Capital Market Comment
February 12, 2018
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
The derivatives, quant models, program trading, algorithms, robo-trading, leveraged hedge funds – the mindless computers – played havoc with the equity market thus far in February. The “creative destruction” products of Wall Street are giving investors (if you can call them that) a huge expensive hangover. An example of a ridiculous concoction that was created by the great minds of Wall Street is the “velocity shares daily inverse VIX futures short-term exchange traded note (XIV)”. What does all that mean and how does it work? If you understand it, please explain it to me. The name alone is enough to make anyone suspicious. In the end, puncturing the balloon of these ridiculous products should prove beneficial to the market. However, in the coming weeks, the effect of the market’s recent decline and the increased volatility on the multitude of these derivative products will be seen. The failures will be reported in the media and should include hedge fund losses, closures, the mispricing of various derivatives, and the losses they have generated. Quant model failures will be discussed, and excuses will abound. Through all this tumult, what has really changed? The dominant factor has been psychology, the shifting expectations associated with it, and the demise of a plethora of highly disconnected derivative products.
Once we sort through the rubble, we suspect we will find little has changed on the fundamental front and only the fear of what could happen has gripped market participants (not necessarily investors). As we wrote in our February 6th commentary, revenues and profits are favorably positioned to expand over the next several years. Moreover, the reduced corporate tax rate from 35% to 21% places greater ownership of many public companies in the hand of each shareholder. This reduction may not be fully understood at this time, but is quite profound. Moreover, the continued liquidation of stocks through buybacks and mergers & acquisitions puts shareholders in an even better position. If you add the repatriation of funds, the debt to equity construction of the balance sheet will change in a more efficient way.
On the monetary front, the uptick in interest rates should be of no surprise to investors. Maybe the “momentum herd” and the inverse VIX players chose to ignore it, and thus suffered the consequences.
The 10-year Treasury at 2.85% should hardly be devastating to the equity market. 80 basis points for the 10-year German bond and 8 basis points for the Japanese 10-year bond offer little competition. The recent pullback in the equity market places the yield on the S&P 500 at an attractive 2% and moves the price/earnings ratio estimate to 17 times earnings or an earnings yield of 5.8%.
The narrower spread between the 10-year Treasury and the S&P yield is constructive, particularly given the expectations of continued dividend growth. The recent move in interest rates has steepened the yield curve, pushing expectations of a recession further into the future.
The apparent shift in inflation thinking and the realization that the Fed might achieve its 2% target (something it has not done for the last eight years) has some market participants concerned. This prospect poses a real threat to long-term bond investors but is not particularly a detriment to equities in the first phase of rising inflation. In fact, higher inflation is a benefit as pricing power returns. What can prove problematic is the Fed’s response, and that remains to be seen. It may be the first time it achieves its goal, and tolerance maybe the first order of business. Consequently, the monetary authorities may not overreact. At the moment, a lot of speculation exists and will persist; but the fundamentals will dictate, and they have improved.
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors. If you have a question or need further information, please contact:
Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, or firstname.lastname@example.org or
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or email@example.com.
© 2018 Mastrapasqua Asset Management, Inc. All rights reserved.
The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.