Wednesday, September 9, 2015

Celebrate Full-Employment, but Separate the Facts from Fiction.

From the Desk of Joe Rollins

There is just no way to classify the month of August as anything but a real bummer. There is just about no way you can characterize it other than what it really was – a long awaited correction in the equity markets. At one point during August, the S&P 500 Index suffered a decline of 11.1%. Anything greater than a 10% correction is considered to be a very normal process in equity investing. Over time, typically these types of corrections occur about every 18 months. While it has been quite unusual, we have not suffered a correction in the U.S. since 2011, and therefore we have enjoyed basically a four-year period when no corrections occurred.

In this posting, I want to try to clarify some issues that seem to be confusing investors. First off, this type of correction is quite common in investing, even though that does not make it feel any better. I also want to remind readers of the long-term positive markets we have enjoyed since the debacle in 2008. Almost every day I am told by a reader that they have not forgotten the loss in 2008, and therefore they fear investing today (7 years later). Let us quickly review the gains that we have enjoyed since that time:

It is been a great run as a rebound from the 2008 loss of 37%. It still amazes me that so many investors quote the stock market of 2008 as the reason they had been uninvested completely since that time. As you can tell from above, the 2008 gains were quickly recovered, and the equity markets have gone on to much larger gains.

It is important to review the August numbers so that you have an understanding of how equity markets work. There appears to be absolutely no chance of recession in the United States any time soon, so the fear of a long-term bear market is just not in the cards. I want to cover some of these points in detail so that you can understand the real facts as compared to the fiction you hear in the financial news of the fear of an upcoming recession. However, unfortunately I have to cover the bad news first.

The Standard & Poor’s 500 Index suffered a decline of 6% during the month of August and is down 2.9% for the year. The NASDAQ Composite was down 6.8% for the month of August, but continues to be up 1.6% for the year. The Dow Jones Industrial Average was down 6.3% for the month of August and is down 5.8% year to date. Even the Barclays Aggregate Bond Index was down for the month at 0.3%, and for the year is up 0.3% or essentially breakeven.

I thought you might enjoy some “First Day of School” pictures of Ava.

Age 2

Age 3

Age 4

While all these numbers are significantly lower, in no way should you be hesitant to continue to invest. As mentioned in the headline, the unemployment report for August pointed out that the unemployment in the United States is now 5.1%. When I was in college learning basic economics, we were taught that the full employment level for the economy was 5%. We will almost assuredly reach that level in the coming months.

Even though the number of newly employed in August was low, that number is extraordinarily misunderstood. First off, what employer is going to hire new employees during the vacation month of August? Historically, it is a weak month, and due to seasonal adjustments, is not reliable as to the actual number of new employees. Going into a seasonally strong season for consumer spending, you may rest assured that the 5% unemployment level will be reached shortly.

With GDP growth revised up to 3.7% in the second quarter of 2015, almost assuredly the third quarter will be in the 3% range. The U.S. economy appears to be very strong with consumer spending up, housing starts accelerating and more people working than in many years. Why would we suffer through a market decline of 10%?

I argue that much of the decline in the equity markets relates to investors just not understanding everything they hear on the news. Maybe it is the old axiom you should read less and study more. As an example, I had one client give me all the reasons why the equity markets would go down, including worldwide debt, ISIS in the Middle East, Civil War in Syria and a long list of other macroeconomic concerns. When I asked her which of those concerns would be paramount in the next three or four years, she was readily agreeable that likely none would be. We invest for periods of time over months, quarters, and even years. However, if you invest for the ultimate end of the world as we know it, likely you would be making significant long-term investment mistakes.

Also, the data is sometimes extraordinarily misleading. I quoted in the last posting regarding the wild fluctuations in the price of oil. Even though the reduction in the price of oil is extraordinarily positive for most all consumers, a good deal of the investment world makes the assumption that the reduction of the price of oil is a negative financially because it reflects lower economic activity, and therefore an upcoming recession. Do not believe everything you read in the paper!

One of the things we always need to be concerned about is whether financial engineering is not affecting things that, in the past, we presumed to be market forces. Clearly, the price of oil is affected by supply. There is no question that the supply of oil in the United States is high, but inevitably, it is coming down dramatically. As an example, a year ago, there were 1,584 rigs drilling for oil in the United States. Today, there are only 864 working rigs. That means that over the last year, 720 rigs have been idle, almost 50% of the working rigs.

One of the interesting aspects of oil that has been drilled with a fracking technique is that those oil wells do not run long-term, and usually burn out within 7-10 years. The fact that we are not seeking new sources of oil indicate that soon the supply of oil will clearly be diminished and the price of oil will have to go up to adjust to the decreasing supply. Remember that the U.S. exports NO oil overseas. Therefore, oil production in the United States is clearly a U.S. only phenomenon, and this production is going to come down.

Why do we have the wild fluctuations in oil? At the end of August, crude oil prices jumped 10% on Thursday, August 27 and then another 5% on Friday, August 28. However, come Monday, August 31 the price jumped 8%, but lost 8% on Tuesday, September 1. If you look at those wild fluctuations of the price of oil, it is an unprecedented volatility. Energy market journalist John Kim calculates that a standard deviation jump of that size should happen just once in every 600 years. In fact, it happened in only five days of trading. This is not a natural reaction to basic supply and demand of energy.

What we are seeing is a wild fluctuation in financial contracts that are impacting the price of oil. These financial contracts are essentially betting on the price going up or going down. It has nothing to do whatsoever with the potential economic impact of a particular economy. Even though the price has stabilized, it would not surprise me to see it go back up or down, based upon the bets of these financial contracts. However, do not read into the price of oil upcoming economic chaos without understanding the huge economic benefits to the average consumer these lower prices project. Do not confuse financial engineering with true supply/demand concerns.

Also, much of this manipulation of equity markets was self-evident when one day the Dow Jones Industrial Average opened down 1,000 points in August. While certainly a scary day, you have to realize that a good deal of this decline was activated by stop-loss orders being executed automatically when certain points were reached in the downward market. Many investors try to protect their investments by basically stopping out the price when there is a dramatic movement. In most cases that leads to a stop-loss at very low prices and does nothing for long-term investing.

When you get a major move to the downside, so many of the automated systems sell out of the equities without any thought as to why the loss even occurred. If you are a long-term investor, like we are, that is a true negative since it stops you out of a position that may quickly rebound in the afternoon or later in the week. I am not trying to state that all selling is due to automated systems. I do want to emphasize though that these exaggerated moves are not done by long-term investors, but rather short-term speculators that try to time the market.

Here is another example of financial manipulation that you should ignore when investing. I had this real bad habit of staying up late and watching the Asian stock markets trade. I really should get more sleep. I normally setup to watch Bloomberg TV which has all the real time quotes from the Asian markets and watch the effect of the U.S. futures on my iPad. One day during August, the Chinese stock market opened down 4% and there was an immediate effect on U.S. futures. U.S. Dow futures went from positive 100 to negative 100 in a nanosecond.

With such a violent move in the futures, I knew at that point there must be some gigantic contract reflected in the futures. I quickly scanned the volume of U.S. futures on my iPad and noticed that the only change had been a contract sold for 1,000 units. It is hard to believe that one guy standing in a dark basement somewhere in the world sold 1,000 contracts against the U.S. market and literally wiped out $1 trillion of wealth. I am often confronted by clients that quote the futures and the effects they would have on the markets. As illustrated, if you believe everything you saw in the futures market, inevitably it will lead to a conclusion not based on facts.

Even though we can explain high volatility during the month of August, the most important point is what do we believe the equity markets will do for the rest of the year? There is almost no question that by using a normal valuation basis stocks will price to move up significantly before the end of the year. The biggest contributor to higher prices today is that there are virtually no alternatives for investing currently. It is not likely that the short-term investors dumped stocks to go to cash earning zero or bonds, which clearly will suffer headwinds and likely will lose money as we get closer to the end of the year. Therefore, in order to evaluate where we stand today, it is important to understand how the stock market is priced today.

The S&P 500 Index now trades at 14 times 2016 consensus earnings. This is an attractive valuation given that over the long history of investing that average has been above 15 times. The S&P 500 dividend yield is now 2.24%, which is higher than a 10-year treasury bond currently earns. One of the technical ways to evaluate whether you are better in stocks or bonds is called the “earnings yield gap”. Basically, it is the inverse of the price-earnings ratio mentioned above of 14.8. If you divide 100 by the price-earnings ratio, you get a yield of approximately 6%. If you then compare that with the treasury yield of approximately 2.19%, you see that the spread differential is an almost full four points greater. What that means is that you are three times better off investing in equities than bonds at the current time. By point of reference, this is the highest ratio in the last 20 years, illustrating a more superior value in stocks than in bonds.

It is never fun or easy to sit back and watch the markets go down. However, after a lifetime investing, it is more important to understand where you are going, rather than where you have been. We have enjoyed seven great years of investing since 2008. Bear markets only come with a recession in sight, and there is no empirical evidence that the U.S. is facing a recession of any kind. While people like to comment on recessions outside of the United States, such as China, Europe, etc., each of those countries/regions have no signs of the upcoming recession either. In fact, China is well above the recession level even with their reduced activity, and Europe has broken out to positive GDP growth and they continue to stimulate their economy.

If any of you think that I have been shaken by the downturn in the market during the month of August, you would be mistaken. In fact, I have developed a higher level of confidence because the economy has strengthened, employment is greater and consumer spending and housing construction is on a much higher trajectory now than at the beginning of the year. As we go into the yearend with Christmas spending, I think that these worries regarding oil, China and any number of other numerous concerns you may quote will be reduced. It is amazing to me that people look for reasons to sell with no viable alternative for investing. To me, the fear is misplaced unless you have knowledge that would indicate otherwise. Once again, I highly recommend that you think before you sell, rather than sell before you think.

I continue to hold my position that the markets would be up roughly 10% in 2015, and therefore we would move from a position of roughly down 5% in early September to a total gain of 10% for the year 2015, and therefore an upcoming rally of more than 15%. There is no question that events may lead to another conclusion, but from valuations, earnings, and the economy, I think the 10% gain is more likely than not.

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

Best Regards,
Rollins Financial, Inc.

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