Newsletter | August 2012

August 20, 2012 – DJIA = 13,275 – S&P 500 = 1,418 – Nasdaq = 3,076

“She Moves in Mysterious Ways”

The questions we face in life are many.  Some easy and, of course, some more complex.  Some answers come with the passage of time and others remain without a clear explanation.  Where the current stock market fits into the maze of mysteries is not certain, but it is a definite enigma. 

It’s far from newsworthy that the markets are a riddle.  We repeatedly point out that the stock market moves in the direction that frustrates the most.  Nevertheless, the recent moves have been especially baffling.  The stock market has rallied over 10% during the past two months and has the indexes approaching 2012’s high point.  The head scratcher, of course, is that there has been virtually no good news to encourage the buying. 

To be sure, this isn’t the first time that prices have risen or declined without obvious reasons.  The task is to look beyond the financial media’s headlines to determine what the markets are focused on.  Identifying the possible causes earlier than the crowd would be a profitable exercise.    

The reason for the advance may be as simple as too much pessimism.  You don’t need an smart phone app to tell you the economic and geopolitical negatives - Europe is in a crisis, China’s economy is slowing down, and the U.S. is facing a fiscal cliff and a contentious election.  Add to this the fact that Wall Street is viewed as a cesspool of conmen and thieves and you arrive at a point where no one is willing to invest in the stock market.  If all of this is so widely known, could the bad news be priced in?  If it is, at some point there is no one left to sell and prices rise. 

If our “sellers’ exhaustion” theory is accurate, it is only a part of the equation.  Hope for further central bank stimulus has a definite bullish influence on the markets.  The belief is that the Fed, ECB and other central banks come to the rescue if developments, economic and non-economic, deteriorate.  With nominal interest rates at 0% and real interest rates negative, the question might be how many arrows remain in the quiver.  Which leads to this newsletter’s “perception is reality” example - if the markets believe further monetary stimulus will help, stocks could rally on a “QE3” announcement regardless of its details.     

Europe must be included in any market analysis and current conventional wisdom can be characterized as hopeless at best.  Things such as the likelihood of a Greek exit, growing Spanish and Italian problems, and the reluctance of further German bailouts are the most popular obstacles.  Without doubt there are many worries when it comes to the Old World, however subtle changes to addressing their problems might have given an unappreciated boost to the summer rally.   

Starting in June, the austerity requirements associated with bailout funding were reduced.  Then in July, ECB President Draghi proclaimed that he would do everything in his power to save the Euro.  Indeed, a dangerous statement considering the circumstances, but it is a reminder of the political power and influence supporting the single currency.  It would be wise to keep in mind how ego and position impact decision making when predicting the Euro’s demise. 

“Let Her Talk About the Things You Can’t Explain”

Europe’s two big trading partners are China and the U.S., so benefits resulting from stabilizing the continent would be felt across the globe.  This could be a contributing reason that the Dow Jones Industrial Average closed last week within 5 points of the highest level in 5 years (right before the financial crisis).  The S&P 500 is 8 points away from its 4 year high reached in May 2008.  Meanwhile, the S&P 500 Total Return Index (includes calculation for dividend reinvestment) is close to an all-time high.

All of the major averages advanced last week with the Dow’s rise marking the 6th consecutive up week.  Here are the averages’ changes for the week as well as year-to-date returns. 

    Last Week    2012
Dow Jones Industrial Average   +67 pts  +8.7%
S&P 500   +1 pt +12.8%  
Nasdaq Composite   +2 pts  +18.1%
Russell 2000    +2 pts  +10.7%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends

Foreign bourses have followed the U.S.’s markets higher.  The Euro Stoxx 50 index is up over 14% from the June lows and it appears to be ready to challenge the March’s highs.  Elsewhere, India’s SENSEX has formed an inverse head-and-shoulders pattern and looks like it could breakout and add to its recent gains.  Korea’s KOSPI traded above its 200-day moving average for the first time since May and Brazil’s Bovespa Index has bounced back to its 200-day moving average. 

As stock prices move higher, Treasury bond prices have moved lower.  After reaching an all-time low yield of 1.4% in late July, the 10-year T-note’s yield closed last week at 1.817%.  The 30-year bond’s yield closed at 2.936% having been below 2.5% in July.  
 
The real excitement has been in the corporate bond market where borrowers are eager to lock in low interest rates.  Through the first 3 weeks of August there has been $40 billion of investment grade bonds sold while junk bond offerings totaled $30 billion.  Two weeks ago the high-yield market saw $13.3 billion of deals representing the 4th largest weekly issuance ever.  High yield bonds are averaging around 6.87% which is approaching record low levels.   

At such a low cost, companies are foolish not to borrow even if they don’t have any immediate needs or plans for the capital.  Of course that doesn’t prevent corporate creativity.  Lorillard, a cigarette maker, sold $500 million of 5 year bonds priced to yield 2.3%.  Afterward they announced a $500 million stock buy-back.  The common stock’s dividend yield is 4.84%.  How much of the annual $12.5 million savings will be earmarked for the finance department’s bonus was not revealed!!

As pleasant as higher stock prices are, they can’t remove all of the problems we face.  Consequently, we think investors need to be aware that significant risk remains.  In the near term, there are some important events on the calendar.  First is Ben Bernanke’s Jackson Hole speech.  QE1 was announced at this annual gabfest two years ago, so market watchers will be listening intently.  The markets seem ready to celebrate further stimulus or plunge if nothing is mentioned. 

Beyond that other important signposts will the August employment data (September 7th), a Fed Open Market Committee meeting (mid-September), and the presidential campaign ramps up after Labor Day.  Of course, there will be constant European news flow for the markets to digest. 

While headlines are important, the markets reaction is equally important.  Looking at the past couple of months, who would have predicted a 10% rally back in June?  Especially as it occurred at the same time that the economic numbers deteriorated, 2nd quarter corporate earnings were only ok, second half 2012 guidance was not very good, and no QE3 announced.  We offer an answer “not very many”.  

We think it’s important that investors identify the proper risk tolerance (how much exposure is the right level), what time period is appropriate (short-term decisions might be much different than long-term ones), and what’s the exit strategy if something goes wrong.  We think flexibility and keeping an open mind will be critical components of every investor’s strategy going forward.  It promises to be an exciting finish to 2012.