Can Trees Grow to the Sky (Part 2)?

BEND, OR / ACCESSWIRE / June 9, 2017 / The nadir, or low point, of the 2008 crash occurred in March of 2009 when the Dow Jones Industrial Average (“DJIA”) bottomed out at roughly 7,300. Since that time, the DJIA has been on a rampage that’s propelled the DJIA to 21,182 (6/8/17 closing price). In the span of just over 8 years, the DJIA has nearly tripled and caused numerous hedge funds with a focus on shorting the DJIA stocks, to close their doors.

As we’ve pointed out in several of our previous newsletters, the skyrocketing DJIA is in large part due to investors forgoing active money management funds (people who actively manage money) and entrusting their funds with passive instruments like ETF’s. After all, why pay fund management fees when ETF’s have provided a superior return during this stellar run?

On the surface, it appears as if the bull market will continue due to a number of factors we have highlighted in previous newsletters. In short those factors are low interest rates, improved employment and stellar earnings. The Federal Reserve Board is set to meet later this month and regular readers know we’ve been anticipating a rate hike for some time. We’re not deviating from that estimate and it looks like we’re going
to be right. However, some recent data we review has us rethinking our prediction that the Fed will raise rates again after their December meeting.

For starters, the May jobs report was at best, a mixed
bag. The U.S. added 138,000 jobs for the month, which was below economists’ expectations of 184,000 new jobs, and 73,000 jobs short of the 211,000 jobs that were added in April. That’s a 35% month over month reduction. The tightening labor market was offset somewhat by the drop in the unemployment rate, which fell to 4.3% from 4.4% in April. While we acknowledge that the jobs report is an imperfect measure of the actual health of the labor market, as it excludes variables such as participation, wage adjustments, and population growth, we still view it as an important relative indicator.

Still more concerning was the auto industry’s performance in March and April. Every automaker without exception missed sales numbers last quarter. To compound the issue, inventories and dealer incentives have been skyrocketing to the point that there is actually speculation that May
incentives were overly aggressive because manufacturers needed to prop up numbers. When you take into account that the auto
industry employs 2.5 – 3 million Americans, another auto-collapse could have sweeping implications for unemployment numbers and GDP, the heretofore bellwethers of our economic salubriousness (ladies and gentlemen, meet the walking dictionary Greg Harrison…I googled salubriousness too J).

Is this a legitimate fault line in the foundation of our economy, or is this just an ephemeral misstep that will get resolved over time? It’s tough to tell for sure, but the news definitely caught our attention.

There are other factors that are also concerning. For starters, according
to Reuters the small business lending index posted a decline for the third consecutive month, taking the index down 5% since April and the lowest level since October. The index is largely viewed as a leading GDP indicator, so the weakness in small business lending is foreshadowing the same outcome as the auto industry.

Then there’s gold. According
to Deutche Bank, gold is trading at a 20% premium to its estimated fair market value because, “there is a heightened perception of risk or uncertainty in the broader markets.” This fact may also partially explain why crypto-currencies have been absolutely ripping this year. Bitcoin, Ethereum, and Litecoin are generally viewed as high risk propositions, but they’re also supposed to be non-correlated assets, which could provide a safe haven for investors in the event of an economic downturn. As an aside, Greg recently purchased bitcoin. I have yet to figure out how to buy bitcoin which Greg scoffs at me about; then again Greg has about 100 apps on his phone whereas I have three. Also, the idea of paying money to get money is odd to me. I will not deposit money into a bank that will charge me to withdraw my money and also I can’t understand why someone buys $100 of bitcoin but only gets $95 worth of bitcoin. Help me with that one Greg! We (I) digress.

We can’t conclude our analysis without some discussion of the U.S.’s decision to exit the Paris Treaty. The economic implications of this decision are so pervasive, it’s impossible for anyone to fully calculate the impact. Typically, creating that level uncertainty is sufficient to roil markets, but given that the new normal for our geo-political climate is the state of tumult, the news was received by the markets with a dismissiveness that can almost be mistaken for apathy (Greg, this is called the new normal or the now famous term, a “nothing burger”). But just because “normal” is no longer correlated with stability, doesn’t mean that there won’t be severe consequences down the road.

Ostensibly the move to quit the Paris Agreement was intended in part to protect fossil fuel industries in the U.S., which would in turn create business growth and more jobs. As unapologetic capitalists, we are generally in favor of actions which yield maximum benefit for our economy. The problem here is that we don’t necessarily agree that removing ourselves from the regulatory obligations of the Paris Accord will produce the intended result. Often times our economy can be overwrought with inefficiencies derived from overzealous regulation. No doubt. But that’s not the same thing as saying that all regulation is, per se, corrupt. There have been times, many times in fact, when sensible regulations have been the catalyst for growth and innovation. Need an example? A few decades ago, the shoe industry predominately used toluene as the glue substance in the manufacture of shoes. Toulene however is toxic and caused serious health problems for factory workers. Regulations were subsequently passed that required manufacturers to produce their shoes in a safer and more responsible manner. Nike
met the challenge by developing a water-based non-toxic adhesive that is still used in shoes today. (Isn’t Greg fun?)

The key takeaways from this real-world example are: 1) had the regulation not been enacted, there would have been no catalyst for change and toulene may very well still be in use today, and 2) had another country imposed regulations instead of the U.S., such innovation likely would likely have come from elsewhere. We’re not trying to make a moral argument about the environmental benefits of abiding by the Paris Treaty. That’s an entirely different discussion. What we are trying to do is make an economic argument about the best way to drive growth and innovation in the U.S. Our belief is that investing in alternative energy sources would provide greater economic benefit than placating the venerable industries of the industrial revolution.

Not surprisingly there are a number of business leaders that share this sentiment, but very surprisingly – almost confounding – Exxon CEO Darren Woods authored an open letter
to the President, encouraging him to keep the U.S. in the Paris accord. Woods’ rationale? Exxon Mobil maintains the view that the U.S. is well positioned to compete within the framework of the Paris Agreement with abundant low carbon resources such as natural gas, as well as innovative private industries including the oil, gas and petrochemical sectors…

When the CEO of the world’s largest energy company is encouraging our President to adhere to an environmentally rigorous set of regulations because we have a fossil fuel dependency problem, it’s a little like a member of Guns n’ Roses saying that you have a drug problem. These guys know what they’re talking about. To be fair, we are selling our own book. As purveyors of the young, undiscovered companies we are partial to exciting new technologies that are potentially disruptive. If one looks at the small cap landscape, there simply aren’t too many startups trying to disrupt the world with fossil fuel technologies; contrast that with the number of companies that are actively fighting to establish a beachhead in the clean-tech revolution, and it should be fairly obvious where the future is headed.

Given that set of facts, how could any responsible capitalists favor a path that benefits stale, century year old technology at the expense of innovation that will likely drive our economy for the century to come? If companies, large and small are dis-incentivized to seek out better, cheaper, cleaner solutions (a’ la Nike), how will the U.S. maintain economic hegemony over time? We’re not so sure that it can.

The upshot of our analysis is that while the economy still seems to be moving along at a healthy clip, cracks are appearing in the foundation. These potential weaknesses will get exacerbated over time if we continue to pursue policies that are destabilizing and promote antiquated industries. Rarely if ever, has myopathy beaten the path to success. We’re not pulling in our horns just yet because we believe the market still has horse power left, but our view is turning from bullish to cautious and then may rapidly turn to scared (rhymes with witless, just subtract the w and add the letters sh). After all, trees can’t really grow to the sky, or can they?

By: Ross Silver & Gregory Harrison

Our “Sylva Standouts” are included in the hyperlinks below. Remember to read our disclaimers and disclosures as it relates to investing in anything we write about. Good luck with your investments, Derby selection (should you play the Derby) and have wonderful month and we will report back in June. If you need more Sylva in your life, who doesn’t :), check out our daily ramblings on Twitter at https://twitter.com/SylvaCap?lang=en.

DJIA: https://sylvacap.com/dow-jones-featured-companies

Healthcare: https://sylvacap.com/healthcare-stocks

Tech: https://sylvacap.com/technology-stocks

Resources (mining): https://sylvacap.com/resources-stocks

June Stock of the Month is Sierra Wireless (Nasdaq: SWIR): https://sylvacap.com/sierrawireless-home-page/

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