Merry Christmas and Happy New Year

The State of the Market

Batten down the hatches! Reality has set in and traditional volatility has (finally!) returned to US equity markets. The Fed’s great money printing experiment that instigated years of equity market prosperity as fresh funds flowed endlessly into the stock market as investors were forced further and further out on the risk curve in search of yield. Now, amid the Fed tightening from two directions – firstly through the highly visible hikes in the Federal funds rate, and secondly through the less visible unwinding of the portfolio it acquired in the depths of the 2008 financial crash – equities have begun to bounce around a bit. Nothing too much really compared to historic trends, but simply a return to how the stock market has typically behaved.

Today, rather than diving into the fundamentals of US equities subsectors, let’s look “under the hood” and focus on what has transpired for the months of October and November.

The S&P 500
The broader S&P 500 has been buffeted over the last several months, moving with higher sustained volatility than usual when compared to the last several years. As uncertainties rose in October, the S&P fell to a loss for 2018. This was reversed in November with the S&P 500 returning to positive territory as strong earnings, a positive election result, muted Iranian sanctions, and resumption in US-China trade dialogue helped calm markets.

A few observations
Earlier, strong quarterly earnings were somewhat shrugged off, with companies that beat expectations rewarded with small rallies, while companies that missed expectations were punished with sharp selloffs. Some uncertainty was removed by the US election that resulted in control of Congress split between the Democrats and Republicans; a largely positive result since President Trump’s economic achievements can’t be undercut while his more questionable moves may be held in check. And elevated oil prices were obliterated after Trump granted waivers to the biggest consumers of Iranian oil when sanctions were reimposed on November 5th (low oil prices are seen as generally beneficial to US companies). Most recently, markets have taken developments in US-China trade talks as a positive after China sent the US a list of proposals to help address US grievances regarding some Chinese trade and business practices (rough Brexit discussions may be the flipside to this positivity for now).

S&P 500 share buybacks are at historic levels 
Some years ago, companies discovered that share buybacks are a good method for returning money to shareholders by avoiding the double tax hit to dividends. A win-win scenario, right (no sarcasm here)? Third quarter buybacks for S&P 500 companies may have now risen above $200 billion. Read more at Reuters! 

Equity markets by the numbers

Up through September 28th, the last trading day before the beginning of October, equity markets had been mostly calm, marching along its upwards trajectory. Apple had crossed the historic 1 trillion-dollar valuation threshold. The Russell 2000 was largely outperforming the broader S&P 500. Among the S&P 500 components, Technology and Discretionary sectors were competing as best sector performers for 2018 (up 19.46% and 19.44%, respectively), with Health Care (up 15.15%) in a not-so distant third place.

This mix of sectors leading performance was (and isn’t) too surprising, largely reflecting areas that have led the most recent bull market and benefit the most from strong domestic consumption, while staying mostly insulated from swirling trade uncertainty.

October
October struck with a vengeance.
Fears rose and the VIX exploded. Treasury yields had been rising relentlessly. Sure, the historic average of 10-year treasury yields is above 5% for the most recent half a century, but the rate at which yields were rising was too far, too fast. Set against the backdrop of relatively weak economic data out of China, global growth concerns began to surface (how could the US equity bull market, alone, continue to rise?).

And oil prices had largely paired September gains – pressuring upstream energy companies – as futures trades were unwound and market participants began to second-guess Trump’s commitment to Iranian sanctions. Political risks were also seen as elevated, with uncertainty swirling about whether the Republicans could maintain control of the legislative branch of the government in November elections.

The US major indexes briefly gave up 2018 gains amid the massive pullback that occurred towards the end of October. By the time November was about to begin, the S&P 500 was barely positive for 2018, and the Technology sector had given back half of 2018 gains.

November
November has been more nuanced so far, with funds flowing between various sectors. Notably, weakness in Communications and Technology - which have lagged the markets so far this month - and strength in Health Care have allowed the latter to take the mantle of best performing sector for 2018.

Oil Markets: The second time is the charm?

US equities may have had a tough time over the last several months, but this doesn’t even begin to compare to the bloodbath seen in the oil markets. Prices for US crude oil have plummeted into a bear market since The Ignorant Investor’s last post in what can only be termed as an “American-made” decline. First, the numbers. The price for December NYMEX futures for WTI have fallen 17.8% to $56.46/barrel since our last post, with the lion’s share (-12.9%, to be precise) of the decline occurring since the beginning of November.

What happened
The case for the bull market, which rested primarily on supply constraints resulting from the expectation that US President Trump would follow through on his stated intention to enforce strict sanctions on Iran, imploded after the US granted waivers to the largest importers of Iranian crude oil (India, China, and six others). The day these waivers were granted, oil markets were faced with the uncomfortable reality that crude supply appeared to be outstripping demand as the world’s largest producers – the USA, Russia, and Saudi Arabia – were raising production to historic levels. Oversupply worries re-emerged amid hefty gains in US commercial crude stockpiles week after week, and oil prices collapsed.

Saudi is furious at what they perceive as the old bait-and-switch
As far back as July, Trump had asked Saudi Arabia to increase oil production to help offset shortages that could occur from strict Iranian oil sanctions. Saudi readily complied, happy to take market share while reducing a major income source for arch-rival Iran. Then Trump relaxed his position on Iranian sanctions, without informing Saudi of his new intentions. Read more about this at Reuters.

What will happen?
Until now, bears have remained in control.  But there is still hope for the bulls! At the end of September, traders held a record number of bullish positions for crude oil in the futures and options markets (according to CFTC data). Throughout October, that crowded trade was steadily unwound to the more reasonable place where we find ourselves today.

With the overhang from financial constructs held in check, we can now turn back to the fundamentals and see that Saudi and OPEC are now talking up the possibility of reducing current production by an aggressive 1.5M bpd to help support oil prices (perhaps this reflects Saudi anger at Trump’s Iranian oil waivers). OPEC may be missing its +1, however, since Russia has mentioned several times in recent weeks that additional production cuts may ultimately prove unnecessary once the situation around Iranian sanctions becomes clearer. Potential production weakness from Venezuela, Libya, and Iraq may also lend some pricing support.

Ultimately, the proof is in the pudding, and prices can be reasonably expected to remain subdued while EIA data continues to show strong weekly builds in US commercial crude stockpiles.

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The Ignorant Investor would like to state that when the market goes up and when the market goes down, a savvy investor can always make money. For these uncertain times, it may be best to take a long-term view of what's happening in the equity markets and try to identify bargains when market selloffs appear overdone (the proverbial babies that have been thrown out with the bathwater). Perhaps that stock you've always wanted to own may now be quite appealing on a two to five year investment horizon.

Oil Markets: The Perfect Storm or was that Another Head Fake?

That in-depth oil discussion The Ignorant Investor promised to deliver has finally arrived! Hang on to your hats, ladies and gentlemen! We are going on the ride of a lifetime.

In the fall of 2017, analysts were talking up the idea of sub-$60 oil through the early 2020s. Then, several weeks ago, market followers suddenly began throwing in the towel following strong 2018 performance and started announcing that oil prices could be reaching *gasp* $100 per barrel as soon as December on supply concerns. Oh, but wait a second- Goldman Sachs later came out and said this almost certainly won’t be the case. After all, supply is adequate for the current demand profile. We won’t even go into the $400 number thrown out this week amid the chaos surrounding the disappearance of a Saudi journalist after visiting the Saudi embassy in Turkey.

As The Ignorant Investor has said before, when multiple contradictory or disparate narratives vie for investor’s – and the general public’s – attention, it’s important to get down to the basics and separate the probable from the fantastical. In this way, the retail investor can form his or her own narrative.

Let us build up our case by looking at the data and then examining both sides of the equation.

Oil Market Fundamentals
Demand and supply hover near historic levels, with both estimated to be slightly above 100 million barrels per day (bpd). This is the result of recently depressed oil prices that followed a huge production boom out of North America (the fracking revolution, if you will).

Recent supply increases from Saudi and Russia ahead of the reintroduction of Iranian oil sanctions has left the world with limited spare supply capacity, which potentially leaves markets vulnerable to supply-side problems.

Additionally, in the more extended term, the theme has been playing out where demand growth for oil and petroleum products in the developing world is exceeding lost demand from the transition to renewables and other types of energy in the developed world.

International Energy Agency (IEA). The IEA reported on October 12th that global oil supply had risen to 100.3M bpd in the third quarter of 2018. This is up about 1.3M bpd from the previous quarter, and up 2.3M bpd from the year ago period. The organization downgraded estimates in demand growth to +1.28M bpd in 2019.

Energy Information Administration (EIA). The United States EIA’s October Outlook estimated global oil supply at 101.3M bpd (up +1.1% from the previous month). Global oil demand fell behind at 100.5M bpd (up +0.20% from the previous month).

This section would also be an appropriate place to delve deep into the bowels of the financial world and examine fund flows and positioning in petroleum futures and options contracts. We could also note such events as the recent decline in NYMEX gasoline crack spreads to help aid in our analysis of near-term oil price movements. That, however, is too complex for a place like this and indeed is beyond the scope of the information The Ignorant Investor is willing to cover here. Instead, let’s examine the medium-term narratives behind the Bulls and the Bears.

Bull’s Case

The world has limited spare oil supply capacity. Saudi and Russia’s decision to help alleviate potential oil supply shortages – and help themselves to Iran’s market share in the process – ahead of Iranian oil sanctions have left the two nations producing at nearly full capacity.

• Seasonal oil demand is fast approaching. Global oil demand historically hits a seasonal peak during wintertime in the Northern hemisphere (ie people use more energy heating their homes).
• OPEC Production at risk in Libya, Venezuela, and Iraq. Libya (1.0M bpd, OPEC) and Venezuela (1.2M bpd) have consistently failed to produce anywhere near their OPEC-imposed limits amid constant infighting within the failed state (Libya) and viritual bankruptcy and civil chaos (Venzuela). Iraq (4.7M bpd) experienced violent protests as recently as last month. Any potential disruption at their oil production facilities could have an outsized effect on output.
• Saudi has limited additional spare capacity. Saudi claimed to have spare production capacity of about 2.0M bpd (this asserted most recently in comments by the Saudi Aramco CEO in India), but analysts suspect this could actually be less. If so, then Saudi is now producing near full capacity.

Iranian Oil Sanctions may be more effective than anticipated. Despite headlines that would seem to indicate the contrary, US sanctions on Iran have been more effective than initially expected, with Iranian production already falling sharply ahead of November 4th. Some analysts have also pointed out that Iran's oil production decline could be as steep as 2,000,000 bpd. Saudi Arabia recently pledging to India to make up for any shortfall created by reduced imports from Iran, although India is separately negotiating with the US to obtain a waiver. China is a major wildcard here since they have expressed an unwillingness to fully comply with US sanctions, although this could be a talking point for trade negotiations.

Oil infrastructure development in North America (fracking regions) is lagging production, resulting in reduced potential for production growth in the near term. Some US companies are struggling to bring their oil to market. Yesterday, the Brent / WTI spread was about $10 per barrel. But do you think NYMEX WTI is cheap here? Think again! Bottlenecks in oil pipeline and transport capacity is creating huge differentials between NYMEX and certain field prices around North America– the spread exceeds $15 per barrel in some major US fracking areas, but in the worst hit Canadian regions the price of crude collapsed this week, falling below $20 per barrel (this is not a typo; we are talking a barrel of crude priced below $20).

Middle East geopolitical risks are rising. This addresses the age-old risk to supply from the Middle East. Conflicts in Yemen and Syria threaten to bring the Sunni – Shiite struggle to the broader region through their respective champions, Saudi Arabia and Iran. Iraq has also recently undergone turmoil with several violent protests taking place last month.

• The Iranian Parade attack. This unusual attack last month may indicate the potential for greater regional instability as Iran continues to agitate behind the scenes with armed groups in Lebanon, Syria, and – most importantly to this article, because of proximity to Saudi – Yemen. Yesterday, Iran claimed to have killed an ISIS commander who was behind this attack.
• The Khashoggi situation. Saudi Arabia came under intense international criticism after journalist Jamal Khashoggi disappeared two weeks ago after visiting the Saudi Arabian Embassy in Turkey. Saudi responded by threatening strong retaliation against any country that sanctioned it in response to Jamal’s disappearance. Several commentaries suggested the country could weaponize its oil production (raising the specter of the 1973 Oil Embargo, although The Ignorant Investor discounts this possibility as basically zero; weaponizing oil would be a Pyrrhic victory for Saudi, hastening the demise of OPEC’s influence on global energy markets by accelerating oil infrastructure development across North America).

Oil prices may be held lower until after the United State’s November 6th elections. Following the US election, Saudi and Russia may be comfortable with somewhat higher oil prices. On top of this, the US government will be able to take a harder line on Iranian oil waivers after political uncertainty is removed.

Background: Both Saudi Arabia and Russia have demonstrated satisfaction with President Donald Trump leading the US government (China less so, but that’s only relevant to Iranian sanctions compliance for this story). In September, Saudi and Russia secretly agreed to raise oil output, privately informing the USA of their plan amid Trump’s vocal denunciation of high oil prices. The remainder of OPEC was left in the dark regarding these developments.

Grey Swan events could create demand supply imbalance. This would encompass the possible unknown, including geopolitical or natural events in the Middle East and other oil production regions or mechanical failures at oil production/transport facilities.

• Infrastructure problems occur on a semi-regular basis. Canada’s extended Syncrude outage in June and the North Sea pipeline outage in December 2017 are several recent examples.

Bear’s Case

OPEC and Russia wish to avoid a sequel to the oil crash that last began in late 2014. This right here is the million-dollar talking point. OPEC and Russia remember what caused the initial fracking boom – high oil prices coupled with new fracking technology in North America (as well as easy access to capital to power CAPEX through the US Fed’s great money printing experiment), resulting in unchecked enthusiasm among exploration and production companies in the USA and Canada. If oil prices move above a certain target range, the balance may begin to slip towards too much supply once again. As primarily energy producing nations, Saudi and Russia plan to avoid this occurrence at any cost.

• Saudi Arabia and Russia have argued ahead of the last several OPEC meetings to raise production quotas, indicating they are comfortable with current prices
• Saudi and Russia secretly agreed to raise production in September and have promised net importers like India to make up for any shortfall that occurs as a result of Iranian sanctions (and, as mentioned before, take market share as part of the process). Iran complained about this situation just last month.

US-Trade tensions may hinder demand growth. If the US and China miscalculate or misplay their hands, China’s economy – which is showing some signs of weakness – could potentially take a turn for the worse. The global economy and/or secondary nations could also be affected by a downturn in US-China trade relations. Yesterday, Commerce Secretary Ross said US and China trade discussions are on “hiatus.”

Higher oil prices and a stronger dollar may cause demand growth to deteriorate. As oil prices move higher, some demand destruction will be seen in energy importers like India and further across the developing world (areas that are helping drive current demand growth). Additionally, the dollar has been strengthening in sympathy with the US Fed raising interest rates in the face of rising inflation. This has negatively affected some emerging market economies by making dollars, and hence, oil, more expensive relative to local currencies (the Indian Rupee-US Dollar pair is a good example of this).

US commercial oil inventory data is showing signs that market is relatively balanced. However, the weekly inventory data is less clear. US oil inventories (excluding the SPR) have expanded by 14.5M barrels in the past two weeks according to EIA data, reversing a recent trend of stockpile draws and shifting back above the five-year moving average (prior to this, inventory data had fallen to about 5% below). Here we must also note that while refinery usage rates are down from the summer highs, gasoline stockpiles have only experience small draws for the same period.

President Trump is willing to use the Strategic Petroleum Reserve (SPR) to cool prices. The US President authorized the release of sour crude from the Strategic Petroleum Reserve in August and may be willing to authorize the release of more supplies in the future. He basically made way for this by stating that current rate of US oil production, which was estimated by the EIA as 10.9M bpd last week, has made the US energy independent, and hence the SPR obsolete (see a chart of US oil production on the EIA’s website here).

The Verdict

Oil market demand and supply is balanced near historic levels. Elevated oil prices – relative to the last several years – and higher volatility can be expected to remain amid current near-term risks.

The bullish case for higher oil prices rests almost entirely on the fact that oil production must operate at near perfection (for the near term) to continue to meet strong demand. Any material threat to this supply has the potential to cause prices to rise sharply from current levels after the US reintroduces Iranian sanctions on November 4th. Should US sanctions prove more effective than planned, a demand supply imbalance may quickly occur. In summary, the Bull’s case is very much a quantitative assessment focusing on the supply side of the equation, with strict enforcement of and compliance with US sanctions on Iran the main wild card.

The bearish case for oil prices – which must be noted is more expecting limited upside to current oil prices rather than any significant downside – stems from powerful energy producers Saudi Arabia and Russia desiring to keep prices relatively close to current levels to minimize North American shale development. Additionally, the US government, friendly to these energy producers (ceteris paribus; we must watch how the Khashoggi situation unfolds) has recently committed itself to keep oil prices in check as Iranian sanctions are reintroduced ahead of US November elections. After all, for the very near term, President Trump has shown himself to be clearly against higher oil prices and he has a tool in the form of the SPR to affect commercial crude supplies. In summary, the Bear’s case lies primarily with demand growth concerns and the combined will of Saudi Arabia, Russia, and the United States aligned to keep oil prices from spiking too far from current levels.

In the world of higher oil prices, there are winners and losers
Bloomberg does a great job identifying the biggest winners and losers, should oil prices move higher, among emerging market economies. Note that the prices cited are accurate through October 12th (the date of the article's publication), but the longer-term themes remain intact. Read all about it here.

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The Ignorant Investor decided to focus on oil prices for today's discussion, although commentary on the various fears currently unsettling markets was also quite tempting. Yes, the news that the US is not talking with China is disappointing (not unexpected, however). True, interest rates have accelerated quite quickly in recent months. And of course equities have experienced a somewhat volatile decline punctuated with sharp moves higher these last several weeks. Since we are not dwelling further on the subject, The Ignorant Investor will merely suggest taking refuge in the fundamentals - wait on earnings! - that have been driving stocks forward while keeping a wary eye on how changing market conditions may affect investments.

An Overview: The S&P 500 Index and the New Communication Services Sector

Today we’ll take a break from the usual posts that revolve around how the events behind relevant headlines affect equity markets. Instead, let's briefly explore what may well be considered a major pillar of the equity investment world as we know it: The S&P 500. The recent addition of the Communication Services Sector to the S&P 500 provides an excellent excuse to dive into the dry details behind the index and examine how this new sector may affect the retail investor.

The S&P 500: Goodbye Telecom, Hello Communication!
The S&P 500 is often used (and cited) as the premier benchmark for the US equity market. In response to questions about stock market performance, most fund managers these days will comment on the S&P 500 – including one or two sectors – and possibly throw in some analyst projections for good measure. Perhaps in a testament to good years and the strong performance of the S&P 500, funds have increasingly flowed into passive investment vehicles like ETFs that track the index. These investors are searching for solid gains with minimal risk (following the diversity is good mantra!), while avoiding the traditionally expensive fees associated with either actively managed funds or mutual funds.

As The Ignorant Investor has mentioned in previous posts, the S&P 500 is a living, breathing composite of various large market-cap companies listed on the NYSE and Nasdaq exchanges. The S&P groups 500 companies into eleven distinct sectors using the Global Industry Classification Standard (GICS). According to S&P Dow Jones Indices, nearly $10 trillion in worldwide investable assets is “indexed or benchmarked to the S&P 500.” Usage can also go far beyond the stock market, too. Want to know how trade policy will affect the US? Look at how various sectors respond to relevant events. In today’s interconnected world - even more so now that a tremendous amount of trading done by algorithms - the extrapolated possibilities for insight and analysis are almost endless.

US economic data and statistics don't follow S&P 500 sector classifications
And it’s all down to standards. In the world of equities, the GICS is mostly dominant at this point thanks to the S&P 500, but still competes on some level with the Industrial Classification Benchmark (ICB). US economic data, on the other hand, is classified using the North American Industry Classification System (NAICS) or, in the case for trade data, the Standard International Trade Classification (SITC). Fidelity has a synopsis of equity sector classifications in their learning center.

Yearly turnover for the S&P 500 is around 25 companies (about 5% of the total index) with membership changes frequently resulting from mergers and acquisitions or occasionally from negative events that make a company unsuitable for the index (bankruptcy, lack of profitability, falling liquidity, etc). Compared to the Dow Jones Industrial Average this turnover rate is relatively high and results in an ever-changing index of companies that have proven to consistently generate profit. This may be reason enough to explain the difficulties active managers experience in beating the S&P 500 (of course, the argument that active managers are incentivized to maximize assets under management – and hence, management fees – rather than profit is best saved for another day)

As far as ownership is concerned, in the tangled and complex network of financial news, data providers, and stock exchanges, one will often be surprised to see just how small this world really is. The S&P 500 index is owned and operated by S&P Dow Jones Indices (which also, incidentally, owns the Dow Jones indexes), whose majority owner (ie parent company) – following several recent divestitures and name changes – is now called S&P Global Incorporated. A brief history of the S&P 500 is outlined below (Reuters put together a spartan but more thorough event timeline here)

S&P 500 Timeline
1957. S&P 500 is created
1982. Chicago Mercantile Exchange begins trading S&P 500 futures contracts
1999. S&P 500 adopts GICS system developed jointly by Morgan Stanley Capital International (now MSCI) and S&P. This original standard classifies companies into 10 distinct sectors.
2016. GICS creates the Real Estate sector. Real Estate and related companies positioned in this new sector, moving primarily from Finance.
2018. GICS replaces Telecommunications with the new Communication Sector. New sector began trading this last Monday (September 24).

The Communication Services Sector
Internet giants like Alphabet (ie Google) and Facebook have grown larger and larger, branching out into various markets and becoming truly multinational companies. Smaller companies like Netflix and Twitter have also been rapidly expanding. What do these companies have in common? Well, under the old GICS, these companies were all members of the powerful and ever-expanding sector called Technology.

The question soon became whether there was a better way to distinguish between these tech companies and whether some may have outgrown their label. Alphabet, Apple, Facebook, and Microsoft were each fast approaching $1 trillion in market capitalization. At the same time, Telecom was becoming less and less influential as a component of the S&P 500 – recently comprising only about 2% of the index by market cap. After kicking the proverbial can down the road for a bit, the verdict was eventually reached to create a new sector that would group existing Telecom companies with companies who, formerly found residing in the Tech and Discretionary labels, could be re-categorized under a broad new "media company" definition. Thus, the Communication Services Sector was born.

In-Depth Discussion and Visualization of Communication Sector Effects
Barron’s published a great article in very good detail earlier this month dissecting the composition of the new communication sectors and breaking down the impact from these new changes on existing equity sectors (they have some great informational graphs and heatmaps to help visualize the changes too). You can read all about it here.

The communication sector comprises nearly 10% of the entire S&P 500 and includes internet giants Alphabet (ie Google), Facebook, and their smaller cousin Twitter. Paypal, Electronic Arts, Activision Blizzard were also moved over from Tech while Netflix, Comcast, and the Walt Disney Company joined from Discretionary. For perspective, Communication is now roughly the same size as Discretionary and about half the size of Technology. While Telecom was commonly referred to as a defensive sector, the new Communication sector will be more nuanced, behaving with less sensitivity to interest rates after the addition of numerous growth stocks.

While funds linked to the broader S&P 500 have been unaffected by this move, investors in funds linked to Technology or Discretionary have seen their risk profile modified following the recent exodus and now face the potential for higher volatility going forward (as a result of fewer companies in the sector). This change may benefit individual tech companies and allow them a chance to shine now that they have been able to step out of the shadow of Facebook and Alphabet. Of course, Apple and Microsoft are now the 800-pound gorillas (with Visa as a smaller gorilla, using this analogy) as outsized constituents of the now-smaller technology sector.

In summary, how does this change affect retail investors? Well, unless that retail investor invests in sectors of the S&P 500 for income generation or to gain exposure to specific industries, nothing much has changed. However, the addition of the Communication Services Sector does allow retail investor a new avenue for getting growth without exposure to broader tech names. Technology has become, well, technology. And large internet growth companies (media companies?) are can now be found in their own separate category. Sector picking, rather like stock picking, may be the biggest beneficiary here.

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Following Up and Filling in the Blanks

Trade tensions remain elevated. The good news coming out tonight is that Canada has come to an agreement with the US and Mexico on a replacement for NAFTA. Analysts also expect an eventual trade agreement between the US and the EU, leaving US-China discussions – or lack thereof – as the remaining source of trade uncertainty (Japan doesn't count at this point since tariffs have yet to be implemented). Since The Ignorant Investor’s last post, trade tensions have risen after the US levied tariffs on an additional $200B worth of Chinese goods and China retaliated with duties on $60B of US goods while canceling anticipated high-level trade talks for good measure.

Tesla: What Goes Around Comes Around. That fast-moving SEC probe we were discussing last month? Well, this week we were hit with the news that Elon Musk could lose his position as CEO and Chairman of the board at Tesla after the SEC filed charged him with fraud. Then, just yesterday, we learned that Mr Musk – wisely – decided to settle the charges for what amounts to little more than a slap on the wrist. It’s a win-win situation for investors, who need Musk to continue to oversee Tesla while also providing some more oversight that may help limit what some see as erratic behavior.

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The Ignorant Investor is intrigued about recent changes in oil price forecasts and hopes to soon complete a quick write-up on the topic. This will be coming sometime in the next two weeks!

Markets, Trade Bickering, and Corporate Governance

Of Equities, Oil, and Politics

Where do we go from here?

Up, up, and away! Just yesterday, the S&P 500 broke its previous record to become the longest bull market in history by most accepted standards (read this article, in more layman’s terms, at PBS). “$1 TRILLION dollar valuation for Apple? This is 1999 all over again!” critics were shouting just several weeks ago. Yet, again, markets are defying gravity even more than Elphaba in the final act of the hit play Wicked (great song!) Or… are they?

Valuations are the name of the game in determining if something is overvalued. What industry does the company belong to (eg, does Facebook in Tech or the Telcom sector? GICS says it soon will be Telecom!)? What is the market cap and how much money does it make? Is it growing and by how much? Once we have answers to these questions we can slap a forward - or backward - P/E ratio onto it and compare it to its peers and its historical average. Of course, if we throw in more variables (dividend yield, etc), then we get other metrics with which to compare our current market conditions.

Are we overvalued? Current metrics seem to indicate this is a yes (besides the P/E ratio, this Forbes article does a great job describing several methods for evaluating the market!). But this doesn’t necessary mean we go lower anytime soon since fundamentals appear to remain strong, ceteris paribus.

The Muddied Waters of Oil Markets

Oil prices have had a remarkable run over the last year. It seems like just yesterday that most everyone, even the esteemed commodity traders at Goldman Sachs, were predicting $50-$55 oil through the early 2020s (see some analyst projections from May 2017 at Marketwatch). WTI prices (The Ignorant Investor is partially focused on US oil markets, after all!) have since risen quite remarkably- up about 40% from a year ago.

Fundamentals have largely driven the bullish sentiment, with US crude oil inventories falling almost 12% from 463.2M barrels at this time last year to 408.2M barrels today (EIA data; follow them on Twitter!). On the supply side, commodity traders have looked to production output weakness in various OPEC nations (Venezuela, Libya), relatively low discoveries of new oil reserves, and – more recently – sanctions being reintroduced on another OPEC producer, Iran. The USA has played around with the idea of a hard deadline to reintroduce sanctions in November while also working on methods for minimizing the impact on oil prices (lobbying Saudi, the de-facto leader OPEC; releasing some supplies of sour crude from the Strategic Petroleum Reserve; among other plans).

The world of commodities is always a tricky place- one month everyone will focus on the supply side of the equation, the next month everyone shifts their attention to the demand side as world economies bicker on trade. And then of course there is the on-again, off again tweets by the leader of the free world about oil prices going too high. Yes indeed, folks, energy markets now more than ever are affected by the whims and posturing of political and trade commentary!

US-China Trade Negotiations live!

Since the last time The Ignorant Investor posted, equities have responded positively to the resumption of trade talks between the US and China with the S&P 500 consistently hitting fresh highs in recent days. Of course, this comes on the back of both countries levying new tariffs on each other (Bloomberg discusses skepticism around the talks in this article). Remain cautious! Soundbites that make their way into the news will continue to move portions of the broader market.

Corporate Governance is important

From a young age, children are often trained to think of the day they’ll sit in that corner office with a great view of the city, down a glass of whiskey, and then make the important decisions that all Chief Executives must make. When we grow older, depending on our career path, this dream may not change all that much- attaining that coveted CEO title is still considered the pinnacle of success. But is the CEO truly at the top of the food chain? Think again! They answer to the board of directors. In a public company, hopefully this board is strong and independent. Then, the board has the freedom, capability and, again hopefully, the desire to ensure everything is operating in the best interest of the company’s real owners: the shareholders.

Corporate governance in various forms has been all over the news these last several weeks. Firstly, in an unprecedented move, US President Trump barged into the SEC’s territory by suggesting it was time to do away with quarterly earnings reporting requirements for public companies (fine, in reality he asked the SEC to review the proposal). Secondly, Elon Musk and Tesla have been repeatedly dragged through the news cycles after Mr Musk announced on Twitter that he planned to take the company private – even going so far as to name a value for the deal (triggering a remarkably fast-moving SEC investigation in the process; the NY Times has a solid in-depth article on what SEC guidelines Elon Musk may have violated here). Investors partially responded with enthusiasm before later selling the company off as skepticism rose (Tweeting can get you in real trouble, people!). Now, as one major bank after another drops coverage of Tesla, optimism has built up again. Quite the roller coaster ride!

What about Complex Capital Structures?

A topic for another day! For now, we won’t even begin to delve into criticism of public companies adopting multiple share classes. One prominent target for criticism here has been Facebook. Why? Well, Mark Zuckerberg owns less than 15% of outstanding Facebook shares, according to filings, but controls about 60% of voting power, effectively giving him (by himself, let alone with other insiders) an iron grip over the company (some shareholders are complaining and want more oversight; read this article by Barrons)

For now, let’s focus in on Trump’s idea- it’s far-reaching topic and surely deserves more attention (read this in-depth article by the NY Times). One theory posited over the last several years is that the quarterly earnings reports have forced CEOs to guide their companies with the object of meeting very short-term goals, sometimes to the detriment of that same company’s long-term future (General Electric may be one victim of both this and other issues). Warren Buffet and Jamie Dimon more or less emphasized this in a statement back in June (read more at Fortune). To avoid the scrutiny of critics (e.g. analysts, activist investors) and SEC filing requirements in their entirety, a growing trend has emerged of taking somewhat-troubled-but-high-potential public companies private before working on years-long turnaround plans (Michael Dell and his eponymous company immediately comes to mind - hey, the guy was still praising the idea a year after taking the company private, quick summary at Business Insider - and, more recently, Elon Musk’s public musings on taking Tesla private). However, is eliminating quarterly reports the best solution for bringing about better corporate planning and governance for shareholders?

For retail investors, without other additional stipulations, the answer is a resounding no. Moving away from quarterly reports may be part of the solution, but to do so unilaterally hurts the retail investor (in fact, this article by the Wall Street Journal includes some contributors who think corporations should report information even more frequently). For this group, times have never been better. Equity trading fees – indeed, trading fees across all markets – have been falling (even hitting the level of “free” with the launch of Robinhood in 2013). Timely company information and solid analyst reports (although these generally tend to be more technical than fundamental in nature) are now available for free through most brokerages. And very powerful analytical tools are now available, as of about 2015, for relatively small fees (as low as $500/month. Still a nice bit of change, but less than it would have been even ten years ago). Eliminating quarterly reports moves against these recent trends by causing a rise in information asymmetry, to the detriment of the retail investor.

How does information asymmetry work in the investment world?

Hedge funds have a decent idea of how companies are performing throughout the year by connecting the dots from outside information that isn’t readily available to the public. Let’s look at the car industry. An analyst will have access to car insurance information from big data providers, allowing him or her to interpolate and approximately project what kind of a year General Motors is having (hey, the analyst can even estimate profit margins based on which vehicles are proving to be the most popular. Volume of sales? That too!). The retail investor will never gain access to this information – it’s just too expensive! Even now, with quarterly reports, the retail investor is at a disadvantage. This disadvantage is only magnified as information asymmetry increases.

Other Highlights

The Amazon Prime Effect on Equity Trading

More good news for the retail investor. Robinhood will soon have a new competitor in the game of free equity trades! And this one is a 1,000-pound gorilla. JP Morgan’s CEO Jamie Dimon has hinted for years that he plans to shake up the retail investing industry- and soon, that plan will come to fruition. Next week, the bank will unveil a new trading service that allows for up to 100 free stock and ETF trades per year. Read this article by USA Today for more information on this new service.

Keep on Trucking! Earnings, Trade, and Trump

And they’re off to the races! Time is flying and we find ourselves more than halfway through S&P 500 second quarter earnings. Most publicly-listed companies in the USA are required to file quarterly reports; this keeps investors updated on how business is going and whether the company in question is on track to meet its full year projections. Analysts really upped the ante for this round, too, with expectations for about 20% (!) average earnings growth. Even more amazing? The S&P 500 has exceeded both earnings and revenue growth expectations, with net profit nearing historic records (Factset has regular updates on S&P 500 earnings progress and an excellent look beneath the hood. Read an overview with some select details on the earnings season here).

Most companies are having a great time. Most. Social media companies (Facebook, down -17.8% for last week through today’s close; Twitter, down -26.6% over the same period) have fallen sharply even as the broader markets are outperforming. When good times come, the stock market parties like it’s 1999. When unexpected news arrives, there's a stampede for the exits. This time, Facebook may well have been the instigator for a stampede out of popular tech names over the past week. Technology (ie Silicon Valley et al) and Discretionary (ie retail stores et al) declined while the broader S&P 500 advanced. Infrastructure-related and the Energy sectors saw the biggest gains, although the meaninfulness of this move may be limited since these sectors have been largely trading in sympathy with the whims of oil markets and government/trade commentary. Some recent movement in other areas may be meaningfully attributable to rotations from growth into value.

The S&P 500 is largely used as a proxy for the broader stock market, considered as somewhat representative of the performance of US companies. The index is living and breathing, with companies added and removed depending on circumstances, and may sometimes consist of more or less than 500 companies. Want to know how trade tensions or other factors are affecting the USA? Look at earnings and other company data and interpolate. It’s a wonderful and powerful tool. Read about how the S&P 500 is constructed at The Motley Fool.

The Facebook Situation. Everyone knows Facebook, so let’s focus on that company for a bit. Even after the recent selloff, Facebook’s market cap is still around some $514 BILLION. It’s been a crowded trade and a perennial favorite of hedge funds and all manner of index funds alike. Facebook, along with several other companies, can affect broader index performance simply because of their size. And last week, Facebook disappointed investors and ended up making its mark on history for all the wrong reasons (this article by Marketwatch comments on the historic nature of Facebook’s one-day fall).

The race to $1 TRILLION. Four companies are currently viable contenders to reach the historic valuation milestone, with Apple, market cap $956 billion, by far the leader. Google, Amazon, Microsoft are almost neck-in-neck for second place with valuations in the mid-to-high $800-million range. All of these are currently (key word, currently, since this will soon change) placed in the Technology sector. With such a huge valuation, these companies have an "outsized" impact on its host sector's performance. Read about the race to $1 trillion and analysts’ favorite at Bloomberg.

By now, we’ve all been deluged by all the information thrown at us about what’s wrong at Facebook. The summary from the earnings report and conference call is that: 1) revenue disappointed and margins are forecast to contract and remaining subdued for the near-term, and 2) global daily active user growth slowed (key word: slowed; growth slowed, but there still is growth). Facebook, the website, is currently the earnings Goliath for Facebook, the company. The stock price then dropped as shares sold off. However, let’s take a quick break here. Step away, and consider for a moment how investors assign valuations to companies.

The long-term Facebook story remains unchanged, but the company's projected performance over the next several years is below what analysts had been hoping (and planning?) to see. These analysts must now change their Facebook model inputs which may result in different valuation targets. Don’t forget, the investment suitability of a public company generically depends on stock market price, profitability, and potential for growth. Hedge funds and all types of other funds may need to adjust their positioning both in Facebook and the broader market in response.

But what of Facebook? The company remains THE powerhouse in the social networking space. The company's dominance hasn't faltered and monetization options for its COLOSSAL user base across the Facebook website and other platforms remain plentiful (click here for a CNBC interview about Facebook monetization options). In other words, the long-term Facebook story appears to remain intact, even in the face of narrower (near-term) margins and stricter privacy regulations. Therefore, long term investors will probably look at this event and shrug. Please note that The Ignorant Investor is talking through considerations surrounding Facebook as a case study in dissecting what's important to keep in mind during "emotional" quarterly earnings events. As always, remember to consult your investment professional before making any moves in the markets.

Trade, Rhetoric, and Results

US President Donald Trump is proving to be very hands-on when it comes to matters of trade. Every week the situation seems to change, with Twitter soundbites countered with official statements or discussions resulting from in-person meetings. Markets appear to have become more insulated over time and reactions more muted to sudden statements about industries and – gasp – individual companies on Twitter. There is no doubt that the trade issue (problem?) has been advancing quickly, however. The Ignorant Investor went as far as to compile a list of no fewer than a dozen meaningful statements from the USA and other countries threatening additional trade barriers or other types of positioning ahead of trade negotiations since my last post.

USA-China Trade. Rhetoric doesn’t mean much amid the rattling of sabers and positioning ahead of trade talks, as long as engagement between the affected parties is maintained and those trade talks are ongoing. Recently, The Ignorant Investor took note when White House National Economic Council Director Larry Kudlow stated that China was not meaningfully engaging in trade talks with the USA, partially by not responding "adequately" to concerns of intellectual property theft (although China had in previous talks offered some concessions on lowering trade barriers and buying more USA products). China responded strongly to Kudlow’s statements (read more on China’s response from this article at Bloomberg). In the investment world, there is no shortage of authoritative figures speaking out on all manner of subjects. Its important to identify which voices to listen to during confusing times. The Ignorant Investor respects Larry Kudlow’s opinions on markets and free trade and tends to believe his words to be credible. Yesterday, the media postulated that there are indications that USA-China trade discussions may resume soon. This is hopeful news, but in the meantime - as discussed previously - tread very carefully around companies that deal in markets that could get caught up in the crossfire.

China Trade issues: What if it’s all about the system? The Ignorant Investor fears that both the USA and China are approaching the trade talks from different intractable ideological positions. For example, China is willing to purchase more goods from the USA to help with what Trump thinks is a problem (ie the trade deficit); however, China will never be willing to change the established Chinese government system. In Communist China, the government has last say in everything and has strict oversight over any business operating in its territory. If foreign companies can operate with total independence, the Chinese system must necessarily have changed. The USA perhaps views the Chinese intransigence on this position as a stubborn attachment to a policy that violates the spirit of free trade. Unless both sides are willing to reach a compromise, this trade spat may turn even uglier. Read about the relatively fruitless recent US-China Trade negotiations in this article by Bloomberg.

USA-Europe Trade. Good news! Last week, the US and the EU announced that they had struck some form a preliminary trade deal and agreed to sit down for detailed negotiations and avoid new tariffs, for now. The Ignorant Investor felt this deserved a mention, although no one necessarily expected at trade war with Europe. The New York Times has more details on what transpired and what this “agreement” currently looks like.

Prescription drug prices voluntarily capped. Pfizer shocked investors when it announced on July 10th that it would cap price hikes for the remainder of 2018, supposedly to give President Trump time to develop (and market?) his plan to lower prescription drug prices. This came after Trump tweeted that “Pfizer & others should be ashamed that they have raised drug prices for no reason.” Even more surprising is that, following Pfizer's lead, Merck, Novartis, Roche, and Sanofi have made similar commitments. Remember Martin Shkreli and the days of 5,500% drug price increases? Apparently, the drug industry has learned from that debacle back in 2015 and is battening down the hatches until the current public and legislative scrutiny dies down or is attracted elsewhere. USA Today has an excellent article summarizing the industy's posture.

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Amid all the concerns floating around the market today (pullback warnings from Morgan Stanley, 10-year yield still flirting with 3%, amid others), The Ignorant Investor recommends stepping back and looking at the big picture. Always consider the fundamentals before making any hasty moves!

Oh, What a Tangled Web: News Stories, Equity Trends, and Trade Tensions

US Equity Markets

The world is a dizzying place. On the news, pundits discuss world events and sway our emotions. Social media keeps us hopping as we seek to keep our friends aware of what we’re eating for lunch. Information bombards us on every corner. Got to keep hustling! Investors face a similar situation. Several weeks ago it was China trade, Italian elections and Spanish politicians. Last week was the G7 show with all its posturing, soundbites, tweets, and counter tweets. This week it’s North Korea this, and struggles over a Yemen port that. And isn’t the Fed about to raise interest rates later today?

Enough! Why not stop by Starbucks, grab a hot cappuccino? Grande, since we don’t want too much caffeine affecting our judgment. Then pause, sit back and just enjoy the moment. It’s helpful to return to the concerns of the market later with a clear head, asking “What is really going on? What is important and what will drive the market, higher or lower, from here?”

This morning, The Ignorant Investor has been focused on the fundamentals driving the market’s current run: strong earnings (peak earnings apparently hasn’t occurred yet!) and solid economic data amid relatively (and inexplicably?) subdued wage growth (read about how slow wage growth can also affect consumer debt in this article by NBC). This while the economy runs hotter as the United States nears full employment. Finally, upcoming company stock buybacks following the quarterly earnings reporting lockup is helpful too.

Jobs outnumber job seekers in the United States. Read more about this at CNBC. However, The Ignorant Investor would like to note that there IS a difference between the reported U-3 and U-6 unemployment rates.

As a whole, the S&P 500 really hasn’t done that much since the beginning of the year. However, an undercurrent of flight to quality, escape from sectors vulnerable to trade spats and interest rate hikes, and simple sector rotations has “hidden” from the broader market performance some extraordinary gains in Energy (up about +13% in the last three months; "smart money" has been buying up energy shares. Read more at Marketwatch) and so-called small cap companies (the Russell 2000 has been outperforming recently!). The age-old favorite of Technology has also booked very strong gains and remains the 2018 leader. Surprisingly, tech is now closely followed by 2018’s second-best performer, Consumer Discretionary; more on that below. The biggest winners from rising interest rates has unsurprisingly been the banks. At the same time, Agriculture companies seem to remain the most vulnerable to international trade spats (for example, soybeans wrt to China as The Ignorant Investor forecast in his March 27th post). Recently, Whisky and Apples - among other goods - have also become targets with the EU, Canada, and Mexico.

Counter tariffs. Quick, easily followed breakdown on counter tariffs that Canada, the EU, and Mexico have planned as part of "dollar-for-dollar" responses. Details at the BBC.

Earnings have also driven investor sentiment. The meteoric rise in select consumer discretionary companies last week is particularly striking (by "select", we are talking about retailers who appear to be not only surviving but thriving in a post-Amazon world. Investors recently bought up Five Under after seeing solid results- Marketwatch showed one analyst's practical comparison between Five and Amazon products). If you are interested in this last sector, The Ignorant Investor suggests waiting until complications from trade tensions are clearer and euphoria has fallen before talking with an investment professional about taking the plunge.

Quality is the name of the game here, however. Quality. Exceptional earnings, strong full year guidance coupled with evidence of growing market share (growth), and a solid share buyback strategy will usually result in a stock that rewards investors (Restoration Hardware Holdings – now RH – performance just yesterday seemed to fit the bill. Earnings details and commentary by the company available via Businesswire).

Dark storm clouds on the horizon

Geopolitics. The chance for armed conflict with North Korea abates. This week, the news has been dominated by the historic event of President Trump flying to Singapore to meet with North Korea’s Kim, with the hope of sealing some sort of denuclearization agreement for the Korean peninsula. Any move towards peace should be applauded and removes or at least forestalls a potential black swan event. Read more about the denuclearization deal at Bloomberg.

Trade. At the G7 meeting last week, President Trump chose to play hardball with some of the USA’s closest allies and trade partners, with acrimonious accusations – some valid, others less so – flying in multiple directions. The questions investors must ask themselves is how these potential issues or an increase in protectionism on multiple fronts will directly or indirectly affect the performance of companies in their portfolio. Admittedly, agreements are expected to be reached and the chance of any real trade disruption is considered small. However, the chance for potential trade disputes now stretches beyond China.

Trade war unlikely. Despite all the noise and actions around trade, tarrifs, and rising protectionism, analysts are not expecting a true trade war to break out - at least not yet. However, there can still be ripple effects across the global economy. The analysts in this article by Bloomberg expect the real effect from recent actions to affect business confidence.

Treasuries. US Treasury Yields rose sharply several weeks ago, crossing above the all-important 3% threshold before falling as geopolitical tensions rose. Remember that Great Money Printing Experiment? Investors who were forced further and further out on the risk curve could start to reconsider their personal capital allocations as that Treasury yield gets higher, causing funds to flow away from the equity markets. When the seas rise, most boats also rise with it. When the seas fall, quality in specific sectors is revealed.

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Following up and filling in the blanks

Guilty as charged. Back in February, The Ignorant Investor talked about the unknown VIX whale that made a real killing (to the tune of $200M) after volatility returned to the markets. The whale has now been identified as Goldman Sachs- read more at Marketwatch. Some individuals at the GS trading desk can look forward to a nice fat bonus after that result!

CRISPR and cancer. Related to our April post, several studies just published in the respected Nature magazine indicate that gene editing with CRISPR could possibly cause cancer. This unexpected news has caused the stock of some drug discovery companies in the space to start on what may be a wild ride. The New York Times has a great article on the this issue.

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Market developments have been coming fast and furiously over the past four weeks. The Ignorant Investor plans to post more frequently going forward, perhaps two or three updates per month depending on news flow and personal scheduling.

Sell in May and Go Away? Off to Singapore then!

The Ignorant Investor treats the "Sell in May" adage as simply an old saying, and not something to be followed or seriously considered. In fact, so far this year, The Ignorant Investor has remained almost fully invested in the markets while treading carefully around geopolitical and trade developments.

Not vacation, per se, but for now The Ignorant Investor is keeping an eye on a plethora of indicators from the visually stunning and relaxing city of Singapore. Markets are moving and many exciting events (for investors) have been taking place worldwide. Meanwhile, if you're a equities trader in the USA, my congratulations!

Gene Therapy: Just One Small Corner in the Complex and Confusing World of Drug Discovery

Biotech companies are widely expected to outperform many other sectors in the face of international trade AND inflation risks. This article will focus on biotech companies working on drug discovery using gene therapy treatments.

Drug discovery primarily falls to small companies under the biotechnology label and larger Pharmaceutical companies. This means that drug discovery is ultimately within the arena of the Pharmaceutical Industry, which is located within the Health Care sector.

Today we venture into the bowels of the stock market to a world that is oft-likened to the casino of stock market investments. Drug discovery has changed. The industry has shifted and transformed significantly over the last twenty years. The responsibilities of drug discovery, once confined to the heavily capitalized and often “wasteful” (ie inefficient) laboratories of Big Pharma (think Pfizer, Novartis, Eli Lilly, Merck, and the like) has now been relegated to lean, startup-esque companies focused on ONE drug or therapy; these tiny companies burn through cash – often tens of millions of dollars per year – and they either sink or swim with the success or failure of their tests. Many of the initial workers at these companies will see their hard-earned stock options either make them millionaires or expire worthless.

Public investors in a biotech company’s stock move in AFTER private money (ie venture capital) has already been present for some years. These initial backers will get a portion of their money back and more at the IPO, while passing some ownership and associated risk out to public investors who choose to partake in the venture. These public investors will now also have the potential for outsized gains or crippling losses.

A land of speculators (ie clueless retail investors), smart institutional investors, and savvy market-manipulators, many seasoned investors prefer to simply gain exposure to the sector through blanket exchange-traded vehicles (baskets of the individual companies, if you will, matching the "diversification is good" mantra touted by advisors). During boom times, this is indeed the safest avenue to gain alpha while protecting initial capital (risk first, reward second - ceteris paribus - as any good advisor will be sure to say).

But what about those analysts and institutional investors who specialize in public drug discovery companies? These have access to resources well beyond the scope, scale, and scientific prowess of the average investor (remember, these investors – as well as most good investors – will also implement a solid hedging strategy to minimize risk exposure from outsized holdings). Indeed, even with access to these resources, these investors sometimes experience staggering losses, since no one can protect against the fact that a drug may fail at any point during testing, even prior to going before the all-important and all-powerful FDA approval committee.

Therefore, retail investor, beware! Dreadful monsters lurk here. This world is rarely the right place for you.

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That being said, Gene Therapy has been HOT this past year and high-quality companies located within the space have benefited from some solid test results and major acquisitions.

About Gene Therapy. Many diseases exist or occur today because of problems with DNA imperfections. Whether from genetics (hereditary) or otherwise, some diseases could in theory simply cease to exist if some genes were slightly modified. Or perhaps with some slight alterations your body’s immune system could be directed to attack cancer cells. In search of these objectives, two methodologies are being pursued with Replacement Gene Therapy: using viral vectors (ie CAR T-cell therapies; remember how Gilead acquired Kite Pharmaceuticals last year? Article by Forbes) and utilizing CRISPR technology, which is used to edit genes by DNA insertion.

Gene Therapies: Read about the science behind viral vectors and their uses in gene therapy from the journal Nature. Read about the science behind CRISPR technology from Live Science 

Just yesterday, Novartis announced that it is acquiring clinical-stage gene therapy company AveXis for $8.7 billion, nearly 90% above its previous closing share price. All this for a company that doesn’t yet have a treatment that has been approved by the FDA (approval is NOT a guaranteed outcome, we must also note). The company has been working on treatment for spinal muscular atrophy in infants, an often-fatal condition. This also follows Novartis acquiring rights to Spark Therapeutics’ gene therapy treatment for a rare hereditary eye condition that leads to blindness (in this case, the therapy has FDA approval).

A very thorough, in-depth overview of companies in the biotechnology space that are experimenting using gene therapy treatments can be found at Barrons. Great article that covers some of the technology behind gene therapy, how it is currently being applied, and which diseases are being targeted by various companies. Read article here: https://www.barrons.com/articles/gene-therapy-is-nearing-a-major-breakthrough-1506140340

Replacement Gene Therapy shows great promise for treating difficult and deadly conditions worldwide. One primary target (outside of oncology) is treatment of hemophilia (think recent Juno and Bioverative acquisitions by Sanofi and Celgene). Novartis’ latest acquisition continues its own buildout into Gene Therapy. Big Pharma is moving, and the Big Question for investors is, who’s next?

Of Trade and Rumors of Trade Wars

US equity markets have embarked on another wild ride as investors responded to the rising spectre of a potential trade war. President Trump recently enacted tariffs on steel and aluminum imports and targeted China with about $60 billion in additional tariffs over "intellectual property" theft. Ultimately, analysts - and as of yesterday, the broader markets - are assuming this is simply a calculated move to bring China to the negotiating table to discuss trade issues. For Trump, the biggest problems with China seem to revolve around intellectual property theft (as previously stated), cheating on trade conditions, non-reciprocity of access to Chinese markets for US investors, and contributions to the USA trade deficit (mostly good points to be sure; only the last one confuses TheIgnorantInvestor since a trade surplus or deficit merely indicates the direction of flow of goods and services, which China can't be blamed for).

Where do goods enter and leave the United States? The main throughways for trade with the United States are typically shipping ports and large airports (yes, of course LAX makes the list): details for 2017’s top 10 throughways can be found here: https://www.forbes.com/sites/kenroberts/2018/02/27/the-top-10-airports-seaports-and-border-crossings-for-u-s-trade-in-2017/

The USA was the world’s largest trading nation (which alternates with China) with $3.7 trillion in goods traded in 2016, followed closely by China’s $3.68T (WTO). Simultaneously, China recently supplanted Canada as the USA’s largest trading partner. Add to this fact that China holds more than $1.2 trillion in US Treasuries, and one might almost say that we either sink or swim together. The possibility of a trade war between the USA and China would be disastrous for both countries, although China would be expected to be slightly more resilient (the average US consumer would not be a happy camper to pay higher prices across the board for goods).

The top five trading partners for the US, in order of dollar-denominated trade size, are: China, Canada, Mexico, Japan, and Germany (US Census). Check out a comprehensive breakdown of 2017’s Top 10 US Trade Partners here: https://www.forbes.com/sites/kenroberts/2018/02/28/top-10-u-s-trade-partners-in-2017-can-be-broken-into-three-tiers/

Plenty of words and some random facts set the stage for the question: where should an investor invest in such an environment? The probability of full-blown trade war is considered small, with China exercising restraint and both sides meeting up to discuss their respective differences. Sometimes news headlines can be very distracting (Facebook, anyone?), and so, when big issues arise and with limited resources at the average investor’s fingertips, it can be helpful to read what analysts are projecting, and what the equity market is actually doing. Examining sector and sub-sector sensitivity to anticipated changes can be very helpful.

How have various assets and asset classes performed since talk of a trade war began nearly a month ago? Nice breakdown with a beautiful illustration provided by Bloomberg in an article here: https://www.bloomberg.com/news/articles/2018-03-26/the-market-is-already-picking-trade-war-winners-and-losers

The Good
Technology would be expected to continue to outperform, since tariffs are difficult to implement against them and they tend to have solid balance sheets these days. The old 2016 Trump-trade of Financials would also be expected to perform just fine (banks, rising inflation and interest rates, anyone?). Health care could outperform. For health care, biotech companies involved in drug research and development are particularly resilient to external (international) pressures.

The Bad
Immediately what comes to mind is that retail (stores that sell clothing, furniture, etc), large multinational industrials, and the automotive industries could easily be hurt by rising protectionism. Domestic production with exposure to raw materials that the US is raising tariffs on would also be expected to see margin pressures. Even emerging market economies with exposure to the USA could be negatively affected. China could also respond to rising US tariffs by targeting Trump’s political support base, in which case agriculture companies and companies with sensitivity to agricultural companies (supplying tools, chemicals, etc) could also be affected.

The US is the world’s largest soybean producer, and China is the world’s largest soybean consumer (article by Reuters): https://reut.rs/2ueeswV

The Verdict
Remain vigilant! On the one hand, earnings season is just around the corner with a strong performance widely expected. On the other, many sections of the US equities market hit correction territory after last Friday’s sharp selloff; the S&P 500 itself hit its 200-day moving average before Monday’s sharp rebound (ie technicals are vulnerable). Staying involved in “safer” sectors (inflation and trade war resistant) could turn out more ideal as the market remains on shakier ground. Finally, remember Treasuries? China holds more than $1 trillion of them. Smart money seems to be treading carefully around that fact.

Bipolar Markets: What Has happened and was it predictable?

Let's take a step back and look at the initial trading days that led into the recent market moves. Note that the VIX, as mentioned in The Intelligent Investor's previous post, had been hovering near historic lows for a very, very long time.

Then, very quietly on Friday, February 2nd, the market began to decline, recovering slightly before gradually and relentlessly declining until the market closed. What was unusual was that roughly 90% of stocks fell, with 90% of the selling volume going into these declining stocks- a rare occurrence with falling demand and rising selling pressure.

Monday, February 5th, opened down slightly and remaining roughly flat before beginning its own relentless decline at midday, a decline that accelerated into market close, with the S&P 500 falling a sharp -4% on the day. Simultaneously, the VIX jumped a whopping 115%. The market, as discussed before, had become quite complacent with many traders ill-prepared for the sharp rise in volatility.

Let's pause a moment there. Volatility blowing up triggered some margin calls and roiled ETNs that attempted to track the VIX's movement. One result of such a violent VIX move was that the small Credit Suisse ETN VelocityShares Daily Inverse VIX (ticker XIV) blew up, falling -80% on the day and becoming totally worthless by the next. Vehicles that attempted to track the VIX also had to make outsized futures' purchases to play catch up.

What happened with the "50 cent" trader's massive (and up until that point, down $200 MILLION) bet for a higher VIX? Read about that here: https://www.bloomberg.com/news/articles/2018-02-12/-50-cent-vix-trade-just-paid-off-to-the-tune-of-200-million

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From Friday's decline and the week of February 5th, the S&P 500 plunged a total of about -8%. Then, this last week of February 12th, the S&P 500 reversed and climbed a total of +4.3%. But the big question is where do we go from here?

While nothing in the world of equity market can be certain (except that, all else equal, a long-term buy-and-hold strategy of the market will always win), understanding the cause of the market decline would help investors decide if they want to trim, maintain, or increase their equity holdings.

More aggressive interest rate hikes (we have a new Fed Chair!) and the spectre of inflation (after all, Friday February 2nd's decline didn't occur until evidence of wage pressures occurred in economic data) have been noted as potential - and inter-related - catalysts. Volatility has been really way to low and the market way to complacent recently as well. And then of course, Treasury yields (10-year, but why not the 5-year? See article below) has been rising rapidly and relentlessly too. And Technicals had also been indicating the market was moving ahead of itself, so perhaps this was only a technical correction.

Treasuries and how they can help us interpret how equity markets might behave (a great article): https://www.barrons.com/articles/bonds-behaving-well-a-tale-of-two-markets-1518234370

We can be certain of one thing: the market is behaving more like it has behaved historically, which indicates that volatility may now be here to stay. If that's the case, perhaps quality is now a trait that investors would do well to pay attention to!

Volatility is Low – Very Low

Earnings season is now off to a very solid start following very strong gains in the equity sectors since the start of 2018. While US Federal Reserve interest rate hikes have been a tremendous benefit to the financial sector following years of quantitative easing, the continued and unabated advance of the equity bull market has also continued to cut into fixed-income and bond trading revenue.

One byproduct of volatility remaining near historic lows has been a steady decline in active trading as funds have flowed into ETFs and other passive investment vehicles. In other words, a cycle may have developed. As the perception of risk has decreased, use of passive investment vehicles has increased. This in turn reduces active investment, then contributing to a reduction in volatility.

Of course, the actual cause for the complacency in the markets could also be caused by the recent switch to algorithmic trading strategies, which can remove the human “emotion” element that may have contributed to volatility in the past. However, most agree that the current environment has been dramatically affected by years of easy money with investors moving further out on the risk curve in search of yield. Should corporate earnings or the policy of easy money be reversed (as has begun by the Fed raising interest rates), investors may soon find that this 9-year bull run is nearly over.

A very pertinent article on this topic, accompanied by commentary from various analysts and other experts, can be found on Bloomberg: https://www.bloomberg.com/news/articles/2018-01-19/why-is-volatility-so-low-some-see-crowded-trades-minsky-moment

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The Ignorant Investor really struggled at finding just ONE topic to comment on at this time, with potential subjects across equity markets, commodities, and currencies. Exciting times!
 

A Year in Review: The Old Bull Lives!

The eight-year old Bull Market

Let's all applaud this aging bull market! The numbers are remarkable. Eight years, fresh new highs for all major indexes, and the triumphant S&P 500 advancing a staggering 19.4% in 2017.

But wait, there's more! The Dow Jones Industrial Average outperformed the S&P 500, rising 25.1% during that same span. Not to be outdone, the Nasdaq outperformed all other major indexes, rising 28.2% (and up in eleven of the twelve months of the year). 2017 was a GREAT year to be in stocks. And in a vote of confidence in the oil markets, NYMEX WTI prices closed over the $60/bbl mark for the first time since mid-2015 in the final days of 2017. Speculative positions in Bitcoin were even more rewarded, with Bitcoin rising 1,221% year-on-year.

2017 was full of geopolitical uncertainty, with equity markets largely held hostage by the spectre of something the GOP called "Tax Reform." In a step towards a concrete accomplishment for President Trump, the corporate tax rate was reduced and the individual tax code simplified in a final vote by Congress and the White House just prior to Christmas.

Quick recap of the US stock market in 2017: https://www.nytimes.com/interactive/2017/12/31/business/A-Big-Year-for-the-Stock-Market.html