Financial markets rebounded this week, despite the escalation of the number of coronavirus cases worldwide. The upturn may have surprised some, but their mistake was underestimating the power of central banks to support the markets.

 

The bear case last Sunday evening was that the Chinese stock market would crater upon opening after being closed for Golden Week, the traditional Chinese New Year. While Shanghai did open down 9 percent, it quickly reversed and spent the rest of the week climbing out of that hole.

 

The main reason for this rebound was the announcement by Chinese authorities that they were prepared to support their financial markets. Publicly, they announced a $22 billion injection into the banking system to provide additional liquidity and support the Chinese currency, the yuan. Here at home, our Federal Reserve Bank continues its "Not QE" repo market operations. Who knows what other actions other central banks have also implemented to calm markets this week?

 

The end result of all this additional money hitting the system was that financial markets once again climbed higher and higher until U.S. markets not only recovered all they had lost (less than 3 percent), but went on to make new historical highs.

 

Last week, I advised investors to look beyond this coronavirus scare. I was expecting no more than a 5 percent correction at worse, so the quick dip and recovery seems to have confirmed my views. That said, we do need a pause of sorts after five days of gains and that was what happened on Friday.

 

The labor market seems to be hanging in there, according to the latest non-farm payroll data announced on Friday. U.S. employers hired more workers than economists had expected. Forecasts were for gains of 165,000 jobs, but the number came in at 225,000. Wage gains were modest, bringing the total to 3.1 percent year-over-year. While a good report, I wouldn’t get too excited about it.

 

The good weather we have had over the last month had more to do with the surprise wage gains than the economy. That’s not to say it wasn’t a good number; just a little inflated in my opinion. I expect that there will be some ups and downs in the macroeconomic numbers both here at home and around the world over the next few months. The vast majority of economists are convinced that the Chinese-born epidemic will have an impact on economic growth. Exactly how much is impossible to predict.

 

China appears to be doing all they can to alleviate the worst effects on the economy. They have already lifted tariffs on a number of American goods this week and are promising a great deal of fiscal and additional monetary stimulus to combat the expected slowdown in the economy due to the coronavirus. However, there will be an impact and when China sneezes, the rest of the world catches a cold, including our own country.

 

One positive by-product of the unfortunate virus and subsequent sell-off is the US Advisors Sentiment survey. Regular readers know I watch bullish sentiment as a contrarian indicator of where the markets might be heading. This week, the number of bulls tumbled from 52.8 percent (a sure-fire indicator that a correction was in the offing) to below 48 percent, which is a much more reasonable number.

 

I know that the higher the markets climb, the more nervous investors may get. That’s a good thing. There is very little exuberance among my clients and given the continuous stream of negative events (geopolitical or otherwise) that we face on almost a daily basis, it is understandable. Yet, remember my "Walls of Worry" principle — markets climb walls of worry. I see further gains ahead, so stay the course. The upside may surprise you.

 

Americans have been moving from high tax states to lower tax states for decades.

 

Climate, cheaper housing prices, less congestion, and jobs are some of the reasons behind such moves. That trend, however, has added taxes to that list, thanks to the Tax Cuts and Jobs Act of 2017.

 

Many of those reasons for moving have been with us ever since Horace Greeley, the American author and newspaper man, reportedly first advised America's youth to "Go west." Back in 19th-century America, the country had embraced the concept of "Manifest Destiny." The Horace Greeleys of the world had argued that it was inevitable, justified, and our God-given right to expand throughout the continent. That turned out to be good for the white guys but bad for the Indians, but that's a different story.

 

Today, I would amend that saying to include the South and any other state where there are lower, or no state income taxes. In truth, most state residents are concerned about their total tax burden — property taxes, incomes taxes, and sales and excise taxes. But over the last two years, many of those who have moved have done so based on the changes in the federal tax code.

 

The 2017 federal tax law, which President Trump signed after a party-line vote in Congress, limited to $10,000 the state and local tax payments that families can write off on their federal income taxes if they itemize deductions.

 

The impact was devastating to those taxpayers in income tax states that were singled out by the Republican-controlled Congress. For many lower-income or retired families, it was the straw that broke the camel's bank. Those who live in New York state, for example, found that they were now paying  2 1/2 times the tax burden of their counterparts in Alaska. As a result, a great migration appears to be gathering steam. The top states Americans are fleeing from include New Jersey, New York, Illinois, Connecticut, California and others.

 

Those states which are "benefiting" from this trend include Florida, Texas, New Mexico, North and South Carolina, Washington, and Arizona, among others. If you look at the total tax burden (as opposed to just the state income tax), Americans are still clearly being driven by the overall tax burdens. The average state tax burden of the inbound migration states totals 7.88 percent compared to 9.55 percent for the top 10 outbound states.

 

As we enter 2020, the migration continues unabated. Conservatives are crowing over the trend, while liberals believe they have been singled out for retribution by the GOP and the president. They complain that it is no longer a country of the people, by the people, and for the people unless you are a Trump supporter. As blue states struggle with maintaining services for their enormous population centers, more and more middle and lower-income families have had enough. And that's the rub.

 

Take me, solidly middle-class. I moved from a higher tax state (New York) to a lower tax state (Massachusetts). Granted, Massachusetts taxes are not much lower, but it did make a difference, especially when it came to state and local property taxes. And given that mortgage tax deductions are now capped, I decided not to take out a mortgage on my new condo. Bottom line: I reduced my overall tax burden considerably. It was a win-win for me, but not so much for Massachusetts.

 

I am in my 70s, and since moving, my health has deteriorated. Over the last five years, my hospital visits have been numerous. As you might imagine, my overall medical expenses have gone up, but the costs to my new state Medicare department have skyrocketed because of me. In addition, I am enjoying all the benefits the state offers in infrastructure, elder-care centers, discounts, etc. and pay relatively little back in taxes. And because I downsized when I moved, I no longer pay much in property taxes because my condo is much smaller than the house I sold in New York.

 

Good for me, but not so good for Massachusetts.

 

How many other migrants are like me? We already know that many who are moving are retirees or the elderly (think Florida and the Carolinas), who no longer pay much in income taxes anyway. Like me, they are also more likely to buy something much smaller, or may even decide to rent. You can bet, as they get older, they too will be consuming a larger and larger share of these low-tax states' goods and services. And since most of them are coming from blue states, they will be bringing their high-brow, liberal political thinking with them.

 

There might come a time in the not-too-distant future where some of these inbound states will not only be forced to raise taxes just to keep up with all this new demand for governmental services, but may even need to legislate their own state income tax.

 

Texas, a traditionally conservative "red" state, with no income tax, is a good example of what might be in store for other historically political and fiscally conservative states. Californians have flocked to this great state over the years. However, that is not the entire picture. Property taxes have been the answer for local politicians in their battle to juggle services, an expanding population, and growth.

 

Today, Texas ranks among the states with the highest share of taxpayers who pay more than $10,000 in property taxes, according to the National Association of Home Builders. At the same time, thanks to all those old hippies from California, Dallas is now a "blue" city. Texas old-timers are complaining that liberals are now making inroads and gaining more political influence in other metropolitan areas. The moral of this tale is to be careful what you legislate. It could turn out that when all is said and done the politicians may have shot themselves in the foot once again.

 

The death toll mounts. The number of cases worldwide builds. Every new update drives the stock market up or down. Where it will end is anyone's guess.

 

It is called a "geopolitical" event. We suffer through them from time to time. The assassination of Iran's key military leader followed by the Iranian rocket attack on two Iraqi military base that injured dozens of American servicemen was the last such event. We never know when they will occur and, in some ways, these events are simply the price of doing business in the financial markets.

 

Some market watchers, while recognizing the severity of the coronavirus outbreak, argue that the markets needed to correct anyway. This outbreak was simply the excuse investors needed to pull the trigger and take profits. I believe there is some truth to that opinion.

 

However, we should recognize that the coronavirus will most likely put a dent in economic growth around the world. Certainly, in the case of China and other nations closer to the epicenter of the outbreak, we can expect a slowdown in economic growth. After all, you simply can't shut down 16-plus major cities during the Chinese New Year, the largest consumer spending day in that country, without consequences to business.

 

In the U.S., a host of companies should also feel the heat as they too suspend business in their Chinese operations. This quarter's earnings season revealed that 25 percent of company managers expect some impact to their bottom line as a result of this calamity.

 

There have been some reports in the media (and accusations by others) that the number of cases reported by the Chinese government are being deliberately low-balled in order to soften the blow on business and to reduce the chance of whole-sale panic. So far, the World Health Organization, while sounding a global health emergency, is more concerned about the spread of the virus in countries with weaker health systems than what is happening in China, where more than 10,000 cases have been reported.

 

While no one can know for sure how long, or what ultimate impact this disaster will have on economies and markets, I believe that like all geopolitical events, they have limited impact and are of short duration.  I can see a 5 percent decline in the S&P 500 Index as a predictable outcome, but not much more than that. We are already off 3 percent from historical highs, so I am not talking about much, maybe a decline to 3,200 or a little below that on the index.

 

This week's Federal Open Market Committee's decision to hold interest rates steady turned out to be a snooze fest for investors. In the Q&A session after the announcement, Chairman Jerome Powell did mention that the Fed planned to begin tapering their purchases of short-term U.S. Treasury bills by the second quarter of this year. He reiterated that the purchases they have made since last September were "not QE" and the Fed could not be held responsible if the financial markets thought differently. Maybe investors are finally beginning to believe that, which may also have contributed to the present sell-off.

 

As of Friday's close, I suspect that we will have given back most (if not all) of the gains we have enjoyed since the beginning of the year. That should have been expected, since historically, we usually have a late January-into-February pullback in the markets. My advice is to look beyond this event and focus instead on regaining the record highs sometime before the end of the first quarter.

 

Over the last few years, investments that focus on environmental, social, and governance issues, or ESG, have been confused with socially responsible investing or SRI. There is a big difference between the two investment styles.

 

The simplest way to understand the differences between the two is the profit motive. ESg investments are focused on making money as a primary objective. They do so by identifying specific risks or opportunities now and in the future and investing accordingly. SRI investors, on the other hand, are willing to forego profits in companies that do not meet their ethical standards. They value ethics more than profits in the investment world.

 

For example, if an individual decides they do not want tobacco, energy, or firearms companies in their portfolio, then, despite the possibility that one, or all three sectors, might generate better returns than the market overall, these companies would be excluded from future investments. If, as a result, their portfolio returned less than the market (or fell further than the market overall in a downturn), the ethical return of knowing you are a socially responsible individual far outweighs the monetary return.

 

An ESG investor may exclude the same three investments, but for entirely different reasons. If, from an environmental point of view, an investor believes that future government restrictions, increasing carbon taxes, and civil or criminal lawsuits (as a result of pollution and oil spills) make the financial returns of energy companies a poor investment versus other areas,  oil and gas stocks might be excluded from an ESG portfolio.

 

Many investors, of course, want it both ways — to see their money invested in stocks or funds that are profitable and to reflect their social values.  Easier said than done, however.  In the past, the SRI world could be quite risky, and one person's values and portfolio choices could be much different from another's. Religion, personal values, or even political beliefs can sometimes create contradictions.

 

You may be anti-conflict, for example, and want to avoid firearm stocks, while having no problem with buying mining stocks in Africa, despite atrocious human rights violations there. You could be a hunter and want guns in your investment portfolio but reject alcohol and tobacco stocks on religious grounds.

 

Many socially responsible investment choices have been in companies and sectors that were overly dependent upon government tax breaks and credits just to achieve an acceptable level of profitability (think solar, water, and wind). If, as has happened many times in the past, governments chose to remove their support for political or budget reasons, these companies could collapse. Other issues involved liquidity, high expenses, and transparency,

 

But times are changing, and some of these areas are finally coming into their own.  Last year, for the first time, exchange traded funds assets began to see a sizable increase in ESG investing. More than $20 billion was invested and, while that is still only 0.4 percent of the $4.5 trillion invested in ETFs, it is growing. Better still, the premise of these ESG funds seems to be working.

 

Nine of the largest ESG mutual funds in the United States outperformed the S&P 500 Index last year. Seven of them topped their market benchmarks over the last five years, which is no small accomplishment given the strong performance of the overall market during that time period. According to Bloomberg, assets managed by the 75 retail funds in its ESP survey were up 34 percent to $101 billion in 2019. 

 

It just so happened that these fund managers during that time invested heavily in the technology and financial services sector, since both areas have historically been in low-pollution emission areas. Those same companies were the darlings of the overall market as well. Companies that are advising other companies on how to become more energy efficient, or helping to minimize nasty environmental impacts on society have also done well. Health care was another sector where ESG investments paid dividends.  

 

This kind of investing is also a good fit for those who are saving for retirement, since most money managers consider sustainability investing as a long-term investment  The jury is still out on how well ESG will do in the years to come but for those who might want their cake and eat it too, I believe the ESG approach trumps SRI at this stage of the game. 

 

The stock market is frothy. The great gains that investors experienced last year are extending into this year. As the indexes climb, more and more of those on the sidelines are jumping in. Is this a good sign?

 

No, it isn't. "The Fear of Missing Out," or FOMO is rearing its greedy head on Wall Street. Those who may have raised some cash in the past few months, fearing a trade war, or the impeachment proceedings, have watched the portfolios underperform the averages, ignore all the negative news and climb higher.

 

On the geopolitical front, we have seen the same thing. Selling on fear of an Iranian response to the killing of one of their heroes was the wrong move and, evidently, so was taking profits on this week's fears that the China-based coronavirus would spread, denting world economic growth.

 

Anecdotally, I have been getting requests from some of my tell-tale clients (those who want to buy at the top and sell at the bottom) to buy stocks at historic highs, where their prices exceed all rational measures of valuations. They are usually a good contrary indicator.

 

As is the U.S. Advisors Sentiment Indicator. This week's numbers underscore the gathering bullishness of market participants Those professionals who are positive on the market's future moved even higher to 59.4 percent. That is the highest it has been since September 2018.  And as the present rally broadens, we can expect that next week the bulls should top 60 percent.

 

In the past, a 60 percent bullish read would have had most who follow this indicator running for the hills, in the short-term. But so far, the opposite has occurred. Granted, investor sentiment, as a contrary indicator, is not the only variable used in trying to discern the stock market's next move. I believe that the actions by the Federal Reserve Bank will almost always trump sentiment as a determining factor. So, let's look at the Fed.

 

As I have predicted throughout the last several months, as long as the Fed keeps pumping money into the financial markets, I believed stocks would continue to rise. Since the beginning of December, the combined reserve management purchases, plus repo injections by the central bank, has been about $400 billion. The Fed argues that since they have only been purchasing notes (and not bonds with a coupon), their purchases do not qualify as quantitative easing (QE). The market doesn't care. To them QE is QE.

 

These "Not QE" purchases, however, have been so huge that the central bank is approaching the limit of purchases it can make of these short-dated securities without disrupting the market. At the present rate, there will be no notes left to buy in a month or two. As a result, traders are now betting (75 percent probability) that by mid-March, the Fed will have to expand their purchases to include longer-dated Treasury bonds.

 

The logical question to ask is why doesn't the Fed simply stop these purchases? It could be because the Fed has created its own version of "Frankenstein's Monster."  As I have written before, the Fed has dumped such an enormous amount of money into this market that by stepping back from more purchases (no matter how small), the Fed could disrupt the whole market.

 

The bet is that rather than risk that, the Fed might simply begin to expand its bond purchases to include longer-dated debt maturities with coupons. Of course, once that happens, the Fed would have to admit that, yes, they have embarked on yet another QE program. You might ask, "so what's wrong with that?"

 

The first question investors might ask is why? The stock market is assuming that everything is right with their world. Jerome Powell, the Fed's chairman, has said so over and over again. The president has said so even more times than the Fed. So why do we need another QE program after cutting interest rates three times last year? What's wrong? The Fed's actions, far more than anything else, have driven the stock market to its present record highs. Investors will demand an explanation — and soon.

 

The second, darker explanation may be that the Fed is no longer the independent body it claims to be. After all, Powell was appointed by the president. The president has voiced his unhappiness with his man's actions since he got the job. Trump is a staunch believer in easy monetary policy and wants the economy to grow as fast as it can to cement his election chances.

 

What better way to do that than by getting the Fed to pump money into the system via "Not QE," since few of us understand something as arcane as the "repo market." Whereas, cutting interest rates to zero at the president's request would be an extremely optic moment for all involved. Whatever the answer, the Fed's future actions should be watched closely.