1. Market summary: interest rates remain the big story for your portfolio. The biggest-picture story for your portfolio remains the end of the decades-long bond rally and the arrival of a multi-year uptrend in interest rates. This leads to two conclusions: first, that bonds will prove to be uncompetitive with stocks; and second, that income stocks will be uncompetitive with stocks that can grow and raise their dividends. Investors who must own bonds should own very short maturities. Interest rates will rise, but we expect the Fed to continue to keep them close to the rate of core inflation. Therefore, we do not see a rate-driven monetary tightening and recession as an imminent risk, and we continue to favor stocks. We like technology growth stocks which have high earnings visibility into the future; some regional bank stocks which have come down in price in the last few days; financial services companies in the credit card and insurance areas; major banks; and materials stocks that will be benefitted by the administration’s desire to create better trade deals for the U.S. and to discourage dumping by foreign producers. We like Germany, and would not hedge the currency. Oil is likely to remain under pressure from U.S. production and from OPEC cheaters. Gold can be bought on dips and has some drivers for gradual appreciation; but absent higher inflation or geopolitical turmoil, we don’t believe gold will move up rapidly.
2. Who will win the AI race? Alphabet, Inc’s DeepMind subsidiary showcased its revolutionary artificial intelligence technologies last year, when its AlphaGo program confounded the experts and defeated the world’s best players of go. Now it is making deals to leverage massive public data sets — in energy and health care — and use its machine learning to deliver improved outcomes and potentially big cost savings to the public. Some critics say DeepMind’s use of these big data sets has not been transparent enough, or satisfied data privacy laws. We think that the potential benefits of AI are so great that its adoption will go forward inexorably, albeit with some public and regulatory concern and pressure. The competition to develop AI and deploy it will be intense. The companies that succeed will be not just those with the best technology and the top talent; they will also be the ones who can maintain the go odwill of the public and of regulators while gaining access to the huge public data sets that will allow their technology to demonstrate its true potential. Although many upstart tech companies have a reputation for arrogance, it may be the companies who can best adapt to being in the public eye who will ultimately be the most successful.
3. Where’s the bubble? An ongoing revival of earnings growth in the United States, and an inflection in economic growth around the world, tell us that U.S. stocks as a whole are not overvalued — although any correction is bound to revive valuation fears. On the other hand, real yields remain extraordinarily low by the historical norms that once kept them more closely linked to inflation and GDP growth expectations. We reiterate that stock market corrections of 4–7% are are positive, as they reset the market for another move higher. They are also normal and common. We believe that with economic and business fundamentals improving, corrections present buying opportunities for stocks, especially in sectors and industries with particularly favorable outlooks. However, with real rates so far from historical norms — and growing signs that an acceleration back towards those norms is on the horizon — we continue to fin d bonds unattractive, if not dangerous.
What the Fed Means For Your Portfolio
World markets are facing a major change, as interest rates have begun a multi-year uptrend.
U.S. and foreign economic data continues to improve. On many fronts, including employment, capital spending, salary increases, backlogs of orders, housing demand, retail sales of home-related items, and many others, the economic outlook for the U.S., Asia, Europe, and the world continues to improve.
U.S. and foreign interest rates are in a rising trend, and will continue to rise for several more years as higher economic growth, higher employment, and higher incomes continue to support business and consumer confidence in a virtuous cycle.
As a result of rising interest rates since mid-2016, the multi-decade bond market rally has come to an end. Therefore, two new trends are in place: first, bonds will prove to be uncompetitive with stocks; and second, income stocks will be uncompetitive with stocks that can grow and raise their dividends. Investors who must own bonds should own very short maturities.
We warn our readers to be vigilant, to avoid bonds with over 3–5 year maturities, and to avoid bond proxies for income accounts. A bond with a maturity of 10 years or more can cause a substantial loss of capital as interest rates continue to rise. In our view, it is wiser to own growth stocks that can raise dividends, until such time as bond yields reach peak and start to decline. Assuming a period of normal economic growth, such a peak in bond yields may be several years away.
Stocks: a Buying Opportunity is Near
World markets, especially the U.S., are finally experiencing a correction after the market rally that began in November, 2016. As we have seen on numerous occasions over the last few years, such corrections are buying opportunities. Historical trends argue strongly for a correction in US stocks prices of 4–7% and they also argue strongly for a rise in stock prices for the remainder of 2017.
In spite of rising interest rates, core inflation will remain low; inflation will rise, and interest rates will rise more. Today CPI core inflation is running at about 2.2%, and 10-year bonds only pay 2.44%; 10-year bonds should normally yield at least 2% more than inflation. So interest rates must continue to rise. If inflation goes to 3%, interest rates could double from here. The Federal Reserve uses core inflation to determine their interest rate policy; for this reason, we expect interest rates to rise, but to stay very close to the rate of inflation. History has repeatedly shown that as long as interest rates are not at least 2% above the core inflation rate, it will not lead to monetary tightness and a recession. So we expect no recession soon.
Outside a recession, a normal 4–7% correction should be enough to spur demand for stocks, and send stock prices up. Currently, stocks have fallen by about 2.5%, so we are nearing the time when they can be bought. Further, stocks in some industries have fallen much more than the market, so they can create good buying opportunities.
We continue to favor the following:
1. Technology growth stocks which have high earnings visibility into the future;
2. Regional bank stocks. Some regional bank stocks have come down in price in the last few days, and can make a very good buys in our opinion;
3. Financial services companies in the credit card and insurance areas;
4. Major banks; and
5. Materials stocks that will be benefitted by the administration’s desire to create better trade deals for the US and to discourage dumping of goods in the US.
Non US Markets
We like Germany. No need to hedge the currency.
Oil continues under pressure due to higher U.S. production and cheating by OPEC producers on quotas. Unless Saudi Arabia cuts production more, they will not get oil up to their hoped-for $70/barrel. We are cautious on oil, and are waiting for action by the Saudis. Strong and growing U.S. production is not bullish for oil prices long-term.
Gold continues to make gradual progress; hold and wait for dips to buy. U.S. inflation is at 2.2% core and 2.7% actual. With oil price falling, inflation will moderate. Gold has some drivers for gradual appreciation. Global political problems or much more rapid inflation will be required for gold to move up rapidly.
Thanks for listening; we welcome your calls and questions.
Google’s Artificial Intelligence Making Waves
At the beginning of the year, we wrote about Alphabet’s [NASDAQ: GOOG] acquisition of a British artificial intelligence (AI) startup called DeepMind. DeepMind made headlines last year when its AlphaGo program defeated the champion go player Lee Sedol of South Korea, then the second-ranked go player in the world. It has since defeated the world’s top player, although only in informal online play.
AlphaGo showcases DeepMind’s transformative approach to AI: machine learning that emulates human learning. Traditional approaches to computer chess, for example, rely on brute force — working out all the permutations of possible future moves to identify the most promising next move to make. That approach is limited because the number of permutations gets so large as the program looks more and more moves ahead. It’s even more limited with the game of go, because there are so many more possible moves than there are in chess. The “decision tree” quickly gets far too large to exhaustively examine and evaluate. That’s why until last year, most experts thought it would be decades before a computer program could compete with world-class go masters. They were waiting for new hardware that could crunch the numbers faster. But DeepMind delivered with revolutionary software instead.
A New Model For Deep Learning
How did AlphaGo do it? By emulating human learning. DeepMind’s “machine learning” emulates the process of human learning — learning by experience, rather than trying to have everything “baked in” from the beginning. It also emulates the neurological structure of human learning, constructing artificial “neural nets” that are formed and persist in the same way as analogous structures in the human brain.
That neurological modelling means that one key weakness of AI is being overcome — the risk of what has been called “catastrophic forgetfulness.” In less dramatic language, this just means that when an AI machine begins a new task, it starts from scratch instead of leveraging previously acquired knowledge of different but related tasks, as humans do. By making “neural nets” more persistent, DeepMind is letting its programs that have gotten good at one video game, for example, carry some of that knowledge over when they begin trying to play a similar game. So far, the programs that are “single minded” are still better, but the programs applying neural nets acquire broader expertise much faster.
Now DeepMind is beginning to apply the same technology to other problems besides gaming. The company has entered into talks with the UK’s National Grid [NYSE: NGG], the company responsible for electricity transmission in the UK and a descendant of the Thatcher-era breakup of the country’s state electricity company. NGG’s job has gotten more challenging as intermittent and unpredictable renewables have risen in the mix of generation technologies. DeepMind’s CEO commented last week that the application of AI could cut the country’s electricity usage by 10% with no new infrastructure — just by optimization and demand balancing.
Managing Public and Regulatory Sentiment
Another — and more controversial — partnership started last year, between DeepMind and the UK’s National Health Service (NHS). DeepMind and the NHS initially portrayed their collaboration as a limited and focused effort to deliver actionable clinical data on kidney disease to doctors using a new smartphone app. However, it turned out that the data provided to DeepMind was much more extensive than initially disclosed. Watchdog groups complained that medical data privacy was being compromised, and DeepMind’s subsequent smaller collaborations have been more constrained and transparent.
Medical applications will be one of the most significant areas for AI deployment, and the potential benefits are very great. Doctors will use AI analysis to make better, earlier diagnoses and to choose more appropriate care for patients, with great potential savings in public health expenditures. Huge data sets will have to be leveraged to get these benefits. There will be public discussion along the way — some of it potentially disruptive, particularly when the private firms involved loom as large in public and regulatory consciousness as GOOG.
However, the power of AI to augment human decision-making power and lead to better and more efficient outcomes will inexorably drive the adoption of AI technologies, even if the process is accompanied by occasional outcry and controversy. Competition will be fierce. Differentiation among the competitors will come not just from technology, and not just from the acquisition of top talent. It will come from the ability to negotiate access to large public data sets — and the ability to maintain public and regulatory goodwill in the process.
Investment implications: Alphabet, Inc’s DeepMind subsidiary showcased its revolutionary artificial intelligence technologies last year, when its AlphaGo program confounded the experts and defeated the world’s best players of go. Now it is making deals to leverage massive public data sets — in energy and health care — and use its machine learning to deliver improved outcomes and potentially big cost savings to the public. Some critics say DeepMind’s use of these big data sets has not been transparent enough, or satisfied data privacy laws. We think that the potential benefits of AI are so great that its adoption will go forward inexorably, sometimes with public and regulatory concern and pressure. The competition to develop AI and deploy it will be intense. The companies that succeed will be not just those with the best technology and the top talent; they will also be the ones who can maintain the goodwill of the public and of regulators while gaining access to the huge public data sets that will allow their technology to demonstrate its true potential. Although many upstart tech companies have a reputation for arrogance, it may be the companies who can best adapt to being in the public eye who will ultimately be the most successful.
Where’s the Bubble? It’s Not In Stocks
Often, when a market correction is underway, analysts and market participants start coming up with what we can only describe as ad hoc explanations of market behavior.
As we write, with a correction apparent in the broader U.S. stock market and especially in some sectors that have performed well this year, some market participants looking for an explanation of the correction are pointing to the rise of the yield on 10-year Treasuries above a key level — a level that may be watched by many algorithmic trading systems. More impressionistic comments focus on political factors, fatigue with the combativeness of the new administration, and so forth.
We don’t know exactly why the correction is unfolding now, but as we have said time and again, corrections of 4–7% are positive, as they reset the market for another move higher. They are also normal and common. From a technical perspective, the market, and particularly the sectors that have rallied most strongly since November, has looked ready for such a correction for some time.
Buy the Dip
Since our attitude towards the U.S. stock market remains positive on a fundamental basis, we continue to regard corrections as buying opportunities, and the present correction as it unfolds will not be different. S&P 500 earnings have resumed growth after treading water for six quarters, and globally, economic growth turned stronger beginning last year. As we have observed before, these trends were in place before last year’s Presidential election in the U.S. Political developments brought some positive possibilities into view that helped revive market enthusiasm — but the fundamental drivers were not political.
The correction is sure to revive talk about the market’s valuation, with some commenting on elevated valuation multiples. Valuations are at the high end of their historical norms; however, we see opportunities for valuation multiples to expand in various sectors as earnings grow and the global economy continues its growth inflection.
Where Is the Bubble?
If there is a bubble lurking anywhere in financial markets, it’s in rates.
As of this writing, the 10-year U.S. Treasury yields 2.4%. The last inflation data from the Bureau of Labor Statistics showed inflation at 2.2% in February. This implies a real rate of just 0.2%, or 20 basis points. This places real rates far outside the historical norm that typically keeps them in closer relation to inflation and GDP growth. Of course, the divergence has been created by the extended monetary easing policies conducted by the Federal Reserve.
Part of the reason that the Fed kept rates so low for so long, rather than starting the normalization process earlier in the recovery, was the suspicion held by some Fed decision-makers that low productivity growth was contributing to a “new normal” of more sluggish economic growth, and that this low productivity growth was being caused by intractable social, technological, and economic developments. (While we never accepted the “secular stagnation” hypothesis, we did point out last year how productivity growth is hampered by excessive regulatory burdens and the discouragement of new business formation.)
There are reasons to believe that the long-run average productivity growth conceals periods of faster growth alternating with periods of slower growth… and that a pickup in productivity growth may lie ahead.
Taken together, the larger picture of economic, productivity, earnings, and wage growth suggest that as the year unfolds, the Fed will continue to communicate a message of rising rates… and bond markets will continue to become less sanguine, and will price in an accelerating pace of rises. This suggests that the investors who should be most concerned about valuations are not stock holders… but bond holders.
Investment implications: An ongoing revival of earnings growth in the United States, and an inflection in economic growth around the world, tell us that stocks as a whole are not overvalued — although any correction is bound to revive valuation fears. On the other hand, real yields remain extraordinarily low by the historical norms that once kept them more closely linked to inflation and GDP growth expectations. We reiterate that stock market corrections of 4–7% are normal, natural, and healthy, particularly after a rally like the one that the U.S. stock market has enjoyed since November. We believe that with economic and business fundamentals improving, corrections present buying opportunities for stocks, especially in sectors and industries with particularly favorable outlooks. However, with real rates so far from historical norms — and growing signs that an acceleration back towards those norms is on the horizon — we continue to find bonds unattractive, if not dangerous.
Thanks for listening. We welcome your calls and questions.
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