Guild Investment Management, Executive Summary, Dec. 8, 2016

Executive Summary

1. Following the market turn: financials. The policy response to the financial crisis and the Great Recession was unusual, with the Federal Reserve using monetary policy to try to make up for the lack of growth-positive fiscal and regulatory policy from the Federal government. After a 7-year weak expansion, the stage is being set for a major policy shift that will take pressure off the Fed and put pro-growth fiscal policy and regulatory reform in the driver’s seat. The stocks of cyclical companies have soared — especially financials, and within that sector, especially regional and investment banks. We think that even though this expansion has been long, it can get longer, and even though the rally in financials has been strong in recent weeks, it can continue, with corrections offering buying opportunities. (Note that financials have underperformed the broader market during the last eight years.) It will take months and perhaps years for the full policy implications of the “Trump turn” to be implemented. While big financials were a partial cause of the financial crisis of 2008–2009, small and medium banks were not involved in the mortgage bond mess that was a big part of the problem. Yet these smaller banks were saddled with big regulatory costs even though they were not the culprit. We remain bullish on these stocks, and remain buyers of small and medium sized financials on weakness. The immediate post-election rally will end, the new administration will hit roadblocks, and sobriety will begin to temper the exuberance. These will be the buying opportunities we’re waiting for.

2. Following the market turn: industrials. Mr. Trump’s victory prompted a strong rally in U.S. industrial stocks. We believe this rally is justified by the magnitude of the policy shift that the Trump administration promises to implement, and by the prospect of a growth inflection in the U.S. economy that lengthens the current expansion and finally gives cyclicals some much-delayed mojo. However, we caution that unlike some of Mr. Trump’s proposed fiscal and regulatory policy turns, the policies that boost growth and bolster U.S. industrials will take longer to implement, and their political path is less certain. There will be pauses, setbacks, and conflicts, during which market participants lose their nerve — and the ensuing corrections will be buying opportunities, as the revitalized expansion may not hit its stride until 2018. Among industrials, we favor small and mid-sized companies with less exposure to exchange rate effects; we like truckers, and we like vertically integrated steels with captive iron ore, coal, and coke.

3. What if we had a referendum and no one freaked out? The Italian referendum came and went; the populists won their vote; and lo and behold, it was already priced in. The Euro did not collapse, and neither did shares of some of Italy’s most troubled banks. European authorities will kick the can again. Trouble lies ahead for Europe, but it is not coming to a head today — and likely not any time soon. Remember, newspapers and financial TV sold fear about Italy: don’t buy it.

4. Market summary. We remain bullish on the U.S. stock market. We will use dips to buy stocks, especially focusing on regional banks, investment banks, industrials that are U.S.-focused, and potentially other sectors that have been battered and are now extremely underpriced. We remain bearish on U.S. bonds. U.S. interest rates will rise. We are bullish on the Japanese stock market now that the yen is weakening, however if you buy Japanese stocks, be sure to hedge the currency or use an ETF or vehicle that hedges the yen exposure. While we believe Japanese stocks will rally, in our view, the world’s most attractive stock market is the U.S.

The Market’s Turn: Financials

In the wake of President-Elect Trump’s unexpected victory, two of the sectors we favor are financials and industrials, and we’ll briefly discuss why. First, financials.

Financials have enjoyed a strong rally in the month since the election. As of this writing, the Dow Jones U.S. Financials Index has produced a 10% one-month total return, but that broad performance masked significant divergence in the performance of different industries within the sector. In many cases, the post-election rally brought companies into the green which had spent the year in the doghouse until the last month.

As we have noted before, regional banks and investment banks have been the strongest performers. We think that in spite of the rally, the tailwinds behind financials continue to make many of these stocks a buy on weakness.

What are those tailwinds?

First, financials are cyclicals — almost the definitive cyclicals — because of their role at the heart of the growth of credit that facilitates accelerating activity during a period of economic expansion.

The current expansion is the fourth-longest in post-war history, and is poised to take third place in April, 2017 when it will top the 92-month expansion that ran from 1981 to 1991. (We won’t hazard to predict the future, but it seems unlikely to us that a recession will hit in the next five months.)

However, it has been an expansion that has been characterized by weaker-than-usual economic fundamentals and greater-than-usual skepticism and suspicion from investors and analysts. The stock-market rally that has accompanied the expansion has also been much hated.

We believe that the current expansion has been decisively shaped by the financial crisis and the government’s response to it. Typically, Keynesian policy responses to recession have involved fiscal stimulus, and often deregulation (consider Reagan’s effective combination of a sharp ramp in military spending, tax cuts, and deregulation). In the current expansion, on the contrary, fiscal stimulus has been largely absent, and regulatory burdens have been increasing. Monetary policy filled the gap, preventing the collapse of the financial system and allowing a weak recovery. But the fact that monetary policy was long operating alone, with fiscal policy MIA and regulatory burdens increasing, has stretched the expansion out and made it weaker. This has been especially true for regional and smaller banks. Big banks caused many problems and they have been more tightly regulated; that’s fine. But smaller banks have been burdened with many new regulatory costs — yet they do not trade mortgage bonds and esoteric derivatives, and were not the cause of the crisis in 2008–2009.

This is where the market’s current turn comes in. We do not believe for a moment that Trump’s policies will be implemented without setbacks, compromises, and failures. But we do think that some of the big-ticket items — such as fiscal stimulus through increased infrastructure spending and tax reform — will be implemented and will do much to alter the low-growth trajectory of this expansion. It has been a long expansion, and it can get longer.

It also looks likely that the Trump administration will relieve the Fed of the growth-creation task that it took on while the Federal government was shirking its job of supporting growth. That means higher interest rates… but probably not at a punishing pace.

All of this is very bullish, supporting growth from many directions. It bodes well for cyclicals, especially for financials. They will be bolstered by:

• Tax cuts;
• Regulatory reforms — especially those that remove onerous regulatory burdens from regional banks;
• Higher interest rates leading to improved net interest margins and better profitability;
• Better real estate markets;
• Rising inflation in the context of interest rates that are rising at a contained pace, thus incentivizing borrowers.

Also, all of these policies and their effects will gradually shift the disinflationary psychology that has set in during this long and so-far weak recovery.

Investment implications: The policy response to the financial crisis and the Great Recession was unusual, with the Fed using monetary policy to try to make up for the lack of growth-positive fiscal and regulatory policy from the Federal government. After a seven-year weak expansion, the stage is being set for a major policy shift that will take pressure off the Fed and put pro-growth fiscal policy and regulatory reform in the driver’s seat. The stocks of cyclical companies have soared — especially financials, and within that sector, especially regional and investment banks. We think that even though this expansion has been long, it can get longer, and even though the rally in financials has been strong in recent weeks, it can continue, with corrections offering buying opportunities. (Note that financials have underperformed the broader market during the last eight years.) It will take months and perhaps years for the full policy implications of the “Trump turn” to be implemented. While big financials were a partial cause of the financial crisis of 2008–2009, small and medium banks were not involved in the mortgage bond mess that was a big part of the problem. Yet these smaller banks were saddled with big regulatory costs even though they were not the culprit. We remain bullish on these stocks, and remain buyers of small and medium sized financials on weakness. The immediate post-election rally will end, the new administration will hit roadblocks, and sobriety will begin to temper the exuberance. These will be the buying opportunities we’re waiting for.

The Market’s Turn: Industrials

Much of what we said above about financials holds true for another sector that has rallied strongly in the month since the election: industrials.

As of this writing, industrials as a whole have rallied 12% in the past month, accounting for just under half of the index’ year-to-date gains. As with financials, the overall gain conceals large divergences in the underlying industries.

Construction and engineering firms, construction materials, machinery, and road and rail rallied strongly — with buyers casting about to find the most down-and-out merchandise that would benefit from Mr. Trump’s vaunted infrastructure stimulus.

We believe that the turn in industrials will be real as well. However, the implementation of policies is more complex, more contentious, and will take longer. As it becomes apparent that the infrastructure push may not begin in earnest until 2018, many of the companies that have rallied strongly since November will experience pullbacks.

Among industrials, we favor steels, particularly vertically integrated companies with captive iron ore, coal, and coke supplies. Chinese producers set the global price, and they will be raising prices to compensate for the higher spot prices they will be paying for their inputs. Vertically integrated steels will benefit from steel price increases, while being able to control their input costs.

Further, among industrials, we favor mid-sized companies due to their relative lack of exposure to dollar-related earnings issues. (Mid-cap industrials have on average rallied 13.7% in the past month, compared to 10.2% for the big caps, and 9.4% for the mega caps.)

Investment implications: Mr. Trump’s victory prompted a strong rally in U.S. industrial stocks. We believe this rally is justified by the magnitude of the policy shift that the Trump administration promises to implement, and by the prospect of a growth inflection in the U.S. economy that lengthens the current expansion and finally gives cyclicals some much-delayed mojo. However, we caution that unlike some of Mr. Trump’s proposed fiscal and regulatory policy turns, the policies that boost growth and bolster U.S. industrials will take longer to implement, and their political path is less certain. There will be pauses, setbacks, and conflicts, during which market participants lose their nerve — and the ensuing corrections will be buying opportunities, as the revitalized expansion may not hit its stride until 2018. Among industrials, we favor small and mid-sized companies with less exposure to exchange rate effects; we like truckers, and we like vertically integrated steels with captive iron ore, coal, and coke.

Italy’s Referendum Is a Non-Event, For Now

The announcement came on Sunday night that Italian Prime Minister Matteo Renzi had spectacularly failed in his efforts to get the Italian people to go along with his attempt to reform the country’s political system. The Euro dipped, reversed within four hours, and closed up on Monday. On Monday, shares in one of Italy’s poster-child troubled banks, Banca Monte Dei Paschi Siena, dropped 5.8%, and then rallied back on Tuesday to a post-referendum loss of just 2%.

We believe Europe has many and deep troubles, as our readers well know. However, we want to take this opportunity to note that the fear generated in the media was excessive. This referendum may eventually turn out to have been one component of troubles that may someday drive Europe apart. That day is not today and probably not tomorrow — in our experience, apocalyptic fears are usually misplaced.

Investment implications: The Italian referendum came and went; the populists won their vote; and lo and behold, it was already priced in. The Euro did not collapse, and neither did shares of some of Italy’s most troubled banks. European authorities will kick the can again. Trouble lies ahead for Europe, but it is not coming to a head today — and likely not any time soon. Remember, newspapers sell fear: don’t buy it.

Market Summary

1. We remain bullish on the U.S. stock market. We will use dips to buy stocks, especially focusing on regional banks, investment banks, industrials that are U.S. focused and potentially other sectors that have been battered and are now extremely underpriced. Stocks move in the direction of their expected earnings trend. The earnings trend for U.S. companies is up. Earnings grow when the U.S. economy grows. The U.S. economy is currently growing at a decent rate, and is expected to continue to grow in 2017. This is bullish for U.S. stocks.

2. We have become bullish on silver, and expect it to rise in coming weeks. Technically silver has broken out of its bottoming process and should appreciate.

3. We are bullish on Japan if you hedge the currency. Several ETFs exist that allow investors to go long the Japanese stock market and hedge the yen. Technically, Japan’s market could approach its old highs at 21,000.

4. We remain bearish on U.S. bonds. U.S. interest rates will rise.

Thanks for listening; we welcome your calls and questions.

Tim Shirata
Executive Vice President
Guild Investment Management, Inc.

12400 Wilshire Blvd. Suite 1080
Los Angeles, CA 90025
Tel: (310) 826-8600 Fax: (310)826-8611
email: tshirata@guildinvestment.com
http://www.guildinvestment.com

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