12-19-2018 

A wonderful San Diego afternoon to all. Before I begin, I want to take a moment to express my gratitude for all of the tremendous business leaders and families that our firm represents. This is the season to recognize blessings, and certainly you are all blessings to us at CMG. This will be my last communication en masse for the year. Because of all of the topics, I will be breaking the message into two emails. None of the following is investment advice.

 
Each day that passes is another day that leaves investors on the precipice, on tenterhooks, and today was no different. Personally, I feel it is nearly impossible to predict anything in the short term under less volatile circumstances. The last 4 months have obliterated all those people who play for the short term, with record amounts of hedge funds closing their shops due to negative yearly returns. Surprisingly, even Renaissance and AQR have had net outflows; something I never thought I would see happen (this video explains). The reasons are described below, including oil exchanges, health care scares, the Federal Reserve, Interest rate spreads, Trade tariffs, POTUS legal issues, and Bellwether stocks getting crushed in equity and debt offerings. 
 
Lots to discuss, but first let’s take a trip from Kansas to the Land of Oz. Ever since its creation under the Federal Reserve Act 105 years ago, the Fed has been tasked with the goals of full employment and controlled inflation. In the task, it was granted powers of bond purchases and interest rate manipulation (among others). Because of quantitative easing, the federal reserve put about $4 Trillion into the economy through bond purchases from 2008 until 2015. These purchases are meant to increase bond prices, lower the prime rates of banks and encourage businesses and consumers to borrow money at new lower rates. 
 
As of January 2018, the Fed has meaningfully let its bond holdings drop by not reinvesting proceeds from bonds that have matured. Sparing you the minute details, not reinvesting proceeds should have the affect of stabilizing rates and curbing inflation. The process is like slowing your car down when you reach a desired speed (AKA ‘neutral rate’). If only it were as easy…
 
This all sounds easy and good when the Wizard Jerry Powell talks us through it, but what’s happening behind the screen? The bonds that remain on the Fed balance sheet (classified as assets) have accumulated losses. As of last week, the Fed’s equity was negative $26 billion ($66 B Losses and $40 B capital Paid in) – note that the Fed does not mark to market due to GAAP standards for Held-to-maturity securities. This month marks one of the only times that the Fed has had negative equity, and is mostly discussed in theory rather than practice. 
 
The issue? Street Credibility. Ability to perform further quantitative easing. Decrease in Fed independence. To illustrate further, the leverage ratio of the Fed (without marking to market) is 0.99 to 1. The S&P 500 as an index has 0.86 to 1 leverage ratio. 
 
Many professionals are questioning the viability of the organization to guide the economy. Some say that the Fed’s negative equity, including all districts, will need to bolster its balance sheet to remain an unbiased arbiter. In theory, how can an organization with negative equity that is leading private borrowing rates decide issues without bias? Others say that the equity balances on the balance sheet should be 100% retained by the Fed, instead of being applicable to other government programs. Both of these camps accuse the Fed of being dependent on and to the US government. 
 
Could it be that the Wizard is no greater than any of us in its decision making? Now I’m thinking that there should be a fin-tech startup in the Fed position rather than a 105 year dinosaur with potential bias.. The mind capitulates.
 
In any event, the actions of the Fed are currently seen as more important then ever. The preponderance of bureaucratic decisions among corporate growth is leaving investors in fits, indicative of where we are in the business cycle. If rates drop via recession, the Fed’s equity is in great shape. 
 
Today, the Fed raised current short term rates and signaled two rate hikes in 2019. Powell says that while inflation is restrained, expected growth in 2019 will warrant additional rate increases. The market responded negatively, with both stocks and bond interest rates settling significantly lower. Obviously, investors are in disbelief that the economy can sustain higher interest rates and that these rates are likely to cause a slowdown leading to a crash. Why would investors think that? Well, I’m glad you asked.
 
In August, I wrote you about the treasury yield curve. In late July, the 2/10 spreads were:
  • About 0.85% (absolute figures) in July 2016
  • About 0.45% in July 2018
  • As of today, the spread is about 0.1%
Conclusion: Long term bonds are being bought while short term securities are being sold. The question on investor’s lips persistently is, “Where’s the inflation?”
 
Year To Date (ex-dividends), there are many stocks that are considered leading indicators of the economy’s future success. Believe me, it gives me no more joy typing these results as you get reading them. 
  • Discretionary
    • GM (-17%)
    • Apple (-4%)
    • Home Depot (-10%)
  • Staples
    • FedEx (-28%)
    • WalMart (-8%)
    • ATT (-22%)
  • Financials
    • Bank of America (-19%)
    • BlackRock (-25%)
    • Citigroup (-30%)
  • Utilities*
    • NextEra Energy (+13%)
    • Duke Energy (+4%)
    • Dominion Energy (-8%)
  • Real Estate*
    • Simon (0%)
    • Prologis (-4%)
    • Crown Castle (1%)
  • Other notables
    • Amazon (+30%)
    • Facebook (-28%)
    • Berkshire Hathaway (-1%)
    • Visa (+15%)
Thus, investors are incredulous at expectations of growth that outpaces increased carrying costs of corporate assets. *Utilities and real estate are often proxies for bonds.
 
12-26-2018
 
The Federal Reserve has no room for error, and the yield curve has consistently tightened over the last 2 years at an increasing pace. Just after my email went out, NY Fed Chair John Williams walked back the entire two day meeting ominously, saying that the Fed will base decisions both on data and the opinions of “business leaders”. Clearly this is a wide deviation from the “data dependent decisions” of yore, signaling that the Fed is also having trouble adapting to the current markets. Or maybe POTUS is having an influence on decision making? In any event, I can’t see the ambiguity as a positive for the Fed or the global economy, though gold is up on the developments.
 
For the first time, US is the world’s leading oil producer as a country (11.7 Million barrells per day). While this is a good offense for the US, it will cause global pain in the short term. How did the US overcome Iran and Russia? Ryan Zinke (Secretary of the Interior) and POTUS. In this video Zinke explains that we have a 35% increase over the last 2 years (8.7 to 11.7 Mbpd), leading to a projected 61% increase over Trump’s first four years. Considering oil production was mostly unchanged from 1988 figures to today, this represents a huge jump. Zinke resigned earlier this month after multiple probes on misappropriation of funds, but it’s worth noting that he may have changed the oil industry for years to come. 
 
His legacy is the largest rollback of federal land protection in US history, including opening virtually all coastal waters to offshore oil and gas drilling to increase lease sales (including Arctic area), rolling back constraints on methane gas emissions from public lands and state-run parks, largely dismissing violations of coal companies, and forming new infrastructure in conservation areas. On the good side of all of these things, you have America becoming more independent and generating more revenue from national parks, especially considering a jump in entrance fees at most parks. On the not so good side, can we or do we want to maintain independence as a global fossil fuel leader? Will public lands be better maintained by private investors purchasing leases? Even more importantly, what will become of the billions of gallons of wastewater from Fracking in the USA?
 
These questions cannot be answered without looking at research studies on both the economic and environmental effects. One thing is for sure, oil around the world is cheaper after Zinke, which undermines the standard of living for most of the world. No bargains in sight.
 
Almost daily, new articles forecast a global recession happening earlier than expected. In light of impotent Zero Interest Rate Policy & helicopter money, economic data, and growing Trade Tariffs, there is mounting evidence in favor of a slowdown. While the US is mostly playing defense by building walls and enacting tariffs, China is on the offensive, ‘partnering’ with every other continent. Since misanthropic ‘recession talks’ are speculative, I will be brief here. 
 
The much-heralded “Belt and Road” Initiative is producing incredible inroads, as evidenced by this WSJ article alleging China’s strong international positions. The theme of the initiative – China works harder and cheaper in China, why not do the same thing outside of China? By developing infrastructure outside of China in developing countries, China is getting access to the countries and taking the position as lienholder. In fifth grade, Mrs. Todd taught us Manifest Destiny; this is all elementary strategy. Seems Premier Xi has been playing a lot of Catan and maybe some Risk…
 
If I were a betting man, I’d say the tariff wars (US and China, US and Europe) will not be resolved in Q1 2019. I have no more chance speaking to how we got into this war to how we will get out of it. My Christmas wish: Trump and Xi call off the war and compete in golf instead of having economies compete.
 
Japan, Germany, and much of the EU have seen inflation projections decimated with each new quarter. When economies around the world buy bonds and take interest rates to negative (ZIRP) to help stimulate economic growth, and the result is still nothing, is there anywhere to go but austerity? Stimulative measures can’t continue forever, either, as I alluded to in part one, and without providing for easy business, will we see a significant change in debt prices? I believe so. Apple’s growing cell phone inventory is also an enormous threat to Global Supply Chains and possibly consumer confidence. Q4 Earnings season starts next week, providing concrete figures. No bargains in sight.
 
My colleagues at Stradling Law group have seen more Leveraged buy-outs the last two years then any other time in the previous two decades, and they tell me performance after the acquisitions has been lackluster. Oh, and even if banks are out of subprime lending, that doesn’t mean fintech is too. Case in point – Elevate Financial (ELVT). With a market cap at less than 6 times forward P/E and about 1/5 of total revenue (of $800 Million), it has been beat up lately. Arguably a bargain, the company made an entire business out of subprime lending. The 34% drop in two months points to lack of investor confidence. Capital One is another huge player in the subprime space similarly left for dead.
 
A couple of weeks ago, the Affordable Care Act (“Obamacare”) was deemed unconstitutional, leaving healthstocks down 12% since the ruling. Why? Possibly Uncertainty. Uncertainty in new regulations, pricing, costs, political opportunism, and of course subsidy challenges. However, the real reason must be investor trepidation for all industry segments. Consider that United Health as risen about 23% each year over the past 5 years. 
 
Unconstitutional: Under the 2017 Tax Reform, the ACA tax penalty levied against those that don’t buy health care was nullified. Point is, young people were either buying insurance plans or paying a tax penalty – in either case, the money was supposed to subsidize the premiums of elderly and those with pre-existing conditions.
 
Effects: Uninsured rates will rise likely, making for much less Gross billables and NPR. Potentially, more folks will not get covered at all (the antithesis of ACA’s goal), and those that do buy coverage will have to pony up more to fill in the void that the uninsured create. 
 
Background: Throughout my career in finance, I have seen health care as important and as exciting an industry as telecommunications, but different. While telecom has been commoditized as a product driven industry, health care as a service industry has enjoyed great margins due to needed expert knowledge. Consumers can buy telephones, telephone parts and know-how from manufacturers and engineers globally. Health care is a hands-on service where any patient will need to be close to a health care provider (within 8 miles on average) and have trust in the provider’s judgments. Importantly, those who visit providers most have the most issues and are elderly, a population that will always require both convenience and trust. This won’t change, ACA or no ACA. Let’s look at numbers.
  • Gross Billing for all patients 
  • (minus) Bad Debt and Charge-offs
  • (minus) Free care
  • (equals) Net Patient Revenue (“NPR”)
  • (minus) SG&A expenses
  • (minus) product and maintenance expense costs
  • (equals) EBITDA or Operating Profit

Over 20 years, Gross billing has increased 400% while net patient revenue has increased 100%, leading to a huge amount of lost revenue but an NPR CAGR of 3.7%. After accounting for interest costs, taxes, depreciation, the net margin has been between 5 and 8% for decades. Also, Private insurance coverage was roughly the same under ACA as in previous decades (just under 40%, excluding medicare and medicaid). All of these details (multiple recessions enduring) point to a bargain opportunity emerging (all else equal), but again, the downward pressure since the ruling is likely due to investor trepidation. Interesting to note that the IoMT movement is just beginning.

 
Other Notables in the news: 
Trump legal issues and the current partial government shutdown. By now, I’m sure everyone knows everything about POTUS. I cannot comment on either of these due more to uncertainty versus a cop out. I am no more able to discuss how we got here than how we will get out. What I will say is that these issues cannot be good for markets, save gold. Unpredictable. No bargains in sight. As a side note, since Congress will backpay virtually all employees losing wages during the shutdown, is there really any point to it other than creating divisions?
 
Marching orders: keep an eye on earnings next week and carefully review health care stocks for bargains.

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