Dorato News, July 2017

A Quarterly Newsletter for the Clients of Dorato Capital Management, LLC.

Portfolio Issues

In 1999, to justify the technology prices, we investors were told that earnings didn’t matter anymore. The world had changed. What really mattered was how many people used the product. Of course, that line of reasoning fell apart within a matter of months. Earnings always matter. People just forget that from time to time.

In a another sign that history may not repeat, but it does rhyme, we are being told again that current earnings don’t matter. But this time what really matters is future earnings. And since certain companies will take over the world, massive future earnings are inevitable.

Amazon is the poster child for this line of reasoning. Even normally staid observers such as Barron’s seem goggle-eyed at the awesomeness of Amazon.

Amazon sells at more than 100 times expected 2017 earnings. True, in the last couple of years earnings have grown fast, but for how much longer? Some analysts now attach a long term growth rate of more than 50% to earnings, reminiscent of technology sector projections of 1999. A high projected growth rate can justify almost any price.

Amazon just announced a deal to purchase Whole Foods, a business with low margins and intense competition. This should bring down Amazon’s potential earnings growth rate, but Amazon’s stock rose on the announcement. Apparently, Amazon will take over the entire grocery business. And just wait until they decide on the next business to dominate!

World domination is a bit harder than it looks. Investors beware.

July 2017 Cartoon
"Did you hear? Amazon is buying Texas."

Market View


Warning Signs

On newer cars, there are several warning lights that illuminate if something is wrong or needs to be checked. You don’t need to jump out of the car and take cover if the warning lights are on, but it’s a good idea to give them your attention. I think the stock and bond markets are operating with a few warning lights right now.

US stocks are up about 10%. Big, expensive stocks are up even more. Stocks such as Facebook and Amazon are up more than 20%. Indeed, five stocks account for a good chunk of the gain in the S&P 500 this year (Apple, Alphabet, Amazon, Facebook, and Microsoft). This is not quite as frightening as in 1999, when technology stocks accounted for 40% of the S&P 500, and for most of the gains; but it is a warning sign.

The striking characteristic of the Amazon, Facebook crowd is the lack of current earnings. (See Portfolio Issues.) Investors seem to be betting that these companies will generate enormous profits in the future, and they don’t seem overly concerned about the paltry profits of today. When a lot of investors buy into the same idea, the rest of us should take note, and maybe take a step back.

Another warning sign is in the bond market. The difference in interest rates between a US Treasury and the highest-rated high-yield (junk) bond is at a ten-year low. That means investors are getting compensated less for taking on more risk. In their search for yield, investors are driving up the price of risky debt, and they may find that they’ve taken on more risk than they should have.

The volatility index is a measure of how much it costs to insure against a fall in US stocks. This measure is at all time lows. Apparently, not too many investors need to hedge against a market drop. In contrast, in 2008 and 2009, when the stock market had already fallen dramatically, the volatility index was at all-time highs. Investing carries inherent risks. Sometimes people forget that; sometimes they obsess about it.

Finally, there is the problem of China and its growing pile of debt. At some point, I don’t know when, that debt will cause problems. And because China is now the world’s second-largest economy, we will all be involved in those problems.

All these warning signs point to investors piling into investments that have done well recently, and to investors growing somewhat complacent about risk.

On the plus side, the US public does not seem to have forgotten the lessons of 2008-2009. Household debt is back to the level of 2008, but both income and net worth are higher, so that debt is not as onerous as it was last decade.

Banks, too, are healthier. They have more capital available to cover losses than they did during the recession, and they have kept to better underwriting standards. When a recession does eventually hit, we’ll see who was taking oversized risks, but most of the banks should weather most storms that come their way, and that should keep us from experiencing the massive sell-off of a decade ago.

I write this Market View not to enable either of us to get in or out of the market, but to help you be aware of what might happen in the next several months or years. You might keep extra cash available, given that other investors appear to be relaxed about risk, but you should continue to stick to your long-term asset allocation. That’s the best route to achieving your financial goals.

Sources: Economist, Financial Times, Wall Street Journal, Value Line, Vanguard