In celebration of the Christmas holiday, our office will be closed on Friday, December 23rd and Monday, December 26th. Our regular office hours will resume on Tuesday, December 27th.
If you have a matter that requires immediate attention over the weekend, please contact Joe Rollins at jrollins@rollinsfinancial.com or 404.372.2861.
We wish you and your families a holiday weekend filled with peace, joy and laughter! Here's a clip from "Elf" -- a great new Christmas classic -- to get you in the holiday spirit:
Warm Regards, Joe Rollins, Robby Schultz and Eddie Wilcox
Last week, while speaking with my son, Josh, he made a very interesting observation which, in retrospect, should have been quite obvious. His education costs have definitely not been wasted. He indicated that he’d been studying the history of the United States in school and that the confederation of our sovereignty, drafted in 1776, was ineffective. It was not until the actual Constitution was signed thirteen years later that the United States was recognized as a functioning institution.
His thoughts were that the problems that the European Union is going through today are similar to the problems that the United States incurred when they tried to create a unified government, and he’s right. A confederation of sovereign states proved to be ineffective with the introduction of the Articles of Confederation in the 1770s and, to no surprise, has once again been proven inadequate, as made obvious by the financial crisis facing the European Union and its eurozone today. While hoping to stabilize the future of Europe by acting as a single entity, the EU must face the realization that they are, in fact, not a country and “lack the political legitimacy to undertake major institutional changes.”
As a result of the Articles of Confederation, the 13 founding states of the United States of America “retained sovereignty over all governmental functions not specifically relinquished to the national government.” Before any action could be taken, however, all decisions had to be agreed on by all 13 states, ultimately creating a weak and powerless government. The ratification of the Articles, alone, took 2 years to be unanimously agreed upon.
And that is, essentially, the challenge that the European Union has to deal with today, as all 27 nations must give their approval before any major decisions are made. Their attempt to “rely on fiscal policy alone has failed,” so they must move on to plan B in order to remedy this current crisis. In 1789, the United States, aware of the shortfalls of the Articles of Confederation, replaced it with the Constitution; unfortunately, the European Union did not learn from the original naivety of the States and certainly does not have 10 years to overhaul the infrastructure of its divergent currency union.
The longevity of the euro has been called into question; can it continue without a centralized government put in place? The European Union currently does not have their own constitution, government, foreign policy, taxation system or military and many say a political union such as that will never happen as “persistent national identities” will make it nearly impossible. There will never be a United States of Europe; the thought of 27 different countries with different cultures, languages, foreign policies and political structures eagerly willing to band together as ONE just isn’t plausible.
So where does the European Union go from here? Does a functional, middle ground truly exist that will allow the euro to once again thrive for those 17 nations that make up the eurozone , while simultaneously serving the best interests of all 27 independent nations in the European Union?
In the United States we do not spend a lot of time worrying about whether one specific state is having economic problems such as Greece in the European Union. In fact, since we are unified in a centralized government with taxing and spending capabilities, the fact that one state is more economically successful than the others does not create problems. Since all of the money is pooled and the taxing authority stays within the centralized government, each state is supported and, therefore, issues with each individual state are irrelevant overall.
This is the where the problem lies with the EU today. Each country is divided in much greater ways than just location and language and their desire to maintain their own sovereignty prohibits them from accepting the idea of a future that would lie in the hands of a centralized European government. The problems today have been emphasized by the wide divergence of each of these countries and their ability, or inability, to function in a very competitive world.
For the last decade, Germany, with its highly qualified labor force, has taken great strides to modernize their work ethic, productivity and formerly rigid work rules in order to remain as a major player in a more competitive world economy. Due to the lack of trade restrictions within the European Union, Germany has been able to manufacture and sell throughout the EU without tariffs or restrictions, allowing them to successfully reap the benefits of free trade. However, countries like Greece have done nothing to be competitive; they continue to impose severe work restrictions and maintain a general “laissez-faire” attitude regarding business. Short of tourism, Greece has very little capacity to overcome the issues associated with their failing economy.
It is not surprising that the European Union, after following in the missteps of the United States, is now in the same predicament that our forefathers faced over 200 years ago. With 27 nations that are essentially related by name only and no one with the authority to control the actions of the others, failure appears to be inevitable. Only after the European Union acknowledges that they need to have a strong central government, will these issues facing smaller countries then be resolved. I do not think this process will happen overnight and it may, in fact, take many years, but that is the only way they will solve these financial problems. Just as the United States learned in the 1770s, a group of independent countries with the desire of sovereignty and preservation of self-worth cannot effectively govern in the best interest of all.
I appreciate Josh for recommending this issue, and I have thoroughly enjoyed discussing the parallels between the United States in its early years and the growing pains of the European Union with him, and now you.
On a side note, here is a recent picture of my two children, Josh and my daughter, Ava, with Santa. I have one child that is 6’4” and another one that is 27”.
As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
I hope you had a wonderful Thanksgiving and that the weather was as beautiful in your neck of the woods as it was here in Atlanta this past weekend. There are many things that I am thankful for – my family and our clients topping the list. We recently celebrated Ava’s six-month birthday, and she gets cuter by the day. She’s up to a whopping 20 pounds and sleeps 10 hours a night uninterrupted. We’re thankful that she’s healthy and happy, and she brings us much joy. She is not spoiled yet – but she will be soon. Life is good!
In economic news, however, there may not seem to be a lot to be thankful for this year. Nevertheless, I’m still optimistic, and in this post I’ll share some of the positives that the media has seemingly swept under the rug. Admittedly, I’m an economic nerd, and while most people probably don’t enjoy researching economic statistics, I find it fascinating. After reading the back page of Barron’s over the weekend, I am more convinced than ever that the economy is doing okay and that the stock market is overreacting to current events.
Over the last two weeks, the broader stock market has gone down approximately 8%, although none of the economic news concerning the United States warranted such a decline. Rather, and as many financial commentators explained, the decline centered on the problems in Europe. After years of a “cradle to grave” mentality, many of the Eurozone countries are now faced with the economic reality that they cannot deliver on their socialist promises. But as I’ve said before, the impact to the U.S. economy and its stock market from Europe’s woes is a mystery to me. I’ll explain why below.
First, the U.S. only exports about $1.5 trillion a year to foreign countries. Of that $1.5 trillion, about 25% -- or $375 billion -- is to European countries. The U.S. GDP is now roughly $15 trillion of which exports are only 10%. How can any reasonable economist think that the $375 billion exported to Europe is going to have any major affect on the U.S. economy?
I don’t understand why anyone would think that just because the European banks are having trouble, European consumers would be any less inclined to buy. It’s perfectly possible that Europe might fall into a mild recession, but even so, it’s likely that consumers throughout Europe will still continue to spend. If that’s the case, exports from the U.S. will continue. However, the real focus for investors should be what the U.S. corporations are doing insofar as the profits they are earning and what prospects there are for the U.S. economy. Those are the facts that affect stock prices.
Noted lifetime bear economist Nouriel Roubini has essentially guaranteed that the U.S. will fall into recession next year due to the European problems. Since Roubini has basically been forecasting a U.S. recession since the turn of the 21st century, however, this proclamation from him should not be a surprise. After all, even a broken clock is correct two times a day.
As I’ve said before, it’s unwise to invest for your future based upon public sentiment and conjecture. The only true catalysts for stock prices are earnings, interest rates, and the economy. These are the hard facts upon which I will bore you with today.
The economic data makes it absolutely clear that the U.S. economy is sound. Except for the residential construction industry, most facets of the U.S. economy continue to operate in a positive fashion. The growth in GDP for the third quarter of 2011 was 2%, and it is a common belief among economists -- and me -- that we should see between 2% and 3% GDP growth for the fourth quarter of 2011 and all of 2012. While this can’t be considered robust growth, it is more than adequate to generate profits.
Let me give you some real numbers. When they announced last week the GDP growth had been revised down from 2.5% to 2%, the market took a major hit. I am positive most of the traders sold on the news without even reading the actual report. I read the report. During the quarter, private business inventories fell by $8.5 billion. This could be for a lot of reasons, but maybe it was due to high sales liquidating inventory.
If inventories had not dropped, the GDP growth would have been 1.55% higher. Therefore, rather than 2% for the third quarter it would’ve been 3.55%, which would have been extraordinarily good. For those that do not find reading the GDP report intellectually stimulating, it is likely that this inventory number will be reversed in the fourth quarter and that gain of 1.55% will then be realized. If so, fourth quarter GDP should be excellent.
For the month of October, the manufacturing capacity utilization has jumped to 77.8%. The full capacity rate is met when capacity utilization is at 80, and so we are just shy of full capacity. Non-residential investment is up year-over-year with close to a 9% jump for the first quarter year-over-year. This is a positive move for any type of building trade other than residential housing.
Automobile production is also up this year. Total automobile product manufacturing (cars and trucks) is up roughly 9.3% year-over-year. Manufacturing of automobiles is a major employment source, yielding a positive sign for new jobs in this industry.
There have been numerous articles in major publications over the last thirty days regarding the increase of oil and natural gas drilling in the U.S. We are seeing an enormous increase of oil production in this country right now – more than anything this country has seen in decades. Natural gas is being located and drilled in many parts of the U.S., forcing the cost of natural gas to all-time lows. This production of new oil in the U.S. has already forced a reduction of our foreign oil imports by 15% in the last two years. This is rarely in the press, however, since environmentalists frown upon drilling for oil and natural gas. However, if we are ever going to be economically independent from our current oil suppliers of oil (many of these are not friendly to the U.S.), we must produce it in the U.S.
Even with the current administration’s attempts to diminish the value of oil produced in this country, drilling is producing jobs unlike any sector of the U.S. economy. While the administration’s “green” job efforts have been a total bust, the traditional jobs created by natural gas and oil productions in the U.S. have been quite lucrative.
U.S. exports are up close to 6% year-over-year while imports are only up less than 2%. We are definitely a long way from balancing our trade budget, but it’s clear that the trend is moving in a positive direction. With further reductions of imported oil, we could get close to balancing the trade budget within this decade. If we did not have an administration in Washington that was against the U.S.’s production of natural resources, we would be closer to accomplishing this goal than we are today. These industries create good, high-paying jobs. The administration’s nearly $90 billion expenditures on green job efforts, in the last three years, has been a complete failure. It has created neither significant energy nor hardly any permanent jobs.
It’s true that unemployment continues to be stubbornly high, but it is trending in a more positive direction. With new unemployment claims falling below 400,000 a week, employment appears to be increasing slowly. Only a year and a half ago, weekly claims for new unemployment were 700,000 per week, and therefore, the current numbers are a significant improvement. In October, the index of leading indicators was up 5.5% year-over-year. This evidence is overwhelming positive for the economy based on economic statistics alone.
The major alternatives to stocks are interest-bearing investments. Of course, interest rates are currently at all-time lows. The Federal Reserve announced that the year-over-year inflation rate is 3.5%. This week, a 30-year Treasury bond was yielding 2.91%. Therefore, by virtue of buying a 30-year Treasury bond, you will have built-in loss of purchasing power over the entire 30-year term. A 10-year bond is yielding roughly 1.9% and a 5-year CD, at its best rate, is yielding only 2.8%. These instruments only assure investors that they will lose purchasing power over their term with inflation at 3.5%.
Earnings this quarter will again set a new record for the highest earnings ever in the history of U.S. finance. Corporate buy-backs and dividend increases have never been higher. It is very easy to purchase utility stocks and other great growth stocks with dividend rates above 3% and many at 5%. As of Friday, the Dow Jones Industrial Average was selling for a price/earnings ratio of 10.6% for the 2012 year. That’s almost a historic low for high quality earnings on large companies. Additionally, the dividend rate for the same group of stocks is greater than 2%, which is higher than the 10-year Treasury bond. This has only occurred a few other times in U.S. financial history.
The FDIC recently announced that bank net earnings during the third quarter were a cool $35.3 billion. U.S. banks are expected to have net profits in excess of $120 billion for the 2011 year. However, bank stocks are selling at a small fraction of their intrinsic value. As of today, Bank of America has a book value of $20.96 per share and has on its balance sheet over $1 trillion in cash. However, the current market value of the stock languishes at $5.50 per share. JP Morgan Chase, one of the great banks of our country, has a book value of $43 per share and the stock sells for $29 per share. Therefore, these two major financial institutions are selling at a discount of nearly 50% of their book value. These types of discounts are rarely seen in the U.S. Furthermore, U.S. banks have never been as financially sound or as financially able to lend as they are today.
It’s easy to be confused by all of this positive economic news when the market was down close 8% in the last two weeks. Like I’ve said before, however, the traders on Wall Street don’t care about economic trends or positive economic results; their only concern is movement (either up or down). Once the market moves, they can adjust either up or down by trading millions of shares for a minuscule gain. Long-term investors like us should not be concerned with day-to-day movements that really mean nothing in the end.
Yes, there are negatives stemming from the crisis in Europe. But in my opinion, even if Europe were to implode, it might actually be good for U.S. companies. How? If the Eurozone countries split up and started creating tariffs among themselves, it would likely benefit American companies. Moreover, the reestablishing of central governments in each of these European countries would be a positive economic benefit for the U.S. because we would have a competitive advantage on currency and corporate strength. To me, the biggest concern is the uncertainty of it all. At the speed they are moving at in Europe, it doesn’t appear that we will see a complete resolution for months, if not years.
I believe that the major negative facing our country is Washington’s complete ineptitude. The Congressional super committee’s failure to come up with a compromise on a financial plan is a classic example. The U.S. is facing $44 trillion in deficits over the next decade and this group of twelve could not agree on a mere $1.2 trillion in reductions. While the issues in Europe are wreaking havoc on the financial markets, at least they are dealing with their problems; U.S. leaders have yet to step up to the plate to deal with ours. In spite of Washington’s incompetence, however, the extraordinarily high levels of corporate profits, rock bottom interest rates, and a stable banking environment provide for a favorable appreciation in the stock market. If we want “real change” in Washington, we need to make a change.
As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
“Real generosity toward the future lies in giving all to the present.” – Albert Camus
This holiday, give your younger loved ones the gift of higher education with a 529 plan. Let’s face it, they’re never going to put it on their wish list over an iPad or a Kinect, but, fortunately for them, they have someone as sagacious as you in their lives. They may not appreciate it now, but they will one day (and if they never do, well you have the option of passing it on, penalty-free, to someone more deserving)!
You can start a 529 plan by simply setting up recurring, monthly payments of as little as $50, or by an initial contribution of at least $500, with no mandatory monthly deposits. And if the low minimums aren’t incentive enough, please note that your investment is never taxable if used for higher education purposes such as tuition, books, supplies, fees, etc. “For 529 plan purposes, an eligible educational institution is any college, university, vocational school or other post-secondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education.”
In the past, we have done numerous, in-depth blogs about 529 plans and we encourage you to peruse these for more detailed information:
Please feel free to contact us with any questions about setting up an account that’s right for you, or if you’d like to make a contribution towards an existing one. And remember, life isn’t always too short, so don’t forget to give your own retirement plan a gift as well!
Have a wonderful Thanksgiving and please note, our office will be closed on Thursday, November 24th and Friday the 25th.
All mankind is divided into three classes: those that are immovable, those that are movable, and those that move - Benjamin Franklin
After 21 extraordinary years in Midtown, our much anticipated move is finally upon us; by the close of the week we will be settled into our “new and improved” home, located at the Atlanta Financial Center in Buckhead. Needless to say, we can’t wait for you to see it.
For your convenience, our telephone and fax numbers will remain the same following the move. Please note, however, that our office will be closing at 3:00 p.m. on Friday, November 11th, in order to accommodate the scheduling needs of the movers. Monday, November 14th, will be business as usual, as we’ll continue to provide our clients with the same great service they deserve.
Thank you to everyone for all the well-wishes and we hope to see you in our new office soon!
I took a short break from posting to the Rollins Financial blog since my principal editor is on maternity leave. Once again, Jennifer Wilcox had to come up with some poor excuse for missing work such as having her second baby. Since Jennifer has worked for me off and on for the last 16 1/2 years, I accepted her excuse. Congratulations Jennifer and Eddie!
And now it’s time for me to get back to expressing my opinions regarding what is going on in the financial world and equity markets…
There’s no way to sugarcoat the third quarter of 2011 – it was a financial disaster. However, as I indicated in prior posts during the quarter, I was never particularly concerned because all the reasons given for the sell-off in the third quarter appeared to be completely exaggerated. I continue to believe that the main reason for the sell-off was that the momentum buyers were pushing the market down to fool investors so they could purchase stocks at a better price when investors sold.
Even though the quarter was painful, hopefully you stayed invested and were able to enjoy the upturn at the beginning of October 2011. Whenever the market turns straight up at the end of a volatile quarter, it’s apparent that speculators are controlling the market and not investors. That is exactly what happened in the third quarter of 2011, and this ultimately created the big turnaround in October 2011.
For the month of October thus far, the Standard & Poor’s Index of 500 Stocks is up greater than 8%. Additionally, the international emerging markets are starting to rally. Many of the reasons given for the market sell-off in the third quarter of 2011 have now been proven unfounded, and therefore, the markets are rallying.
You may recall that in August and September of 2011, many economists were screaming that the U.S. was falling into a recession. Additionally, we repeatedly heard the proclamation that the earnings for the third quarter would be disastrous given the uncertainty of Europe and the potential slowdown in China. The financial media was also reporting that Europe was starting to implode. I read and heard more articles on the ultimate demise of Europe then on any single subject. However, the scare tactics that were relayed regarding the potential default of Greece were not even believable given the lack of financial exposure the U.S. had to the country of Greece.
As we roll into the third week of October, now we find all of those supposed fears were definitely exaggerated just as I predicted. In fact, it looks like for the third quarter of 2011, the GDP in the U.S. will be 2.5%. That’s certainly not great, but it’s not negative, either. Those economists who forecasted a negative GDP growth must feel really bad today – if they are smart enough to even realize they were wrong. An additional number of financial analysts told us in no uncertain terms that the earnings of the U.S. companies would be disastrous for the third quarter given the financial turmoil of Europe. Once again, they could not have been more wrong.
For the third quarter, most of the major U.S. corporations have already reported their earnings. To this point, 75% of the reporting companies have exceeded their estimated earnings. Quite frankly, earnings of major U.S. corporations have been nothing short of breathtaking. There used to be a time when corporations would report adequate earnings of hundreds of millions of dollars. Today, it is not unusual for major corporations to report $5-$6 billion in net income for a given quarter. Never in the history of the U.S. financial markets have earnings been so spectacular.
Corporate U.S. balance sheets border on unbelievable with the extraordinary cash accumulations. Apple, Inc. recently announced they have accumulated in excess of $80 billion in cash on their balance sheet with no presumed need for it given their profitability. This is a corporation that will very likely generate a $15 billion net profit for this year and throws off $20 billion of internal cash flow. I guess there is a reason why this is the largest capitalized corporation in the U.S.
The list of cash balances goes on from Microsoft’s $52 billion to Cisco’s $32 billion and on and on. It was reported before this quarter that U.S.-based corporations had on their balance sheets roughly $2 trillion in cash – and that figure continues to grow this quarter. Therefore, the multiple items that were holding back the equity markets in the third quarter seem to have moved to the positive in the fourth quarter. Corporate earnings are spectacular and are growing.
It was particularly unusual during the third quarter 2011 that even the safe-haven type investments suffered losses. In fact, almost every type of mutual fund, both conservative and speculative, lost money during this quarter. We normally use a fair amount of high yield bond funds for our clients since they pay a rate of return much in excess of cash and are fairly conservative. It was unusual during the third quarter that even these types of bond funds suffered large losses. Some of these bond funds were down for the quarter roughly 7-10%. There is no economic justification for this type of loss in these types of bond funds. With corporate America generating record profits, the default on these bonds will be less than 2%. The type of losses incurred in this third quarter can only be explained by investing based on fear. There was no economic reason for these types of losses – people weren’t investing based on common sense.
If you review the vast number of mutual funds that are available for purchase, you will see that the only type of mutual fund classifications that were in positive territory for the third quarter were mutual funds backed by the U.S. Treasury bond and a few gold-based funds. Virtually all growth equity funds, all international funds, and most blended funds, had losses of 20% or greater for the third quarter in 2011. It was just a brutal period not justified by the economy.
The economic view has all of a sudden gotten better in October. Corporate profits are still outstanding and interest rates are low, and all of these positives should provide superior investment returns in the fourth quarter. Actually, my previous projections of double digit returns are still not out of the question. The only potential hold-up for this projection is the news from Europe. For whatever reason, the Europeans cannot seem to make a definitive resolution to their problems. If this issue drags on for another three months, it would endanger the fourth quarter 2011 performance. However, I don’t anticipate for Europe to be that indecisive.
While the U.S. economy is not fabulous, it is still growing and that’s important. The one major detriment to the short-term financial future is the completely dysfunctional group of politicians we have in Washington. Due to the government’s inability to create a budget and live by it, Americans are faced with a bunch of amateurs running the Federal government. In fact, the U.S. Senate has yet to approve a budget for the last two fiscal years which have already ended! If you review the recent history of the Federal deficit, you will see how fast our government has fallen in disarray. Please see the chart below of Federal government receipts for the last five years:
As you can see, there is blatant uncontrolled growth of expenditures. While revenue has decreased in the years during the recession, outlays have exploded! The one major hold up of the U.S. economy is the risk that the Federal government has on our economic future. Note that in 2007, the Federal deficit was only $161 billion. It’s hard to believe that any government could take responsibility for blowing the deficit up ten times in such a short period time. At the end of 2011, we have had three straight years of deficits in excess of $1 trillion. Sadly, our economy is no better for the money that’s been spent.
The other item that is important from this chart is that the Federal budget can never be balanced by increased receipts. There is not enough income to be taxed in the U.S. to do balance the budget. The only way it could possibly be balanced would be to reduce expenditures to 2008 levels with some minor increases in taxes. Therefore, if you ever hear any politician indicating that the Federal government cannot cut expenditures to balance the budget – something I heard at least four times yesterday on the nightly news – they are lying.
Even with all the negative news in the financial press, it’s highly likely that the U.S. stock market is now in a rally mode which could go on through the spring of 2012. I know it seems impossible to believe with all the negative news that the equity market could increase, but as I have pointed out many times before, the equity markets grow with higher earnings and lower interest rates. There has rarely been a time when each of those components is so favorable to higher stock prices than what we are currently experiencing.
As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
No surprises here – at the close of the 2-day Federal Open Market Committee (FOMC) meeting on Wednesday, the Fed announced its latest effort to encourage the economy – a strategy to help further lower long-term interest rates and decrease mortgage rates consistent with expectations and my forecasts discussed in . Here’s the meat of the plan:
By the end of June 2012, the Fed will be purchasing $400 billion of mid- and long-term Treasury securities (maturities of 6 to 30 years), and it will sell an equal amount of short-term Treasury securities (maturities of 3 years or less).
The Fed will also reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities with remaining maturities of 3 years or less.
The Fed will keep the target range for the federal funds rate at 0 to ¼ percent.
As anticipated, the Fed will not be printing any new money in this plan.
Market Reaction
With the FOMC pointing out “there are significant downside risks to the economic outlook” as its decision to extend the maturity of its securities holdings, the world markets tumbled yesterday. But this is likely a short-term hiccup, and as I stated on Tuesday, the Fed’s move is better than doing nothing. It will hopefully spur companies to start investing their cash and also allow for better borrowing terms and an increase in household spending. All of these positives would ultimately help increase employment and promote price stability – the Fed’s two statutory mandates.
Even so, the Fed’s somewhat dour outlook along with signs of a slowing in Germany’s economy and a shrinking in China’s manufacturing hammered stocks and commodities yesterday. Meanwhile, the Dollar Index climbed to 1.3% – a 7-month high – and 30-year Treasuries dropped to record lows. Still, the FOMC did say in their announcement that they expect the economy to improve, stating that “The Committee continues to expect some pickup in the pace of recovery over coming quarters.” This statement wasn’t discussed much in the press, which mostly focused on the dismal news. As you may recall, the first two quarters of 2011 were marginally positive. With the Fed’s forecast of an increase in the recovery pace, I can only assume that they believe the second half of the year will be better than the first.
Last week, the market had a positive return of over 5%. Over the last two days, the market has gone down over 6%. To me, this emphasizes the volatility of the market and not the overall direction in which the market is heading. As I write this post, the S&P is down 10% for the year, and as last week’s performance indicated, this could be cut in half in only five trading days.
This morning on CNBC, Jack Welch, the former Chairman and CEO of General Electric, stated that of the 11 public companies for which he consults, not one of them is down. He optimistically opined that U.S. corporations are functioning okay on the low side and fabulous on the high side. His sentiment is that corporate America is leaner, more productive and more profitable than ever. Hence, what has happened in the market since the Fed’s announcement on Wednesday is a mystery to those of us who evaluate the market based upon these fundamentals.
It feels like we’re receiving an avalanche of misinformation regarding the U.S. economy. I’m not sure if this is because technology spreads news like wildfire – much of which seems to be distorted – or if politicians intentionally misstate financial facts and data. During last night’s fifth GOP presidential debate, there was a lively discussion regarding Fed Chairman Dr. Ben Bernanke – with some candidates suggesting that Bernanke was intentionally destroying the value of the dollar and undermining our future by cutting the international value of the U.S. dollar. Interestingly, the value of the dollar is actually unchanged for the last four years – another reason to not believe politicians when they spout off economic “facts.”
In spite of the market’s performance, the Conference Board, a global research association of independent business leaders, released a report on Thursday reflecting that the index of U.S. leading indicators was higher than its original forecast in August, signifying accelerated growth heading into 2012. So while the market may seem disappointed that the Fed delivered only what was expected and nothing more – and even with the bleak economic news around the world – I don’t foresee the markets continuing to spiral downward.
I also disagree with those who say ‘Operation Twist” will likely fail and that the U.S. is on the verge of falling into another severe, prolonged recession. As I’ve indicated on numerous occasions, while growth certainly isn’t robust, I still believe there will be a pickup in recovery over the coming quarters and the unemployment rate will decline – even if only at a gradual pace. So, while my belief that equities will improve in the months ahead remains the same, we will continue to watch the markets closely and make any necessary changes to our portfolios under management. For now, however, I still believe that we are better off invested in stocks than anywhere else.
The worldwide sell-off in the equity markets is riddled with inexplicable contradictions. For the first time since 2008’s broad market sell-off, equities and gold took a simultaneous nosedive; these asset classes typically move inversely to one another. With the rally of the dollar, almost all commodities were hard-hit yesterday. But the price of crude oil was down dramatically, which is a direct positive for the economy and an indirect positive for the stock market.
Last night I reviewed the worldwide GDP growth to make sure I haven’t been hallucinating. It appears that China will have GDP in 2011 of approximately 9%. India’s GDP growth is anticipated to be 6% to 8%, and Brazil is expected to have GDP growth of 5%. From the raw data, it appears that Europe will be flat or marginally negative, and the U.S. will be flat or marginally positive. There are currently no solid facts that would explain such a massive market sell-off under these predictions.
I mentioned that the U.S. GDP for the first two quarters of 2011 was marginally positive, and it certainly appears to have picked up in the 3rd quarter of 2011. Based on my rough calculations, it appears that the GDP will be about 2% positive for the 3rd quarter, which ends next Friday. That’s certainly not robust, but it’s not negative or indicative of a major ongoing recession, either.
I see very few solid facts to back-up the selling spree on Wall Street. Fear seems to be the main driver, which – in a contrarian sort of way – is positive. With dividend yields on utility stocks now in excess of 6%, it is hard for me to imagine a knowledgeable investor continuing to sit in a 10-year Treasury at 1.7% when AT&T can be bought with a 6% dividend yield. That being said, I fully understand the apprehension when the market is so volatile. Corrections are often painful to endure, but the natural mechanism of the market is that there are major swings on both the upside and the downside due to traders trying to gain an advantage. Investors should expect a market move of 10% to 20% at any time, and should certainly not be surprised by such moves. In the end, however, fundamentals will rule – and the current fundamentals concerning earnings bode well for investors.
It was also argued that the market sell-off was due to a rotation from equities into the safety of Treasury bonds. However, the 10-year Treasury is currently trading at 1.73%. No savvy investor would buy a 10-year bond at this low rate when inflation is expected to exceed 2%. These buyers are either dramatically concerned about a possible worldwide depression or they simply do not understand the time value of money. It’s hard for me to join the depression camp when I’ve not read a single reputable economist projecting negative GDP in the next few years.
This sell-off is also contradictory because it is happening in the face of extraordinary earnings. It now appears that 3rd quarter earnings will reflect the highest earnings ever recorded for the S&P 500. How is a major stock market sell-off even reasonable in the face of such extraordinary earnings? The S&P 500 has a dividend yield in excess of the yield on the 10-year Treasury bond, which has happened only a few other times in history. This brings to light the major difference between traders and investors. Aside from those investors making fear-based decisions, most investors would never buy a 10-year Treasury earning 1.73% when the S&P index generates 2.25%. Moreover, the 30-year bond is trading at 2.8%, which is the lowest yield ever recorded on such a long-term bond. While everyone would like to believe that inflation will be less than 2.8% over the next 30 years, there’s certainly no historic evidence to indicate that to be true.
My next post will focus on the difference between traders and investors. Traders work on short-term variations while investors look to the long-term, and I will provide my complete analysis on this subject and how it impacts the stock market early next week.
Lastly, I want to reiterate our standing invitation to discuss your portfolio and financial matters with us in person or over the telephone, whichever is more convenient for you. We’re aware that the markets have been worrisome over the last few months, and we want you to know that we are always available to discuss your questions and concerns and our strategy for your financial goals. Please contact us at 404-892-7967 if you would like to schedule a meeting to review your personal financial plan.
As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
Regardless of your financial situation, an estate plan at the time of your death, even the most basic one, will save your loved ones a lot of unnecessary time and money. Trying to figure out where to begin seems to be a concern for many of those without an existing one in place, so I thought I’d take a few minutes to just run through the basics. The following is not applicable to those with estates totaling $5 million or more, as legal advice should be sought.
Every dollar spent on probate is avoidable
The simplest way to get started would be to create a list of all your assets (retirement savings, IRAs, 401(k)’s, life insurance policies, real estate, etc.) and ensure that they are properly titled. When given the opportunity to appoint beneficiaries for accounts, always do so. These are known as ‘non-probate assets’ and will be passed on privately and automatically upon your death, typically without any involvement from the courts; naming a person as your beneficiary, as opposed to an estate, is also recommended in order to avoid probate costs. Assets that don’t require a named beneficiary, such as deeds, CDs and brokerage accounts, have caused countless problems that could be easily avoided by simply having a Transfer-on-Death or a joint tenancy with right of survivorship (JTWROS) agreement in place.
Where there’s a will there’s a way
Everybody needs to have a Last Will and Testament in place. This crucial document specifies exactly how your affairs will be handled in the event of your death. It also prevents your family members from having to take on the labor-intensive task of trying to track down all of your existing assets; a will allows you the opportunity to conveniently itemize all of your assets and specifically state how they are to be distributed. A will is also ideal for directing what you would like to have done with your remains, and, if relevant, establishing guardianship for your children.
The show must go on
In addition to your will, you should also assign a power of attorney to handle your finances should you no longer be able to do so yourself. Let’s face it, you’re more likely to become ill and incapacitated than face an instantaneous death and like it or not, the bills still have to be paid. Find someone you trust to deal with these financial matters on your behalf. Many people choose a trustworthy family member to take on such responsibilities, but you are not required to do so; just make sure it’s someone you can rely on to act in your best interest.
And while we’re on the subject of incapacitation, an advance healthcare directive should be put in place as well. This allows you to leave instructions regarding what type of medical care you want and also allows you to name a medical power of attorney to ensure that your treatment preferences are adhered to. These documents can easily be created along with your will; although the cost varies depending on the complexity, the price is usually very reasonable and well worth the peace of mind gained by knowing every decision made is your own.
Out of sight, out of mind
You would be amazed by how many people have no idea who they have listed as their beneficiaries. They most likely designated these people years and years ago and never gave it a second thought. You should always verify your listed beneficiaries upon life changing events (e.g., divorce, remarriage, death of spouse, etc.) and update them where necessary. The last thing you want is your ex-spouse laughing their way to the bank after you’re long gone because you forgot to revise your beneficiaries after the divorce.
In closing…
With the current Estate Tax in place ($5 million/person), the estates of very few individuals will be taxable; unfortunately, like all good things, this too will eventually come to an end so it is important that you remain aware of any changes that may have a direct effect on you.
For more in depth information about titling estate documents, please refer to our Q&A Series: Estate Planning under the Tax Relief Act of 2010 from June 13th. As always, we welcome the opportunity to meet with you personally to discuss any questions you may have regarding your individual estate plan.
And now she has another certificate to prove it. Rollins & Associates’ very own Danielle Van Lear is now, officially, a CPA; she passed all four parts of the exam with flying colors on her first attempt - less than 20% of first time test-takers can say the same!! Rollins & Associates is our sister CPA firm, which has been operating in Atlanta since 1981.
Danielle received her undergraduate degree from the University of North Carolina (sorry Duke fans) in 1996 while majoring in Mathematics and Secondary Education. After graduating, she taught math in both middle school and high school for over 5 years before deciding it was time for a career change. Not abandoning the classroom completely, she soon found herself adjusting to the role of student as opposed to teacher. And in 2003, she received her MBA from Georgia State University with a concentration in finance.
Luckily for us, she graciously accepted a position with Rollins & Associates in February of 2004. Throughout the years she has completed countless hours of Continuous Professional Education courses as well as over 30 hours of accounting classes, while still working full-time for Rollins & Associates. Needless to say, all of her hard work has paid off and she continues to amaze us all with both her knowledge and determination.
So kudos to Danielle, and if you haven’t had the privilege of working with her, know that when you do you’re in excellent hands!
Some people succeed because they are destined to, but most people succeed because they are determined to. ~Author Unknown
The Federal Open Market Committee (FOMC) began their 2-day meeting today on interest rate policy. At the meeting’s close tomorrow, investors are anticipating Fed Chairman Ben Bernanke’s announcement of ‘Operation Twist Light,’ a plan wherein already low long-term interest rates would be decreased to an even lower level.
OPERATION TWIST LIGHT
At last month’s FOMC meeting, most members supported additional policy measures to help encourage a stronger economy, even though Bernanke didn’t talk about the possibility of the Fed taking further action in his Jackson Hole speech last month. The market’s performance over the past month, however, has made it clear that the market expects the Fed to take some modest action, although it’s not demanding another full-on round of quantitative easing.
How would ‘Twist Light’ work? By increasing the timespan (longer maturities for the bonds) – but not the amount – of the securities held by the Fed (approximately $2.6 trillion). And unlike the full-fledged Operation Twist program instituted in 1961 that it was named after, the Fed wouldn’t be selling short-term securities to buy long-term debt. Rather, the Fed would “begin passively increasing [its portfolio’s] average maturity” by investing its available cash and reinvesting its longer-term mortgage-backed security proceeds.
WHAT MIGHT THE TWIST ACCOMPLISH?
The hope is that the extension of the Fed’s portfolio holdings would cause long-term interest rates to reduce, making it more desirable for companies to invest their stockpiles of cash. Theoretically, it would also allow for better borrowing terms and an increase in household spending while boosting employment and keeping prices from falling.
And what about the potential benefits to the market? Optimistically, Twist Light would help nudge investors away from deposits and riskless assets, taking the market higher. Even so, if the FOMC passes Twist Light – and it probably will, even with Philadelphia Fed President Plosser and Dallas Fed President Fisher expected to dissent – analysts generally aren’t counting on a huge impact to the market. Rather, rallies on both the upside and downside will likely continue through the end of the year.
The most important facet to Twist Light is that there would be no monetization plans (i.e., printing of new money). Unlike QE1 and QE2 wherein the Fed printed new money to purchase securities, none of that will take place in Twist Light. Since there’s no expansion of the monetary system and only an extension of the terms, I can’t see how it would hurt – and it might just help. The Fed certainly has my blessings to proceed.
Of course, with long-term yields already at low levels and with low borrower demand, there is some debate as to whether this action would really provide any economic benefits. After all, even worthy borrowers have thus far been uninterested in taking loans from banks that are sitting on hoards of cash. However, with unemployment continuing to hover at approximately 9% and with stalling growth, Twist Light seems to be a reasonable effort for the Fed to undertake.
Treating financial market volatility lightly is never my intention, but the current sell-off in the equity markets appears to be confusing to the average investor. My feeling is that things are not nearly as bad as they are being represented by the media, but undeniably, your account balances are going down almost daily. Undoubtedly, the wild swings in the equity markets are upsetting and confusing, especially to those who may not fully comprehend all the economic terms being used by the financial press. In this post, I’ll give you some background information to help you understand the economic impacts of the global sell-off.
LIPSTICK ON A PIG
The difference between a hockey mom and a pit bull? Lipstick.” That was one of the memorable quotes from Sarah Palin’s speech at the 2008 Republican National Convention. Shortly thereafter, Obama ridiculed McCain and Palin’s promises of change by stating, "You can put lipstick on a pig. It’s still a pig.”
What happened next? An uproar ensued with some insinuating that Obama is a sexist who called Palin a pig. He didn’t, of course, call Palin a pig; the “pig in lipstick” metaphor is fairly common and there are several examples of its use from decades ago.
Using this adage in the context of today’s financial woes, I would say that lipstick has been slapped on the pig that is our economy to make it more attractive. Is it working? And who is right – the bulls or the bears?
EQUITY MARKETS SELL-OFF
Last Friday, the equity markets sold-off over 300 points. Many have attributed that sell-off to the resignation of the European Central Bank’s chief economist, Jürgen Stark – the second German ECB official to jump ship in recent months over policy differences. Stark disagreed with the ECB’s increasing market interventions; he feels it is up to the Eurozone governments to bailout the distressed regions.
There’s almost no question that Greece will be forced to default on their obligations, and many publications have reported that it only has a few weeks of cash left in its budget. It’s also been reported that Greece has failed to meet the austerity goals it agreed to follow under the aid package. Even though Greece has significantly increased its taxes, there are very few people who actually do pay taxes in Greece. And so, increasing taxes on the few people who pay them may force them to leave the country, worsening the problem.
Additionally, Greece’s “cradle to grave” philosophy simply isn’t working. A majority of Greece’s citizens are government employees (directly or indirectly), although none of them have been laid off to this point. It seems apparent that the measures Greece is taking to close the budget shortfall are not enough. It’s no wonder that Germany is now unwilling to help Greece avert default.
This story is interesting, but it doesn’t explain the dramatic impact on the Dow Jones Industrial Average – a loss of almost $1 trillion in equity values in the U.S. financial markets on Friday alone. Many argue that Greece’s default would reportedly cause severe financial implications to the United States, but U.S. bankers have stated that they have little exposure to Greek sovereign debt. In addition, since this crisis has been ongoing for several years now, it’s unlikely that banks do not have credit insurance on these Greek obligations. As such, assuming that the U.S. financial banks would incur a huge hit from a default on Greek government bonds makes little sense.
Moreover, even if there were a default on Greek government bonds, it would not be a 100% loss. Presumably, the Greek government would be forced to abandon the euro and issue its own currency. Since Greece’s own currency would be highly inflated with “funny money,” the debts would be repaid with deflated Greek currency, almost ensuring that Greek government bondholders would suffer a loss. But by no stretch of the imagination would these losses be 100% of the bonds’ face value.
My point is that the U.S. banks have almost no exposure to Greek debt. And to the extent that they do have exposure to Greek debt, the banks almost assuredly have credit insurance against that debt. Finally, even if Greece were to default, it would certainly not be 100%. Therefore, I’m still baffled by the sell-off in the U.S. markets due to this situation.
Many have argued that the major European banks in France and Germany will become insolvent from to the situation concerning Greece. This argument is naïve, and it baffles me whenever I hear it reported in the financial press. So far, the ECB has purchased $75 billion worth of sovereign debt from various countries in the EU. This was done to stabilize the bonds of these countries, but it still hasn’t worked. The bonds have continued deteriorating and its yields have skyrocketed.
The analysts seem to forget that these European banks exist in the heart of Socialist economies. Neither Germany nor France is hesitant to invest money directly in their banking system in order to stabilize the banks. In fact, before 1980 almost every major bank in France was owned directly by its government, not the private sector. It would be much less expensive for these particular governments to invest money directly into their own banking systems rather than purchase the government bonds of a country with no financial controls such as Greece. To say that the reason the equity markets in the U.S. are going down is because the banks in Europe run the risk of insolvency is an uninformed statement.
The equity markets sell-off on Friday, September 2nd – which was attributed to the jobs report reflecting a net zero increase in employment – is also confusing. The financial press again failed to report all the pertinent information, which caused a volatile market response. For instance, 45,000 Verizon workers were on strike during August, and those workers were included in the unemployment figures. During September, these workers returned to work without a contract and will be counted as employed for this month. If you add-back these workers, the actual jobs report would have indicated a 45,000 increase in employment during August.
These employment levels certainly aren’t stellar, but they’re hardly as devastating as reflected by the performance of the equity markets. After all, it wasn’t that long ago that the employment reports were reflecting 400,000 to 600,000 negative jobs each month. The fact that the numbers have increased to zero should indicate that the economy – even if it’s not robust – isn’t worsening.
Time and time again I point out the excellent earnings of major U.S. corporations. Many reported this week that if the U.S. falls into recession, corporate earnings would be cut dramatically. But that statement doesn’t appear to be supported by the facts.
In reviewing the first quarter of 2011, the economy functioned at a less than robust 0.7% GDP. Basically, this represents a flat line on economic activity. However, the S&P Index of 500 Stocks reported record earnings during this muted GDP growth. Therefore, if you assume that the third quarter of 2011 GDP was essentially zero, then why has almost every analyst forecasted record profits during this same quarter?
FINANCIAL MARKETS INCONSISTENCIES
The inconsistencies in the financial markets right now are overwhelming. Although it seems much worse, the S&P 500 is only down 7% for 2011 through Friday, September 9th, but is up over 20% for the last year. In long-term investing, a 7% decline should not be unexpected by investors; a true 20% movement in the market isn’t that unusual, so a 7% decline clearly isn’t that extraordinary. Due to the extraordinary volatility in the markets, it certainly feels like the losses should be significantly greater.
As of Friday, September 9th, the S&P 500 was at 1,155. Yesterday, a Bank of America/Merrill Lynch strategist, David Bianco, reconfirmed his year-end target for the S&P 500 at 1,400. This means Bianco expects the S&P 500 to increase 21% in the next 3½ months. He stated that the market has priced in an 80% chance of recession for 2011. Also, neither he nor I believe a recession is in the near future. Most investors would find it inconsistent that on the same day the financial media is reporting chaos in the financial markets and a worldwide sell-off, the chief market strategist for the largest brokerage house, Merrill Lynch, is actually reconfirming his year-end target of the S&P 500 being up 21% from the current level.
These are not the only inconsistencies being reported by the media today. Ironically, almost all states are currently reporting higher revenues from sales tax, state income taxes and other income sources. It is illogical to assume that sales tax revenues would increase without corresponding sales increases. The Federal government is also reporting higher payroll tax receipts in 2011. If employees weren’t earning more, then payroll taxes wouldn’t be increasing.
In August, the Department of Commerce reported a large increase in U.S. exports. This can only mean that U.S. manufacturing is increasing, reflecting that U.S. exports is one of the bright stars in our economy in recent months. This can mainly be attributed to the lower dollar and the higher efficiency of the U.S. worker. For instance, German automobile manufacturer, Daimler AG (maker of Mercedes-Benz), is producing cars in South Carolina that are being exported around the world.
As I’ve indicated in prior posts, analysts are projecting that the earnings for the S&P 500 for 2011 will be approximately $100/share. Even if the analysts are off by 10% and earnings are only $90/share, given a conservative multiple of 15, the S&P 500 would have a current valuation of 1,350. Given the S&P’s current level of 1,155, then that index would be undervalued by 17%. With the low yields on U.S. Treasury bonds at 1.9% today for the 10-year bond, a multiple of 15 is quite conservative. Furthermore, even though the markets continue selling off, valuations are more than fair – and perhaps even undervalued – at the current time.
There’s also been a drastic movement in the bond market. As I mentioned above, the 10-year Treasury bond sells today for 1.9% even though inflation is forecasted to be close to 2% in the coming decade. It’s difficult to imagine why any knowledgeable investor would buy a Treasury bond that would most assuredly lose money in purchasing power over the next decade. Unfortunately, many seem to have done so.
The financial media is reporting that the U.S. is falling into a serious recession. Meanwhile, the National Association for Business Economics slashed their potential growth forecast for 2011 and 2012 this week. These economists are forecasting that the economy will grow at 1.7% for 2011 and at 2.3% for 2012. While the media talks about a recession, NABE economists are talking about reasonable growth over the next two years. Should investment decisions be based on what the financial media reports or on projections from economic experts?
THE AMERICAN JOBS ACT PLAN
Clients have asked me to comment on President Obama’s new jobs plan and the potential for QE3 by the Federal Reserve. While the jobs plan will help GDP growth some, it’s hard to imagine that it would help enough to offset another half trillion dollars in debt. If Congress approves this plan, we should expect some GDP growth in 2012 from this bill. Hopefully the growth will be enough to offset the additional money that will need to be borrowed to finance the plan. Regardless of what the president says about the plan being fully paid for, it will clearly be an outflow of cash in 2012 and an inflow of cash in some later year. In other words, it may be paid for, but not in the same fiscal year it’s spent.
Last Thursday night, President Obama gave his speech on his American Jobs Act plan. In it, he indicated that everything in his proposal has been supported by both Democrats and Republicans. Yesterday, Obama outlined how the $447 billion jobs bill would be paid for – by various tax increases that have been systematically turned down by Congress a number of times over the last three years, even when Democrats controlled both the House and the Senate.
Frankly, I don’t understand why President Obama’s solution is to increase taxes. I find it even more distressing that while the money would be spent in 2012, the tax changes would not go into effect until January, 2013 – two months after the November, 2012 presidential election.
As for QE3, the most recent proposal is that the Fed will sell some of their short-term Treasury bonds and buy longer term Treasury bonds. It would take another post to explain the rationale for this approach, but my opinion is that QE3 wouldn’t hurt. Why? Because the Fed wouldn’t be printing any new money or expanding their balance sheet; rather, they’d be selling some items on their balance sheet and buying others. I can’t imagine this having a negative effect, and therefore, bring on QE3!
I recognize that these news items are inconsistent with the stock market’s continuing decline, and frankly, that’s the reason our firm isn’t selling. Instead, I’m holding out for sanity to return to the markets. With the volatility in Europe and the constant fear of a recession in the U.S., I don’t expect the wild swings in the market to stop anytime soon, but I still believe that the markets will eventually increase. In my opinion, 2011 will still reflect double-digit positive numbers when all is said and done.
As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
We're very excited to announce that, after 21 years in Midtown, we will be moving to a new location! In November 2011, Rollins Financial, Inc. and Rollins & Associates, P.C. will be relocating to the heart of Buckhead. The new space will be conveniently located in the Atlanta Financial Center, within walking distance of Lenox Mall, Phipps Plaza and countless restaurants.
As always, our clients will continue to receive the same personal and professional service they have come to expect from our experienced staff.
We’ll keep you posted as to when we’ll finally be in our new office. In the meantime, to learn more about the Atlanta Financial Center, please visit their website.
We’re looking forward to showing you our new location - and remember,
¢hange is good...
In observance of Labor Day, the offices of Rollins Financial and Rollins & Associates will be closed on Monday, September 5th. Please note that all major U.S. stock exchanges will also be closed due to the Labor Day holiday.
If you require immediate assistance on Monday, please contact Joe Rollins at 404.372.2861 or jrollins@rollinsfinancial.com. Our office will re-open for business on Tuesday, September 6th at 8:30 a.m.
You may have heard a certain Republican presidential candidate spewing rhetoric that may lead supporters to believe the Federal Reserve is the devil incarnate. Rick Perry is calling any moves undertaken by Chairman Ben Bernanke to expand the money supply “treasonous,” a statement Sarah Palin agreed with during an appearance on Fox Business. (“printing more money to play politics at this particular time in American history is almost…treasonous in my opinion.”) Clearly, neither the Texas governor/presidential candidate nor the former half-term Alaska governor/Fox pundit has any idea what the Federal Reserve’s economic goals are or how it operates. I’m not saying they’re debauched, just uninformed.
The Federal Reserve System was created by Congress in 1913 after a series of financial panics. The role of the Fed has evolved over time, but its two primary goals are to maintain price stability and increase employment. The main way the Fed controls economic activity is through interest rates, under the theory that the lower the interest rates, the better the economy. If interest rates are low, businesses can borrow inexpensively, build plants and equipment, employ more people, and expand. Likewise, consumers can buy cars, TVs and other products and services with low interest rates and easy credit.
In 2008, the Fed reduced the Federal Funds Rate and the primary interest rate to almost zero. Since they couldn’t go any lower than that, in 2009 they began utilizing a less conventional technique to stimulate the economy – quantitative easing. This leads to today’s Q&A, as follows:
Today’s question comes from Mike, a client who is wondering about the effect of quantitative easing on the stock market.
Q: The Fed has instituted quantitative easing policies twice to stimulate the economy. Have those efforts artificially propped up the stock market?
A: Considering all the talk in the press that Fed Chairman Ben Bernanke may announce another round of quantitative easing (QE3) tomorrow during the Fed’s annual symposium in Jackson Hole, Wyoming – and commentary as to whether or not QE1 and QE2 were effective – this question is on the minds of many investors.
The Background
In simple terms, quantitative easing is when unconventional methods are used to pump money into an economy to drive down interest rates and encourage more borrowing and growth when typical monetary policy isn’t working.
In the U.S., the first round of quantitative easing, “QE1”, introduced “credit easing” – wherein the Fed purchased government-sponsored bonds, mortgage-backed securities and Treasuries, and recorded that it had done so. This is called “expanding the balance sheet”. This money is then made available for banks to borrow in the hopes that it will increase the amount of money in the economy and, therefore, reduce long-term interest rates.
QE1 ended in the spring of 2010, but the economy continued to waver. And so, in the fall of 2010, the Fed indicated that they would take on new quantitative easing measures in an effort to combat persisting high unemployment and low inflation – actions that came to be known as QE2.
QE2 was a different animal than QE1. Whereas QE1 utilized credit easing to increase money in the economy and reduce long-term interest rates, in QE2, the central bank reinvested proceeds from its mortgage-related holdings to buy Treasury debt and also purchased additional long-term Treasury securities. The QE2 efforts ended on June 30th, with economists giving it mixed reviews.
QE’s Impact on the Economy and the Stock Market
So, has QE provided any benefit to the economy? It’s hard to say for certain, and as stated above, economists’ opinions have varied on the subject. When the Fed buys bonds from the public and private sectors, one would intuitively think it would force interest rates down; and that when the Fed quits buying these bonds, it would force interest rates back up. On the contrary, almost exactly the opposite has happened.
When QE1 began, interest rates actually started to rise, although from a very low level and only to moderate rates. It was generally presumed by the markets and the so-called experts that as soon as QE2 was scheduled to end on June 30th, interest rates would almost assuredly skyrocket. In fact, since June 30th, the 10-year Treasury bond – the benchmark bond issued by the Federal government – has plummeted to 2%, a record low for the last 60 years. Oddly, quantitative easing actually caused interest rates to increase when implemented, and rates to decrease when the program stopped.
Politicians often speak of the Fed “turning on the printing press.” It’s true that the Department of Treasury has the ability to print new money, and therefore, it’s possible to produce new money to pay off old debts. In fact, quantitative easing’s effect was basically the same as printing new money without ever turning on the printing press. The Fed’s purchase of public and private sector debt instruments put tons of cash into the U.S. monetary system which, in theory, should have increased economic activity. This is what Governor Perry was criticizing as being political.
It’s a misconception by many Americans – including some politicians – that the monetary base is diluted when the Fed prints money. But as the above example indicates, even though printed money was utilized, the Fed actually purchased assets. There’s no net increase in assets owned by the U.S. by substituting cash for bonds – it’s a one-for-one transfer. The Fed simply has the bonds on their balance sheet which can be sold at any time and the cash put into the economy. It’s a form of putting excess cash into the economy rather than bonds in the hopes that people holding the cash will use it for the betterment of the economy. This method has been used by central banks worldwide throughout history.
For example, U.S. banks currently have $1.7 trillion in cash on deposit with the Federal Reserve. U.S. corporations are said to own over $2 trillion in cash that’s accumulated on their balance sheets. There’s no question that the monetary base has exploded by the Fed’s actions of taking money from its pockets and putting it into the pockets of consumers, companies and banks in the U.S.
Theoretically, once this money is in the system it will be utilized to create commerce. Unfortunately, this is where the theory has failed. In a nutshell, a combination of economic uncertainty, a distrust of Washington, and conservatism are causing U.S. corporations to refuse to spend their hoards of cash. Banks are covered up in cash right now, and the reason CD rates are so low today is because banks have little interest in more deposits since they received more than they could ever loan to the general public and businesses. Likewise, businesses are also covered up in money and have no desire to borrow from banks.
While approximately 10 million people in the U.S. would benefit from refinancing their mortgages to lower interest rates – which would, in turn, help the economy – banks are unwilling to lend to these potential borrowers – even those with good credit. This is a Catch-22 – money is everywhere, but no one is willing to loan it or utilize it due to the uncertainties. And although there’s a lot of talk of the potential for the Fed to go forward with another round of quantitative easing, (“QE3”), for the foregoing reasons, I just don’t think that announcement is in the cards for Bernanke’s speech this Friday.
Those who are critical of the Fed’s QE efforts thus far must remember that just as easily as they were able to put money into the system, they are able to remove it from the system. To do so, the Fed would reverse the effects of QE by selling the bonds that they currently hold on the open market and withdrawing the cash. To the extent that the Fed is holding Treasury bonds, they would simply force the banks to buy them and remove that cash from circulation. As such, if you believe that the Fed’s flooding of the economy with cash is a negative, the argument could easily be made that the positives far outweigh the negatives. But if the Fed doesn’t retire that cash and take it from the monetary system at some point in the future in an effort to shrink the money supply, it would undoubtedly be inflationary and would decrease the value of the dollar.
It could be argued that since the beginning of the Fed’s efforts, QE has been successful since it has kept interest rates very low; it has forced the value of the dollar down (helping exporters); it hasn’t created inflation in a broad sense to this point, and; it hasn’t diminished the value of most assets in the U.S. (depreciation). On the other hand, QE has been unsuccessful in that it created very little economic activity. In fact, the economy slowed dramatically during the period of time QE was in effect. It has also forced down the value of the dollar, increasing the value of all commodities. Oil and other needed commodities move inversely to the value of the dollar. This means that oil and commodity prices have increased. Higher gas and food costs are a drag on the U.S. economy in some way or another.
There are also those who argue that quantitative easing has made the stock market soar, but it’s hard to draw a direct parallel between quantitative easing and the stock market. There’s an indirect parallel in that quantitative easing was very successful in keeping interest rates low. With interest rates as low as they are, there’s virtually no incentive to buy interest-bearing certificates. For example, the dividend yield today for the S&P 500 index is actually higher than the 10-year Treasury bond yield. Therefore, if quantitative easing was successful in making interest-bearing certificates unattractive, then it could be argued that it’s inflated the stock market. However, the real reason stock prices are higher is because earnings are clearly superior and getting better. I’m not sure there’s any direct correlation to earnings being great and quantitative easing, and therefore, I question whether QE has caused higher stock prices. Perhaps the best answer is, “It depends.”
So, if you’re anticipating Uncle Ben to wave his magic wand on Friday and announce QE3, it’s unlikely that fantasy will be unfulfilled. My guess is that Bernanke, as always, will talk thoughtfully about the many options that are available to the Fed to stimulate the economy. But it appears that the moves in monetary policy to stimulate the economy are few and far between. Hopefully, Bernanke will state that they’ve done all they can do, and it’s now time for Congress to do something positive. But I wouldn’t count on that, either – they’ve already proven themselves to be incompetent.
My guess is that rather than Bernanke announcing QE3, he will simply extend the maturities on the bonds held by the Federal Reserve which now amount to $2.7 trillion, successfully reducing long-term interest rates. Since a change of that nature would be subtle and doesn’t constitute a direct intervention in the economy, I suspect we’ll see a market sell-off on Friday following Bernanke’s speech since the traders will want much more.
At the end of the day, none of Bernanke’s comments have much effect on the stock market. Rather, the stock market is driven by the economy and corporate earnings, and all this talk is distracting. Even though the stock market has sold off 15% from its high, as of today, nothing has changed fundamentally. Corporate earnings are still extraordinarily high and interest rates are extraordinarily low. Gold is now selling off and is correcting, and interest rates are starting to rise. Each and every one of these indications almost assuredly indicates a higher stock market in the future.
While the traders are working their way into a frenzy over what Bernanke will potentially do, none of it will really matter come next week since it’s earnings that control the stock market’s future. Currently, our future seems to be better invested in stocks than anywhere else.
Thanks for your question, Mike. We’ll have to wait and see if the Fed has decided to go forward with QE3 this Friday when Bernanke speaks at the Jackson Hole symposium – and what the market does after his speech.
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I’ve spent many hours over the last several days watching the stock market reports and the carnage taking place in the international equity markets. On Thursday – due to a rumor that was reported – the U.S. stock market also suffered a major decline. The rumor basically asserted that the European banks were suffering liquidity issues and had to borrow money from the EU in order to meet their current liquidity needs. In a market as jumpy as this one, all it takes is an unfounded rumor to create a massive sell-off.
I am amazed by the bargains currently available on the stock market. The only two asset classes that have increased in recent weeks are U.S. Treasury bonds and, of all things, the commodity gold. About two weeks ago, the S&P downgraded the U.S.’s credit rating, and ever since that day U.S. Treasury bonds have (counter-intuitively) rallied dramatically. At one point on Thursday afternoon, a 10-year Treasury bond was selling below 2%, a rate so low that it hasn’t been seen in the U.S. since just after WWII.
Additionally, gold continues to skyrocket beyond any reasonable level. No one has been able to give any economic explanation for the rally in gold; it’s so overdone at this point that it’s almost laughable. It’s hard to laugh, however, when U.S. Treasury bonds and gold are the only two financial assets to have increased while everything else has seemingly thrown the baby out with the bath water. Who is going to buy your gold when all other assets are worthless?
It’s fairly easy to see that those who are selling the market nowadays are doing so indiscriminately. It makes no difference whether you have a high performing stock like Apple or a low performing stock like Hewlett-Packard – they’re all being sold. It also makes no difference whether a country is financially strong like Germany or if it is a weak, essentially bankrupt country like Greece – they’ve all suffered the same selling pressures. The point I’m trying to make is that it would be an unusual time, indeed, if every financial asset other than Treasury bonds and gold were essentially worthless. I’ve never believed that before and I don’t believe it today.
I couldn’t help but look into the valuations of two of the major bank stocks – CitiBank and Bank of America. CitiBank has an international franchise and $273 of cash for every share of its stock. Cash today on CitiBank’s balance sheet is approximately $800 billion. The book value per share of its common stock is $60.33. However, today it’s selling for $27.84/share – less than 50% of its book value.
Bank of America’s valuation is even more pronounced. It has $63 per share of cash on its balance sheet equaling $640 billion. Its book value is $20/share, and it’s selling at $7/share – a mere 35% of its book value.
It should be fairly clear to anyone who even attempts to understand the value of these bank stocks that they are ridiculously low. There’s no question that banks face potential liabilities, but it’s unreasonable to believe that 35% to 50% of their net worth will be wiped out in unaccrued liabilities.
This week’s sell-off occurred when it was decided that the EU couldn’t possibly fund its debts. Clearly, in the eyes of many, the entire region was falling into a recession. While it’s true that Germany’s Q2 GDP was only marginally positive, it would be a mistake to dismiss that country as being financially weak. It’s one of the greatest engineering exporters in the world. Even if other countries in the EU fall into a severe recession, Germany will likely avoid it. If that’s the case, however, then why did Germany’s stock market index fall 10% this week?
The major market movers are again forecasting a severe and prolonged recession in the United States, but with very few facts to support their forecast. While it’s true that GDP has been low, very few economists are actually projecting a recession in the second half of this year. In fact, earnings projections for the largest companies have remained stable. It’s certainly not a guarantee that earnings wouldn’t be diminished if the U.S. fell into a recession. Since most of the Fortune 500 companies sell almost 50% of their products overseas, a recession in the United States wouldn’t necessarily impact valuations.
It was announced this morning that many of the major money market accounts are having a hard time showing a positive rate of return. Interest rates are so low right now that sponsors of money market accounts can’t even cover their own operating costs. A 10-year Treasury bond is selling at 2.1% today despite the fact that nearly everyone believes the rate of inflation will be greater than 2% over the next decade. Isn’t it interesting that people are willing to invest in money markets earning zero and 10-year Treasury bonds with a negative real return over inflation rather than a stock like AT&T with a fairly secure dividend yield of 6.1%?
My point is that reason has been abandoned because of fear. There’s a fear sweeping the world that is unsupported by the economic facts. After my most recent post, a client pointed out that I was perhaps missing a major component of stock market valuation – investor sentiment. While investor sentiment is undoubtedly impacted by Washington’s incompetence and the lack of leadership out of the Executive Branch, I still think our current issues have more to do with fear than with reality (although I’m not so sure I understand the root of that fear).
Today, it’s perfectly possible to buy a large number of utility and other stocks with dividend yields in excess of 5%. You can also very easily buy high-yield bonds yielding 8% or greater from very strong financial companies. Valuations on U.S. stocks are at multi-year lows and there are essentially no better alternatives for investing. Despite those positives, the market consistently goes through waves of fear. When investors are fearful, they do not sell based upon reason.
It’s also possible that – due to the extraordinarily negative investor confidence and the reductions suffered by the stock market over the last few months – the consumer could completely shut down. However, I really doubt that will happen. Retail sales for the last three months have been up consistently higher and car sales have been okay over the last six months, but will likely accelerate moving towards the end of the year. In the U.S., we are junking far more cars than we are selling new ones to replace them. With interest rates as low as they are, 30-year mortgages are now bordering on 4%. If you have contemplating refinancing your mortgage, now is the time to do so.
I turned off the financial news for a while to evaluate the facts and see if I was missing something in this market sell-off. It’s true that the cost of oil has decreased almost $20/barrel in the last month or so. The price of gasoline is $1/gallon cheaper, which provides an enormous windfall for consumers. Corporate earnings – rather than being diminished – have actually increased. Corporate earnings for Q3 were significantly higher than they were in the 3rd quarter one year ago, and projections for next year are even higher. The cost of buying almost everything is significantly lower due to lower interest rates. While unemployment is high, it is now trending lower. While the economy is flat, it’s a long way from being negative. The number of known positive facts to the number of known negative facts appears to be significantly greater. I can’t evaluate rumors, suspicions or even scare tactics, but evaluating only the facts doesn’t leave me feeling all that bad.
Before arriving at the office this morning, my anxiety was high. I was feeling a need to reallocate our portfolios, but after reviewing how they are currently invested I came to the conclusion that there was nowhere better to go. Our portfolios are invested with the best money managers in the world – all of them didn’t just wake up stupid! Valuations are extremely cheap right now and I believe the market will rebound very soon. Hopefully, you will be patient enough to enjoy the upturn.
As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
Atlanta-based Rollins Financial Advisors is a registered investment advisory (RIA) firm, putting our clients first for more than 30 years. The firm is led by Joe Rollins, Robby Schultz, Eddie Wilcox, and Danielle Van Lear.
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