Value vs. Equal Investing: It’s More Than Just That Month

The US stock market had a marvelous year in 2017. The major benchmark S&P 500 returned 21.60%[1] including dividends. But savvy investors probably noticed that there were some significant discrepancies among the major indexes: If you chose the tech-heavy NASDAQ composite, you would have made 29.58%[2] last year, while if you invested in the small-cap Russell 2000, you would have profited only 14.52%[3].

It appears that volatility wasn’t the only number that was suppressed in the stock market last year: Stock correlations also remained low. So what does it mean to investors when stock correlations are low?

Simply put, stock correlations measure the contemporaneous movement among stocks and explain why stocks move in different directions. Stock correlations are particularly important statistics for portfolio weighting, while weighting is important for portfolio returns. For example, the large-cap S&P 500 is value-weighted, meaning that each stock makes up a portion of the index according to its market cap. Therefore, the mega-caps in the S&P 500 are capable of single-handedly driving up the index. However, if the S&P 500 were equal-weighted, then all the stocks would contribute in the same way to move the overall market.

How much does the weighting scheme matter to a portfolio? Let’s compare the value-weighted and equal-weighted S&P 500 performance history, as shown in Figure 1 below. Starting from the bottom of the financial crisis in March 2009, the equal-weighted ETF RSP outperformed the value-weighted ETF SPY by 30%, simply due to the weighting difference.

 


Figure 1. SPY vs. RSP since March 2009
Source: Yahoo! Finance
To form a comprehensive picture of the value vs. equal investing difference, we construct a 30-year portfolio starting from 1986. We include all stocks listed on the NYSE, NYSE American, NASDAQ, and ARCA markets, excluding ADRs. Both portfolios are monthly, including distributions. The difference between the two portfolios after 30 years is quite significant: While the value-weighted portfolio generated an 1,838.66% return, the equal-weighted portfolio returned 2,443.71%. We notice that value outperformed equal rather well during the tech-bubble period, when stock correlations were relatively low due to the crowded trade in the Technology sector. Nevertheless, during the following years, when stock correlations reverted to normal, the equal portfolio outperformed the value portfolio.

Figure 2. Value vs. Equal Since 1986
Source: Center for Research in Security Prices

Is there anything else that explains the equal weighting outperformance besides stock correlations? Yes. The answer is January. We notice that the equal-weighted portfolio averages a 3.98% return in January across the 30 years, 3.11% above the value-weighted portfolio, while there is no dramatic difference for the rest of the year. This pattern suggests that the difference between the value-weighted and equal-weighted portfolios comes mainly from just one month. In fact, this “January effect” has long been documented by academic research. Scholars find that while stocks generally rise in January, small-caps tend to be more affected than large-caps are. Generally, low stock correlation dictates the divergence between value and equal investing. Beyond that, low stock correlation signals a stock picker’s market – more specifically, one needs to choose the right sector to generate alpha.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


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[1],[2],[3] – Source: Bloomberg



S&P 500 Index To Reach 3000?

We think that stocks in the US market will be fully valued when the S&P 500 Index hits the 3000 mark by the end of this decade. Here’s why.

A classic value method is to observe and estimate the equity risk premium (ERP). This method compares the earnings yield (earnings divided by price) to the riskless yield (US Treasury). Some use shorter-term Treasury yields; others use longer-term. Some modify for risk to adjustments in the corporate earnings outlook, while others add an expectations component. Over time, the way an estimate of ERP is derived has become complex.

We use a dozen methods in our shop. The key is either to decide on one method or to use many methods and adjust the mix by weighting them. In any case, take the earnings yield and subtract the selected riskless yield and the difference is the ERP.

The key to the ERP is to assume that it is the amount an investor is getting paid to take on the risk of owning stocks instead of choosing to buy a riskless bond or an interest-paying security.

Let’s just use one reference method for this commentary: the 10-year US Treasury note.

We have now seen enough to estimate 2019 earnings of $150–$160 for the S&P 500 Index. This is the range of estimates after analysts have had some time to revise their numbers and to consider the effects of the tax code changes. These estimates are based on static analysis. We think they are low because we expect some positive impact from repatriation, and we estimate that the US GDP growth rate will be close to 3%, rather than the current updated consensus estimates of 2.5%–2.6%. Remember that in the national accounting system after-tax profits are derived from the GDP with adjustments for foreign factors. Earnings of public companies that trade on the stock exchanges are a part of the profit picture in the GDP accounts. The tax code changes boost after-tax profits; hence they boost earnings.

So let’s use the high-end estimate of $160 for 2019. Now add the nominal GDP growth rate of 3% real plus 2% inflation. Also adjust for internal corporate leverage, because earnings grow faster than nominal GDP does. We have not adjusted for repatriation funds used in stock buybacks. That is going to happen, but we do not know to what extent. That adjustment will only raise earnings per share, but we will assume it is zero for the exercise.

So where are we now? About $160 for 2019 and about $170 for 2020.

The next step is to assume what the interest rate will be on riskless alternatives. We will use 3%. That is our best guess for the 10-year US Treasury note yield a year or so from now. Prices in the bond market today suggest that the 3% number is a bit high, but we will use it anyway.

History says that an ERP of about 3 is a fully priced market when using a 10-year riskless yield. We derive that result by looking at a century of data. So using the 3% number for riskless and adding 3% for our ERP, we get to a 6% earnings yield for a fully priced stock market. That equates to a 17 price-to-earnings (P/E) ratio.

Take the 17 P/E and multiply by the $170 estimate for 2020. The result of this exercise takes you to about 3000 on the S&P 500 – or, shall we say, close to it.

Close enough for our purpose. We could get a little extra earnings kick, and we could also get a weaker earnings picture. We could also get a lower US Treasury yield or a higher one. The key is not to try to guess the actual numbers – hitting them with a two-year forecast is nearly impossible.

For investment management purposes, however, the key is to guesstimate whether the market is richly priced (stay away), fairly priced (be careful but remain at least partially invested), or cheaply priced (raise the weight of stocks compared to bonds). We have been in a long period during which stocks have been favored over bonds. ERP helps explain the rise in stock prices.

Now we are approaching a time when the tailwind for stock prices will stop blowing. Rising interest rates, still-rising stock prices, and a refined earnings picture in the wake of the tax code changes make this wind shift clearer.

Our conclusion is to stay invested in the US stock market but to maintain heightened vigilance. We have not reached the end of this bull market, but we are getting close to the time when it will not pay for investors to overweight stocks.

Lastly, it is important to note that the stock market has often overshot. In the tech stock bubble of 1998–1999, the market had a massive overshoot. In the tech sector in 1999–2000, the ERP was actually a negative number. In other words, investors were paying a premium for the privilege of owning stocks. That is madness. It was madness then, and it will be again if this stock market overshoots. But we are not there yet.

We expect the stock market to experience an interim correction this year, but the trend is still toward higher stock prices as long as the ERP is as attractive as it is today.

We remain nearly fully invested. The last several years have been terrific for US stock market investors who could handle the risk required to be in it. The next two years will be okay but a lot harder. Still, the trend appears to be up.

We can send anyone who is interested the performance results for our ETF strategies over the last few years. Just email me for them.

January is off to a good start. It will be a fascinating year. And the politics of a midterm election year will certainly add to the entertainment, as we have already observed.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Marijuana Discussion: A Follow-Up

We thank readers for their diverse and sometimes intense responses to our recent comments about marijuana legalization in California and about the reversal of a US policy.

The link to that piece is here: http://www.cumber.com/california-high-on-cannabinoid-wellness/.

Many good points and counterpoints were argued. Some of them are quoted below.

Our position of supporting change is rooted in the failure of policy over decades. When a substance is illegal and desired, the price rises in a black market. High prices attract criminal risk takers. Murder and mayhem follow, as we see in country after country confronting drug cartels.

With increasing legalization we now see price suppression with marijuana. The cost of criminality attached to marijuana usage and distribution has been reduced or eliminated. Those who want to be “high” can do so without stealing a car or snatching a purse. Meanwhile, those seeking a medical benefit from cannabinoids may obtain it.

Americans are often polled about marijuana legalization. The overwhelming majority support it. And nearly ALL AMERICANS support medical usage with supervision and prescription. That is why 8 states now permit recreational use and 29 permit medical applications. Both numbers seem destined to rise.

We recall that in 1933 Prohibition (of alcohol) was repealed and alcohol regulation was delegated to each state. Criminal activity associated with alcohol became a closed chapter in the history of whisky and wine. Today both are supervised and regulated and generate tax revenue for many levels of government.

Yes, there are still drunken drivers. Yes, there is abuse. And yes, things are much improved from the machine-gun era of US history, which is now just the subject of films that appear on the classic movie channels.

Why not repeat this with marijuana? Take out the crime. Remove the financial incentives for criminals. And deal with drug addiction and substance abuse with new approaches.

Who wins? Government does, because it spends less on prisons and more to help citizens have productive employment. Taxpayers also win, with reduced levels of violent and invasive crimes. Who loses? Contract prison operators and criminals who prey on habitual users. Also players in the marijuana business that cannot succeed when the price is low and only succeed when artificially induced scarcity raises the price and induces criminality.

Other views are below. We are glad to have triggered the debate.

Bill A. wrote:

“David, I guess that at age 89 I am just too old fashioned in rolling my eyeballs on this whole marijuana issue. We have spent billions of taxpayer dollars on “the war on drugs” and the war on cigarette smoking, and now we are promoting the use of a drug which can and will be smoked. I can see the use for medical purposes, but what makes us think that usage will be controlled any better than that of opioids???

“My opinion is that approval for recreational usage is insane and will create both medical and safety problems.

“The New York Times reported earlier this week that in Colorado traffic deaths among drivers who tested positive for marijuana had doubled from 2013 to 2016 and that visits to emergency rooms for marijuana users had increased by 35%. What is going on among young people in this country is bad enough without turning out a nation of legal hopheads.”

Michael W. wrote:

“I agree with legal use of pot for medical purposes. I agree that arresting people for pot is a waste of time.

“But, I have seen the effects of prolonged use to be high, a complete lack of drive and motivation follows, ask Tom Keene, he said he watched it destroy lives while in college.

“For me, I watched my older son progress from pot all the way to complete opioid addiction, for him it was a gateway drug.

“I can have a glass of wine and be fine, other than medical purposes to use pot is to be high.”

Marc G. wrote:

“I have no expertise with medical marijuana but appreciate its efficacy.

“I am antagonized by the wave of legalization for recreational use. The data from Colorado is highly disturbing to me as a parent and a grandfather. The Obama administration left us in a dangerous place in relation to drug usage.

“We need a national discussion; I support our AG but sense that you do not.”

Dr. John S. wrote:

“I notice you don’t quote any peer-reviewed medical studies regarding medical marijuana. I also notice that you blur the lines between the labels of recreational use and “medical” use. Why? You have “seen it work for seizures”? This is a silly statement. It’s not scientific. We have effective treatment for seizures. Perhaps what you saw was efficacy in the case of non-epileptic seizures? Poor.”

Lee D. wrote:

“ ‘[Kotok wrote:] By yearend, 8 states will have recreational Marijuana; 29 will have medical usage. Meanwhile a reversal of established policy gives an “in your face” to the majority of the country. That is the result of the latest gesture by the US Attorney General Jeff Sessions.

‘CNN summarized as follows: “In a seismic shift, Attorney General Jeff Sessions will announce (he subsequently did -Ed) Thursday that he is rescinding a trio of memos from the Obama administration that adopted a policy of non-interference with marijuana-friendly state laws.” CNN goes on to say, “While many states have decriminalized or legalized marijuana use, the drug is still illegal under federal law, creating a conflict between federal and state law.” ’

“CNN’s take misses the mark as usual. The responsibility for law resides in Congress. Congress can change the law any time they so decide. All Sessions did is bring the Justice Department back to enforcing existing law. Policies of the previous administration to circumvent and manipulate government in unconstitutional ways were always going to be temporary as long as no laws were changes to make them permanent. This is a key feature of the ‘Swamp’ that Trump supporters are so adamant about fixing.

“Thanks for the quoting of my response to a previous post. Glad your family has experienced the benefits of the rapidly progressing marijuana derivatives evolution. I assume you are familiar with the CBD (Cannabidiol) derivative which is virtually devoid of the psychoactive components and yet seems to have beneficial effects for pain management, and joint comfort (in my own experience). We live in a time a rapid change. Let’s do our best to support legal changes that enable further progress and definitively leave behind the manipulations used by weak leaders and timid legislators that failed to really address problems, swept too many things under the rug and repeatedly ‘kicked the can down the road’.

“PS – appreciate the link to CB1 Capital LLC Newsletter – had not come across them before.”

Frank M. wrote:

“I suspect one of the first Sessions targets will be a local credit union in Seattle that accepts deposits and has accounts with marijuana dealers licensed by the state.”

David B. wrote:

“My daughter lives in Colorado with three dogs. Her oldest dog has lived on for many years – he’s a big bull dog and 13 years – with various tumors that she has treated with a special kind of medical marijuana that they sell in Colorado dispensaries. To the surprise of the Vet the tumor has shrunk and gone away and the dog acts in many ways like a younger dog despite his size and weight. If you believe Rebecca the government has research confirming the cancer treating properties of special forms of cannabis and suppresses it.

“It is a shame that we are happy to have massive fire power on untrained individuals, beer and liquor openly available, but can’t let a rather benign drug be treated with the same understanding.”

Dale K. wrote:

“I live in Colorado part of the year. I’ve witnessed what you describe. And I’ve had personal experience and do charitable work to rescue folks. I just don’t write about it often. Criminalize any substance and we raise the price, incentive crime and impose high societal cost. That policy has failed in America after decades of trying. This legalization process is underway, as we know. It, too, has flaws. We shall see.”

David F. wrote:

“You people are all nuts. Although medical marijuana use may help some with pain relief this overall embrace of this drug is nonsense. Dope makes you stupid and increased use will make the majority of users dumber than wood. Dr Michael Savage knows of what he speaks and I suggest you learn more before jumping on this stupid horse. Jerry Brown and the rest of these lunies will ruin the country.”

(Kotok responded:

“Thank you. I guess you prefer murder and mayhem by making this substance illegal. That creates artificial scarcity value by raising the price and thereby incentivizing criminality.

“We tried that for decades in America. We incarcerated millions of folks. We created an entrenched taxpayer-funded special-interest business to operate the prisons.

“I wonder who is the nut.”)

Liz W. wrote:

“Thank you for taking the time to share your thoughts on Sessions’ rolling back the Cole memo deprioritizing marijuana crimes. This seems at first glance to be contrary to the wishes of many Americans including those of us who have seen marijuana’s medical benefits firsthand – or who voted for Gary Johnson in the last election. However, the action – casting aside a policy promulgated post legislation – seems more in line with the rule of law, whether or not that was Sessions’ intent. Perhaps a more ‘judicious’ action would be for Congress to rescind federal laws and regulations over areas best handled at the state level. Similarly, the practice of lowering charges, e.g., in drug cases, to avoid mandatory sentencing laws begs the question, ‘Why are we not changing the law rather than recasting the crime?’

“The Wired article linked below provides another view you might find of interest – and possibly comfort.” (https://www.wired.com/story/sessions-legal-weed-crackdown-startups)

Byron W. wrote:

“Sessions is out of touch and is missing the sweep of history. He will succeed in further reducing the respect for federal power, enhancing states rights. If not careful he will further empower civil disobedience. He’s missing what US denizens do in their daily lives, he missed the anthro 101 observation of man’s universal need for intoxicants, and he’s clueless to the real-time social agglomeration and reinforcement powers of the internet. On the opposite side, Congress is a bit more sensitive to the flow of power. And maybe, just might write legalizing legislation. Either checkmating Sessions or falling for the bait of the evil geniuses manipulative powers to get Congress to act.

“Yesterday Trump tossed yet another bizarre career-limiting (except for Trump) non-presidential bit of meat into the grinder.

“Trump’s defense of himself as ‘a very stable genius’ is an example of the perils of unchecked self-esteem (and he’s arguably neither stable nor a genius). Ironically, could the tipping point in the Republican voter revolt away from this president and the party may be from Sessions’ recast ganja policy? Too many have tried pot, find it helpful, and fear the ravages of cancer without it. Pocket book, medicine, relief from pain are powerful motivators. As is simply the recreational aspect. The public has been clear on this since 1968. We are retiring now, we tolerate alcohol a lot less. We like a quality spliff when we want one. No ambiguous street weed for us, we have standards, we have needs. We are gourmet not fast food. We are older, wiser, grumpier, less tolerant of hurdles to our well being, and we vote. #GoodGanjaMatters, #WeedWantsToBeFree, #MedicateMe, #EarlyOnsetCrankiness. First amendment, second amendment, smeckle amendment pale in our need to celebrate the sacraments of the blessed herb.

“A ramblin’ rant from a former Wall Street analyst. I appreciate your work and opinions, and not because they are always the same as mine. Keep on keepin’ on.”

Robert K. wrote:

“I also seek clarity and as much veracity as can be obtained from available, credible information.

“In other words, I try to align the strength of my beliefs with the quality of the supporting data.

“I fully recognize the distress involved in the circumstances surrounding a diagnosis of cancer. However, having administered cancer chemotherapy to thousands of patients, and in the process helped a few, I can assure you that chemotherapy does not cause ‘pain.’ It causes many side effects, some ugly, but not pain as the term is generally employed. Suffering, perhaps, when added to the suffering intrinsic to the underlying disease, unless a favorable effect is achieved, which still, regrettably, is not often enough.

“In the 1970s, as a trainee at the National Cancer Institute, NIH, I participated in a trial of delta 9-THC, purified from crops grown on US government farms, for Rx of nausea in childhood acute leukemia patients. They still vomited, but according to them, it was beautiful. In 1985, the drug MARINOL (dronabinol capsules, USP, synthetic delta-9¬ tetrahydrocannabinol [delta-9-THC] was approved in the US for Rx of nausea related to chemotherapy (and is still on the market). Older people, like us, do not do well on it – mental adverse reactions – however, it never did well because there are MUCH better, highly effective anti-nausea meds with much less side-effect problems available.

“In truth, we know almost nothing about cannabis – probably hundreds of unique chemicals within the multiple species.

“Personally, I expect the medicinal use of cannabis to dwindle as synthetic versions of the active ingredients are developed. Recreational uses, and ‘needs,’ probably will easily be addressed by the use and availability of the whole plant. The astute buyer will rapidly be ‘growing their own’ and won’t need ongoing purchases, except maybe for special events! I wish I knew enough of the commercialization being implemented to short these new ‘businesses.’

“Even more important, especially in the weed imported from south of the border, there are impressive levels of pesticides, DDT, etc. being consumed by the public – but, but ‘It’s organic – it’s NATURAL.’

“ ‘Caveat inhaler.’ ”

Joe Z. wrote:

“Regarding the Medical Use of any Medication, one of the most important things that I’ve learned as a licensed physician for the past 46 years: The patient is always right. If they say a drug works, then it works.”

Finally, Dennis Gartman wrote, in today’s Gartman Letter:

“We are openly opposed to the legalization of marijuana here at TGL, despite the fact that we are libertarians in almost all instances and libertarians on balance support legalization of it and many other drugs. But we have seen the dangers of drug usage and despite the arguments otherwise we are of the belief that marijuana usage is detrimental to health and welfare. Let the Millennials and others younger than we argue otherwise; we’ve seen what we’ve seen and it is rarely if ever benign.

“However, we are even more opposed to federal government trampling upon states’ rights, for we are even greater believers in the rights of the individual states to make their own decisions on these sorts of questions. It is up to the states to decide on alcohol consumption; it is up to the states to decide who can and who cannot drive in that state; it is up to the states to decide the questions regarding marriage; it is up to the states to decide how and where they will educate their children, these things are not up to Washington to decide. These are the things that the citizens of Virginia, or Massachusetts, or Ohio, or Iowa or California are to decide. These are state’s rights.

“Hence, although we would openly oppose any attempts by Virginia, where we live, to legalize the use of marijuana, for we do indeed believe that allowing it to be used widely by the states citizens and youths can be and will be deleterious to the state. However, it is up to the voters of Virginia or the legal elected legislature to make that decision, and if the “people” of Virginia make that bad decision it is up to us to either move to another state or to make our peace with that decision. The voters of Colorado, California, Oregon, Washington and Nevada have chosen to allow their citizens to imbibe in marijuana and that is the right of the citizens there to make that ill-advised decision. If the citizens of these states wish to expose themselves to “impaired” drivers or to expose themselves to “slacker” labor forces, then that is their right and it is our duty to defend that right. In the end, rest very much assured that Colorado, California, Oregon, Washington and Nevada will see their states deteriorate; businesses will fail; tax revenues will fall; deficits will rise and populations will fall… but again, that is their choice. It is not Washington’s choice to make and it is not the right or the obligation of the US Attorney General to intervene.

“We shall make enemies with this comment; so be it. It won’t be the first time and certainly it won’t be the last. But we know this: we won’t be investing in the drug culture. Others may get wealthy buying marijuana stocks. We wish them well. We pass.”

We thank all readers for their responses and especially Dennis for permission to quote his morning missive.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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California High on Cannabinoid Wellness

“California High on Cannabinoid Wellness” is the title to this commentary which was written a few days ago.

Now we must ask: “What about the rest of the nation?”

By yearend, 8 states will have recreational Marijuana; 29 will have medical usage. Meanwhile a reversal of established policy gives an “in your face” to the majority of the country. That is the result of the latest gesture by the US Attorney General Jeff Sessions.

CNN summarized as follows: “In a seismic shift, Attorney General Jeff Sessions will announce (he subsequently did -Ed) Thursday that he is rescinding a trio of memos from the Obama administration that adopted a policy of non-interference with marijuana-friendly state laws.” CNN goes on to say, “While many states have decriminalized or legalized marijuana use, the drug is still illegal under federal law, creating a conflict between federal and state law.”

Personal disclosure. I have personal experience with family members who have used medical marijuana derivatives to deal with pain from Chemotherapies. It works. I know cases where a derivative product has helped with seizures. It works. This change from AG Sessions is a reversal without support because of its blanket and broad nature. What it means for a confrontation between the states and the federal government remains to be seen.

Let me get to the lessons from California, the most populous state in the United States and the size of what would be the fifth largest economy in the world were it to be a standalone country. And let’s get to our original comments about the changing world of cannabis.

Todd Harrison is known for previous work (Minyanville, Ruby Peck Foundation, etc.). He is now the founding partner & chief investment officer at CB1 Capital LLC, https://twitter.com/CB1Cap. Todd describes CB1’s effort as a cannabinoid wellness fund and an emerging disruptive healthcare enterprise. I called Todd after reading the CB1 morning note below, and he granted us permission to reproduce it and send to our readers.

The subject of California and the opening of recreational marijuana sales on Jan. 1, 2018, is huge. It is now legal to buy and sell recreational pot in California. As CB1 notes below, California is “the eighth and largest state by far to make the move.”

The morning note that Todd’s firm sent discusses many issues. Federal rules and the restriction on banking and money transfers are among them, as is the whole issue of finance and investment in the developing industry of marijuana agriculture and distribution in this rapidly expanding asset class.

At Cumberland we are watching the development of this industry closely. We haven’t seen any “marijuana bonds” in the municipal space yet. We expect they will be developed and issued by jurisdictions that want to finance state and local government activities with marijuana revenues. Why not? We have seasoned tobacco settlement bonds as a model.

We have seen the launch of the first ETF, whose symbol is MJX. The launch is too small for us to use now and not seasoned enough for Cumberland to place in managed accounts. That situation could change with time. For now a Cumberland client or trader has to buy MJX on his or her own and only for their personal account.

We’ve also watched products derived from cannabis used to treat pain, and we’ve seen the relief afforded to those who are suffering from chronic diseases. So this industry may be about “getting high” for some folks, but it is also a legitimate and now legal industry with a health component.

We have personally observed cases where juveniles have incurred criminal records and had to endure negative consequences in their lives because they were convicted on a charge involving marijuana. Those same cases would never be prosecuted today. Is there a way to cleanse those records? Would expunging those convictions allow many young adults with no other infractions more educational and employment opportunities?

And, finally, there is the antiquated federal legal structure that constitutes an impediment to marijuana-related banking and finance. It is time for a change here. We wonder at the extent of the off-the-books and cash transactions that are taking place due to the federal intransigence. We’ve watched workarounds devised in states like Colorado, where cash commercial activity thrives because of federal restrictions on conventional banking system usage.

Questions abound, but one thing is certain. With recreational marijuana now legal in California, pressures for a national evolution of this industry will intensify greatly. We expect that with those pressures will come changes in the federal system.

We thank Todd Harrison for granting permission to share the following morning note with readers.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


CB1 Capital LLC Newsletter – Morning Headlines

It’s more important now than ever to update outdated policies, right the wrongs against communities of color, and continue our work to lift up the voices of the many Americans who are speaking out in favor of legalization.” -Senator Ron Wyden, D-OR

California Prepares For Recreational Marijuana Sales On Jan. 1.
(audio)

On January 1, it will be legal to buy and sell recreational marijuana in California. It’s the eighth and largest state by far to make the move. It’s had to rush to get regulations in place since voters approved the measure just over a year ago. From member station KQED, Katie Orr reports. 

https://www.npr.org/2017/12/27/573870651/california-prepares-for-recreational-marijuana-sales-on-jan-1

California Marijuana Start-Ups, Shut Out From Banks, Turn to Private Backing

Marijuana is becoming legal in California, and entrepreneurs are rushing in with infused artisanal chocolates, specialized farming equipment and security teams to guard large hauls. On Jan. 1, companies will be able to produce and sell marijuana in the state, making it one of eight in the United States where the recreational use of cannabis has been legalized. But finding expertise and financing won’t be easy. Cannabis use still lacks legal standing with the federal government. That means growers, processors and retailers can’t open accounts or access lines of credit from federally insured banks. They can’t write off business expenses when they file their taxes, and it’s extremely difficult to purchase crop insurance (think of the recent spate of fires in California). “It’s federally illegal, and that makes running a cannabis business more challenging than arguably any other kind of business,” said Kris Krane, co-founder of 4Front, a medical marijuana investment and management firm. Cannabis-focused accelerators and investment companies aim to change that. These enterprises have long been a presence in Silicon Valley, offering mentoring and investment in exchange for an ownership stake. Companies that provide these types of resources are critical to expanding a nascent industry around legal marijuana, said Mr. Krane, if only because they can introduce its entrepreneurs to angel investors and other private capital sources. Funders have reason to be interested. Selling cannabis in California has the potential to generate $5 billion a year, once a critical mass of businesses have proper permits, according to the Agricultural Issues Center at the University of California at Davis. Each harvested acre of cannabis could be worth millions of dollars, based on current prices in Washington, Oregon and Colorado, according to Greg James, the publisher of Marijuana Venture, a monthly business magazine. Two years ago, Ben Larson and Carter Laren co-founded Gateway, an accelerator in Oakland that has helped expand 19 cannabis-related start-ups specializing in a wide variety of business activities, including payment solutions, cannabis products aimed at seniors, agricultural technology and hemp-based plastics. When the pair started, medical marijuana had been legal for two decades, but Gateway found many companies’ business practices were still “not far departed from those of the black market,” Mr. Larson said. With legal adult use in sight, the industry is making a rapid transition to more sophisticated, transparent and mainstream business practices, he said. Gateway now offers $50,000 in exchange for 5 percent of a company’s ownership, and brings the management team of start-ups into its offices for about six months to work with experts, mentors and potential investors. Applicants present their business plans and answer questions on legal issues, trends and the competitive landscape. Mr. Larson sometimes assigns homework, asking founders to conduct customer interviews and do market research. Entrepreneurs bring a wide variety of ideas because the industry is just forming. For example, new apps, sensors and machinery help control growing conditions, save energy and reduce labor costs in greenhouses. Even “the boring areas” of the marijuana industry offer terrific opportunities, said Mr. Larson, because growers are currently spread too thin. The same company might be cloning plants, harvesting crops, selling to dispensaries and making deliveries. “There may be eight different steps in their value chain that could be specialized” and contracted out, he said. Increasing brand recognition for products and retailers is another major opportunity for start-ups. “There’s no Starbucks or Nordstrom’s yet — names that mean things to people,” Mr. Larson said. While states are collecting hundreds of millions of dollars in tax revenues from marijuana businesses, and a rising number of Americans favor legalization in some form, Attorney General Jeff Sessions’s firm opposition to it poses a risk to cannabis-related companies. He could “shut the industry down tomorrow,” said Micah Tapman, co-founder of the Canopy cannabis accelerator and venture capital fund in Colorado. Of course, there are other challenges. Evolving rules and regulations, like new packaging requirements, can add unexpected costs to processors and retailers. Companies forced to deal only in cash can run into safety and theft issues. Many small growers emerging from the black market “have no idea how to run a commercial-scale facility,” Mr. James of Marijuana Venture said. Despite the hurdles and uncertainty facing the industry, Mr. Larson of Gateway has remained optimistic. “People are gaining confidence as legalization spreads, and the growth is going to be huge,” he said. 

https://www.nytimes.com/2017/12/27/business/smallbusiness/california-marijuana-start-ups.html

ETF Focused On Marijuana Industry Launched 



This ETF might bring “high” returns. MJX, an ETF focused on the cannabis industry, made its debut on NYSE Arca on December 26. The fund previously planned to make its debut as the “Alternative Agroscience ETF” and claims to be “one of the first of its kind.” It intends to mirror returns from the Prime Alternative Harvest Index. According to the fund’s managers, the index “tracks companies likely to benefit from the increasing global acceptance of various uses of the cannabis plant.” The fund was earlier targeted at the real estate market in Latin America. ETF Managers Group LLC is behind MJX. “As an ETF issuer we are excited about opportunities for innovation, the chance to give investors exposure to new markets and doing our part to impact the continued evolution of the ETF industry by meeting the appetite of investors interest,” said Sam Masucci, founder and CEO of the company. MJX has 31 holdings, with more than 80% focused on the healthcare and consumer staples sector within the cannabis industry. The top three holdings in the ETF are Canadian. Its largest holding is Cronos Group, a supplier of cannabis to medical institutions. CannTrust Holdings, another company aimed at the medical cannabis industry, and Canopy Growth Corp., a cannabis producer and distributor, are the other two holdings. The MJX fund has $5.7 million in assets and an expense ratio of 0.75% and its managers plan to rebalance it on a quarterly basis. Across the pond, the Horizon Marijuana Life Sciences Index ETF also tracks businesses within the marijuana industry. 

https://www.investopedia.com/news/etf-focused-marijuana-industry-launched/

Pot Stocks Soar as California Gets Ready to Get High (video) 



Marijuana companies are higher than ever as California rolls toward recreational legalization. The BI Canada Cannabis Competitive Peers index is having its best day ever as Californians prepare to light up, or eat up, marijuana products starting Jan. 1 at 12 a.m. Among those reaching intraday records are Canopy Growth Corp., Cronos Group Inc., and producer Aphria Inc. Some marijuana companies are creating multinational franchises on the heels of legalization, said RBC analyst Nik Modi this month. Green House Brands North America has a joint venture in Canada with Canopy Growth and Organa Brands, which sought to invest in and acquire cannabis brands in the U.S. There is overlap among the alcohol, tobacco and cannabis industries AdvisorShares Investments Managing Director and Chief Operating Officer Dan Ahrens said in a Bloomberg TV interview, with mergers and acquisitions or “at least” joint ventures likely. The three work well together, he said, noting his AdvisorShares Vice ETF includes an allocation of about 20 percent cannabis-related stocks. The industry is in its “infancy” and “just getting started,” Ahrens said. Canada’s also legalizing recreational pot next year. Ahrens isn’t alone in that sentiment. Bloomberg Intelligence analyst Kenneth Shea, in his 2018 outlook, highlighted key trends for the cannabis group, which included more and larger mergers and acquisitions and a rising number of states legalizing medical or recreational use. Earlier this year, in fact, Constellation Brands purchased a 9.9 percent stake in Canopy Growth that could catapult the marijuana producer into a league of its own, according to GMP analyst Martin Landry. Of the 34-member Canada Cannabis Competitive Peers (BINACCCP) index, 32 are trading up today, while 60 of the 69-member BI Global Cannabis Competitive Peers index are also in positive territory.
https://www.bloomberg.com/news/articles/2017-12-27/pot-firms-steal-the-spotlight-as-california-prepares-to-get-high

Marijuana stocks rise after Canadian regulators’ ruling

Shares of Canadian marijuana companies rose Wednesday after two Canadian regulators rejected Aurora Cannabis’s request to shorten the minimum deposit period to 35 days from 105 days for its hostile takeover of CanniMed Therapeutics Inc. Aurora’s request, if approved, would have increased the likelihood of the hostile takeover by preventing CanniMed’s bid to buy Newstrike Resources Ltd. Alberta-based Aurora offered to buy CanniMed for $24 per share in Nov. 24, but within days CanniMed adopted a shareholder rights plan, or a “poison pill”, viewing the offer as “coercive”. Earlier this month, CanniMed approached the regulators to declare Aurora’s decision to take the buyout offer directly to CanniMed shareholders as an insider bid. The regulators also rejected CanniMed’s request to consider the offer as an insider bid. An insider bid is a takeover offer made by a company insider or their affiliates within a year before the bid. Canadian securities laws demand disclosure, review and approval processes in the event of such a bid to protect minority shareholders. In response to Wednesday’s announcement, CanniMed was up 4.7 per cent to $20.89 in mid-afternoon trading, while Aurora was up 9 per cent to $7.86. Meanwhile, Canopy Growth Corp. was up 17 per cent and Cronos Group Inc. rose 19 per cent. Cannabix Technologies Inc., THC Biomed Intlernational Ltd and Aphria Inc. all rose 10 per cent. OrganiGram Holdings Inc. was up 6 per cent. A decision to shorten the minimum deposit period would have tested Canada’s rules for hostile takeover bids, leaving less time for the target company to react to the acquisition The marijuana industry has seen a lot of M&A activity as it prepares for legalization in 2018. Canopy Growth Corp plans to acquire some assets of Green Hemp Industries. In June, Organigram Holdings acquired Trauma Healing Centers.
https://www.theglobeandmail.com/globe-investor/investment-ideas/marijuana-stocks-rise-after-canadian-regulators-ruling/article37433180/

Over 100,000 patients registered for Pa. Medical Marijuana Program (video) 



The Medical Marijuana Program was signed into law by Wolf on April 17, 2016. The program became effective on May 17, 2016, and is expected to be fully implemented by 2018. It will offer medical marijuana to patients who are residents of Pennsylvania and under a physician’s care for the treatment of a serious medical condition as defined by the Medical Marijuana Law. You can read more about the law at www.health.pa.gov.
http://www.wpxi.com/news/top-stories/over-100000-patients-registered-for-pa-medical-marijuana-program/669805639

The Profit in Marijuana Country Humboldt County (video) 



California is home to an estimated 10,000 illegal pot farms and source of much of the illegal marijuana in America. But things are changing fast in Humboldt, as California becomes the eighth state to legalize recreational weed. In a special episode of “The Profit,” Marcus Lemonis looks at how legalization is changing the landscape in this legendary outlaw county. The Profit in Marijuana Country Premieres Jan 2 | Tues 10P ET/PT
https://www.cnbc.com/video/2017/12/27/the-profit-in-marijuana-country.html

Virginia’s hemp research program ‘a work in progress’

Virginia is wrapping up its second year of a research program that allows farmers to grow hemp, a crop long banned because of its association with marijuana. The 78 acres planted across the state in 2017 was more than double the 2016 total. But research reports and interviews with those involved in the program show the challenges that come with cultivating a plant that had not been grown in Virginia for decades. “It’s still a work in progress, but there’s movement toward identifying those varieties that are going to be more successful in the Virginia soil, Virginia climate,” said Erin Williams, a senior policy analyst with the state agriculture department. Here’s a look at the work in 2017 and what could be ahead in 2018. In 2015, the General Assembly passed a bill signed by Gov. Terry McAuliffe establishing a research program in Virginia. During 2016, the first full year, three research universities planted approximately 37 acres in industrial hemp, according to the state Department of Agriculture and Consumer Services. In 2017, four research universities participated, planting 78 acres. Advocates are hopeful hemp could eventually become a profitable cash crop used, in part, to replace tobacco. James Madison University, the University of Virginia, Virginia State University and Virginia Tech have hemp research programs underway. Some of the hemp was grown by farmers on privately owned land and some was grown on university-owned or managed property, according to an annual report from the agriculture department, which manages the program. “What we’re all trying to learn is what actually works best,” said Dr. Michael Timko, the lead researcher at U.Va. The work in 2017 helped narrow down details such as planting times and density, the best variety to use and how to manage different growing locations, he said. U.Va., which is partnering with plant biotechnology company 22nd Century Group, is also conducting research into developing hemp varieties that have high cannabinoid levels for medicinal use but low THC levels, Timko said. Another arm of the project taking place at the U.Va.-Wise campus in southwest Virginia is focused on finding varieties of hemp that could be used to clean up and reclaim abandoned coal mines through a process called phytoremediation. Limited rainfall and aggressive weed growth limited the growth of that crop in 2017, according to the annual report. The agriculture department has been working on legislation for the General Assembly session that begins in January that would expand the research program and simplify the registration process for potential growers. The bill would maintain the university research program but add the authority for the department to manage its own research as well, said Williams, who oversees the current licensing program. The legislation will also include a registration option that would allow a third party to get the raw material from a farmer and process it, she said. McAuliffe’s proposed budget, which will serve as a starting point for negotiations during the session, includes funding for two new positions at the department to staff an expanded research program. “All of this is going to take some trial and error, but the learning curve is going quicker as we get more and more people involved,” Timko said. The U.Va. team will have a bit of a head start in 2018, he added. The team collected seed material in 2017 that can be replanted in the new year, instead of having to import seeds from out of state, eliminating a logistical headache. Overall, Timko said he’s excited about where the project is now, but noted how much more work there is to be done, including on researching the processing and manufacturing aspects of dealing with harvested hemp. “Which farmer is going to spend hundreds of thousands of dollars on seeds and plant hemp if he has no place to sell it or there’s no outlet for the manufacturing?” he said.
http://www.richmond.com/news/virginia/virginia-s-hemp-research-program-a-work-in-progress/article_c7cdf4e2-e996-5ca9-84e9-690f78ab8e76.html

Veterans and access to cannabis: 2017 in review

2017 was a year of frustration but also incremental progress for military veterans, veterans’ organizations and supporters, as they continued to lobby federal and state politicians to expand legalized medical marijuana research — as well as greater veteran access to legal pot for treatment of a variety of ailments, including chronic pain and Post-Traumatic Stress Disorder (PTSD). Despite concerns about crackdowns, as well as some setbacks, steady pressure was applied to politicians to at least consider an evolution of current policies. Here’s a roundup of how some of those efforts have played out over the course of this year:
http://www.thecannabist.co/2017/12/27/military-veterans-cannabis-legislation-ptsd/95367/


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December 2017 FOMC Minutes

On Wednesday, the Fed released the minutes of the FOMC’s December meeting.  As usual, the minutes followed the standard format, mirroring the way presentations and discussions proceed at FOMC meetings.  It began with a brief summary report by the manager of the Open Market Desk in New York.  There were only two notable pieces of information in that summary.  The first was that market participants attributed the narrowing of spreads between short- and long-term securities to the anticipated continuing rise in the FOMC’s target federal funds rate and the belief that the Treasury would increasingly concentrate its issuance of new securities to the short end of the curve.  This would push up short-term rates while increasing upward pressure on longer-term securities’ prices and decreasing longer-term rates.[1]  The second piece of information was simply the confirmation that the reinvestment operations are proceeding on course, but there was no information provided on what changes have taken place in either the size of the portfolio or its composition.

The minutes then continued with separate discussions of staff summaries of real-economy and financial-market conditions leading up to the December meeting.  Again, these separate summaries reflect the organizational structure of the Board, whose Division of Research and Statistics focuses mainly on the real economy, while its Division of Monetary Affairs concentrates on financial markets.  These discussions were then followed, as is customary, by a summary of the “Staff Economic Outlook,” which this time was quite brief.  The main change noted from the previous meeting was the staff’s upward revision of real GDP growth for 2018 as the result of a reassessment of the likely impact of the new tax legislation. Otherwise, aside from a slight uptick in the inflation forecast and a continuation of the decline in the unemployment rate, the staff viewed the risks to the forecasts as relatively balanced and the uncertainties surrounding the forecasts as similar to what they have been over the past 20 years.

The minutes then turned to the discussion of participants’ views on current conditions and their outlook, which is where the real meat of the minutes begins.  One can skip everything that precedes this discussion and get to the heart of what actually happened substantively at an FOMC meeting.  After a boilerplate description of the “Summary of Economic Projections,” the discussion turned to how the participants viewed the economy.  Similar to what the staff saw, participants viewed growth as solid.  The hurricane disruptions were seen as minor in terms of their impact on overall activity.  Labor market growth was viewed as consistent with above-trend growth of GDP over the previous two quarters.  Inflation was expected to remain below the 2% target, and near-term risks were balanced.  All these assessments were consistent with what the Board staff had provided and were viewed as likely to continue assuming a continuation of the gradual adjustment in policy.

After presenting the summary conclusions, the minutes then began to highlight some of the issues and differences in views of participants.  With respect to the tax legislation, which was passed by Congress subsequent to the meeting, a few expressed the view that anticipation of the tax changes was already having an impact on consumer spending, while others voiced considerable uncertainty about the likely impacts on spending. Similar views were also reflected in participants’ uncertainties about the impacts of the tax changes on business investment spending.

With respect to the labor market, participants saw continued stretching in labor demand, but few cited any evidence of a pickup in wages, except for scattered increases in wages of unskilled workers.  To some this meant that there was opportunity for even further gains in employment.  Their emphasis on labor markets and wages reflected not only the committee’s dual mandate but also the view that wage increases have a causal effect on prices.  In other words, the Phillips curve framework still seems alive and well, at least as far as some participants are concerned. The discussion of inflation in the minutes also mirrored much of the recent public discussion by Chair Yellen, who acknowledged the difficulties the committee has in understanding current inflation dynamics and why inflation continues to remain below target, despite very accommodative policies.  Among the possible explanations cited were transitory factors, secular trends in globalization and technology, and a decline in inflation expectations.

The minutes also reflected participants’ concerns for the impacts that accommodative policies are having on financial markets, including low rates, easy terms for risky borrowers, elevated asset values, and low volatility.  Particularly noteworthy were the low term premiums on longer-term assets that are due in part to previous purchases of assets by central banks, low inflation, and high demand for longer-term assets.  Concern was expressed that the lower term premiums, while not of current concern based on historical experience, are still worth careful monitoring as a harbinger of a potential inversion that signals a future downturn, posing a risk to financial stability.

When it came to the policy implications of their assessment of current and future economic conditions, all but two participants seemed comfortable with not only a tightening at the present meeting but also with the gradual path for tightening that they saw going forward.  Of course, some members felt that developments, especially a jump in inflation, might be grounds for a steeper policy path, while others argued that they were uncomfortable with the number of rate hikes implied by their forecasts for 2018, given the persistence of inflation below target.[2]  The discussion concluded with the obligatory recognition that future policy moves will depend upon how the economy evolves in coming months.

Noteworthy at the conclusion of the minutes were the explanations for the dissents to the majority decision to raise rates by Presidents Evans and Kashkari.  President Evans argued that a pause is in order in view of the persistence of inflation below target and that such a pause would better support an increase in market inflation expectations.  President Kaskari was also concerned about the failure of inflation to move towards target and about the flattening of the yield curve, which he believes contributes to falling longer-term inflation expectations and suggests a lower neutral rate for policy.  President Kaskari dissented in every meeting when the policy rate was raised this year, while President Evans voted with the majority in June but chose to dissent in December.  Both of these presidents will be replaced as voting members this year by presidents who are much more inclined to favor the current policy path.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] There was only one short paragraph suggesting input from the Division of International Finance and no indication this time of material attributable to the Division of Financial Stability.  That is not to say that there weren’t presentations by staff of those divisions.
[2] Use of the term members in the minutes refers to the Board of Governors and the five voting members of the FOMC while participants refers to the Governors and all the reserve bank presidents.

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Q4 2017 Credit Commentary – Taxes, Pensions, Ratings

The fourth quarter was dominated by tax reform and its effects on the supply and pricing of municipal bonds. The prospect that one of President Trump’s major initiatives would finally be passed by year-end buoyed the stock market http://www.cumber.com/market-volatility-etf-portfolio-4q-2017-review-will-the-bull-market-continue/. For a recap of the tax law changes and effects on the municipal market, please see John Mousseau’s commentary “The Muni Take on the Tax Bill (Round Two)”: http://www.cumber.com/the-muni-take-on-the-tax-bill-round-two/.

As we move on from tax reform, many are hopeful that an infrastructure plan will be addressed this year. The ability of municipalities to continue to issue private activity bonds had been threatened in the tax reform process. These bonds help fund traditional infrastructure projects from hospitals to airports and are expected to be instrumental in furthering an infrastructure initiative. Improvement of our infrastructure is important to our nation’s continued growth, as the country depends on the preparedness of our electric, water, and wastewater utilities and it depends on safe roads and bridges to provide for efficient transport of goods and services.  As we have noted in past commentaries, the American Society of Civil Engineers, while noting some improvement, still gives US infrastructure a D+ rating, similar to the last major assessment in 2013: https://www.infrastructurereportcard.org/americas-grades/.

The quarter also experienced significant natural disasters, which we commented on in our Dec 22nd commentary, “Wildfires Abound” (http://www.cumber.com/wildfires-abound/), and in our October 10th Q3 commentary “Whirlwind Is an Understatement” (http://www.cumber.com/q3-2017-municipal-credit/).

State ratings activity waned a bit in Q4, compared to past quarters. State ratings volatility may continue to decline, as the downgrades of the past few years have targeted attention to the growing liabilities and some states’ overreliance on narrow revenues. Some states and other municipalities are making inroads at reducing large and mounting unfunded pension and other postemployment benefits (OPEB), such as promised healthcare liabilities. These actions include reducing earnings assumptions on invested assets to realistic levels that reflect market conditions, fully funding annual contributions, and gaining concessions from employees. States such as Alaska and Oklahoma, which are overly reliant on oil and gas business or royalties and which have not yet addressed long-term fixes, have already been downgraded.

High-tax states will have to manage the implications of tax law changes that may affect their citizens disproportionately – and in some cases substantially – by reducing the tax deduction for state and local taxes and mortgage interest. These changes effectively raise federal taxes and reduce the flexibility of states and localities to raise taxes. Connecticut is an example of a high tax state that has already lost population in response to high taxes and a difficult operating environment. High-growth states such as Texas and Florida will be watched to see if there is pressure on their budgets for infrastructure and social services. Many municipalities, having learned a lesson from the financial crisis, have made an effort to keep reserves or rainy day funds at healthy levels.

State rating actions this quarter include the following:

Wisconsin was upgraded by Fitch to AA+ on improved fiscal performance as a result of improved reserves, improved liquidity, and reduced dependence on “one shots” or one-time revenue items. This move follows last quarter’s upgrade by Moody’s and an improved outlook by S&P.

In November S&P revised the outlook on Colorado’s AA rating from stable to negative, based on low pension funding levels. For a number of years, Colorado has shorted the annually determined contribution to its pensions, resulting in lower funding ratios than comparatively rated states. This outlook denotes only a trend change, not a ratings watch, which would indicate that S&P could downgrade the state in the near future. However, the rating report cautions that if progress is not made on funding or a plan is not made to address the shortfalls, then Colorado ratings could be lowered. Colorado has a diverse economy and good growth and management, so it is anticipated that the state will take corrective action.

In December, six months late, Pennsylvania finally passed its budget. Fitch removed the state’s negative rating watch and affirmed the AA- rating but with a negative outlook. Although the rating was removed from rating watch negative, the negative outlook speaks to the continuing budgetary pressures that result from growing liabilities (pension and OPEB) and one-time budget-balancing items that reduce reserves. On a positive note, the state recently projected a surplus for fiscal 2018, compared with a deficit in 2017.

Some municipalities wrestling with pension reforms are turning to pension obligation bonds: A recent example of a municipality taking corrective action is the City of Houston, America’s fourth largest city, with a population of over two million. The city issued pension obligation bonds to fund a shortfall in its pension funding level. Moody’s affirmed the city’s Aa3 rating, noting,

“The issuance of pension bonds by themselves is typically an interest rate arbitrage gamble and thus credit neutral at best. In the case of Houston, however, voter approval of the bonds is credit positive because it allows the retirement benefit reforms the state authorized in May to take effect. Savings from reduced pension liabilities will more than offset the increase in the city’s debt burden from issuing the pension bonds.” [Pension obligation bonds are taxable.]

Concessions from employees included a reduction in the cost-of-living adjustment and the ability to reduce costs further for unanticipated cost hikes. Because numerous causes of a growing liability were addressed and Houston has a strong credit rating, this transaction should benefit the city.

However, as noted by S&P, pension obligation bonds, if issued just prior to a market downturn, can produce less than optimal results. When a municipality is distressed or attempting a one-time fix for budgetary weakness, the issuance of POBs could be a negative. When a local government issues a POB, it typically deposits the proceeds in a trust and repays the debt from the general fund. This strategy essentially addresses unfunded pension liabilities by shifting them into debt. The funded ratio for the pension plan is immediately increased, which may have multiple effects, such as lower annual actuarially recommended contributions and improved relations between management and employees, who gain assurance that a promised benefit will be there when they retire. But in exchange for the improved pension funding at the time of issuance, the government entity takes on an increased debt burden.

On another front, National Public Finance Guaranty, a subsidiary of MBIA Inc., no longer requires a rating since it is in run-off.   This past December, in response to National’s notice that it no longer wanted a debt rating, S&P affirmed its A rating as stable for the next year and then withdrew the rating. Kroll also downgraded its rating on National’s claims-paying ability to AA with a negative outlook and then withdrew the rating. So that it can keep its clients informed, Moody’s has retained an outstanding rating on National as long as it continues to have enough information to assess credit quality. (That’s somewhat surprising since its A3 rating was lower than the other agencies’ ratings were.) Moody’s could continue to maintain a rating for National for some time, as bond insurers are generally transparent and have extensive information available on their websites regarding insured risks and investment portfolios as well as required SEC and statutory quarterly filings and there is easy access to investor relations.

In June 2017, S&P downgraded National to A, essentially putting it out of business because its ratings (A/A3/AA+) were not high enough to provide enhancement to issuers. However, at the time, S&P and other rating agencies stated that National continued to have very strong claims-paying resources. Further, in September, after Hurricane Maria devastated Puerto Rico, eroding the estimates of recovery on various Puerto Rico bonds to the range of 35– 65% per Moody’s, Moody’s reiterated its opinion that National has strong claims-paying resources, as did S&P and Kroll.

National has insured very little debt since the 2008 financial crisis and has a very low market share, which is one of the reasons S&P lowered its rating in June. Cumberland does buy bonds insured by National as well as Assured Guaranty and Build America Mutual (BAM). It is expected that the S&P ratings on National insured debt will revert to the rating that S&P may have had on the underlying issuer of the insured bond, or may be non-rated (NR) . The reduced number of ratings may reduce the liquidity of some National insured bonds. However, the bond insurance continues even though the bond insurer is no longer rated. To the extent that National has adequate reserves, investors will continue to have two payment sources. The majority of insured bonds are of BBB or A credit quality, which is considered investment-grade.

Cumberland will continue to follow developments in areas such as tax reform and infrastructure funding, as well as trends in pension funding strategies (or lack thereof), economic growth, and other factors that affect public finance and municipal bonds. As always, we invest only in high-quality bonds that are liquid, a strategy that enables us to move in and out of positions should we see a compelling credit or a structural need to invest in holdings or pull out.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Puerto Rico – Fourth Quarter 2017 Review

The Commonwealth of Puerto Rico entered the fourth quarter having suffered one of the most devastating natural disasters in the island’s history. Hurricane Maria left billions of dollars in damage in its wake, including both infrastructure damage and economic losses. The human costs have been equally terrible, with millions of US citizens suffering.

Three months later and the lights are still out – only 70% of power has been restored.  Many businesses remain closed due to the lack of electricity and the high costs of using diesel generators. An estimated 20%-30% of the island’s 65,000 businesses may close permanently. Residents have fled to the mainland in the wake of the hurricanes. According to a study by the Center for Puerto Rican Studies at Hunter College in New York, the island’s population is expected to decrease by 14% to 2.9 million people by 2019, as residents flee the devastation. Whether they return remains questionable. The deeper the roots they establish on the mainland, the less likely they are to return home. Hurricane Maria has magnified an already exceedingly complex situation. Rebuilding will take months, a full recovery, years.

Fortunately, bipartisan support for the Commonwealth remains strong. Many millions of dollars have already been spent on recovery and rebuilding and they are set to receive a share of the multi- billion dollar disaster aid package currently making its way through the Senate. How much the island ultimately receives remains to be seen; but whatever the amount turns out to be, it should help with their long-term financial health. The influx of federal dollars is indeed a benefit to bond insurers, even in light of the rhetoric that creditors should not benefit from the destruction, as previously dilapidated infrastructure is rebuilt to a more resilient form.

The island’s electric grid will be modernized and resistant to future hurricanes according to FEMA officials. That’s welcome news: Maria will not be the last to strike. Our hope is that they will use this ‘Hurricane Andrew moment’ to look closely at how they build on the island.

On the legal front, court proceedings are again underway following a delay due to the storms. The Commonwealth, COFINA, Employees Retirement System (ERS), Highway Authority (HTA), and Electric Authority (PREPA) are currently restructuring their debt under Title III of the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA). The Aqueduct and Sewer Authority (PRASA) may also eventually follow this path due to damages sustained during Hurricane Maria. The restructuring of the Government Development Bank for Puerto Rico remains the only Title VI restructuring currently underway.

We await the Commonwealth’s new five-year fiscal plan, which will incorporate storm related damages and economic losses. The fiscal plan will likely contain no debt service payments for the five-year term. How the fiscal plan accounts for federal dollars and treats creditors remains to be seen. Additional court decisions expected in 2018 should give welcome clarity and a clear direction to the Title III cases highlighted above.

If Hurricane Maria was a left hook, then the Tax Cuts and Jobs Act may be the overhand right that knocks the island to its knees. Congress is set to end one of the Commonwealth’s few competitive advantages that helped to make it a medical manufacturing hub at a time when billions in taxpayer dollars are expected to be spent on recovery and rebuilding. The legislation includes a tax on intangible property of controlled foreign corporations (CFC), including those operating on the island. This tax would essentially treat Puerto Rico and other US territories as foreign countries.

Congress’s well intended attempt to protect American jobs with this new tax may have the unintended consequence of doing the exact opposite in Puerto Rico, where roughly 235,000 US citizens are employed in the manufacturing sector. This would not be the first time the island’s future has been directly impacted by the United States government. It was the phase-out of section 936, signed by then-president Bill Clinton, as well as their own inability to adapt, that marked the beginning of the end. The problems they face require long-term reforms that spur economic growth. We hope that future legislation addresses those needs.

Uninsured debt traded lower in price in response to the hurricanes, driven by the expectation of a reduction in economic activity and the possibility for lower recoveries. Insured debt has been driven to higher yields because of uncertainty and tax-loss selling pressure. With the entire picture in view, we think that carefully selected insured debt can still offer an attractive opportunity. As such, we remain buyers. Cumberland Advisors’ Puerto Rico Insured strategy does not include uninsured debt from any island authority but focuses instead on the headline-driven opportunity in carefully selected insured debt.

Shaun Burgess
Portfolio Manager & Fixed Income Analyst
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Tactical Trend, Q4 2017

Recognizing strengths and weaknesses among primary asset classes is the core goal of our Tactical Trend strategy. The strategy seeks to identify relative strength and trend strength in an attempt to allocate capital to the strongest asset classes while underweighting or eliminating exposure to the weaker asset classes. We perform rigorous surveillance on the following asset classes: US equities, international equities, fixed-income, commodities, and cash.  A mix of these asset classes make up 100% of Tactical Trend’s total allocation at any given point in time.

Year-to-date our allocation has not shifted much, with both domestic and international equities trading well and continuing to exhibit asset class leadership. As previously noted, political and global headlines may dominate the newswires, but equity markets and prices have enjoyed a steady bid, with pullbacks being historically shallow. In our analysis, we try to spend twice as much research time on the opposite side of our trade as we do on our position. So what currently bothers us? Most of our concern in Tactical Trend revolves around our secondary indicators, which are sentiment-driven. The 4th-quarter bullish confidence numbers among both individual investors and professional money managers have continued to rise and have reached levels that caused the market to pause or correct in the past. This situation can also be viewed through the lens of the very low readings of the CBOE put/call ratio, which tells us that call buyers are dominating the action. We will continue to monitor and analyze these indicators.

US Equity: (63%) Solid broad market exposure through QQQ & RSP. Bullish moves in Transports, Basic Materials, and Consumer Discretionary.

International Equity: (30%) Primary exposure in Asia with smaller additions in Latin America. Japan and our emerging-market positions have had a strong year but have shown some recent waning of momentum.

Fixed Income: (0%) No position at this time

Commodities: (0%) No positions at this time

Cash: (7%)

Matthew C. McAleer
Managing Director & Portfolio Manager
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Welcome to 2018!

Happy New Year Wishes.

The final Congressional Budget Office (CBO) scoring of the tax bill was submitted to the House Ways and Means Committee on December 15. A summary of the scoring is available here in PDF form: https://www.cbo.gov/system/files/115th-congress-2017-2018/costestimate/53415-hr1conferenceagreement.pdf.

Mike Englund of Action Economics (http://www.actioneconomics.com) had this to say about the CBO analysis:

“The CBO Score of the new tax bill shows a bigger 2018–19 GDP fiscal boost than in the earlier Senate scoring. We expect year-end tax arbitrage, as corporations pull expenses into 2017, while individuals delay receipt of bonus income to Q1 and pre-pay January state tax in December. Asset sales will be delayed to Q1 given higher AMT limits (and no corporate AMT), leaving a likely January stock market pullback. The new tax code has lifted the value of corporate income, leaving a big ‘wealth effect’ for 2018, while consumer inflation will be restrained by lower corporate tax costs. Finally, disposable income will be boosted when new withholding tables are applied, while after-tax corporate profits will surge, leaving a likely 2018 boost in real GDP to the 3% area.”

We think Mike has it right on the mark. Taxes matter. Most folks and businesses view taxes as expenses. For nearly all of America that expense just dropped.

Forget the “postcard” metaphor. The tax code is now more complex than ever. And you cannot deduct the higher accountant fees and tax advisory costs that you will need to incur in order to sort through it. So much for political fixes!

Once the transitional shock of yearend is absorbed, we think the tax bill will raise the valuation of US stocks. Simply put, the tax bill will generate a permanent shift upward of somewhere between $10 and $14 in the threshold of S&P 500 earnings. Once you adjust for that permanent shift, you may continue to factor in the earnings growth rate that you expect from a US economy that is going to grow at 3% instead of 2%. We believe that growth rate is likely for a couple of years.

So, S&P 500 earnings should range up to and then above $150 by the decade’s end. They will do so while the Fed is still engaged in a gradualist restoration of interest rates to something more “normal,” whatever that word means. And those earnings will occur while a repatriation effect is unleashing $1 trillion of stagnant cash in some form of robust redistribution (dividends or stock buybacks) or as productivity-enhancing capex spending. Bottom line is no recession in sight for at least a few years; and low inflation remains, so interest-rate rises will not derail the economic recovery, nor will they alter rising stock market valuations.

Years ago we projected a 3000 level on the S&P 500 Index by 2020. Those writings are archived at www.cumber.com. We stick to that forecast.

We still like the tax-free bond, as we have for a considerable period of time. And now we know the tax bill effects, which make Munis even more attractive to the American individual tax-paying investor. However, blindly buying Munis is a mistake. Credit-risk research is important. We’ve written on that subject many times – again, refer to the archives at www.cumber.com.

“Aren’t you worried about the federal deficit?” readers ask. Of course we are. But for the next few years the impact will be benign. Over time – and that means years – the expanding deficit will raise the interest burden of the nation and will become more visible in the federal budget. For now, a national interest bill of $500 billion in a $20 trillion economy doesn’t stop the momentum of growth. That might change if Bitcoin were to replace the US dollar as a world reserve currency. But sorry, crypto fans, that just ain’t going to happen.

In 2018, the US growth rate picks up, and the US adds to worldwide growth. So we are projecting a global expansion and a rising trend in global asset prices.

Bitcoin remains a fascinating chapter to be added to the next edition of Charles Mackay’s famous classic, Extraordinary Popular Delusions and the Madness of Crowds. Other modern chapters include one about the bowling-alley stocks of yesteryear. The casino stocks (remember Resorts International?) and the dot.com bubble of 1998–1999 also make Mackay’s list. With regard to bitcoin, please remember that there are now about 1200 cryptocurrencies floating about, and that they may be created in near-infinite numbers. Thus attributing a “value” to a millennial fantasy is impossible. We think that a crypto gold-tied exchange medium (there is one now) or a crypto fiat currency will ultimately become accepted. There are plenty of folks in the world who wish to make payments in a form that bypasses government sanctions and scrutiny. For them, a cryptocurrency is an efficient substitute for a suitcase filled with cash.

We are a little worried about real estate. On November 8, 2017, Bloomberg reported that,

“In the U.S., retailers announced more than 3,000 store openings in the first three quarters of this year.  But chains also said 6,800 would close. And this comes when there’s sky-high consumer confidence, unemployment is historically low, and the US economy keeps growing. Those are normally all ingredients for a retail boom; yet more chains are filing bankruptcy and rated distressed than during the financial crisis. That’s caused an increase in the number of delinquent loan payments by malls and shopping centers.” (“America’s Retail Apocalypse Is Really Just beginning,” https://www.bloomberg.com/graphics/2017-retail-debt/. This sobering report by Matt Townsend, Jenny Surane, Emma Orr, and Christopher Cannon belongs in your reading pile.)

In the new tax law, note that the preservation of the despised “carried interest” tax break is an example of a how politics get manipulated by a special interest when the heat of scrutiny is replaced with the sense of political urgency. But we do not believe the special tax treatment for certain real estate and other venture-capital agents will be enough to offset the pressure discussed in the Bloomberg report.

We start 2018 with optimism for markets. We expect households to spend some of their tax cuts. We think the boost to the economy is front-loaded. We’re bullish in the nearer term.

Longer-term risks remain and are serious. A partial list includes rising protectionism, political turmoil in the US as the midterm elections approach this year, and rogue governments from North Korea to Venezuela. And the Middle East remains a cauldron of pressure-cooked factional forces.

Lastly, the US seems to have trouble getting its emergency-funding act together. Congress fiddles (they did just pass a bill in the House) while California burns, Puerto Rico and the Virgin Islands struggle to recover, and Texas and Florida slowly recover, though they are relatively wealthy states with wounded areas. We saw the evidence of this halting recovery on our research trip to Key West and Big Pine Key.

America can do better when it comes to looking out for many of its citizens. That challenge still remains before us.

We’re scheduled for a visit with Scarlet Fu on Bloomberg TV tomorrow (January 2) afternoon at 4 PM.

Happy 2018.   We start out nearly fully invested.

David R. Kotok
Chairman and Chief Investment Officer
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Taxable Total Return 4th Quarter Review

The fourth quarter of 2017 continued to produce records in the equity market, while the yield curve in the fixed-income market continued a flattening trend. The largest movement in yield was on the short end, as short-term rates continue to rise. As of December 20th, the 1-year and 2-year Treasury yields increased 42.6 and 41.9 basis points respectively, to 1.72% and 1.905% since the beginning of the quarter. The 10-year Treasury yield is only up 9.1 basis points to 2.425% while the 30-year Treasury yield is down 9.9 basis points to 2.761% for the same period. The main factor driving the flattening yield curve continues to be the Federal Open Market Committee’s (FOMC’s) push to raise short-term interest rates. The following graph shows that the spread between the 2-year and 30-year Treasuries reached a 10-year low on December 15th, when a buyer of Treasuries could only pick up an additional 85 basis points of yield for extending maturity to 30 years rather than buying a 2-year Treasury.


Source: Bloomberg

At the December 13th FOMC meeting the Fed raised the fed funds target rate 25 basis points to a target range of 1.25–1.50%. After holding rates steady at the third-quarter meeting to announce the roll-off of their balance sheet, the Fed raised rates for the third time in 2017 and for the fifth time in this hiking cycle. The Summary of Economic Projections “dot plot” continued to show three hikes for 2018 and just over two for 2019. The statement accompanying the meeting remained in line with forecasts from the third-quarter meeting. Growth has remained strong, with two consecutive quarters of above-trend GDP advances. The statement also revised the labor market outlook from “some further strengthening” to “strong,” as the unemployment rate approaches historic lows at 4.1%. The more hawkish tone of the statement points to positive near-term economic growth and continued strong equity markets.

Over the last few weeks of 2017, we have been presented with an opportunity to take advantage of relative cheapness in the tax-free municipal market by doing crossover buying into taxable accounts. Last year we were given this opportunity with the “Trump selloff,” as yield skyrocketed after Donald Trump was elected president and tax-free municipals came to market at Muni/Treasury yield ratios of 130–140%. This year a similar opportunity has presented itself with the tax bill. The tax bill threatened to eliminate Private Activity Bonds and advance refundings, which caused issuers to rush to market to refund old debt at lower yields. This rush to issue bonds has once again blown out the Muni/Treasury ratio to the 140–155% range. We believe this situation represents a relatively inexpensive (and potentially defensive) opportunity. You can read more about the tax bill and how it is impacting the municipal market in John Mousseau’s piece “http://The Muni Take on the Tax Bill (Round Two).”

Cumberland’s taxable total-return portfolios have also continued to benefit from the inclusion of defensive assets on the short end of the barbell strategy. We continue to maintain a weighting in short-term defensive assets in the form of Treasury floating rate notes, T-bills, and agency multi-step securities to protect against rising interest rates. These securities are used as ammunition for potential cheap deals in the near term. We also continue to maintain other short-term assets in the form of taxable municipal bonds and corporate bonds. We expect that as rates continue to rise and bonds mature, we will be able to reinvest the proceeds at higher yields.

As we transition to a new year, Cumberland’s current projection is that the Fed will raise rates two or three times in 2018, which is in line with current “dot plot” projections. The FOMC will remain extremely judicious with regard to raising short-term interest rates and will focus on economic data and overall market conditions to determine whether to continue increasing rates. Our goal is to remain defensive in our approach to investing as we navigate a rising-interest-rate environment. We will continue making our investment decisions conservatively while extending durations and picking up additional yield as opportunities in the market become available.

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
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Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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