Gold Pass to go snowboarding this winter at Ski Santa Fe and I hope it is a wet one.

Upcoming Events

Please join us for our quarterly gathering to discuss economic and market related events. It will be held at 2218 Old Arroyo Chamiso in Santa Fe on Tuesday, December 5 at 3:30 p.m. (MT). We generally go until 5:00 p.m. The open mike conference call, available to out-of-town clients and friends, will occur on Thursday, December 7 from 3:30 to 4:30 p.m. (MT). The call-in number is 719.234.7872, after which you will be prompted to enter the code: 470070#.