Happy Anniversary. Robinson Investment Group completed its twentieth year anniversary as a Registered Investment Advisor on February 14, 2016. We believed it significant to reflect in this newsletter the historical changes that have occurred in the financial markets during the past twenty years and hopefully give you some perspective on the challenges we face in serving you as investment advisor.
As the President of RIG, I have worked in the investment business since 1983. My partners Paul Heer, Amy Campbell and Trent Green have worked in the investment business for 47, 30, and 20 years respectively. Our staff has a cumulative 130 years of investment experiences. We have occupied our corporate offices at 5301 Virginia Way, Suite 150, Brentwood, Tennessee for 18 years. We recently were audited by the Securities Exchange Commission at the end of 2014 and passed the examination with no material issues. Our accounting firm is Frasier, Dean and Howard, Nashville, Tennessee.
Stock and Bond Market Scorecard 1996 vs. 2016. Since 1996, the Dow Jones Industrial Average has risen from 4,996 to its all-time high of 18,351 in 2015, nearly quadrupling. The 30 year U.S. Treasury bond yield has fallen from nearly 7% to its present low of 2.60% during the same time period. The short-term 30 day Treasury bill yield has fallen from 5% to its present yield of 0.24%. The low yield on Treasury bills indicates that the economy remains anemic and deflationary pressures appear in the form of declining wages, low housing starts, and declining discretionary income.
In twenty years, we have endured five Presidential Administrations, three Federal Reserve Chairmen, and the Republican controlled Congress switching to a Democrat Controlled Congress in the early 2000’s and more recently switching to Republican control in the past five years. During this period, the stock market has enjoyed three good market moves up and two recession linked market declines. The stock market endured the 1998 collapse of Long-term Capital along with Russia and Indonesia which caused a 15% drop in the U.S. stock market in one day. As a counter measure Alan Greenspan ramped up money supply growth in the late 1990’s resulting in a significant advance in stock prices extending into 2001. Another concern was the anticipation of the Y-2-K calendar year changeover. Many leading experts predicted that a financial meltdown would occur as a result of a digital glitch in the software of every computer in the world relating to the calendar year switching from 1999 to 2000. Once it was determined that we escaped disaster, the Fed reigned in the economy by inducing the recession in 2002-2003 by raising interest rates.
The market proceeded with a great move up from 2003 through 2008 as all commodity prices appreciated with oil reaching $147 a barrel in May, 2008. During this period of time, Wall Street was able to benefit from easy money and provide 150% housing financing, and other measures of runaway leverage that lead to the “Great Short”. In March of 2008, Bear Stearns CEO James Cayne was playing in a Bridge tournament when he learned that the Bear was about to go down during the financial crisis of 2008-2009. Six months later, Lehman Brothers became insolvent as lending dried up. At that point, the entire Wall Street financial system ran amok. The stock market essentially shut down in the fourth quarter 2008. All major bank stocks dropped nearly to zero as liabilities exceeded assets in most instances. The crisis triggered financial hedging instruments held by AIG Insurance Company which caused it to become insolvent.
During the next 120 days, the U.S. Treasury and the Federal Reserve implemented the famous TARP program to stabilize the world wide banking system. Bankers who were directly responsible for the greed and avarice that lead to the problems were given billions of fresh cash to “fix” the problem. Of course the Federal Reserve stepped up the money supply growth rates which probably prevented the system from total collapse. The aftermath of the crisis was the collapse of both Fannie Mae and Freddie Mac, the two government sponsored enterprises that had been fraudulently reporting their respective financial conditions for a good ten years. Consequently, the housing market suffered for the next three years as foreclosures were rampant. The 150% housing financing allowing people to buy houses they could not afford came back to bite the economy in a bad way.
Complete Financial Deregulation and its Perils. In 1999, the U.S. Senate sponsored and signed legislation that allowed the complete deregulation of financial institutions. The Gramm–Leach–Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999 and commonly pronounced ″glibba″, (Pub.L. 106–102, 113 Stat. 1338, enacted November 12, 1999) is an act of the 106th United States Congress (1999–2001). It repealed part of the Glass–Steagall Act of 1933, removing barriers in the market among banking companies, securities companies and insurance companies that prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. With the bipartisan passage of the Gramm–Leach–Bliley Act, commercial banks, investment banks, securities firms, and insurance companies were allowed to consolidate. Furthermore, it failed to give to the SEC or any other financial regulatory agency the authority to regulate large investment bank holding companies. The legislation was signed into law by President Bill Clinton. (Wikipedia).
Translated, the GLBA effectively and completely allowed the large money-centered banks to underwrite securities selling billions of good and bad loans off instantaneously. As in the 1920’s, the banking system became a financial free-for-all which eventually lead to excessive lending to unqualified borrowers. Money market funds were purchasing debt instruments issued by Wall Street that were non rated and substandard credits which should never be purchased in money market funds. People with $40,000 in annual incomes were purchasing million dollar homes on balloon mortgages fully aware that the mortgages would never be paid off. Mortgage professionals made very high fees off of substandard mortgages. Banks went from financial leverage of 9 to 1 in the regulated environment to 40 to 1 in the unregulated environment. Over the course of 20 years, the financial system became fully deregulated as the commercial banking system merged and acquired itself evolving into mammoth institutions with great political power.
Resurrect Glass Stegall. “If banking institutions are protected by the taxpayer and they are given free reign to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you.” Paul A. Volcker, Federal Reserve Chairman, 1979-1987 Stock Traders’ Almanac, March 31, 2016. We believe that commercial banks should be separated from investment banks. Furthermore, we believe that the large banks should be broken up into regional banks allowing for capital formation in each of the regions of the country which would restore regional financial stability as deposits and capital fled the regions once these mergers occurred. Essentially, the Glass Steagall Act should be reinstituted that would require the separation of commercial banks from investment banks. Interest rates were set by the coordination of FDIC and Federal Reserve policy makers for fifty years and it seemed to work. We believe that the current system remains flawed with the same issues that caused the collapse in 2008-2009.
Commissions on Stock Trading. As financial deregulation evolved, the stock brokerage industry became more technologically oriented. Fixed rates of commission established back in the mid 1970’s became under attack in the 1980’s as brokerage fees became negotiable. Large blocks of stock were traded in the early 1980’s at 30 cents a share. Brokerage firms actually positioned blocks of stock and made markets in stocks on a national and regional basis. Financial deregulation led to falling brokerage commissions over time. The advent of discount brokerage firms became more popular in the late 1980’s and early 1990’s. Charles Schwab bought his firm back from Bank America in 1987 and grew his retail brokerage firm into a boutique for an estimated 6,000 registered investment advisors with over $1 trillion held in custody. Charles Schwab is the largest discount firm with TD Ameritrade a distant second. Now the NYC firms trade at 1 cent a share for the same thing which cost 30 cents a share in the mid 1980’s.
Program Trading and Electronic Trading. More recently, the electronic trading firms have taken substantial transactions away from the New York Stock Exchange. Around 40 percent of all U.S. stock trades, including almost all orders from “mom and pop” investors that go through brokerages, now happen “off exchange,” up from around 16 percent six years ago (Reuters). The mysterious dark pools and high frequency trading companies have contributed to great market volatility on the upside and downside as evidenced in May 2010 with the Flash Crash. The May 6, 2010, Flash Crash also known as The Crash of 2:45, the 2010 Flash Crash or simply the Flash Crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes. Stock indexes, such as the S&P 500, Dow Jones Industrial Average and Nasdaq Composite, collapsed and rebounded very rapidly. The Dow Jones Industrial Average had its biggest intraday point drop (from the opening) up to that point, plunging 998.5 points (about 9%), most within minutes, only to recover a large part of the loss. It was also the second-largest intraday point swing (difference between intraday high and intraday low) up to that point, at 1,010.14 points. The prices of stocks, stock index futures, options and exchange-traded fund (ETFs) were volatile, thus trading volume spiked. A CFTC 2014 report described it as one of the most turbulent periods in the history of financial markets. (https://en.wikipedia.org/wiki/2010_Flash_Crash).
High frequency trading platforms employ mathematical algorithms which dictate the direction of the buying and selling for sophisticated investors that include hedge funds, sovereign wealth funds, and private investors. We believe the unfair advantage being allowed by the SEC and the New York Stock exchange should not be allowed. In a fully deregulated financial market, it remains challenging for investors to compete with pools of assets that do not adhere to same rules and regulations that registered investors must maintain.
The George Soros Phenomenon. During the crisis of 1998 when Long Term Capital collapsed as a result on George Soros’ bet against the Russian Ruble and the Indonesian Rupiah, the Federal Reserve realized that commodity prices were no longer stabilized as gold dipped to $251 per ounce. Many noted economists including the late, great Benjamin Graham, have researched and written extensive reports about the importance placed on having stable commodity pricing. Under normal circumstances, commodity prices rise when short term yields are below long term yields on U.S. Treasury securities. Alternatively, commodity prices fall when short rates are higher than long term yields leading to recession. Since 2009, interest rates have remained low, yet commodity prices have dropped substantially especially since June, 2014. On a worldwide basis, the Central bankers are dealing with deflation and are no longer worried about inflation.
The Great Inflation has been delayed and put on hold for the foreseeable future. At this juncture, we believe that interest rates will not rise significantly until 2020. In order for rates to rise, or “normalize”, worldwide inflation rates would need to rise in a big way.
Ten Largest U.S. Based Corporations by Revenues, 1996 versus 2016. With the Dow Industrial Average trading at the 5,000 level in 1996, the ten largest companies by revenues included General Motors (168 billion), Ford Motors (137 billion), Exxon (110 billion), Walmart (93 billion), AT&T (79 billion), IBM (71 billion), General Electric (70 billion), Mobil Oil (66 billion), Chrysler (52 billion), and Altria (53 billion). During 1996, the price earnings ratio for the S&P 500 fluctuated between 15 to 18 times earnings. The dividend yield for the S&P 500 traded below 3% in 1996.
At the beginning of 2016, the ten largest U.S. based corporations based on revenues include Walmart (485 billion), Exxon Mobil (398 billion), Apple Computer (233 billion), Phillips 66 (164 billion), General Motors (152 billion), AT&T (147 billion), Ford Motors (144 billion), Verizon Communications (131 billion), Chevron (129 billion), and General Electric (117 billion). The current price earnings ratio for the S&P 500 is 14.4 times 2017 earnings. The current dividend yield for the S&P 500 is 2.3%.
Ten Largest U.S. Based Corporations by Market Capitalization, 1996 versus 2016. On a different note, the top ten market capitalizations in 1996 included General Electric (162 billion), Coca Cola (130 billion), Exxon (121 billion), Intel Corp. (107 billion), Microsoft (98 billion), Merck (95 billion), Altria (92 billion), Royal Dutch (91 billion), IBM (78 billion), and Proctor & Gamble (73 billion).
In 2016, the top ten market capitalizations include Apple Computer (586 billion), Alphabet, Inc. (535 billion), Microsoft (443 billion), Exxon Mobil (324 billion), Berkshire Hathaway (323 billion), Amazon (316 billion), General Electric (314 billion), Facebook (296 billion), Johnson & Johnson (284 billion), and Wells Fargo (277 billion).
During the past twenty years, several companies remain on both lists. Both revenue and market capitalization comparisons indicate how explosive the stock market has grown during the past two decades. Collectively, the 2016 top ten market capitalization list trades at 28.7 times 2017 earnings. The 2016 top ten revenue companies trade at 15.9 times 2017 earnings. The markets at the beginning of 2016 cannot be considered undervalued on a historical basis.
U.S. Bond Market Changes, 1996 versus 2016. On fixed income markets, the raging bull market in U.S. Treasury market continues to confound gravity. Yields on the 30 year Treasury bond have fallen from 7% in 1996 to the current level of 2.55%. Since 1996, the U.S. outstanding Treasury bonds have increased in size from $5.22 trillion to the current $18.825 trillion. Along with the unprecedented increase in the value of the dollar, the overvaluation of our Treasury bonds is the greatest mystery in both Washington and New York. The politicians will keep spending as long as Wall Street keeps peddling our bonds to the Chinese and large pension funds. In the late 1970’s, the bond market sold off when the U.S. economy had real wage-induced inflation. American workers have not experienced any wage growth in 20 years. The question we ask, “Would you lend your money to the U.S. government for 30 years at 2.55%?”
Mutual Fund Changes, 1996 versus 2016. In 20 years, the passively managed mutual funds have supplanted the actively managed mutual funds. In 1996, the ten largest mutual funds included Fidelity Magellan (51 billion), Inv. Company of America (27 billion), Vanguard 500 Index (23 billion), Washington Mutual (21 billion), Fidelity Growth and Income (19 billion), Fidelity ContraFund (19 billion), Fidelity Puritan (17 billion), Twentieth Century Ultra (16 billion), Income Fund of America (15 billion), and Vanguard Windsor (14 billion). (Data supplied from Kiplinger, October 1996.) In 2016, the ten largest mutual funds include Vanguard Total Stock Market (401 billion), Vanguard S&P Index (368 billion), Pimco Total Return Bond Fund (221 billion), American Funds Growth (145 billion), American Funds Europacific Growth (128 Billion), Fidelity Cash Reserves (115 billion), Fidelity Contrafund (108 billion), Franklin Income (97 billion), Vanguard Wellington (87 billion), and Dodge and Cox International Fund (67 billion). In 20 years, Vanguard supplanted Fidelity in the rankings.
Exchange Traded Funds, 2016. In 1996, the exchange traded funds was primarily the S&P 500 Spider fund. Today, the ETF industry is on the heels of catching mutual funds. The ten largest ETF’s include SPDR S&P 500 (167 billion), Core S&P 500 ETF (62 billion), iShares MSCI EAFE (53 billion), Total Stock Market (51 billion), S&P 500 VOO (38 billion), NASDAQ QQQ (34 billion), Core Total Bond Market (32 billion), Emerging Markets VWD (30 billion), Total Bond Market (28 billion), and iShares Russell 1000 Growth (27 billion). Most of the larger ETFs are passively managed. ETF’s represent just another alternative to straight asset management or mutual funds.
Largest Hedge Funds, 2016. For the more sophisticated market, the hedge fund industry has become a formidable alternative to Wall Street and mutual fund companies. The ten largest hedge fund companies include Bridgewater Associates (150 billion), J.P. Morgan Alternative Asset Management (59 billion), Och Ziff CMG New York (47 billion), Brevan Howard –Europe (40 billion), Blue Crest Capital Management-Europe (34 billion), Blackrock NYC (31 billion), AQR CM Greenwich CT. (30 billion), Lone Pine CM Greenwich CT. (29 billion), Man Group Plc. (28 billion), and Viking Group Greenwich CT. (27 billion). So if you like to visit the Northeast, then you can enlist the help of these investment companies. The fee structure is a bit expensive.
Private Equity Funds, 2016. Finally, the ten largest private equity firms include Apollo Capital Leon Black (150 billion), Blackstone Group Stephen Schwarzman (146 billion), Carlyle Group David Rubenstein (124 billion), KKR (98 billion), ARES Management (75 billion), Oaktree (70 billion), Fortress (67 billion), Bain Capital (65 billion), TPG (62 billion), and Ardian Capital (45 billion).
Largest Pension and Endowment Assets, 2016. We did consider discussing the sizeable public pension fund market and endowment funds. Many of these do manage their assets internally. Many use some of the mutual funds, ETF’s, hedge funds and private equity funds. The ten largest pension funds represent $4.48 trillion. The ten largest endowments total $57 billion.
In conclusion, our goal was to inform our clients to the market evolution which has occurred since 1996. Additionally, the process has become more complicated and more competitive than twenty years ago with multiple avenues to manage your assets. We have maintained that value investing remains the most conservative methodology to preserve capital and benefit from holding assets for the long term. Periodically, we recognize that our process underperforms the market as growth prospects from technological innovation or shifts in demographics may create new industry that addresses those newly created markets. Additionally, since 1996, the financial markets have spawned new investment approaches which include day-trading, program trading, and now high frequency trading. We believe these new-fangled approaches have only served to increase market volatility and not necessarily improved overall investment returns. For these styles, fifteen minutes is considered long term.
Most of our clients embrace holding assets for the long term. For the most part, our process remains focused on lower price earnings ratios, higher paying dividend yield, and reasonably good balance sheets. We are not very good at predicting the direction that the stock market or bond market may take. We do believe that when we make a decision to invest that we are willing to hold that investment for three to five years. Many times we hold those assets for a much longer period of time. We appreciate the decision you make to engage our services to manage your assets.
Robinson Investment Group
5301 Virginia Way, Suite 150
Brentwood, Tennessee 37027