Wednesday, February 5, 2014

Phew, glad that's over...

From the Desk of Joe Rollins

As is almost always the case with January, we saw massive volatility as portfolios were rebalanced; although this time it occurred in order to take advantage of the huge positive stock market we had in 2013. There is a lot of jockeying going on where fund managers sell their winning stocks and move to those with more potential. Since no one wants to create a taxable transaction in December, as it’s the last month of the year, this almost always occurs in January. It is fairly common to note that the large cap mutual funds in January lost money, but for the most part, mid and small cap funds fared much better.

However, there is no avoiding the issue that January was a rough month. For the month of January, the S&P Index of 500 stocks was down 3.5%. The Dow Jones Industrial Average and the NASDAQ Composite were down 5.2% and 1.7%, respectively. The Barclays Bond Index was up a surprising 1.6% for the month. Even though it was a down month for stocks, you cannot lose sight of the fact that for the one-year period ending January 31, 2014 the S&P is up 21.5% with the Dow up 16% and NASDAQ up 32.4%. Even with the dismal month of January, the 12-month returns are nothing short of extraordinary.

Several clients have told me they think the stock market is on a downward trend. When pressed for examples of why they think that to be true, they never seem to have any facts or data to back it up - it’s just a “gut feeling.” I prefer to evaluate financial markets based upon what I know, not what I feel. A “gut feeling” based upon conversations you’ve overheard or the “insight” you gain from biased media is almost always incorrect. Let’s review some facts and hopefully I can change some opinions.

Although it was not emphasized in the media, the economy grew at a surprising positive 3.2% for the fourth quarter of 2013. This coupled with the 2013 third quarter growth of 4.1% was pretty impressive given the seemingly sluggishness of the economy. This newsworthy growth seemed to have been overlooked due to so much negative news currently in the media about “Obamacare”, the Middle East, and crises elsewhere. People are finally realizing that emerging markets are not the best investments. Many of these markets are very thinly traded and can be manipulated by large swings of money being transferred in and out of these countries. We saw that during January where the volatility of the emerging markets was almost extraordinary in its nature. Clearly the best place to invest at the current time continues to be in the United States and a strengthening Europe.

I saw a survey the other day that indicated that most people thought the economy was on a downward spiral. There is virtually zero evidence to support that cause. GDP is strengthening and the unemployment rate has fallen precipitously over the last 12 months. Yes, you could argue that employment participation is at one of its lowest levels ever, but I am not convinced that it is to the same degree we saw in the past. With so many Americans currently on unemployment, Social Security disability, food stamps and any number of other government supported payments it is certainly no surprise to me that they are not looking for jobs. Numerous studies have indicated that as long as you are giving people government support, many will not actively seek employment. My sense is that this lack of participation in employment is due to the government’s handout programs which, in my opinion, do more harm than good.

I’ve also noticed there seems to be general confusion regarding profits. We are about halfway through the final quarter reporting for 2013 and the profits of large companies are averaging about 7.9% higher than last quarter. This occurrence is quite astonishing. Despite the media reports focusing on the lack of an increase in gross revenue, they fail to mention that net income is much higher. In fact, 67% of the companies have exceeded their sales projections. What increases stock prices is profitability, not gross sales! Corporate America has realized that growth in revenues will be meager, and therefore they have cut costs to improve their profits. Coming off of record-breaking third quarter profits, it looks like the fourth quarter of 2013 will be even higher.

Interestingly, the Federal Reserve announced in their January meeting that they would cut back on their bond purchases by another $10 billion. Thus far they have announced that they are tapering their purchases going forward by $20 billion per month. However do not be confused, they continue to make a mind boggling $55 billion in additional bond purchases every month. Under normal circumstances, this would be negative for bond prices. If the Federal Reserve is buying fewer bonds then someone else is going to have to pick up the slack. As I have projected in the past, when this happens interest rates most assuredly will go up and bond values down. Amazingly during January 2014, the 10-year Treasury note actually moved in the opposite direction - its yield went down and the bond values went up. How would one explain this contradiction of economic terms?

During January, we had some external political events that affected the way people viewed the economy and the world in general. In several countries, such as Turkey, Argentina, Venezuela, and other countries run by so-called democracies, there is a genuine shortage of U.S. dollars. In order to keep the currencies from completely imploding, these countries were forced to significantly increase their interest rates or devalue their currencies. With all of the problems we currently have in the States, isn’t it interesting that nearly everyone in the world currently wants to be in U.S. dollars. When this happens, the flood of money coming out of emerging markets creates instability in those countries due to the desire for people to hold U.S. dollars, rather than their local currency. This political upheaval forces investors in the United States to sell risk assets and buy non-risk assets, such as U.S. Treasury bills. Additionally, the perceived slowdown in China is creating an exodus of money out of Asia and back to the United States for investment purposes.

You must always separate the trends of traders from those of investors. Traders are interested in only the current event, not long-term investing. Because traders pay very little if any to trade, they are perfectly okay with swapping out stocks for treasury bonds on a daily basis. However, from an investment standpoint this positive trend in bonds will definitely not continue as the year progresses. I continue to stay with my projection that interest rates will rise over the course of the year and bond values will decline. While certainly some bond programs such as high-yield and U.S. corporate bonds are fine, the ultra-safe U.S. treasuries will most likely lose money in 2014.

One of the largest factors continuing to drive stock prices is the fact that there are really few other investment alternatives. With money market accounts paying virtually zero and CDs having a negative real rate of return over a five year period, people are being forced to seek higher yields in stocks. As I have often told people, it is kind of silly to invest in a five-year CD earning 1.5% when you can buy very conservative stock, such as Southern Company yielding 4.5%. In fact, virtually all the big tech stocks, such as Cisco, IBM, Microsoft, Apple, etc. provide a higher yield than a five-year treasury bond.

In summary, while January was a negative month and I’m glad it’s over, I am not particularly concerned. I still think the year 2014 will result in returns much like I described in my blog of January 14th. I think once investors realize that the political implications of China’s slowing and emerging market volatility is being controlled by those particular countries, they will focus once again on investing and the trend will be up. As long as corporate profits continue to be good, alternatives for investment low and the economy improving, stock prices will be higher at the end of the year than they are today.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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