What a Long Strange Trip It’s Been

/0 Comments/in /by
Four months into 2016, it might be difficult for some to recall that the year had the worst start ever for the stock market.  This is partially a function of the historic recovery that started in mid-February which erased all of the earlier losses as well as the markets’ nightmarish memories.  This bounce has included a string of 5 consecutive advancing weeks and 8 out of 10 weekly gains ending in mid-April.  While this returned the major averages to marginally positive year-to-date numbers, they remain below their all-time highs reached last May (the Nasdaq’s high was in July).
Here are the major averages through May 5th:
2016YTD
Dow Jones Industrial Average   +1.4%
S&P 500                                     +0.3%
Nasdaq Composite                     -5.8%
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
It may surprise many that this back and forth action has been in place well beyond 2016.  For example, the Dow Jones Industrial Average closed above 18,000 for the first time in December 2014.  Then after peaking at an all-time high last May, stocks fell in August on fears surrounding China.  Prices recovered somewhat into year-end but plunged in January.  However, the rally of the past two months has helped the Dow recover this 18,000 level again.  Obviously, the Dow was little changed during this almost 17-month stretch, but remarkably, the index traveled 42,155 points during the trip!!  That’s a lot of mileage to end up where you started.
Stocks have struggled during the past few weeks.  The Nasdaq has been the weakest area as some high profile companies reported some disappointing 1st quarter earnings.  Google, Apple, and Netflix, three of last year’s heroes, all fell after their earnings reports. Of course, Amazon and Facebook are two stocks that reacted positively and have moved higher.
However, there are many high profile stocks trading below the 50-day moving averages.  This might be a sign of a consolidation before another move higher or a signal for a market dip.
Unfortunately, we are entering the historically weaker 6 months of the year as we are in the “sell in May and go away” timeframe.  Since 1929, the S&P 500 has averaged a 5.04% gain during the months November through April.  This is contrasted with an average gain of just 1.87% in May to October period.[i]  While this latter period is positive, there have been some memorable stock market declines during these six months.
Last weekend Warren Buffett hosted Berkshire Hathaway’s annual shareholder meeting.  Naturally, it was the focus of the financial media and Mr. Buffett reminded us that the U.S. is the greatest economy in the world.  But before everyone finished shaking their heads in agreement, Stanley Druckenmiller, speaking at the high profile Sohn Investment Conference, told listeners to sell everything and buy gold.  Mr. Druckenmiller, one of the most successful hedge fund managers in history, criticized the Fed saying that there is no “end game’ for the “radical monetary experiment”.[ii]
Two really smart, successful investors on the opposite ends of a bull-bear debate highlights the uncertainty in the markets.  Both make compelling arguments in defending their view which makes it difficult to determine who the market will side with.  Perhaps the sidewinding price action will be with us for a while longer until a clear winner is declared.
I The Bespoke Report, April 29, 2016
[ii] Yahoo, Finance, May 4, 2016
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
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
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.

It’s Darkness Before the Dawn

/0 Comments/in /by
After the worst start to a year, the stock market has amazingly recovered.  The nightmare that began 2016 was a tortuous six week drop.  The widespread damage to the global equity markets was relentless.  The panic and fear increased to a point where the Chinese closed their markets for a couple of days to try to combat the selling.
In mid-February, as pessimism was everywhere, something completely unexpected happened – the global markets stabilized and U.S. stocks went on a five week rally that erased all of the losses.   So after the first three months of the year, we’ve had a lot of price movement but little change from where we started.  More importantly, the markets’ emotional state is back to its normal neurotic condition.
Despite ending the quarter with just a small gain, it was a historic three months.  It was the first time in 82 years where the S&P 500 was down over 10% during a quarter and then recovered and closed up at the end of that same quarter.  It last happened in the 4th quarter of 1933.
It was a remarkable shift in investor emotions during 2016’s first three months.  Conventional wisdom during the decline was that the emerging markets were imploding, commodities were dropping, and the world was plunging into recession.  Sentiment switched during the second half of the quarter to a calmer view of the global economy and re-established confidence that the central banks would be able to navigate through the challenges.
The trading action in these three months reflect the decline and then the recovery.  In 2016’s first 48 trading days the S&P 500 moved 1% over half of the time (26 times).  In contrast, March only had 4 days of 1% moves.  That is a lot of motion without much movement (the S&P closed the quarter less than 1% higher than where it began the year).  Of course, inquiring minds want to know if that volatility and recovery signaled a sustainable low.  In other words, did February’s reversal represent a panic point that priced in all of the bad news and none of the good news?
Here are the major averages returns for through April 1st.
2016YTD
Dow Jones Industrial Average        -2.1%
S&P 500                                            +1.4%
Nasdaq Composite                           -1.9%
Russell 2000                                      -1.6%                       
 
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
As referenced above, recession worries and the Fed have been two of the biggest market influences.  This likely remains the background although at any given time Mr. Market will also focus on the potential terrorist threats, BREXIT (Great Britain’s possible exit from the EU), presidential polls, and polar cap ice cover.
While economic reports have improved, progress remains challenged.  For example, the unemployment rate has dropped to 5% but job growth is frustratingly below historic standards and wages are stagnant.  Secondly, automobile sales are at record levels but it’s been assisted by cheap financing.  Finally real GDP, while still positive, is lower on a year-over-year basis.
As the markets digest these reports, their eyes remain on the Fed.  After their December interest rate increase, investors have been on edge over how many more increases will take place in 2016.  Last week Janet Yellen gave a very dovish speech.  While she didn’t provide details on the future monetary policy, she was clearly in no hurry to raise rates again. Some market strategists were looking for up to four fed funds rate hikes in 2016.  Those expectations have been severely reduced post speech to the point where several commentators are forecasting only one more move this year.  Some are predicting no hikes in 2016.
In addition to the economic cycle and monetary policy, stock valuations is another important variable.  As measured by the S&P 500, stocks are trading at a price-to-earnings (P/E) ratio of just under 20 times.  The long-term average for this index is 15.42.  According to Bespoke Investment Group (April 1, 2016, The Bespoke Report), this P/E level is higher than 82% of all daily readings since 1929.  That’s far from an “all clear” sign and unfortunately the recent trend has seen the denominator (earnings) decline.  High valuations are not always the catalyst for falling stock prices but they will not be helpful if markets retreat again.
The S&P 500 has averaged a gain of 2.7% in April during the past 10 years.  Given a recently confirmed supportive Federal Reserve, this trend might continue.  However, there are substantial headwinds to a sustained rally.  Reestablishing corporate earnings growth would be an important development to continuing the stock market’s advance.  First quarter earnings and management’s guidance for the rest of 2016 should be a helpful sign in determining if this is developing.  Otherwise 2016 might turn into a “sell in May and go away” year.
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
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.

“It Was the Best of Times, It Was the Worst of Times”[i]

/0 Comments/in /by
A Tale of Two Cities offers a good description of 2016’s capital markets.  Stocks began January by recording their worst start of any year in history.  By February 11th the Dow and S&P 500 had fallen over 11% while the Nasdaq and Russell were each down over 16%.
From those dark times, stocks have rebounded.  In fact, the major averages have surged around 10% from the February lows and have recorded three consecutive weekly gains. Indeed, in 2016’s nine weeks, Wall Street has experienced both the ‘worst of times’ as well as some care free trading.
Now, investors are facing the debate of whether the February bottom is the end of the selling versus the view that the rally will fade and markets will retreat again.  Bulls point to continued strong employment data (last week’s report estimated that 242,000 jobs were added in February well above the 192,000 forecast).  This helped calm fears over the U.S. economy slipping into a recession which was one of the main worries in January.
The bears contend that the three-week bounce is just a counter-trend move and that prices will ultimately drop to fresh lows.  They maintain that central bank policy (negative interest rates, QE, etc.), China’s economy, and the collapse of commodities (especially crude oil) will have negative economic influences which will eventually result in lower equity prices.
After this year’s selling and then buying, here is where the averages closed last week.
2016YTD                                        
Dow Jones Industrial Average  -2.4%
S&P 500                                    -2.2%
Nasdaq Composite                    -5.8%
Russell 2000                              -4.7%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
“It Was the Age of Wisdom, It Was the Age of Foolishness”[i]
This market environment is making both investors and traders feel frustrated and foolish.  One month Armageddon is at hand while the next month markets believe that central banks will cure all of mankind’s problems.  Indeed, no matter your time frame or investment mentality, it’s hard to find suitable investments ideas.
With the belief that markets trade to extreme levels (both higher and lower), one strategy is to look among oversold and beat up areas of the market.  After the start to 2016, this shopping list is long.  One option worth considering is the high-yield sector of the bond market.  This portion of fixed income was especially hurt in 2015 because of the worries surrounding energy company bonds.  Further, other non-energy issues within high-yield were sold over recession concerns.  Maybe this is a case of the baby being thrown out with the bath water and the selling was overdone.
First, some review is in order.  High-yield bonds are debt securities issued by companies with credit ratings of BB and lower.  In general, these securities offer higher returns in the form of interest payments.  However, the issuing companies’ financial condition is below that of a blue chip organization.
Now let’s turn to some ways of investing in high yield bonds.  Many readers might not be familiar with closed end funds but they offer a structure that would help in gaining exposure to high-yield bonds.  Closed end funds offer some advantages (and disadvantages) over the more familiar conventional mutual funds.
A closed end fund is an investment security that invests in a variety of other things such as stocks and bonds.  In this way, a closed end fund is like a mutual fund – it is a portfolio of stocks, bonds, commodities, currencies, or a mix of the above.  Like the more popular mutual fund (open ended), a closed end fund calculates the NAV or net asset valued.  The difference is that an open ended mutual fund trades at that NAV which is computed after the market close.  A closed end fund trades throughout the day during market hours and often trades at values that greatly differ with the NAV.
A closed end fund sells shares at an IPO and uses that capital to invest. On the other hand, a mutual fund buys and sell shares daily based on investor demand and the share count is continually increasing and decreasing but always at the NAV.
Another important difference is that closed end funds typically use leverage.  This is something that traditional mutual funds don’t do.  The leverage that closed end funds apply is often in the form of preferred shares or repurchase agreements. This additional capital is used to buy more assets in the fund’s strategy.   The intention is to create a positive difference between the fund’s longer term return and the cost of the leverage.  The result is that closed end funds have a higher cost structure but can provide enhanced returns when the strategy is executed properly.
Closed end funds, like mutual funds, can focus on a market sector, industry, geographic region, and various asset classes.  For example, there are closed end funds that cover technology, banking or energy.  Municipal bonds are a popular area for closed end funds and there are several choices from individual states to nation-wide funds.  Staying within fixed income, different approaches include Treasury, corporate (investment grade as well as high-yield), and international sovereign (developed together with emerging market).
Within the equity universe, closed end funds have similar broad ranging options.  From domestic large-cap to international small-cap and everything in between, there is a large assortment of approaches.  There are generic growth and income as well as a variety of value styles.  You can even choose country specific funds such as China, Japan, Germany, India, China, Korea, Taiwan, Turkey, or even Mexico.
Also, it is important to recognize that some well know investment companies offer closed end products.  Nuveen, Blackrock, Eaton Vance, John Hancock, Morgan Stanley, JP Morgan, to name a few of the fund sponsors.
”

It Was the Epoch of Belief, It Was the Epoch of Incredulity”[ii]
Returning to our high-yield theme, we think the closed end funds offer some attractive ways to invest in this part of the bond market.  Before getting into some specifics, let’s review these bonds’ recent performance.
As mentioned above, the high-yield market has been declining since the spring of 2015.  High-yield energy has been the leader in this retreat.  Many exploration and production companies used debt to finance the sizable growth in the drilling industry.  The price declines in crude oil and natural gas are headwinds to these bond issuers’ abilities to service their debt.  Consequently the markets have priced in this additional risk by lowering the bond prices.
In addition, to the energy sector, recession worries also played a role in weakness of high- yield bonds.  As we know, bond prices decline when interest rates move higher.  While this does influence high-yield fixed income, these bonds often trade in the same direction of the stock market.  This is primarily a function of the belief that high-yield bond issuers have an easier time of servicing the debt in a good economy.  Recessions, which are often accompanied by lower stocks prices, make it more challenging for some companies to make interest payments.  Below is a 15-year chart of the Barclay’s U.S. Corporate High- Yield Index and the S&P 500.  While they don’t always move in lockstep there are clear signs of correlation.

This chart clearly shows a divergence since the beginning of 2014.  We would expect this to be resolved – either the S&P 500 declines towards the Barclay’s Index or the high-yield index climbs back to the S&P 500’s level.  Of course, there is the possibility that the correlation has been broken and the divergence widens but 15 years of data would favor convergence.
Below is a table with some specific closed end bond funds.  It gives an overview on four high-yield funds.  Also there is a fifth fund (AllianceBerstein Income Fund) that focuses on Treasuries.  It is included because of some unique recent developments.  Specifically, the closed-end fund (symbol ACG) is being acquired by the AB Income Fund (an AllianceBerstein mutual fund).  This has forced a narrowing of the gap between ACG’s price and its NAV (recently below 2%).  But a 4.9% dividend is available until the deal is closed later this year.
Similarly, The Deutsche High Income Trust recently announced that they are terminating the fund and liquidating the assets.  Upon shareholder approval, it is expected to be completed by November 30, 2016.  This decision was driven by an activist shareholder – Saba Capital Management LP. While the spread between price and net-asset-value has narrowed, it remains approximately 7%.  We would expect this to gradually shrink as the fund begins returning capital to shareholders.  Add this to the 7% dividend yield and you get a pretty compelling total return.
The two Blackstone sponsored funds have a different type of catalyst – since their inception they have a scheduled liquidation.  The Floating Rate Fund (symbol BSL) has to be liquidated and the funds returned to shareholders by 2020.  The Strategic Credit Fund’s has a longer stretch before its liquidation date – 2027.  Notwithstanding other bond market problems, these funds should see their discounts to its net-asset-value contract.
[i] Ibid
[ii] Ibid
[i] “A Tale of Two Cities”, Charles Dickens
“We Were All Going Direct to Heaven, We Were All Going Direct The Other Way”[i]
Charles Dickens’ words seem applicable to our stock market, but provide little help in predicting its future directions.  Investor sentiment has improved from the pessimism of the start of the year.  Some of the worries over systemic issues have been reduced.  Also, U.S. economic growth seems be continuing although at lower levels than previous expansions.
Nevertheless, the challenges facing global economies and markets are not insignificant and its far from clear that the emerging markets contractions and developed countries negative interest rate policies won’t negatively impact our economy.  The bottom line is that there is still a great deal of risk and uncertainty.
In an effort to provide stability and return, closed end funds focusing on the high-yield bond market, might part of the solution.  As explained above, both these bonds and these closed end funds have unique risks that must be considered.  However, recent declines in the price of the bonds as well as the discounts to net-asset-value within the closed end funds offer a margin of safety.  Please contact us with any questions.
[i] “A Tale of Two Cities”, Charles Dickens
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
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.

If at First You Don’t Succeed, Try, Try Again

/0 Comments/in /by
It’s no secret that economic growth has been disappointing.  According to The Bureau of Economic Analysis and the Congressional Budget Office, real per capita GDP growth in the U.S. is averaging 1.3% annually during this recovery (2009-2015).  That is compared to an annual average of 2.7% for recoveries from 1790-2008.  In other words, our current economic recovery is growing at a rate (after adjusting for inflation) that is over 50% below the average rate for the past 200 years.
As we know, considerable efforts have been made to assist economic growth.  The means to that end, from a monetary policy standpoint, has been reducing interest rates and buying bonds.  And everybody is doing it – European Central Bank, Bank of Japan, Peoples Bank of China, Swiss National Bank, and many others.  Amazingly, global central banks have cut interest rates 637 times and have purchased $12.3 trillion worth of assets since March 2008.[i]
Some define insanity as repeating the same thing over and over again and expecting different results.  We’re not sure “insane” describes our central banks’ policy but certainly “unconventional” does.  Collectively they are reading the same playbook and no one is deviating from the script.  This translates into more interest rate cuts.  Furthermore, this is not limited by ZIRP – zero interest rate policy.  The bureaucrats and bankers are so convinced that low interest rates will work that they haven’t stopped at 0%.  Sweden’s Riksbank (the world’s oldest central bank) lowered their main policy rate which was already negative.  The European Central Bank (ECB) and Swiss National Bank have had negative rates for almost a year.  Japan recently joined the gang as the Bank of Japan lowered chief interest to below 0%.  ZIRP has turned in NIRP (negative interest rate policy).
According to Economics 101, lower interest rates are supposed to help the system through providing more money to invest and spend – the stuff that drives the economy.  So if low interest rates are supposed to help, it’s natural to conclude negative interest rates must be even more of a benefit.  As usual, it’s not that easy.
First, negative interest rates are an additional cost to the banking system.  Banks deposit their liquidity at central banks as a matter of convenience as well as safe keeping (central banks don’t go out of business).  In addition to this custodial service, normally the central bank would pay a small interest rate to the depositing bank.  However, under a negative interest rate environment, this is reversed and the service turns into an additional cost – they are charged interest rather than earning it.
Another headwind is that lower interest rates across the yield curve means that banks are receiving less interest from their loans.  Less interest income from loans combined with added costs from increased regulation and having to pay for deposit services equals a squeeze on banks’ margins.  A weaker banking system usually hurts an economy.
Central banks implement a negative interest rate policy to encourage banks to do more loans.  By penalizing banks for keeping too much capital in cash, policymakers hope that lenders will be motivated to do more lending.  However, the ECB has had negative interest rates for almost a year and hasn’t seen much economic improvement.  After six years of cutting interest rates and printing money to buy bonds, the markets seem to be questioning central bank effectiveness.  The emperor may be naked.
Negative rates go beyond bank deposits at their central bank.  More than $8 trillion of high-grade sovereign debt trade at a negative yield.[i]  In other words, investors are more concerned with the safety of the investment than the return on that investment.  They are so worried that they are willing not only give up a return but actually pay someone to take their money.
As for negative rates in the U.S., Fed Chair Janet Yellen was quizzed about it at her recent Congressional testimony.  As expected, her response dismissed that the Fed was considering it.  Recent trader talk, however, has not discharged the possibility.  With some soft economic reports, the Fed is forced, at a minimum, to reconsider the intention of more interest rate increases in 2016.
Turning to the markets, 2016 has been the worst start of any year in history for stocks. In other markets, U.S. Treasury bond yields have declined, gold has moved higher, oil has continued to fall, and the U.S. dollar has been slightly weaker vs. other major currencies.
Despite the stock markets’ ugly start to the year, U.S. markets rebounded last week.  It capped a strong rebound that began on the prior Thursday (the 11th).  After that day, the S&P 500 rose 1% for three consecutive days – October 2011 was the last time this happened.  Another positive was that market breadth was strong.
It was a welcome move after an 11% drop for the S&P to start the year.  The next worst start to the year was 1948’s decline of 9%.  Since 1928 there have been 16 other times where the index started the year down 5% or greater.  The average return for the rest of the year (from that low point) was positive 3.82%.
Volatility has been another noteworthy characteristic of 2016.  The S&P 500 has moved 1% up or down in 21 of the 34 trading days this year (61.8%).  We have to return to the Great Depression to find years with greater moves (1931, 1932, 1933).  Returning to a more stable stock market environment would be a sign of less selling and might be the beginning of a bottoming process.
 
Here are the year-to-date numbers at the end of last week. 
                                           2016YTD
Dow Jones Industrial Average  – 5.9%
S&P 500                                      –  6.2%
Nasdaq Composite                     -10.0%
Russell 2000                                -11.1%                                
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
While the rally in equities was welcome, there were some important blemishes.  The volume on this move was materially less than that of the selloff.  This might indicate a lack of conviction by the bulls.  Furthermore, the best performing stocks during the move were the worst performers going into the bounce.  Also, they were the names with the highest short interest (stocks sold with the expectation of a move lower).
This led many to conclude that last week was an oversold, short covering rally as opposed to a longer term bottom.
Recent economic reports have been mildly ok.  The importance of this is the debate over whether the U.S. is sliding into a recession.  Industrial production, which has a weak point, came in a little better than expected.  And the employment data remains strong.  However, these are backward looking and the recession argument is based on the energy industry’s implosion and several foreign economies that appear to be slowing.
Pessimism and negativity have become pretty widespread across the capital markets.  This could mean that a lot of the worries facing the global economy are already reflected in the current stock, bond, commodity, and currency markets.  However, these obstacles have many uncertainties remaining.  For example, we are only beginning to work through bankruptcies and defaults involving the energy industry.
While it doesn’t look like the fallout will be anywhere near as wide as the sub-prime mortgage problems, it’s unclear who will be the losers and how far the damage travels.
Returning to the central banks, if the markets start to doubt the ECB, BOJ, Fed, et al., it will bring more selling.  This could take the form of acknowledging that the approaches are not working.  Another view is that policymakers are out of ammunition and there is nothing more they can do.  Central bankers have long had critics.  But if global economies don’t start to show signs of significant progress, the number of detractors would grow in size and volume.  This would result in a continued and sizable shift to risk aversion – selling stocks and buying government bonds.
If the markets can hold last week’s moves, it could turn into a base from which further upside could develop.  The drop in stocks and the increase in treasury bonds during 2016 will not likely be reversed in the short-term.  However, stability for the capital markets would be a first step to a widespread recovery.
[i] ibid  [i] The Telegraph, February 15, 2016
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
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.

“Quoth the Raven ‘Nevermore'”[i]

/0 Comments/in /by
January’s capital markets were in upheaval.  It began with the worst first 5 days in history and then fell further.  While the S&P 500 ended the month with a nasty 5% loss, it was down more than twice that amount before a month-end rally provided some relief.  During this stretch, naturally the financial media were franticly trying to determine the causes as well as seek predictions regarding what the future held for the markets.
A common thread from the responders was to quote Ben Graham.  It’s usually a safe move to refer to the late Mr. Graham in any response involving the financial markets.  He is considered the father of value investing and wrote two iconic books on investing – “Security Analysis” and “The Intelligent Investor”.  Further he taught at Columbia University teaching such famous students as Warren Buffett, Irving Kahn, and Walter Schloss.  So, as mentioned, when the markets are especially confounding without logical explanation, quoting Ben Graham is good decision as very few question his wisdom.   That probably explains why he’s not quoted nearly as much when the markets are behaving and trading higher.  After all, a bull market makes everyone look wise!
Here are how the major indexes performed in January.
2016YTD
Dow Jones Industrial Average  -7.0%             
S&P 500                                       -8.0%                               
Nasdaq Composite                      -12.9%
Russell 2000                                 -13.2%                       
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
“Once Upon a Midnight Dreary, While I Pondered, Weak and Weary”[ii]
After the ugly January, there is widespread debate over whether the U.S. stock markets are in a bear market.  Further the discussion centers on what caused January’s drop and what’s the direction from here.
Looking at what is troubling the markets, falling commodities and a slowing China are the common reasons offered.  While they have influenced the markets, these issues were not new to 2016.  Looking for other causes, some are questioning if sovereign wealth funds (SWF) have turned from buyer to seller.  Countries such as Norway, United Arab Emirates, China, and Saudi Arabia built up massive amounts of funds during the past 10 – 15 years.  SWF’s were estimated to be $3 trillion 10 years ago and have more than doubled to over $7 trillion recently[iii].  These countries invested the funds and, as the SWF’s grew, it helped support global markets.  Things have changed.  With plunging commodities and oil together with a slowing China, perhaps these pools of capital have switched from “buyer” to “seller”.
Monetary policy is obviously a large impact on the markets.  The Bank of Japan surprised everyone a week ago as they adopted a negative interest rate policy.  The BOJ lowered their main interest rate from +0.01% to -0.01%.  It was the first time they’ve adjusted this interest rate in 5 years.  They join Europe in implementing negative interest rates in hopes of stimulating their economy.
Global stock markets rallied on the news and, as expected, the Yen fell hard.  Japan will welcome a lower currency to remain competitive on international trade.  Despite the market’s reaction, there is a possibility that traders question if this is a move of desperation.  This then brings in the risk of a loss of confidence in all policy makers.  A confidence crisis of this type would make January’s markets look like a picnic.
In addition to monetary policy, crude oil’s implosion has many worried.  The concerns involve the fallout over the lower prices.  This is counter to the logical view that lower energy prices are an economic boost. Since the financial crisis, drilling for oil and gas has been a large contributor to economic growth.  Not only has it driven job growth and purchased a lot of equipment and machinery, it provided a boost to other business in the drilling geographies.  In other words, if you’re a car dealer in an area of a lot of exploration activity, you’re in the energy business.  Same for restaurants, hotels, and a lot of other services.  These ancillary businesses are slowing as drilling activity contracts due to the fall in crude.
The damage to the exploration industry has also spilled into the bond market.  Drillers and suppliers of energy infrastructure financed the expansion through debt, much of it by selling bonds.  Because the fixed income markets considered many energy companies higher risk, the bonds were sold at higher interest rates (high-yield).  With oil’s collapse, there are growing worries that these companies will not be able to service this debt and defaults will increase.
These concerns go beyond loans to exploration and production companies. Bank exposure through derivatives are a different problem.  The Bank of International Settlements estimates the notional value of the commodities related derivatives market at around $4 trillion.  The risk is that low crude oil causes bankruptcies in commodity producers with large derivative positions.  A bankrupt entity that would not be able to fulfill its commitments in the futures market could result in a wide reaching problem.  This is likely the reason why the stock market and energy markets have recently been moving together.
The worries caused by these issues have been centered on banking stocks.  They have been battered to the point that the banks within the S&P 500 are selling at their cheapest price-to-book valuation since 2009.[iv]
While stocks and crude are holding hands, bond yields have been moving in one direction – down.  Despite the Fed’s December rate increase on the short end of the yield curve and the upheaval in the high yield market, U.S. Treasury rates have dropped since the beginning of the year.  The 10-year note ended 2015 at 2.27%.  This same bond’s yield closed last week at 1.84% which is lower than the levels reached during last August’s stock market sell off.  In fact, this is the lowest level for the 10-year since last April.  Having closed the year above 3%, the 30-year bond yield was down to 2.68% at the end of last week.
Falling yields could be a signal of investors fleeing risk and seeking safety.  In a clear sign of risk aversion, the S&P 500’s dividend yield is at 2.32%, well above the 10-year’s yield.  Also, it could be a sign of a slowing economy with less loan demand.  Another possibility is that the negative interest rate policies in Europe and Japan are impacting U.S. markets.  Global deflation, a possible result of the central bank policies, could be on the horizon.  Under these conditions, the Fed’s inflation goal of 2% seems to be very challenging.
“Deep into That Darkness Peering, Long I Stood There Wondering, Fearing”[v]
Stock have bounced since January 20th.  This is probably a combination of being oversold as well as the start of earnings reports that were not as bad as had been expected.  A February that follows a greater than 5% January loss usually sees further losses.  Median losses are an additional -2% in the previous 9 times when January lost this much.[vi]
Putting all of these cross currents together, markets are focused more on the economic obstacles rather than the positives.  That may continue for the intermediate future until there is better clarity on the fallout of lower commodity prices, what Japan and Europe’s negative interest rate policies mean, and how the U.S. economy performs.  It’s hard to believe that all of the risks are priced in at current levels, however with the passage of time these issues will be resolved.
[i] The Raven, Edgar Allan Poe
[ii] Ibid
[iii] GaveKal Research, January 22, 2016
[iv]  The Bespoke Report, February 5, 2016
[v]  The Raven, Edgar Allan Poe
[vi] The Bespoke Report, January 29, 2016
“Quoth the Raven ‘Nevermore'”[i]
[i] The Raven, Edgar Allan Poe
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.

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’ve Got Some Bad News For You Sunshine

/0 Comments/in /by
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

/0 Comments/in /by
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]

/0 Comments/in /by
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]

/0 Comments/in /by

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]

/0 Comments/in /by

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.