On this week’s show, Karl discusses the various items concerning investors over the past few weeks. The stock market passed the first test when the House passed their tax reform bill. Now, it moves to the Senate and Republicans are hopeful it makes it to the President’s desk in 2017.
There’s also been a lot of discussion regarding a flattening yield curve. What is it and what does that tell us about the economy and future stock market returns? Karl explains.
Karl Eggerss: Hey good morning everybody. Welcome to the Eggerss Report. It’s your investing playbook. My name is Karl Eggerss. This is the Eggerss Report. We thank you for joining us. This is the podcast that we do each and every week here and we put it out on Saturday mornings and we really distribute it a lot of different ways. Of course if you are a subscriber to our website, then you get it delivered in your inbox usually around 8:00 a.m. Central Standard Time. And if you want to do that, all you got to do is go on our website and on the home page you’re going to see kind of down the middle of the page you’re going to see where some of our … it says the Eggerss Report. You click on that and it’ll take you to a subscription and you can either subscribe right on the site or you can subscribe on Apple podcasts with your iTunes. That is an easy way to do it so every time we deliver one, it pops right into your podcast.
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Well we’re going to get right into it. We had a pretty interesting week this week. We had a lot of things going on. Of course in the past couple of weeks I’ve been talking to you about somewhat of a warning of a few things that I saw that could derail the stock market. One of them was about the high yield or what’s referred to as the junk bond market. You say what does that have to do with me? Maybe I own some high yield bonds and a mutual fund but it’s not a big portion. Well high yield bonds sometimes can tell you where the stock market is going. And what we have seen is really since about mid-July when it peaked, the high yield bond index has fallen about 3%. You say, “Well what’s the big deal about that? It’s just 3%.”
In the bond market that is a big deal and the fact that it’s diverging from the stock market meaning high yield bonds are seen as a risk appetite vehicle so when high yield bonds are going up it kind of confirms that people want to take more risk and may continue to buy stocks. So when high yield bonds starts to fall, sometimes people view that as de-risking and that it’s going to lead to a falling stock market. So that’s been one thing to keep an eye on. And of course Thursday when we had the big 200 point Dow Jones advance, high yield bonds went up with it. So that was a positive.
Another thing that we’ve been thinking about is the inverted yield curve possibility. What in the world does that mean? That means when short-term rates are higher than long-term rates. You see in a normal world the higher, excuse me, the longer length of time that you lend somebody money, the more risk there is of them paying you back. And so you need to be compensated with a higher interest rate. So generally long-term rates are higher than short-term rates. That’s what’s called a normal yield curve when you go on maturity the higher the interest rate should be. And that’s typically what you see. Sometimes you will get what’s called an inverted yield curve where the short-term rates are actually higher than the long-term rates.
And again, you may be asking why does that even matter? Because when that happens, it typically signals a recession is coming at some point. And so we’re not there yet but it’s been getting what they call flatter and flatter and flatter. Meaning the short-term rates are not much different than the long-term rates. And see here’s the problem. If the Federal Reserve which is supposed to raise interest rates next month does it and then does it again four more times in 2018, and the long-term rates stay where they are today we will be inverted. In other words they would cause an inverted yield curve signaling a possible recession.
So that’s been a concern for the markets watching that going, uh, oh, if things are so great shouldn’t long-term rates be going up? And that is true. Long-term rates should be rising right now if the economy is rip roaring, right? Because people take more risk. They sell bonds, buy stock, do other things. Interest rates should be rising. That’s not happening right now so that is something to continue to watch. An interesting little fact here though from Ned Davis Research is they went back and looked at really the last six times that we had an inverted yield curve since 1972. And what’s interesting is the median return during that time for the stock market after basically during the inverted yield curve, basically not inverted. They were showing it from flattening, we’ll call it. Where basically there’s only a 1% or less difference between short-term rates than long-term rates.
And during that time the stock market has actually performed pretty well. About 6.6% during that time frame. Kind of like where we are now. And one of the best areas was energy stocks during that time. One of the worst things to own are utility stocks which we have been bearish on. That’s been an incorrect trade for us and an incorrect thesis. The thesis has been right I think as far as we believe that utility stocks are expensive by historical measures. And they continue to go up. So that doesn’t mean we want to own them just because they’re going up. In fact we want to bet against them because they’re going up. They’re getting more and more expensive. But when interest rates rise or when you get this flattening yield curve, utility stocks tend to fall. So, that is something to be aware of if continue in this period. What things do great and what things do poorly.
Another area that struggles with a flattening yield curve would be consumer discretionary stocks typically have fallen about 3 1/2% during that time. So a couple statistics there from Ned Davis that hey when we get that, there are winners and there are losers. And obviously you need to know which is which.
So, the other thing that is obviously the elephant in the room is tax reform. So of course about three weeks ago, four weeks ago, we heard about the House’s tax proposal. And I said at the time and I still believe this that it was more of a business tax cut. More of a traditional Republican trickle down tax cut. Businesses do well therefore you would do well. But it was kind of weird in the sense that it gave you more of a standard deduction but they took away the personal exceptions. The eliminated AMT tax which is good, the Alternative Minimum Tax. Took that away. There were some good things in there. Of course lowered the corporate tax rate.
And I said at the time hey when the Senate’s version comes out if it’s dramatically different, the stock market may not like that. And we saw the Senate’s proposal come out and indeed it was different. Now there were some similarities but it was different. A lot of things were different about it. And the stock market had some tough days. A lot of things were struggling including small cap stocks were struggling. Small caps peaked in October. They fell to a low on Wednesday about 4% from high to low. So they were struggling because small caps would be one of the areas that would theoretically benefit from a tax cut.
So the difference was, uh, oh, are we going to have a struggle to where nothing gets done? Well we saw the Senate’s version come out as I said. And then on Thursday of this week we saw the House pass their version. Now some folks are saying, look they’re rushing this because due to some scandals the Republicans could lose control of this majority and if that happens they need to rush something through. They need to get tax reform through while they can and they want to be able to say, “We did something. We did tax reform.”
But you know what happens when there’s sloppy legislation of any sort and things that are rushed. Go back to health care. We need to read it to see what’s in it. Basically we signed it now we need to go read it. Some of these folks, I’m listening to these interviews, some of these folks don’t know what some of the terminology even means that they’re putting in these tax bills which is scary. One of the big debates is carried interest. Basically the hedge funds get to claim their income in a lower tax bracket because it’s considered capital gains versus regular income. And there’s a big debate around that and so this is far from over. They’re hoping that they can get something done on the Senate side. Come to some agreement with the House. Get something to the president by Christmas Day to get signed.
So there is a rush going on because look, you control the whole thing here. There’s some pressure on you to get something done and they want to get it done but is it the right thing? Look there’s one, I don’t have the gentleman’s name in front of me, but one Congressman that says, “Look this isn’t enough.” And I believe he’s a Senator and he said, “This is not a bill. I’m all for tax cuts but I’m not for this particular one because it does not do enough for the small business owner which is generally a pass-through entity.” An S corporation for example.
And he’s right. He’s absolutely right that right now if you’re a small business owner and you have a pass-through entity, all that business income that you have just flows right on to your tax return and you’re in the same tax bracket you would be on your personal side. He’s saying, “Look, for big corporations like Walmart and IBM and all these companies to be able to have their taxes lowered but yet the small business owner and a pass-through entity does not really, that’s not going to fly.” And he’s exactly correct. We need bigger tax reform on that side because the small businesses are the drivers of this economy.
And so that’s going to be a debate so let’s see over the next few weeks if that can get resolved. But time is running out and of course you throw in the Obamacare repeal on top of that. There’s a lot of things going on here. But the day that the House did vote to approve their version, the stock market went up 200 points that day. It’s kind of risk on Thursday and party on Wayne. Do you remember the Wayne’s World back in the ’80s, right?
So business as usual. Market heads back up. So let’s see over the next few weeks what happens. Of course we got the Federal Reserve looking to raise rates. We’ve gotten a new fed appointee head of the fed. We have this tax reform towards year end. We’ve got tax loss harvesting going on so a lot of things happening right now that are potentially market movers but yet we will are in a pretty benign stock market. I mean look, people are talking about the market selling off. The S&P fell 1% over a few days. Now there are some stocks and this is something to clarify. There’s a lot of stocks, individual stocks, that are down 20, 30, 40%. That’s happening and so what we need to watch is does the stock market continue, because it started, continue to deteriorate underneath the surface.
For those of you, I mentioned at the beginning of the show, some of you have been listening for 10 years or longer to my podcast, radio shows in some form or fashion. You recall way back when in ’07 and of course I did not know that a financial crisis was coming, but we could see that the underpinnings of the market were getting weaker at the time. Not only economically, but the stock market itself was losing some leadership. There was deterioration underneath the surface so the Dow Jones was making new highs every day but yet underneath the surface most stocks were not going up. In fact they were going down.
That’s started to happen just a little bit. If that continues and get worse and worse and worse, and the selling pressure builds up and there’s just not enough demand to move us to another level, look out below for a significant correction. Now it doesn’t mean run out and sell everything today, but those are things that we need to continue to monitor and we have seen in the last month or so I would say it’s more of a pause and the sellers seem to be winning out a little bit. Again, looking at statistics because look I think if you bought stocks based on the economy getting better, based on all that. We had the hurricanes. Now, many people are sitting back saying I own enough stocks. I’ll wait to see if I get any good news. Tax reform. Better earnings than I thought. Whatever it might be. What’s the next catalyst? So we could be in this lull for a while and of course as we enter the end of the year, will there be people selling stocks they had gains on in January? Because now they can recognize that gain without having to worry about taxes for a whole year if they wait until January.
So those are things on investor’s minds right now. But you do have some things still moving up in this market. Of course one of those things is Bitcoin which had a pretty good week continuing to bounce around after a 30% drop. Kind of a big drop there. You had the retail stocks perking up especially on Friday. Of course the big move from Walmart that kind of blew it out of the water on their earnings and so forth. Full disclosure, we own Walmart in our dividend plus portfolio and have for a while. And we felt like they are one of the few companies competing with Amazon and they’re showing that. Doing very well in that category.
Banks did well this week. Home builders did well. Had some good housing numbers on Friday. So those were some of the big movers on the week. Telecom kind of bounced back after a rough go of it with all the stuff going on with AT&T. And we own AT&T by the way in our dividend plus portfolio as well. Another disclosure.
On the down side, energy stocks which had a real … having a tough time but I think take a look at some of the energy stocks, the energy ETFs, energy funds. They were in a really nice down trend starting in about late December last year. About a year ago and they’ve been in that down trend all the way until mid-August. They now seem to be in an uptrend. Volatile but in an uptrend. So watch the energy stocks. We’re starting to see some good things technically speaking, money flowing into the energy area.
You also did have really a tough time for steel stocks. Like I mentioned energy stocks. Biotech had a rough week. And oil was down just a hair on the week. So of course the major industries pretty much flat given that they had such a week Monday, Tuesday and came back Thursday with a good day coming back after the House passed their version of the tax bill.
So I want to shift gears for a minute. There’s usually, and I don’t know if you’ve noticed this, but when there’s a new ETF that gets introduced onto the market exchange traded fund, it reminds me of the late ’90s with mutual funds. Dependent on the flavor of the month. Depending on the mood of investors and the appetite and whatever it might be, big mutual fund companies would introduce all types of funds with fancy names that were meant to attract assets based on what people were wanting. If somebody could invent right now a mutual fund that was in Bitcoin, they would do it because they know people would buy it. And we’re starting to see that by the way with the Chicago Mercantile Exchange who’s going to do Bitcoin futures which is going to open the door for funds, ETFs, things to track that.
There’s going to be more ways to invest in Bitcoin. You’re already seeing them capture that. But in the ’90s we saw that type of internet mutual funds and all these mutual funds, B2B was a hot buzz word in the … that stood for business to business. That was kind of an internet type thing and so there’s mutual funds that followed that and invested in that. And it was all meant to attract assets. And it’s really no different nowadays you know where you get an exchange-traded fund that has a really cool title but when you dig down how it’s calculated, how it’s done and you look at how it’s structured it really isn’t much different than maybe the overall market. And so you’re like, what am I really getting in terms of those names?
And we’ve seen that a lot and unfortunately some of those just go out of business. They don’t track enough assets. It’s very expensive to start an ETF. But I saw one in the last couple of weeks that was introduced and it caught my attention. You know I’ve been a big opponent, not proponent, opponent of market-cap weighted funds ETFs. I do own some but market-cap weighted is essentially saying the things that have already run up, have a big market cap. The stocks. And funds, the S&P 500, the Dow Jones, they invest based on the price or the market cap of a stock. So the higher it is, more of your money goes into that. So you are buying high. You are buying high.
So there have been over the years smart beta ETFs. There’s been equal weight ETFs. I like those. They’ve underperformed a little bit the last couple of years. They’re still going up but not as much as a cap-weighted index. But I like those a lot. Unfortunately, you’ve seen those but now what came out that I think is really interesting is there is a reverse cap-weighted ETF. The first of its kind. I don’t own it but I think it’s very interesting to look at. Reverse cap-weighted. What does that mean?
So take the S&P 500 and I don’t know exactly where it stands today but let’s say Apple is the biggest stock in there. Heaviest weighing because it’s the biggest capitalization. This particular ETF instead of owning the majority of the fund in that, it would own the least percentage of Apple. So the 500th smallest company would be the biggest weight in this ETF and Apple would be the smallest weight. Pretty interesting huh? Now they’ve gone back, they’ve only gone back to ’07 which I hate back testing that only goes back so far. But they go back to ’07 and they show that reverse weighting it would actually have produced a much better return than the S&P equal weight and better than the S&P 500. So that’s their pitch. I think this one has merit and I think it has merit right now in particular because of where the stock market is.
Again, majority of the stock market’s gains in 2017 have come from a handful of stocks. So you’ve got some good deals out there. People believe the stock market iv overpriced because they continue to look at the market, the cap-weighted market and say well the S&P 500 has a PE ratio of X. But again if you dissect it and break it up into segments, there are plenty of good deals and companies out there that are very cheap. We believe the airlines are cheap right now as a group. There are plenty of stocks. I’m not going to mention some that we own because I’d have to … where do I stop, right?
But we own some companies that we think are just dirt cheap. I mean they are dirt cheap. They’ve already fallen 30, 40, 50% so we’re going hey let’s buy these because at some point when the market starts to sell off, you could see the overpriced ones fall much harder and the ones that are undervalued take off and hold up much better. So essentially you’re still getting the 500 biggest companies in the world but how you own them is opposite of what a traditional ETF would do. So I think that’s an interesting one and it just came out a couple of weeks ago. Again, I’m not suggesting to run out and buy it by any means, but I do think it’s something to … and I think that is the … it’s Guggenheim is who does it and I believe it is called the Guggenheim Reverse Cap Weighted ETF. You have to be a little careful. Some of these are new. They don’t have a lot of assets in them.
But I think this particular one caught my attention out of all the new ETFs that I see every day practically come out. This one makes a lot of sense to me. So, take a look at it and again this wouldn’t be exclusive. This could be something that might balance out how much market cap-weighted things you own in your portfolio. So it’s really important to know what you own and why and then build your portfolio around those things. And you’re putting together essentially a puzzle when you put together a portfolio if you’re doing it correctly.
And to be honest, market cap-weighted only indices and bond market, a plain Jane bond market index have done very well the last four or five years. But what do they do over the next 5, 10, 15, 20 years? Because that’s your time horizon. It’s not a three-year period, a five-year period. So you have to come up with a cohesive investing plan that makes sense and looks back at history on what’s normal, right? We talk about international stocks typically do very well relative to U.S. stocks. They haven’t the last five years so it’s an opportunity. So take a look at those types of things when you’re building a portfolio.
Hey, just a reminder. We try to do, we missed it this week, but we try to do a technical Tuesday on YouTube. So I have YouTube channel. It’s Karl Eggerss. You can follow me on there and anytime that one’s posted you get some type of alert usually on email I believe from YouTube. And they’re real short. They’re like five minutes and I go through two or three things I’m watching from a technical perspective. So check out my YouTube channel.
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I appreciate you guys. Thank you very much and hey, have a great Thanksgiving. We’ll probably be posting some stuff next week but it’ll be a little light obviously. We will have our show next Saturday but have a Happy Thanksgiving and we appreciate another year with you guys and as we wind down 2017. So take care everybody. Have a great week and weekend.
Speaker 2: This show is for entertainment only. Any information provided by the host, guest and this station should not be deemed as advice. Your investment decisions should be based on your own specific needs. You should do your own research before you make those decisions. As president and CEO of Eggers Capital Management, Karl Eggers may hold securities mentioned in the show for himself and his clients. Just don’t buy or sell anything based on what you get from radio or TV. Use your own judgment or get yourself a trusted advisor.