I SPY...

"If one does not know to which port one is sailing, no wind is favorable."
- Lucius Annaeus Seneca

Buy, Sell or Hold? It depends on where you are heading. If you have a long time- horizon you should consider putting up the storm sails and steering your investment ship tight to the wind and weather with an eye toward the choppy port of Buy. If you are looking toward the medium-term "steady on" toward the port of Hold, and if you are looking short term hoist all your sails put up your top gallants, and run toward the safe harbor of Sell. "Aye... my investment compass is pointing toward the shores of Hold, but my spy glass has Buy just 6% off the starboard bow" to be said with a sea faring accent. The difference between Buy and Hold in this nautical analogy is an expected return of 7% over the next ten years vs. 8%. Which port are you headed for?

I browsed across the above quote attributed to Seneca (a noted and controversial orator who served the Roman Emperor Nero around 50 AD) while researching an angle for this note, and I just could not help myself. The match up was too good, given the alignment in history of the Roman Empire and the current US political environment. The analogy has depth, and while history doesn't repeat, it often rhymes. If you're scratching your head and wondering what I could be getting at read on.

The Federal Reserve has continued to raise interest rates, and it looks as if that trend will continue for at least another 1% in quarter point steps over the next year. That will move short rates from 3% to 4% and mortgage rates into the mid 5-6% range. Not a lot in an absolute sense, but huge in a relative sense. Using my time-tested dividend discount model, which accounts for market risk and long-term interest rates, I find that for each .25% move up in interest rates the stock markets fair value losses drops 2%. So, on the one hand earnings are expected to put an upward trust of 12-14% over the next year, on the other hand rising interest rates will put a downward pressure of 8%. The market is being buffeted by these two forces in opposition. When netted out you get an upward vector of 4-6% which historically the market has valued at a trailing P/E of 14.5, that's roughly 6% below the current level of $2700.

The change in tax rates has provided a one-time 20% lift to the earnings of US large cap stocks, but for US small cap is has turned out to be almost 30%. So, while the large cap segment is still selling in hold territory, small caps appear to be selling at prices that signal buy. My model is also pointing to international and emerging markets as having value as well. However, with the dollar continuing to get stronger relative to every other currency in the world it is difficult to know what the catalyst for higher prices in those markets will be. It's like trying to catch a falling knife. Y ield starved investors around the world are buying dollar denominated debt hand over fist for its higher yield, and this is killing the relative value of these stock markets in dollar terms. All one can do is dollar cost average in and ride out the cycle.

There are a lot of good reasons to be optimistic about the US economy, but there is no doubt that the walking dead are among us. Companies like Sears, GE*, and Campbell Soup are in for a world of hurt as interest rates go higher. Next year I expect that from time to time there will be news of bankruptcies, and this will have the tendency to spook the market and add to its volatility. Companies with low debt, good cash flows, and growing revenue that are selling at fair prices will hold their own. Hyper priced growth and unicorn stocks will be dead money.

What to do about bonds?

Bond market mavens have been credited with the ability to read the economic tea leaves and gaze farther into the future than the their stock market equivalents. To a certain extent this is true, but the bond market has had the wind at its back over the last 50 years as long rates have steadily headed down (as interest rates go down bond prices go up.) Unless inflation gets out of hand how the bond market deals with an upward trend in rates should occur in step wise fashion (as interest rates go up bond prices go down). It's a boiled lobster's death, slow but sure as the temperature rises. Over the last year interest rates have risen 1% and the average value of the long bond is down over 8%. With another 1% projected by the FED There is more of this on the way. Is it priced in? Thank you, sir may I have another? No! Who wants to collect a 3% coupon and watch the value of their long bonds go down 10%? No one! But...there is a way around the problem, with a higher level of cash and FRN's (floating rate notes). The US Treasury 2-year FRN fits the bill nicely. They can be bought directly at Treasurydirect.gov or at auction through a friendly broker for short money. These 2-year notes currently offer a whisker over 2.2% on an adjustable basis, and as rates go up these bonds hold their market value near par because they reset each quarter to a smidgen over the prevailing 13-week rate.

Mea Culpa!

Last September I wrote that GE was probably worth $22.50 a share and was invest-able at that price or better. I was wrong. The companies problems were far bigger than the previous CEO John Flanerry let on, and as a result he has been shown the door. Unfortunately the "GE way" included lessons on how to plunder a companies value, get away with gross negligence, deceive shareholders, and commit "deniable" accounting fraud while getting paid for it. Thank you Jeff Immelt! The SEC is now investigating GE, and I genuinely hope some people get carted of to jail, but the trail went cold years ago, and I doubt anyone will get prosecuted.