I’ve Got Some Bad News For You Sunshine

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In case you hadn’t heard, January 2016 is the stock market’s worst yearly start in history.  Every index, large and small (except for the Dow Jones Utility Index’s less than 1% gain), is down over 7% in just two weeks of trading.  Many averages are down over 10%.  And the carnage extends beyond U.S. equities and includes foreign stocks, commodities, bonds, and currencies.
Markets began deteriorating in November.  Stocks then regained losses later that month but retreated again in December.  There was a Santa Claus rally although it was not nearly as strong as expected.  Despite the market’s sloppiness, there was no indication of what was to happen.
As 2016 trading got under way, the markets encountered problems starting in Asia as China’s Shanghai index collapsed 7% on the first trading day.  Weaker than forecast Chinese economic data was one of the reasons, however an unexpected devaluation of China’s currency played a bigger role.  In the past the People’s Bank of China (PBOC) controlled the value of the renminbi (vs. other currencies primarily the U.S. dollar) to a very narrow range.
Last August the PBOC first loosened the renminbi peg and the markets revalued it to around 6.5 renminbi to the dollar from 6.2.  The PBOC provided little guidance with this announcement which, as expected, lead to confusion and questions.  That uncertainty rippled through the global capital markets and contributed to the August/September  selloff.
Apparently the PBOC didn’t learn from that debacle as they repeated the decision during the first week of January.  Once again Chinese officials allowed their currency to decline against the dollar, and once again turmoil ensued.  The questions started – was China encouraging currency depreciation to boost growth?  Others worried that the Chinese officials had lost control of the financial system and that there was a run on the currency.  Of course, rumors were that the economy was imploding.  Whatever the real reason, the capital markets were confused and uncertain. This resulting in selling which spread globally.
China’s markets has remained the focal point during this two week sell off.  This is a function of being the world’s 2nd largest economy as well as it’s where the trouble started.   The attention intensified as the authorities and officials made so many missteps it resembled a Three Stooges episode.  This climaxed when the Chinese stock market opened with another plunge in the first 15 minutes and then closed trading for the rest of the day.
As we know, the damage wasn’t contained to Asia.  The U.S. markets were under pressure from the first trading day as well.  Stocks declined, commodities fell, and bond yields were lower.  As mentioned, it was the stock market’s worst start of a year.
 
Here are the major averages for the first two weeks. 
2016 YTD: 
  Dow Jones Industrial Average  -8.2%                  
  S&P 500                                           -8.0%  
  Nasdaq Composite                      -10.4%
  Russell 2000                                  -11.3%                                 
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
 
While the China’s issues have not helped the markets, U.S. equities appear to be more tied to crude oil prices.  This has been a recent development and appears to be related to the large amounts of debt that the energy sector accumulated over the past 5 – 6 years.  This capital helped finance the U.S. drilling boom.  A significant amount of this debt was raised by smaller companies as high yield bonds.  Crude’s implosion has increased the risk that the debt can’t be serviced.
It’s intuitive to think that lower energy prices are a huge economic benefit.  However Wall Street is worried that widespread default on fixed income could have a much larger negative impact on the financial system.  As a consequence, for the time being, lower crude means lower stock prices.
As pessimism over the stock markets increases, it’s helpful to look back at previous weakness to start the year.  2016 is the worst start in history.  Using a sample of the 15 worst 5 days to begin a year, the declines range from 5.96% (2016) to 1.79% (2000).  Of these past examples, January ended up being higher 36% of the time with an average increase of 1.34% (there were some large recoveries such as 14% in 1934 and 9.5% in 1985).  Looking to the rest of the year, the S&P 500 ended the year up 43% with an average return of 0.85%.
Given the size of the declines in 2016, it’s hard to see a recovery during in the month’s final two weeks.  Another important indicator is flashing a more troubling signal.  The December Low Indicator measures the Dow Jones Industrial Average’s low point in December as a tipping point.  If the Dow trades below the December low in the New Year’s first quarter, it signals a warning.  For the record, the Dow’s low last month was 17,128 on December 18 and we have sliced through that on January 6th.
There have 33 occurrences of the December low being violated.  The Dow has averaged a 10% further decline in those instances.  The index closed higher from that lower “low” in 19 of those 33 examples.  Applying this to 2016, there is risk that we have not seen the bottom for this sell off.
On the positive side, there are several things pointing to somewhat of a bottom.  Two option related statistics are that the equity put/call ratio closed above 1 which has only happened 5 times since 2011 and usually signals at least a short-term bottom. Also the 5-day average of this ratio reached .93 which is the highest since 2009.
The American Association of Individual Investors (AAII) bullish sentiment reading was the lowest in 10 years (this is viewed as a contrary indicator – low bullish numbers can be market bottoms).  Also, the second half of January is seasonally positive.  Last week’s Barron’s cover featured the headline “Bear Scare”.  Clearly there is a good amount of pessimism which is often associated with bottoms.
Whether the problems in the capital markets spill over to the economy is far from certain.  Indicators are still pointing to growth however slower than previous years.  Nevertheless, it would be naïve to think that the headlines and news reports about the global markets won’t have an impact.  Moreover, when these type of avalanches take place, there is usually a sideways period rather than a “V” shaped move as the market adjust and rebalance.
It would be natural for equities, commodities, and bonds to retrace a portion of January’s move.  Assuming this takes place, metrics like market breadth, the number of new 52-week highs vs. 52-week lows, volume (both absolute and up volume vs. down volume) and credit spreads will be important signs of bounce’s health.
It’s a long shot that we repeat the market’s 2008-2009 path.  The banks are not as heavily exposed to energy as they were to the mortgage market.  Further, such things as job growth and corporate earnings remain supportive.  Currently, however, Mr. Market’s focus is on the visible negatives we face.  If that changes together with some further positive signs for the economy, we may find a bottom.

There is Nothing Permanent Except Change

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Three weeks ago the Federal Reserve raised the federal fund rate and Disney Studios released Star Wars – The Force Awakens.  Both have been among 2015’s most anticipated events.  Also, both are notable because they’re the start of many more to come – more Star Wars sequels and more Federal Reserve interest rate increases.  While the Star Wars movies will be a continuation of its storyline, the financial markets are in a process of adjusting to a new landscape.
The Federal Reserve Open Market Committee raised its overnight lending rate to 0.25% – it was the first increase in 9 years.  It’s been so long that many have probably forgotten how markets act when interest rates are moving higher.  Of course, the amount of future increases as well as their timing is a hot financial topic.  There is a growing contingent that believes that the Fed should have waited in December.  On the other hand, it seems that the consensus is for up to 4 rate increases in 2016.
Those in the ‘wait’ camp point to some softening economic statistics.  Industrial production in the U.S. contracted on a year-over-year basis.  It’s the first time that this has happened since the recession.  And while it’s important that production is still positive, a decline in industrial production usually coincides with a recession.
Furthermore, the Institute of Supply Management (ISM) survey remained below the important 50 level for the second month in December.  The index fell to 48.2 which is the lowest level since June 2009.  Unfortunately, most components (employment, new orders, etc.) show little signs of recovery.
Another cautionary sign is that corporate profits as measured by the S&P 500’s 3rd quarter’s earnings declined year-over-year. It was the second consecutive quarter of an earnings decline.
Margins are being pressured by wages and higher interest costs.  Labor expenses are starting to rise.  Employee compensation as a percentage of total corporate expenses has risen recently from a cyclical low of 57% to 58.5% in the 3rd quarter.  The normal long term level is in the low 60%.  A move back toward this level would be a headwind to earnings growth.
Revenues are obviously another important component of the equation.  Unfortunately, there are some challenges in this area as well.  The U.S. dollar has been on a steady rise and has broken above its long term trend line and moving averages.  The higher value of the greenback means that when U.S. companies translate their foreign sales from euro, yen, or rupee back into dollars, it is a lower number (all things being equal).  And as we know, international business has become an important part of the U.S. economy.  Lower sales together with higher labor costs are a troubling combination for profit growth.
Another notable market development has been the turmoil in the corporate bond market especially in the high yield sector.  As we know, the collapse in crude oil and commodities has hurt any company that drills, mines, transports, services, or is involved in any way to these industries.  This hit has increased the risk that some of the entities can’t repay the interest and principle on their borrowings.  Within the fixed income market, these company’s bonds were sold (lower bond prices and higher yields).  While a lower bond price doesn’t immediately hurt the company that issued the bonds, it essentially closes them from selling new bonds to rollover the debt when the older issues mature.  If new debt can be sold to the market, it will be at a substantially higher interest rate (cost to the borrower) at the same time that the borrower is experiencing lower revenues.  A double whammy.  These factors probably had an impact on stocks prices.
Here are the major averages returns for 2015. 
2015 YTD
Dow Jones Industrial Average  -2.2%                     
S&P 500                                    -0.7% 
Nasdaq Composite                   +5.7%
Russell 2000                             -5.7% 
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
Before readers begin reaching for the hemlock, there are positives.  Staying with the fixed income markets, high yield bonds have never had two consecutive down years.  Perhaps 2015’s carnage has priced in all of the bad news surrounding the commodity and energy industries.  If that is the case, 2016 could turn out to be a year of stabilization and recovery.
Another reason for optimism is that there is too much pessimism.  Investor sentiment is typically thought of as a contrary indicator.  In other words, if there is too much bullishness, it is viewed negatively as investors have already acted on this and have done their buying.  The current landscape, as measured by traditional surveys, is far from upbeat.  The AAII (American Association of Individual Investors) weekly report stood at just 25.1% bullish respondents.  This is a low number.  There were only 8 weeks of 40% and above during 2015 which was the lowest number in 25 years!  By far the largest group is neutral or perhaps “confused”.  51.3% of the survey were in this neutral position which is a 12-year high.  Strategists and professionals are similarly situated – a strong statement given that the economy is growing albeit at lower levels.
The capital markets are dealing with some large cross currents.  The Fed will be raising rates while the ECB (Europe Central Bank) is cutting rates.  In fact they are expanding their monetary stimulus as their bond buying program will be to one of the largest ever.  U.S. corporate profits are forecasted to grow but are facing new obstacles such as increasing costs and a slower global economy.  This will likely result in growth but at a lower level than recent years.  Toss in terrorism, geopolitical tensions, and emerging markets problems, it is easy to be confused.
The markets are always facing uncertainty.  It is reflected in such things as earnings multiples and interest rate spreads.  It will be the same in 2016 as the markets digest the news flow and then adjust to new uncertainties.  Unless one of those ‘new uncertainties’ is a recession, investors can expect to find some opportunities amongst the market ebbs and flows.

“Which Way Should I Go?”[i]

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After years of stock prices steadily moving from lower left to upper right, the recent trend breaking decline has bulls and bears struggling as they frantically determine the stock market’s next direction.  The debate centers on whether this is just the long awaited correction or the start of a bear market.  And this will be determined by the direction of the economy.
The capital markets continually digest the ongoing flow of news, data, and corporate earnings.  This is part of the discounting and forecasting process that ultimately helps set prices. But this latest turmoil has brought forth additional issues into this valuation process.
These developments include volatile foreign exchange markets with several devaluations – the most significant being China.  This has further strained the emerging markets economies which have been in retreat for over a year.  Also, the U.S. has recently coughed up some soft data and yield spreads are widening.  Importantly, corporate earnings are facing some stiff headwinds.
The events concerning China, the world’s second largest economy, are both straightforward and complicated.  The obvious is a slowing growth.  Much of the infrastructure needs have been met and demand for housing has peaked which has shelved construction projects.  The ripples from this have traveled throughout the world contributing to the emerging economies’ slowdown.
China’s currency devaluation is something that involves more complications and uncertainty.  First the Peoples Bank of China (PBOC) gave no hint or any forewarning of the move so the markets were caught off guard.  Secondly, it came after the Chinese stock markets collapsed during the summer as stocks plunged over 40% in two months.  Finally, implementing the change was an administrative disaster.  The PBOC waited more than 48 hours after announcing the new currency peg until having a press conference.
This delay provided an opportunity for the rumor mill to shift into high gear.  The conjecture included that the devaluation was for international competitive reasons, it was a panic move to deal with a slowing economy, China was encountering a liquidity crisis, and fears of a 1930’s-type civil war.
Investor’s reaction, as would be expected, was to sell first and sort out the details later.  As everyone looked to de-risk, global stock markets fell, the dollar and bond prices (lower interest rates) rose, and precious metals caught a bid (or at least they stopped going down).
During the selloff, the major averages across the world gave back their year-to-date gains and turned negative.  In fact most major global indexes were lower for the past 12 months (as measured in U.S. dollars).  Furthermore, the MSCI All Country ex-US index (a broad world index that removes the U.S.) recently reached a two year low.
The challenge now becomes factoring these events into current prices and future expectations.  Of course, there is the possibility that these developments are nothing more than speed bumps and that everything returns to the “normal” of recent years.  This is likely an unrealistic dose of wishful thinking because of how much the landscape has changed.
China wasn’t the only country to devalue their currency – Kazakhstan and Vietnam (3 times in 2015) both cheapened their currency in dollars terms.  Besides this foreign exchange turmoil the markets have seen bond yield spreads widen (as compared to U.S. Treasury bonds).  Specifically, corporate bond yields have pushed higher as Treasury yields have remained at around the same level.  This means that the markets have adjusted their view of the safety of corporate bonds.
This has partially been caused by the fall in energy and commodity prices as many drillers, miners, and suppliers of raw materials finance themselves by issuing bonds.  As the prices of the products they sell have fallen, their revenues have dropped and the markets have viewed their bonds as more risky.
Furthermore, corporate profits have leveled off an, in many cases, have declined somewhat.  The stronger dollar has contributed to this as companies with international sales see a reduction as those foreign sales get converted back into U.S. dollars.  For an example of how this is impacting U.S. corporations, we look at the S&P 500 which is comprised of the largest companies most of which have substantial international business.
The total earnings per share for the second quarter earnings reports were 3.2% less than 2014’s second quarter earnings per share.[ii]
Unfortunately, this trend seems to be continuing as we are in the heart of third quarter reports.  Assuming the pattern of the first two weeks carries on, it will be another lower quarterly earnings for the S&P 500 – Thompson Reuters is forecasting a 2.8% decline.  The disturbing significance of this is that the only other times that we’ve seen multi-quarter negative earnings during the last 25 years, stock prices have fallen dramatically. The examples are 4Q 2007 through Q3 2009, Q1 2001 through Q2 2002, and Q1 1990 through Q2 1992.[iii]  All were accompanied with painful stock market sell offs.
Despite year-over-year earnings being negative, October\has been a pretty good month with the S&P 500 advancing 8%.  This has the index back on the positive side of the year-to-date ledger. Despite a strong end of the week, the Dow narrowly missed getting positive YTD.
Here are the major averages 2015 performance.
2015YTD[iv]

                               

Dow Jones Industrial Average   -0.9%                         
S&P 500                                        +0.8%                           
Nasdaq Composite                     +6.2%
Russell 2000                                -3.2%                           
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
“I Gotta Have More Cowbell!!”[v]
The October rally has been in spite of soft earnings and economic data.  Last week, for example, U.S. equities rallied strongly (478 Dow points on Thursday and Friday alone) predominately on news from Europe and China.  First, the European Central Bank announced further easing and promised to move interest rates, which are already negative, even lower.  Second, China’s central bank unexpectedly cut the required reserve ratio for banks and lowered both lending and deposit rates.
On one hand, lower interest rates (for longer) and more quantitative easing is a Halloween treat for the markets.  The potential trick is that the global economies are in need of more stimulus.  As Mohamed El-Erian summarizes, “Markets are right to welcome the China news as confirmation that the Fed, the ECB, the People’s Bank of China and other central banks remain their best friends. But what markets really need is a transition away from this liquidity assistance, toward genuine growth.”[vi]
It was not all central bankers last week, there was some help from corporate earnings.  Amazon, Google (Alphabet), and Microsoft had strong earnings reports on Thursday and each opened 8.5% higher on Friday.  Last week marked the fourth consecutive weekly gain for U.S. stocks and has brought the indexes back to the August levels just before the decline started.  However, there will likely be resistance at these levels as well some time needed to digest October’s jump.  Price action over the next couple of weeks should help indicate the direction into year end.
Although there has been some soft economic data (ISM survey, rising inventories, retail sales, etc.), there are still some rays of light.  Jobless claims are at 40 year lows.  Last week weekly initial claims were reported to be 259,000.  This was the second straight week of a sub-260,000 reading which hasn’t happened since 1973.
The job market is a focus of the Fed as they consider raising interest rates for the first time in 9 years.  Of course, the Fed’s interest rate decision has become a monthly reality show as every financial media outlet spends days of debate, interviews, predictions, and analysis on the event.  The markets are reaching a point of fatigue on this and Janet Yellen risks losing the markets’ confidence in her ability.  On the other hand, the Fed’s decision will have an impact beyond the U.S. and they must consider what a rate increase will do to fragile international economies.  Finally, after the decision to raise rates is behind us, the pace of any future increases will be important.  Likely, by all indications, the speed will be very, very deliberate.
Despite all of the talk of higher interest rates, U.S. yields have drifted lower from the summer’s levels.  The 10-year treasury traded around the 2.45% level in July but has retreated to below 2% earlier this month.  At the other end of the spectrum, however, things have priced in the decision and moved higher.  For example, the yield on a 6-month CD back in June was 0.25%.  Now it is 0.55%.  Noteworthy, the 1-year CD has not adjusted as much.  A 1-year CD yielded 0.45% in June and now is at .55%.  It would seem that this market has priced in an interest hike within six months but nothing beyond.
Market watchers have been looking for a correction for over 4 years.  We finally got it in August.  Unfortunately, we don’t know whether October’s rally signals a resumption of the longer term bull move or whether another leg lower is forthcoming.  The currency turmoil and damage done to the international economies, especially emerging markets, should not be ignored.  From a seasonal perspective, November and December are a historically strong period.  Corporate earnings (and forward guidance) should be the best answer to how the markets’ direction ultimately gets resolved.  Trick or treat indeed.
[i] Lewis Carroll, Alice in Wonderland, 1865
[ii] Raymond James, Investment Strategy, October 19, 2015
[iii] ibid
[iv] The Wall Street Journal, October 24-25, 2015
[v] “Saturday Night Live”, April 8, 2000
[vi] Bloomberg View, October 23, 2015

“The Record Shows I Took the Blows and did it My Way!”[i]

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Central banks from England to Australia have been busy suppressing interest rates and buying bonds.  Although the European Central Bank’s (ECB) mandate may differ from the Bank of Japan (BOJ) which is different from the Federal Reserve’s, all are deeply involved in the global markets.  (Mandates typically range from price stability and economic growth to full employment.)

 

The markets have long understood that central bank policies influence the economy and, consequently, corporate earnings.  In recent years, however, this has risen to a hyper sensitive level.  Short term movements seem to be driven by statements, speeches and policymaker appearances.  Stocks drop whenever a member of the central banker sneezes and rally with any hint that interest rate increases will be delayed.

 

The markets’ obsession with the Fed, ECB, BOJ, PBOC (China), and et al. are understandable but also puzzling.  As mentioned, monetary policy influences the economy which impacts corporate earnings which drive stock prices.  Despite this ‘hip bone connected to the thigh bone’ situation, policymakers, like everyone else, are pretty bad forecasters.  Otherwise we wouldn’t have needed a countless string of QE programs in the U.S. and the European mess would have been solved years ago.

 

Going back further, it is the Fed’s responsibility to avoid a financial crises not just plot a recovery.  The Federal Reserve was formed 100 years ago as a response to the Panic of 1907.  This crisis involved bank runs and failures, a 50% drop in the stock market, a near collapse of the stock exchanges, and a severe recession.  Business and government leaders agreed to form a central bank to guard against future calamities.  Obviously, reviewing the financial history of the past 100 years, success has not always been accomplished.

 

Given the long strange trip that the Fed has chosen, perhaps they should be viewed as part of the problem rather than the solution.  As we know, interest rates are a critical piece of the economic system.  They help assign a price to risk as higher financing and capital costs are associated with riskier situations.  Also interest rates reward the postponement of consumption and savings.

 

These are just a couple of the important roles that interest rates play.  However, if rates are being unnaturally influenced, normal economic relationships are distorted.  As Jim Grant observed, “With one hand, the Fed is manipulating interest rates, therefore the value of the myriad financial claims tied to interest rates.”[i]

 

While this is not suggesting that stocks are overvalued, it does emphasize that the Fed’s role in the markets have influenced stock and bond prices.  The markets have adjusted to this.  However, it becomes an additional wrinkle (risk) as they allow interest rates to return to being market driven.  In other words, we question the Fed’s level of confidence in their ability to simply and easily transition back to the pre-crisis landscape.

 

The recent astounding sell off for the German 10-year Bund (equivalent to the U.S. 10-year note) might be a glimpse of what could happen.  On April 20th the Bund recorded a record low yield of 0.07% – attention please – that yield means bondholders get 70 cents of annual interest for a $1,000 investment!!  Less than a dollar a year!!

 

The yield spiked to 0.608% by the first week of May which equals an 87% move within a couple of weeks.  Clearly, the market was overbought. This was a result of trader and hedge fund buying earlier in the year after Mario Draghi and the ECB announced a quantitative easing that would involve bond purchases.  Apparently by May, there were no buyers left and the leveraged holders could not all find seats when the music stopped.

 

Charles Gave of GaveKal Research observed, “The broader message is that markets can become awfully unstable as a result of central bank actions to try and manage asset prices.  The argument I made a few weeks ago was that the effort of central banks to suppress volatility was creating dangerous feedback loop…”[ii]  Central banks should be careful what they strive to do – they may end up with the exact opposite result.

 

Beyond the securities markets, the Fed’s policy has changed strategic planning as businessmen and women are rewarded to act differently than normal.  Why invest in riskier options such as starting or expanding a business when the markets reward other decisions such as borrowing money at low rates to buy back their stock (in the case of publicly traded businesses) or buy out another.

This has the unfortunate consequences of subduing incomes and job growth.  For example, there are fewer full time U.S. workers than in 2007 at the same time as part time jobs has risen by 2.5 million.[iii]

 

While the merits of world central banks policies are debatable, there is no doubt that they are deeply involved in the financial markets.  And as mentioned, every central banker’s word and facial expression is viewed with a magnifying glass.  To that end, we thought this piece from The New Yorker illustrates that the Fed even comes up at a wine tasting.[iv]

 

 


Turning to the stock market, the U.S. averages have been grinding slightly higher while trading in an upward sloping range.  Selloffs in January and March, which looked as if they would lead to larger declines, were contained, prices stabilized and plodded higher.  The Nasdaq has is having a good year and is leading the major averages.

                                    2015YTD[v]

                               

      Dow Jones Industrial Average    +1.05%                      

        S&P 500                                         +2.4%                    
        Nasdaq Composite                      +7.1% 
        Russell 2000                                 +3.5% 

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

 

There are some wide divergences within different sectors of the U.S. stock markets.  The Dow Jones Transportation Average is down 9.2% and the Dow Jones Utility Average has declined 5% year-to-date.  The Transportation Average has been pressured by the rumors of airfare discounts and some disappointing economic numbers.  The potential of higher interest rates is a headwind for the Utility Average.

The leading sectors on the upside include biotech (up almost 21% through May) and pharmaceuticals (up 10.6%).   The real winners for 2015 have been outside the U.S.  The Chinese Shanghai Composite is up 42.6% for 5 months.  The Hang Seng (Hong Kong) is up 16.2% and Japan’s Nikkei Average has risen 17.8%.  Looking across the Atlantic, stocks in Europe are doing well despite all of the news.  The Stoxx Europe 600 Index is up 16.7% year-to-date.  Within the continent, Italy has jumped 23.6% and France is up 17.2%.

 

Returning to our shores, U.S. markets are digesting soggy economic numbers and the prospect of the higher interest rates.  The long, brutal winter is part of the blame for below target GDP estimates for the first quarter.  Housing, auto, and retail are specifically blaming weather as well as the Los Angeles port strike.  Forecasts for the 2nd half of 2015 are for higher levels of growth as we get past the effects of the weather and reap the benefits of lower energy prices.

 

Concerning interest rates, we turn to the Federal Reserve once more.  Everyone on Wall Street knows that they will gradually start raising rates but the debate is centered on when it begins.  And as the feeble economic numbers hit the news wires, predictions keep getting pushed further into the future.

U.S. valuations are another market anxiety.  We know, thanks to the Fed, that Treasuries are overvalued.  Stocks are fully valued at a minimum with some pundits throwing around the “bubble” term.  We don’t think there is a widespread bubble but there are certain sectors that are generously priced.

Stocks in the U.S. have been resilient so far during 2015.  We feel that economic growth will be an important component to drive equities higher.  If GDP can match predictions for 3% annualized growth in the second half of the year, it should help the stock market.

 

The international markets might continue to offer opportunities.  Japan, for example, has undergone a change of their corporate culture.  They are starting to do such things as share buybacks and dividend increases to better enhance shareholder value.  Further, monetary policy remains growth supportive.  The world’s third largest economy is leading the way in developments of robotics as well as automobile technology (sensors, autonomous navigation, etc.).

 

As with the U.S., the global business community will adapt to whatever foolish things the policymakers and politicians do and figure out how to succeed.  And contrary to conventional wisdom, maybe higher rates stimulate businesses to reinvest and grow their operations.  An economy that is free of suppression and intervention might actually operate ok.

 

Jeffrey J. Kerr, CFA

[i] “Grant’s Interest Rate Observer, March 20, 2015

 

[ii] Gavekal Dragonomics, May 12, 2015

[iii] GaveKal Dragonomics, May 6, 2015

[iv] Paul Noth, The New Yorker

[v] The Wall Street Journal, May 30-31, 2015

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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

“There are decades where nothing happens; and there are weeks when decades happen” – Vladimir Lenin[i]

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Sometimes historical events gradually evolve and develop – progress almost seems imperceptible.  Other times they happen very quickly and are impossible to ignore because they often have far reaching consequences.  For the past several years of the financial market recovery, we’ve experienced the former.  However lately we’ve gotten some “weeks when decades happen”.

 

These recent “decades” take the form of an over 50% plunge in crude oil within a few months, the stock market’s October drop and then extraordinarily quick rebound to new record levels, a bond market “flash crash”, and European bond yields that are negative (that’s right – depositors/lenders are paying the borrower to take their money). To be sure, these incredible developments are within the context of a pretty amazing backdrop of central banks championing more inflation (with no opposition from their citizens) and irresponsible fiscal policies.

 

Few 2014 stories rival the collapse of crude oil.  After peaking over $100 per barrel in July, prices slid throughout the rest of the year with the collapse accelerating during December.  This final dive was sparked by Saudi Arabia’s Thanksgiving Day announcement of their production would not be cut.  For many years the Saudis would increase or cut production to stabilize prices within a range so this decision indicated a new direction.

 

However, oil’s decline is about much more than OPEC’s production or falling demand.  While crude inventories have risen, they have not spiked to a point that would result in the price collapse that we have experienced.  For example, U.S. crude inventory totaled 1.752 million barrels at the beginning of January 2014.  They increased 5% to the 1.84 million barrels at the beginning of January 2015.[ii]

 

Rather than just pure supply and demand, there is a belief that crude’s implosion is a function of the end of quantitative easing (QE).  Capital expenditures in the oil and gas industry have been running above long term averages for the past few years driven, in part, by easy money.  The oil and gas fixed investment as a percentage of total U.S. private investment ranged between 1.5 and 3% for the 20 years from the mid 1980’s to the mid 2000’s.  From 2005 to 2014 this increased from 4% to approximately 7.5% of total capital expenditures, well above the trend and unsustainable for the long term.[iii]  As crude prices started to decline, the realization of this potential overcapacity accelerated the move lower.

 

Another related development that contributed to oil’s drop was artificial demand through the crude oil futures market.  Like the capital expenditures story, this has its roots winding back to QE and ZIRP (zero interest rate policy). In a world of increasing dollars looking for a return, the crude oil futures market presented a yield alternative.  As oil was near $100 a barrel and, more importantly, the term structure offered “positive carry” (longer dated contracts were bought at discounts to the spot price), traders were paid to hold the contract as its value increased with the passage of time.

 

Wall Street is infamous for taking a good idea and then pushing it as far as it will stretch so when this started to work everyone piled on.  The result was a lot of long crude oil futures contracts.  Josh Ayers, Paradarch Advisors, LLC, estimates that the futures market added net $56 billion of added demand at the June 2014 peak.  Furthermore, Ayers estimates that the rate of growth was highest from the beginning of 2013 to June 2014 and during that time speculators increased the paper demand for oil to over 400,000 barrels per day.[iv]

 

Clearly the unwinding of this condition was a contributor to crude’s drop.  Where crude ultimately makes a bottom is subject to much debate.  However, the net positions held by speculators, still much higher than historical levels, suggest crude could move lower before bottoming.

Heads They Win, Tails We Lose

 

Another more complicated event is the negative interest rates spreading throughout the markets.  To be sure, it is hard to fully understand the mechanics of negative yields and what this means but it’s essentially allowing banks to charge interest for depositing money in your account.  Or in the case of the bond market, fixed income buyers getting back less than the principal at maturity.

 

This bizarre financial state is another extension of central bank policy.  As the Fed, ECB and their counterparts keep short term rates at zero, the longer dated rates also move lower.  For example the French 10-year debt was priced to yield 0.60% while the German 10-year bond’s yield closed last week at 0.28%.  Remarkably, Germany’s 2 and 5 year bonds were priced to yield negative 0.22% and 0.14% respectively and the Swiss 10-year yield is negative 0.30%. These levels are more astonishing when compared to the U.S.’s 2% on the 10-year note.[i]

 

A reasonable question is why anyone would consider buying these bonds.  The reality is that a bond mutual fund or some other institution might be forced because that’s the only market sector they can invest in.  Also, investors seeking safety during tumultuous times, like those facing Europe, turn to the shelter of government debt regardless the terms.  This bizarre situation will someday end but let’s hope it’s a result of a return of normal markets rather than loss of confidence together with another crisis.

 

Switching from Old World debt markets to the New World stock markets, it seems like decades are happening daily on the U.S. exchanges.  As we referenced above, we had a quick 8% pullback in October which appeared to be the start of something larger.  But prices swiftly reversed and not only were losses recovered but stocks went to reach new all-time highs in December.

 

After climbing back to this record level, stocks traded in an approximate 5% range for the next seven weeks and actually finished January with losses.  This reversed in February as the major indexes broke out of this range mid-month and have rallied to new records.  Here are the averages for February and year-to-date.

 

                                         February 2015     2015YTD[i]
Dow Jones Industrial Average  +5.6%            +1.7%
S&P 500                                 +5.5%            +2.2%
Nasdaq Composite                  +7.1%            +4.8%
Russell 2000                           +5.8%            +2.4%

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

 

It’s likely a futile wish for a return to “decades when nothing happens”.  And looking at the current financial market landscape, it’s pretty easy to predict continued rapid change.  Some obvious items include:

  • The Fed will likely start raising interest rates later this year.
  • Greece may exit the European Union.
  • U.S. stocks are no longer undervalued.
  • 2015 earnings estimates are being reduced (energy companies are part of this).
  • Geopolitical tensions.

Of course, these might just be bricks in a “wall of worry” that stocks often climb.  From that perspective, there is plenty of ammunition.  But considering that we will reach the 7th anniversary of the stock market’s financial crisis low later this month, maybe we are entering a period where risk is priced higher.  It’s a potential headwind should it occur.  However, economic growth seems likely to continue and with it corporate earnings.  This higher trajectory for the bottom line should ultimately help equities.  Whatever develops, we expect “decades happening in weeks”.

  

Jeffrey J. Kerr, CFA

[i] The Wall Street Journal, February 28, 2015

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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

 

 

[1] Lenin – Selected Works, 1975

[1] www.eia.gov/dnav/pet/hist

[1] Gavekal, Dragonomics, January 6, 2015

[1]Paradarch Advisors, February 15, 2015

[1] The Wall Street Journal, February 28, 2015

[1] The Wall Street Journal, February 28, 2015

 

 

 

[i] The Wall Street Journal, February 28, 2015

[i] Lenin – Selected Works, 1975

[ii] www.eia.gov/dnav/pet/hist

[iii] Gavekal, Dragonomics, January 6, 2015

[iv]Paradarch Advisors, February 15, 2015

 

 

 

 

 

 

 

 

 

 

 

 

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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.

“I Ain’t Gonna Work on Maggie’s Farm No More”[i]

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Every market nerd (hand raised) knows that September’s employment data is released this Friday.  However, last week we got some different yet important jobs related news.  First as everybody knew, Derek Jeter retired.  But the other headline was a real shocker as Bill Gross unexpectedly changed employers.

 

Derek Jeter, for those who don’t read The New York Post sports page, was the shortstop for the New York Yankees for the past 20 years.  He had an all-star career winning 5 World Series championships and will be voted into baseball’s Hall of Fame.  He announced his retirement before this season began and played his last game on Sunday.

 

As the financial world knows Bill Gross is the co-founder of Pacific Investment Management (PIMCO).  The firm’s flagship mutual fund, the Total Return Fund, had over $270 billion in assets while the firm wide total exceeded $1.25 trillion as of June 30th.  With these remarkable numbers it is no wonder that Mr. Gross is considered one of the kings of the fixed income market.

Naturally the media was abuzz about Gross’s decision as everyone wanted to analyze both the why as well as its consequences.  Heck we suspect it was even a topic on Friday’s “The View” and “Good Morning America” but only in between fashion updates and coverage of George Clooney’s wedding.

 

Of course, Mr. Gross’s decision presents more challenges than just learning his way to Janus’s men’s room.  Undoubtedly there will be massive outflow from PIMCO and a corresponding inflow to Janus.  But perhaps more importantly, PIMCO, led by Gross, was noted for its “New Normal” economic forecast.  This centered on a slower potential growth rate for the U.S. when compared to past recoveries.  This included such things as subdued job growth and lower reported inflation.  Further it called for lower than normal interest rates for longer than others were predicting.

 

This “New Normal” approach resulted in PIMCO being a “vol seller” or taking positions that benefit from lower volatility, lower interest rates, and low inflation.  Reportedly, this was implemented by such positions as long high yield spreads, TIPS (inflation protected bonds), emerging market debt, and maybe some short positions in equity.  As these positions get unwound and re-established, the markets trading those securities could be a little choppier than normal.

 

Last week’s markets were wild enough without the Gross bombshell.  The Dow Jones Industrial Average moved 100 points or more in each of last week’s trading days – 2 days higher but 3 days lower.  Thursday was especially bloody as the Dow plunged 254 points and all of the major averages lost between 1.5% and 2%.   An astounding 92% of trading volume on the NYSE was in declining stocks.  It was the highest reading since February 3rd.  The glass half-full view is that this can be a sign of capitulation and recent occurrences have happened around the lows of a move.  On the other hand, market internals continue to be poor and traders usually look for capitulation after a more painful correction.

It’s possible, however, that given the declines by the small and mid-cap market sectors (covered in the previous newsletter), the average stock has experienced a meaningful decline and is ripe to recover.  This also points to the narrow leadership driving the major averages which masks the underlying stock market weakness.  For example, on September 19th the Russell 3000 set a new record high.  Significantly, this index equals 98% of the investable stock market.  As the index made an all-time high, only 55% of its components were above their 200 day moving average.  A more typical and much healthier percentage would be above 80%.   The last time such a level of narrow leadership happened was March 2000 – not a good time for the markets.

 

Coming into the end of September (and the 3rd quarter), stocks have had a tough month.  The S&P 500 is down 1.4% for the month (with two days to go) while the mid and small cap indexes are down over 3% and 4% respectively.  Here are the year to date performance for the major averages.

2014 YTD[ii]

 

Dow Jones Industrial Average  +3.2%                           

S&P 500                                       +7.3%
Nasdaq Composite                      +8.0%                           

Russell 2000                                 -3.8%                            

I

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

 

The lousy performance outside of the large caps, including a painful three months for small caps, might be a function of a correction in the high yield market and strong U.S. dollar.  First, junk bonds reached a multi-year high (in price) toward the end of the second quarter.  Since then these bonds have lost around 3%.  Certainly on the surface this is not an alarming number but in the lower volatility world that is supposed to be fixed income, this is a big number.  Also, it represents a large portion of the 4.5% – 5.5% yield that most high yield bonds provide.

 

The losses in the junk market might be a result of reduced risk appetites, the end of Fed bond buying (although QE was not in high yield), or worries over the economy’s strength.  Whatever the cause, this sector of the bond market is at the riskier end of fixed income and it usually correlates with stocks especially smaller caps as they use this market for capital.

 

Turning to the U.S. dollar, it will record its best quarterly performance in more than 5 years with a better than 7% advance.  Looking at a longer term measure, the U.S. dollar index remains well below the levels of early to mid-2000’s, but this recent rise has pressured oil, gold and other commodities.  Crude oil closed last week around $93 per barrel and gold finished at $1,214 per ounce.

 

“For Everything There is a Season, and a Time for Every Matter Under Heaven”[iii]

 

As 2014’s 4th quarter begins (head shaking in disbelief), we face typical market cross currents.  On a global stage, we are confronted with protests in Hong Kong, the Ukraine, ISIL, Ebola, and a struggling Europe.  Within our stock market, we have weakening signals and worrisome divergences.  On the other hand, the 4th quarter has historically been the best three-months for equities.  According to Bespoke Investment Group, during the past 100 years October has averaged a gain of 0.22%, while November and December have averaged increases of 0.71% and 1.47% respectively[iv]


Once again it seems that the capital markets are at an inflection point.  Perhaps we are entering a long anticipated painful correction that many have been calling for and we see the large cap indexes move lower.  Or perhaps we regain momentum with the bullish seasonality and we madly sprint to year end.  Or perhaps the correction has already taken place in certain sectors and the areas that haven’t been hit just slither sideways for a while.  We may not get developments such as Bill Gross’s departure from PIMCO but it promises to be an exciting stretch.

[i] Bob Dylan, 1965

[ii] The Wall Street Journal, September 27-28, 2014

[iii] Ecclesiastes, chapter 3, verse 1

[iv] The Bespoke Report, September 26, 2014

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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.

 

2ND QTR KILDARE ASSET MGMT PERFORMANACE LETTER

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Often, when making investment decisions, the obvious needs to be questioned.  In other words, when something becomes so widely known that virtually everyone “knows” it, it’s a pretty good bet that it is already reflected in the current price.  If this obvious information is already in the securities price, future price movement will likely be caused by other reasons.

An example might be our recent financial crisis.  Money printing, bailouts, QE, and poorly thought out stimulus programs causing record fiscal deficits were the policy responses implemented to fix things.  Many thought these would ultimately lead to more and bigger problems and even those in favor of these extreme and untried approaches acknowledged that they contained risks  And when it seemed ‘obvious’ to everyone that things were going from bad to worse, the economy and markets stabilized and began to move higher.  This was largely in spite of policy rather than a result of it as businesses figured out the new landscape, adjusted and moved forward.  The point is that what appeared to be obvious (bad approaches would cause more and deeper problems) ended up missing new developments (businesses adapting and figuring out how to progress).

 

Within the context that history doesn’t repeat itself but does often rhyme, the 2014 stock market has some similar underlying characteristics that force us to look beyond the obvious.  Right now everyone knows the stock market is at all-time highs.  However, this clear fact has an element of distortion.  First the Dow and S&P 500 both began at record levels so any move higher, no matter how small, results in a new record.  This nugget seems to be overlooked by journalists as they report on the daily stock market action.  To be sure, a “record stock market close” is much more interesting than reporting that the Dow inched higher by 10 points.  However, a casual follower could easily be misled by this omission.

 

2014’s advance, in addition to being shallower than perceived, has also been narrow.  The 6-month chart below show both points (Please note this chart includes July.  Also, the color code is as follows Dow – blue, S&P 500 – red, Nasdaq composite – purple, and the Russell 2000 – green).  As you can see, the S&P 500 has had the smoothest journey this year and especially in the second quarter.  Further, despite the media’s portrayal, the majority of the market has made little progress above the March highs.

 


The chart points out another important development – a substantial divergence between the large cap and small cap of the market.  From the beginning of April, the Nasdaq and Russell gave back all of 2014’s gains and then some by mid-May.  While they rallied along with the rest of the market throughout July, their 2014 performance has lagged the S&P 500.  This divergence grew materially in July as you can see.

 

Of course, the deviation in the averages can also be seen in the major averages’ quarterly and year to date numbers. Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends

 2nd Qtr       2014 [i]                    

Dow Jones Industrial Average    +2.24%         +1.5%
S&P 500                                      +4.69%         +6.1%
Nasdaq Composite                      +4.98            +5.5%

Russell 2000                                +1.70            +2.5%

 

For Kildare Asset Management clients, accounts averaged an increase of 4.7% in the second quarter while the weighted average increase of all Kildare Asset Managed accounts was 5.22%.

 

The year-to-date performance for 2014 was an average increase of 14.54% and a weighted average increase of 14.36%.  These numbers are after all expenses.

 

While there are few steadfast investing rules, divergences can be a significant indicator of future price action.  There has not been this type of separation among the major averages in recent years and certainly nothing came close during 2013’s rally.  This type of movement (the broader averages weaker than the larger, narrower ones) might be an indication of upcoming turbulence.  Of course, there are past examples where this type of divergence is resolved with the broader market regaining strength and closing the price gap (weaker averages catching up).  Nevertheless, it is something to monitor.

The markets are flashing other red flags.  The cumulative advance-decline ratio (the summation of the number of issues advancing and declining) has weakened.  Further as the market regained record territory at the end of June the number of stocks trading at new 52-week highs was not as great as the number when the April highs were achieved.  This means fewer issues were leading the charge.

While this deterioration must be watched, there is no arguing that this has been a remarkable rally.  As measured by the S&P 500, we have gained 193.5% during the past 1,942 calendar days which ranks fourth in strength and duration.  Interestingly, this move will have to continue through early May 2015 in order to overtake the third longest rally which started in October 1974 and ended in November 1980 (2,248 days).  In terms of strength, third place belongs to the 1980’s (August 1982 through August 1987) with a 228.8% gain.  For those interested, the same two bull markets capture first and second in both longevity as well as percentage gain.  Second place transpired from June 1949 and ended August 1956 (2,607 days) and rose 267.1%.  As some might guess, the greatest rally began in December 1987 and ended when the tech bubble burst in March 2000 (4,494 calendar days).  During this stretch, the S&P 500 rose an amazing 582.1%.

While it would be quite enjoyable for the current rally to continue to gain on these other historic moves, we must consider the possibility that it falls short.  To that end, I continue manage your account with risk control being a high priority.  As you know, this involves using part of the portfolio in a combination of hedges and cash balances.  Further, I remain diligent in looking for opportunities that present favorable risk vs. return situations.

 

Looking forward I think the markets will face some obstacles.  Current conditions offer many sources of possible causes – geo-political conflicts, the end of QE, inflation, etc.  Any of these developments could worsen to a point that they impact the stock market and the economy.  This market setup reminds me of a quote from global hedge fund manager Paul Tudor Jones.  Mr. Jones is quoted as saying “I’m always thinking about losing money as opposed to making money.  Don’t focus on making money, focus on protecting what you have.”[ii]  Indeed this will be our priority.

Thank you for your continued trust and business.  Please contact myself or Connie with any questions or comments.

[i] The Wall Street Journal, July, 1 2014

[ii] Raymond James Equity Research, July 23, 2014

 

 

Sincerely,

 

Jeffrey J. Kerr, CFA

 

 

 

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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.

“Speak in French when you can’t think of the English for a thing”[i]

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Two weeks ago France’s government dissolved – in Paris the capital markets reacted with the CAC 40 (the French stock market index) jumping 2% while interest rates dropped to fresh lows.  Naturally, the mind is immediately overwhelmed with the possibilities of these developments providing similar results in markets around the world including the United States of America.  While it’s possible that the former French government was more incompetent than Washington, Wall Street’s response to a change in our Federal leadership could potentially be beyond belief.

 

Of course, anarchy is not a good outcome, something that even the most callous Wall Streeters realize (or at least most of the callous Wall Streeters realize it).   However, watching the quote screens during the past few weeks it seems U.S. stocks aren’t waiting for a government collapse to move higher. Prior to last week the S&P 500 had not had a down week since the last week of July.  In late August the index reached the 2,000 level for the first time.

 

Of course, reaching this threshold combined with the widespread excitement of the Dow Jones Industrial Average repeatedly reaching records gives the illusion that the entire equity market is having another gangbuster year.  And while the S&P 500 and Nasdaq are providing very nice returns so far in 2014, the Dow was only up 3% year-to-date on September 1st (‘only’ relative to the number of records it has set) while the Russell 2000 increase was less than 1%.

 

Here are the major averages year-to-date results through August. 

2014 YTD[ii]                                  

Dow Jones Industrial Average     +3.1%
 S&P 500                                       +8.4%
          Nasdaq Composite                        +9.7%

Russell 2000                                  +0.9%

 

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

 

“Twinkle, Twinkle, Little Star”

 

As mentioned, the Dow has gotten a lot of mileage out of a 3% return. However the security that has unexpectedly become the 2014’s star is the long term government bond.  Few realize that many long maturity fixed income securities have provided double digit total returns.  In fact the total return of the long-bond ETF (symbol = TLT) is 16.88% in the first eight months.

 

Please remember that at the start of the year the overwhelming consensus was that bonds were to be avoided.   Yet the 10-year Treasury bond’s yield has declined from 3.03% at the end of 2013 to last month’s low of 2.30% – falling yields mean higher bond prices.  The August low (in yields) might be an important level as the yield has moved higher in September and closed last week at 2.61%.  With the end of QE (although interest rates actually fell when other QE programs concluded) and economic growth seeming to strengthen, perhaps August was the low for the longer end of the yield curve.

 

Staying in fixed income and returning across the pond, Spain sold a 50-year maturity bond at a remarkable yield of 4% in early September.  This is noteworthy in the terms but also given the underlying credit as Spain’s S&P credit rating is BBB or at the low end of investment grade.  It’s astonishing that this got sold at such a long term with such a low rate.  However when we compare it to Germany, it is not that noteworthy.  Investors buying 2-year German debt in August effectively paid the government to invest as the yields were negative.

We wouldn’t expect European interest rates to move higher as ECB president Mario Draghi announced a continental version of quantitative easing.  On September 4th the European Central Bank unexpectedly cut interest rates and said they would begin buying asset backed securities and euro denominated covered bonds in October.  This was a new step for European bankers and is thought to help the economies as they weakened and risked falling back into a recession.

“Or Just a Brilliant Disguise”[iii]

 

The fixed income markets are not the only area of unnoticed deception.  While our aforementioned S&P 500’s accent on the 2,000 is historic, it masks some troubling undertones.  According to Bespoke Investment Group, the average stock in the S&P 500 is down 7.5% from its 52-week high even as the index is making all-time highs.  This divergence is larger within the mid and small cap sectors.  The average stock in the S&P 400 Mid Cap Index is 11.1% lower than its 52-week high and the average S&P 600 Small Cap Index name has plunged 17.3% from its high.  As Bespoke points out, “For this area of the market, the average stock isn’t far from bear market territory”.   Blending it together, the average stock in the S&P 500 is 12.4% lower than its 52-week high.[iv]

 

Breaking it down by sector, Utilities (-6.6%) and Financials (-8.6%) are only sectors where the average stock is not down by more than 10%.  The energy sector is the biggest loser – the average stock is down 19.7% from the 52-week high.  Combining the two weakest sectors (small cap and energy) results in stocks with lower approval ratings than the NFL.  The average small cap energy stock is 29.4% lower than their 52-week high!!

 

That the average stock is weak at the same time that the indexes are reaching record highs is a clear sign of sector rotation together with a narrowing of breadth.  This could be considered a healthy sign in that nothing gets too overheated and there is an eventual recharging of buyer power.  On the other hand, a smaller number of stocks leading the charge to record levels could result in these “generals” ultimately falling and the arrival of the long awaited correction.

 

This rotation could also be a function of the global investment landscape.  Excitement over the new I-Phone together with Alibaba’s IPO and a steady economy is offset by numerous international conflicts, a slowing Europe, an Ebola outbreak, and an ending of US monetary easing.  Interestingly, as these crosscurrents get digested, the S&P 500 has traded in a narrow range in the past few weeks.  At the end of August and beginning of September, the index traded between 1,997 and 2,002 for 8 straight trading days!!  Recently the S&P 500 spent 13 consecutive trading sessions without closing 0.5% higher or lower than the previous close.  We have to return to the year 1995 to find a comparable stretch.

 

MKM Partners researched similar behavior to see what happened after such compression.  Going back to 1980, there were 5 instances where the S&P 500 traded 10 days or more without closing more than a 0.5%.  The average returns after these churns was positive in 1 week, 2 weeks, 1 month and 3 months – respectively 0.85%, 1.24%, 1.83% and 4.71%.[v]  If history rhymes with these past occurrences, the S&P 500 will break out to the up side.  Many are watching 1,990 on the S&P 500 as major support.  This trend could be broken if the index falls below that.

 

France is the 5th largest economy in the world (larger that the United Kingdom, Canada, Australia and the BRICs).  It is remarkable that such an important country’s government can fail and then re-form without much more than a hiccup.  Out of such change opportunities often arise and perhaps this is an indication of political irrelevance together with a sign that the global economy is, in general, doing ok.  And if Europe can take steps to resolve their problems, the S&P 500 might continue to make history.

 

[i] Lewis Carroll, “Through the Looking Glass”

[ii] The Wall Street Journal, August 30-31, 2014

[iii] Bruce Springsteen, 1987

[iv] The Bespoke Report, September 12, 2014

[v] MKM Partners, “Technical Strategy”, September 8, 2014

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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.

“The Internet is just a world passing around notes in a classroom.”[i]

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It is remarkable that smartphones and tablets allow their users to access virtually anything ever written in seconds.  Having this instantaneous access to news or any other piece of information is supposed to be a good thing.  To be sure, getting headlines while standing in line at Starbucks is considered productive and reading about who played well in the Jets training camp scrimmage as you are waiting for a happy hour beverage is invaluable.  However, as convenient and industrious as this is, we check the “undecided” box in regard to the total usefulness.

This reluctance in the belief that having unlimited information at your fingertips is beneficial is not a Luddite yearning for the good ole days.  Rather it is the fear that blogs and social media sites are viewed with more creditability than they deserve which can then lead to a distorted view of reality.  We think the risk of this misinformation is especially high when it involves financial news and data.

 

No one enjoys the convenience of accessing stock prices more than we do and using various apps to stay on top of the market is vital.  Nevertheless, we think many mistake instant access to prices and news for analysis and as a result have a misperception of the markets.  As an example, recent client meetings have included a fair amount of surprise when they were told the Dow Jones Industrial Average was only up 1.5% in 2014’s first six months.  The incredulity increased when we pointed out that as recently as May the Russell and Nasdaq Composite were negative year-to-date.  The Russell remains slightly lower for 2014 which would probably win a few trivia bets.  For the record, here is where the major averages stand as of the end of last week.

 

2014 YTD[ii]

                                   

Dow Jones Industrial Average    +2.6%
S&P 500                                       +7.6%
Nasdaq Composite                     +8.7%

 

Russell 2000                                 -0.3%

 

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

 

There is no doubting that the S&P and Nasdaq have a good 2014.  The former has had a much smoother trip in contrast to the latter’s multiple journeys into negative territory and explosive spike from the May lows.   The eye openers are the Russell’s break-even year and the Dow’s “meager” gains.  Many are stunned to hear that the Dow is only up a couple of percent given that seemingly every day’s headlines include “all-time highs for the stock market”.

 

The Dow began the year at a record so naturally any move higher from that level produces another record.  In the job of being read, journalists realize that reporting blue chips advanced 5 points doesn’t have the same appeal as a “New Stock Market Record” headline does.  So we get the juicer version.  And with the repetition of this news that we have seen in 2014, it’s no wonder that investors are surprised when they look at the Dow’s YTD returns.

 

Of course we must consider the possibility of a widespread distrust of Wall Street and consequently people don’t care.  To this end, a recent Wells Fargo /Gallup Investor and Retirement Optimism survey reveals some helpful results.  When asked during late June and early July only 64% of respondents (1,000 U.S. investors with at least $10,000 invested were polled.) realized that the stock market was up in 2013.  Further only 7% knew that the S&P 500 was up over 30% last year.  And when asked their preference on where to put new investment funds, only 41% would choose stocks.[i]

 

While this clearly demonstrates a pessimistic public, it could also be viewed as a pipeline of future buyers if they somehow have a change of heart.  Admittedly that isn’t so easy to imagine.  With increasing tension surrounding the multiple geopolitical issues, it is hard to throw caution to the wind.  Also, in an ironic twist, European economies (lead by Germany and France) are feeling the effects of the Russian sanctions and are close to slipping into a recession.  And finally, the Federal Reserve has been reducing stimulus and will continue to move in that direction.

 

Sometimes figuring out why the market goes higher is not easy.  With

the above list in mind, the current rally qualifies.  As bombs are flying and governments crumbling, stocks have moved higher.  The average S&P 500 is up 4% from the August 7th lows to the last week’s close.

 

Declining jobless claims is one driver of the move.  Recently the weekly claims report fell to 279,000 claims which is the lowest number since before the financial crisis.  The four-week moving average has moved down to the 300,000 level again the lowest since 2007.

Second quarter earnings have also helped stocks.  The S&P 500 companies’ quarterly earnings growth year-over-year will be around 9.6%.  Furthermore, profit margins (operating) remain in the high single digit to low double digit range.

 

As confounding as the stock market is, it can’t hold a candle to the fixed income market. The 10-year Treasury yield began the year at 3% with everyone predicting a move higher.  A combination of a growing economy and the Fed’s “taper” would certainly push interest rates much higher in 2014.  Last week the note’s yield closed at 2.40%.  Many reasons are offered for this unexpected move lower including a flight to safety given the geopolitical conflicts as well as a shortage of Treasury bonds.  This last point is hard to conceive – how can a government with fiscal deficits as large as the U.S.’s have a dearth of bonds.  We must remember that the Fed through its QE has been buying billions of dollars of these bonds each month.  Institutions who need to offset their liabilities with high quality fixed income investments have had to bid these securities higher (lower interest rates).

On the other hand, the high yield sector of the fixed income market has seen carnage.  From late June through July, the high yield exchange traded fund (HYG) suffered a 3.14% decline.  This is equivalent to over two-thirds of the fund’s annual yield of 4.25%.  It’s hard to make up 66% of your expected yield.  To make matters worse, investors pulled $361 million or 3% of the assets in one day at the end of July.  This is a significant move to a more conservative approach and could spread to other parts of the capital markets including equities.  For now it seems contained as the higher quality parts of the corporate bond market (investment grade) did not encounter the same selling.

 

As summer unfortunately winds down we look to the last four months of 2014.  Whether the start of fall increases public’s focus on the stock market is hard to predict.  We would expect the cross currents surrounding the global conflicts to impact investor’s perception of risk.  On the other hand, corporate earnings will likely be the counter balance to those events as it appears the U.S. economy is strengthening.  Oh if there was only an app that reconciled this battle.

 

[i] Raymond James, August 13, 2014

[i] Jon Stewart, “The Daily  Show”

[ii] The Wall Street Journal, August 23, 2014

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

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 NASDAQ Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Russell 2000 Index is an unmanaged market-capitalization weighted index measuring the performance of the 2,000 smallest U.S. companies, on a market capitalization basis, in the Russell 3000 index. It is not possible to invest directly in an index. Investing involves risks, including the risk of principal loss. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. 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.

 

Past performance does not guarantee future results

“There is Nothing More Deceptive than an Obvious Fact”[i]

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The Dow and S&P 500 both closed last week at record levels. Obviously, one would conclude, stocks are having another good year.  Even an experienced market observer would naturally feel it’s a redux of 2013’s 30% advance given that seemingly each day’s headlines include “a new stock market record”.  The obvious is that the indexes are at record levels.  The current deception is that the underlying signals are suggesting caution.

 

This most recent rally began in mid-May.  Prior to that the markets spent six weeks trading sideways to lower and was marked by a divergence between the blue chips and the rest of the market.  Specifically the Dow and S&P 500 moved sideways while the Nasdaq and Russell were soggy.  (The Nasdaq was down 3% and the Russell fell over 6% from the start of April to the middle of May.)

 

But just as the “sell in May and go away” crowd was feeling emboldened, equities stopped retreating and buyers returned.  And while the Dow and S&P grabbed headlines, the lagging Nasdaq and Russell has also participated and have recovered their year-to-date losses within a few weeks.  Here are the major averages for 2014.

2014 YTD[ii]                                  

Dow Jones Industrial Average         +2.1%
S&P 500                                                  +5.5%
Nasdaq Composite                              +3.5%                           

Russell 2000                                          +0.1%                           

 

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

 

Naturally record stock market levels often coincide with increased investor enthusiasm.  While emotion is somewhat difficult to accurately measure, there are clear signs of complacency.  Last week Investors Intelligence showed that over 60% of responding advisors were bullish which is the highest level since October 2007.   Importantly, Investors Intelligence defines any number above 40% as “excessive optimism”[iii]  Also, there were only 17% bearish advisors which is lower than in October 2007.

 

There are a couple other attention grabbing nuggets to pass along.  The CNN Fear and Greed Index reached 86 on Friday which is the highest in a year and also in extreme territory.[i]  This survey’s scale ranges from 0 to 100 with higher numbers reflecting greed.  Lastly, the CBOE Equity Put/Call ratio hit a low of .43 last week which was the lowest one-day reading since January 2011.  This index is based on the buying of put options (bearish) vs. call options (bullish).  Readings below .50 and above 1.00 are viewed as abnormal.

 

For those unfamiliar with these statistics, they are used as contrary indicators.  In other words, widespread optimism and few worriers is usually a headwind to higher prices as bullish investors have already put their money to work which could mean a peak in buying power.  In the past it has been prudent to step away from the crowd when sentiment gets this ebullient.

 

Combining the market’s current emotional state with some fundamentals results in even more alarming signs.  John Hussman points out that when sentiment is optimistic (II survey above 60% bullish) at the same time as market records and an S&P 500 P/E above 18 (measured by trailing earnings), it has been a sign of a top.  Dr. Hussman states that only times that these three stars have aligned were October 2007, January and May 1999, August 1987, and January 1973.[ii]  Attention, please.

 

Dr. Hussman points out that these may have not been the top ticks but, importantly, all preceded material market corrections.  While short term timing is difficult, there are some other trends that support near term caution.  During the past 10 years, June has averaged a 1.33% decline making it the worst month by a wide margin (the next worst is August with a .45% average decline).  Also as a point of reference, over the past 50 years September is the weakest month.

 

The above data probably suggests a correction (they can be very unpleasant for those who’ve forgotten) but we wouldn’t expect a bear market.  Aside from investor’s emotional state, the economy is doing ok.  Corporate earnings continue to grow.  According to Factset, 497 of the S&P 500 companies have reported 1st quarter earnings with 74% exceeding the mean estimate.  53% have reported revenues above the mean estimate.  The estimated growth for 2nd quarter earnings is 5.4%[iii]  Further corporate balance sheets remain strong and mergers and acquisitions have been very active.

 

“Abby someone?  Abby who?  Abby Normal.”[iv]

 

Turning to the fixed income market, the U.S. 10-year treasury has had a roller coaster ride recently.  From a 2.70% yield at the end of April, the yield dropped to 2.4% at the end of May.  The yield then rebounded back to 2.65% during the past 1 ½ weeks.  For those not familiar with the bond market, this may not appear

to be that significant, but it is not normal behavior.  It is incredible volatility on both an absolute and relative basis.  There has been a lot of ink spilled over the cause but there has not been a definitive reason identified.  We’ll be keeping an eye at this and will continue to search for causes.

 

Today’s capital market conditions are challenging.  But this is nothing new.  We wonder if the record stock prices is the ‘obvious fact’ or the ‘deception’.  After all, it seems illogical that this is happening in the face of terrible fiscal and monetary policy.  Which leads to the following quote which has been making its way around investment blogs and other social media platforms recently.  We think it accurately describes 2014’s markets but it was actually written 25 years ago by the sagacious Merrill Lynch strategist Bob Farrell.

 

“Money managers are unhappy because 70% of them are lagging the S&P 500 and see the end of another quarter approaching. Economists are unhappy because they do not know what to believe: this month’s forecast of a strong economy or last month’s forecast of a weak economy. Technicians are unhappy because the market refuses to correct and gets more and more extended. Foreigners are unhappy because due to their underinvested status in the U.S., they have missed the biggest double-play (a big currency move plus a big stock market move) in decades. The public is unhappy because they just plain missed out on the party after being scared into cash after the crash. It almost seems ungrateful for so many to be unhappy about a market that has done so well. . . . Unhappy people would prefer the market to correct to allow them to buy and feel happy, which is just the reason for a further rise. Frustrating the majority is the market’s primary goal. . . .” [i]

[i] Robert Farrell, September 5, 1989

[i] www.money.cnn.com/data/fear-and-greed/

[ii] www.hussmanfunds.com, “Weekly Market Comment”, June 9, 2014

[iii] Factset, “Earnings Insight” June 6, 2014

[iv] Young Frankenstein, 1974

 

 

 

[i] Arthur Conan Doyle

[ii] The Wall Street Journal, June 7, 2014