First Quarter Perspective

Accelerating or Decelerating

The Federal Reserve ended Quantitative Easing last fall and since then they have tried to prepare investors to expect interest rate increases this year. While the debate rages on the broader effect of QE on the economy, it was clearly responsible for putting a reliable lid on stock market volatility.

 

 

 

Believe it or not (and we don't) the Fed's reasoning for raising rates is based on their observation that the economy is accelerating rapidly enough that higher rates are needed to stave off inflation pressures. The Feds flirtation with rate increases was a primary factor in the massive rally in the US dollar/decline in the Euro since August:

 

Euro US Dollar

 

Earnings are the Focus

Without Fed intervention investors are finally shifting their focus back to market fundamentals. A string of macro-economic data points in the last three months is stirring concern about stock prices and valuations. The most concerning news is the dramatic decline in earnings expectations for the first three months of 2015

 

Reduced earnings expectations have brought renewed concern about corporate profitability as well.

 

http://www.yardeni.com/Pub/peacockfeval.pdf

 

As expectations are reduced, companies are getting their excuses in line. Unlike last year when weather was the go-to excuse for poor results, the strong dollar will be the primary scapegoat in 2015.

 

 

Corporate profits as a percentage of the overall economy are at the extremes of historical relationships. This heightens investors' attention

 

 

 

Growing Pains

The consensus is building that the economy must pick up steam to justify both current prices and further gains in domestic stocks. The problem for growth going forward is that the market no longer has billions of dollars in Fed stimulus greasing the economic skids each month. Even if the Fed surprised investors with another round of QE it did little to stimulate the main street economy. The turnover of dollars in our economy is actually less stimulative now than after the recession ended.

 

Canaries

Transportation stocks are a reliable barometer of economic trends and the Dow Transports Index has diverged negatively from the S&P 500.

 

 

Poor first quarter earnings and weak leadership from transports help explain why the S&P is stalling out in 2015.

 

Forecasters now expect the Federal Reserve to wait until later in 2015 to raise rates instead of the mid-year. So, investors and the Fed are waiting for a clearer picture of economic activity to emerge from spring. Clarity will determine if an aging bull market will make it 7 years in a row.

 

Something Bigger

In the meantime, the risk of a mild market correction boiling over into something more aggressive grows as investors that relied on leverage to boost their returns become impatient.

 

 

Something Better

The dollar rally created several compelling investment opportunities that look like a promising alternative to the earnings issues in our domestic economy. Relative to the S&P 500 global markets have underperformed for years.

 

 

As the Fed ended QE here the European Central Bank started QE in Europe. Already low interest rates there have turned negative.

 

 

Foreign markets have outperformed the S&P 500 in 2015

 

Conclusion

The US is six years into a bull market without the Fed stabilizing demand. The consensus view is that domestic earnings will disappoint. The silver lining is that the dollar rally has muted economic activity to the point that the Fed will postpone rate increases and contrarian bets that the dollar will reverse course are starting to yield results.

1. http://www.bloomberg.com/news/articles/2015-03-16/calpers-chief-sees-lower-returns-as-bull-market-in-stocks-ebbs

Commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Content is derived from sources deemed to be reliable. Information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's portfolio. Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. There are no assurances that a client's portfolio will match or exceed any particular benchmark.

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Perspective: The Relationship of Corporate Profits to GDP

Hoy GrimmAs earnings season builds momentum and we risk being swamped with the minutiae of each corporate announcement, I wanted to share a longer term perspective on where company profits stand in relation to both our current and historical economic situation.

First I graph corporate earnings growth since the 1940. I am using the after tax data series from the St Louis Federal Reserve FRED:

In comparison to profits, GDP is a smoother data series.

 

Which leads to the comparison of the two:

We could continue to add complexity through additional variables but this simple comparison tells an interesting story. Compared to economic activity, corporate profits are stretched to the extreme. If profits are to wiggle higher from here, we need the economy (GDP) to grow. The takeaway seems clear.

I'm working on charting the profits/GDP relationship on several foreign markets as well. That should generate some interesting observations.

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Signs to look for in Q1 Earnings- End Demand and Currency Effects

Hoy Grimm

Earnings expectations for the first three months of 2015 have plummeted. Since January analysts reduced their estimates for company profits so much that earning will be considered on target even if they are 4% less than last year. Stock market bulls who are comfortable buying the market at current levels believe that the second half of 2015 will see an acceleration of activity which will more than justify expensive PE ratios. The Fed was forced to rethink the timing of interest rate increases because of a series of poor economic data point.

For our part, we are positioned with a healthy cash cushion because we are suspicious about where this excess demand will materialize from. China growth is very weak, Japan is no better and other than Germany, Europe is resorting to artificial stimulus through the ECB to stave off a recession. Despite this overwhelming body of evidence, the S&P 500 is still trading at 17 times forward earnings - a valuation that is normally reserved for periods of steady, predictable earnings growth. The stakes for US stock investors couldn't be higher than right now.

Alcoa kicked off earning season last week with earnings per share that was 2 cents better than the reduced guidance but revenue that was less than expected. On the day the stock dropped 3% and is down more than 10% this year.

As more companies announce their financial results here are two key factors that investors should be paying attention to:

 

Demand

Over a three month quarter most competent CFOs can manufacture a decent report or at least offer a plausible excuse (weather, the dollar) for any shortcomings. Dig into their business to discern any change in demand trends. This is most readily measured through top line revenue and through inventory. If demand is strong, revenue will be up and they will be turning their inventory over faster.

 

Is the strong dollar helping or hurting business

Companies that have little international sales exposure should realize economic benefits from the strong dollar. They produce in dollars and sell in dollars. Domestic businesses are more focused on controlling manufacturing costs and inventory than their exposure to the strong dollar. The dollar rally was a primary driver in the decline of energy prices over the last 6 months and that should provide a cost savings to domestic producers.

US companies with a global footprint are still dealing with the effects of the strong dollar. The dollar rally has persisted long enough that these companies have had enough time to hedge some of the currency risk away. If they use the strong dollar as an excuse for missed expectations it likely means they aren't managing their business well and will subject their shareholders to more earnings uncertainty.

 

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We’re Halfway There

kevin-painterWhile perusing through social media last week, I saw a post that caused me to stop and really think. Today we are as close to 1990 as we are to 2040. Ouch! That hit me like a ton of bricks. It's impossible that 1990 was 25 years ago. I was a freshman in high school. I had grown 7 inches in 6 months and had a mouthful of braces. I was wearing Tommy Hilfiger shirts and rolling my jeans.

The words to a famous Bon Jovi song then came to my head, "Whoa, we're halfway there. Whoa, Livin on a Prayer." For a child of the 80s, this was our anthem. But, oh wait, I just turned 40. What's even more troubling to me is that I'll be 65 in 2040. Our kids will be out of college, our mortgage will be paid off, and I better be ready to retire.

Life is constantly in motion. Good things happen to us like graduations, marriages and births while sad and difficult experiences such as job loss, illness and death of a loved one also plague us during our journey. We can't predict what will happen tomorrow, but we can prepare for it.

Planning for the future isn't easy. It takes discipline, commitment, time and perseverance. Those are all behaviors that need to be rewarded or modified. If you had to pick one, what has kept you from reaching your financial goals? We often talk about birthday risk with our clients. We can't control where interest rates or stock prices will be when we turn 65. You can control how much you save, spend and what you risk you take on your nest egg.

When you're 15 you want to be 18, when you're 18 you want to be 21, when you're 21 you want to be 25, and when you're 25 you want to stay 25. Unfortunately, it doesn't work that way. Time doesn't wait for us. We are all a quarter century older than we were in 1990 and we're 25 years closer to retirement. If you haven't planned for the future, what are you waiting for?

 

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The Market’s Response to The Fed was Golden

Hoy GrimmInvestors that were battered and bruised by the euro-dollar currency war landed some heavy counter punches after the Fed meeting ended on Wednesday.

 

Janet Yellen faced reports after wrapping up the two-day March Federal Reserve Open Market Committee meeting. As was widely expected, The Fed eliminated the phrase “patient” from their descriptive language on when they will start raising US interest rates.

 

As she fielded questions, the big reaction was aroused by the Fed’s acknowledgement of a string of weak economic data (that some forecasters blamed on winter storms) that is tempering her rush to raise rates. Yellen pointed to the strong dollar as the culprit and explained that just because the Fed removed patient from their stance doesn’t mean they will be impatient.

 

 

The collapse in the dollar was immediate and dramatic:

 

usd-eur 3-18-15 post Fed

 

 

And had a knock on effect on commodities was equally intense (XOP, S&P Oil & Gas Expl & Production ETF):

 

xop 3-18-2015 post fed

 

And gold, (GDXJ, Market Vectors Jr Gold Miners ETF):

 

gld 3-18-2015 post fed

 

Why the huge reaction? The markets interpretation of Yellen’s economic warning is that QE did not make the US economy immune from the weakness sweeping across the rest of the globe. The speculation-driven dollar rally that heated up last August was based on the premise that our economy had enough velocity to pull ahead even if the rest of the world was going in reverse. It is becoming apparent that our economy can’t withstand a global slowdown after all.

In regards to the question about how far the dollar rally will last, we probably have our answer. The question that will be answered in the coming weeks is how fast speculators unwind the short euro/long dollar trade that is getting squeezed hard today.

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