July 24, 2016 Observations

Risk/Reward Vol. 315

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

Another week and more record highs on both the major stock indices. This, despite another quarter of fewer earnings--albeit better than expected. Of the money I manage personally, I am 30% invested. I am contemplating taking profits and heading to the sideline.

Here are some observations:

1) The S&P 500 (SPY) is trading at 21 times trailing 12 months earnings. This is above the long term average of 16 times earnings, but no where near the multiples that pervaded the NASDAQ back in the dot com days. Is it a bubble? Maybe. But I am less concerned by the S&P multiple than I am by the S&P's possible interplay with that which is clearly a bubble: the world's bond market. If and when rates start to rise there will be a stampede to sell the trillions of dollars worth of bonds that are currently yielding at or below 0%. As the once and current bond kings, Bill Gross and Jeff Gundlach, have warned, in the wake of Obama's Dodd-Frank legislation, money center banks, once the dominant player in providing bond liquidity, can no longer make a market in bonds. No institutions have taken their place. In short there is insufficient liquidity in the bond market. If and when the stampede starts there will be few if any buyers, and the value of bonds will plummet. To meet obligations, investors may need to sell other assets at bargain prices including stocks. We could see 2008-2009 again. And you wonder why the Federal Reserve refuses to raise rates even as unemployment falls below 5%?

2) The domestic oil rig count rose for the fourth consecutive week and now numbers 371. This is a far cry from the 1600 that operated domestically in 2014, but the increase did contribute to the price of oil falling to $45/bbl. For students of Joseph Schumpeter, the collapse in the price of oil presents a classic case of "creative destruction." Until recently, domestic producers could not profit from oil prices below $60/bbl. Innovation forced upon producers by declining prices has resulted in some being able now to operate profitably at $40/bbl. This is the beauty of capitalism.

3) Two of the largest public pension funds, CALPERS and CALSTERS, announced their June, 2016 fiscal year results. One earned 0.6%, the other earned 1.4%. They pay benefits based upon an actuarial assumption of earning 7% on their assets, an average return they have not seen in years. The pension funds of 20 states are below 70% funded despite increasing contributions more than 75% since 2007. This unfunded liability is one of the greatest financial threats facing America. O K, maybe we owe long term public employees their pensions, but why promise these goodies to new hires? .

4) No one expects the Federal Reserve to raise rates at its meeting next week, but look for any hint of a September increase in the press release following the meeting.

5) For those of you chasing yield by purchasing emerging market securities or junk bond funds, I highly recommend reading Jason Zweig's article in Saturday's Wall Street Journal. Zweig is the editor of the most recent edition of Benjamin Graham's classic "The Intelligent Investor."