Friday, September 23, 2011

Twisting the Market Away

From the Desk of Joe Rollins

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.

Best regards,
Joe Rollins

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