Weekly Commentary October 28th, 2013

The Markets

Contrarians probably are waiting for the other shoe – or, in this case, U.S. stock markets – to drop.

If you’re not familiar with contrarian investing, the theory goes something like this: Consensus opinion is often wrong. When the majority of investors have a bullish outlook and believe stocks are going to move higher, the chances are stock values will drop. Likewise, when the majority has a bearish outlook and believes stocks are going to move lower, the chances are stock values will rise.

Why would Contrarians expect markets to head south? One reason is bullish sentiment is high. On October 23, the American Association of Individual Investors’ Investor Sentiment Survey, which measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months, shows 49.2 percent are bullish and just 17.6 percent are bearish (the rest are neutral). The long-term averages for bullish and bearish sentiment are 39 percent and 30.5 percent, respectively.

Contrarians also are eyeballing the fact that stock markets in the United States have run up for 519 sessions without as much as a 10 percent correction, according to Barron’s. That means markets have weathered bombs at the Boston marathon, chemical weapons in Syria, monetary policy uncertainty, U.S. government shutdown, and Miley Cyrus’ VMA performance. Of course, 519 sessions is not the longest winning streak ever, not even close. In fact, if we assume about 250 trading sessions in a year, then the current rally would have to last until about 2018 to match the record (1,767 sessions) set between October 1990 and October 1997.

Investors aren’t the only bullish faction. Money managers who participated in Barron’s latest big money poll also seem to have adopted Alfred E. Neuman’s motto: What, me worry? Their outlook seems to focus on the Fed’s loose monetary policy. According to Barron’s, “Four of five money managers in our big-money poll expect stocks to be the best-performing asset over the next year, even as 71 percent see U.S. shares as already fairly valued. Thanks to unending central bank support, we all expect above-par stock returns from sub-par economic growth.”

So, what’s going to happen? Only time will tell.

where are interest rates headed? According to the Federal Reserve, economists assume interest rates will move toward equilibrium or a ‘natural’ real rate of interest that takes into account inflation over the long term.

The idea of a natural rate of interest was first introduced by Swedish economist Knut Wicksell.  Recognized as an economist’s economist in the late 1800s and early 1900s, Wicksell is known for his macroeconomic text Interest and Prices which noted the difference between the real rate of return on capital (aka: the natural rate of interest) and the market rate of interest (aka: the rate borrowers pay). According to The Economist:

“If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and plowing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and, eventually, financial interest rates.

Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results – or, some worry, speculative credit booms.”

So, where are interest rates headed? Apparently, they’re going to move higher. According to the Federal Reserve’s September 2013 economic projections, the federal funds rate (the rate at which banks lend to each other overnight) is expected to reach 2 percent by the end of 2016. Currently, it is at 0.25 percent. (The Fed also expects the United States will be close to full employment at that time with the unemployment rate nearing its long-term average of 5.2 to 5.8 percent.)

 

Weekly Focus – Think About It

“It has always seemed strange to me... the things we admire in men, kindness and generosity, openness, honesty, understanding and feeling, are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest, are the traits of success. And, while men admire the quality of the first, they love the produce of the second.”

--John Steinbeck, Pulitzer and Nobel Prize-winning American author

Weekly Commentary October 21st, 2013

The Markets

Curse of Chucky, Scream 2, Final Destination 5, Freddy vs. Jason… You know Halloween is nearly upon us when you can’t surf channels without exposing yourself to or relishing in a multitude of horror flick sequels.

Propagating alarming situations seems to be all the rage in Washington, too. Last week, a last-minute deal raised America’s debt ceiling, saving us from a debt default and ending the government shutdown – until next January. In the meantime, hoping to avoid a sequel just three months down the road, the members of Congress agreed to put their heads together and produce a 10-year budget plan by mid-December.

Like the hero or heroine of many a terror-filled fantasy, stock markets generally have proved resilient despite facing formidable challenges. Just last week, the Standard & Poor’s 500 Index hit a new all-time high. According to Barron’s:

“Since the rally began, in March 2009, there has been the flash crash, the Greek default drama, the U.S. debt-ceiling debacle, the Standard & Poor's credit-rating downgrade of the U.S., the sequester, and the great taper scare. Each of these, we were told, could have ushered in a new bear market. Instead, the S&P 500 squirmed out of the traps and headed higher. And, for its latest trick, the market had to avoid the double whammy of a government shutdown and a potential default.”

The short-term resolution of budget and debt-ceiling issues doesn’t mean markets have escaped the (choose one: axe-wielding maniac, flesh-eating demon, Stay-Puffed Marshmallow Man) quite yet. Looking ahead, they’ll have to confront the menace of potentially contentious budget negotiations, the possible end of quantitative easing, and the phantasm of resolute fiscal policy.

it may be the holy grail of investing… If you could accurately predict how share prices would move, you’d probably be quite wealthy. If you could offer insight that helps analysts and investors do a better job predicting such things, you might win the Nobel Prize. That’s what happened last week when American economists Eugene Fama and Lars Peter Hansen from the University of Chicago, and Robert Shiller from Yale University, jointly received the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013. They were recognized for their empirical analysis of asset prices.

Eugene Fama is best known for his work on the efficient frontier which demonstrated stock prices are extremely difficult to predict over the short term because new information is incorporated into prices very quickly. His research not only influenced future research, many credit the emergence of Index-linked investments to his theories.

Robert Shiller, a student of behavioral economics, challenged Fama’s efficient markets hypothesis with the belief that markets are driven by human psychology which can and does create large and sustained pricing errors. Shiller established when the ratio of prices to dividends for stocks is high, prices tend to fall, and when the ratio is low, prices tend to increase.

Lars Peter Hansen developed the Generalized Method of Moments, or GMM, which proposed a “straightforward way to test the specification of the proposed model… Hansen’s work is instrumental for testing the advanced versions of the propositions of Fama and Shiller… If you want to do serious analysis of whether changing risk premia can help rationalize observed asset price movements, Hansen’s contributions will prove essential.”

According to the Nobel committee, “There is no way to predict the price of stocks and bonds over the next few days or weeks. But, it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years… The Laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions.”

 

Weekly Focus – Think About It

 “Many men go fishing all of their lives without knowing that it is not fish they are after.”

--Henry David Thoreau, American naturalist and author

Weekly Commentary October 14th, 2013

The Markets

Do world stock markets believe Congress is just offering up some Halloween excitement? 

Last week, they responded to the government shutdown in the United States and the possibility the U.S. might default on its debt for the first time ever with the bravado of teenagers standing in line for a haunted house. Markets around the globe finished the week higher with some notable exceptions that included Chinese and Mexican markets and America’s NASDAQ.

It’s also possible market performance could be attributed to the lack of economic data available since the government shutdown. Even private economic indicators sometimes rely on federal government information to calculate their numbers, so markets may be weighting signs that America’s elected officials are making progress more heavily than they might if other data were accessible.

The positive progress in U.S. stock markets is particularly interesting since a lot of Americans – many of whom may be investors – have negative feelings about the fiscal policy impasse in Washington, according to a new NBC News/Wall Street Journal poll. Sixty percent of Americans polled said “if they had the chance to vote to defeat and replace every single member of Congress, including their own representative, they would.”

That may go a long way toward explaining the recent deterioration of consumer sentiment in America. The Thomson Reuters/University of Michigan's overall index on consumer sentiment declined for the third month straight in October. The change was relatively small, but sentiment reached its lowest level in nine months.

A Federal Reserve System primer… Last Wednesday, vice chair of the Board of Governors of the Federal Reserve Janet Yellen was nominated to take over as Chairman when Ben Bernanke steps down in January. If confirmed, she’ll take the helm of the institution entrusted with safeguarding our country’s monetary and financial system.

Congress established the Federal Reserve System a century ago in response to the financial panic of 1907. According to the Federal Reserve Bank of Boston:

“Financial panics and bank runs were all too common during the 19^th and early 20^th centuries. Some were more severe than others, but most followed the same general pattern. The misfortunes of a prominent speculator would undermine public confidence in the financial system. Panic stricken investors would then scramble to cut their losses. And, because it wasn’t uncommon for speculators to double as bank officials, worried depositors would rush to withdraw their money from any bank associated with a troubled speculator. If a beleaguered bank couldn’t meet its depositors’ demands for cash, panic would quickly spread to other banks. (Remember! There was no federal deposit insurance until 1933. If a bank failed, depositors had little hope of ever seeing their money again.)

The panic of 1907 ended when J.P. Morgan intervened and set up emergency loans for financial institutions. The clamor for reform led to the passage of the Federal Reserve Act (which created the Federal Reserve System (Fed), which became law in 1913.

Today, the Fed includes a Board of Governors in Washington, D.C. and 12 Federal Reserve Banks. The Board of Governors oversees the Fed. Its members are appointed by the President of the United States and confirmed by the Senate. They serve 14-year terms. The Reserve Banks are responsible for the Fed’s day-to-day operations which include “conducting monetary policy, supervising and regulating banks, and providing payment services all help maintain the stability of the financial system.”

Monetary policy is set by the Federal Open Market Committee (FOMC) which is composed of 12 voting members and includes the seven members of the Board of Governors and a rotating group of five Reserve Bank presidents. The chairman of the Board of Governors is also the chairman of the FOMC.

 

Weekly Focus – Think About It

 
“The greatest thing in family life is to take a hint when a hint is intended – and not to take a hint when a hint isn't intended.”

--Robert Frost, American poet

Government Shutdown Thoughts

Many of you have contacted us about the government shutdown and its potential impact on the markets. Here is our current thinking on the matter. 

While the inability of our government to agree upon a budget has forced it to shut down, we don't believe this is terribly important for investors – at least for the moment. Rather, the duration of the shutdown may be meaningful, but not devastating. Bloomberg estimates that a two-week shutdown would reduce Gross Domestic Product (GDP) by 0.3%. This is much smaller than the enactment of the government sequester at the beginning of the year, which is estimated to lower GDP by a full percentage point. Yet, this fiscal drag has not prevented the S&P 500 from rallying nearly 18% YTD. Additionally, during the 1995-1996 shutdown, the stock market initially dipped 3.7%, but then proceeded to rally 30% over the course of the year.

We are not suggesting the current shutdown is bullish for stocks. Rather, stocks rarely have meaningful reactions to political dysfunction. Some may compare the current situation to 2011, but that was a much different time. Our economic recovery was on much shakier ground and some were concerned about a double-dip recession. Additionally, many feared the dissolution of the European Union causing another "Lehman-like" event and that China was going to undergo a "hard landing". Today, the world economy is on much firmer ground.

However, the one potential commonality between now and 2011 is the need to raise the debt ceiling. Unlike the government shutdown, this is terribly important for stocks. Over the next couple weeks, should politicians choose to play chicken with our credit and reserve currency status, then we expect the potential for considerable volatility.

If you have any questions regarding the government shutdown, please contact us so we may promptly assist you.

Weekly Commentary October 7th, 2013

The Markets

For Sturm und Drang enthusiasts, the third quarter of 2013 held plenty of mayhem and emotion. It began with an overthrow of Egypt’s democratically-elected government and ended with the United States government at risk of defaulting on Treasury and government obligations. In between:

Fed officials had a lot to say. Like background music that manipulates your emotions, the U.S. Federal Reserve’s ongoing commentary about potential changes to U.S. monetary policy affected global stock and bond markets throughout much of the year, and third quarter was no exception. When the Fed didn’t adjust quantitative easing in September, markets celebrated. Apparently, they’d lost sight of the fact that the Fed could decide to taper at its next meeting in October. When reminded of that fact, markets retreated a bit.

Emerging market currencies bounced. Changing expectations for U.S. monetary policy had a profound effect on emerging markets. Many saw their currencies lose value relative to the U.S. dollar early in the quarter; some regained it as the quarter progressed. The most spectacular performance may have been delivered by the Indian rupee which went from being Asia’s worst performing currency to one of the world’s best in just five days.

Shibor Shock startled investors. During the second quarter, China’s GDP grew at the slowest pace in more than two decades. As curtains opened on the third quarter, the world saw Chinese banks staggering as the Shanghai Interbank Offered Rate (Shibor), China’s benchmark interest rate for an overnight bank lending, exceeded 25 percent. Shibor was about 2.5 percent early in 2013. The ensuing cash crunch created concern China’s economy might be in trouble. Apprehension increased when the country’s finance minister, Lou Jiwei, confounded analysts and investors by suggesting China’s Gross Domestic Product (GDP) growth rate for 2013 might be 6.5 or 7 percent rather than the official target of 7.5 percent.

Europe may have turned the corner. In mid-August, the Eurozone’s GDP grew by 1.1 percent annualized. Markets breathed a sigh of relief on the tentative hope positive growth signaled a turning point for the region’s lagging economy which had been in recession for 18-months up to that point.

As the quarter ended, the world’s attention turned to U.S. fiscal policy as Congress battled over budgets and debt ceilings. Last week, Congress reached an impasse and the government shutdown partially. If they are unable to resolve differences, the U.S. government is at risk of defaulting on its debt; an occurrence experts say could send shockwaves through the global economy. Needless to say, the new quarter holds endless potential for storm and stress.

 

 

If you’ve been lamenting the state of america, take heart… We’re still really good at some things. For example, we have more entrepreneurs – people who organize and operate businesses – than any other country in the world. About one of every 13 Americans is an entrepreneur, according to The Economist. That’s almost 7.5 percent of our population! The Netherlands isn’t too far behind us in the ratio of entrepreneurs to population at large (about 6.5 percent). However, less than 4 percent of Brits are entrepreneurs and less than 3 percent of the citizens of France, Sweden, and Germany are so inclined.

 

Forbes.com postulates entrepreneurship in America can be attributed, in part, to the fact that our country is a magnet for venture capital. During 2012, the U.S. ranked second overall – ahead of Sweden and behind Israel – in venture-backed capital as a percentage of GDP, according to The Organization for Economic Cooperation and Development (OECD). Also, we value the entrepreneurial spirit. Let’s face it, Americans love the underdog. We don’t see failure as failure when risk-taking is involved. We see it more as daring. As Teddy Roosevelt once said:

 

“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”

 

The Forbes article also pointed to the influence younger generations, specifically Millennials, are having on our economy. According to CMO.com, Millennials buy fewer cars, prefer renting to owning, and eat less fast food. They want transparent workplaces and collaborative work environments. In response to their preferences, car sharing, media sharing, home and vacation sharing, and other types of collaborative businesses have been born. Millennials are creating opportunities for entrepreneurs everywhere!

 

Weekly Focus – Think About It

“After a storm comes a calm.”

--Matthew Henry, English commentator on the Bible