Weekly Commentary July 30th, 2012

The Markets

“Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough.”

                                                          --Mario Draghi, European Central Bank (ECB) President

It’s quite amazing how one sentence from one man can help spark a major rally in stocks, bonds, and the euro currency. Draghi’s comments last Thursday in London represent a significant ramping up of the ECB’s willingness to use its resources to hold the euro together and investors responded enthusiastically. On the day of Draghi’s comments:

·         The euro and the British pound each gained more than 1 percent against the U.S. dollar.

·         Stocks were positive in nearly all European markets.

·         Italian and Spanish indexes each jumped more than 5 percent.

·         The Spanish 10-year bond yield dropped nearly half a percentage point from the day before and the 10-year Italian bond yield was down a similar amount.

·         The S&P 500 index rallied 1.6 percent.

Sources: The Wall Street Journal; CNBC

Between Draghi in Europe and Fed Chairman Ben Bernanke in the U.S., central bankers seem to be exerting an outsized influence on the markets. Normally, you expect markets to roughly trend with corporate earnings.

Speaking of earnings, several high-profile companies including Amazon, Facebook, and Starbucks, fell short on their second quarter earnings numbers released last week, according to CNBC. Overall, earnings for the companies reporting so far this quarter have been a bit on the light side, according to CNBC.

While earnings ultimately matter in the long run, today’s markets seem focused on the support provided by central banks. And, yes, an up market is an up market regardless of what’s propelling it. However, for long-term sustainability, we need the markets to go up based on their earnings growth – not artificial stimulus.

THE BEST AND THE WORST DAYS IN THE STOCK MARKET tend to occur rather close to each other and that has major implications for how to be a successful investor.

While it’s tempting to try to aggressively “time” the stock market and be in on the best days and sitting in cash on the worst days, that’s not a viable strategy. The chart below shows how just a few days each decade made a profound impact on the performance of the market over that decade. 

Decade	Annualized Return by Decade	Return Excluding 10 Best Days	Return Excluding 20 Best Days	Return Excluding 30 Best Days	Return Excluding 40 Best Days
1970s	1.6%	-2.3%	-5.0%	-7.2%	-9.1%
1980s	12.6	7.6	4.6	2.0	-0.4
1990s	15.3	11.0	8.0	6.0	3.0
2000s	-2.7	-9.2	-13.2	-16.9	-19.5

Source: BMO Capital Markets

For example, during the 1980s, the S&P 500 had an average annualized return of 12.6 percent. However, if you excluded the return of the 40 best days during that decade, then the return would have fallen to a negative 0.4 percent. In other words, just 40 days out of that 10-year period accounted for all of the return for the decade. Wow!

Now, you also have to know that missing the 40 worst days during the decade would have a profound positive impact on your performance. But, here’s the rub – it would take perfect foresight to know in advance when these 40 best and worst days would occur. And, of course, none of us have that.

What makes aggressive timing even more difficult is that these best and worst days often happen pretty close to each other. BMO Capital Markets discovered that since 1970, more than 50 percent of the 40 best days occurred within two weeks of one of the 40 worst days! So, imagine this… the stock market has one of its worst 40 days for the decade and you are lucky enough to be sitting 100 percent in cash that day. Now, realistically, after a big drop like that, are you going to have the nerve to jump 100 percent right back in? If you didn’t, you’d miss more than half of the 40 biggest up days since those big up days often occur within two weeks of a big down day.

The lesson here is simple. Markets are volatile and the price of long-term return is enduring the pain of periodic declines.   

Weekly Focus – Think About It…

“The most important thing in the Olympic Games is not winning, but taking part; the essential thing in life is not conquering, but fighting well.”

--Pierre de Coubertin, founder of the modern Olympic Games

Weekly Commentary July 23rd, 2012

The Markets

The man with his finger on the pulse says the U.S. economy faces two main risks. We have no control over one of those risks and the other, well, we do have some control, but whether our politicians will appropriately exercise that control is a big question.

Federal Reserve Chairman Ben Bernanke faced Congress last week and he delivered a rather subdued outlook in his semi-annual monetary policy report. He said our economy faces two major headwinds:

1.      The Euro-area fiscal and banking crisis and its potential spillover effects on our economy.

2.      The unsustainable path of the U.S. fiscal situation (e.g., the “fiscal cliff”).

Source: Federal Reserve

The U.S. has little control over the euro-area situation so we’re at the mercy of European leaders to make bold and tough decisions to get their houses in order. The second item, though, is clearly within our control.

The so-called fiscal cliff, in which a series of tax hikes and spending cuts will take effect in 2013 if Congress takes no further action, could throw the economy back into a recession. The Congressional Budget Office estimates if no policy changes are made, then our 2013 federal budget deficit will decline by about $600 billion. On the surface, that sounds great. However, such a huge shock to our system in a short period of time could be problematic.

So, will Congress agree to adjust the legislation for the benefit of the economy? We’ll see.

For his part, Bernanke said the Federal Reserve “is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” It’s good to know that the Fed is ready to help if needed.

IT’S BEEN ALMOST A YEAR since August 5, 2011, the day the U.S. lost its coveted AAA credit rating from Standard and Poor’s. So, how have the financial markets responded in the year since? Quite well, actually.

It may not feel like it, but the broad U.S. stock market, as measured by the S&P 500 index, rose 13.6 percent between August 5, 2011 and last Friday, according to data from Yahoo! Finance. Despite all the angst from the credit downgrade, the threat of a double-dip recession and the turmoil in Europe, the stock market has hung in there.

The returns in the bond market are perhaps even more startling. The 10-year Treasury yielded 2.56 percent on August 5, 2011 and by last Friday, the yield had dropped to 1.46 percent, according to Yahoo! Finance. Normally, you might expect interest rates to rise after a credit downgrade since the ratings agency is essentially saying your bonds are riskier than previously thought.

The U.S., though, is perhaps a “special” case. The day after the credit downgrade, none other than Warren Buffett went on Bloomberg television and said he thought the U.S. should be a “quadruple A” rating. And, to this day, the U.S. dollar remains the world’s leading reserve currency as more than 60 percent of the world’s foreign currency reserves are held in U.S. dollars, according to BusinessWeek.

We shouldn’t get overconfident, though. While the U.S. has tremendous assets, it might only take a few bad decisions from our leaders to undo what took decades to build.

 

Weekly Focus – Think About It…

“There is nothing wrong with America that the faith, love of freedom, intelligence, and energy of her citizens cannot cure.”

--Dwight D. Eisenhower, 34th president of the United States

Weekly Commentary July 16th, 2012

The Markets

 Should the Federal Reserve raise interest rates to fire up the economy?

 For the past few years, the Fed has been on a mission to lower rates as much as possible. The thinking is lower rates will spur economic growth by making it less costly for businesses and consumers to borrow money.

 Unfortunately, it hasn’t quite worked as planned.

 Short-term interest rates are near zero and 30-year mortgages are at a record low, yet the economy is still just muddling along, according to Barron’s. Now, some investment managers are saying the Fed should reverse course and raise interest rates.

 Last week, prominent money manager David Einhorn went on CNBC and said, “I think having very low zero rates is depressing to people. I think it deprives savers of reasonable incomes, the ability to forecast a reasonable income, and it cuts down on consumption.” He went on to say low rates drive up food and oil prices and lower standards of living.

 Folks relying on a stream of income from their fixed investments can probably relate very well to what Einhorn is talking about. As recently as July 2007, $100,000 worth of 1-year Treasuries would have generated about $5,000 of annual income (a 5 percent yield), according to data from the Federal Reserve. Now, it would generate only about $200 (a 0.2 percent yield).

 The Fed may be in a classic Catch-22, according to CNBC. With sluggish economic growth, it’s certainly hard to justify a rate hike, yet, low rates are increasingly ineffective. CNBC says a growing number of analysts suggest the best course of action is to allow “the cash-rich private sector to sort out its own problems without the government's interference.” However, they acknowledge it “likely would be painful, but could be the only sustainable path to recovery.”

 With the Fed on the record as saying they plan “to keep interest rates at their historically low range of 0 to 0.25 percent through late 2014,” investors shouldn’t expect the Fed to raise rates any time soon, according to Fox Business. Only time will tell if this low rate strategy is the right medicine for the economy.

HOW DO YOU TURN A PENNY INTO 1.25 BILLION DOLLARS? Sounds like a magic trick, right? Well, there’s really no magic other than the law of large numbers.

Here’s how it works and how it may benefit our economy.

A report from the Federal Highway Administration shows Americans traveled approximately 2.94 trillion miles in motor vehicles for the 12 months ending April 2012. Now, when you figure how many gallons of gas that burns up, you get a really big number! Moody’s Economy.com chief economist Mark Zandi has done the math and, by his reckoning, each penny change in the price of a gallon of gas equates to, you guessed it, about $1.25 billion over the course of a year, as reported by CNBC.

With the wild swings we’ve seen in the price of gas, the savings – or cost – can add up quickly. A recent check with AAA showed the average price for a gallon of regular gas dropped by about $.25 over the past year. So, multiply $1.25 billion by 25 and you get, to quote Carl Sagan, “billions upon billions” of additional coin in consumer’s pockets. And, that coin could fuel further growth in consumer spending. 

You’ve heard the old saying, “A penny saved is a penny earned.” Today, a few pennies saved on gas can add up to billions!

 

Weekly Focus – Did You Know…

There’s about $1.1 trillion of US dollars in circulation today – an all-time record high. However, most of it is not “floating” around in everyday transactions. About 75 percent of the $1.1 trillion is in $100 bills which don’t circulate much. On top of that, about 50 to 66 percent of U.S. cash is held abroad. Despite the proliferation of credit cards and debit cards, we still seem a long way away from a cashless society.

Source: CNNMoney

Weekly Commentary July 9th, 2012

The Markets

Where is the recovery in jobs?

In the 10 recessions between World War II and 2001, the jobs lost during the recession were fully recovered within 4 years of the previous peak in employment, according to the blog, Calculated Risk. In fact, with the exception of the 2001 recession, the previous 9 recessions had recovered all their lost jobs within a relatively short 2½ years. 

The 2007 recession, however, is a different story.

At its nadir in February 2010, the U.S. economy had shed nearly 9 million jobs from its prior peak, according to the Bureau of Labor Statistics (BLS). As of last week’s June employment report, the U.S. economy had recovered less than half of those lost jobs – and we’re more than 4 years removed from the peak employment level of late 2007, according to the BLS.

Why has the jobs recovery from this recession been so painfully slow? Here are several reasons:

(1)   Recoveries from recessions caused by financial crises – like this one – are notoriously slow.

(2)   Extremely high economic policy uncertainty emanating from Washington made corporations cautious in hiring.

(3)   The extension of unemployment benefits to 99 weeks reduced some people’s desire to find new work.

(4)   Uncertainty from events related to the euro crisis dampened business demand and the need for more workers.

Sources: Gary Becker, Nobel Prize Winner and Richard Posner blog; The Wall Street Journal

There is some good news, though, that could eventually provide a spark for new hiring.

Corporate profits as a percentage of gross domestic product (the value of all goods and services produced in the U.S.) recently hit an all-time high, according to Business Insider. This means corporate profits are at record levels. On top of that, corporate cash levels have reached historic highs which suggest corporations have plenty of money to reinvest for growth, according to Yahoo! Finance. With corporate profits and balance sheets looking solid, all we have to do is get these companies to start spending some of that cash on new hires. If that happens on a large scale, it could be a huge boost to the economy and the financial markets.  

INVESTORS HAVE GROWN VERY FICKLE in recent years as measured by how long they hold on to a stock. There was a time when investors were really investors and bought a stock for the long run. In fact, between 1940 and 1975, the average length of time a New York Stock Exchange stock was held before it was sold was almost 7 years, according to data from the New York Stock Exchange as reported by a September 2010 Top Foreign Stocks blog post. By 1987, it had dropped to less than 2 years. And, in the highly volatile year of 2008, the average holding period was less than 9 months, according to The New York Stock Exchange.

So, does this fast trading result in better returns?

A highly quoted study by Brad Barber and Terrance Odean of University of California-Davis published in April 2000 analyzed the results of nearly 2 million trades from a discount brokerage firm between 1991 and 1996. The study concluded that the 20 percent of investors who traded the most frequently underperformed the 20 percent of investors who traded the least frequently by a whopping 7.1 percentage points on an annualized basis after expenses.

The main conclusion of the study was, “Trading is hazardous to your wealth.”

One very interesting tidbit from the study was the gross returns between the frequent and infrequent traders were basically the same. In other words, stock selection was not a problem for the fast traders; rather, it was the expenses of the frequent trading that caused their net returns to lag far behind the infrequent traders.

From a practical standpoint, selling a stock is necessary from time to time. The study simply drives home the point that keeping trading costs as low as possible is critical to having net returns come close to gross returns.

 

Weekly Focus – Think About It…

“Learn every day, but especially from the experiences of others. It's cheaper!”

--John Bogle, founder of The Vanguard Group