10 Reasons Why Terril & Co. Is Reducing Your Portfolio’s Exposure To Stocks And Long Duration Bonds

In no particular order …

1. The market doesn’t seem to care that the budget deficit is now running at more than $1 trillion per year, an all-time high. Pundits say the deficit doesn’t matter anymore. We disagree.
2. Cover stories in mainstream business media proclaim the “death” of inflation. It is buried forever, the experts say. Again, we disagree.
3. Investors seem to trust that no matter the real world shocks dealt to the international economy and investment markets, central bankers will simply cut interest rates and save them from losses. We believe that could be a very costly assumption.
4. In 25% of the industrialized world, the interest rate on newly issued debt is negative. Yes, banks are PAYING the buyer to warehouse their money. This is not normal. This is the type of extreme condition often seen at market tops.
   Markets seem complacently certain that interest rates worldwide will remain at current or lower levels forever. We remember the days when an interest rate of 5% was considered low.
5. Investors are taking on more risk every day in an attempt to boost returns. Abandoning risk guidelines to chase momentum stocks is commonplace – and is seldom a smart long-term investment strategy.
6. A larger than once imaginable segment of current presidential contenders are extolling the merits of socialism. Amazingly, they are finding a following.
7. The IPO market is again red-hot with offerings of companies that have little, if any, chance of ever generating positive cash flows. Enamored with rosy sales growth projections and swelling customer counts, IPO investors are ignoring seriously flawed business models that cannot generate profits.
8. Bitcoin and other cyber currencies continue to have a following even as the sector deals with scandal after scandal. The notion that central banks will stand by idly and lose control of their currencies is ridiculous. A core function of government is to control the means of financial exchange and the creation of same.
9. Market volatility is unprecedented. Liquidity is poor in major moves up and down – a sign that many of today’s investors are short-term speculators, not long term holders.
10. Computer algorithms rule today’s trading floor. Typically, algorithms base buy-sell decisions on price momentum, not investment fundamentals.

Investment markets in late 2018 decided it was likely that the world economy was approaching a recession. The prevailing thought was that banks would end up with billions in bad loans and interest rates would return to zero. We didn’t agree with this reasoning in December, and we continue to be skeptical of it today. Consumers in the U.S. and most other industrialized countries are in their best financial position in 50 years. Central bankers around the world continue to provide ample liquidity and are acting to keep interest rates at historic lows. The movement toward more economic freedom and away from socialism is alive and continuing to progress, albeit slowly.

We believe the world economy will continue to grow in 2019. It may be at a slower pace than in 2018, but it will be growth nonetheless. Also, interest rates are likely to rise slightly in the coming year.

The stock market developed a love affair with growth stocks about 6 or 7 years ago. Buy growth at any price was the mantra. We believe this love affair is now on the rocks (witness Apple, Netflix and Tesla). We see value stocks – the laggards of the last 6 years – beginning to get some affection. Steady earnings, increasing dividends, stock buy-backs and good balance sheets do matter. A dominant position in an industry also helps. Last year, banks, energy, pharmaceuticals, basic materials and computer chips were laggards. While the fundamentals of these businesses were good, their stock prices were down. This dichotomy will change in 2019.

The political atmosphere stinks. Partisanship is worse than ever. After nearly one month, the U.S. government remains shut down. Brexit issues overhang Britain. China’s trade dispute with the U.S., Canada and Europe remains front and center. Budget deficits are obscene. It is easy to get depressed.

However, political events like the above are not likely to cause a major world recession. We continue to believe in the economic potency of creative entrepreneurs, the world citizens that produce and trade with each other. Their determination to create a better life for themselves tends to overcome the incompetence of their governments.

We remain constructively positive on the outlook for the world economy and investment markets.

Inflation and interest rates are both moving higher. We see this trend continuing through year end. Fixed income markets, year to date 2018, are DOWN 4% to 9% depending on the duration of the bonds held. We believe this trend will continue with the over-all losses widening. Our portfolios avoided this down activity by keeping, on average, our maturities less than a year. We are benefitting as we own an abundance of floating rate issues. The rate re-sets every 90 days. A year ago, the rates were close to 1.5%. Today they are paying 3.5%. By next summer we expect 5%. The Federal Reserve Bank is committed, over the next two years, to shrinking the size of their massive balance sheet. The Fed is reducing the size of their reserves at the exact same time they will need to keep inflation from accelerating. This will result in higher interest rates.

To date, the stock market has ignored all issues that could be considered negative. The amount of speculation in stocks with no earnings, no cash flow, and increasing debt, is high. The complacency of investors willing to believe stocks can never go down is growing daily. Investors fearful they are missing out on performance, so they are “now” willing to put all their portfolio into aggressive stocks at all-time high prices, is also increasing daily. Their ability to consider potential risk is minimal.

Historically, all the above actions have spelled a top in stock prices. We believe this time is no different. Add in the coming major increase in interest rates and we see little reason to hold major stock positions.

We "are" holding our financial stocks. The growing cash dividends will continue. The higher interest rates are not a negative for the financials. Issues that benefit from higher commodity prices are also attractive.

The investment climate has changed in the last few months. No longer is the world economy, inflation, interest rates and corporate profits front and center. The issue now is world trade. The current administration is attempting to use severe tariffs (a tax on imported goods) to force other countries to change their policies on world trade. The response so far is retaliatory. Other countries are imposing tariffs. Said plainly, when two parties both increase the cost of doing business, the result is less business. If the “trade war” escalates there is a high probability that the world economy slows dramatically. At days end, there are no winners in a trade war.

For decades, individual nations have protected the business entities in their country. This includes the U.S. Subsidies to farmers and the agriculture industry are just one example of U.S. protectionist policies. Major tax credits and incentives for the high-tech industry are another. In recent years, by mutual agreements with participating members, including the U.S., the world trade organization has granted advantages to certain countries. From time to time the need to make changes in the world system are negotiated. It appears this methodology is now to be abandoned in favor of instituting severe tariffs to force trading partners to “do as we say.” If the trade situation worsens it will be a major impediment to investments. We hope calmer approaches will prevail.

For perspective, we offer these observations.

1. Running a $25 billion trade deficit with country X doesn’t mean the U.S. lost $25 billion. We received $25 billion of goods and services we wanted. It was a value for value trade. Country X gave us one type of asset and we gave Country X another.
2. It is impossible for us to run a balanced trade account with poorer countries. The U.S. is 40 times as rich as Mexico. How can they possibly buy as much from us as we buy from them? A big part of this deficit is tourists traveling to Mexico. Are we to hurt U.S.-based airlines because Mexico’s citizens aren’t coming in equal numbers to tour New York, Chicago or Nashville?
3. Where is the evidence of the problem? We have run trade deficits with the balance of the world for over 30 years. Yet the standard of living in the U.S. is the highest in history. Unemployment is historically low at 4%. The economy is growing nicely and even gaining momentum. Interest rates and inflation are low. The U.S. dollar is strong.
4. We run trade surpluses with most countries in services such as banking, insurance, hi-tech consulting etc. Those surpluses are not reflected in typical trade deficit calculations
5. The xenophobic rhetoric we now hear about China is a repeat of what was said in the late 1980’s and early 1990’s about Japan. What happened to the economic takeover of the U.S. by Japan because of our huge trade deficits?
6. What IS a problem? Our ballooning BUDGET deficits! Countries that perhaps would buy more U.S. goods and services end up buying our Treasury bonds instead. We voluntarily give them an incentive to buy our bonds rather than our products.

If the trade war worsens, we will turn bearish on stocks and bullish on high quality fixed income. If the trade war is averted, our outlook is the opposite.

Year to date the U.S. stock market is unchanged. The bond market (fixed income) is down approximately 3%. Our belief is that by the end of 2018 stocks will be 3 to 5% lower and bond funds will be 10% lower. The main reason for this outlook is the probability that interest rates are going higher in the U.S. The budget deficit for the U.S. is moving up to the ONE TRILLION dollars per year level. With this new money demand, plus rolling over maturing debt, the markets will demand a higher interest rate to buy the debt. Couple this with inflation moving higher and the Fed’s intention to decrease the size of their balance sheet and it points to higher interest rates.

We remain positive on energy issues as the demand world-wide for oil continues to increase. Banks should also do well in an increasing interest rate environment. Major pharmaceutical stocks are also reasonably priced for investment. What is grossly over-priced is big technology companies. Particularly the ones losing money and burning cash such as Tesla and Netflix. Amazon generates cash and owns a profitable cloud computing division. The balance of the company, including home delivery, burns cash. The price of the stock is much too high. Bonds and other fixed income investments are a potential disaster. From such current low- low -low levels of interest rates, there will be major reductions in principal values as rates move up. In Europe, interest rates reflect a market controlled by the European Central Bank. When the Central Bank steps aside of the market price discovery will return. The level of interest rates the market will demand is much higher than current level. Two-year Greek bonds, (yes, the same Greece that was and is on the verge of bankruptcy), currently yield less than similar U.S. issues. Does anyone believe the credit of Greece is better than the credit of Uncle Sam? German credit is excellent. However; their ten-year bonds trades will a yield of only 5/8 of 1 %. Historically it trades more in line with U.S. debt currently 3.08%. There is a major price revision waiting when the market begins to set the rates.

Our floating rate bonds are performing well. We continue to expect movement towards this structure. We also favor gold mining stocks of major producers. The spread between the cost of production and the cash price of gold is at historic levels. Thus, gross profit is high.

Hi-Tech stock prices are in the beginning stages of moving much lower in price. The companies, sometimes referred to as the “FANGS”, drove the various equity markets higher for the last two years. Their stock prices rose to levels that defied logic. Investors mistook pure speculative momentum investing as fundamental justification for the stock prices. This speculation is now in the process of unwinding and it will drag the overall market lower. ETF funds, mutual funds, investors on margin and hedge funds will all be scrambling for liquidity by selling indiscriminately. With this selloff will come bargains as funds drive the price of basic companies lower in their search for liquidity. We hope to take advantage of their forced selling.

The potential for a trade war is truly a wild card. Without this potential, interest rates around the world are destined to move higher. We are still very bullish on the world economy. With this strong world economic growth will come higher inflation and higher interest rates. If, however; a tit for tat trade war begins to unfold around the world, then the opposite will happen. We will try to adjust our portfolios quickly if this happens. For now, we are staying with the assumption that political leaders around the world are smart in the filed of economics and realize a trade war is a loser for everyone involved. Yes, we know we just used the term politician and smart in the same sentence.

We are bullish on the gold miners, the energy mlp’s, the bio-tech/pharmaceuticals and the bank stocks. We remain extremely bearish on bonds. Our fixed income portfolio is dominated by short maturities and floating rate issues.

This update is titled NO PRICE TO PAY?, or if you prefer, NO WORRIES, IT'S FREE! When the liquidity crisis of 2008 hit the world economy like a massive blow from a top ranked heavy-weight boxer, central bankers around the world responded in unison. They printed money at previously unheard-of levels. This solved the problem. No longer did a liquidity crisis exist. Money of all currency types was everywhere. In fact, there was so much money, interest rates around the world plunged to zero or even negative rates. Why pay a fee to rent money when the supply is overwhelming? Likes grains of sand on an ocean beach, the quantities are beyond most capabilities of counting.

So why worry? Pop open some more bubbly and party on. The crisis is over. Economies around the world are doing great. Equity markets world-wide are turning 201k's back into 401k's and most often 6-7-and 801k's. Interest rates around the world continue to be at levels that make housing, autos and yes, speculation, very affordable. So, as stated at the beginning of this paragraph, why worry?

Maybe it's conservative financial roots. Maybe it's a lifelong observation. Or maybe, it's the notion that nothing in life comes completely free. There is always a price to pay. Is it foolish to think that maybe there might be a price to pay for printing trillions of Dollars, Euros, Yen, Pounds, Francs and Renminbi to solve our problems? When a wannabe dictator tries to solve his/her problem of "how to get power and keep power" by printing the local currency at unheard of rates, it always backfires. The currency citizens worked for is diluted by the printed variety. In time, the whole lot loses value at a rapid clip and the local economy suffers. Said plainly, inflation soars, and people scramble to deal with the aftermath. Is it time to worry that maybe the recent pick-up around the world in inflation rates is the start of the price we pay? Some say this type of thinking is outdated or "out of touch" with today's world. Okay, counterpoint duly noted. Thank you for presenting the perceived reality of the modern world. Now, forgive if you will, returning to the belief that there are things in life that are conceptual. In any world, two plus two equals four. Two million plus two million equals four million. The result doesn't change with the calendar or because of the size and complexity of the number. Certainly, the sum doesn't change because the equation is being computed in London, New York or Tokyo rather than in an unheard-of capitol of South America or Africa.

Recently is has become public that the Swiss National Bank (SNB) printed a rather stunning number of Swiss Francs to help stem the rise of the Franc against other currencies. (Remember back to the stampede into the Swiss currency when the very existence of financial Europe was in question). For an export economy like Switzerland, it was a good move to stem the rise in value of the Franc, correct? It's the rest of the story that causes worries. They sold the printed Francs and used the exchanged currencies to buy billions in bonds and equities. This holding of equities and bonds is now worth close to 800 billion. From a printing press to billions in value. The SNB is a major holder of Apple, Google, Microsoft and others. As said, NO WORRIES, IT'S FREE! Is there NO PRICE TO PAY for such modern-day alchemist maneuver? This is not meant to be critical of the Swiss. Quite the contrary. Cool move. Congrats. Would only a damn fool would worry about the actions of the European Central Bank and the complete dizziness of the artificial bond market they have created? (Note a two-year GREEK bond trades at a lower yield than a two-year U.S. Treasury). The Central Bank owns something close to 30% of the entire European Bond market. NO PRICE TO PAY for the false pricing mechanism created by their quantitative easing?

This is our update. We "ARE" worried about the excesses created by central bankers world-wide. Inflation is a reality. Around the world it will continue its march higher. Central bankers will either ignore and hope it will go away (Not a good idea: would you Ignore pneumonia and just hope it goes away?), or be forced to begin a tightening move that markets are completely unprepared for. It is not normal for interest rates to be below inflation rates. Interest rates world-wide must go significantly higher until they exceed the rate of inflation.

There will be a price to pay. Massive expansion of Central Bank balance sheets simultaneous with governments running increasing budget deficits will not be free.

We would like to call your attention to an interesting article in this past weekend’s Wall Street Journal. The article points out higher than expected rate of inflation in India is causing their central bank concern over their ability to control interest rates. Terril & Company believes this theme will play out globally in 2018.

2018 Outlook

Barron’s highlights potential investment market risks for 2018. Randall Forsyth, warns of potential consequences of the current bond market bubble in "Up & Down Wall Street" column. He astutely points out as investor attention is focused on Bitcoins meteoric price rise they are missing an even greater bubble. That being global bond prices propped up by global Central Bank bond purchases driving interest rates to near zero. In Terril & Company’s opinion and as pointed out in Randall Forsyth’s column this easy money investment environment is beginning to show itself in higher inflation as measured by the New York Fed’s Underlying Inflation Gauge, currently showing prices rising in the 3% area verses the 2% Fed goal. In Terril & Company’s opinion this dynamic means higher interest rates, lower long-term bond prices, and lower equity valuations as P/E ratios contract. We recommend Randall Forsyth's, Up & Down Wall Street column titled "2018's Greatest Risk".

Year End MLP Commentary – Unusual Investment Opportunity for 2018

We are receiving many client inquires as to why Terril & Company invested in the energy infrastructure or MLP industry given its poor year to date performance. No question, 2017 has been a volatile year for the MLP sector, through Dec 7, 2017, the Alerian MLP index is down over 16%. This decline is quite frustrating as we watch the Dow Jones, S&P 500, and Nasdaq set new records. What is even more frustrating is watching the MLP sector trade lower in the face of overwhelming positive industry fundamental data. The positive data include growing US oil and natural gas production, growing global energy demand, increasing industry cash flows, lower industry capital spending in 2018, above average growing distribution yields, and attractive valuations. As we head into 2018, Terril & Company believes the MLP sector is set up for attractive returns driven by the winding down of current tax-loss selling, recognition of the positive industry fundamentals, and attractive distribution yields. Additional details on our thesis can be found on the attached Whitepaper. Please copy the url and paste in your browser to review the whitepaper. http://www.terrilco.com/ClearbridgeMLP2018Rebound.pdf

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