Posts Tagged Nasdaq Biotechnology Index

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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2014

“Teach your tongue to say I do not know, and you shall progress.” – Maimonides (1135-1204 Spain)

 Investment management is the combination of science and intuition, anticipating what others anticipate, about a future set of events that are inherently unknowable.

 That’s what I will attempt to do in this market letter: Anticipate what others may anticipate about capital markets performance and behavior in 2014. Before I progress any further, I do need to disclose that I do not know. Having established some faith and confidence here, let’s pay a quick visit to 2013.

I prefer to look at returns on investable indexes (Exchange Traded Funds) rather than benchmarks because they are more realistic in the sense that they reflect management fees.

  • So according to iShares, Nasdaq Biotechnology Index was the top global performer with 65.61% return, followed by DJ US Select Investment Services Index 65.37%. The bottom feeders were Gold Miners Investable Markets Index -52.21% and Silver Miners Index -51.46%. Wow! Gold itself (GLD) brought a whopping -28.32% loss. So much for being a safe investment.

  • As you can tell, best results came from the US, as its S&P 500 Index returned 29.6% (capital gains only). The rest of the developed world such as Germany and rest of the Europe were also mostly positive as the Eurozone got out of recession in Q2.

  • Even though it was a good year for the residential housing market, the same can’t be said for the returns on Real Estate Investment Trusts (REITs).

  • Bonds? Ouch! 2013 was a markedly bad year for bonds. The 20 year treasury index lost over -15% due to the tapering and rate increase expectations.

I looked at my Jan 2013 market letter and the headline said it all; “A Ticking Time Bond?” In so many ways, it was anticipated, but the timing is always the toughest and the most important part of investment management. In 2011, most bond fund managers thought it would be a bad year for bonds, only to watch double digit returns to slip away. They were right, but early.

In short, the best performing capital markets in the world was the good old US equity markets with all else trailing it.

One hard to believe figure came from the Bureau of Economic Analysis on third quarter Gross Domestic Product (GDP) growth over second quarter: 4.1%! This was surely unexpected and underlines the sustainability of the recovery. We still don’t have the fourth quarter results so we can only estimate 2013 GDP growth rate to be around 2.5%. This is still below averages but surely above recessionary levels.

Inflation has been tame at 1.2% through November. This actually gives mixed signals. A low inflation is a good thing, but too low will waive the deflation flag (prices coming down) and it is a serious risk to the health of the economy. With falling prices, investors prefer to stay in cash, consumers wait as much as they can to get a better price and the whole economy can get in to a grid lock. This is one of the reasons the FED (I speculate) hasn’t been as aggressive as some anticipated in cutting their bond purchase program that is now referred to as the tapering.

According to the Bureau of Labor Statistics, the unemployment rate dropped to 6.7%, yes another surprising result. A year ago it was 7.9% and most analysts didn’t expect it to drop to these levels until the end of 2015, we are two years ahead of schedule so it seems. Now…some surely will argue that this is due to less available labor pool, people giving up on looking for a job, it’s a flawed statistic and so on and so forth. True, can’t say no but this rate is still important to watch closely as it’s one key metric the FED  pays attention to while making interest rate related decisions. This figure, once below 6.5%, may start pressuring wages to the upside, great news for the individuals and consumer stocks and potentially bad news for the overall corporate profitability.

So much could go wrong in 2013 and yet we came through: an economic recession, military action on Syria, tensions with Iran, fiscal cliff, debt ceiling, fights on Obamacare and tapering were some big risks we had faced in 2013. Now what? After an approximately 30% return in US equities, what to expect in 2014?

As I have said, I don’t know, but please read on!  I do think that there are some possibly probable events ahead of us in 2014 that may or may not happen and here they are:

I think two big words to pay attention this year are seasonality and earnings. I anticipate positive returns in the US equities, but certainly nothing like the ones we had in 2013, with a pull back or two during seasonally weak summer months.

Where would gains come from? Earnings growth. Yes, there is still room for growth in company earnings and if you can find the sectors that may benefit from global macro trends or if you are a bottom up stock picker, find those companies with healthy earnings (low accruals), you’re golden. Oh, don’t forget to buy them low and sell high, so easy!

Bonds may have another tough year in 2014 as interest rates may face upward pressure due to the recovery in the US and Europe. So stay with high yields and low duration bonds.

A great comeback story may be seen in the emerging markets following an upsetting 2013. They have been trailing the developed markets and a catch up is due at some point. Remember, not all emerging markets are equal and this year, pay attention to Asia rather than Eastern Europe and Middle East.

Europe is two years behind the US with the central bank giving away free money game. So, its equity markets may have more cards to play as they were late coming to the table.

Commodities could also be a comeback story, as they have been an area of the markets we all loved to hate in the past few years. Global economic recovery can trigger a run on industrial commodities and transportation stocks. Watch for themes supporting global recovery until summer months or the end of the bull run whichever comes sooner, go defensive if the anticipated pull back occurs, and go back to your seats in fall or the bounce back whichever is first.

With fracking, the US is turning into an oil exporting country, which translates into low energy and overall industrial production costs. Add the fact that the employment costs are rising in China, you get a reversal of the trend that had shipped jobs to overseas. I sincerely hope fracking won’t have lasting environmental damages that will prove true an old adage from an Indian Chief: Money won’t mean anything after the last fish is caught, but the economic future of the US is surely promising as a result of this and the demographic trends similar to the post World War II era. While the rest of the developed world population has been shrinking, the US has been able to manage population growth with the help of immigration. The cultural implications may keep some folks out of their comfort zone but the economic implications have been favorable.

Iran is being pulled back to the global system. I am not an international political science expert but one can call me a political junky and as far as what I’ve gathered, it seems like Asad’s presence in Syria will be tolerated by the US, as the alternatives have proven to be even worse options, like Al Queada dominance for instance. Can someone say unintended consequences? It’s a reversal of the US policy in Syria. The agreement it seems will result with Iran stopping the progress on the nuclear warhead development and being more transparent about it. In return, it will be allowed to keep its 40,000 troops in Syria to help Asad win his war while Iran continuing to sell oil to the international markets. An interesting twist in the conflict between the Sunni camp with the Saudis-Kuwait-Turkey-Katar-US coalition against the Shia camp with Russia-China-Iran-Syria coalition.

It seems like Putin has saved Obama from the Syrian dilemma by arranging this deal with Iran, which of course the neo-conservatives along with the Israelis are all up in arms about. I will leave politics to the experts but lower oil prices and a more stable Middle East in the short term are logical conclusions. Remember my thoughts on commodities? Well, keep oil out of that potential comeback story and if you are looking into buying baskets, make sure oil allocation is low.

Put your trust in the market itself more so than forecasts. Monitor market moves and be ready to react because 2014 will not be as easy as 2013, but again who thought 2013 was going to be easy? Just remember how troubling the fiscal cliff alone was, or fights on Obamacare and yet sometimes things did turn out to be better than expected.

One final thought before a suggestion for your New Year’s resolution. In my last market letter, I have suggested that a bull run is a possibility until the fiscal negotiations in February. I am reversing that statement as the Congress, thanks to Republicans’ realization of how damaging this can be to their political careers, has already shown signs of a much easier tone and some agreements have already been made. A pull back is still a possibility in that period but not as much as I have previously anticipated. The other big risk I have also talked about was tapering, FED’s reversal of the bond purchase program. This too is appearing to be of less concern as the FED has been doing a great job managing expectations around this issue. A decent part of this action is already priced in the markets. Tapering may slow the markets this year no doubt, but probably not as heavily as previously thought. Also, say hi to your new FED Chairwoman, first woman in that post, San Francisco’s own Janet Yellen.

2014’s Financial Resolution:

I don’t believe in New Year’s resolutions because I think meaningful change happens instantly when you’re ready and it’s impossible to schedule for it. Once you have had enough of the unwanted and you can’t accept it anymore, once the conditions are ripe for a change, that moment instantly shifts your gears towards the wanted.

All that said, I do think every year, you should have at least one financial goal to accomplish and I suggest you look into your estate planning this year.

Estate planning involves finding answers to questions such as: “If something happens to me, are my assets going to be handled exactly the way I want them to be and in the most tax efficient way? If I get into a coma, what happens then?”

I am a Certified Financial Planner and I understand estate planning enough to talk about them, but ultimately you should meet with a trust attorney and put everything in writing until it feels right. A good trust attorney will walk you through different kinds of scenarios and help you make the right decision. If you have further questions on this, I would be happy to answer or point you to the experts in this field.

Hope you have enjoyed reading my Newsletter. Please feel free to forward it to your friends and family and don’t forget to email your questions or comments to: 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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