Weekly Commentary September 24th, 2012

The Markets

Corporations are putting more cash in investors’ pockets.

In the past week, more than half a dozen Blue Chip companies announced increases in their dividend payouts. In fact, Standard and Poor’s Corporation said S&P 500 companies paid a record $34 billion in cash payments to investors in August. That’s a pretty nice stimulus!

And, the largesse may continue. Howard Silverblatt, an analyst from Standard and Poor’s, was quoted in MarketWatch as saying, “2012 should set a record high for cash dividend payments, 16 percent above that of 2011.”

While dividend payouts look good, another part of the stock market is “diverging” and sending mixed signals.

There’s a century old investment management system called “The Dow Theory” which was developed by Charles Dow through a series of editorials in The Wall Street Journal between 1900 and 1902. According to this theory, in a healthy stock market, the Dow Jones Industrial Average and the Dow Jones Transportation Average should rise in sync.

The theory is based on the idea that companies in the industrial average “make the stuff” while companies in the transportation average “ship the stuff.” If there’s a divergence in the movement of the industrial average and the transportation average, then you have to wonder which one is potentially giving a misleading signal about future economic activity.

So, what’s The Dow Theory signaling now? It’s flashing red because, as of last week, the Dow Jones Industrial Average was up about 11 percent for the year while the Dow Jones Transportation Average was down more than 2 percent. And, just last week, the industrial average was flat while the transport index dropped a significant 5.9 percent – a substantial divergence in just one week.

Like all investment systems, though, The Dow Theory is not foolproof and this divergence could just be noise. In any case, it’s worth keeping an eye on it as a possible early warning sign.

CAN YOU IMPROVE YOUR INVESTMENT PERFORMANCE BY TAKING A TRIP to the local drugstore and forking over two dollars to buy a spiral bound notebook? Yes, says Nobel Prize winner Daniel Kahneman, one of the country’s preeminent psychologists.

In a recent conversation with Tom Gardner of The Motley Fool, Legg Mason Capital Management chief investment strategist Michael J. Mauboussin recounted a conversation he had many years ago with Professor Daniel Kahneman. Mauboussin asked Kahneman this question – What single thing can an investor do to improve their investment performance? Kahneman said buy a notebook and when you make an investment, write down why you made the investment, what you expect to happen with the investment, and when you expect it to happen.

Hmm. How does that translate into improved investment performance?

As humans, we often succumb to what’s called “hindsight bias.” Hindsight bias means we tend to think our forecasts were better than they really are. For example, few people predicted the severity of the Great Recession, but, after the fact, many people said they saw the signs of a bubble about to burst. These people “misremembered” what they were thinking prior to the Great Recession.

Kahneman says writing down what you’re thinking and what your expectations are – at the time you make an investment – allow you to go back after the fact and see how accurate you were. This black and white analysis helps keep you honest about your ability to make predictions and make good investment decisions. It helps you avoid becoming overconfident. Overconfidence is bad because it makes you think you’re smarter than you really are which could lead to making riskier investments and losing lots of money.

Sometimes the best ideas are also the simplest.
 

Weekly Focus – Think About It…

“Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you.”

--Neil Armstrong, astronaut, first person to walk on the moon

Weekly Commentary September 17th, 2012

The Markets

I am the Federal Reserve, hear me roar.

                                              Printing dollars in numbers too big to ignore.

With an apology to Helen Reddy for paraphrasing her early 1970’s anthem, the Federal Reserve dropped a bombshell on the markets last week, and the reverberation may endure for years to come.

In an eagerly awaited announcement, the Fed launched another round of money printing and said it would start purchasing an additional $40 billion per month in agency mortgage-backed securities. This, on top of an existing debt buying program, will add about $85 billion per month to the Fed’s balance sheet through the end of this year. While that part of the announcement was not too surprising, the twist that turned investors’ heads was the following two excerpts from the Fed’s statement.

1)      If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

2)      The Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

Source: Federal Reserve

The Fed did two new and astonishing things in these excerpts. First, they made this intervention “open-ended” whereas in the past, they put a fixed dollar amount and time frame on it. Second, they said the intervention would continue long past the time when the economic recovery strengthens, which suggests the Fed may keep pumping the economy full of gas even if the tank is already full.

With this aggressive action, two words come to mind—unintended consequences. Already, we’ve seen commodity prices, precious metals, and long-term interest rates rise and the U.S. dollar slump. To take a quote from Aldous Huxley and, before him, William Shakespeare, we’re in a brave new world with these moves, and as your advisor, we’re doing our best to succeed in it.

“SITUATIONAL AWARENESS” IS A MILITARY CONCEPT that has some applicability to our role as a financial advisor. In the military sense, it’s defined as:

Knowledge and understanding of the current situation which promotes timely, relevant, and accurate assessment of friendly, enemy, and other operations within the battle space in order to facilitate decision making. An informational perspective and skill that fosters an ability to determine quickly the context and relevance of events that are unfolding.

Metaphorically, you could consider Wall Street the “battle space” replete with friends, enemies and all kinds of noise and news that may or may not affect the battleground. Making sense of all this cuts to the heart of situational analysis.

Not surprisingly, there’s a process to situational analysis. Air Force Colonel John Boyd developed the OODA Loop in the 1950s, which stands for Observe, Orient, Decide, Act. Through this iterative process, military folks observe a situation, process what it means through orientation, decide on a course of action, and then act to solve the problem. Similarly, financial advisors use a process to analyze incoming information and then take action.

In theory, this sounds like a reasonable way to make decisions in a complicated world. And, for many years, it worked for the military and advisors alike. But guess what? Times change. As the military realized, the world is evolving from being merely complicated to the more nebulous complex; one characterized by more ambiguity and hyperspeed in information.

In today’s complex financial world, the OODA Loop process has lost some effectiveness. To evolve with the times, we have to become better critical thinkers. We have to challenge more assumptions and offer alternative scenarios. We have to think about unintended consequences and potential “Black Swan” events. We have to get comfortable in making decisions in a world of uncertainty and ambiguity.

Will we always get it right? No. But we can assure you we are continuous learners and strive hard to make effective decisions on your behalf.

 

Weekly Focus – Think About It…

“Complexity is the prodigy of the world. Simplicity is the sensation of the universe. Behind complexity, there is always simplicity to be revealed. Inside simplicity, there is always complexity to be discovered.”

--Gang Yu, PhD, Associate Professor, UT Southwestern Medical Center

Weekly Commentary September 10th, 2012

The Markets

It’s about time.

Believe it or not, the U.S. stock market as measured by the S&P 500 index hit an all-time record high last week when you include reinvested dividends, according to Bloomberg. Now, you may not have seen that headline in the news last week because the index itself is still 9.3 percent below its all-time high reached on October 9, 2007.

Here are a few other interesting stats to ponder:

1)      In 2012 alone, the rise in the U.S. stock market added $1.9 trillion to investors’ wealth.

2)      As of last week, the S&P 500 index rose 112 percent from its 12-year low reached in March 2009.

3)      Even though economic growth is sluggish, U.S. corporate earnings are projected to reach a record high this year. If reached, this would place earnings about 20 percent higher than 2007’s – the year the U.S. stock market hit its all-time high.

4)      By historical standards, “The S&P 500 is trading 13 percent below its average valuation since the 1950s.”

5)      World central banks expanded their balance sheets by about 9 trillion dollars since the financial crisis started.

Sources: Bloomberg; Barron’s

 

Number 5 above is an important point to keep in mind. Easy money has greased the world economy and now there’s talk of even more monetary stimulus in Europe and the U.S., according to MarketWatch. What remains unanswered is, how much of the market’s rise has been stimulated by the stimulus and what happens when the stimulus is no longer available or effective? Can the economy stand on its own?

Barron’s framed it this way, “At some level, the market gets priced not simply for the monetary-easing cure to remedy economic ills, but for that drug being administered to a healthy patient for recreational purposes.” Translation – if central banks overshoot and markets get addicted to the easy money high, the inevitable withdrawal of the money drug may be painful.

CAN GOOD NEWS BE GOOD FOR THE WRONG REASON? Last week, the government released the eagerly awaited monthly payroll report. It showed a modest 96,000 increase in non-farm jobs in August compared to the month before. While that number was disappointingly low, the unemployment rate showed a surprising (and positive) drop to 8.1 percent; down from 8.3 percent the previous month.

Here’s where it gets tricky: the drop in the unemployment rate occurred for the wrong reason, according to The Economist. The main reason why the unemployment rate dropped was 368,000 people left the labor force. With fewer people being counted in the labor force, the unemployment rate looks better than it might be otherwise.

A related statistic, called the labor force participation rate, measures the share of the working-age population either working or looking for work. This figure fell to 63.5 percent last month – a three-decade low, according to The Economist.

Is a declining labor force participation rate a bad thing? According to Matthew O’Brien writing in the Atlantic, “Less people in the labor force means, all else equal, that we will produce less stuff in the long run. And, less stuff means we have less wealth, lower stock prices, and fewer taxes to pay for retirement.”

So, why are people leaving the labor force? Here are a few reasons:

·         Going back to school

·         Raising children

·         Retiring

·         Going on disability

Source: The Wall Street Journal

Now, there’s one more big reason why people leave the labor force – they get discouraged and simply stop looking for a job even though they want one. Conveniently, the government tells us there are, unfortunately, nearly 7 million of those folks as of the end of August; that’s up from about 4.4 million near the end of 2007.

Fed Chairman Ben Bernanke recently called the unemployment level a “grave concern” and the numbers seem to support him. Bottom line, even though the unemployment rate dropped, it dropped for the wrong reason and we still have a long way to go to get this country working again.

 

Weekly Focus – Think About It…

“Laziness may appear attractive, but work gives satisfaction.”

--Anne Frank, The Diary of a Young Girl

Weekly Commentary September 4th, 2012

The Markets

Now that the traditional end to summer has arrived, things might heat up on Wall Street as traders return to their stations and face a host of pressing risks.

The omnipresent Mohamed El-Erian of PIMCO took to the airwaves on Bloomberg last week and laid out his list of the four major risks facing the global economy:

1.      The looming fiscal cliff – in which automatic tax increases and spending cuts are set to take effect at the first of the year in the U.S.

2.      The continuing sovereign debt crisis in Europe.

3.      Geopolitical risk in the Middle East and elsewhere.

4.      The economic slowdown and pending political transition in China.

Source: Bloomberg

One could argue that the first two on the list are within the power of western politicians to solve without causing global harm. Of course, so far, politicians have engaged in a game of “kick the pressing problems down the road.” However, sooner or later – and likely sooner rather than later – that road will end. Only time will tell if our politicians solve the problems before they hit a dead end.

The last two are trickier. Geopolitical risks are always unpredictable, particularly in the highly combustible Middle East. And, China, that’s another wildcard. The country’s economy is clearly slowing down, albeit from a very high rate compared to American standards. The upcoming once-in-a-decade political transition is also a cause for reflection as the Bo Xilai affair disrupted what party officials hoped would be a smooth political transition.

Yet, despite these four risks, the U.S. stock market is still near a post-crisis high. The fact is, there’s always something to worry about and sometimes the stock market defies expectations and keeps climbing the “wall of worry.”

DOES STRONG ECONOMIC GROWTH ALWAYS LEAD TO RISING STOCK PRICES?  Typically, strong economic growth translates into rising corporate profits. Rising profits, over time, tend to lead to rising stock prices – or so one would think.

Consider China. For many years we’ve heard how China is supplanting the U.S. as a manufacturing and economic powerhouse. And, in many respects, it’s true. Between 1989 and 2012, China’s gross domestic product rose at an annual rate of 9.3 percent – dramatically above the growth rate in the U.S. – according to Trading Economics. Today, China has the world’s second largest economy and it’s projected to overtake the U.S. in just four years, according to the International Monetary Fund as reported by BusinessWeek.

So, yes, China is an economic powerhouse. But, has their economic growth translated into stock price growth?

Let’s go back about 12 years, November 10, 2000 to be exact, and see how the Chinese stock market has performed as measured by the Shanghai Stock Exchange Composite Index. The Shanghai Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

Back on November 10, 2000, the Shanghai index closed at 2,047, according to data from Yahoo! Finance. Now, almost 12 years later, where do you think the Shanghai index closed last week?

Shockingly, the Shanghai index closed at 2,047 – exactly the same price as it was nearly 12 years ago! This flat stock market performance occurred despite the fact that the Chinese economy grew by more than 500 percent between 2000 and 2011, according to The World Bank.

Now, before we conclude there’s no connection between economic growth and stock prices, we have to go back even further. On December 19, 1990, the Shanghai index was created with a starting value of 100. At last week’s closing price of 2,047, this means the Chinese stock market, as measured by the Shanghai index, has risen more than 1,900 percent between 1990 and 2012. On an annualized basis, that’s more than 14 percent per year – an exceptionally high return.

Okay, after all these numbers, what can we conclude? A couple things:

1.      Fast economic growth in any given year does not necessarily translate into rising stock prices that year.

2.      Fast economic growth eventually shows up in stock prices, although some of the growth may be “pulled forward” and “priced in” to stocks well ahead of when the growth actually occurs—as happened in China.

This lack of a linear relationship between economic growth and stock prices is one more variable we have to consider when developing portfolios.

 

Weekly Focus – Think About It…

“Without labor nothing prospers.”

--Sophocles, ancient Greek playwright