Friday, June 21, 2013

Let’s Discuss Investing (not Speculation)

From the Desk of Joe Rollins

The media has been shouting for the last several days that the financial markets are in turmoil and a severe correction has started. If you read the front page of many national publications, you can almost rest assured that the information is sensationalized. While the markets have undoubtedly been extraordinarily volatile over the last three weeks, there is no reason for investors to panic.

The markets have been down in excess of 500 points over the last two days, but don’t be so quick to forget that on Monday and Tuesday together, they were up greater than 200 points. These movements in the market are symbolic of trader activity – traders who were likely trying to take a position before June’s triple witching day. This is the third Friday of March, June, September and December, and it is the expiration day for three types of standardized contracts: stock options, stock index options and stock index futures. Investors often unwind their positions on these contracts during or immediately before triple witching days, leading to increased trading volume. Unfortunately for us, none of these items have to do with investing – they have to do with speculation.

At approximately 3:00 p.m. EST on Wednesday, June 19th, Federal Reserve Chairman Ben Bernanke gave a press conference regarding the economy. Almost immediately afterwards, the markets took a huge nosedive. The sell-off continued on Thursday, causing the Dow to fall 354 points for the day – its biggest loss of the year. What did Bernanke say that caused such an adverse effect on the markets? That the economy was falling into a recession or depression? That unemployment was getting ready to skyrocket or that the U.S. government was going to default on its bonds? Nope, not at all.

Bernanke said Wednesday that, based on current positive economic conditions, the Fed might start to cut back its bond purchasing starting in the fall and stop buying them entirely during 2014. He also said that the Fed would hold onto the securities it owns and reinvest the interest from them, which he expects would help keep long-term rates low.

There’s been great anticipation in the investing world as to what the Fed would do with its bond buying program. The Fed is currently buying $85 billion monthly in bonds in the open market to keep interest rates low, and they have been tremendously successful in keeping interest rates near zero which is helping the real estate market. Bernanke basically gave us his strategy in the bond buying program, and said that if the economy does not perform as expected, then they would not cut back and ultimately end its bond purchasing. What explanation could have been clearer?

Responding to a question from the audience, Bernanke made it absolutely clear that he didn’t anticipate any interest rate increases until 2015. Make sure you understand that he is talking about a two-year period from today before the Fed even contemplates increasing interest rates – a move that they will only make if the economy can support such increases. I can’t imagine anyone who was paying attention to his words misinterpreting Bernanke’s specificities and the Fed’s intentions.

Not only was the information relayed by Bernanke good news for investing, it also provided two other important positive indicators for investing. Specifically, the Fed moved up its GDP projection for 2014 to a range of 3% to 3.5%. This isn’t robust, but it’s a long way from negative. The Fed also forecasts the U.S. unemployment at 6.5%-6.8% in 2014, a remarkably better percentage than the current rate of 7.5%. Therefore, the Fed’s analysts feel that the economy is set to improve through 2014. Once again, this is a very positive sign for equity investing.

As a supplement to the other financial information, the Fed reported that its anticipation for inflation actually ticked down. They expect inflation over the next few years to be less than 2%. In fact, the core rate (excluding gas and food) for the last 12 months is only up less than 1%. Low inflation in an improving economy is a very positive sign for the stock market.

Given all of the positive information provided by Bernanke, who would’ve expected the negative reaction by the financial markets? In addition to the Dow’s 5% sell-off, bonds were absolutely crushed over the last two days. The 10-year Treasury bond has gone from 1.4% in May to 2.43% - a historic move in such a short period of time. And did I mention that the anticipation for inflation was virtually zero, which would imply lower bond yields, not higher interest rates? Duh – what is going on here?!?

My point is this – the reaction from traders should be ignored by investors. Investors need to evaluate the underlying investing environment and not worry about the day-to-day volatility brought on by traders. The truth of the matter is that for the month of June alone, the S&P is down only 2.5% and continues to be up 12.4% year-to-date. This performance is quite remarkable only 5.5 months into this investment year.

There’s no question that bonds have been crushed over the last few months, but I believe this topic has been grossly exaggerated. For the first time in years, a 10-year Treasury actually has a positive real rate of return. If you can buy a Treasury bond at 2.4% and inflation is only 2%, you are finally actually making some money. That has not been the case over the last three years when Treasuries have had a negative real rate of return.

While the correction in bonds has been severe, I anticipate that they’re highly likely to make money over the next year. It’s unlikely for the rates to continue going up an enormous amount over the short-term. My forecast is that a few years into the future, interest rates will have to increase and bonds will have negative rates of return. But, I don’t believe that is an immediate concern for the next 12 months.

As for equities, virtually every positive economic indicator remains intact:

  • Corporate earnings continue increasing going forward.

  • The economy is forecasted to continue to expand up through 2014.

  • The Fed has indicated there will be no significant interest rate increases through 2015.

  • Even though interest rates are higher, they are still at historic low levels.

  • Because interest rates are still low, buying Treasuries or CDs provides rates of return that barely matches the cost of living.

  • Money markets are paying virtually nothing.

  • Corporate balance sheets are rock solid.

  • Corporations and individuals currently have $3 trillion of un-invested cash in money market accounts.

    There’s no question that the economy is improving in our part of the country. There’s new residential construction everywhere around my house, and the house across the street from mine (which was vastly overpriced) sold in less than 30 days. Potential homeowners are finally seeing that when interest rates start to move up, they need to move quickly to purchase property before the move occurs. Economic activity, again, is created every time a new house is built or sold.

    I will provide a more in-depth analysis after the end of the financial quarter (June 30th), but because of the high volatility in the markets this week, there were some things I wanted to point out to you regarding investing. At Rollins Financial, we are not traders, and if you are an investor, nothing that has happened in the last 30 days has been anything but positive for investing into the future.

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

    Best regards,
    Joe Rollins
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