Interest Rates Keep Rising; Is Anything Working? Jarvis® Update - September 23, 2022

Interest rates continue to rise. Can anything work in this market? We answer that question and more in this week's Jarvis Update. I'm your host, Brian Dress, director of research here at Left Brain, joined as always by our CEO and chief investment officer, Nolan Langford. Nolan, welcome to the program.

Thank you, Brian.

Thanks, Nolan. And it's been another tough week on Wall Street. And a lot of that poor market performance was centered around the Federal Reserve and the news this week. So we have two topics for you as we normally do. The first is asking the question and answering, how is the Fed impacting financial assets? And then the second is gonna be a topic that we've covered for a number of weeks in a row, but we're gonna keep hammering it home, and that's pivoting to the bond market. Before we get into the meat of the show, a few announcements for everyone. First of all, we produce this show for the everyday investor. And whether you have a 401(k) or an IRA, if you manage your own investments or you work with an advisor, we'd love to be helpful to you. If we can be a resource, get in touch with us with the number on the, on the screen below. We'd be happy to give you a second opinion on your portfolio in a difficult time here. Also, if you're an institutional investor, we've got something for you, and that's our research service. That's Left Brain Investment Research. That's our analyst team putting out 8 to 10 full-length stock reports per month. So check that out. We'll put the information down below as well. Either way, we'd love to have you sign up for a biweekly newsletter. We're off this week, but we've got plenty of other content out for you to your inbox every Saturday morning. So sign up at the link below and we love to get you on the mailing list and get that out to you every week. And then of course, we appreciate everyone that's taken the time to watch our videos and we'd ask you to comment down below. We'd love to engage with any investment questions you may have, like the video and share it with your network. That helps it get found by other like-minded investors. Hit the bell for notifications so you can find out when the next video comes out. All right, we'll jump right into the market recap. The 3 indexes that we follow, they were all down this week. First of all, the S&P was down 3.7%. The tech-heavy Nasdaq was down 4.2%. And then in a reversal of what we've seen over the last few weeks, the Russell was down itself 5.6%. So small caps brought up the rear this week. If you haven't heard, the Federal Reserve raised interest rates 0.75% once again. 75 basis points is what we call it around the office. That's pushed interest rates up heavily across the curve. The 10-year Treasury rates are now above 3.7%. That's as high as they've been in quite some time. And then the 2-year Treasuries are up over 4.1%. So interest rates are moving up and moving up quickly. Again, weakness was pronounced in small and mid-caps. That's a reversal of what we've been seeing recently. And then, Nolan, just, you know, we're going to jump in with an easy question for you and probably difficult answer. What are your initial thoughts on the week's action?

Yuck, yuck. That's my initial thought. You know, the 75 basis points, 0.75% increase, was well telegraphed, so that couldn't have spooked markets or investors. I think it was a commentary that Chairman Powell made in regards to them sort of sticking to their knitting, especially in the face of weakening economic conditions. You know, you and I have spoken about this, and we had our analyst call— for the viewers, we have an analyst team and we analyze individual Securities. And we did that on yesterday. And one of the things that we noted is if you look over month to month, the last 3 months, inflations have actually been coming down. And so I think most investors think if the Fed just gives it time, you're going to see those numbers come down and come down pretty aggressively. We've seen weakening all over the place. So I don't think investors like what they heard in the commentary, hence the stock market activity last couple days.

We don't like it. Jay Powell's not our favorite guy right now, Nolan, but hopefully things will shake out soon. We'll jump right into our topics. So topic 1, it's the impact of the Fed on financial assets. Unfortunately, interest rates seem to have a broad impact on almost everything in the financial world. Uh, again, stocks across the board were weak, small caps, mid caps, large caps, mega caps. And as Nolan mentioned, inflation does seem to be decelerating, but you wouldn't know it from the Fed's action and from the Fed's commentary. First question here under this topic: What is the impact of a hawkish Fed on markets of all types and sizes?

So when we say the word hawkish, Fed is intent on bringing all financial assets down. When inflation gets out of hand, that means the government or the Federal Reserve no longer has control of economic conditions, and they want to regain control. Hence why they're being so aggressive in bringing rates down, and they, they're very comfortable that If they can get inflation and keep it to that 2% range, they can sort of control economic conditions. Ways that you do that to tighten monetary conditions, you make it tougher for people to buy homes and you make financial— the value of financial assets decrease. You take liquidity out of the system and that definitely cools things. Now there's some knock-on effects that are not so pretty in what the Fed has said they're willing to deal with those. In exchange for regaining control of the economy.

Excellent. And it's definitely had a lot of impact on a number of different financial assets. And we've seen it in growth stocks. We've seen it in tech stocks, a lot of stocks that carry high multiples. Well, those multiples are falling because of the higher interest rates. So the Fed certainly has a huge impact on stocks like that and pretty much everything— industrials we've also seen. But Nolan, we try to be optimistic here. We're always looking for opportunities here at Left Brain. So I guess the first question I would have for you under that is what areas may actually work despite the current environment?

Yeah, so there's a few that we like. Uh, the one area— and again, we just got finished with second quarter earnings releases, uh, a few weeks ago— and when we went back and took a look at the transcripts, uh, a few things stuck out. One area, uh, you mentioned growth in tech, but cybersecurity. There's been a lot of areas where we've seen economic slowdown and companies are starting to report the macroeconomic environment is causing them to sort of guide down on their revenue and earnings numbers. And that's part of one of the reasons the market's been weak. It's kind of an earnings recession. We heard that late last week with Federal Express, which is just in a horribly bad earnings announcement that they made. And it's such a bellwether stock that it cast a pall over everything else. But in the cybersecurity space, you have not heard any slowdown at all. Instead, you've heard not only continued acceleration, but it's one of the parts of the enterprise where these chief security officers are getting expanded budgets. And the need for cybersecurity, you know, whether it's bring your own devices or businesses going to the cloud, the attack services increasing, that's an area where we've seen business conditions improve. So cybersecurity is an area of focus. Businesses continue to do well. The second area, one of the areas that we have really highlighted and continue to highlight, is the energy or the oil space. Now, since June, you know, early June, oil prices really peaked— not natural gas. Natural gas continues to do well because of what's going on in Russia being cut off from Ukraine. But oil prices have crested at about $120 a barrel in early June. and they're back around the $80 barrel range now. So it's taken a wind out of the sails of some of the energy stocks, at least for the time being. But an area of energy that we still like, that's still very attractive, are the pipeline companies. These are companies that basically are infrastructure plays. You know, that oil gets pumped out in East Texas or the Permian, and then, or the Midland Basin, And then it has to get there from a refinery and from the refinery to your local gas station. That's typically done by these pipelines. The business conditions really aren't affected by the price of oil and gas. It's just the volumes, and the volumes continue to be strong. So it's an area that is very, very attractive. The businesses are very consistent. Dividend yields are high. Even in the index we're going to talk about here in a second, you get yields at 7% or more. And again, when we took a look at some data and we went back 10 or 20 years and we took a look at the dividend or interest-paying categories of different groups of investments, it's the one category that still has a dividend yield that looks attractive to compare to where it was 10 or 20 years ago. So I think there's a lot of room there for appreciation. So those two areas really stand out.

Okay, Nolan, I want to get you— give you a chance to expand upon the pipeline story. You sort of alluded to it, but, uh, what's a good way that investors can play that? That's, uh, pretty simple for them to execute.

So there's a lot of individual names we like. With the pipelines, they typically are set up as publicly traded partnerships. So you'll— we'll have a general partner and then limited partner interest. And the long and short of it is at the end of the year, you're going to end up with a K-1. That's a problem for most investors, which means you're probably not going to do it in an IRA account because of a UBTI or unrelated business taxable income. And so for a lot of investors, the individual securities are sort of off limits. However, there is an ETF, AMLP is the ticker, where you can buy these securities in a basket. You don't have a problem there because it issues a 1099, not a K-1, so you can buy it in a retirement account. And basically an ETF is an exchange traded fund, which is a basket of these pipeline companies. A little over 7% is the dividend yield. And that's a way for investors to gain exposure to that asset class.

All right, Nolan, thank you for letting us know where things are actually working in the stock market. There's always something working, so we're always looking. With that, we'll move on to topic 2. So topic 2 is our continued pivot to the bond market. Interest rates are changing the conditions in the bond market. We haven't seen interest rates as high as this for over a decade and bond prices as low as this for that long. Um, so it's driving down the prices of bonds quite sharply. Nolan, just to open up our notebook here a little bit for folks, we had a bond database in our Jarvis system that was a little under 500 names just about 2 months ago. Now we're almost near to 900 bonds. So lots of opportunities seem to be developing in bonds. On a general basis, there was what was called the 60/40 portfolio that was 60% allocated to stocks and 40% allocated to bonds. Well, with interest rates being so low over the last decade, that's gotten out of whack for investors. Lots of investors have much more in stocks and much less in bonds. We think there's maybe an opportunity to bring things back into balance for a lot of investors, uh, regardless of your risk tolerance. How do we like owning bonds, Nolan? Uh, do we like individual bonds or do we like bond funds?

Yeah, so let's start with the way that you'd have to be really careful about owning bonds, and that's in a bond mutual fund. And the reason is, as we've seen, it's a sort of a barbell reaction where interest rates go up, bond prices go down. And if you own them in a bond mutual fund, there is no natural maturity date. Bond mutual funds naturally are what we call a perpetuity, meaning that there's never really a maturity date because the bond manager is always going to be buying a new bond. And so when prices go down, there is really no natural catalyst to get the price to go back up. And what you really want when you buy bonds is you want to fix— you want to fix your maturity date. You also want to fix your income stream. You don't get— you get neither when you buy a bond mutual fund. So be very careful. I know a lot of investors will think here, bonds, go to their 401(k) or their retirement account at work, and then check the box for bond fund. And that's really a tough way to go. We think the ideal way to play bonds is to actually fix it. We like a fixed maturity date. We like a fixed coupon. And even if you buy a bond and you bought a bond back in January, it's pretty universal. No matter which bond you have purchased, if you want to sell it today, you probably are going to be selling at a lower price than You bought it in January. No need to fear. As long as you hold it to maturity, you're going to get your promised interest payment back as well as the principal, as long as the issuer doesn't default. That's what we mean by fixed return. So those are the type of bonds we're focused on now. We really like the idea of going out anywhere between 2 and 5 years, buying bonds with attractive coupon payments. Investors now can buy those bonds, most of them below the issue price. So that means your return is going to have two components. One is your current income from the coupon, and then the other one is going to be capital gain from the price you pay and the maturity value.

Excellent. Now, in the last few weeks, we've covered why we like discount bonds. If you want to learn more, go ahead and watch a couple of our previous weekly update videos. You can learn a little bit more about the discount bond strategy, and we're going to be putting out more content like that in the future. No, let's talk again. Let's bring it into the concrete, into the actual— what's a bond that we like that kind of fits the criteria you just described?

One of ours we really love is by issuer. The corporate parent name is Signet, S-I-G-N-E-T, and a lot of viewers probably will not know the corporate parent name, but the individual businesses that they will. So Zales Jewelers, Kay's Jewelers, Jared Jewelers. Those are the operating businesses of Signet. Really healthy company, uh, really good earnings, really good cash flow. The stock itself pays a dividend, and I guess you could make a case for the stock. I know it's one of the businesses that you love, uh, Brian, going back to last year, but they just have one bond outstanding, which is a 4.7% coupon it matures, I believe it's April of 2024. So it's about an 18-month maturity. And you can buy this bond now at about $0.95 on the dollar. The last we look is where it was trading. So what that means for $10,000 worth of bonds, you can buy it for about $9,500. And if you take your coupon plus the fact that the bond's going to go from $9,500 to $10,000, gives you a yield to maturity of about 7% for an 18-month issue. And we think that's very, very attractive, especially considering the fact that Signet has enough cash on their balance sheet to pay the bond in full.

Thanks, Nolan. I think that's good, a good description and a good example of the type of strategies that we think make sense right now, which is looking for short-term bonds where you can get an outsized yield over and above what you can get in treasuries, park that money, and then hopefully markets will settle down by the time those bonds mature. We're putting together a list of bonds like this, trying to be able to build portfolios for folks who are, who are in need of income or in need of capital preservation in their portfolios. If you are interested in either of those two goals, definitely reach out at the number below on the screen. Well, Nolan, we're running out of time. Any thoughts as we leave the investors and bid them adieu till next week?

Yes. So the one I would say is You know, I know this has been a really, really tough year in the markets, but it looks like inflation at this point hopefully is starting to crest. And things can change very quickly in markets. We're starting to get to the point where as soon as it looks like we get some inflation figures, it looks like we're coming to the end of inflation rising, um, you know, investors will, will turn their focus and take a look at companies that will do well looking out a year or two. So there should be some powerful rallies, uh, coming up because it looks like we're probably getting closer to the end of interest rate increases. You know, even the Federal Reserve Board themselves, if you just take a look at what they're forecasting, they forecast more rate increases short term, but then real quickly they're forecasting they're going to have to turn around and start lowering rates. And so it's like you and I talked about, there's going to be some interesting opportunities not only in the stock market but the bond market, because if you can lock in yields, especially good coupons, for a decent amount of time and rates top out and start to go down, you'll have the ability to see capital gains not only in stocks but also in bonds.

Thank you, Nolan. Thanks to the viewers, and we'll be back again with you next week. Bye now.