What is Wrong with the US Stock Market?

“Life is pleasant. Death is peaceful. It is the transition that is troublesome.” Isaac Asimov

 

A client and friend asked why the current US stock market was having a hard time finding a path and if I saw this lack of a path as a threat to the global financial stability.

I started my reply with “In short…”, only to realize I had promised in my last newsletter, to share reasons to be bearish in my next newsletter and Eureka! Without further adieu: “6 reasons why US stock markets are having difficulty forming an uptrend.”

Reason 1: Transition from the Industrial Revolution to Information Age

We are at a juncture where multiple trends are ending and are in transition to the next. The biggest one of these is the end of the Industrial Revolution, which started in the late 1800s in England and probably lasted until the end of the 20th century. I use caution here as trends and cycles are difficult if not impossible to define while in them. Most of the political and economic concepts we live in or with, were either born or have grown strength as a result of this mega step in human history. The world’s governmental and economic systems are built to support this industrial life style based on production, transportation and consumption of goods, while supported by the banking system whose function is to turn profits into investments for businesses and lending for consumers.

And then, there came the technological revolution and globalization. In this new world, information and ideas may have become more important than having access to capital, as money is easily and readily available to invest in marketable ideas. Labor markets are global and therefore more competitive. National borders are less meaningful, as resources move faster than ever. Education systems, at least here in the US, fail to prepare the youth for the skills needed in this new economy. Automation is taking over human participation in production. Productivity growth no longer equals income growth. Since 1970’s incomes haven’t been able to keep up with productivity growth and the gap has been widening (except in the last few years because of falling productivity). With the use of computerized trading systems and financial engineering, risks and returns have grown exponentially. The level of welfare and the income distribution policies are a discussion for a heated debate, as haves can reach resources globally, while have nots end up competing against poorer parts of the world who are willing to work for much less.

As a result of this mega shift, there are 5.5 million job openings in the U.S. that can’t be filled, which was 3.5 million only two years ago. The capital markets and investors are trying to adapt to this new wave of technologies, business models and get a better sense of the present and projected valuations, while seeking balance in risk/return relationships. This tug of war between the past and the future is forcing the global economic machine and its capital markets to give errors in the forms of global financial crisis, massive computerized trading errors, discrepancies in valuations and increased volatility. Are these new challenges? No. But their magnitude brings us to an uncharted territory and at times, the capital markets act like a deer in the headlights. This long period with a sideway trend we have been in since November, could be one example.

Reason 2: Global Economic Slowdown

Are we in a global economic recession? No. According to the Organization of Economic Co-operation and Development (OECD), there have been 13 global downturns since 1960, last one being in 2011, with average length of 22 months. It looks like every 4-7 years, we go through a global recession and it wouldn’t be outside of historical averages if we experience a slowdown in the next 3 years. According to IMF calculations, global economic growth rate was 3.4% in 2014, estimated to be 3.5% in 2015 and 3.8% in 2016. So there is no global downturn currently or in the projected near future. However, it is not robust growth by any means and so it’s vulnerable to shocks. The strongest headwind for growth is the debt hangover. Governments and consumers are trying to pay down their debt as opposed to investing and spending, a minus effect on growth.

In most cases, when the US joins the international community and contributes to negative growth, markets react with a sharp decline. However, when the US is in growth mode while the rest of the world slows down, US stock markets typically go sideways. Given the problems in the EU zone and Japan, the slowdown in the Emerging Markets and US growth rate at around 2.5%, the sideway trend can at least partially be explained by the state of the global economy as a whole.

Reason 3: The Federal Reserve (FED)

We are in a central bank driven, multiple expansion based bull market. (Multiple expansion is paying a higher price for given earnings). Once the FED starts the tightening phase, we will be in a different zone and the US stock market’s reaction will depend on the speed of the rate increase.

Usually market tightening cycles start during an uptrend. Going back to all tightening cycles since 1946, the S&P continues the uptrend for another 4 months after the tightening begins (average of 5 cases). In the case of a fast tightening cycle though (7 cases) a sharp decline immediately starts with the tightening, lasts for 3 months to fully recover in 6

months (Source: NDR). So the speed of the hike is more relevant than the hike itself. Will the FED push rates up at a fast or slower pace? Most likely at a slower pace because the economy is growing at an annual rate of 2.3%, and the inflation rate that FED considers is at 1.8%. Slow growth, no inflation and lackluster income growth doesn’t give FED enough room to push the paddle to the metal. Even so, the markets are trying to adjust to the fact that probably the tightening cycle is only a few months away and as Isaac Asimov noted: “Transition is troublesome.”

Reason 4: Strong Dollar

It is usually a good sign when a currency strengthens. It shows that a country’s stability, the value given to its promises and its credibility are rising. It is however a headwind in the short term for the exporters as it makes the exported goods more expensive. About half of all revenues generated by the S&P 500 companies come from overseas. A strong dollar shrinks those revenues and makes it harder to increase market share. It is however also making imports cheaper, lowers input prices and so mutes the inflation. Since the US doesn’t have an inflation problem, the dollar strength isn’t helping. In time, a better and more efficient allocation of resources can and will usually fix this problem (which is good to have), but it does hurt growth while adjusting to it.

Reason 5: Low Energy Prices

Similar to a strengthening dollar, lower energy prices can be a good thing only if those savings were allocated efficiently elsewhere. The reason why it is a negative for now is that the energy companies are the largest contributors to capital expenditures (capex). Low oil prices mean low revenues for energy companies and low revenues mean low capex. Since one’s expense is another’s income, lower spending subtracts from growth. Also, their profit decline lowers their stock prices, adding more pressure to the market indexes.

Reason 6: Stretched Valuations

Valuation is how much one pays to a security for expected returns (capital gains and income) at the risk level of that return to materialize.

Currently, the stock valuations are a bit stretched. Not so much that major indexes are in a bubble territory, but they certainly are not fairly or underpriced. One area that is in bubble territory is the dividend paying stocks. Those seeking yield have been discouraged by the bond market and have found refuge in dividend payers, which made that space a bit crowded.

The market is more vulnerable to shocks with stretched valuations. There is still upside potential…but the volatility in prices is harder to handle for many investors.

Summary:

The bottom line is that the bull market doesn’t end because it gets tired or it expires. It usually ends because of a recession, bubble type extreme valuations or extreme investor optimism. Currently, we are experiencing none of the above.

I have shared with you the reasons to be bullish and bearish in two market updates. Hope you have enjoyed – see you next time.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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Markets Comfortably Numb, or Confused?

“It is easier to find man who will volunteer to die, than to find those who are willing to endure pain with patience.” Julius Caesar

If you think the stock market was down 5% since November, then up 8%, then down 2%…and it’s been on a trade mill during which time the end result performance has been flat for the last 8 months – you’d be correct (you’d get a very similar result with Dow Jones). In more detail:

On November 26th 2014, S&P 500 closed at 2072.83. Lowest we’ve seen this large cap US equity index that we call “market” hit since then, was on December 16th at 1972.74. The highest point was on May 21st 2015 at 2130.82. The drop from November to December was 4.8%, and the increase from December to May was 8%. On Friday June 12th, this index closed at 2,094.11, 1% above November 26th high!

Well, then bonds must have done relatively well, right? No…20 year treasury (Symbol TLT) index is down 2.9% in the same period (Nov 26 – June 12) and in fact down 6.3% year to date…

How about commodities (Symbol DBC)? Down 17.8% since Nov 26th and down 4.7% year to date.

US small cap equity index (Symbol IJR) is up 5.6% since Nov 26th and up 4.9% year to date.

Lastly, a safer bet in stocks, utilities is down 6.9% (Symbol IDU) since November.

Emerging markets (EEM) is down 4.98% since November 26th and developed internationals (EFA) is up 2.6% (Please note that I look at investable ETFs instead of an index as they are better indicators of money flow.)

So what does this picture tell us about the present and the future of capital markets? Short answer: it’s a mixed message. Volatile and yet flat, not knowing which direction to take. Let’s dive deeper.

The U.S. Economy

The good and bad news about the US economy is that it’s growing at a moderate paste, or one can call it a “sluggish growth”. This is good because we are far from recessionary pressures as some fear mongers would like to argue, bad news because it is below the historical averages and expectations.

Every period has phrases that become short term clichés and sometimes for good reasons. Last quarter’s cliché reward goes to “Extreme Weather Conditions and Port Disruptions”, which was seen as the main root of the negative real annualized GDP growth of 0.7% during the first quarter. (Notice how I used negative growth as opposed to contraction…it should say something about our addiction with growth). Market reaction to this news was a “meh”…for two reasons 1 – The cliché accurately described the main reasons behind the contraction and both conditions dissipated, which signaled an expected stronger second quarter as a result. 2 – By some measures, there was no contraction. For instance if you look at Gross Domestic Income (GDI), which in theory should be the same with Gross Domestic Product (GDP), as one’s spending is another person’s income. GDI grew 3.6% year over year versus 2.7% growth in year over year increase in GDP. The difference arises due to different data sources and these two figures converge in the long run. The gap suggests that GDP is not accurately capturing all the output in the economy and understating growth (Source: Ned Davis Research).

So first quarter contraction should largely be ignored and deservedly it was. The economy did slow down because of a shrinking shale gas industry, stronger dollar and the cliché mentioned above but there is a big question mark on contraction.

Second quarter and second half of this year is expected to bring stronger economic growth. I base this conclusion on forward looking indicators such as Purchasing Managers Index and most current data on revised retail sales to the upside, exceptional strength in auto sales, strong employment trends and rising incomes.

Stocks, Bonds and Commodities 

The mixed message from the main asset classes is probably the following: the longer term uptrend in stocks is likely to continue. Shallow declines should be seen as buying opportunities. Long term bull markets in bonds and commodities are likely to be over.

When the stock market goes sideways for 3-4 months let alone 8, unless a catalyst for a deep correction is on its way, it usually builds up for the next up trend. Why? Because this period frustrates the investor, bullish sentiment quickly fades, patience is replaced by pessimism and negative sentiment is bullish for stocks (just like extreme optimism is bearish). Negative sentiment is bearish because it signals a built up of potential buyers if and when the tide turns.

Along with an improving US economy, negative investor sentiment is likely to turn into a tailwind for the stock market during the second half of the year.

Those who have been waiting for a correction may not be aware but one form of a correction is a long side-way trend. Is 8 months long enough? We shall see.

Summary

A few take-aways from the market action during the first half of the year are:

  • Long term bull market in bonds and commodities might be over.
  • Second quarter US economy and second half stock market may perform better than the prior period.
  • Small cap out performance gives hope for a sustained uptrend.
  • Utilities under performance confirms the possibility of an uptrend. Why? Because as the market matures, the defensive sectors outperform growth oriented sectors (a rotation towards lower beta). Defensive sectors’ under performance keeps the bulls in the game.
  • International opportunities may out shine US investments, but for only those with patience and longer time horizon, as the timing of this switch is impossible to guess.

The contrary view to the market building for the next uptrend argues that the valuations based on price/earnings ratios are stretched, margin debt (to borrow and invest) is at extreme highs, we are coming close to the end of the business cycle, cash ratios are at extreme lows (everybody who is to be invested already is) and we haven’t had a meaningful correction (over 15%) since 2011.

In my next newsletter, I will expand on these bearish opinions because they are noteworthy. For now, the bull is still running, a little confused and tired may be, and so taking it’s needed rest, but until proven otherwise, a benefit of the doubt should be granted.

How to counter the bears and what to say about FED’s next move? That’s for the next commentary.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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Macro Factors In Play

“It is better to be vaguely right than precisely wrong.” –   Wildon Carr, 1942

 

My last market commentary’s title was “Dollar Is Up, Oil Is Down, Stocks Get Confused”. If you’re wondering why I haven’t written a newsletter for the last few months, that’s because this analysis has been as valid as it was a few months ago. Since November 2014, stocks have been in a sideway trend, dollar has been climbing up and oil looking for a bottom at around $40-$50 per barrel.

Some investment strategists argue that at this stage of the bull market, the name of the game is picking individual investments instead of indexing. They put this forward by looking at breaking correlations among asset classes and securities. In the early stages of a bull or a bear market, correlations rise, related asset classes move in tandem. As the trend starts to mature, correlations break and stock/bond pickers become popular again.

Though there is some truth in this, correlations haven’t shown a sustainable divergence pattern, meaning, just when they seem to be on their own, a heavy hitter gets a seat at the table and a brand new set of cards are dealt. The US dollar, oil, cold weather, port disruptions, Janet Yellen and foreign tensions are the most noteworthy examples.

I’ll argue, macro factors such as mentioned above are still the dominant players and paying attention to them would be wise. British Philosopher Wildon Carr’s quote makes so much sense when applied to capital markets. A diversified portfolio by definition will have less than perfectly correlated securities and some of them will zig while others zag. If you call this being vaguely right, it surely beats being precisely wrong on a stock holding that is 100% of your portfolio. So please remember this before you get too comfortable with your individual stock selections and don’t dismiss your diversified portfolios entirely, but rather supplement your allocation with individual holdings to get the best of both worlds.

Oil

Oil has been, and probably will for a while be, a headline topic for market followers. It has lately settled in $40-$50 per barrel range with significant daily price fluctuations. I have recently seen a report on future oil contracts, an estimate of the future price traders are willing to pay, and it points to $30/barrel oil. I personally think $40 dollar is the near term floor simply because below those levels, there aren’t many producers that can survive without making money.

This is a double edge sword. Cheaper oil pushes prices down and as a result helps improve savings rate along with consumer confidence. On the other hand, troubled refineries and depressed levels of oil production put a cap on capital spending. This has already been seen in shrinking durable goods orders, which is a big red flag for the markets. In the long run however, once the savings come back to the system as investments or pent up demand, the lost production can be re-gained. So in the short term, lower oil prices may hurt production and capital spending, but increased savings can translate into investments and higher consumption in the coming months.

Dollar

 Can you have too much of a good thing? Too strong of a dollar can surely be an example. The timing of the dollar strength has taken care of two interrelated worries for some: An overheating economy and inflation. If you remember, the 3rd quarter growth rate was 5%, which is high enough to cause inflation and push FED to move with their rate hike sooner rather than later. A stronger dollar lowered import costs and subdued inflation, while making exports more expensive and lowering large exporters’ profits. 4th quarter economic growth rate was 2.2%, clearly nowhere near overheating territory, accompanied by a 1.8% inflation rate. The strong dollar is not solely responsible, but surely had a role in it. In the short term, we may observe a reversal of this trend as there has been an excessive momentum behind the dollar. In the long term however, especially against the currencies where the central banks are implementing their own version of monetary easing, it is hard to see how the dollar can lose significant ground. If you’ve read about the Euro/Dollar parity, this projection refers to Euro and the US Dollar being equally valued, which would require the Euro to lose about 7%. That’s Goldman Sachs’ projections by the year end.

The FED

 Six years since the beginning of the recovery and the bull market, the biggest gorilla in the room has been the FED. There are two unstoppable forces I’d never knowingly (can’t say I haven’t made mistakes) stay in front of: the market trend, and the FED. I take pride in writing my commentary as an easy read in everyday language, but if the FED is the most important player and the timing of the rate increase is extremely important, then let’s make an exception and dive deeper into the statements of their last meeting.

In the US, the FED has two mandates, to keep the inflation at or around 2% and sustain full employment, which is 5.5% unemployment rate. So, since the current inflation rate is at 1.8% and the unemployment rate is at 5.5%, are we right at the doorsteps of a rate increase? No, not for another 6 months or so it seems, and here is why: NAIRU.

Not to be confused by Nibiru, the Babylonian god Marduk’s home planet, NAIRU stands for non-accelerating inflation rate of unemployment, meaning the unemployment rate below which inflation rises. In other words, once the unemployment rate goes below NAIRU, the FED would see this as an inflation warning and start sharpening their pencils to increase interest rates to fight inflation.

This unemployment rate, the rate below inflation rises, has historically been 5.2%-5.5%. The most recent FED statement lowered it to 5.1%. This is significant because it simply means the FED will not use unemployment as an excuse to raise rates until it reaches to 5.1%, not the previous estimate of 5.5%.

Also, if you add the part time employed to the unemployed number (U6), it is 11%, and all the more reason for the FED to delay the rate hike from June to September.

Extreme Weather Conditions and Port Disruptions

 While here in California we are dealing with a drought in historic proportions, the East Coast and Mid-West has gotten hit hard with extreme cold weather conditions this year and especially the latter has significant short term effects on the economy. When it is freezing cold, people shop less, certainly delay purchasing big ticket items such as cars, home appliances and real estate. To add insult to injury, strikes in major ports, especially on the West Coast, has slowed down or stopped all together the shipment of goods.

In aggregate, the US economy has slowed down more than anticipated and the markets have noticed. Like any other short term headwinds, these conditions have for the most part passed (except the drought) and the pent up demand will likely start adding to the economy in the coming months.

All these macro factors are affecting your investments in one way or another. With some exceptions, no individual holding is immune to macro regimes. A strong dollar lowers large US companies’ overseas profits, cheap oil makes it more difficult to profit from energy related industries, these two trends tie  in to interest rate and inflation expectations, and Janet Yellen’s statements are carefully watched by the markets.

The bottom line is that the uptrend in US stocks is still intact. So use the dips as buying opportunities, have a globally diversified portfolio, look for companies with wider access to domestic markets and rebalance periodically.

Hope you’ve enjoyed my market update. For questions or comments, please feel free to reach me at bbakan@shieldwm.com

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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Oil Falls, Dollar Rises, Stocks Get Confused

“Reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.”  George Soros.

As we come close to the end of a volatile year in stocks, one sudden an unexpected development (for some surely it was expected) slowed down the pace of a typical Santa Claus rally, it caused a shallow pull back, and raised a lot of questions. Crude oil price’s sharp decline caught many investors off guard and the confusion increased volatility.

Meanwhile, the dollar’s rise is also raising eye brows and questions (this is especially entertaining as I remember reading and listening the experts arguing over a crash in dollar’s value during the years following 2009). These two macro level trends create their winners and losers, and their impact is so huge, I wanted to clear some of the confusion and discuss pros and cons of each of them.

Also in this market update, as promised, I will go back to the list of indicators outlined in the previous market update, to help us objectively monitor the direction of the markets.

I picked the above George Soros quote because more often than not, the stock market makes no sense, at least in the short term. Eventually, things settle down but markets can and do stay irrational longer than investors can remain solvent. The reaction to the oil and the dollar price movements is no different, confirming Soros’ conviction.

Oil

Let’s start with oil. Oil is a commodity, which means its price is determined by the global supply and demand, and once set, it’s the same price everywhere you go. So the crude prices fell because there is a glut of it, exceeding the demand. The US is now the largest oil producer along with the Saudis. Shale oil and fracking technologies opened up global reserves twice the size of crude. This is so significant that it’s worth a pause here: the world’s known crude oil reserves are 1.7 trillion barrels, while shale oil reserves are 3.3 trillion barrels, of which 2.6 trillion is in the US. In other words, the US has more shale oil than the rest of the world has crude! How about that?

On the demand front, the Chinese economic growth rate of 8-9% is starting to look like a thing of the past. The world is adjusting to a growth rate of 6-7% in China, which implies less demand for oil. Europe is also not doing so well, neither is Japan, so there is lower demand for oil. Also, here is something for those who would like me to be a more creative. Over the past couple of years, Putin’s Russia has grown to be a more bold, wealthy and aggressive country, not shying away from threatening Europeans of cutting off their natural gas. The drop in oil prices is an enormously effective economic sanction policy as Russia heavily relies on energy exports. So one can speculate: Is Putin being “put in his place”? Clearly, the Russian elite are shaken, which is the only force that can pose a threat to him.

So how do these developments affect you or your investments? Why is the stock market falling along with oil prices? Stocks are falling, because the market is confused and tending toward disequilibrium. The stock market is pricing the scenario in which the falling oil price is due to a slowing down world economy. Partially this is correct, but it doesn’t factor in the benefits of lower oil prices, such as more money in consumers’ pockets, lower input prices and inflation, lower interest rates and less pressure on the FED to increase rates. So in net, it is good for the US consumer, an economy which relies 70% on consumer expenditures. So it should be a good thing for the stocks, also right? Yes and once this is realized, it will be a tail wind for stocks.

Dollar

The US dollar’s uptrend can also be explained by the supply and demand to it. Everywhere you look whether it is China, Japan or Europe, you’ll find accommodating central banks opening their can of quantitative easing packages. They do this to stimulate economic growth, keep rates low, turn cash into thrash, escape deflation trap etc. Rings a bell? As the whole world is drinking the FED’s cool aid, FED is (finally) saying enough is enough. This divergence in central bank policies will raise interest rates in the US, make its securities more attractive, bring foreign investors and push the dollar up.

Just like falling oil prices, rising dollar is also a net gain event. Yes it makes exports more expensive and less competitive, but import prices go down, helps keep rates lower, taking the pressure off of the FED to increase rates, encourages bringing production back to the US, improving the consumers’ purchasing power. A stronger dollar by definition means relatively cheaper Euro, Yen and Yuan, which gives Europe, Japan and China a competitive advantage over the US in the global markets, hence the “currency wars” being back in the headlines. This advantage may translate into better performance overseas in 2015, which for diversified investors is welcome news as in 2014, international stocks have lagged significantly.

Naturally, these moves create winners and losers; for instance, companies that heavily rely on exports may find their margins squeezed, while energy stocks may  feel the heat but overall, a net gain for the US consumer, is a net gain for the US economy and the investor. As for the losers, my biggest concern is a contagion created by troubled Russian banks and a banking crisis in Europe. For now, this is a low probability event, but almost all financial crises seem to be so, prior to becoming obvious.

Let’s now move on to the market watch indicators, but first refresh our memories, my select list is:

Investor and trader sentiment, technical readings and seasonality, valuations, breadth, cash ratios, volatility, economic indicators and demographics, FED, political risks, interest and inflation rates.

Since we have been discussing currency, interest rates and central banks, let’s follow the theme and take a look at FED’s policy.

The FED

March of 2015 will mark the end of the sixth year of the US equity bull market, which has been driven by FED’s policies. Now that the monthly bond buying program is officially over, can this tip the scale so much that bears get their day under the sun? I don’t think so. The US economy is growing moderately, the inflation rate is below the 2% target, and wage growth is still lagging and exposing the recovery’s Achilles’ heel. The FED doesn’t want to slow down the housing recovery, so while raising short term rates, it will aim keeping long term rates the same (flattening the yield curve), and keep mortgage rates low. In other words, just because FED has stopped the bond purchasing program, doesn’t mean it is out of the accommodating game all together, and if the last six years have thought us anything, it’s this ; DON’T FIGHT THE FED. So long as the FED is not tightening, which will be driven most likely by inflation rate peaking its head above the 2% target, its policies will be a positive for the market.

Economic Indicators and Demographics

To summarize, this can be said: the US economy is growing moderately and demographics are favorable. Today (12.23.14) third quarter 2014 gross domestic product growth rate came in at 5%, which is the fastest growth since the third quarter of 2003. So it is extremely difficult to argue in favor of a recession. As for demographics, the largest age group in the US is millennials, or generation Y; those born (roughly) between 1980 and 2000. The significance of this is that these folks are stepping in to their highest spending years in 2015 (please note that these figures are reported differently by different analysts, so there is some room for subjectivity here). The US economy will have a tailwind as a result of this for the next 15 years. Granted, some of the effects will be offset by the mega baby boomers retiring trend, but in net, this is a positive. So, two out of ten indicators are so far, favorable.

Let’s leave it here for now and pick up where we’ve left off in the next market letter. In it, I will also dust off my crystal ball and include 2015 projections.

I wish you all Happy Holidays and a great New Year.

 

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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Lower Energy Prices, Lower Yields, Macro Factors in Play

Central Bank stimulus programs and dropping oil prices have been the dominant macro factors affecting the capital markets.

As the European Central Bank is launching its quantitative easing program, China is joining the stimulus party with lower interest rates, and Japan is continuing with Abenomics’ easy policies.

Simultaneously, in spite of the falling oil prices, OPEC isn’t lowering production.

In this environment of lower yields and energy prices around the globe, winners and losers emerge.

Countries that rely on exports and production, like Germany and China, are benefiting from low energy prices.

On the other hand, countries that rely on energy exports, like Russia and OPEC countries, see their profits being squeezed.

In the US, the unexpected result is the sustained low yields in bonds. 

As many anticipated a rise in interest rates, stimulus packages around the globe are keeping yields down, and US bond yields are affected by this.

Rates in the US are still expected to rise in 2015, but may be not as much, and not so fast.

Stronger dollar makes it more expensive for US export goods, while keeping inflation in check with lowered import prices.

These trends are likely to continue in 2015, and so their effects…

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Most Hated Bull Still Running

“You know how advice is. You only want it if it agrees with what you wanted to do anyway.”  John Steinback, Author (1902-1968)

Recently, I’ve got invited to a Rotary Club to share my thoughts on current economic and market conditions. I chose instead, a topic more interesting and not as dry for many, and talked about the findings of a relatively new field of study called Behavioral Finance. It is a hybrid of psychology and economics and aims to understand how people make financial and consumption decisions.

The main premise of this field is that we are not rational beings, and in fact quite predictably irrational. A good book on this topic is called “Predictably Irrational” by Dan Ariely. We are wired and conditioned to work really hard on avoiding cognitive dissonance, a mental state of stress when faced with conflicting information and a decision has to be made. So we’d rather look for information that supports our current opinions, pre-existing biases and choices, which behavioral finance calls “confirmation bias”. Having my thoughts around the topic, the opening quote by John Steinback caught my attention. I allowed myself to fall victim to confirmation bias and picked a quote on confirmation bias.

The bull market run in stocks, which started on March 2009 is now 5 years and 8 months old. Many call this the most hated bull market in history, and there is some truth to it. Usually investors love bull markets, this is when you see your investments grow, but why the hate?

The stock market correction and Global Financial Crisis that started in 2007 was so big, so deep and so wide spread, it wiped out many investors hard earned savings and/or cost them their jobs. From peak to trough, the S&P 500 index lost 56%, meaning if you had 100 dollars in Oct 2007, you had 44 left in March 2009. This trauma caused investors, both professional and individual, build such strong negative associations with the market, that they are having hard time adjusting to its 3 fold or 200% growth from the bottom.

From the get go, it was a lonely bull. During its first two months, a 50% knee jerk reaction jump caused many people to question its sustainability. A popular term at the time to describe it was “a sucker’s rally.”

Since then we had a dozen or so pull backs and corrections, and each time there were those who argued that this has been a rally stimulated by FED’s quantitative easing policy and a new bubble has been formed. Since we have just experienced what happens when we have a bubble in our hands, it is/was time to play it safe…and so goes the argument today just like yesterday.

The losses of 2007-2008 caused many to stay out of stocks all together or with less than usual allocation towards. This can be seen with striking numbers among millennials. Those who are between the ages of 14 and 34, are not interested in equity investing, in fact, investing in general. This lack of interest spills over to buying a home or a car and the popular trend among this age group is renting rather than ownership. They saw the consequences of being at the wrong place at the wrong time and they don’t want to fall victim to their parents’ mistakes. This attitude puts them in the spectator seat of a bull market that would have other-wise helped with growing their assets.

To be fair, the $1.2 trillion dollars of student loans hanging over their shoulders isn’t helping the situation, and of course there is always someone out there claiming fame after a pull back with a sign waiving “I told you so”.

At this juncture, approaching its 6th year anniversary, we need to answer whether we are close to the end of a short term bull market, or the beginnings of a long term bull. The difference between the two are the length and breadth (how wide spread) of the trend. The shorter term (cyclical) trends last somewhere around 3 to 5 years. Examples since the tech bubble burst are 2002-2007 bull followed by the 2007-2009 bear and 2009-present bull. The longer term (secular) markets last 10-15-20 years, like the 1982-2000 bull and 1966-1982 bear. Of course, there can and most likely will be cyclical bears and bulls within secular bears and bulls, only to last shorter, if they face against the longer trend.

If the bull market will prove to be a cyclical one, the end, by definition, can’t be too far in the distance. If however, we’re in the beginnings of a longer term trend, then even with 10-15-20 percent pullbacks and corrections, like the 2010 and 2011 16% and 19% corrections respectively, the bull can run for another decade or so.

The unfortunate reality is that we can only accurately know the answer to these types of questions after the fact. But that doesn’t preclude us from taking a calculated guess, and while doing so, we should always keep John Steinback in our minds and avoid confirmation bias.

Without looking for information confirming our hatred and death wish of this current uptrend, or our love and wishes of long and prosperous life, objectively how can we tell where we are right now?

We luckily have historical guidelines on our side to make and attempt to judge our coordinates. Here are some of the 10 indicators to watch:

1) Investor and trader sentiment

2) Valuations

3) Breadth

4) Cash ratios

5) Volatility index

6) Technical readings and seasonality

7) Economic indicators, demographics

8) FED Policy

9) Political risks, domestic and foreign

10) Interest and inflation rates

This list, of course can be broadened until cows come home but believe me, if you can make an objective analysis of these indicators, you will be ahead of many of your competitors.

When I look at these indicators, I see a mixed picture. In my next newsletter, I will get in to a deeper analysis of individual readings, but for now, this much I can say: stretched sentiment, valuations, cash ratios and technical, accompanied by high margin balances, are headwinds for the stock market.

On the other hand, seasonality, mainly post mid-term election period, low interest rates, low volatility, accommodative FED, low inflation rates, relatively calm politics and most importantly a growing economy are tailwinds.

This mixed picture, at least for now, is still in favor of a continuing bull market and a stronger argument for a secular trend. Once again, we can only have definitive answers in hind sight, but a 60/40 chance in favor of a secular trend versus a cyclical term makes more sense to me.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

In my next newsletter, I will elaborate more on this topic with more details on the above indicators.

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Glass Half Full (or empty?)

“It all depends on how we look at things, and not how they are in themselves.” – Carl Jung (Psychologist, 1875-1961)

When the markets don’t give us a clear direction and has mixed data flowing from many different sources, depending on our bias, one can easily call it half full or half empty. Either way, we would be right. Today, one can conclude that the stock market is due a correction or that it is building momentum for an uptrend. How so?

The glass is half empty because:

  • We are in a seasonally weak period for US stocks. Historically, most of the stock gains occur Nov through April and summer months are typically volatile. Like any other historical data, this doesn’t always hold true. 2008 Nov through 2009 April was one of the worst periods in the stock market, and as recently as last year, May through Oct brought decent returns. Nevertheless, the probability of summer months’ weakness carries statistical significance.

  • This is a midterm election year, also the second year in the presidential cycle. In all four presidential years, second year has the worst record for stock market returns.

  • Valuations are stretched, meaning stock prices are not cheap and in relation to earnings (Price/Earnings ratio) they are close to correction territory. An uptrend in stocks without improved earnings, makes it expensive to invest and less attractive.

  • Falling bond yields signal weak economic activity ahead. If there is one big, in fact huge, surprise for many investors for 2014 (actually, it really started in 2011, but a more widespread consensus was for 2014) was falling bond yields and rising bond prices. By now, many analysts have been speculating a much higher Treasury bond yields. In fact, the opposite has been happening due to global easy money policies by central banks, shrinking US budget deficit and less Treasury auctions, low inflation expectations and slow economic growth.

  • Extreme optimism can be seen in the results of the Investor Intelligence’s bulls versus bears study and mutual funds cash holdings, both of which signal an overly optimistic investor view. Extreme optimism is one of the many conditions of the beginnings of a pull back.

  • Housing, a locomotive sector, has been slowing down and showing signs of topping. There have been talks of Obama administration pushing for looser lending standards through FHA loans, which could help but nevertheless, current conditions signal a market top.

  • European markets were expected to improve much better in 2014 and so far the results are not impressive. China is trying to clean up its property bubble and Japan is working on restructuring to fuel its economy. International markets were expected to play some catch up with the US stock market but except a few isolated incidents, results are sub-par.

Then why is the title of this commentary “Glass Half Full”? Because:

  • Even though the first quarter 2014 Gross Domestic Product, a gauge of US economic activity, has been revised down to -1%, this is hugely attributed to a harsh winter season and cold weather conditions. Bad news is behind us and pent up demand could push second quarter and second half of 2014 economic growth up to 3% – 4%. Growing economy means growing earnings and more attractive valuations.

  • Forward looking economic indicators such as Purchasing Managers Index, Industrial Supply Management index and employment trends have been signaling a stronger growth ahead.

  • Lower bond yields imply a lower cost of capital which is good for stocks.

  • Increasing mergers and acquisitions activity has been very strong and is showing signs of continuing strength.

  • Global markets are mostly above 200 and 50 day moving averages. So the global bull market is still intact.

  • Europe, China and Japan central banks are signaling more monetary easing on the way, which would weaken their currencies, lower cost of capital and stimulate their economies.

  • Technical readings show a bounce back from more cyclical investments such as technology stocks, small cap and energy. The pullback in biotech and pharmaceutical stocks has been contained and didn’t signal a widespread weakness.

  • Major indexes are still above their longer term moving averages indicating upside momentum and FED, even with tapering at hand, is still accommodating.

The executive summary of all this is that the overall trend is still up with a short term pull back a decent possibility. For longer term investors, pullbacks should be viewed as buying opportunities. One of my favorite analysts never gets tired of reminding us, that a successful investor sees opportunities in downtrends, not reasons for panic. We also know that successful investors change their minds when facts change. So stay tuned with facts, don’t fight the trend, which ever direction it is headed.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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