“‘Bout Working All Summer, Just to Earn a Dollar”[1]

As measured by years, it wasn’t that long ago that the markets abhorred central bank intervention.  As measured by perception, the days that were without meddling and manipulation seem like they should be preceded by “BC”.  So dramatically has the market landscape changed that an investment banker or hedge fund manager waking from a Rip Van Winkle snooze would react to ZIRP, QE and Twist by clicking the sell button (of course, he or she would have first tried to call their floor broker only to learn they were replaced by an algorithmic trading computer).

 

Monetary policy makers have become so ingrained that imagining smoothly functioning markets without them is the same as imagining the Jets winning the Super Bowl.  Federal Reserve activism began to increase in the 1990’s.  Global central banks intervened as a response to 1997’s Asian Crisis by cutting interest rates and expanding the supply of money.  This easing then contributed to the Dot-Com bubble which eventually burst and was fought with more money printing and lowering of interest rates.  In turn this contributed to the housing and credit crisis which led to the current state of quasi-free markets.

 

Coming out of the Great Recession, the markets initially disliked this stepped-up intervention but changed their mind as they accepted it as necessary to save the system (a debatable issue).  Since then investors have become so comfortable with the Fed’s finagling that they look forward to any “Fedspeak”.  Now, every speech by a Federal Reserve board member is scrutinized for a sign of policy adjustment.  Every press conference and testimony is broadcast on the financial networks.  Indeed things have changed.

 

Yet this change in perception goes almost unnoticed.  Perhaps it’s analogous to a frog being placed in the pot before the burner is turned on – the change is imperceptible but becomes drastic over time.  Perhaps it’s a function of the wave of younger traders and managers who accept this new environment as natural and can’t imagine the economy working without the Fed’s current role.  Whatever the cause, there is widespread belief that the Fed’s intervention is needed and is a benefit.

 

Financial details like earnings growth, margins, and cash flows remain important.  However, in the modern investing world they are trumped by central bank policy.  To be sure, monetary stimulus or tightening will impact virtually every company’s performance. However, the degree and speed with which the market judges a verb or adjective’s impact on our almost $16 trillion economy is lunacy.

 

During Chairman Bernanke’s May 22nd congressional testimony, he stated that daily bond purchases might be “tapered” beginning in September.  The words barely hit the tape and stocks plunged.  The Dow Jones Industrial Average, which had reached a new high before his appearance, reversed course and fell 235 points.  The 10-year treasury note’s yield spiked to above 2.04% from the morning’s 1.88%.

 

“Taper” was suddenly the word on everyone’s lips and the debate over whether we had finally reached the end of quantitative easing began.  The stock market reversal ushered in a 2013 rarity – a three day losing streak.  Stock chopped around for the next two weeks trading lower 7 out of the next 10 days.

 

While stocks fell over 6% during the month, the real pain was in the fixed income market.  Interest rates started rising at the beginning of May moving from 1.63% on the 10-year note to the 2% level after Bernanke’s testimony.  The yield eventually topped out above 2.7% in early July.  20% losses were common in the bond mutual fund sector and it was a shocking wake up for those who thought fixed income investing provided stability.

 

U.S. stocks have recovered aided by what else but soothing words by Ben Bernanke.  In June, the fed chairman reassured the markets that “The overall message is accommodation.”[1]  Equities rebounded in late June and resumed this year’s pattern of slowly and steadily climbing with the Dow, S&P 500, and Russell 2000 making new all-time highs last week.  Here are the major indexes’ year-to-date returns through last week.

 

 

                                                                                    2013[2]

Dow Jones Industrial Average                                    +18.6%
S&P 500                                                                      +18.6%
Nasdaq Composite                                                      +18.8%

Russell 2000                                                                +23.7%

 

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

 

While U.S. stocks are having a very good year, there are other areas with negative returns.  The underperformance of the emerging markets is a development that has gone somewhat unnoticed.  At the end of last week Brazil had fallen 22.8% this year while the Chinese Shanghai Composite is down 12.2% and Russia has declined 9.6%.[3]

 

Fighting the fed is a perilous occupation.  Equally hazardous is blindly following central bank rhetoric.  The degree to which the Bank of Bernanke influences the direction of the markets is remarkable.  That this is a recent phenomenon matters little except to add another influence and perhaps increase risk.  The risk primarily surrounds the fact that so many are trading the same way.  When everyone trades the same way, it inevitably leads to an excess which results in a painful adjustment.

 

There are many smart strategists who believe quantitative easing is far from being over (see Pimco’s Mohamed El-Erian June 14, 2013 Financial Times article).  While this market tailwind will continue to a positive for risk assets, it is not solving all problems.  The ongoing Europe saga remains without a solution with unemployment in the southern European countries at alarming levels.  The Middle East is in turmoil and global growth is slowing (the OECD industrial production is contracting year-over-year).

 

Perhaps most troublesome is the recent spike in interest rates.  Possibly rates retrace this jump higher but, if not, it could be an economic growth obstacle.  The rise in nominal rates (the stated rate) has caused real rates (nominal rate minus the inflation rate) to dramatically increase.  This type of move in real rates often can slow economic activity.  Maybe this is what’s disturbing the emerging stock markets.

 

There are some market pros who are pointing to 2013’s move as a beginning of a huge multi-year bull market.  While this is possible (and the Fed certainly is rooting for it), stocks rarely move in one direction forever.  A normal cycle has corrections and pauses.  This year has been an exception.  Other than the June pullback, the averages have steadily climbed.

 

However, there are a few signs that we are getting closer to a dip.  Sentiment is at a minimum complacent, but can be considered overly bullish.  Rising prices have pushed valuations beyond what can be considered cheap.  At recent record levels, the indexes are encountering significant resistance.

 

If a correction occurs, it might be an opportunity.  Presuming a normal pullback that has little economic impact, lower prices should encourage buying which could setup a good end to the year.  In the meantime, traders’ summer reading includes Federal Reserve meeting minutes.

 

 


[1] The Wall Street Journal, July 11, 2013, sec 1, pg2.

[2] Ibid, July 20, 2013

[3] Ibid, July 20, 2013

 

 

 

 

 

 

 

 


This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The NASDAQ Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Russell 2000 Index is an unmanaged market-capitalization weighted index measuring the performance of the 2,000 smallest U.S. companies, on a market capitalization basis, in the Russell 3000 index. It is not possible to invest directly in an index. Investing involves risks, including the risk of principal loss. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.

Past performance does not guarantee future results

 


 

Jeffrey J. Kerr is a registered representative of

LaSalle St. Securities, LLC, a registered broker/dealer.

Kerr Financial Group is not affiliated with

LaSalle St. Securities, LLC. Securities are offered

Only through LaSalle St. Securities, LLC

940 N Industrial Drive, Elmhurst, IL   60126-1131

Member FINRA/SIPC

 

News from Kerr Financial Group

When he is talking about investing, listening to Warren Buffett is probably wise. Similarly, although his stature may not be as great, listening to Jim Grant can be wise.  And when Jim Grant quotes Warren Buffett, it is probably noteworthy.  Such an event happened in the July 26th issue of “Grant’s Interest Rate Observer”.  Actually, Jim Grant quoted Warren Buffett who quoted John Burr Williams author of The Theory of Investment Value.  The quote was “The value of any stock, bond, or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset”.[i]

While the Oracle of Omaha has had wittier quotes and scribes, it does not detract from the importance of this statement.  Further it is a simple, direct proclamation that could be lifted from a Financial Analysis 101 textbook.  Nevertheless it has three important assumptions that go to the heart of investment analysis – cash inflows, cash outflows, and the discount rate (interest rate).

Jim Grant followed the Buffett quote by focusing on the interest rate component.  He asks, “It would be nice to know where they’re going” and “It would even be nice to know what they mean”.[ii]

The direction of interest rates in the U.S. is a white hot topic and debate over their future has intensified. As for the meaning of the current state of interest rates, it is clearly distorted by central bank intervention and manipulation.

In May Fed Chairman Bernanke mentioned that the central bank may “taper” the monthly $85 billion buying of Treasury bonds and mortgage securities.  This put a scare into the fixed income markets.  Interest rates, which had been rising since the beginning of the month, accelerated their climb.  The 10-year Treasury note moved through 2% and has kept moving higher throughout June and July reaching 2.73% at the start of August.

It’s easy to dismiss a 2.7% level as unimportant or inconsequential.  And for those who can remember life before the financial crisis and quantitative easing, these interest rates are still low.  To better understand the pain in the fixed income markets during the past few months, one needs to consider a 100 basis point move relative to a 1.65% starting point.  In other words, we’ve had a 60% move higher in the 10-year’s yield.  While many were predicting higher interest rate, not many investors were prepared for such a dramatic move in a short time.

What the future holds for interest rates is a critical question.  Some believe that the Fed will begin to slow their bond buying program which will apply further upward pressure on rates.  Others forecast higher rates due to increased inflation and economic growth.

There are others predicting a reversal of this recent spike.  Their view revolves around the belief that the Fed won’t end QE and that the economy is not that strong.  July’s employment report makes a case for this view.  While there was an increase of 162,000 jobs in the month and the overall unemployment was the lowest since December 2008 (7.4%), some underlying details were weak.  A low participation rate (63.4%), a drop in weekly earnings, and a high number of workers considered long-term unemployed (4.2 million Americans) give defense to those who argue against any near term end to Fed bond buying.

For those supporting the glass is half full view, second quarter earnings have not been bad.  According to Merrill Lynch, sales and earnings expectations are higher now than they were when the quarterly earnings reports began in early July. Sales predictions for the quarter are now 1% higher than they were on July 1.  Furthermore, Merrill Lynch is now forecasting that second quarter earnings will be 2.7% higher than a year ago.[iii]

This just scratches the surface of the discussion over which direction interest rates will move.  And while both sides of the debate make strong cases, returning to Jim Grant’s first question, knowing the eventual direction of forthcoming interest rates will be important to the markets. We think investors should be flexible enough to adjust to either result.

As for the meaning of interest rates, it’s not what it used to be.  The zero interest rate policy (ZIRP) being implemented by virtually all central banks has clearly distorted the role that rates used to play.  Once upon a time, interest rates helped put a price on the cost of capital.  Further they were the reward for postponing consumption and saving money.  With the nominal level around 0% and the real level (the level after subtracting inflation) negative, they don’t have the same function.

In recent years, the most important meaning interest rates have is as one of the tools used to stimulate the economy.  In this regard, there has been an uneven reaction.  While the job market hasn’t responded as hoped, housing has been a clear beneficiary.  Looking across the rest of the economy, the impact has been lumpy.

The stock market has been another clear benefactor of ZIRP and QE.  After Chairman Bernanke’s “taper” remarks, equities weakened into late June.  From there they rebounded and made fresh record highs on August 2.  Stocks retreated a little last week as the Dow Jones Industrial Average lost 1.5%, ending a stretch of six weekly gains for the blue chips.  Here is the major averages year-to-date performance.

                                                                        2013[iv]

Dow Jones Industrial Average                           +17.76%
S&P 500                                                             +18.6%
Nasdaq Composite                                            +21.2%

Russell 2000                                                       +23.4%

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

If the current meaning of interest rates is unknown, the stock market is at least an equal mystery.  Are stocks that dependent on the Fed that as soon as the end of easing is just mentioned prices move lower?  Are corporate earnings sustainable without low interest rates?  To these questions add variables such as the European crisis, geopolitical issues, and fiscal deficits that are not being addressed.  We offer that neither Warren Buffett nor Jim Grant have definitive answers.

Despite these issues, it’s hardly the time to raise a white flag.  While we don’t

 think it’s time to be “all in”, there are opportunities whether tapering starts or is postponed.  The markets have had a good July and sentiment has gotten pretty complacent.  This can lead to a consolidation or pullback.  Another short-term headwind will be expectation of a Fed announcement at the Jackson Hole conference or at the next FOMC meeting in September.

As we plod through the markets’ gyrations, we’ll be on the lookout to buy situations with increasing cash inflows or decreasing cash outflows or, preferably, both.  Buying these situations at the right price, as Warren Buffett would attest, is the goal.


[i] “Grant’s Interest Rate Observer”, July 26, 2013, pg 9.

[ii] Ibid

[iii] The Wall Street Journal, August 5, 2013.

[iv] Ibid, August 10, 2013

 

 

 


This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The NASDAQ Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Russell 2000 Index is an unmanaged market-capitalization weighted index measuring the performance of the 2,000 smallest U.S. companies, on a market capitalization basis, in the Russell 3000 index. It is not possible to invest directly in an index. Investing involves risks, including the risk of principal loss. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.

Past performance does not guarantee future results

 


 

Jeffrey J. Kerr is a registered representative of

LaSalle St. Securities, LLC, a registered broker/dealer.

Kerr Financial Group is not affiliated with

LaSalle St. Securities, LLC. Securities are offered

Only through LaSalle St. Securities, LLC

940 N Industrial Drive, Elmhurst, IL   60126-1131

Member FINRA/SIPC

 

“I’ve Got Good News, I’ve Got Bad News”

The recent developments surrounding the financial markets cause, at a minimum, mixed emotions. First, the good news – stocks are at record levels. Further, belief is quickly spreading that even higher prices lie ahead. Worries over the election, the fiscal cliff, and sequestration seem to be antiquated emotions of the good old days. More recent developments such as China, North Korea, and Cyprus are quickly dismissed as unimportant or, at worst, easily fixable.

 

The bad news is that stocks are at record levels – at the same time as interest rates are manipulated, debt is monetized, and currencies depreciated. Some argue that these artificial factors are the only reason for the market’s ascent. While they are not insignificant market influences, stimulus and easy monetary policies are not the lone reasons for the rally. Valuations are reasonable, profit margins are strong, earnings are growing and non-financial balance sheets are well positioned.

 

Whatever the reason behind it, stocks have had an incredible 2013 with the occasional selloffs being little more than one-day wonders. This steady levitation has resulted in the major averages, except the Nasdaq Composite, reaching new all time highs in the first quarter. This page from the tortoise’s playbook may have played a part in what seemed to be a generally subdued reaction to this market milestone.

 

While economic growth and corporate fundamentals have been important components driving equities, central bank policy has also played a key role. Our Federal Reserve with it many versions of QE (a fancy name for debt monetization) has been an active market manipulator for many years. Of course, among the gangs that can’t shoot straight, the European Central Bank (ECB) appears to be especially incompetent. Regulators and policy makers propose their final and ultimate bailout solutions on a monthly basis. Not to be left behind, the Bank of Japan has recently committed to fighting deflation by printing as much Yen as it takes. Given that the Land of the Rising Sun has been fighting deflation for over 20 years and conceding that creating currency with the press of a button is effortless, we wonder if “deflation” is still favored to win.

 

This renewed Japanese commitment is commonly referred to as “Abeonomics” as it is a key part of Prime Minister Shinzo Abe’s economic plan. It includes goals of helping domestic manufacturing through currency devaluation as well as motivating its citizens to move further out on the risk spectrum. In addition to buying the Nikkei, this can be done through selling the Yen and buying stocks with the newly purchased currency. Of course the U.S. dollar can be the recipient of this capital flow which then presumably finds its way into the stock market.

 

There is little doubt that the capital markets have welcomed this stepped up liquidity. Whether this ultimately increases GDP remains a question among some. However, central bankers and regulators strongly believe intervention and price manipulation are necessary steps to support the current system. As far as any associated risks, Chairman Bernanke repeatedly tells listeners that they are “manageable”.

 

“Once upon a time there lived a vain Emperor whose only worry in life was to dress in elegant clothes.”

 

That manipulation and intervention qualify as sound procedures troubles us. We are further disturbed by the widespread confidence that is seemingly placed in a group whose track record is far from spotless. This is largely the same cadre who were supposed to save us from the crisis that befell us. Everyone assumes, like Hans Christian Anderson’s emperor, the Fed , ECB, and BOJ are fully clothed. But the realization that they are naked is not part of today’s bids and offers. Perhaps there never comes a time when the markets see through this folly, but it won’t be pleasant if they do.

 

The incredulous need not look very far or hard to find catalysts. Some of the obvious include fiscal deficits without a semblance of a cure, a slowing China, and Europe without a fix. Cyprus bank depositors being included in the “bail in” is a new and alarming component to addressing a bank crisis. Furthermore, Italy can’t form a government. And how does one price the risk associated with North Korea?

 

Our worries are not a prediction for a stock market collapse. However, a painful correction would not surprise us. In addition to being a historic stretch without a pullback, we think there is too much complacency surrounding the economic landscape and global developments. If the markets continue their climb without an adjustment, there are always opportunities.

 

 


This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The NASDAQ Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Russell 2000 Index is an unmanaged market-capitalization weighted index measuring the performance of the 2,000 smallest U.S. companies, on a market capitalization basis, in the Russell 3000 index. It is not possible to invest directly in an index. Investing involves risks, including the risk of principal loss. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.

Past performance does not guarantee future results

 


 

Jeffrey J. Kerr is a registered representative of

LaSalle St. Securities, LLC, a registered broker/dealer.

Kerr Financial Group is not affiliated with

LaSalle St. Securities, LLC. Securities are offered

Only through LaSalle St. Securities, LLC

940 N Industrial Drive, Elmhurst, IL   60126-1131

Member FINRA/SIPC