Don’t Turn Out the Lights – October 2018

One of the most important lessons I learned investing, is to stay calm and focus on the long term regardless of how rocky the markets can be.

The markets, meaning the stock market and the bond market, have been quite rocky lately.

Stock prices, as measured by several indices are down this year. The Dow Jones Industrial Average has returned -0.10% (10 basis points) year to date. The Standard and Poor’s 500 has returned -0.60% (60 basis points) year to date and the Russell 2000 is down -1.60%.

What this means is that in 2018, the return on stocks is slightly negative. Don’t panic. Stock prices can be hugely positive one year and negative the next. By the end of this year returns could be positive. For a long-term investor, it is the average annual return over time that is important.

Bond prices are down because interest rates have gone up. Interest rates have gone up because the Federal Reserve is implementing a monetary policy tool (raising interest rates) to “slow” an economy that might be growing at a rate that, in the future, could cause inflation.

The impact of monetary policy and the decisions the Fed makes today, play out over time. The Fed is basing their decisions on surveys and data, basically backward-looking information. They are not making decisions based on what is happening in the stock market or the bond market today.

What is happening today is market misbehavior. Financial pundits and economists are all looking for “the reason” the markets are misbehaving.

The reason market misbehavior is hard to pinpoint is because it is never ONE reason.

Recent headlines point to the following three factors for the gyrations in the stock and bond markets:

• The Trade War
• Rising Interest Rates
• Corporate Earnings

What I think about is: How are these three factors related?

Underlying factors that move the market do not happen suddenly. Changes in the economy do not happen suddenly. Don’t change your long term investment strategy based on the daily news.

The Trade War:

The problem with an escalating trade war is that companies are forced to prepare for a worst-case scenario. Here is an example of how things can go wrong:

The lightbulbs in the ceiling of your office go out. Someone calls maintenance to replace the lightbulbs. Except, the lightbulbs needed are imported and now have a tariff. They cost 20% more than they used to.
What does the lightbulb company do? Do they pay the higher price to import lightbulbs and then pass on the higher cost to you? Or do they absorb the cost to stay in business, unwilling to increase prices.

Corporate Earnings:

When prices go up for mundane things, like lightbulbs, the increase in price is known as inflation (The Fed is the official inflation fighter).

If the lightbulb company does not pass on the cost to the consumer, the earnings of the company decline as they absorb higher costs.

Investors (shareholders) get nervous about the prospects of the lightbulb INDUSTRY and start selling the stock of every lightbulb manufacturer.

The price of lightbulb stocks takes a nose dive. The lightbulb company has not decided how to handle the increase in prices, but investors are anticipating what could happen and are driving stock prices down.

The anticipation of higher prices (inflation) and lower earnings becomes a downward spiral for the lightbulb company.

Rising Interest Rates:

The Federal Reserve is responsible for controlling inflation. One of the tools they can use to control inflation is to increase or decrease interest rates. Currently the Fed is increasing interest rates because they anticipate a strong economy. A strong economy can lead to inflation.

With rising interest rates, it now costs more to borrow money for a home or a car (this is one way to slow down an economy), but it also means that short term interest rates are high, and (spoiler alert) you will be paid a higher rate of interest than we have seen in years, to invest in bonds.

It will also cost more for the lightbulb company to borrow money. Now the lightbulb company is faced with higher interest costs AND paying more to import lightbulbs. Double Trouble.

So, think about the millions of light bulbs used in office buildings. Or the little lightbulbs that are now being wrapped around skinny little trees with no leaves in New York City.

You can’t imagine a world without light bulbs.

The combination of tariffs, higher interest rates and the impact of corporate earnings on stock prices is a nasty trifecta. All three factors point to slower, not higher, growth.

I was in New York City during the blackout of 2003. The reason for the blackout had nothing to do with lightbulb prices but I do not want to find myself sitting the dark because lightbulbs are yet another casualty of a trade war.

The United States International Trade commission has a nifty 900-page guide to the Harmonized Tariff Schedule. Yes, it is called the Harmonized Tariff Schedule. It sounds so, harmonious, considering the disharmony in the world of trade.

If you are in the mood to torture yourself with data, here is the link to the Harmonized Tariff Schedule: https://hts.usitc.gov/current.

The code in the schedule for lightbulb tariffs is: 8539.22.8060

My Modest Prediction:

Escalating Trade War + Rising interest Rates + Decline in corporate earnings = a slowdown in the economy. Not today or tomorrow but first half of 2019.

Unless:
The Trade War ends (not likely), The Fed stops raising rates (more likely) and corporate earnings improve (it’s quarterly data so we won’t know right away).

What can you do with this information?

I think it is time to invest some, not all, of your cash in short term Treasuries.

If there is a company you are interested in, and the stock price has declined recently, it might be time to buy a FEW shares. Not more than 1-2% of your portfolio.

I am going to be looking at lightbulb companies.

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.