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SHOULD WE FEAR AN INVERTED YIELD CURVE?

Summary Points:
  • The Federal Reserve pursued a zero interest rate policy from December 2008 until December 2015 when it raised the target Fed Funds rate to a range of .25-.50%. The next 25 basis pointincrease was a year later and since then there have been five more quarter point increases. Today the target range is 1.75-2.00% and the market widely expects another increase thismonth.
  • The Fed controls the short end of the yield curve through its Fed Funds targets. On the other hand, the market largely determines the yield on longer maturities. Those rates haverisen as well, but at a far slower pace, causing the yield curve to become nearly flat. Many commentators extrapolate this trend to anticipate an inverted curve where short ratesexceed long rates. Historically, inverted yield curves in the United States have been followed by recessions and stock market losses.
  • Flat yield curves can persist for a long time before inversions occur. 1995-1999 is one such example. For five years there were many faulty predictions of the next recession and bearmarket.
  • The yield curve is not like a compass that independently points to growth or recession. The Fed controls the arrow, either lowering rates to stimulate or raising rates to slow inflationor cool an overheating economy. Market forces including massive demand for high-quality, longer duration bonds around the world may invert the curve, but that is no certain signalof recession or stock market retreat.

FURTHER COMMON SENSE THOUGHTS ON TRADE

Summary Points:
  • After World War II there was a gradual acknowledgement of the gains from global trade. It was only after 1984 that there was a rapid expansion of regional agreements. The globalfinancial crisis put a severe dent in the progress, and subsequent populist movements, like the Brexit vote in the U.K., signaled the first meaningful signs of actual retreat.
  • Last month's Offit Capital Commentary discussed the importance of trade to the advancement of the global economy. Beyond the strong case for freer trade, however, liesthe reality that tariffs and other trade restrictions are often politically attractive. The changing shape of trade makes these debates particularly complicated because winnersand losers are not always easily identified.
  • The rising tide of global growth in trade and national incomes has not raised all boats.
    Those left behind have shifted the debate to put freer trade on the defensive.
  • Economic growth is not automatic. Technological change and population growth are essential ingredients. As a result, restrictions on the flow of goods, services and humancapital all work against broad economic progress. Public policies to retrain displaced workers can focus on alleviating any negative factors that might arise from trade andimmigration. We should work hard to not throw away many of the benefits of economic growth that we sometimes take for granted.

SOME COMMON SENSE THOUGHTS ON TRADE

Summary Points:
  • Trade is fundamental and essential to economic progress.
  • Trade deficits are more a result of the economic cycle and less the cause of it. A strong U.S. and global economy typically leads to U.S. trade deficits.
  • Trade today is vastly different than it was 50 years ago featuring many more services and intermediate factors of production versus the traditional concept of trade in finished goods.
  • As long as the United States dollar is the preferred reserve currency of the world, a trade deficit is required to supply that currency to everyone else.

THE CALENDAR SHOULD NOT MATTER – BUT IT MIGHT

April 01, 2018
Summary Points:
  • There is a long standing debate between traditional and behavioral economists as to how far from ideal markets really are. The traditionalists argue that in general there should be no simple trading rules that produce extraordinary returns. Behavioral economists argue that there are persistent psychological biases in humans that create such opportunities.
  • Few markets are as closely studied as the U.S. equity market. The general experience has been when “anomalies” have been identified in the market data, traders step in and any pattern disappears. This is what one expects when people learn through time and there are potentially great financial rewards for the quickest students.
  • Examining S&P 500 total monthly returns since 1950 suggests that where returns occur in the calendar may matter. If the year starts off on a positive note, as measured by performance across January and February, it seems the entire calendar year should be positive. Specifically, in the 68 years examined, there were 42 times where the first two months cumulatively were positive. Without exception those 42 years ended up with gains.
  • Investors may indeed be influenced by the psychology of a good trading start to the calendar year, but this result may just be the result of luck in a generally upward trending market. 2018 will again test this trading rule. Remember that past performance is most certainly not a guarantee of future results.

THE DARK SIDE OF VOLATILITY

March 01, 2018
Summary Points:
  • The sudden spike in volatility in the first week in February should have reminded everyone that market risks never leave the stage permanently. With the rapid rise in trading products based on VIX, an additional dynamic has been introduced. Rapid trades in one area like volatility-backed ETNs are quickly translated back to VIX futures and options contracts and then back to the S&P 500 options and ultimately the stock market. This seems to be a case where the volatility tail wagged the stock market dog.
  • Exchange-traded options on individual stocks began in 1973 at the Chicago Board Options Exchange (CBOE). A decade later the first index futures began trading on U.S. stocks with index options following shortly thereafter. These simple tools continue to be effective in managing risks inside equity portfolios, but they have spawned activities that have little to do with anything but short-term trading.
  • The VIX is the most popular measure of stock market volatility, being based on the implied volatility of S&P 500 Index options. Once it was simply used as an indicator of market conditions, like temperature or wind speed. In 2004, VIX futures were introduced by CBOE and two years later options were introduced. These products made it easy to trade volatility directly. They also allowed the creation of Exchange-Traded Notes (ETNs) and structured products that are sold to the public.
  • Most investors don’t understand the basics of options and how they translate into VIX. That has not stopped billions of dollars from being invested into VIX-based products, betting on either increases or declines in market volatility. From the perspective of long-term investors, these products have always been fundamentally deficient. Market events in early February brought these flaws into focus. Sadly the tuition paid by the owners of these instruments to learn about them was quite steep.
  • Volatility should be managed through proper portfolio construction. Attempts to enhance returns by selling volatility and collecting implicit option premiums often disappointment. Retail-oriented products on either side of the volatility trade always come with careful disclaimers about how they might behave. It is time investors start taking those cautions seriously.

THE TAX CODE AND THE GLOBAL STOCK MARKET

February 01, 2018
Summary Points:
  • Late in December the President signed new legislation that affected many parts of the personal and corporate tax codes. By far the most significant change was a radical restructuring of corporate taxes that brought the United States into conformity on territorial taxation while slashing the top corporate tax rate.
  • For many years the United States pursued a policy of trying to tax U.S. corporations on their world-wide earnings in contrast to virtually every other country that taxed only the income generated in their jurisdiction. The U.S. approach mainly encouraged the establishment of foreign based entities and the sheltering of global income, usually in lower-tax countries.
  • As more investment and earnings by U.S. corporations occurred offshore and beyond the reach of the IRS, foreign-sited cash hoards grew, discouraging easy reinvestment at home. While this backdrop was in place, many other developed countries systematically lowered their corporate tax rates, putting additional competitive pressures on U.S. companies wanting to invest at home.
  • There is no way to precisely estimate how much the out-of-sync U.S. corporate tax code cost the country in terms of investment, growth or job creation, but directionally the effects seem clear. The new tax code not only brings the U.S. into conformity in terms of what income is subject to tax, the 21% marginal tax rate is now near the lowest among developed and major developing countries.
  • The U.S. marched to the beat of its own drum for many years, effectively advantaging other nations around the world. Now it has set the cadence for the entire parade. It is likely that more corporate tax rates will come down around the globe in an attempt to offset any new U.S. advantage. If that happens it will translate widely to more growth and earnings.

BITCOIN REVISITED

January 01, 2018
Summary Points:
  • Bitcoin and other cryptocurrencies cannot presently be considered viable substitutes for traditional money because their price variability makes them impossible to use for routine transactions and they cannot be considered to be a dependable store of value. They are trading instruments.
  • Since we last wrote about bitcoin in 2013, its price has gone up 18x, and more than a thousand new cryptocurrencies have been introduced. While the supply of any single digital asset, also called coins or tokens, may be fixed, there is no limit to how many such products can be created cheaply and brought to market.
  • Governments around the world are starting to wake up to various issues ranging from the uncontrolled flow of capital, tax evasion, circumvention of anti-money laundering and know your customer laws, and soon the ability to get around international sanctions against countries like Venezuela and Russia.
  • Nobody knows how these cryptocurrency markets will evolve in the short run. They are created by people trying to exploit the psychological allure of easy wealth, and like all such schemes through the ages, they inevitably disappoint. When we are no longer talking about cryptocurrencies, we shall likely be benefitting from real advantages from blockchain innovations that will touch many other parts of our lives.

UNINTENDED CONSEQUENCE OF ULTRA- LOW INTEREST RATES

December 01, 2017
Summary Points:
  • The long economic recovery since the financial crisis has not uniformly lifted all corporate boats. A historically high percentage of small cap public companies are not profitable and have not been for many years.
  • The policy of near-zero short-term rates in the United States, Japan and Western Europe has distorted yield curves around the globe. Unsurprisingly, many corporations have taken advantage of this and added to their debt burdens.
  • Not all of these companies have great business models or prospects, but the availability of easy credit has allowed these companies a much longer runway toward hoped-for success. In some cases this just delays the inevitable failure.
  • As interest rates rise, some of these companies will be unable to sustain their losses and will fail. This will have two major implications. It will likely usher in opportunities for a new profitable distressed debt cycle. It should also prove to be fertile ground for active equity managers versus passive investing where all names are purchased indiscriminately according to their current market weights.
  • None of these risks would appear imminent. Economies around the developed world are expanding in a coordinated fashion for the first time in over a decade. Central banks are still accommodating and as a result liquidity is plentiful. The table is getting set, however, for the next cycle and each of these trends warrants close scrutiny.

UNCERTAINTY AT THE FED

November 01, 2017
Summary Points:
  • The Federal Reserve began raising policy rates from a long-held zero base late in 2015, paused for a year, and then resumed the process into 2017 with three more 25 basis point increases. The market widely expects another 25 basis point hike in December. Public communication from the Fed suggests more hikes are planned for 2018 and beyond.
  • Complicating this picture is the possibility of a new Chair in February when Janet Yellen’s current term expires. There are also currently 3 unfilled slots on the Federal Reserve Board and Federal Open Market Committee (FOMC), making today’s forecasts from the board and district bank presidents subject to considerable change.
  • No matter who becomes the next Fed Chair, chances are good that policy making will continue to be carefully reasoned based on all the best available data and not a formulaic approach that would hamstring independent action by the FOMC.
  • The leading names discussed in public for the next Chair terms are serious economists and bankers, expert in monetary affairs, which should ease most fears in the stock market. They do, however, present different philosophies that could lead to varying emphasis between growth in GDP and inflation in forming monetary policy. It is probably a wasted exercise to try to position portfolios anticipating either tight or loose monetary policy starting next year.

HURRICANES, ENERGY PRICES AND INFLATION

October 01, 2017
Summary Points:
  • The cost in lives and the physical destruction from hurricanes Harvey, Irma and Maria have made 2017 a year for the record books for the people of Texas, Florida and the Caribbean. Our deepest sympathies go out to everyone affected.
  • Beyond the direct human and physical losses, such disasters also have an impact on key markets like oil and gasoline. Given the importance of the energy sector to the economy, it is natural to speculate how this will all play out in terms of growth and inflation.
  • With property losses in the tens of billions of dollars, there will be a meaningful spike in construction activity in the affected areas. The big question is whether at today’s low unemployment rate enough labor resources can be marshalled to complete the recovery work quickly.
  • The recent spike of August CPI to .4%, the highest since January, has prompted some to forecast a general up trend in inflation. While the energy sector has been disrupted, recent price action is likely to be temporary and reversed over the next several months. When inflation accelerates from its generally benign state, it will be from an expanding economy and higher wages.

HOW DO ACTIVE MANAGERS ADD VALUE TO THE INVESTMENT PROCESS?

September 01, 2017
Summary Points:
  • The debate about active versus passive investing is often carried out on a superficial statistical level where the focus is on who has earned higher returns lately. A more fundamental question should be how it is possible for active managers to add value.
  • There are only three broad avenues to added value: 1) having superior information; 2) seasoned judgment and analyzing public information with better models or technology, and; 3) managing investments with lower costs.
  • A fourth element of trading success comes from taking advantage of other participants in the marketplace who either fall prey to emotional mistakes or are forced into trades because of liquidity concerns. This is again judgment in the form of relative trading skill, which may or may not be repeatable in all environments.
  • When evaluating whether an active manager has a good chance of outperforming in the future it is critical to find the sources of past added value. It may never be possible to conclusively separate skill versus luck, but by doing a deep dive into past attribution and not relying solely on return numbers, investors improve their odds of associating with managers who have the best chance of long-term success.

THE MYSTERY OF WAGES UNRAVELED

August 01, 2017
Summary Points:
  • There is a mystery as to why wages appear to be growing more slowly than past recoveries given that unemployment is so low. Part of the answer lies in the composition of the official measures. The reported statistic gives the growth in the total wage pool. As the mix of workers changes either because of the economic cycle or demographic events like the retirement of peak earning baby boomers, the calculated average ebbs and flows in sometimes unintuitive ways.
  • The official wage numbers offer some insights into the state of the economy, but they need to be considered in conjunction with other data points like total employment and the demographic composition of the labor force.
  • Today’s real wage growth at roughly 2.5% per year is often cited as a disappointing statistic, but when combined with a growing, younger labor force it provides reinforcement for the belief that our consumer-oriented economy is on a steady upward path.
  • Someday there will be the next recession and another bear market in stocks. We just don’t know when they will occur. There are pundits who have been calling for both on a regular basis since 2011, and they have been very wrong. Given the strong labor market and rising real wages, the Fed is probably wise to be raising policy interest rates and planning to shrink its balance sheet.

UNRAVELING THE VIX MYSTERY, PART 2

July 01, 2017
Summary Points:
  • VIX, defined and described in last month’s Offit Capital Commentary, continues to be at historically low levels, but with a large spread between spot and forward values.
  • There are multiple ways to express an opinion in the volatility market. Professionals and retail investors alike can access S&P 500 options, VIX futures and a wide assortment of exchange traded notes (ETNs) that allow one to go long or short volatility. Each of these is connected back to the stock market through a web of professional arbitrageurs.
  • Basic option time decay allows option writers to earn the time premium on average. This truism plus quieter than average markets has encouraged more and more money to come into the short volatility space. This has lowered the price of S&P 500 options and suppressed spot VIX. It has also increased the risk of a snap back should these positions all try to reverse at the same time.
  • Long periods of quiet markets do not in themselves forecast a sudden jump in market volatility. What they do, however, is cause investors to diminish or eliminate their fear of market reversals. Writing options or trying to profit by being short volatility futures or ETNs is analogous to picking up nickels and dimes in front of steamrollers. Investors should never forget that there are always steamrollers someplace on the street and the aggressive investor will likely meet one when volatility spikes.

UNRAVELING THE VIX MYSTERY, PART 1

June 01, 2017
Summary Points:
  • VIX is the most widely followed indicator of stock market volatility, being based on the prices paid for S&P 500 Index puts and calls traded at the Chicago Board Options Exchange (CBOE). When writers of options demand high premiums to sell, and buyers are willing to pay up, VIX reflects this by increasing. Conversely, cheaper options produce lower values of VIX. Last month saw spot VIX drop below 10 twice, the lowest levels observed in over 10 years.
  • VIX is not like most government statistics, which look backwards and capture events that have already happened. VIX is determined on a moment to moment basis by buyers and sellers of S&P 500 options, which can be highly variable.
  • Spot VIX has very little predictive power for the direction of stock market changes in the short run. Time and again, history shows that VIX reacts to market moves. It does not predict them.
  • Investors should recognize spot VIX on any given day is of limited utility in guiding their decisions. A better indicator is forward VIX, which reflects opinions about time horizons and portfolio insurance choices more relevant to most long-term investors.
  • Traders can and do regularly influence measured VIX, and such trades may be more reflective of fund flows than they are fundamental volatility in the stock market. Next month we shall explore more deeply how trading in volatility based futures, options and exchange traded products may be distorting spot VIX and creating systemic forces in the stock market.

EQUITY MARKET VALUATIONS: A DEEPER LOOK

May 01, 2017
Summary Points:
  • Market commentators have for some time looked at the P/E ratio of broad U.S. large cap stock indexes like the S&P 500 and suggested that today’s near-record levels represent a severely overvalued market and a risk of a major correction.
  • Market averages by definition consist of potentially divergent sectors. Most of the times the differences are small and evolve gradually. The shock to the energy sector that began in 2015 was neither small nor gradual and it may have warped our impressions of the market as a whole.
  • Excluding the 7% energy sector recently from the S&P 500 Index creates a less dramatic picture of the general market. Stock market valuations have risen in the last few years, but the average stock is likely not as expensive as the total index would make it appear.
  • Index distortions can also come from specific stocks. If Amazon, which has a trailing twelve months P/E ratio of 183 and a weight in the S&P 500 of 1.6%, had an “average” valuation, the P/E ratio of the entire index would be another .3 points lower. The lesson is that these numbers can move around a lot and nobody should obsess over where the recorded index is today versus historical values that may have very little comparability.

SHOULD EQUITY INVESTORS FEAR HIGHER INTEREST RATES?

April 01, 2017
Summary Points:
  • The Federal Reserve pursued a zero interest rate policy beginning immediately after the financial crisis in 2008 until December 2015, when it started inching up policy rates. Since then there have been three rate hikes, totaling 75 basis points, with the Fed guiding the market that it expects further hikes this year and next.
  • Traditional wisdom says that equity bull markets don’t die of old age but are usually killed off by an aggressive Federal Reserve raising policy interest rates. Since December 2015 the S&P 500 is up over 13%, running counter to that traditional thinking.
  • Given current low interest rates, modest private leverage and inflation, and healthy but not stretched labor and stock markets, the course of rate hikes over the next year or two may not be terribly restrictive to the economy, corporate earnings or stock prices.
  • It is in fact possible that these policy rate increases will help the consumer side of the economy as savers earn more interest income which then gets recycled as additional spending. This force is particularly important today with an increasing number of baby boomers retiring and depending on such income to support their consumption.
  • There are always many factors that stock market investors should watch carefully, but rising interest rates today doesn’t seem to be near the top of the worry list.

GOVERNMENT DEBT: THE FORGOTTEN TOPIC

March 01, 2017
Summary Points:
  • The U.S federal debt over the last 15 years has grown steadily to a level relative to GDP not seen since the end of World War II. Near-zero interest rates have hidden much of the potential pain of this mounting problem.
  • Mandated entitlement programs, including Social Security and Medicare, will explode spending obligations in the future as more of the baby boomer generation move into retirement. Currently there is no plan to pay for these added expenditures.
  • The Congressional Budget Office projects that the ratio of debt to GDP will rise rapidly over the next 30 years. With that increase the percentage of federal spending devoted to interest on that debt will grow from 6% today to over 20% in 2046. There will likely be problems long before then.
  • Debt crises typically deteriorate quickly. Markets sense the inability or unwillingness to pay. Credit ratings tumble. The cost of new borrowing skyrockets. It is far better to address the debt problem now than to wait for a future critical moment that could threaten the stability of the entire world’s economy.

TAX RATES AND TAX REVENUES REVISITED

February 01, 2017
Summary Points:
  • As the new administration takes office there is considerable discussion surrounding reshaping U.S. personal and corporate income taxes. This discussion invariably leads to speculation about how any new program will impact tax receipts and the federal deficit.
  • There is no simple relationship between tax rates and revenues collected. Tax rates change incentives to work or invest, but many other features of the tax code are at least as important in determining economic activity and total revenue.
  • Every time there is a discussion of revising the tax code someone trots out the Laffer Curve to support or attack the proposal. The Laffer Curve has been around for over 40 years because it is one of the great generalizations in economics. It lacks, however, enough specificity to be of much use in debating among various tax plan proposals.
  • Whatever ultimately arises as tax reform in the new administration will matter. Early stock market returns suggest considerable optimism that the changes will be supportive to income and investment. It remains to be seen whether what results is as consequential as the Reagan tax reform from 30 years ago or as insignificant as virtually all the changes since.

PAPER MONEY UNDER ATTACK

January 01, 2017
Summary Points:
  • Around the globe, governments are implementing plans to remove the largest denomination notes from general circulation. This is done with the stated objective to curtail corruption and illegal activity. A less public motive is for central banks to try to shrink the liabilities that outstanding currencies represent.
  • At one end of the spectrum such plans merely stop issuing new notes. At the other extreme the retired notes quickly lose their legal tender status. When the latter approach is used in places like India and Venezuela great hardship befalls the poorest segments of society who have few resources but rely heavily on cash for their daily transactions.
  • In the United States the $100 bill is the most widely circulated note by a wide margin, growing more than fourfold in 20 years. Some of this may be due to the grey economy and illegal activity. Many of these bills find their way abroad to meet the cash demands in countries with less reliable currencies.
  • Radical currency exchanges and proposals to move to a cashless society may have reasonable motivations, but they have a darker side as well. Such moves always impact the freedom and anonymity of every citizen. Criminals and terrorists may have to work a little harder to keep their activities secret, but they have the motivation to do so. It is everyone else that pays the cost.

LABOR MARKET METRICS POINT TO ECONOMIC STRENGTH

December 01, 2016

INVESTING IN INFRASTRUCTURE

November 01, 2016

REGULATION CHANGES HOW WE INVEST CASH

October 01, 2016

SORTING THROUGH THE HYPERBOLE

September 01, 2016

WHAT WILL HAPPEN WHEN EVERYONE WANTS TO INVEST PASSIVELY?

August 01, 2016

CURRENCY AND THE EQUITY MARKETS: A COMPLICATED PICTURE, PART 2

July 01, 2016

CURRENCY AND EQUITY MARKETS: A COMPLICATED PICTURE, PART 1

June 01, 2016

PERSONAL SAVINGS: A BLESSING AND A CURSE

May 01, 2016

ETFS REVISITED: THE REVOLUTION CONTINUE

April 01, 2016

The Deep Freeze: Below Zero Interest Rates

March 01, 2016

Infrastructure, the Gax Tax and Politics

February 01, 2016

Housing and the Pace of Economic Recovery

January 01, 2016

What to Expect From the Next Phase in Fed Policy

December 01, 2015

The Return of Volatility

November 01, 2015

Chinese Currency Management: A Study in Contradictions and Challenges

October 01, 2015

The Productivity Puzzle

September 01, 2015

Official Active Management of Stock Markets

August 01, 2015

Overconcern About Bond Market Liquidity

July 01, 2015

The End of Zero Interest Rates; Maybe Not So Soon

June 01, 2015

October 2009 Commentary

May 01, 2015

ETFs Revisited

May 01, 2015

Market Volatility: Risk or Opportunity?

April 01, 2015

Inflation Measures: What the Fed Watches

March 01, 2015

Asset Allocation in 2015: Diversification Still Matters

February 01, 2015

What is Money?

January 01, 2015

Eyes on the Currency Market

December 01, 2014

Uncertainty and Market Volatility: the Case of Ebola

November 01, 2014

Hedge Funds: A Compensation Structure or Investment Strategy?

October 01, 2014

Global Forces at Work in the U.S. Treasury Market

September 01, 2014

The Changing Muni Bond Market

August 01, 2014

The Dynamic U.S. Oil and Gas Equation

July 01, 2014

Why Are Current Interest Rates So Low?

June 01, 2014

Are the Equity Markets Rigged?

May 01, 2014

Innovation in T-Notes

April 01, 2014

Tune Out the Noise

March 01, 2014

Stock Indexes Are a Portfolio Decision

February 01, 2014

Interest Rates Revisited

January 01, 2014

Bitcoins, Are They Really a Currency?

December 01, 2013

Uncertainty, Volatility and Rationality

November 01, 2013

The Cost of Protecting Your Equities

October 01, 2013

Bernanke-Speak and the Labor Market

September 01, 2013

Detroit Bankruptcy Opens a New Chapter in Municipal Bond Investing

August 01, 2013

A Changing Market Dynamic Is Impacting Volatility

July 01, 2013

The Many Nuances Around Inflation

June 01, 2013

Can One Predict Market Stress?

May 01, 2013

Market Bubbles

April 01, 2013

Real GDP and Stock Market Returns

March 01, 2013

Gold Revisited

February 01, 2013

The Mystery of the Shrinking U.S. Labor Force

January 01, 2013

Negative Real Interest Rates & the Allure of Equities

December 01, 2012

Housing and the U.S. Economy

November 01, 2012

How Big an Issue Is LIBOR Manipulation?

October 01, 2012

The Importance of Dividends in Today's Environment

September 01, 2012

China in Perspective

August 01, 2012

The Only Perfect Hedge Is in an English Garden

July 01, 2012

A New Source of Demand for U.S. Treasuries

June 01, 2012

Passive vs. Active Investing—A Discussion Without Theology

May 01, 2012

Natural Gas—A Story of Technology

April 01, 2012
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