“Do You Find Me Undesirable?” – Mrs. Robinson[i]

/0 Comments/in /by
Investors face some undesirable choices.  Undesirable candidates, undesirable interest rates, undesirable policy makers and leaders, undesirable social unrest, undesirable economic growth, and an undesirable stock market.
Unfortunately, there is plenty of time for the presidential campaign to get even more undesirable as there is 6 weeks until election day.  Lots of opportunity for a higher level of lunacy.
Turning to the undesirable economy, since the end of the financial crisis, as most know, it has struggled to achieve a normal growth trajectory.  For the past seven years, GDP has expanded below historical recovery rates.  To be sure, some statistics appear strong.  For example, the unemployment rate has fallen and certain real estate markets have rebounded well beyond last decade’s levels. However, the overall level of economic performance has been disappointing, despite the rhetoric.
Last week we had two much anticipated central bank pow-wows.  The Bank of Japan and the Federal Reserve both conducted meetings that included interest rate decisions.  The Bank of Japan announced more unconventional policies on top of the past 20 years of unconventional monetary policy.  The decision included the goal of keeping the yield on the 10-year Japanese government bond at 0%.  The BOJ would adjust the pace of its current bond purchasing program to achieve this objective.
Earlier this year the Bank of Japan joined the Europeans and introduced negative interest rates. The intent was to fight deflation with the goal of 2% inflation. Many questioned this decision as it was more of the same policies used since the 1990’s.  In other words, if you’ve had an ongoing battle against deflation for over 20 years without progress, maybe it’s time to question the tools that you are using.
This was likely what was on Mr. Market’s mind last week as the reaction was not what the central bankers wanted.  Unexpectedly, the yen strengthened instead of weakened and the yield curve flattened.  A stronger yen will be an economic headwind which could increase deflationary pressures.  Further a flat yield curve hurts banks which restricts loan creation.  Again, not helpful if you want higher inflation.
The big news surrounding the Fed’s decision to leave interest rates unchanged was that there were three dissenting votes (voting for a 25 basis point increase).  This marked the most dissention since December 2014.  In defense of holding rates the same, we’ve had some soft economic numbers recently.  There were weaker than forecast ISM numbers at the beginning of September and last week housing starts and building permits were below expectations.  While Chairwoman Janet Yellen suggested an increase in December, the decision will depend on forthcoming data on such things as inflation, employment, productivity and GDP.
The U.S. markets welcomed the announcement and strongly rallied on Wednesday afternoon and Thursday.  That brought the major indexes back to recent highs with the Nasdaq Composite closing at record levels on Wednesday and Thursday.  So much for a September swoon!
Here is where the major averages’ year-to-date performances stand at the end of last week.
2016YTD
DJIA                        +4.8%
S&P 500                  +5.9%                           
Nasdaq Composite +6.0%
Russell 2000            +10.5%                                
 Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
The fixed income markets also surged after the Fed meeting.  Bond prices jumped (lower yields) as the 10-year Treasury note’s yield traded back to 1.61%.  This retraced a move higher for this yield as it had spiked to 1.75% earlier in the month as markets absorbed Janet Yellen’s Jackson Hole speech and anticipated the BOJ and Fed.  More importantly, as yields moved lower last week, it eased worries that these higher rates would be an obstacle for stocks and the economy.
Despite being close to all-time highs, many think the markets are whistling past the graveyard.  The list of “undesirables” above are a part of the blemishes that skeptics point to. Also, stocks valuations are not cheap and earnings estimates are being reduced.  Many believe that stocks are up due to central bank policy reducing the relative attractiveness of bonds.  If global central banks stop buying bonds (or even reduce the pace), some believe that the equity markets will fall.
On the bullish side of the debate, stocks have had plenty of chances to retreat but haven’t.  On the contrary, the S&P 500 recently broke above a 2-year range which is strong sign.  Our “undesirables” are widely known and could be priced in.  Further, there are some high profile strategists that think we are just in the middle of a major bull market.  Part of their view is that earnings growth will begin soon and support higher stock prices.
In the short term, it will be constructive if the S&P 500 remains above the 2,140 – 2,150 level.  Trading below this level won’t mean that the party is over but may signal a correction.  On the other hand, this support level could lead to a move to new highs and a year-end rally.
Whatever direction the market moves, it will do so with less investor participation.  $150 billion has been pulled out of domestic mutual funds and ETFs so far in 2016.  Since the financial crisis, outflows have exceeded inflows in every year except 2013.  Investor sentiment is equally pessimistic as bullish percentages have been at historically low levels for many weeks.
To be sure, investors need to remain flexible.  There are opportunities across the assets classes.  Certain sectors of the bond market offer a good balance of risk and reward.  Of course, there are pockets of opportunity within the stock market.  Keeping some cash to take advantage of future situations is also advisable.
It’s remarkable that the markets have done so well considering these indicators.  We would offer that investors view stocks as more than “undesirable” and bordering on “deplorable”.  It would seem that investing in the U.S. stock market is currently the ultimate contrarian position.  There is a Wall Street saying that the ‘hard’ trade is the best trade.  Buying U.S. stocks might fit this definition.

“It’s Been a Hard Days Night”[i]

/0 Comments/in /by
Just as everyone was getting comfortable quoting stock market statistics at their favorite watering hole about the narrow trading range (43 trading days without a 1% move), the Dow hits an air pocket and drops 395 points last Friday.  It’s not clear that stocks have transitioned to a different pattern but the volatility continued this week.  Prices rebounded on Monday (up 239) but gave that up on Tuesday (down 258).
The possibility of higher interest rates and further geo-political tension gave investors reasons to sell. Boston Fed President, Eric Rosengren, offered that gradual interest rate increases will prevent the economy from overheating.  There is a Fed interest rate decision on September 21st so the timing of this statement got investors’ attention.  Also, he is considered a dove among Fed officials so this was out of character.   This happened after North Korea conducted another test of a nuclear bomb and, taken together, Wall Street choose to “sell”.
The calendar may partially explain this volatility.  Had these taken place in July or August, stocks may not have reacted so dramatically.  But as we know, September (and October) have historically been tumultuous months so news can have larger impacts than expected.
“Vacation – All I Ever Wanted.  Vacation – All I Ever Needed”[ii]
Amazingly, September is the only month with negative monthly average returns for past 100, 50, and 20 year timeframes.  This suggests a repeating adjustment of investor sentiment.  Anatole Kaletsky of GaveKal Research proposes an explanation for this September trend.  “During the summer holidays, when trading is light, people tend to defer big decisions. The return to work concentrates minds, and the result is often a drastic market re-pricing to reflect events that were not sufficiently recognised or analysed (sic) during the summer months.”[iii]
As we know, there have been plenty of noteworthy developments over the past several months so it’s possible that the markets may not have fully considered their importance.  For example, the ‘Brexit’ vote was in June.  While the global markets initially fell hard, they quickly recovered and may have overlooked the longer term fallout of Great Britain’s withdrawal from the EU.
More than 25% of the OECD government bonds trade with a negative yield and this percentage is rising.  Negative interest rates are not part of a normal economic system.  Maybe the markets are more ‘sufficiently’ becoming aware of this and re-pricing assets accordingly.
The U.S. presidential election is another variable with an unknown outcome.  The campaigns have repeatedly resembled a “Three Stooges” episode and it’s unclear if the markets have properly considered a Clinton or Trump administration.  This is similar to how the markets have become complacent regarding BREXIT.  It’s easy to see these things taking unexpected twists and turns over the upcoming weeks, but are the markets prepared?
As the markets re-think the above issues, the U.S. economy may be slowing.  The August employment report was disappointing and the latest ISM Purchasing Managers Index report came in at 49.4 which was lower than expected and lower than July’s 52.6 mark.  Readings below 50 are often associated with recessions.
Before last Friday’s drop, the S&P 500 had climbed almost 20% since the February lows.  20% moves in a six-month stretch are pretty rare and usually coincide with strong growth.   Unfortunately, as we know, GDP is only expanding at around a 2% rate and corporate profits have been stagnant.  In fact, analysts have been reducing their bottom line estimates.  The result is unattractive stock market valuations and investors are starting to notice.
While everyone is scouring every word from Fed officials trying to determine when the next interest rate increase will take place, the market is not waiting.  The 10-year Treasury note’s yield closed at 1.54% on September 7th.  Two days later (last Friday) yields spiked to 1.67%. and touched 1.75% on Tuesday.  Obviously, higher borrowing costs are an economic headwind, but they also reduce the current value of future earnings and cash flows.  This doesn’t help our ‘challenged’ valuations and provides another reason to question the summer rally.
Market trading has changed in recent years.  Trading has become dominated by computer programs, algorithms and passive strategies.  These are reactive to developments as opposed to the process of discounting future expectations with the goal of finding undervalued opportunities.  These trend following black boxes will likely increase price volatility in both directions.
Last Friday’s decline left the S&P 500 below its 50-day moving average and vulnerable to test the 200-day moving average which resides over 3.5% below current levels.  If the averages can stabilize and then recover the 50-day, it would be a bullish sign.  However, we would expect some further selling as the uncertainties facing the global economy are properly priced in.  In the meantime, that hated asset class, cash, might become more popular than just at happy hour.
 [i] John Lennon, Paul McCartney
[ii] Gary Knight, Connie Francis, Hank Hunter
[iii] GaveKal Research, September 12, 2016
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional

Tail Wagging the Dog

/0 Comments/in /by
The day after Janet Yellen’s Jackson Hole Speech two Fridays ago, The Wall Street Journal’s headline read, “Yellen Sends Strong Signal on Rates”.[i]  According to the article, the Fed chairwoman believes the economy is at a point that the Fed will more strongly consider raising interest rates.  Naturally fed funds futures increased the likelihood of a September increase to 36% and a December hike to 64%.  Other markets reacted as expected – bonds yields moved higher and stocks reversed morning gains and sold off.
This has become a common occurrence.  Every press release, statement, speech, hangnail and sneeze are analyzed for clues of future policy changes.   Only the most isolated or distracted (such as excited Met fans after their team got back into the wildcard race) are not aware of the intense level of focus that the markets have on the Fed.
To be sure, the FOMC’s interest rate decisions are a component of monetary policy which have economic influences which affect capital market prices.  Undoubtedly they are significant.  However, the markets have developed an addictive condition when it comes to the Fed that has grown to a point where it appears to be a case of the tail wagging the dog.  In other words, rather than the Fed watching the economy and adjusting policy accordingly, the economy and the markets are watching the fed and trying to front run their next move.  Corporate earnings and valuations have become afterthoughts.
During the past several decades the relationship between the Fed and the capital markets has changed.  The Fed traditionally used money supply and short term interest rates to implement the desired monetary policy to slow activity when the economy was too strong and to boost things when needed.  Dating back 100 years, the central bank’s original purpose was to smooth out the cycle of booms and busts and keep the economy as steady as possible.
Obviously, this role has transformed into its current character of financial repressor and protector of asset prices.  The Fed claims to be ‘data dependent’ so they are closely watching and striving to get better GDP growth.  But the reality is that setting interest rates at zero and buying bonds has done very little to help the economy.  Indeed, the chief result of the zero interest rate policy (ZIRP) and quantitative easing has been to drive speculation into higher risk assets.
While stocks have probably been the biggest beneficiary of global central bank mechanizations, perhaps the capital markets are starting to wonder if their confidence is misplaced.  Interestingly, on the day of Janet Yellen’s speech, the Journal’s front page headline was “Fed Stumbles Fueled Populism”.[ii]  The article critically points out how the Fed has misjudged the effectiveness of their decisions.  Further it hints that some discontent is growing among the markets.  Jon Hilsenrath, the author, notes, “Three key miscues by the bank since the financial crisis add to public disillusion with institutions”.[iii]
While a confidence crisis could be a problem, the fact remains that stocks trade at record levels.  This is more impressive given we are in the dreaded August – September period.  During the past 5 years, August has averaged a 1.87% drop which makes it the worst month for the period.  September has been the second worst month with an average decline of 1.19%.[iv]  Stocks made it through August 2016 in good shape (minor losses for the month) so maybe this trend is changing.
Here are the year-to-date returns for the major indexes as we begin September.
                                      2016YTD                      
Dow Jones Industrial Average  +6.1%
S&P 500                                    +6.7%
Nasdaq Composite                    +4.8%
Russell 2000                              +10.2%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
After breaking out in July, the equity markets have traded in an incredibly narrow range.  Looking at the past 40 days, the S&P 500 has traded in a range of 1.77% which is the tightest 40-day range ever!![v]  Given the volatility in the first and second quarters, maybe we continue sideways for a little longer.
The markets’ resiliency in the face of all of the obvious headwinds has caught many off guard.  As noted in previous newsletters, there have been many high profile predictions for a nasty market drop starting in the spring.  Yet stocks refuse to fall (so far).  We think investors should remain flexible and open minded.  The stretch from Labor Day to New Year’s Eve could see a return of the dog wagging the tail.
[i] The Wall Street Journal, August 27 – 28, 2016
[ii] Ibid, August 26, 2016
[iii] Ibid, August 26, 2016
[iv] The Bespoke Report, September 2, 2016
[v] Ryan Detrick, CMT, September 7, 2016
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional