MARKET BUBBLE OR PEAK OF IRRATIONAL PESSIMISM?

We have had our 3rd straight quarter of US corporate revenue and earnings growth.   The global recovery continues as one more BEAR or negative analyst /money manager gives up and is at least “bullish into the early part of 2014."  Pessimism still reigns with the most stalwart of Bears holding to the premise -" the rise in the stock market has been due primarily to the Federal Reserve stimulus."  Of course, the US has increasing federal debt mostly due to entitlements - ever broadly defined.   However, given the current economic cycle and the reprieve the US and the dollar have received as a result of other countries' woes, perhaps our debt crisis is not at hand - yet.   Fortunately, the US has been given time to change our fiscal trajectory!  It's a very short term, historically fast moving market and we need to be open to the current economic cycle.   Sentiment - too negative or too positive- should not govern investment allocation.  Unbiased examination of the investment and global economic environment coupled with one's personal investment policy /risk tolerance suggests appropriate holdings.

The market's value is fairly priced based on a formula using a little optimism and honest acceptance of the improving global economic data.   Prior to interest rates normalizing, expect some volatility /downward pressure on stock values but be open to adding to select positions in 2014.   After about 5 years of outflow /selling stock mutual funds, 2013 is the first year of net inflow/purchases of stock funds.   Would this flow reverse just after one year?  (Certainly possible but is unlikely).  The trends of interest rates rising and bond selling should continue to result in increased allocation to stocks.  Dysfunction in Washington is working.  The drag on the consumer due to tax hikes will be dropping out.   Unemployment has reduced more than expected.  The Federal Reserve reflation is working; they keep moving the goal post of unemployment.  Perhaps the end of the taper (spending/printing money) will be by December of 2014.  Despite the government shutdown, unemployment was not increased as much as expected.  Wet weather- one of the rainiest - this past spring/summer had a negative effect on hiring in the 3^rd quarter.  The returning noise from politicians will most likely be muted as both parties look to picking their battles anticipating the mid-term elections.   In hindsight, the Federal Reserve could have tapered in September and may be behind schedule which could add to volatility.  It's doubtful tapering will start in December (no one likes to be a Grinch) but early 2014 is likely.  The nature of accommodation is to error on the conservative side - to delay the taper.  

All 10 major US domestic sectors are up 10% or more this year.   The Global economy and interest sensitive sectors – industrial, technology, and energy should continue to accelerate in 2014 along with a substantial increase in capital investment.  Europe, specifically Germany, is a road block to increasing global growth due to reluctance to stimulus/lowering rates- “trashing ” the euro - that is required to get/keep Europe out of a recession.  Austerity (raising taxes, cutting government spending) is not working and perhaps with Germany's Merkel and her coalition getting in place, they will get it right.  Reform in China, although really not serious or material, is a step in a positive direction.  Japan is on-line and adding to the global economy.  The US is ready to overtake Russia in energy production with the biggest story being natural gas exports.   Immigration reform appears stagnant but would be positive for the US economy.  US Trade is also an issue with the Trans Pacific Trade Agreement on the rocks.    States continue to struggle with underfunded pension funds, lower tax bases, and high unemployment. However, many state governments have made fiscal progress and are less of a head wind to a growing US private sector; zero state government growth vs. negative growth is a plus.  In fact, just factoring in more muted effects of tax increases, federal government sequester/spending cuts, and less contracting state governments, suggests a private sector growing at 3 to even 4%.  

Federal Reserve tapering will reduce “bubbling” but should allow continued growth of this bull market into 2014.   Appearance of progress in Iran is good for the US consumer via lower prices at the pump.  This should ease concerns regarding a flat to mild increase in holiday spending.   5-6% increases in corporate earnings in 2014 should be reasonable.   Based on history, this would not be an exceptional expectation.  

Steve Erken, CFP
Principal
November 26th, 2013

 Investment Outlook for 2nd Half of 2014:

INVESTMENT MARKETS RECEIVE SUPPORT BUT MAY LIKELY BE CHALLENGED BY HEADWINDS

What happened the first half of the year? Profits for the 1st quarter of 2014 were actually better than expected, despite the country’s deep freeze.  The blizzard conditions shut down the transportation of goods and services.   Healthcare spending was lower than expected and inventories were drawn down.   We had market declines in February and April which were read as distractions to what continues to be a generally solid, yet moderate, economic recovery.   April’s decline was the 7th drop in the market in the 3-8% decline range over the last 36 months.  Clearly, the US economy dropped into a hole, as evidenced by the 1st quarter seasonally adjusted GDP decline of 2.9%.   However, the market’s declines were very slight relative to the very large stock gains in 2013.   Perhaps the declines were muted due to the more promising outlook for the 2nd quarter and second half of the year.  Also, large volumes of company stock buy backs kept values buoyant.

What’s going right?  Presently, we are having a stronger rebound from a deeper hole.  Using the stock market as a leading indicator – up about 10% since the February low and 7.5% from the April low –suggests that second quarter earnings will be better than expected.  If we focus on leading indicators, irrational pessimism should again be disproven suggesting a US growth rate of 2.5% to 3% - slow and steady – and global expansion in the 6-7% range with support from China’s stabilizing growth.  The  Federal Reserve has communicated no immediate plans to raise interest rates and the global central banks continue maintaining a policy to keep rates very low; no recession on the horizon, stock valuations are not euphoric and have been correcting in pockets of market froth; investor sentiment is reasonably balanced; industrials and transportation sectors are pretty solid.  The momentum going into 2nd quarter earnings is positive with increasing gains in employment and improving consumer sentiment.  

What are the concerns?  If profits start to disappoint along with corporate outlooks softening, stocks may sell off.   Assuming this does not happen, event driven market declines such as geopolitical noise are likely buying opportunities.   Structural economic changes such as interest rate increases or a sustained spike in oil prices are a bigger concern.  Geopolitical risk, primarily in the Middle East, could result in spiking oil prices.   This could send Europe into a recession and would have a negative effect on the US economy and equity markets.  The Federal Reserve may be behind on raising interest rates and communicate the rate increase sooner than what the financial markets expect, resulting in a rapid and possibly  deeper market decline.  Both of these could lead to a structural change and effect the economic recovery.  Assuming neither one happens, market gains may grind forward leading to higher valuations and possible bubbly conditions.  Rates rising sooner may likely slow the economy and cause a market correction but limit possible bubble scenarios in the longer term. 

 Allocation of funds? Cash provides a negative return after inflation.  US government bonds are likely overvalued to stocks, however the interest rate bottoming process may go on for quite some time.  Although various stock valuation methods present a range from overvalued to fairly valued, there are select U.S., developed and emerging market stock sectors that appear attractive, assuming the trend of global recovery continues.    Expect headwinds that could lead to stock declines, perhaps shallow and in short duration.  Assuming nothing structural, it may be an opportunity to reallocate and reinvest.  NOTE:  CUSTOMIZED CLIENT INVESTMENT POLICY MODELS ARE CONSERVATIVE WITH PRESERVATION OF PRINCIPAL, CONSERVATIVE, MODERATE AND MODERATE PLUS.

Steve Erken CFP® Principal
July 18^th, 2014

GOVERNMENT SHUT DOWN AND DEBT CEILING SHOW DOWN - OPPORTUNITY FOR INVESTORS?

As you are probably aware, without a last minute agreement for a short term resolution, it appears that the US government is heading for a “shut down” at midnight tonight. The more significant date is October 17th, which is the due date for raising the US debt ceiling.   Without an agreement or resolution by this date, the US government would effectively default on its obligations.  A short term resolution could raise the debt ceiling into November.  “Kicking the can” or some longer term agreement will be the most likely outcome.   As long as the domestic economy is not damaged by this debate, fundamentals and corporate earnings suggest that the stock market is within a reasonable range of value; larger dips in prices should be looked upon as opportunity to invest.  With the US economy running at near 2.5% growth, the Federal Reserve using a “show me the data” stance and the “noise” coming from Washington, it may be helpful to consider the context of the debate within the economic environment.    A split country can lead to a perception that does not give weight to improving economic data.   Despite increased regulation and Washington headwinds, domestic and global economic date continues to show stability on an improving trend line.  Low inflation, low interest rates, and global recovery are tail winds to this market that supports values and the trajectory for new market highs.    The misalignment of values, due to artificial reasons (Federal Reserve Quantitative Easing, record corporate debt refinancing funding  corporate stock buy backs) and the enormous US Debt are serious concerns for the mid and long term economic outlook.    However, looking at the next 3-12 months, beyond October and the Washington noise, 4th quarter earnings may suggest stock values being sustained and going higher.   Thus, we have held more cash in portfolios for just such a pull back and opportunity to redeploy at possible lower market prices.  Also, with the recent drop in interest rates, it is another  opportunity to sell bonds that are of a longer duration and move to shorter durations/less sensitive to interest rate risk .   Asset classes consisting of short term bonds and cyclical sector – technology, industrials, and energy, select consumer discretionary, select healthcare - are focus areas.  Also, the economies of Europe (Germany) Japan and Mexico continue to show some valuation promise.   With the reasonable expectation of a stronger global economy, the emerging markets and eventually materials look valuable.

Global/US Economic Environment
China and Europe are showing some light.  US domestic unemployment continues on a decreasing trend, construction and consumer spending continues to be sustained or is improving.   Labor cost are about flat, productivity continues to be stronger than expected.   There has been a global turn in manufacturing, work week and overtime increasing, and the private sector continues to grow faster than Federal Reserve consensus.  Though the decrease in the US work force is a concern, changing demographics, rise in participation rate of older females working, delay in younger people being skilled enough to participate in the workforce and the more affluent society, particularly with baby boomers, can help explain this decrease in the participation rate of workers.   In more affluent societies, citizens do not want to work as much.  Leisure industries are booming.    Moderate but unclear drops in discouraged workers and the part-time workforce is encouraging.   The increase in interest rates may be the result of the global improving economy.  Labor markets are strengthening, getting back to levels before the sequester(forced government spending cuts).   The rate increases/bond markets are telling us things are getting better.  The US has moved from number 7 to number 5 in terms of competitive ranking - economies/manufacturing, etc.    Russia, India and Brazil continue to have problems and are still stimulating their economies but will be helped by China’s growth.  Japan is growing at about 3% vs. flat or contracting.   Recent tailwinds to the US stock market have been the recent change in likely new head of the Federal Reserve (YELIN), no bombing of Syria and the short term effect of the no taper without evidence of solid recovery by the Federal Reserve. 

Fixed Income/Bonds:
Still negatively impacted by the increase in interest rates, although recently since no Federal Reserve tapering, rates have come down some/bond prices coming up.   Muni bonds continue to be effected by rate increases and headline risk- recent City of Detroit bankruptcy and credit downgrade of Puerto Rico.

Recent Data:
Productivity data from China is at a 6 month high.  This is helping commodity prices and those countries associated such as Australia.  China continues to move to a service economy and not just a consumer of goods.    Cyclical stocks – industrials, technology and energy – still in the limelight.   Merkel’s recent reelection should be favorable for Europe.  She will be building a coalition and can be looked as not just a leader of Germany but of Europe.   Germany is acting as an anchor bank for Europe/Greece.   Domestic indexes continue to show improvements.    Company revenue increases are a concern as well as declined earnings estimates for the 3rd quarter – reporting starting soon.    The Federal Reserve’s delay in tapering/ reduction spending/printing money, can be viewed as lack of confidence in the state of the US recovery, help to get through the Washington debate, or a way to communicate that the US recovery is ahead of the Fed’s expectation and rather than discuss future rate increases, they will simply comment about the current state of economy.   Actually, unemployment has declined faster than the Federal Reserve forecasted.   So, a rate increase may happen sooner now than later.   Is this really a message that the economy is not recovering?   Certainly no taper has led to a lowering of interest rates and perhaps that was the Federal Reserve’s intent.  The recent dollar weakening is good for our exports as the emerging markets work to promote internal growth. The impact of increasing growth in demand in Europe and other countries for US goods and services is significant, accounting for as much as 40-60% of sales for large US technology, industrial and energy companies! 

Outlook
Beyond the budget fight, debt ceiling drama, and challenging 3rd quarter earnings, the last 2-3 months of the year may prove to be promising and a catalyst for market increase into 2014.  Accelerating growth as the Sequester fades (government job cuts, etc.) could lead the US GDP to go from about 2% to 3-4% range for 2014.  

Noise from DC will increase volatility but historically has been a time to buy on the declines.  

Steve Erken, Principal
September 30th, 2013

MARKET NEGATIVE SWING IS SYMPTOM OF UNWINDING CARRY TRADE:  BUYING OPPORTUNITY?

What to do with my money?  Give into my emotions and rush out of stocks?  Or put emotion aside and look at explanations for the recent down turn?  Values will not always go straight up but 100% in cash is likely not the answer.   Let’s explore recent volatility:

What is this Carry Trade?  It’s a strategy when an investor sells one country’s currency which has a relatively lower interest rate and uses the funds to purchase a different country’s currency which has a higher interest rate.   If the investor uses leverage (borrows against other securities such as stock) the difference captured between the two rates can be substantial.   However, when the support of lower rates changes, such as the Federal Reserve reducing (tapering) the amount of money that it’s pumping into the US economy, the Carry Trade can reverse and result in wide swings in currency prices.    Moreover, as a currency drops in value, the investor may have to sell stocks that were used to borrow against to make this investment.   As these stocks sell off to generate cash, prices come down which may lead to buying opportunities because structurally, there is no real immediate change in positive economic outlook.

We just had the first leg of this unwind and the initial fall out can be the largest swing in market prices.  The countries with the weakest fundamentals such as Argentina, Turkey and other emerging countries (Russia, Venezuela, Chile, Brazil, Turkey, etc.) will experience the largest downturn in their currency values.  Likewise, emerging market countries tend to be very dependent on exporting their goods to China; when China slows and imports less, these countries are negatively affected and get a double whammy as interest rates are just starting to go up in developed nations such as the U.S. and the U.K.   As discussed above, these rate increases change the value of currencies.  For the most part, our clients are not invested in these economies- generally, it’s noise to understand but to put into context. 

The markets have been overdue for some correction and the Federal Reserve is past due in reducing its spending to support the US economy.  The U.S., China, Japan and Germany –the 4 largest economies- are growing.   Moreover, this coordinated global economic recovery should require growth in inventories which will result in an acceleration of economic growth.   Companies have been too cautious and conservative to meet this demand.    Corporate guidance reflects this caution by reducing expectations and then exceeding analysts’ target returns. 

Expect some further volatility anytime China reports slowing growth or problems with their banking- the Shadow Banks – smaller banks that use unregulated methods to raise capital.  China has massive government reserves to stabilize their economy and banking system which should “fence in” these concerns.   Also expect more headlines about currency and the weaker emerging market countries.  Look for more market volatility to result from these currency changes. 

All of this is and was expected as the global recovery continues.  It’s a normal phase and current global condition; historically this has been viewed as opportunity within the cycle of the markets.  Emerging economies are important- some more than others.   Their pain will continue as the balance moves back to developed countries.  As emerging economies slow, we will be looking for the effects on the global recovery.

Steve Erken, CFP
Principal

January 27, 2014