Q3 2016 Market Update and Outlook: A Golden Summer

At the end of Q2 2016, uncertainty was on the rise, the geopolitical environment was fragile and financial markets appeared highly susceptible to exogenous shocks. Global stock indices wobbled, safe haven trades such as long Japanese yen and long US treasuries gained steam, all while gold rallied in tandem with investor uncertainty. We expected much of the same for the summer months of Q3 2016 as the US election cycle unfolded. Yet, the resilience of financial markets has truly been phenomenal. The US stock market, as represented by the S&P 500 TR index is up over 8% for the year. The NASDAQ composite hit another all-time high in September. Truly, this resilience may not be an anomaly after all. Excluding 2008, the US stock market has been up every year since 2003, many of these years it’s been up double digits, though past performance is no guarantee of future results. For those of us who value fundamentals and see the current economic landscape as a highly intricate house of cards, the continued rally, and subsequent drop in equity market volatility, is perplexing. Chairwoman Janet Yellen punted on increasing interest rates this quarter. Although the yield on the 10-year treasury was ultimately up in the third quarter, it also hit an all-time low in July of 1.36% in the post Brexit flight to quality. Ongoing massive global central bank stimulus (bond buying) led to an even larger supply of negative yielding bonds globally, making our US 10-year treasury look like a high yielding security relative to our foreign brethren. Can this continue forever? Surely, at some point in the not too distant future, negative interest rates will be viewed as some kind of insane experiment where we all should have known better. Yet, we feel that the financial markets seem as complacent as ever, comfortable and warm in a central bank security blanket.

We firmly believe the Fed should raise interest rates this year; yet, this assertion is materially dependent on the strength of economic data as we move into Q4. At the same time, the US is not an economic island. We could see economic data continue to improve; but if Europe continues to struggle, growth in China slows further, or other global forces take hold, the potential for a Fed rate hike could disappear. As we sit here today, the yield curve continues to flatten; which has been an economic harbinger. What’s nearly for certain in our minds is that global central banks will intervene with appropriate liquidity to prevent any political crisis from turning into a financial crisis. But, with zero to negative interest rates globally, central banks are already constrained and have limited tools to stabilize markets.

Accordingly, we believe investors should look to diversify portfolio risks away from long-only holdings in stocks and fixed income, dependent of course, on the individual’s goals and risk tolerances, among other factors. The traditional 60/40 portfolio has been a winning asset allocation since the depths of the financial crisis but in our opinion has overstayed its welcome. We are in no way predicting a crisis; rather, we view this as a market in which preemptive thinking is paramount.

The Times They Are A-Changin’

As we approach the end of summer, here’s my perspective on economic issues worth watching.

Employment
The big new noise is the July employment report. Job growth surged, according to the Department of Labor. The US economy added 255,000 positions, according to the Department of Labor, far more than the 180,000 increase that economists had been predicting. Average hourly wages rose 0.3 percent, also higher than expected. The unemployment rate remained unchanged at 4.9 percent.

I am going a bit out on a limb here, but I go back to what appears to be some changes in the pattern of hiring and layoffs as the US has shifted from an industrial to a service economy. Ordinarily July is a big layoff month as factories historically shut down for a good part of that month to install new, more productive equipment. In addition, some service entities, including educational facilities, also have reductions in force around that time. But the times they are a-changin’. School facilities are altering their schedules, and factories don’t necessarily have to close for upgrading. Typically, close to one million people leave the work force in July. That gets seasonally-adjusted to a positive number about which we all talk. As I have said, I have never met a seasonally-adjusted person. It will be interesting to see what happens this year with the labor market relatively tight and the patterns changing. This affected the numbers in May and June with May being understated while June more than made up for that understatement. The pattern YTD is about 100,000 short between the seasonally-adjusted numbers and the unadjusted numbers. Let’s see how the job numbers play out in coming months—revised numbers will be released in September. Meanwhile, I think we should pay more attention to the wage numbers, which are rising. Over the year, average hourly earnings have risen by 2.6 percent. Higher wages are a big component of the Fed’s inflation gauge. Both the July employment numbers and higher wages could affect the Fed’s thinking in September.

Brexit
In the meantime Brexit continues to be newsworthy. Bank of England Governor Mark Carney has taken precautions to ease the potential downside for Britain. In response, instead of punishing the UK, the EU has an opportunity to move toward a more United Europe. It has to take a harder look at what has to be done throughout Europe on the fiscal side and with regard to the debt and negative rates. The question is, will it? I think it has to. Raw democracy may get in the way.

What else?
As I have previously observed, I think the emerging markets with some volatility are where the growth is. India has to fall in that camp. The reform steps are a start. One has to remember that India is the world’s largest democracy. Whether Indian Prime Minister Narendra Modi can navigate his way through this is another question. I think he can, but it will be a volatile road.

As I have said before I find the Americas the most interesting set of markets. They have had quite a run in anticipation of change from Cape Columbia to Tierra del Fuego. Just think if our focus was to make America great in the broadest sense of the definition. We still have long-term issues of growth globally. It will be a slower pace overall, but the opportunities may prove to be broader. Maybe a measure of stability in real assets and some understanding of the value of illiquidity premiums become a focus. So, pay attention to the Americas, all of them.

Macro, Markets, and Malarkey

Stocks and Bonds
It feels like forever ago, but back in February, the S&P 500 hit its lowest level since 2014 as global growth fears spooked investors, leading to liquidations and deleveraging—most notably for sovereign wealth funds.

Fast forward to now…as of the end of July 2016, the S&P 500 closed at 2,173.60—up 7.5% from the beginning of the year. And, 10-year treasury yields started the year at 2.24%; as of the end of July 2016, rates were at 1.46%—a 35% decline in yield from the beginning of the year. These are big movements in both domestic stock and bond markets which investors shouldn’t take lightly.

Fig1_S&P+10yrTreasury

Also, more than $11 trillion in negative yielding bonds are outstanding, largely in Europe and Japan. The Financial Times wrote a great piece recently highlighting the post-Brexit surge in investor bond purchases.[1]

Fig2_GlobalNegYieldSovDebt

This means that if an investor holds one of these bonds until maturity, they actually lose money. They are also paying the issuer for the right to own these bonds, versus receiving some sort of payment in return—as Finance 101 teaches us should be the case. Governments with massive stimulus policies (ECB, Bank of Japan, and now the Bank of England) are buying up bonds, bidding up the price of these bonds and thus sending yields negative. Accelerating the decline in yields is the fact that the supply of such bonds is not ample enough to meet this demand. Negative yields are supposed to entice investors to invest in other assets, since they clearly lose money by investing in such bonds. This hasn’t happened. And yes, this is completely backwards and deflationary.

Currencies and Commodities
Currency markets have not been immune to this storyline; as Europe and Japan use monetary policy to help grow their economies, foreign investments flow to the US for its higher yields. Since May, foreign buying coupled with more hawkish Fed speak has strengthened the US dollar versus other currencies.

Fig3_USDollarIndex

If the US dollar continues to strengthen or simply stays strong on a relative basis, this has the potential effect of placing a lid on US inflation. The stronger the US economy gets versus its global counterparts, the stronger the dollar looks versus other currencies.

A strong dollar is usually a negative for commodities. And in fact, the strong dollar has kept commodity markets mostly in check since early May, as we wrote about in Commodities at a Crossroads. Of note, crude oil fell to under $30 a barrel earlier this year, sliding alongside the S&P 500, touching its lowest levels since May of 2002. It then spiked to above $50, and now hovers just north of $40 due to dollar related price pressure—nearly 20% below its peak in June of $50.11.

The US Economy and Election
That’s not all. We’ve barely discussed the domestic economy. Here at home, despite anemic GDP growth of 1.2% for Q2, economic growth is indeed expanding as evidenced by the latest payroll and hiring figures. Non-farm payrolls increased by 255,000 in July on a seasonally-adjusted basis, with the unemployment rate at a very healthy 4.9%. Wage growth and labor market improvements here in the US makes a strong case for the Fed to raise rates. Our view is they should raise rates in September, ahead of the election. Whether they will or not remains another question.

Lastly, and as an homage to Vice President Biden’s favorite saying, “malarkey,” rhetoric around the US election has truly captured the American public, including ourselves. We are seeing raw democracy at work here and elsewhere. People are voting against the establishment; it’s a small segment of the human race, but it affects us all. In the meantime, it may become clearer that at extremes, when enough of the populace is truly feeling disadvantaged, capitalism has to make some changes. Otherwise capitalism and democracy are not going to work when the rule of law favors a few as opposed to the many. While this line of thinking may be too philosophical for a financial markets blog, it merits consideration because it does affect one’s view on investing.

Thus far financial markets have not reacted to the election news melee, but investors should pay attention. Should the Republicans lose their majority in the House and Senate, and Hillary Clinton is elected, this could have a dramatic impact on GDP as government spending will very likely increase…then again, it will also increase if Trump builds his wall.

What Should Investors Do?
Stocks can be at record highs throughout the year. The reality is that it doesn’t take much of a move to set a new record high when you have just made one. Odds are we will see low growth for the rest of the year, maybe the rest of the decade. One should expect dispersion by country and company with thoughtful, well analyzed decisions to make on what to own. This is going to take real professionals who are either doing real fundamental analysis or machine learning or can take advantage of the volatility and the anomalies. It’s going to be a different market. We all know that global and country growth comes from demographics and technology (of which productivity is a subset if you can measure it). But, there is a payback when the easy money goes away, causing slower growth than the demographics and technology would suggest.

In light of this, our view is that investors should have two areas of their portfolio well covered. First, there are downside risks to the market right now. Ignoring this fact would potentially leave one’s portfolio without a buffer, and we believe every portfolio needs uncorrelated assets. While it is self-serving to advocate for managed futures, Altegris has a focus on managed futures because time and time again they have performed during some of the worst periods for traditional equity markets.
Fig4_PR_ManagedFuturesPerfDuringEquityMarketStress_1288-NLD-882016

Equity markets could continue to push for new highs, but we believe they are also susceptible to periods of steep losses. Managed futures performance has historically been uncorrelated to the performance of the broad stock market, and we strongly believe all investors with risk capital should consider this diversifying return stream, given the current macro picture.

The second bookend to investors’ portfolios, given the market environment, is private equity. Private equity was one of the few areas that didn’t sell off when investors panicked earlier this year, and whose returns can be orthogonal to the returns of traditional markets. Now, private equity is not a liquid investment option, so investors must be thoughtful in terms of just how much they allocate. But it is the forgoing of frequent liquidity that makes private equity attractive in our opinion. This is what is commonly referred to as the illiquidity premium, which is essentially the potential reward of enhanced returns—over time. This potential for enhanced returns may be particularly attractive for investors given the uncertainty in traditional equities at present.

The bottom line is that investors should aim to diversify portfolios. Look for ways to grow and preserve capital in your portfolio and seek returns in areas where investment managers have a real edge and understanding of the underlying investments. Pay attention, and invest for the future of your portfolios.

 

Data sourced from Bloomberg unless otherwise specified.

[1] Financial Times, June 29, 2016: http://www.ft.com/fastft/2016/06/29/negative-yielding-sovereign-debt-rises-to-11-7tn-globally/

REITs vs. Your Home

Many people don’t have an investment allocation to real estate investment trusts (“REITs”) because they believe they already have “enough” exposure to “real estate” through ownership of their home. REITs and your home are very different asset classes with very different characteristics. REITs invest primarily in commercial real estate, which is any non-residential property used for commercial profit-making purposes. Your home is an investment in residential real estate, which is a type of property, containing either a single-family or multifamily structure, which is available for occupation and non-business purposes.

Performance

Over the past 20 years publicly-traded REITs have returned an annualized 11.23% total return and homes have returned 3.47%, or just a little more than inflation. Over these 20 years, REITs returned more than 7x (740%) while homes didn’t quite double (98%). Publicly-traded REITs have been one of the top performing asset classes and homes have been one of the worst over the past 20 years.

Fig1_REITs_vs_Homes_08-2016

There are many differences between REITs and your home that contribute to this notable difference in performance. The largest contributor is that commercial real estate can generate positive cash flows but the residential home you live in cannot. By living in your home, you are effectively consuming the market rate rent that your home might have procured. If you forgo rent, as you do by living in your home, the return profile changes to be basically little more than an inflation hedge.  Performance of real estate follows the following formula: Total Return = price change + rent collected

Fig2_TBL-REITvsHome_080116

Diversification

With your home, 100% of the asset is in one property type and in one geographic market – this is concentration in its purist form, the opposite of diversification. On the other hand, with publicly-traded REITs, investors can choose from dozens of property types (including, but not limited to, specialized real estate sectors such as data centers, cell phone towers, casinos, medical research labs, infrastructure, prisons, ski areas, etc.) across any market in the U.S. and most major markets in the world. The opportunity for diversification in publicly-traded REITs vastly exceeds that of a single home.

Liquidity

Homes are relatively illiquid compared to public REITs that can be traded every day the stock market is open and settle to cash virtually immediately. This is in stark contrast to the home market, which may be illiquid for months, seasons, or even years, and can take months to settle to cash.

Transaction Costs

Transacting a home is much more costly than transacting in publicly-traded REITs. When you sell a home, the typical transaction cost is more than 6% of the home’s sale price (for perspective, based on data from the last 20 years as shown in the Total Return chart above, this is equal to about five years’ worth of your home’s price appreciation after inflation). In contrast, it costs little more than pocket change to trade shares of a public REIT ($7.95 per trade at Fidelity[1] and $4.95 per trade at Scottrade[2]).

Flexibility

Home ownership is not flexible. The entry price for a home is typically six-figures and you can’t really buy or sell a percentage of a home – it is binary: either you are in all the way or you are completely out. With publicly-traded REITs you can buy almost any amount you wish in single share increments (typically $20-$50/share) on the stock market. With public REITs you can trim, add or change a position in almost any amount on almost any day.

Supply & Demand

Perhaps the single most impactful factor that undermines home price appreciation is the ability of developers to add new product to the market. In our opinion, homes are the type of real estate most likely to be oversupplied because we believe they are the cheapest, smallest, quickest and least complicated real estate product type to build. AACA also believes that whenever the cost to build new homes is below the current market value of existing homes, builders will build new homes, which could create a price ceiling on the appreciation of your home. Additionally, in recessions, construction costs (materials and labor costs) decrease, which makes building new homes less expensive and creates additional new supply. This combination of factors could dampen your home’s price rebound out of a recession relative to public REITs, as shown in the historical graph below.

Volatility

Let’s look at volatility of publicly-traded REITs and homes. Below is a graph of the past 10 years, which includes the financial crisis. Since public REITs trade on the stock market, the share price of these REITs are subject to fluctuation in the stock market and as such experience volatility. However, we would argue the underlying physical real estate owned by the REITs can’t be much different in volatility than your physical home. The difference is that your home isn’t bought and sold every day and marked to that market price. That being said, in the graph below we see that homes sold off -32.81% and public REITs sold off -58.89% in the financial crisis. However, looking at a longer period of time, homes captured 56% of the downside and 8% of the upside of public REITs over the past 10 years – homes have been asymmetrical to the downside. And public REITs have since gone on to return 105.17% over the past 10 years while homes have returned 8.56% in that same time period.

Fig3_REITs_vs_Homes_08-2016

Final Thoughts

We believe you should think of your home first and foremost as the place you and your family live and second as an inflation hedge for your invested principal – nothing more than that. You should not think of your home as an investment in real estate (as history shows there has been almost no meaningful return after inflation). Publicly-traded REITs and your home are very different asset classes with very different characteristics.

But what if I rent my home out?

But what if I buy a home and rent it out? That would be good, right? Sure, you will grab the warranted rent (assuming you can find a good renter), but you may also be the one grabbing a plunger to fix the toilet on Christmas Eve when your renter calls. Also, you still need a place to live so you will presumably either be buying or renting a home to live in. Additionally, it is probably unlikely that you can rent one house as efficiently as a public REIT that has professional leasing, revenue optimization software, economies of scale, expert experience, market knowledge and real-time industry data. Lastly, if you want to buy a home and rent it out, there are several publicly-traded REITs that do that.

[1] https://www.fidelity.com/trading/commissions-and-margin-rates?s_tnt=76947:8:0

[2] http://welcome.tradeking.com/scottrade-comparison/?engine=google&campaign=ckws+-+scottrade+-+phrase&adgroup=scottrade+-+phrase&network=g&device=c&model=&keyword=scottrade&matchtype=p&position=1t2&adid=112556498471&ADTRK=sgo+ckws+-+scottrade+-+phrase+-+scottrade+-+phrase&gclid=CjwKEAjw5cG8BRDQj_CNh9nwxTUSJAAHdX3fPoZt6xE0DtdNphAY9XH6vkU3v3Kz-Yvhl8TO8_aeGRoCNW_w_wcB

The Wave of Private Capital Behind Public REITs

Flush with record levels of cash, many private capital real estate managers are buying up publicly traded real estate investment trusts (“REITs”) to take advantage of the gap between public REITs and private real estate valuations.  Historically, commercial real estate in the private market has usually transacted at, or near, fair value (or else the property doesn’t trade), while shares of REITs often trade at a discount or premium to their underlying net asset value (“NAV”) in the public markets.  This is because REIT share prices fluctuate in the public stock market while the underlying real estate NAV remains relatively constant (in the same way private real estate’s NAVs do).

Most of the REITs recently acquired by private capital have been trading at a material discount price to NAV in the public market; however, when these discounted REITs are acquired, it is at a price closer to NAV.  These REIT acquisitions have been readily agreed to because they can create value for the private capital (who may get institutional-quality real estate relatively quickly, easily, and less expensively) and for the REIT shareholders (who may get a nice return from the substantial share price increase from the pre-deal share price).  This activity of private capital buying beat-up REITs can effectively create a put option for the holders of the publicly traded REITs – if the price drops enough, the REIT may be taken out closer to NAV, and certainly at a premium to the discounted pre-deal share price.  In addition to creating a price floor for individual REITs, this buying activity can also create a supporting tailwind bid for the entire REIT asset class.

  • The current market cap of domestic public REITs is about $1 trillion[1]; the total value of underlying real estate assets is about $1.5 trillion, assuming 33% leverage, which is typical for public REITs[2].
  • As of 6/30/15, private real estate managers had a record $249 billion[3] in unspent capital commitments (this is equal to about 25% of the total public REIT market cap!). Private capital typically employs meaningfully greater levels of leverage than REITs do, which only further increases its REIT-buying power.
  • It is generally faster, easier, and less costly for private capital real estate managers to buy public REITs than private real estate.
    • Private capital can buy a large REIT portfolio in one bite.  For example, Excel Trust was recently acquired by Blackstone for approximately $2 billion.  The Excel Trust portfolio included 38 retail shopping center properties across 18 states.  If Blackstone had to buy these properties in one-off transactions, they would have had to travel to every property, conduct  their own data gathering and due diligence, review and audit financials and every lease contract, and successfully create and close potentially 38 separate deals with 38 different parties.  It is much easier, faster and less expensive for Blackstone to buy an institutional quality portfolio, already equipped with GAAP accounting, lease abstracts, financial audits, and publicly available granular property level data, in one fell swoop.  Not only are transactional costs less, but it may be getting it at an arguably cheaper price.
  • In the past year, a number of REITs have been purchased by private capital, including but not limited to the following list:

TBL_Blog_REIT_072816v2_sansStockColumn

Investors sometimes pose the question, “Why buy the goods when you can buy the store?” In effect, private capital is answering that question by buying discounted REITS instead of individual properties. Expect this trend to continue as long as REITS trade at material discounts to their NAVs and as long as private capital is looking for ways to deploy nearly $250 billion in unspent capital commitments.

[1] https://www.reit.com/data-research/data/industry-snapshot

[2] https://www.reit.com/data-research/data/industry-snapshot

[3] http://www.pionline.com/article/20150907/PRINT/309079983/managers-snap-up-market-battered-reits

 

A Different Liquidity Trap

Liquidity has its dangers. The evidence is fairly clear that humans (and that category includes most investors) tend to make economic decisions that are not in their best interest. Liquidity, as it turns out, can enable this irrational behavior.

Let me back up. Behavioral finance is a young science that uses psychology to understand irrational thinking. A well-known experiment in the field gives a good illustration of the phenomenon. Imagine you could save $7 on a $25 pen by traveling 15 minutes away to a discount store. When asked, most people say they would be willing to do that. But they would not be willing to travel 15 minutes to the same discount store to save $7 on a $488 suit.

“What’s going on here?” asks Dan Ariely in his bestseller, Predictably Irrational. Saving $7 should mean the same to the consumer regardless of the item being purchased. The problem, he says, is relativity. Wrongly, most of us see a $7 savings on a $25 pen as somehow worth more than a $7 savings on the $488 suit. Yet, the return on investment of the time spent is the same, having nothing to do with what is being purchased.

It’s not just social scientists who are poring over evidence of our irrational behavior. Dalbar, the Boston firm that evaluates the financial services industry, has been studying money flows in and out of mutual funds for 30 years, and concludes that investors can be their own worst enemy. They tend to make bad decisions at critical points, in both up and down markets. The worst case was October 2008 when equity investors lost 24.21% while the S&P 500 Index lost 16.80%. The second biggest underperformance gap took place in March 2000, when the S&P surged 9.78% but investors took home only 3.72%.

Dalbar’s studies show a substantial spread between returns of funds and the returns of the investors in those funds, primarily related to timing of investments.  Philip Maymin of New York University and Gregg Fisher of the investment management firm Gerstein Fisher, wrote a more academic piece a few years back that reached similar conclusions. Their title says it all: “Past Performance is Indicative of Future Beliefs.”

Which brings me back to the subject of liquidity. The ability to convert any asset into cash immediately and easily sounds like a perfect goal for investors. In 2008, the opposite happened as liquidity decreased for every asset except cash and short-term Treasury bills. The experience was not easily forgotten. In fact, behavioral finance tells us that investors remember losses more vividly than gains, even if their gains are greater. Investors reasonably concluded that step one in avoiding similar losses required staying liquid.

It’s no surprise that liquid alternative mutual funds experienced a 22% annual growth in assets (excluding commodity funds) between 2010 and 2014, versus 12% for mutual fund industry overall.  Investors were also looking for potentially higher, risk-adjusted returns, of course, but that goal had to include liquidity.

As the above referenced studies suggest, though, the liquidity “trap” can come at a cost, behaviorally speaking. The ease with which the average mutual fund investor has been able to buy and sell securities does not always turn out to be an advantage.

Does that mean investors should protect themselves from themselves by allocating assets to illiquid investments?  It’s a question more will be asking as private equity, considered one of the least liquid of investment alternatives, makes its way to the retail market.

Traditionally, private equity has been available to institutional investors or high net worth individuals—accredited investors–who could meet the high minimums and who could afford to lock up a portion of their assets for years. Private equity mutual funds now coming to market (full disclosure: our firm, Altegris, offers one) give a broader group of investors access with characteristics similar to mutual funds.  But, importantly, they do not offer daily liquidity. Thus managers of these private equity funds can ignore the market’s demand for instant performance and untimely withdrawals.  They can focus intensely on investments that generally take more time and potentially more effort to work.

Of course, private equity funds haven’t marketed themselves as a safeguard against irrational behavior. It’s their track record that has attracted university endowments, foundations, pension funds and wealthy investors. To wit, in the 25 years through September 2015, the Cambridge U.S. Private Equity index returned 13.4% annually compared with 9.9% for the Standard & Poor’s 500 index, according to Cambridge Associates.

We have just passed the seven-year anniversary of the bull market, making this the third longest rally in history.  When the rally ends, behavioral finance studies suggest many investors, trapped by the ability to sell, will sell at the bottom and fail to get back in as the market recovers. We have already seen that in the increased volatility experienced over the last 12 months. Illiquidity might prevent you from doing just that.

This requires a very close look at what one’s liquidity requirements really are, which, of course, depends on one’s investment goals. That 3.5% illiquidity premium, as measured by the performance of the Cambridge Associates Index vs. the S&P 500, can compound into some large numbers for a child’s education or a different kind of retirement if it is maintained.

Of course, past performance is no guarantee of future results. This applies to both the liquid and illiquid markets. The odds are that we are in for a five to ten-year period of a “Warren Buffet market,” with lower GDP results, lower equity returns and greater dispersion. As Buffett recently observed, investors should be on the lookout any time the market value exceeds the value of GDP.

With a potentially lower return from the traditional markets, meeting an investor’s financial goals today does require a fresh look at allocations and some real discussions about the liquidity trap.

 

A version of this article was originally published on ThinkAdvisor here: http://www.thinkadvisor.com/2016/05/25/a-different-liquidity-trap

The End of the Beginning or Beginning of the End (Redux): Written Commentary

For those of you who did not have the time to watch the video on this topic, below is a more complete text of what I had to say:

  1. Tragedies in Orlando and in England by themselves are difficult to comprehend and clearly represent elements of extremism that indicate some “permission” to behave at the raw end of emotions. This has on the margin an impact on the US elections and the Brexit vote. The next few days may tell us what direction this pushes voters’ thought process.
  2. This adds to the near-term elements of uncertainty. But, what happens if the first event, the Brexit vote, is REMAIN as opposed to EXIT? This removes an element of uncertainty against a backdrop of central banks already having provided liquidity to deal with a negative vote. This reminds me a little bit of Y2K. If the vote is EXIT we may already be set up for that. If it is REMAIN we have a lot of “excess liquidity” in the system.
  3. In the meantime, while economic data, as always, is mixed globally—in the US, with the exception of some of the employment numbers which we can’t ignore, other numbers could be said to support Fed action: Core CPI is up 2.2%, year-over-year unemployment claims remain low, wages and housing seems to be fixed, GDP may surprise, and wages are up not just in the US but elsewhere, up 10% in China, about 2% in Europe, and even up in Japan.

All this would support rate increases by the Fed, but as I said in a recent video, it may wait for the July employment report which isn’t available until first week in August. Why July? We are seeing major shifts in hiring, firing and exit patterns in the employment rolls. If nothing else, this makes it very difficult to “seasonally-adjust” (SA) any reported numbers. We had a reported seasonally-adjusted number for May of +38,000. As one can see in the tables below, 651,000 not-seasonally-adjusted (NSA) persons actually joined the payroll, which is well below the 900,000 number for May, 2015. YTD, the total employment numbers SA and NSA are 748,000 and 476,000 respectively. This compares to final numbers for 2015 for the same period of 1,033,000 and 881,000.

There will be further adjustments when the BLS adds the pluses and minuses from the data on another 20% of its 650,000 establishments as it completes the May survey over the next two months. Given the first seasonal-adjustment to 38,000, which is less than 6% of the NSA number, it wouldn’t take much to move the month into a negative number. The last time May was a negative number was in 2009 (-303,000 SA) when the NSA additions to the payroll that month were only +384,000. On the other hand, July could be an upside surprise. As one can see from the table for 2015, July is a big month for reduction in real payrolls. This is a result of reductions in the educational field and changing patterns in retailing. And, it is typically a big shutdown month for manufacturing entities to make changes to processes. Given that the industrial sector has become a smaller part of the makeup of the work force while more in-line changes are taking place, this number could surprise. How this gets translated into a seasonally-adjusted number is difficult to judge. It continues to amaze me that so much weight is put on this seasonally-adjusted number. Seasonal adjustments are difficult enough in a stable environment. When patterns of hiring, firing and exits from job participation are changing and the mix of services versus industrial continues to favor services, any single number has to be viewed with some circumspection, but has to be recognized. There are other numbers that give a better view of what is going on in the labor market as the Fed ponders.

TBL_Blog_OTM Change_Jan11-May16_032816

However, markets may anticipate and the excess liquidity will be put to work in a risk-on mode if the Brexit vote is Remain.

We will be paying attention to employment to determine if this is the end of the beginning or the beginning of the end—an expression I stole from Anatole Kaletsky at Gavekal. I think we are at the end of the beginning of what has been a strange cycle. There is more to come. In the meantime, my comfort level with fundamental analysis is low, while the more sophisticated trend followers are seeing movements that to me support a continuation of the cycle. These uncorrelated sets of strategies deserve some attention as well as less liquid strategies of those who can handle the illiquidity and take advantage of the time arbitrage that exists for those managers who do not have to deal with the needs of investors who fall into the liquidity trap—something I just wrote about in Think Advisor.