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September 2018 Performance Review

October 7, 2018

In early October the unemployment rate dropped to its lowest level since 1969. This is sending interest rates back up to 'normal' levels. The difference this time is the stock market is now sinking along with bonds.

In September, larger market value stocks crept up slightly in the U.S. while smaller-cap stocks fell. Abroad was a similar story — big companies in major economies were up marginally while riskier emerging market stocks continued to sink.

Bonds where weak across the board with bigger drops in longer-term interest rate sensitive bonds as rates continued to move up on good economic news and general optimism. The backdrop of a strong economy helped junk bonds and higher risk debt score fractional gains as defaults seemed less likely. All in, our benchmark global balanced fund by Vanguard was down fractionally, as was our Aggressive model portfolio. The recent changes to our Conservative model portfolio helped it eke out a positive month.

Our Conservative portfolio gained 0.18% in September. Our Aggressive portfolio declined 0.37%. Benchmark Vanguard funds for September 2018 were as follows: Vanguard 500 Index Fund (VFINX) up 0.55%; Vanguard Total Bond Market Index Fund (VBMFX) down 0.54%; Vanguard Developed Markets Index Fund (VTMGX) up 0.73%; Vanguard Emerging Markets Stock Index (VEIEX) down 1.31%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 0.18%.

The strong economy is pushing interest rates up, which so far has been good for U.S. stocks and higher risk bonds. Foreign stocks and bonds have been weak as the brunt of the trade war seems to be hitting markets that export to us.

But there also could be another reason that rates are going up that is not just the backdrop of a growing economy with rising inflation. In fact, inflation isn't rising that fast — nor are wages, which would warrant higher interest rates across the board. No, what we may be seeing is just too much borrowing.

Our government is now increasing borrowing in a strong economy that normally would lead to a slowly shrinking yearly deficit (as was the case in recent years and is the case with most foreign governments). Corporations are borrowing more too. While a handful of tech companies are swimming in trillions in cash, most are still borrowing, and a good chunk have credit ratings that are either junk grade or just marginally investment grade — they're basically subprime borrowers. Lucky for them bond fund managers and increasingly index funds keep loading up on borderline junk debt just like investors did with low grade mortgage debt in the mid 2000s.

These companies seem to be using the increased cash flow from tax cuts to buy back more stock and not pay off debt, which is good for stock prices, but not bonds. In fact, the tax cuts make debt less valuable in financial engineering because the tax deduction of interest rates becomes less valuable. The problem is twofold — CEOs are compensated (highly) when stock prices rise. Paying off debt doesn't increase the value of their stock options like buying back stock does.

In the movie Scarface a young climber up the criminal ladder played by Al Pacino is given sage advice by a more conservative successful drug dealer: Don't get high of your own supply. Today many companies are high off of their own supplies of bonds. Buying other companies, buying back stock etc.

Low interest rates and debt-hungry investors make it all work, at least for now. But many of these marginal businesses are in no position to handle higher interest rates. They need to stop buying stock at high prices and start paying down debt because refinancing at 2-3 percentage points higher isn't going to work — companies that need to leverage are already having problems. GE's stock price is not far off from the 2009 levels when the world economy was in perhaps the worst debt crisis in history.

Stocks may look reasonably valued compared to past bubbles when you look at the dividend yield (1.96% on the S&P 500) but when you consider that some of these companies need to cut back on the dividend sooner rather than later and start paying off debt, and that payout ratios (how much of earnings are going out as dividends) are already higher than in 2000, and that earnings are somewhat juiced by low interest rate borrowing — a spread that can quickly decline with rising borrowing costs — the market is almost as expensive as the biggest valuation bubble in history, early 2000.

The days of rising rates hurting bonds while stocks go up with the economy and earnings likely ended in early October as the market blew through 3% on the 10-year government bond. Nobody knows how real estate is going to do with 6% or even 7% thirty-year mortgages, but we're already seeing indicators that the 5% level just hit this week is causing issues. Nobody knows what happens to Ford when customers can't finance a new truck at low rates. It is completely possible 1/3 of the S&P 500's earnings could away at a 5% 10-year bond rate a level.

More disturbing is how our government is going to finance the $20+ trillion in debt at 5% — or $1 trillion a year in interest costs alone. We currently shelling out $500 billion a year in interest costs. As recently as 2012 that number was $360 billion. We're now paying 2.5% on the debt pile, which (lucky for us) is barely above inflation. Yes, it takes quite some time to change this rate given the vast portfolio of maturities and debt type, but it is going up.

Best case: if interests keep rising (and they may not because the demand to borrow at higher rates could plunge) we'll have to raise taxes and cut spending rapidly (like Greece) and some leveraged companies (like GE) will go bankrupt. You don't want to know the worst case.

The longer corporations and our Government use excess debt to drive GDP growth and stock prices during these good times, the harder the next fall is going to be. The President — no stranger to debt problems — knows this which is why he, according to inside the White House stories, wanted to raise the top income bracket to help pay for the corporate tax cut. Republicans talked him down because Republicans don't do that. If interest rates continue to climb somebody is going to be paying more taxes soon. Maybe that's the real reason we're adding tariffs to imports.

Stock Funds1mo %
Proshares Ultrashort Russel2000 (TWM)4.68%
iShares Global Telecom ETF (IXP)3.51%
iShares MSCI Italy Capped (EWI)2.07%
Gold Short (DZZ)1.69%
Homestead Value (HOVLX)1.14%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)0.73%
[Benchmark] Vanguard 500 Index (VFINX)0.55%
Vanguard Telecom Services ETF (VOX)0.52%
Vanguard Europe Pacific ETF (VEA)0.35%
Proshares Ultrashort NASDAQ Biotech (BIS)0.19%
Vanguard Value (VTV)-0.04%
Vanguard European ETF (VGK)-0.32%
Vanguard Utilities (VPU)-0.38%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-1.31%
iShares MSCI BRIC Index (BKF)-1.32%
PowerShares DB Crude Oil Dble Short (DTO)-8.31%
Bond Funds1mo %
Dodge & Cox Global Bond Fund (DODLX)0.75%
[Benchmark] Vanguard Total Bond Index (VBMFX)-0.54%
Vanguard Mortgage-Backed Securities (VMBS)-0.60%
SPDR Barclays Intl. Treasury (BWX)-0.74%
Vanguard Long-Term Bond Index ETF (BLV)-1.27%
Vanguard Extended Duration Treasury (EDV)-4.11%