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Panic Buying Precedes Panic Selling

hoyAs summer draws to a close and the calendar turns to fall investors are contemplating how 2013 will finish. Using corporate earnings as a clue raises questions about the sustainability of the stock rally. The May announcement from the Federal Reserve regarding tapering their financial stimulus blistered bond investors over the summer. Second quarter earnings were up modestly from a year ago but excluding financial stocks (who are the primary beneficiaries of Fed stimulus) earnings were down from last year. Evidence is mounting that the Affordable Care Act (aka Obamacare) is pushing employers to shed jobs, cut hours and healthcare benefits.

China and their emerging markets counterparts are still trying to grow in a no-growth global economy but it is getting harder and harder to sustain. Since the recession ended in 2009 our economy has created about 6 million jobs domestically. China graduated 7 million from universities this summer alone. Their economy is one fourth the size of the US economy yet they have to create as many jobs each year as we have in 4 years.

With so many reasons to be concerned about stocks, bonds, commodities and every other asset class, I would expect investors to be exercising caution. Instead I have observed a number of instances where investors are willing, if not eager to throw caution to the wind and buy into the stock rally (whose duration now longer than the average rally). It appears that investors are acting on the notion that stocks are the only asset class to be in. As we have shared before, Warren Buffett has encapsulated his successful investment philosophy as, “Be greedy when others are fearful and fearful when others are greedy.” At present, the inverse of this thinking appears to be driving investor behavior.

Calling market tops is useless conjecture. Observing historical precedents and applying empirical rigor to your investment process is prudent asset management. To employ Buffett’s aphorism, investors need to learn how to sell when everyone else is buying, wait patiently and buy when everyone else is selling. Emotionally this is easy to say but very difficult to practice. I summarized our portfolio rebalancing actions to a new client last month by observing, “This is what selling high feels like.”


Back to School Time Already?

hoyCommon stocks should be simple investment instruments. A share of stock represents ownership of a business. If that business makes more money (bottom line profits or earnings per share) eventually the stock should increase in price. If the business can’t grow its profits, eventually the value of the company will reflect this fact and decline.

Large public companies like those on the Standard and Poor’s 500 Index employ accounting loopholes that add complexity to the earnings analysis process. After they sell their product and generate revenue their cash flow can be diverted and accounted for through a labyrinth of rules and regulations that provide the company with ample opportunity to obfuscate the trends in their underlying business. Google, Apple and other large companies keep much of their overseas profits in foreign accounts to avoid paying U.S. corporate income taxes. In July some of the biggest banks in the country announced profits that exceeded estimates only to acknowledge that the only way the beat expectations was to recapture profits that they earned in previous years through legal (but liberal) accounting rules.

None of this is new and investment analysts have learned how to grapple with these vagaries. Investors do have a new mystery to unravel and the stakes are higher than ever.

In an unprecedented move the Federal Reserve has added 85 billion dollars of artificial stimulus to the economy every month since December 2012. To put this 680 billion dollar stimulus into perspective it’s helpful to understand that the annual profits of the top 10 Fortune 500 companies are only $176 billion combined.

It would be laudable if this stimulus helped create jobs, higher wages or pay down debts, but all it has succeeded in doing is temporarily inflate stock prices and allow every major corporation to lower their borrowing cost through historically low interest rates.

Stock investors know that this massive stimulus is responsible for pushing stock prices up and even Bernanke has been transparent about this fact. Stock prices become less transparent when you begin to subtract this from their valuations. What will interest rates do? What are stocks worth without the heavy hand of the Fed intervening on Wall Street’s behalf?

Bonds and stocks dropped from May to June on the unexpected news that the Federal Reserve would begin to reduce the stimulus later this year. The market reaction to the thought of life without Quantitative Easing is telling. Coupled with a growing list of statics depicting broad based weakness in the economy, we interpret the tapering of the Fed stimulus as a “sell on the rumor, buy on the news” stock event.


August 2013 Market Commentary

Markets slip as risks return

August was a difficult month for financial markets across the board. The Dow Jones Industrial Average fell 4.11 percent—performing worst of the major U.S. indices—while the S&P 500 Index declined 2.90 percent. The Nasdaq did best, losing 1.01 percent.

Losses were driven by a mixture of external risks and internal market factors. External risks included turmoil in Egypt, which potentially threatened the Suez Canal; a higher probability of U.S. intervention in the Syrian civil war; and interest rate volatility caused by the possible Federal Reserve (Fed) “taper” of bond market support. Completion of the corporate earnings season, with a slowing growth rate for both the revenues and earnings of U.S. businesses, also depressed market sentiment.

Besides the fundamental picture, the change in investors’ appetite for risk was apparent in the technicals. The S&P 500 dropped through its 50-day moving average mid-month and, after a brief rally, continued to decline. This was not definitive—the S&P 500 also spent time below the 50-day average in late June and early July before recovering—but it was a sign of weakness (see chart). If prices continue to decline, the technical weakness could become more pronounced. Interest rate-sensitive sectors, such as consumer staples, telecommunications, and utilities, were the worst laggards, while the previously embattled materials and technology sectors held up reasonably well.

The S&P 500 Index broke below its 50-day moving average and is
near its 100-day moving average.







Source: Bloomberg

International markets were mixed but generally stronger than U.S. markets. Developed international markets, represented by the MSCI EAFE Index, lost 1.32 percent, while the MSCI Emerging Markets Index also did better than U.S. markets but still gave up 1.90 percent.

Fixed income markets outperformed equity markets, although they could not escape the effects of rising interest rates. The benchmark 10-year Treasury bond yield rose over the month, from 2.58 percent to 2.78 percent, driving losses in the fixed income indices. The Barclays Capital Aggregate Bond Index was down 0.51 percent for the month. Performance was worst for international and, particularly, emerging market bonds, which suffered a 2.89-percent loss, according to the JPMorgan EMBI Global Core Index, as investors repatriated assets into U.S. dollars. Bank loans and short-duration bonds performed relatively well because of their lower correlation to changes in interest rates, but investors still saw a small decline in these asset classes.


Earnings growth above expectations but still modest

At the end of earnings season, according to FactSet, earnings growth came in at 2.1 percent, which was above the 0.6 percent that analysts had predicted. More than half of companies beat revenue estimates, while almost three-quarters beat consensus earnings-per-share estimates. This was good news. Even so, both results were below average compared with the past four years, and overall earnings growth results for the quarter were the third lowest in four years, also according to FactSet.

Much of the earnings results were dependent on the strong performance of the financial sector; excluding financials, aggregate earnings actually declined 3 percent. This broad weakness may continue, given that 85 of the S&P 500 companies have issued negative guidance for the third quarter—only 19 companies have issued positive guidance.

The declining growth rate and discouraging trends in forward guidance combined to make investors more cautious, as demonstrated by the broad-based declines in stock prices. Although equity prices were still at historically high levels, the declines from their peaks suggested that investors were moderating their expectations. Volatility, also an indicator of investor risk appetite, increased in August, with the CBOE Volatility Index(a.k.a., the VIX Index or the “fear index”) rising from 13.5 to 17, an increase of more than 25 percent.

Political risks trump economic risks in August

Although the slowing growth rate for corporate earnings was certainly a factor in the market declines, political risks dominated the headlines. Investors began to debate in earnest whether the Fed would start to taper or reduce the volume of its bond purchases in September. According to a Bloomberg poll taken in mid-August, 65 percent of the economists surveyed expected at least a small reduction in monthly purchases, with the median respondent predicting that purchases would fall from $85 billion to $75 billion per month. If tapering does occur, this would likely continue to put pressure on certain asset classes, particularly emerging market bonds and equities. If the Fed decides not to taper, these assets could experience a significant rally.

Though the likelihood of tapering on the part of the Fed appeared to increase in August, speculation regarding that possibility was overshadowed by uncertainty over who would succeed Ben Bernanke as Fed chairman. The campaign between supporters of Larry Summers and Janet Yellen brought into relief the potential for unexpected changes in Fed policy.

Another concern is the pending debate in Congress over securing funding for the new fiscal year and raising the debt ceiling. In late August, the U.S. Department of the Treasury announced that it would run out of maneuvering room on the debt before the end of October. Investors remember the 2011 debt ceiling debate, which led to a significant market correction, so they will likely watch events in Washington closely.

Finally, the very real potential for U.S. involvement in Syria also acted to unsettle markets. The use of chemical weapons in Syria sparked heightened rhetoric about the possibility of U.S. and allied military intervention. The price of internationally traded Brent Crude oil spiked from $108 per barrel at the beginning of August to $114 at month-end. U.S. stock markets were also affected. The Dow fell 170 points as Vice President Biden announced he had no doubt that Syria had used chemical weapons, and speculation increased that an intervention would occur.

The real economy continues its recovery

Despite the political risks, the real economy continued its slow recovery. Housing slowed, driven by an increase in rates. According to the Wall Street Journal, 30-year mortgage rates have risen from 3.7 percent at the beginning of the year to 4.6 percent at the end of July. Though the rise in rates was largely sparked by Fed Chairman Ben Bernanke’s comments back in May, the data has only recently suggested that his words have had an appreciable effect on housing demand. Notably, the volume of new home sales fell more than 13 percent in July. At this point, however, the slowdown in housing appears to be a healthy adjustment, as values continue to increase and sales remain strong.

Even with the headwinds in the housing market, however, unemployment claims remain low and consumer confidence is still strong. Leading indicators ticked up during August, and growth for the second quarter was revised upward to 2.5 percent—a result of much stronger-than-expected exports, apparently driven by economic improvements elsewhere in the world.

This is a healthy reality check

The increase in interest rates and declines in stock prices reflect the renewed realization by investors that there are significant political and economic risks going forward. This realization is actually constructive, as it has introduced an element of caution and helped keep valuations real. The ongoing recovery in the real economy, although moderating as housing slows, also seems well supported.

The rise in rates and decrease in earnings growth also represents, in many ways, a normalization of the markets and the economy. As the Fed starts to exit, and as companies increasingly compete based on a normally growing economy, we can expect some volatility; however, once the transition has been made, the economy should be better placed to grow in the future. For now, it makes sense for investors to maintain their long-term perspective, knowing that, despite potential short-term volatility, the overall long-term trend is favorable.


Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The JPMorgan EMBI Global Core Index is a subset of the broader JPMorgan EMBI Global Index and measures the performance of most liquid USD-denominated emerging market sovereign or quasi-sovereign bonds. The EMBI Global Core Index includes fixed, floating-rate, and capitalizing bonds with a minimum outstanding of $1 billion USD and a minimum remaining maturity of 2.5 years. Eligible countries are those classed by the World Bank as having low or medium per capita income for 2 consecutive years, or countries that have restructured their external debt over the last decade.The CBOE Volatility Index (VIX) is a market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes. VIX uses near-term and next-term out-of-the money SPX options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network®


Summertime and the Livin’ is Easy!

kevin-painterThe markets cheered the June jobs report on July 5th as the economy created 195,000 jobs and revised previous month’s numbers upward. As I wrote in our column in May, the economy is slowly creating jobs, but at this rate will take until March 2022 to get back to pre-recession levels.  To further compound this problem, temporary positions (those without benefits and insurance) have accounted for more jobs than any other sector since the Recession began.

According the Associated Press, 2.7 million temp jobs have been created in the past four years. Out of the 6.2 million job total since 2008, temp positions have accounted for 41%!  It’s not surprising then that the majority of jobs created are lower wage positions compared to the pre-recession levels. This chart from www.nelp.org shows the wage disparity in recent job creation:

The majority of jobs lost in the recession were middle class jobs.  Since the recovery began, less than 30% of those jobs have been replaced.  However, more lower wage jobs have been created than were lost in the past four years. People want to work and are willing to accept lower pay to have a job. In addition to these lower wages, workers also face the 2% payroll tax that came back in 2013. Further, the Department of Defense began their furlough program this week, reducing wages by 20% for 650,000 workers over the next three months.  For a worker making $50,000, this eleven week reduction in hours worked, results in 4.2% of their salary, or $2,115.

Finally, in that same April blog post I referenced Regal Cinemas and other companies reducing worker hours to avoid upcoming penalties surrounding the upcoming Obamacare law changes. According to the UC Berkeley Labor Center, 2.3 million workers face reduced hours due to the health care law later this year. Those workers coupled with the 650,000 Department of Defense workers, total almost 3 million workers that presumably have benefits.

Job growth is anemic, the majority of jobs we are creating aren’t permanent, are paying less than they were five years ago, and we can look to reduce hours for up to 3 million workers. The equity markets continue to rally on assumptions that the Fed will continue its quantitative easing program. But what happens to equity prices when the data show a different reality when it comes to the labor market?


Maintaining Your Investing Discipline (When Others Aren’t)


The June swoon is upon us. In late May the Federal Reserve warned investors that they would begin to unwind the financial stimulus that they have added over the past five years at the end of 2013. Amid a new European recession, Chinese growth stagnation, suspect employment trends domestically and flat corporate earnings, investors view the quantitative easing measures by the Fed as a necessity for higher prices.

Against this backdrop, the Fed’s unwind announcement was equivalent to yelling “fire” in a crowded theater. Investors panicked at the thought of life without artificially inflated prices. As the panic spread Interest rates increased at a historically unprecedented pace, gold lost more than 20 percent and the stock market dropped close to 10 percent. As you check your accounts online or wait for the mail to come, you’ll feel it this month.

Even the most disciplined investment approach won’t completely insulate you from widespread market disruption like we have seen recently. Operating from a clearly defined investment process, though, should give you the opportunity to take advantage of other investors’ lack of discipline. Our investment process begins with a thorough analysis of the steady stream of economic and financial indicators. This analysis led us to reallocate our bond holdings from long maturity bonds to shorter maturity and adjustable rate bonds this spring. We also pared our exposure to stocks as earnings and profit margins came under pressure. In late June we reallocated money into some bond sectors that were down more than 10 percent. We remain very cautious on stocks until we see better news on earnings and profit margins.

We share our investment techniques in this column to help you define your own process. Our previous columns addressed many of the issues that investors panicked about in June. Being early isn’t fun or easy. You will second guess yourself, and, worse still, have to endure the talking heads on television telling you how wrong you are until you are proven right. At that point, you get the pleasure of using your discipline to make money from investors who lack it.

Panic is the moment disciplined investors wait for. Warren Buffet has become an investing legend this way. At the end of March his company had amassed more than $44 billion dollars in cash and his insurance (the majority of Berkshire Hathaway’s assets) subsidiary’s investment portfolio was 57 percent stock and 43 percent bonds and cash. It is safe to say that Warren was waiting for a day when prices were lower before he put that cash to work.


July 2013 Q2 Market Commentary

As the Federal Reserve considers its exit . . .

The key news events for June were the Federal Reserve (Fed) meeting and news conference, where Fed Chairman Ben Bernanke announced that he believed the real economy was improving. He also stated that members of the Fed Board of Governors had begun to consider the circumstances under which it would slow the pace of the central bank’s bond purchasing program.

Markets interpreted this as an announcement that the Fed would be no longer be supporting the economy, and they reacted accordingly. Interest rates rose, and stock prices fell. Subsequent announcements that a reduction in stimulus would not occur in the near-term were reassuring to investors. Both interest rates and markets recovered, though rates remained higher and markets lower by month-end.

The downward adjustment and subsequent partial recovery may reflect a growing understanding that the real economy is normalizing and that interest rate policies must do so as well. At the same time, the gradual withdrawal of the Fed from fixed income markets may require further pricing adjustments as overall demand drops.

. . . Volatility returns to markets . . .

The volatility that started in May continued in June. Equity markets ended the month down across the board, with the Dow Jones Industrial Average losing 1.25 percent, the S&P 500 Index losing 1.34 percent, and the Nasdaq losing 1.52 percent. Volatility persisted throughout the month, with multiple moves of more than 1 percent, both up and down. Price movements were particularly high at the end of the month, with a more than 5-percent drop in five days followed by an almost 3-percent recovery.

Even as stock prices have fluctuated recently, investors should feel good about returns this year. This has been the strongest first half for U.S. equity markets since 1998, with the S&P 500 returning 13.82 percent. In the second quarter, it rose 2.91 percent.

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