Monday, August 24, 2015

“Do not try to buy at the bottom and sell at the top. It cannot be done - except by liars.” -The great speculator, Bernard Baruch

From the Desk of Joe Rollins

Anytime you have a stock market like we had last week, you start to question yourself. The S&P unexpectedly lost 5.7% and is now down 3.1% for the year through Friday, August 21st. Most of the damage was done on only two trading days, Thursday and Friday, when the markets fell roughly 5%. At the current time, the Dow Jones Industrial Average now sits in correction territory having lost 10% from its all-time high. While the S&P and the NASDAQ are just shy of a 10% correction, it seems a lot worse since the losses all occurred in one calendar week.

It is very important when the market sells off like this to evaluate why the market was so volatile on the downside, and maybe what course of action you should do in the future from the upside. There is no question we are closely evaluating the daily volatility and reevaluating what steps we should make. However, this particular selloff seems to defy most any type of logic, and certainly the economic numbers do not support it. I thought I would give you a mid-month update and just see whether you agree if the numbers are realistic or not.

It is important to understand that a 10% correction in the market is not particularly unusual. As we often quote in these postings, you can expect a 10% movement in the market virtually at any time. It has been unusually calm for the last four years and we really have not had a movement that large. We came very close in October 2014, when the S&P bounced up against the 10%, but did not close below that level. Even though we are not at that level yet, for anyone to assume that a movement such as this is rare or unusual is just misinformed. Markets move sometimes for no particular reason. However, it looks like the reason for this movement centers principally on the Chinese economy, and certainly not based upon U.S. economics.

Stock markets tend to fall into major down cycles when the economy is moving towards a recession. There certainly is no evidence that any recession in the United States is anywhere close. The second read on the GDP for the second quarter was at 2.3%. It is generally believed that the final read on the GDP will increase the GDP in the second quarter to above 3%. The current projection for the third quarter GDP also is greater than 3%. Clearly, there is no reason to assume the U.S. economy is anywhere close to falling into a recession.

Contrary to the tragedy in the European markets last week, the European economy continues to improve. Manufacturing in Europe is better and improving. While Japan is certainly not gangbusters, it is also certainly not currently in a recession. While the slowdown in China is troublesome, their last read on the GDP was 7% and there are few who believe it will fall into a recession anytime soon. It must be remembered that the Chinese government has strong control over their economy, and they have shown a desire and willingness to support the economy and hold a higher level of growth. I would fully expect that they will continue to do so this time if a true slowdown occurs.

While I guess what is particularly baffling to me is that when China devalued their currency two weeks ago its sole purpose was to stimulate exports, which is very good for the U.S. economy. Basically that means the goods we buy from China will be cheaper in the future. We actually export very little into China. It is believed that exports to China amount to less than 1% of the GDP for the United States, UK, France, Italy and Spain; Germany exports 2.6% to China; and 2.7% for Japan. None of these numbers are extraordinarily high, and certainly the Chinese economy is not going to zero. Assuming that there is a decline of 25% in exports to China, the effect on the GDP in the United States would only be one quarter of 1% - almost insignificant.

Interestingly, economic numbers of the United States were particularly robust with residential existing house sales expanding at one of the fastest rate ever to its pre-2007 level. New housing starts are up over 10% for the year-over-year numbers and nonresidential spending is up a robust 15%. The unemployment rate is 5.3% and the number of unemployed has fallen 15% year-over-year. Yes, if you are confused by the very upbeat economic news in the United States and the stock market performance that lost over 5% in one week, you would not be the only one.

To even further confuse the issue, large U.S. bank stocks fell close to 10% last week in trading. That is very difficult to reconcile given the strong economic numbers - and clearly they have zero exposure to China. Yes, you could understand the decline in oil related stocks, but now with Royal Dutch Shell and BP yielding 7% on their dividends, you would have to think even that is overblown. So we have to sit back and decide whether there is economic support for continuing to invest in the stock market or moving aside.

At the current time, the Standard & Poor’s index of 500 stocks is selling at a reasonable 16.7 times earnings for 2015. The current dividend yield is 2.2%, which is higher than the 10-year Treasury bond. Therefore stocks, even in this broad-based index, would appear to be a much better investment than bonds.

The numbers are even more pronounced in the Dow Jones Industrial Average, which sells at a 15.9 times earnings and has a dividend yield of 2.6%. The Euro Stoxx 50, which is the 50 largest companies within the Euro countries, is selling at an extraordinarily low 13.9 times earnings with a 3.8% dividend yield. Even the extraordinarily beat up Shanghai composite is valued at a modest 14.4 times earnings with a 1.8% dividend yield.

There was a lot of commentary this week about the decline in Apple stock. Interestingly, this company fell 6% on Friday alone. It was argued that investors were concerned about Apple selling iPhones into China. While it is true that China is its second-largest market after the United States, what was not pointed out was that Apple buys virtually every iPhone they sell from China, which would be cheaper with their currency devalued. Just on a financial ratio basis alone, Apple sells at 9 times earnings if you reduce its value by its $150 billion in cash. There has hardly been a company that grows at a 30% annual basis net of its cash sell for such a low multiple.

I have closely reviewed all the data and information from the weekend press. At the current time, I see no change warranted in our long-term investment philosophy. Market movements such as this are not rare or terribly unusual. However, we will continue to evaluate the situation and see if by chance we have misread the economic data or we clearly do not comprehend its importance, although I see nothing at the current time to warrant any type of prolonged selloff.

It seems to me that a good deal of this selloff has to do with financial engineering and not economics. Since there is clearly not an economic event, it must be something other than the economy. In 2007 and 2008, there was clearly an economic event. People seem to forget that the GDP in 2008 a negative 6.5%. We are anticipating a positive 3% GDP growth at the current time, so clearly that is not the cause.

Sometimes you wake up with a conspiracy theory that all the market momentum people crowded into the same trade. Oil is a good example of that phenomenon. Currently, oil is selling at less than $40 a barrel, even though that is less than the cost to extract it from the ground. This is in spite of massive cutbacks on the number of rigs drilling oil and the budgets to exploit that oil. Nothing at this point indicates that the price of oil should be in the $30’s per barrel, yet that is where it is trading at today. You may rest assured that the oil companies would not agree that $30 is a fair price.

I guess we will not know whether this is financial engineering until the market turns around. If, as I suspect, everyone is short to market you will see a massive short-cover rally soon, and the market will go up as quickly as it went down. Both of these are financial and not economic, and the move up would be equally as meaningless as the move down has been.

While the markets may not jump back this week, the markets will definitely do so at some point soon since it clearly cannot be a long-term down market when economic statistics continue to be extraordinarily robust and positive as they are now.

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

Best Regards,
Rollins Financial, Inc.

Tuesday, August 11, 2015

Why Are You In Such A Bad Mood?

From the Desk of Joe Rollins

I am a little overwhelmed by the high degree of skepticism that you read today in the financial markets. When I logged onto Yahoo the other morning and read the endless list of meaningless reports on various things from entertainment to the economy, I could not believe that six of the lead articles proclaimed that the stock market was ready for a huge tumble. They gave all kinds of different examples of why the market would fall, but principally the only reason the editorials could give is the fact that the market has been up for six straight years. They did not quote any economics, nor did they give us any additional news on which to base an educated opinion, it was just a gut feeling that the editors wanted to express.

I see the same sort of skepticism among a few of my clients. Almost every day, I receive some sort of comment about, “Do I think the market is overvalued at the current time?” I think my blogs for the last six years have expressed my opinion and evaluation; certainly, this month they are no different.

In preparing for this posting, I went back and reviewed my blog from July titled “Greek Tragedy 2015, Again?”. I am amazed that the issues that I previously discussed have come and gone. At that time, we were all concerned about the implosion of Greece. Here we are one month later, and there is really no change. Greece has done virtually nothing to solve its economic problems except increase taxes. Of course increasing taxes slows the economy, which will put them into another recession, meaning they will not be able to pay bills in the future. Absolutely nothing has changed, yet one month later, you rarely hear anything about Greece.

Certainly, we have the issue of The Iran Accord, but honestly any accord we have with Iran will be ignored and their ability to flood the world with new oil resources is almost illusionary. Iran does not have the capital to exploit oil without the help of the West. Now realistically, who believes a country in the West would invest money in Iran, given their political ideology against the United States. While certainly Russia would invest money to exploit Iranian assets, they would only do so if oil were anywhere close to a reasonable price. Since Russia borders on bankruptcy itself, it is not likely even they will get involved. While the world is so fixated on Iran flooding the oil markets, this is based solely on a world of misinformation.

I discussed in early July that the stock markets were actually very stable, and would likely continue to trend upward. Amazingly, at the time I wrote that article the market was down significantly due to the situation in Greece. However, as I correctly predicted the market was up nicely during the month of July, even in the face of huge headwinds.

A 30-year client turns 95!

My staff celebrating with the birthday girl.

The Standard & Poor’s index of 500 stocks was up 2.1% for the month of July and continues to be up 11.2% for the one-year period ended July 31, 2015. The NASDAQ composite was up 2.9% for July and is up 18.7% for the one-year period there ended. The Dow Jones industrial average was up 0.5% for the month of July and is up 9.3% for the one-year period there ended. In contrast, the Barclays aggregate bond index was up 0.9% for the month of July and is up a less than sterling 2.9% for the one-year period ended July 31, 2015.

Virtually every week we speak with an investor that sold out of the market for 2008 and as of this date has not reinvested. It is not that they invested in bonds when they sold out; they have just been sitting in cash for close to seven years. That would not be a bad deal if cash were earning anything, but as we all know, cash is earning virtually zero.

I just wanted to give you one illustration of how flawed trying to time the stock market is based upon numbers as we see today. We all know that the S&P 500 index was down 37% in 2008. We also know the market rebounded after that point to have six excellent investment years. In fact, the S&P 500 index has averaged 7.7% for the last 10 years, which includes 2008! If the average investor had done nothing during 2008, they still would have had averaged 7.7% in the intervening 10 years – how could you incur such a huge loss in one year but yet average a rate greater than 3.5 times the rate of inflation? It seems that most investors only show any interest in the markets when it is down and tend to ignore it when it is up. Over the last 10 years, we have had substantially more up markets than down markets.

In comparison, the Barclays Aggregate Bond Index, which is considered safe, has returned 4.3% over the same 10-year time period. So if you had been invested in stocks, even with the huge downdraft, you still would have made 7.7%, but conversely if you had been invested in so-called safe investments, such as bonds, you would have returned 4.3%. If you compare these numbers and can make any rational evaluation, you would see that investing in stocks has been more profitable than investing in bonds, even during this time of high volatility.

Returning to my rant on investor pessimism, I am encouraged that investor sentiment is so bad. As an example, the AAII Investor Sentiment Survey reached a low of 26%, which is extreme given that the long-term average is 39%. That level has only been seen twice since 1995 - early 2003 and early 2009. Both of those time periods were followed with very significant gains in the market. In addition, there is a high level of pessimism among investors, since Merrill Lynch now reports that 5.5% of all of their portfolios of asset managers are in cash. That is a significantly high percentage placed in an asset that earns virtually zero. You see ultimate pessimism everywhere around you, yet no one gives you a specific reason why they are so negative. Maybe I can give you some reasons to be optimistic.

Recently, we received the first estimate on GDP growth for the second quarter, which is at 2.3%. In addition, they revised the first quarter from a negative number to a positive 0.6%. While certainly neither number is a barn-burner on its own, it is clear the trend is positive not negative. I do not expect to see a runaway increase in GDP for the next few years, but how anyone could interpret these numbers as being recessionary is just trying to stir the pot.

Okay, let us assume you are the ultimate cynic and you really do not believe economic data or anything else that the government publishes. You are so negative that the assumption by you is that the entire world is lying about the economy and how could it be good given all the bad you see around you. I certainly encourage your curiosity; however, it is very clear you are not familiar with your surroundings.

You do not need to be an economist to count the construction cranes as you drive down Peachtree Road in Atlanta. Also, have you ever considered that all of the apartments being built in Atlanta are being built for a reason? Companies would not be building huge apartment complexes if people were not moving here to take jobs. If you think your eyes are lying to you, just try to find a contractor to do anything today. I am pretty much like the old Murphy Brown television series in that I have had the same painter for well over 20 years. There are many who probably think Reggie lives with me, while in reality I actually pay him for his presence. The other day I asked him why it has been so difficult to find a contractor in the last six months. In Reggie’s famous way, he explained everything you need to know about the economy by saying, “Mr. Joe, there is a damn lot of work out there right now.”

The economic numbers are also supported by the government’s statistics. There are 2.4 million additional employed workers in the United States for the one-year period ended July 31st. That is a huge number of people creating commerce. Each person creates their own GDP, along with creating additional jobs for people that work in the companies in which they shop. It creates a better livelihood for them and their families, and therefore a stronger economy. Do you really want to know about construction contracts, which are now up 11% year-over-year? And do you think the housing is about to start back? New housing starts are up 26% year-over-year and house permits are up 30% year-over-year. Everywhere you look, houses in my part of town are being torn down to build newer, bigger and nicer homes. There is absolutely, unequivocally no question, the economy is on the upswing and anyone who tells you otherwise is doing so to mislead you.

Along with everyone else, I project that the Federal Reserve will increase interest rates a quarter of a point in September. Really, how much time are we going to spend in discussing interest rates going from 0 to 0.25%? The rates are still at historic lows, and this minor adjustment affects virtually no one in the economy. Please do not even spend a minute thinking about this scenario when it comes to investing. While certainly the economy affects stock prices, it really only does so when the economy is negative. There is certainly no evidence to indicate a negative economy anywhere around.

One of the new worries that seem to be impacting the investment community is the gigantic selloff in commodities, including oil. There seems to be a misconceived correlation between the price of oil going down and a suffering economy. There is no empirical evidence to support that assumption; however, a lot of momentum traders do not need a reason, they just trade and think later.

For the last several months, I have studied the oil market in detail. I am of the impression today that the price of oil is impacted less by normal supply and demand, and more by institutional buyers dealing in hedges, futures and short-selling. The selloff in energy stocks is borderline ridiculous. When you have Chevron yielding 5%, Royal Dutch Shell 6.4%, and BP 6.7% as compared with the S&P 500 yield of 2%, you can see the selling has been exaggerated. In addition, we are seeing a selloff not only of crude oil, but also copper, gold, and virtually anything else commodity-based.

One of the questions I receive on a weekly basis is why we do not invest in gold. As mentioned here often, I cannot evaluate gold since it has no yield, is not scarce, and it has absolutely no value in an inflationary economy. All of those are personal opinions, but the fact is that the ETF of GLD (Gold), which has assets of $23 billion, is down 42% from its 2011 peak. So yes, I am negative on gold and I have a right to be negative, given its terrible performance. Yet I still see many investors that have 100% of their assets in gold for reasons even they cannot explain.

One of the interesting evaluations today is that it is presumed by some investors that because the Chinese stock market is down significantly from its high, this must imply the Chinese economy is also sliding into a recession. How they make that correlation based upon any type of empirical evidence is a mystery to me. It is assumed that the average investor in China owns a large portion of his net worth in Chinese stocks. However, the Chinese research firm PCR Macro estimates that less than five percent of household savings in China are invested in the stock market – basically, blowing the theory that the economy is impacted by stock market performance.

In addition, the slowdown in their economy would have little or no effect on the U.S. economy. It is now assumed that if the U.S. exports to China fell to half, the effect would only be a 0.25% decrease in the U.S. GDP. Therefore, the assumption that the slowdown in the Chinese economy is reflected in the stock market or in an actual slowdown itself is completely false.

Based upon my analysis of oil and oil futures, there is a gigantic effect on price by the financial markets, not by supply and demand characteristics. While oil is certainly plentiful today, there is a shortage coming and that is clearly reflected in the cutting of exploration budgets by the large oil companies. Additionally, the oil rig count is down dramatically and therefore less oil is in our future. While certainly today the production levels are the same, you do not have to be a mathematical wizard to realize those numbers will drop off as oil rigs are idle and new exploration budgets are nonexistent. The most basic form of economic analysis is supply and demand. There is no question that supply constraints are coming; it is just a matter of whether it is three months, six months, or a year away. With the low price of oil, eventually that lack of supply will force it higher. Based on the numbers I continue to read, fair price on oil is roughly $70 per barrel at the current time. I would not be shocked or surprised to see oil return to that before the summer of 2016. And if that is the case, why do the commodity markets continue to sell off?

Once again, I refer to those traders that make their living pushing any point beyond its normal rational economic explanation. In this particular case, it has been a winning trade to sell short any commodity, any stock, or any asset that ultimately could be a commodity. Until those guys have exhausted the downward pressure on the market, you should not expect to see normalized commodity levels. Additionally, they will buy as quickly as they sold – and for no good reason.

As the second quarter earnings come to a close, it has been quite a satisfactory earning period. A lot of negative forecasters give a lot of credence to the fact that while earnings have been superior (except in the oil industry), revenues have been down. A major effect on reduced revenues is the strength of the dollar and the affect that foreign exchanges have on major multinational companies. Believe me, this is a temporary situation since the dollar cannot continue to accelerate against foreign currencies for much longer. At some point, when the dollar becomes anti-competitive for U.S. companies, then the effect of conversion to lower dollar will be the primary influence of the Federal Reserve. However, if you are taking into effect your lack of revenue based upon an occurrence that only happens in the short term, then you are not properly evaluating earnings going forward. I think that is the mistake many analysts are making, yet they need an excuse to downgrade stocks and this is a handy one.

In summary, there is really no change in my evaluation over the last 30 days. Earnings continue to be superior, both year over year and from quarter to quarter. If you excluded the major oil companies from the most recent quarter, it appears the earnings are 4% higher than they were this time last year, which were also record earnings. Therefore, the three criteria that contribute to higher stock prices all are positive. Interest rates are low and will continue to be low even when the Federal Reserve increases them in September. The economy is okay, not great, but there is certainly no recession in sight. Most importantly, earnings continue to be quite excellent and continue to grow. There is absolutely no economic or empirical evidence that anything should affect stock prices over the short term, and therefore no action is needed on our part.

With bonds almost assuredly to lose money over the next six months, stocks continue to be the superior asset class of choice. Yes, you are going to see high volatility, but just like July, we saw high volatility but the market was higher. I anticipate that volatility will reach extreme levels between now and October or November. There is a very practical reason why this volatility is so dramatic during the summer. With fewer people working, the traders can affect the market greatly since there is low volume. Only when professional traders come back to the market in the fall will some form of stability be reached.

I read these articles virtually every day that comment on a particular month being good or bad for the stock market. I am amazed that people read that with any type of credence. Do not tell me what the month of the calendar is; tell me what the economic circumstances are in that particular month. While August and September are historically bad months for the market, rarely have we seen interest rates this low, earnings this high, and a stable economy as strong as it is right now. Therefore, I expect volatility but the market should continue to struggle higher as we move toward the end of the year. Given that no other financial asset offers us that opportunity for economic gain, we continue to be invested in equities, both in the U.S., Europe, and Asia. And as always, we will adjust accordingly as circumstances dictate.

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

Best Regards,
Rollins Financial, Inc.