Video Newsletters: Insights and Observations

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From Kevin Coyle and John Finley

  • August 2019

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    Kevin: Greetings. August 7th, 2019 market update. A little bit of a fun in the last week John?

    John: Volatility is back. We saw it in May, we're seeing it again now in reaction to the latest news from tariffs and our trade relationship with China.

    Kevin: So the market's down about 6% from the peaks over the last week. We had a similar kind of a decline in May, correct?

    John: Right.

    Kevin: Mostly related to tariffs in the China dispute. You know, just to put things in context , I mean the market being down 19% fourth quarter of 2018, we had a nice run up and through July of 20% or so. Volatility is back. Volatility normally comes from uncertainty. Correct?

    John: Right, right. And there is always going to be uncertainty, but markets tend to overreact. But it seems like the backdrop now is a little bit more, I would say cautious, look what the Fed did cutting interest rates and that was an “insurance measure” on their part to help sustain the expansion in the U.S.

    Kevin: So the bond market, if we turn to that for a second, you have another decline in the 10 year treasury. You have short-term rates in some circumstances being below the longer term rates. Oftentimes they say that's a predictor of recession, but a lot of that might have to do with currency flows, and negative interest rates in Europe, and money trying to find a place where it's getting a positive yield.

    John: Well, I also think it's a “fear trade” as well. I mean there's a flight to quality that drives bond prices up and yields down, so we're definitely seeing that now too.

    Kevin: Well you put that all together and you say, where are we at in terms of the economy in terms of earnings?

    John: Well, we're looking for a 2% of real growth in the U.S., which is subpar, but earnings were great last year related to the tax cuts. So now we're seeing year over year quarterly earnings on the S&P 500 maybe down 1%.

    Kevin: The market seems to be digesting that reasonably well in terms of understanding that comparison.

    John: Right.

    Kevin: So we're still really in the range of long-term PE ratios if you feel that the earnings are sustainable. Just putting it all together is there is a heightened risk, there is uncertainty. You've got things like Brexit. You have the economy having a prolonged expansion here, which people keep thinking it's going to end ultimately. But there doesn't seem to be any egregious signs of excess, but there's areas of concern or uncertainty which cause more volatility. And like we said before, in line with your overall objectives, it's a reasonable time to be reducing risk if you feel appropriate according to your needs.

    John: Well, there's also the backdrop of a slowdown in global growth, China in particular, so markets are watching that situation very closely. But I think businesses, business sentiment is also waiting to see how this is all going to play out before they make additional investments.

    Kevin: Right. So it's like cautious and patient kind of a sentiment, really.

    John: Yeah. Well, there are good things happening. Of course unemployment is very low. We have more people participating in the job market in the U.S. That's a backward looking indicator, but still pretty healthy. So we've got some good signs still out there that may be supportive of the market going forward, but certainly these clouds are beginning to develop.

    Kevin: Well then you got to go back. So the market will decline at some point in time for some reason, you know? The last one we had was over a 50% decline in 2007. It took five years and change for it to get back to its peak. Hopefully we're not looking at something like that. I don't think the comparisons really ring true in terms of the amount of leverage and debt in the system. But, as long-term investors, going back to our earlier point, is to be aligned with what you need to do. Have the appropriate risk on the table, any appropriate risk off. This kind of thing is going to be a discussion we're going to have on an ongoing basis for the rest of our careers, anyway. Until next time, enjoy.

  • May 2019

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    Kevin: Greetings. May 8, 2019, Market Update. A bit of a change since our last update in February. John maybe retrace our steps, fourth quarter of 2018 to now.

    John: Well, fourth quarter was ugly. We had the market's down almost 20%, but we're seeing a nice bounce back so far this year, almost 16% through yesterday. So that's being led by again, growth and, in this case a little bit more small cap, mid cap, than large cap, but still a growth story.

    Kevin: You have international behaving a little bit better, some signs of improvement there. But so we're 2% below the all time highs now, which was what established recently, 10 years or so, just about near the longest expansion ever. A lot of people will say that that's cause for concern. Just because it's an old rally, does it mean that we're at the final hour? Or what are the positive signs you still see out there?

    John: While I'm comfortable saying that we're in late stage of the cycle, but who's the say when the cycle's going to end? There's plenty of things underpinning the market that could cause us to think that it may have legs for a little bit longer.

    Kevin: Well, the feds backed off, so the market likes that. Volatility is decreased because of that. Earnings have been positive. Valuations, at least if you believe that the earnings are sustainable, are reasonable.

    John: Well, most stocks, except for the ones that have been leading the market, most stocks are down about 13% on average from their 52 week high. So it's still a pretty much a large cap growth tech story, that's been driving the market.

    Kevin: So you do have a concentrated rally still here and a slower growth environment, which we've had since 2007. That's normally the types of stocks that are going to behave better, are the stocks that have more visible earnings growth. But then you have more of your value plays, stocks that some of the stock managers we talk to where they are actually seeing valuations that are attracted to them.

    John: Right. Well, and from an economic perspective, we've got very strong employment, which is good when consumer's continuing to spend. That's also another supportive factor. There's plenty of things we can point to as being potential headline risk, certainly the tariff situation, Brexit, China, you name it.

    Kevin: Well, interest rates, wage inflation, things of that nature.

    John: Yes.

    Kevin: But in the meantime, steady as she goes. Well, you've talked about those risks and I think and as you go forward, certainly it's not a bad time if you need liquidity in the near future is trimming from the areas that have been going up and or adding to areas that have not been participating as much. My hindsight's 20/20, it's my foresight I have trouble with. And without further ado, I guess we'll hopefully see some warmer weather in Chicago and we'll be talking to you in August.

  • February 2019

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    Kevin: Greetings. John Finley, Kevin Coyle, February 6th market update. So we had a nice fun Christmas present Christmas Eve and since then there's been a bit of a change. John, a little bit of comment of fourth quarter and year-to-date market?

    John: Christmas Eve was the low point of the stock market since the all time high back on September 20th. We're down almost 20%. Since that time till now, we've recovered about 60% of that value back, and now it's more of the small cap stocks that are leading the way.

    Kevin: So you have more of a risk on. So it seems like the appetite for risk, high yield, small cap, emerging markets. The earnings backdrop, the economy?

    John: Economy's strong. We have still very strong employment situation. Hourly earnings are up over 3%. That's good for consumer spending. Maybe not so good for earnings for companies because now their margins are going to be squeezed a little bit. But we still have very low inflation, which is good. And then we also have the Federal Reserve kind of backing off, a little more dovish now.

    Kevin: The initial reaction to the Fed's raising rates seemed to be getting the market's attention in terms of declines. So now we kind have seen posturing that middle zone in terms of not too hot, not too cold in terms of backing off and earnings seem to be at least ... Earnings report so far and this month seemed to be positive as well..

    John: And just to set the expectations, last year had tremendous over 20% earnings growth. This year is going to be much more normalized. It's going to be in the single digits. That's not necessarily a bad thing. Studies have shown that when earnings come down from a high like that, the stock market actually tends to do pretty well.

    Kevin: Kind of like when the markets like a divided House and Senate, perhaps, maybe. Not too hot, not too cold. So you think about earnings, you think about where the markets were at when the market declined. A lot of comments that the valuations were relatively more attractive in terms of entry points in terms of risk management. But all things, you come back to the beginning which is the most important element, which is structure. So expectations as we go through this year and the importance of structure.

    John: Well, you look at the stock market over the very long term, even back to 1926, the return has been just under 7% nominal. The markets kind of ebb and flow, but that the channel has been pretty consistent. However, most of the returns, or at least two-thirds of the returns for most of that period, came from dividends. That's not true anymore. Now we would expect more of the return to come from capital gains than dividends.

    Kevin: So the importance of structure and having appropriate levels of risk and/or growth in your portfolio and being able to make sure you're comfortable with your volatility exposure, i.e., exposure to fluctuations when they happen, which they will.

    John: And you want an allocation to bonds to help be a ballast against that kind of volatility.

    Kevin: And, hopefully, warmer weather. We've gotten through the February period in Chicago. We're looking forward to spring around the corner. Days are getting longer. Until next time, enjoy.

  • November 2018

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    Kevin - Greetings, Kevin Coyle and John Finley, November 14th, market update. So, John we had an October decline which is not a great shock.

    John - October's the most volatile month on average and when there's volatility, stocks tend to go down. And stocks around the world went down in October, not just the U.S., down about 7%.

    In the U.S. value was down about four, and growth stocks were down about 9%.

    Kevin -So, year to date, we've had a couple of drops of plus or minus 10%, it seems to be in a trading pattern. The comment you made earlier though, when you look at the net returns year to date, plus or minus 3%, a lot of that is the growth component of the market.

    John - We still have large cap growth stocks leading the way, Amazon, Microsoft, Apple in particular, but for most of the other stocks are trading well below their all time high, 10%, even 20% below their all time high.

    Kevin - So, some of the value managers that you talk to are seeing some opportunities-

    John - Definitely. Yes, there's cheap stocks out there to be had.

    Kevin - We're also seeing the same thing in the international emerging markets significantly.

    John - Sure. Relative to the United States, valuations overseas are much more attractive.

    Kevin - So, a diversified portfolio year to date is not going to be showing the numbers that a portfolio that's concentrated in the index or concentrated in the growth stock area, because international emerging market's down, value is down, bonds slightly down. So, you're not going to see quite two to 3% across the portfolio structure, but you're seeing more of the opportunity, at least the managers are saying this, that you want to run in the areas that haven't seen the momentum.

    The bond market, any comments there?

    John - Still have a very flat treasury curve with the Fed on target to raise again in December, and probably a couple more times at least in 2019. Long end of the curve stays a little over 3% on the 10 year, which tells me that long term investors are not seeing inflation as a big risk right now.

    Kevin - Post election, the market seems to have digested that well, having a divided house in Senate normally is a positive thing, in terms of capping spending perhaps. Any other thoughts there as we go into the new year?

    John - Well, the economy is still very healthy, unemployment is still very low at 3.7%, the lowest it's been in 50 years, growth world-wide is slowing a bit, China in particular, but still 3.7% is the estimate for next year world-wide. So, profitability in corporate America is still very, very healthy.

    Kevin - So, maybe we get some positive news on the trade war front and tariffs if you will. So, stay the course. Until next time, enjoy. 

  • August 2018

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    Kevin Coyle: Greetings. Kevin Coyle, John Finley, Augusts 2018 update. Markets have almost recovered to their January of 2018 peaks.

    John Finley: We're up 7 1/2% overall in the U.S., and that's led by large cap growth companies again. Tech's up 12% this year, large cap growth companies up over 10%. Internationally, the story's not so good, down slightly negative in international developed and emerging markets.Kevin Coyle: So total return portfolio with some international emerging markets, bonds, and some of the tech, then you should be up around 2 to 3% so far this year. The earnings backdrop?

    John Finley: Earnings are strong. They're still, with 80% of the companies reporting, over 25% increase in earnings per share. Top line growth is good, year over year over 9% for S&P 500 companies.

    Kevin Coyle: So a lot of the talk has been this rally has been for so long, and the yield curve is bordering on inverting, with the short term being at 2 1/4%, the 10 year bond being around 3%. So even though people have been worrying about inflation, the bond market seems to be saying something different.

    John Finley: Yeah, we've got the Fed on one end, raising rates because of a fear of overheating economy, and inflation but they're doing it in a measured way. We expect them to raise two more times to bring the Fed funds rate up around 2 1/2%. The investors at the long end of the treasury curve however, the reason I think that the yields are still so low is that they're not convinced in that continuing growth story or that potential inflation story.

    Kevin Coyle: Now whether that leads to a recession remains to be seen. But with the global backdrop and generally the sentiment as well as corporate management seems to be positive as we move going forward. Tariffs?

    John Finley: Well, that's the big news item this year. It's creating a lot of volatility and uncertainty in the markets. Although the stock market so far in the U.S. has been kind of shrugging that off-

    Kevin Coyle: In earnings calls, management has been expressing that they felt that it's not material issue as well as that prices could be passed through.

    John Finley: Right. So, what will yet to be seen is a lot of saber rattling in the international arena, between the Trump administration and these other countries, especially China, which has considerably more to lose in a trade war-

    Kevin Coyle: Well, they export $500 billion to us and we export $175 billion to them. So they would seem to have more skin in the game, put this all together, cautiously optimistic as we move forward.

    John Finley: Right. I agree with that.

    Kevin Coyle: Midterm elections coming up. Summer in its last month, seems like summer is ending on August 1st these days, is a bit depressing but it beats subzero temperatures. Until our next update, see you in September, October.

  • May 2018

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    Kevin: Hello, John Finley, Kevin Coyle, May 2018 market update. Maybe start with a quick recap of how we've done year-to-date, John, and over the last year.

    John: Year-to-date, we're about flat, but year-over-year, we're still up double digits, about 14% in the U.S. The market hit a new high on January 26th, but we're down about 6% from that.

    Kevin: We've had a lot more volatility than usual. We were kind of lulled into a false sense of security maybe in 2017 with very, very little fluctuation and mostly up days, but this would be more normal.

    John: Right.

    Kevin: If you look back historically, we're going to have a lot more of these types of down days during the course of the year. The global backdrop, growth-wise, what does that look like?

    John: It's still very supportive. We have global, synchronized growth. Maybe 70% of developed countries are in a pretty strong expansionary economic situation, which is good and low inflation. So it's a very supportive economic backdrop.

    Kevin: So there are some fears out there, which we'll talk about in a second, but the correction that we had, maybe 6% down from the lows combined with increased earnings, part of that from the tax cuts, but from historical measures, the market would appear to be fairly valued at this point in time.

    John: Right. The forward price earnings we're right about at the average, long-term average, and we're expecting earnings in the U.S. to be up about 20%, year-over-year, 25% on earnings per share basis, and the revenue top-line growth is still pretty healthy. It's 7%.

    Kevin: So we talked about potential fears out there of inflation, which we'll talk about in a second. The other one, which has been since this recovery started, it's been a long but slow recovery. A lot of people think, "Well, it's nine years." It's what, the second longest expansion that it can't have legs much longer. It's got to be running out soon. What are your thoughts on that?

    John: Well, this has been a different recovery coming out of the financial crisis than the other post-war recessions that we've had. We bounced back much quicker before, and we've just been plodding along at about 2% or so real GDP growth. And the reason for that is we've got the two components of GDP growth are population growth and productivity, and both of those are relatively low rates of growth right now.

    Kevin: So if you look the numbers, the length of the expansion has been long, but the degree of the recovery has not been as significant.

    John: Right. We’re seeing unemployment continue to drop, and that's creating some issues, maybe some labor shortages in certain industries.

    Kevin: But we're not seeing that really show up in the inflation figures.

    John: Not yet.

    Kevin: So we're afraid about the length of the recovery, and we're afraid about inflation, but we're not really seeing signs.

    John: Right.

    Kevin: That those are rearing their heads this year.

    John: Oil is up to $70 a barrel now, and lumber prices are up, so there are indicators that inflation may be on the rise. The Federal Reserve said recently that their inflation in the U.S. is approaching their 2%.

    Kevin: Well so the Fed had been taking precautionary action, and they've been raising short-term rates, so you have that going on. You also have the Federal Reserve trying to unwind its balance sheet from the quantitative easing from the bonds they've purchased since the recovery. And then, you also have record deficits on the horizon, and this all adds up  as potentially inflationary as well, correct?

    John: Well, certainly, it's going to put pressure on interest rates as the Fed unwinds the balance sheet, and the government has to sell bonds to finance a trillion dollar deficit for the next five years. But the bond market is not really reacting yet to any higher inflation expectations. And, in fact, it may be a bit concerned the Fed will overshoot.

    Kevin: So you have this balancing act going on, where you have potential inflation, but the bond market's saying that it's not seeing it, so rates have gone up, but the yield curve is still relatively flat. So the bond market's saying that it's seeking more potential of recession as opposed to inflation. But then you put that together with the global backdrop. The earnings and the economic climate is still positive, so it's kind of a different recipe of this Goldilocks scenario from couple years ago. It's all kind of mixing together, where it's kind of steady as you go kind of a scenario.

    John: Right. Oh, yeah, it doesn't appear that, from what we can tell, the indicators that we watch, that there's a recession around the corner, certainly. And the backdrop, again, is very supportive from a global economic perspective.

    Kevin: With all that being said, stick to your plan, but the volatility, I would imagine, will continue to be present because there is some uncertainty as to some of these issues that are out there. So those are the things we'll be looking for going forward. Until our next update, enjoy.

  • November 2017

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    Of Pigeons, Information & Interest Rates

    Have you ever noticed how pigeons walks? Their heads bob back and forth with each step they take. Although I consider myself a recreational bird watcher (as opposed to an actual birder), I never gave this behavior any thought until I read a fascinating book: Storm in a Teacup: The Physics of Everyday Life, by physicist Helen Czerski. The author explains that this movement is necessary because the bird cannot process the changing visual scene fast enough as it walks. Czerski writes: “The head stays in the same position throughout the step, so the pigeon has more time to analyze this scene before moving on to the next one.”

    I can sympathize with the pigeon, since I often feel like there is way too much information available to me every day from numerous sources, all clamoring for my attention. After all, we live in the information age. And yet we must attempt to sort it out; to make some kind of sense out of it all; to discern the signal from the noise.

    One of the five guiding principles of our investment philosophy at Coyle Financial Counsel is that investment decisions should be based on information, not emotions. And because we also seek to be evidence-based in our investment process, gathering and analyzing information is essential.

    This will be the second Commentary in a row to discuss interest rates, but this time I want to address a point made in the video, that the yield curve is flattening. A yield curve (also known as the term structure of interest rates) plots the yield-to-maturity of an issuer’s debt securities by date of maturity. We want to answer the question of whether there is useful information in the shape of that curve.

    Here is a plot of the term structure of U.S. Treasury debt for two different dates:

    The curve dated January 2, 2014 is much steeper than the curve we have now. We know from last quarter’s Market Observer Commentary that inflation expectations are a key determinant of the general level of interest rates and that the Federal Reserve influences what short term interest rates will be through the market activities of the Federal Open Market Committee. Inflation expectations at the end of 2013 were higher than they are today.

    Besides inflation, there is one other interesting historical feature of the shape of the yield curve which might give us information as to the future health of the economy. The measure we use for this is called the term spread, the yield difference between longer and shorter maturities. If we compare the current yield-to-maturity on the 10-Year maturity Treasury note (currently at 2.37%) to the 2-Year maturity (1.76%), the current term spread is 0.61%. This is the lowest reading we’ve seen in almost 10 years, since just before the Global Financial Crisis:

    If you look closely at this chart, notice what happens to the term spread just before the economy slips into an economic recession (the gray vertical bars): the spread turns negative. This is called an inverted yield curve and it has been an almost infallible leading indicator of economic recessions in the U.S.

    The intuition around using inverted yield curves as a recession indicator is as follows: an economy in significant decline tends to exhibit falling inflation, causing long term rates to fall along with falling inflation expectations. Short term rates, on the other hand, lag behind, anchored as they are by the Fed until it decides to start lowering them to stimulate the economy as it implements monetary policy.

    Another theory used to explain this is called the Expectations Theory. The intuition here is that longer rates can be thought of as a series of future short term rates strung together. If investors believe that the Fed will start lowering short term rates in the future, they will start buying more long term securities to lock in higher yields, which gradually has the effect of lowering long term rates (this is because bond prices and yield are mathematically inversely related).

    A declining (but still positive) term spread is certainly not cause for alarm. A quick glance at the graph shows many instances since 1976 where it declined but failed to invert. It is just one of many economic variables that we monitor as part of our investment process. While recessions are notoriously hard to predict, we don’t believe the U.S. is in any immediate danger of slipping into one.

    As we mentioned last quarter, we are not in the business of predicting the future course of interest rates. But, like the pigeon, we try our best to process the continuous flow of economic and market information available to us, without getting too overloaded. Even so, trying to discern the signal from all the noise is easier said than done.

  • August 2017

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    What’s (Not) Up With Interest Rates?

    Credit is the lifeblood of any healthy economy and the price of credit (or the cost of borrowing) is measured by the annual rate of interest charged. There are as many different rates of interest as there are types of credit available. For example, consider borrowing from a bank to purchase an automobile. If you’re fresh out of school and newly employed, the interest rate on your auto loan might be in the double-digits. But if you have a long, well-established credit history, you might be able to buy a new car with zero percent financing.

    Or, consider what sovereign governments have to pay investors to borrow in the capital markets. The United States can borrow for ten years right now at an annual rate of 2.19%. Brazil, on the other hand, must pay investors close to 10% per year to borrow for ten years.

    How are interest rates set? Interest rates are established like any price, by market forces, via the supply and demand for loanable funds (there is one important exception which we will discuss in a minute). Think about that bank making an auto loan. They have several things to consider when deciding to extend credit to someone: (1) the creditworthiness of the borrower, (2) how many years to pay the loan back, (3) the cost of funds that the bank has to pay to depositors, and (4) the rate at which the purchasing power of the currency declines over time (the inflation rate).

    Let’s focus on the last point, inflation. Savers and bond investors hope to earn income on their funds at a rate that exceeds the rate of inflation, otherwise they lose the purchasing power of the income stream. Therefore, one component of the interest rate setting process by the market must consider what the future rate of inflation is expected to be.

    The last slide in the Market Observer video showed that there has been a very close correlation between the US inflation rate (as measured by the CPI) and market interest rates (in this case, 3-month Treasury Bills). While other things come into play when thinking about how interest rates are set, such as credit quality and the term to maturity, inflation expectations are a key consideration. It is the reason that the US can borrow at just over 2% for ten years while Brazil must pay almost five times as much: inflation in the US is below 2% compared to almost 9% in Brazil.

    This is why any discussion of the future course of interest rates must take into account inflation expectations. The US Federal Reserve, through Monetary Policy, started targeting core inflation at 2% in 2012. Since that time, inflation has struggled to get anywhere close to 2%, with the most recent reading at 1.7% (July, 2017). This has been a conundrum for many economists, policy makers and market participants, particularly since unemployment is now at a low 4.3%. Even though the US economy is barely growing at a 2% real annual rate, some expect wage pressures to start pushing consumer prices higher. So far this has not happened.

    Persistent low inflation has created a lively debate within the Fed’s Federal Open Market Committee (FOMC). The FOMC decides where to set the one interest rate that is not market determined, the Federal Funds Rate (the overnight lending rate on bank excess reserves). The Fed has been trying to “normalize” the Fed Funds rate recently after almost a decade of keeping the rate near zero since the depth of the Great Financial Crisis of 2007-2009. Even though the effective Fed Funds rate has now been raised to over 1%, the market is pricing in only a 36% chance that the Fed will raise the Fed Funds rate for the third time this year in December. Meanwhile, the bellwether 10-year Treasury yield has dropped again to 2.19%.

    For some time now, there has been much talk about the prospect of rapidly rising interest rates, particularly since the Fed first raised the Fed Funds rate in December, 2015, from zero to 0.25%. But the Fed controls only one rate, the overnight bank lending rate. They do not set mortgage rates, or auto loan rates or other bank lending rates, much less the yields on longer term treasury, corporate or municipal bonds.

    While we are not in the business of predicting the future course of interest rates, our guess is that as long as inflation stays low and the economy limps along at an average 2% real GDP growth, long-term rates are more likely to stay low than to rise significantly from here.

  • May 2017

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    When it comes to stock investing, investors often ask if is it better to hold a well-diversified portfolio of hundreds of stocks or a concentrated portfolio of, say, 20 or 30 stocks? The answer may not be as clear-cut as you think. Let’s look at what academic research might have to teach us.

    The Case for Diversification

    The essence of diversification is captured by the old adage that we shouldn’t put all of our eggs into one basket. Investing in capital markets involves the risk of loss, so we should spread our investable wealth across many securities. In support of diversification, research provides some very sobering facts about investing in stocks.

    One study looked at the stocks that composed the Russell 3000 Index from 1980 to 2014. The index includes about 98% of all listed stocks in the U.S. The author found that two-thirds of all the stocks that were included in the index over those years actually underperformed the index itself. In fact, 40% of the stocks produced negative absolute returns over their life-span.¹

    Another study was even more ambitious, looking at the performance of all listed stocks from July of 1926 to December of 2015, a total of almost 26,000 stocks. The author summarized his findings by writing that “the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks.” In fact, he found that only 86 stocks account for over half of the roughly 32 Trillion dollars in stock market wealth creation. Worse yet, he found that 58% of those 26,000 stocks returned less than one-month Treasury Bills over their life-span (The median life-span of a stock was seven years).²

    We are often surprised to hear that stock returns are driven by just a handful of stocks. For example, in 2015, the S&P 500 Index returned just 1.38%. The top 10 performing stocks that year included the four so-called “FANG” tech companies, Facebook, Amazon, Netflix and Google (now known as Alphabet). According to another research piece published early in 2016, removing the impact of these 10 stocks would have reduced the index returns by 3.7% that year. The author then looked at the S&P 500 Index annual returns over a longer period, from 1995-2014, and found that the 2015 results are actually quite normal. The average performance impact of the top 10 performing stocks over that 20-year period was 4.1%.³

    In summary, the implication of what we have discussed so far is that we should diversify to spread the risk of owning losing stocks while increasing our chance of owning the relatively few stocks that will survive and grow in value.

    The Case for Concentration

    The most obvious reason in favor of concentration is that every successful business in the world, big or small, was started by somebody who had a vision and, in many cases, were willing to risk everything. This is wealth creation as the fruit of the entrepreneurial spirit. It is the opposite of diversification and the risk of failure is high.

    We call this idiosyncratic risk and finance theory says that a sufficiently diversified portfolio can eliminate almost all of the idiosyncratic risk among the different stocks in the portfolio. The risk that we are left with cannot be diversified away, and this is called market or systematic risk. The reward for bearing market risk is the equity risk premium over Treasury Bills that historically accrues to long-term stock investors. In addition to the equity risk premium, investors have historically earned additional long-term premiums for bearing the risk of owning small cap stocks, low volatility stocks or value stocks, for example. This is called factor-based investing.

    In 2015, Fidelity Investments issued a research piece titled “Does the Number of Stocks in a Portfolio Influence Performance?” They analyzed the returns of U.S. large-cap equity mutual funds over the 20-year period from 1994-2014 and concluded that there was no evidence of a meaningful relationship between the number of stocks in an actively managed portfolio and its performance. They added that portfolios with either higher or lower number of holdings have beaten their benchmarks with the same success rate.⁴

    Recently, research was presented at a conference sponsored by AQR Capital Management which compared these two approaches to equity investing. The first was called Quantitative, characterized by well diversified, rules-based, systematic, factor-based investment approach, designed to capture various market and factor risk premia. The second was called Fundamental, which relied on individual stock managers using a “Best Ideas”, thematic approach to managing concentrated portfolios, designed to capture more idiosyncratic sources of return, such as mispriced stocks.

    They compared the investment performance of the top 25% of U.S. large-cap core managers, both Quantitative and Fundamental, from December of 2000 to December of 2015. They concluded that both groups had identical excess returns after fees of 1.7% per year and that combining the two approaches could actually improve the risk-adjusted returns versus using just one of the approaches alone.⁵


    We conclude, therefore, that there are advantages to using both a diversified and a concentrated approach to investing in equities. At Coyle Financial Counsel, we utilize a “Core and Satellite” investment process to capitalize on this idea. We use a well-diversified, quantitative, factor-based approach for our core portfolios while using certain concentrated “Satellite” stock managers who seek to outperform using a fundamental, “Best Ideas” approach. We believe that this combination will help our clients achieve their long term financial objectives.

    John G. Finley, CFA

    May 18, 2017


    1. “The Agony & The Ecstasy: The Risks and Rewards of a Concentrated Stock Position”, by Michael Cembalest, J.P. Morgan Asset Management (“Eye On The Market”, J.P. Morgan, 2014)
    2. “Do Stocks Outperform Treasury Bills?”, by Hendrik Bessembinder, Dept. of Finance, W.P. Carey School of Business, Arizona State University, Draft: February, 2017, (Accessed 5/8/2017)
    3. “SNAFU: Situation Normal, All-FANGed Up”, Cliff Asness, AQR Capital Management (1/11/16), (Accessed 3/13/17)
    4. “Does the Number of Stocks in a Portfolio Influence Performance?” by Michael Hickey, CFA, et al, Fidelity Investments (Leadership Series / Investment Insight, FMR LLC, 2015)
    5. Author’s notes from attending AQR University Event, Chicago, Illinois, May 9, 2017, Sponsored by AQR Capital Management
  • February 2017

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    Passive versus Active Investing

    The recent unseasonably warm weather and complete absence of snow this year in the Chicago area has been a very pleasant surprise. Flowers are pushing up through the soil and many migrating bird species have arrived a bit earlier than normal.

    What’s not so surprising is the ongoing debate in investment circles about the relative merits of active versus passive investing. Passive investing refers to the use of mutual funds or exchange traded funds that replicate well-known market indexes such as the S&P 500 or the Russell 3000. Active equity managers attempt to beat the market by offering superior stock picking.

    Investing in passive, index-based strategies has grown enormously in popularity in recent years. Last year alone, Morningstar estimates that $262 billion moved from active to passive U.S. equity funds (1). This is understandable: Index-based funds tend to have lower fees than active funds (1) and the average active manager does not outperform its index benchmark after fund fees and expenses (2).

    While the trend from active to passive seems to be showing no signs of slowing down, although, in theory at least, there is a limit to how far it can go. The reason is that indexes use only one characteristic to rank the constituent stocks: price times the number of shares of a company’s stock. Market value, of course, depends on price. And how are prices determined? Buying and selling of those shares on stock exchanges done by active managers.

    The price of a share of stock is a critical piece of information for skilled active managers, especially value investors. Value investors, such as Warren Buffett, seek to buy stocks that are undervalued and cheap relative to other stocks. They analyze the fundamentals of a company to arrive at an estimate of what the intrinsic value of a stock is, then compare that to the current price. If there is a sufficient discount (or margin of safety), the value manager purchases the stock in the hopes that eventually other investors will agree with that valuation and bid the price up to its fair value (or higher).

    Academic research has consistently shown that value investing outperforms growth over long periods of time, though it may underperform growth for shorter time periods. One problem with passive investing is directly related to its sole reliance on price valuation because popular growth stocks will always have a greater weight in the index than unpopular value stocks. Popular growth stocks also tend to have more price volatility.

    This became abundantly clear during the dotcom bubble of the late 1990’s when technology stocks (growth stocks) were everyone’s darling, eventually driving the tech sector to a weight of over 29% of the S&P 500 Index. That bubble ended in a three year bear market, where value investing (buying cheap stocks) outperformed growth (owning popular stocks) seven years in a row.

    While some may worry that our “Early Spring in February” may not end well for the flowers when the freezing weather returns, we need not fear that active managers will be driven to extinction by passive indexing any time soon. Skilled and experienced equity managers who can find quality companies with good fundamentals, purchased below their intrinsic value with a “margin of safety”, should always have a prominent place in every investor’s portfolio. The goal is to grow wealth over the long haul by diversified exposure to the global capital markets, capturing a share of what the market has to offer as cheaply as possible, with less volatility, and avoiding the never-ending parade of popular investment fads.

    (1) Morningstar Direct Asset Flows Commentary Feb. 14, 2017

  • December 2016

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    The human impulse to make predictions about future events is understandable, and is another thing that separates us from the rest of the animal kingdom (along with the need we have for meaning and purpose). I can’t imagine that my pet Border Collie ever worries about where her next meal will come from or if there will ever be another frisbee toss coming her way. But for us humans, there are any number of things we can choose to worry about, and that worry is always focused in the future. Hence, the unending quest to predict things, to reduce or eliminate the anxiety and fear which often accompanies uncertainty.

    I marvel at the accuracy of weather forecasts, the fruit of years of sophisticated meteorological computer modelling, which most of us take for granted nowadays. This benefits us all. But even with such impressive advances in forecasting, we are sometimes prone to put too much stake in expert predictions based on complex statistical models. The recent U.S. Presidential Election stands as a good reminder of this. Right up to the night of the election, most election polls predicted Mrs. Clinton would emerge the victor over Mr. Trump.

    Like many of you, I stayed up to watch the election results. I kept a close eye on the Dow Jones Industrial futures contract. At one point that evening, blue chip stocks were selling off by over 800 points. Now, several days later, as we discuss in the accompanying Market Observer Video, U.S. stocks are up significantly, with certain sectors like financials and industrials up significantly. Why?

    Ironically, we can point to the experts again. Only this time, we’re not talking about political pundits but pundits from the world of investing. The reasoning is simple enough. If Mr. Trump can fulfill certain campaign promises, such as significant increased government spending on U.S. infrastructure improvement projects like roads, bridges and airports, certain industries and businesses will benefit from all that spending. It all sounds so logical. “Investors” then placed bets on those stocks, driving up stock prices, based on that prediction.

    The problem with this line of thinking is that it more closely resembles short-term speculation rather than long-term investing. A moment of reflection surfaces many questions. What will the actual infrastructure spending look like? How quickly will the legislation get passed? Will it involve outright government contracts or funded through individual states? Will it have a private component? How will the architects and construction companies be chosen? How long will all of this take before any of it actually gets counted in the GDP calculation? (Does anyone remember the phrase “Shovel-ready projects”? Google it. It wasn’t that long ago.) Similar questions can be raised about the assumptions underlying the big run-up in financial services stocks.

    The point of all this is to bring us back to something else mentioned in the accompanying video, that stock price valuations in the long run must be anchored to corporate profitability, and not on short-term speculation based on the thinly conceived predictions of so-called stock market “gurus”. It’s the growth in expected future cash flows from businesses that creates wealth in the form of increased stock prices.

    So, the next time I notice my dog staring at me, I can be reasonably sure that she is not worried about how the predicted deregulation and certainty of rising interest rates will benefit commercial banks in the future. She probably just wants me to know that I forgot to feed her (again).

  • August 2016

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    As we saw in the first last quarter, the market experienced some big swings and then bounced right back to previous levels. At the end of the second quarter, we saw the short term Brexit response (a two-day 5+% drop), was followed by a bounce back to pre-Brexit levels just one week later. Since then the S&P 500 has risen steadily, up close to 7% for the year.

    Interestingly friends and clients have said that the market is doing poorly. Rather than focusing on actual returns, they are reacting to market volatility, something that we see continuing until there is more certainty regarding interest rates, the direction of the economy and the presidential election. 

    With regard to interest rates, they are holding relatively steady at historically low levels, slightly above 1.5% right now for the 10-year Treasury bond. With inflation mild globally, the overall view is that the Fed and central banks in other developed countries will remain highly accommodative.

    Central bank accommodation along with energy prices stabilizing should help GDP and contribute to improved corporate earnings. The risk of any near-term recession appears minimal.

    Some Quick Takeaways:

    • Short-term swings drive fear and unnecessary trading; long-term returns drive future wealth creation.
    • Recession risk in the U.S. is limited as central banks remain accommodative.
    • History has shown that whichever party ends up in the White House does not have a big impact on the market. Don’t let the news stations get you thinking otherwise.
  • May 2016

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    The first quarter for the stock market was a perfect example of drama that takes you nowhere. If you only looked at the market at the first and last days of the quarter, you wouldn’t know the difference — no real change. In between, you saw a decline of 11% and subsequent complete recovery, mirroring the swing also experienced by oil prices.


    Oil’s impact on stock prices resulted partly from expectations that, if oil prices stay low, profits for oil production and related companies would continue to drop, and losses would steepen as more projects put in place over the past few years at higher oil prices became uneconomical.

    Partly due to oil’s impact, GDP growth for the first quarter of 2016 was a sluggish 0.5%, a first quarter phenomenon we have become familiar with. Similarly, corporate profits were soft — both because of oil as well as the strong dollar. In a period with a strong dollar, overseas profits look weaker when translated back into US Dollars.

    On the positive side, wage growth has been increasing. While not having an immediate impact, some economists believe that this will lead to greater consumer demand and consequently higher profit growth in the second half of the year.

    Another positive that has not been talked about much is the budget deficit. In 2009, coming out of the crisis, the budget deficit was 11% of GDP. It’s now down to 2.5%, a level we haven’t seen for 10 years.


    The latest quarter picture leaves us with no clear direction. A recovery of oil prices from their lows, the leveling off of the appreciation of the dollar and signs of real wage growth are providing some hint of stronger growth through the end of the year and into next year. The budget deficit is still growing, but at a lower rate. Because of growth uncertainties, the Fed has slowed down its plans to increase interest rates. Where does this all lead in terms of investment strategy?

    Balance between your cash flow needs and your long-term plans. We would reasonably err on the side of caution for your more immediate to intermediate liquidity needs. Make sure you have money available for cash flow in case we do run into a recession, but long-term money should stay where it is today — in line with your long term allocation plan.

  • March 2016

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    It finally happened. In December the Federal Reserve finally raised rates; just a one quarter percent increase. Unlike previous rate actions by the Fed, albeit it appears that additional increases going forward will be modest and gradual with rates at current levels until there is more clarity about the economy.


    After the sharp drop in global stock markets, the Fed quickly shifted to a more dovish, status quo posture, which provided some calming effect.

    Is a recession looming?

    With the Fed indicating more of a status quo stance and the market falling off, does this indicate weakness in the US economy? We don’t think that’s the case. Employment continues to improve and corporate earnings show resilience. As the chart below points out, unemployment at the end of last year stood at 5.0% (now at 4.9%), which is the lowest since 2008. Wage growth shows modest improvement.

    As we pointed out in our last report, corporate earnings, excluding energy companies, while tepid were positive and overall look like they will strengthen in 2016. Furthermore, we expect to see a lagging but positive impact on consumer purchases as a result of declining oil prices.

    Growth and Momentum vs. Value

    There are clearly some disconnects in the market. While the S&P 500 was up about 1.5% this past year, if you took out the FANG stocks - Facebook, Amazon, Netflix and Google – the rest of the market was down 4%. In fact, most stocks (60% or more) are down more than 20% from their highs.

    All of this points to growth stocks and the momentum from these stocks being a big driver last year. As we see it, momentum works, until it doesn’t.

    Value on the other hand, works over long periods of time. If you buy something and you feel comfortable with its value, you can hold that asset confidently for an extended time. That’s how Warren Buffett invests. Yet even his company, Berkshire Hathaway, was down 11%. That, of course, is a short- term picture.

    Avoid chasing momentum in this market and focus on value; after reviewing the liquidity and balance in your portfolio, that’s where you want to concentrate your risk management.


  • November 2015

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    We’ve been waiting for two events to happen this year. The first one occurred in August – the market experienced a 12% correction.  We like to see a 10% correction now and again. It’s been four years since the last one, so the market has been waiting a long time. The good news: as of this writing, the market has recovered most of those losses.

    The second event hasn’t occurred yet - the Federal Reserve has not yet raised interest rates.  While the odds that they will raise rates in December have been increasing lately, it won’t be a surprise if they maintain the status quo.  As any Chicago Cubs fan is used to saying, we may have to “Wait ‘til next year.”

    Corporate Earnings

    Earnings for the S&P 500 look like they will end the year at around the $117 per share amount from last year. There were two key factors holding back the earnings number: (1) lack of profits from energy companies (because of cheap oil) and (2) the strong US Dollar. As the first chart below shows, energy sector earnings fell off completely in the first half of the year but are expected to partially rebound for the rest of the year.

    Coming into 2015 and continuing through the year, the US Dollar has appreciated substantially relative to other currencies. While this makes it cheaper to buy goods overseas, it creates a big headwind for corporate profits of US companies with overseas revenues.

    With energy earnings improving and the future impact of a strong US dollar leveling off, 2016 earnings growth is expected to get back on track. They are currently projected at $128 per share.

    Concentration Versus Diversification

    While the stock recovery in October and early November has been solid, its strength has come from the safe mega-cap stocks. Each area of the market will have periods of underperformance and outperformance. Right now it is mega-caps; in the late 1990s, it was tech stocks.

    If you were concentrated at the time, it looked great; then it didn’t. At the bottom of that tech bubble the place to really be was in the areas that were most undervalued - emerging markets and developed international.

    So why have diversification? It’s not so much because you’re trying to hit a home run as it is that you want to have some dry powder to buffer your losses in a down market.  When you have a narrow rally, like in just mega-cap stocks, that’s when people forget the lessons of a full market cycles.

  • August 2015

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    Following a weak but positive first quarter, the US Economy grew at a more reasonable rate of 2.3% in the second quarter. It is the same sluggish growth we have seen before. General sentiment is pointing to a slow but steady growth rate of 3% in the second half.


    One consistently positive piece of data has been the decline in the unemployment rate, which is sitting at 5.3%, slightly below the 5.5% trigger rate for the Fed to begin raising interest rates.


    While we have reached that target, there are many factors, including wage growth that are influencing the Fed’s interest rate decision. One thing we know with certainty is the Fed will begin slowly raising interest rates. When and what the impact will be remains unclear.

    Uncertainty regarding Fed timing, the impact of a stronger dollar on GDP and whether consumers will step up their spending have contributed to the US Stock Market taking a break from its steady rise during the past two years. For 2015, the market has been relatively flat and appears to be sitting and waiting for more clarity.

    With the current lack of clarity, many people are asking which investment choices are best. We believe that uncertainty (and there is always some) is best addressed through diversification. Guessing what is going to be strong today leads to poor results. Diversification ultimately wins out over the long-term.

    We hope that by our third quarter report some of the uncertainty will have lifted and we will have more clarity from the Fed about interest rates. Although we are not going to hold our breath on that one.

  • May 2015

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    First quarter results for the US Economy were tepid at best. Following a common, winter chill theme, GDP grew at just 0.2%. Bad weather, cheaper oil and its impact on the energy sector and a stronger dollar were the likely causes.

    Lower oil prices have not fueled an increase in consumer spending or at least not yet. As the chart below shows, consumers realized $112 Billion of expense reductions from lower gas prices which contributed to an overall increase of savings of  $120 billion. Whether these expense reductions lead to future spending remains to be seen.

    In response to the GDP slowdown and still tepid job growth, the Fed is extending its timeline for raising interest rates, possibly out to December. Improvement in job growth and the unemployment rate will be key to the timing of any rate increases.

    First quarter equity markets showed us a switch from last year. The S&P 500 eked out a 1% increase, while International stocks performed better. This trend continued in April, where the S&P was flat, while International Developed stocks rose close to 4% and Emerging Market stocks rose nearly 8%.

    Valuations of US companies are relatively more expensive than those of International Developed and Emerging Market companies. At the same time, earnings for US companies are at peak levels, while the profits of International Developed companies are still below their historical peaks.

    The rapidly strengthening dollar is a key driver here. The stronger dollar causes a reduction in US company earnings when international sales are translated into dollars and causes US products to be more expensive overseas, hurting exports.

    The Fed is rolling back its timing to raise interest rates. US consumers are choosing to hold on to what they’ve got for now. Several factors including European Capital Bank accommodative monetary policy hint at the possibility of the continued relative strength of the International Developed markets. Where does this leave us?

    According to the Barrons recent Big Money poll, 50% of the participants are neutral on the U.S. market over the next six months. Ask them what’s going to happen in 12 months, however, and you find that 82% are bullish on the US and 83% are bullish on Europe. Caution mixed with longer term optimism – a healthy viewpoint during a time of transition.

  • February 2015

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    In 2014, the United States Economy, as measured by GDP, grew by 2.4%. This was on the heels of a 2.2% increase in 2013. Since the Great Recession, GDP growth has lagged the 3% average growth rate of previous post – WWII recoveries by about 25%.

    Inflation remained tame last year, averaging just under 2%, similar to the rate over the past five years. Internationally, inflation is close to non-existent, at least by traditional measures. A fear of deflation looms as Europe deals with stagnant GDP growth.

    Based on its August, 2014 Baseline Budget Forecast, the CBO is forecasting a 2015 Federal Budget Deficit of under $500 Billion. This deficit is under 3% of GDP, which is more in line with post- WWII deficits, and has resulted from increasing tax revenues and a slowing of Government expenditures. It is hoped that continued progress on the deficit front will stop the acceleration of accumulated Federal Debt levels experienced since 2008.

    Over the past two months, the US stock market has rallied and then pulled back around 4% to 5% on several occasions. This volatility of “angst” and uncertainty somewhat reflects the fully valued nature of this market. The S&P 500 Index stands at 16 times forward price earnings.

    Interest rates, as measured by the US 10-year Treasury Note, moved lower last year. This was a major surprise to most economists, market analysts and investors. Declining yields helped push large US stocks higher by about 13% in 2014. Small-cap, Mid-cap, Developed International and Emerging Market returns were between -4% and +6%.

    The big question this year is what will be the effect of lower oil prices on the consumer and the economy. Output may not be materially affected until mid-year due to drilling and fracking projects already in the works when oil began to dip last fall. The consumer is seeing $60 per month on average of savings at the pump. It is believed that consumers are using there savings partly to reduce debt, add to savings and increase spending. As measured by XLY, the Consumer Discretionary Select Sector ETF, we saw a blip up in consumer spending over the past two months. It’s still too soon to determine the net overall effect on economic growth in 2015 resulting from reduced energy related capital expenditures and possible job losses in the oil patch versus the offsetting increases in consumer spending and savings. We’ll have to wait and see what happens.

    Over the past six months, the Federal Reserve has been signaling an interest rate increase may occur around mid-year. Over the past year, the economy has added over 200,000 new jobs per month. The unemployment rate has dipped below 6% and is trending lower. The Federal Reserve has cited these developments along with other factors to support its intent to allow interest to rise to manage inflation expectations going forward while hopefully not interfering with what appears to be our ongoing recovery. We will have more to report in May.

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