Carl’s Corner – 2014

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Carl Perthel, CMT

Disclaimer: The views expressed are those of Carl Perthel, CMT. These views are subject to change at any time and The American Asset Management Group, Inc. (AAMG) disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for AAMG are based on many factors, may not be relied upon as an indication of trading intent on behalf of AAMG.

 

*** Carl’s Corner for December 2014 ***

For those of you who were unable to tune-in to the Conference Call on November 12th, a transcript is now available at www.aamg.com under the tab, “Past Market Views-Archives-Markets Unplugged XII.” I would invite you to visit the website and read the Conference Call transcript regarding our current views on the financial markets. We hold these calls twice a year on the second Wednesdays in May and November.

November started the first month of the equity market’s “favorable” season — six consecutive months, lasting from November through April. Right out of the gate November is in lock-step with the “favorable” season, rising +2.69%, including dividends.

In last month’s Carl’s Corner, we cited the equity market’s “about-face” coinciding with the St. Louis Federal Reserve President’s “dovish” remarks promising the continuation of “easy money” policies. After the release of the Fed minutes two weeks ago, Ben Levisohn, in the November 24th issue of Barron’s Magazine, called Janet Yellen’s Federal Reserve, the “Land of Confusion.” He summarizes that the messages coming from the U.S. Federal Reserve are mixed and contradictory. With that in mind, because the last statement on October 16th was “dovish,” should we look for “hawkish” Fed language soon, in order to slow down the market’s meteoric rise since mid-October? I wouldn’t be surprised…

A few weeks ago China cut its interest rates while European Central Bank’s top dog Mario Draghi stumped for quantitative easing. Earlier last month the Bank of Japan issued a directive for larger asset purchases.

From around the world global central banks are following the path that the U.S. Federal Reserve blazed back in 2009. Maybe Barron’s next article should be entitled “The Land of Easy Money!”  As we stated in Markets Unplugged XII, “It’s an interconnected world. That’s why we are seeing a concerted effort by central banks around the world to keep up with stimulus programs. We need each other as trading partners and a slowdown in one part of the neighborhood {world} may produce negative consequences for other neighbors.”

How do these global economic data points affect the United States?  Put simply, weaker global growth can adversely affect the United States. A government report from early November showed September’s U.S. trade deficit unexpectedly jumped 7.6% to $43 billion due to exports dropping to a five-month low based on lower demand from our global trading partners. Let’s hope that global central bank “easy money” policies translate to real growth.

At November month end oil prices dropped the equivalent of 1,000 DJ-30 points on OPEC news that they would not cut production.  According to HSBC, low oil prices are, on balance, a positive for equities. Since 1970, in the 12 months following a -25% fall in crude, global equities have returned +19% in real terms. Lower gas prices will act as a tax cut for consumers of gasoline.  Could this event “jump start” the global economy and spur global consumers to purchase additional goods and services? Or is this news a harbinger for deflation?

Mid-term elections are over! The Republicans take the House and the Senate!  Matt Eagan, staff writer for CNN Money, pointed out in his November 5th article, “Stocks love when mid-term elections are over.” In the same article, he noted that Credit Suisse research found that “in the 21 midterm election years since 1930, {the equity markets} have seen an average return of +7.4% in the 100 days after a general election day, while returning nearly +17.8% on average in the subsequent calendar year after mid-term elections.”

Now, there are no guarantees that we are going to see these historical performance returns having just ended mid-term elections but, if history is any guide, the evidence may point to stronger equity markets until springtime.

But, in between now and springtime, with prices on the major equity indexes over-extended above their 50 day moving averages, we have reached “overbought” conditions. A pullback in prices here would allow this market to catch its breath. It’s been an all-out sprint higher since October 16th. Not even Usain Bolt, the fastest man on earth, can keep up this pace!  How about a pause to refresh?

Until next time, I wish you all a joyous Holiday Season!

Carl Perthel, CMT

 

*** Carl’s Corner for November 2014 ***

In last month’s note we warned that October, like Halloween, historically gives investors “tricks and treats,” due to volatility. Last month, we cited how the end of the historically “unfavorable” six month cycle occurs in October. The end of this cycle typically ends with a stock market bottom. True to form, the “scare” came as investors witnessed close to a -10% correction, bottoming on October 16. It’s been 30 months since a drop of that magnitude has occurred. But since then, the stock market has given investors the “treat” of rising +8.34% in the past 11 trading days. Last month, we warned that after an October bottom, prepare yourself for upward price movement, since “positive seasonality” for the next six months starts after the bottoming process ends. It’s started…

Coincidence or not? On Thursday morning, October 16th, the day the equity markets were accelerating to the downside, James Bullard, the “hawkish” St. Louis Federal Reserve President suggested to Bloomberg TV, that the Fed should consider putting a pause on its taper of the quantitative easing program. Now, I know the Fed is supposed to be “impartial” relative to the equity markets and has a dual mandate of pursuing the economic goals of price stability and maximum employment. But, after the “jawboning” by Mr. Bullard, I am beginning to believe that an informal, third mandate, of “price stability for the equity markets,” appears to be a reoccurring theme among Fed leaders during market downturns. Until that comment, Bullard was the most out-spoken member on the Fed Board, calling for the end of “easy money” policies. Why did Mr. Bullard make these “about face” comments exactly when the stock market was falling off the precipice, if the Fed is supposed to be impartial to stock market pricing?

In April 2010, at the end of Quantitative Easing (QE1), the SP500 corrected -17%. At the end of QE2 in June, 2011, the SP500 corrected -21%. On October 16th, 2014, the market was correcting close to -10% on the news that “tapering” was to conclude at the end of October. Without Mr. Bullard’s comments, were the equity markets on their way to dropping -17% to – 21% like those times before? For the equity bulls, please raise a glass and toast, Mr. Bullard, who may have single-handily staved off a larger correction in the stock market during the month of October, 2014.

Preliminary government data, released on October 30th showed the U.S. economy grew at a +3.5% annualized rate between July and September. This GDP number comes after a +4.6% GDP number in Q2, 2014. A spike in national defense expenditures and a shrinking trade deficit, two factors that cannot be counted on for long-term growth, added to this GDP number.

On a year-over-year basis, inflation-adjusted GDP rose +2.3%. Some argue that these numbers still represent an anemic U.S. recovery relative to post-war cycles. Still, the U.S. is the best house in a bad neighborhood, if you count the rest of the world as our neighbors. Whether the U.S. recovery is sustainable in the quarters ahead or enough to lead a global recovery remains a question.

While the U.S. markets got their help in the middle of October thanks to Fed member, James Bullard, the Bank of Japan (BOJ) threw its “stimulus” hat into the ring with the announcement of its decision to buy more assets at month end. BOJ will boost purchases to an annual rate of about $713 Billion (U.S.). This decision puts the dollar back on track against the yen, while driving gold and silver to their lowest levels since 2010. BOJ’s decision will help ease concerns about the end of the Federal Reserve’s U.S. stimulus program. Europe will likely follow Japan’s stimulus policies in the months to come. To assist global equity markets, Japan’s $1.2 trillion Government Pension Investment Fund announced new portfolio allocations that will double its holdings of domestic and foreign stock holdings.

The mid-term elections are upon us next week. If the Republicans take back the Senate, the market will likely move higher on this news. From a policy standpoint, the log-jam of bills already passed by the House of Representative, but blocked by Harry Reid (D-NV) from getting to a vote on the floor, may see the light of day. Even if President Obama finds his “veto pen,” there is the likelihood that some Democrats, distancing themselves from Obama policies, will fall in line with the Republicans in the near future. In this case, future Obama vetoes may be overturned. Dare I say, to wind up this note, that law makers on the Hill may “rise from the dead” (take some action on policy implementation) if the American people “vote in” a Republican majority in the House and Senate? Okay, enough for Halloween. Welcome to November. Until next month, have a Happy Thanksgiving!

Carl Perthel, CMT

 

*** Carl’s Corner for October 2014 ***

According to the Stock Trader’s Almanac (Wiley 2014), October is typically a transition month in the equity markets, with well-known bottoms occurring in 2008, 2002, 1997, 1987, 1979, 1978 and 1929. On the other side of the coin, many bull markets start by the end of October: 12 occurrences from 1946-2011. Also, the historically “unfavorable” six month cycle from May-October terminates at the end of this month. There are many cross-currents in October and it’s important not to lose this perspective if volatility presents itself. Volatility characterizes the month of October.

For the “bullish” case:  October presents the beginning of upward price moves, on average, in the financials, technology, healthcare, materials, cyclical, telecoms and transportation. Our research shows that since 1970, the DJIA-30 has achieved, on average, a positive return nearly 86% of the time from mid-October to the end of each calendar year. If you are a bull, keep an eye on these aforementioned sectors (especially technology) and this time frame.

The “big” news since our last Carl’s Corner is that the Federal Reserve Bank will be leaving interest rates at low levels “for a considerable time.” Fed Chair Yellen’s “concerns” continue to focus on unemployment and a slowing housing sector. Therefore, even though “tapering” ends soon, “easy money” policies are still a viable option in the months to come. A target for raising rates points to mid-2015. Please refer to Carl’s Corner (August edition) for an in-depth discussion on how rising rates typically affect stock market pricing.

Markets are a discounting mechanism and therefore, a leading indicator of economic events. For example, the recent demise of the Russell Small Cap Index (IWM), down –6.19% in September, may reflect investor’s concern over higher interest rates in the coming quarters. The smaller companies that comprise this index borrow heavily, more so than the larger capitalized companies that comprise the SP500 and the DJIA-30. In light of Fed “jawboning” about higher rates to come, on a relative basis, the “big cap” indexes have outperformed IWM this past month. Currently, “value” resides in the “large caps,” not the “small caps.” Small caps hate a rising rate environment.

In 2013, bonds moved lower while stocks moved higher – a reflection of money exiting fixed income and seeking yield in the equity market. In 2014, stocks and bonds have moved higher together. One thing is for sure, when the Fed does increase rates, stocks and bonds will not react favorably in the long run. Expect bonds to move lower first.

Initially, certain sectors of the market (like energy and materials) will respond favorably to rising rates, reflecting better economic conditions. Financials should also respond favorably, should the spread in interest rates get wider as rates rise. Industry groups that need to borrow money for on-going operations will suffer lower earnings in a rising interest rate environment. For investors, it will become a “stock pickers” market. If interest rates rise to unsustainable levels, then buying opportunities among equities will narrow as rising rates squeeze earnings expansion. In turn, lower profits typically result in lower stock prices.

Technical support levels on the SP500 occur at 1,950-1,965 near-term, with resistance at 2,000-2011. As for interest rates, in examining the 10-year yield we find that support occurs at 2.38% – 2.44%, while resistance occurs between 2.65% – 2.76%. If yields on the 10-year break above 2.65% and hold, it would appear that higher yields may be in store for market participants in the coming quarters. Remember, the market does not have to wait on Janet Yellen’s proclamation for “raising rates” before interest rates move to higher levels.

Typically, the oil patch relaxes between summer and the beginning of December. This year, the energy sector has followed this pattern. In addition to this seasonal phenomenon, the U.S. dollar is moving higher. Since oil is priced in dollars, it takes fewer dollars to purchase crude. Energy companies will see lower stock prices as a result of a higher U.S. dollar over the next few months, before the winter season arrives.

The Peak Oil Consulting Group predicts lower crude oil supply, coupled with higher demand in 2015 and 2016. They conclude that a gap will form between supply and demand that will send oil prices higher. There is a one-to-one correlation between a developing world and rising energy prices.  Companies providing “oil services” are the first on the scene when companies decide to start exploring. Drilling and services are the foundation to extracting energy. As a gap in supply and demand continues, oil services should benefit as growing demand continues in years to come.

Carl Perthel, CMT

 

*** Carl’s Corner for August 2014 ***

The U.S. economy, as measured by the Gross Domestic Product (GDP), surged to +4.0% in the second quarter, more than offsetting a first-quarter contraction of -2.9%. This preliminarily number puts growth back on an upward trajectory for 2014. GDP is the broadest measure of goods and services produced across the economy. The broad-market’s reaction was negative and remained so through the end of the month.

The investing public thinks a strong economy bodes well for an advancing stock market. The reality is typically different, and here’s the reason why: A stronger economy equates to stronger consumer demand. When consumer demand is strong, the cost to produce goods increases. More employees are needed to build more goods in order to meet demand.  There is an additional need for manufacturers to borrow money for holding their growing inventory, as well. Warehouse space must be built or rented which adds to their cost. Also, marketing and distribution costs increase since finished goods must be transported to wholesale and retail outlets to meet final demand.  Bottom-line: In a robust economic environment, most businesses will need to borrow money, leading to higher interest rates.  Higher interest rates translate to a squeeze on a company’s profit margin, leading to reduced earnings and eventually, falling stock prices. Initially, this is the stock market logic behind the negative price action in reaction to the “positive” GDP report.

Haver Analytics (http://www.haver.com/) released a chart reflecting the Consumer Price Index (CPI) from mid-June.  They noted the CPI breaking above a down trend line starting in October 2012. The “breakout” implies higher consumer prices ahead. The surprisingly strong GDP number of +4% at the end of July enhances the likelihood of a CPI trend continuation to the up-side.

Additional support for higher interest rates is reflected in the price action of the Russell 2000 index.  “Small cap” equity issues perform poorly in anticipation of rising interest rates, since smaller companies are highly dependent on borrowing, more so than their larger capitalized brethren that reside in the SP500 and the DJIA. The need to borrow in a rising rate environment will negatively impact profit margins and earnings growth.

Putting these data points into perspective, let’s not lose the notion that interest rates on an absolute basis are at generational lows. Mortgage rates use to be higher than 10%, while the “prime” was upwards of 20% (when I bought my first car). Right now, the equity market will react negatively if it believes the “rate-of-change” in interest rates is rising. Low historical rates do not guarantee a calm market. Even though low rates are always preferred by the borrower, it’s the direction of interest rates that concern the equity markets.

The Federal Reserve Bank of the U.S. is still “tapering” and “on point” towards reducing its “easy money” policies. The goal of “easy money” has been to spur the economy and induce higher employment. July’s preliminary GDP is a positive data point for the U.S. economy, compared to last quarter. But let’s not get ahead of ourselves. There will be a few more revisions before we know what the “real” number will be. But, should positive economic numbers over the broad spectrum continue, then expect the Fed to continue to reduce the “easy money” policies that investors in the equity markets have grown used to for the past 5 years. Let’s compare the Fed’s “easy money” against the possibility of a “tighter” monetary policy. How might we make the comparison? How about this: the implementation of a “tight money” policy is akin to taking candy away from a baby. We might have to put up with a bit of crying from the equity market while it adjusts to getting less candy than usual.

Carl Perthel, CMT

 

*** Carl’s Corner for July 2014 ***

This stock market reminds me of the marquee song in the musical,  Show Boat (1927) and the lyrics of Oscar Hammerstein II, “The Old Man River (substitute “Market” for River)…what does he care if the world’s got troubles…he must know something…he keeps on rolling along.” And the fact the equity market keeps on rolling along (higher) after 63 months, with nary a negative -10% correction in almost three years, has me eyeing the lifeboats.

Although the “cons” outweigh the “pros,” the “pros” have one thing going for them:  support from the U.S. Federal Reserve Bank and the perceived benefit that the Fed is in the investors “corner” should there be a “hiccup.” The Fed’s language still puts a positive spin on June’s disappointing economic numbers, while dismissing a contracting GDP in Q1, 2014.  Money seeks yield. For conservative investors seeking yield, there is no better place to find yield than the U.S. stock market. Hence, the market “keeps on rolling along;” a cyclical bull market going into its 64th month.

“Bearish” market participants can offer a host of sound reasons to be concerned: (a) market over-valuation at 15.5x forward earnings and 17x trailing earnings AND a Shiller CAPE P/E ratio of 26.1 vs. a 16.5 historical CAPE average; (b) a GDP that is shrinking, not expanding; (c) economic numbers that are mixed; (d) Fed tapering that is ending; (e) no (negative) correction of -10% or greater since August 2011; (f) a narrowing spectrum of issues being purchased; (g) more “small lot” purchasing while the “smart money” has exited the market in the past year; and (h) weak housing data. Nevertheless, the price action in the equity markets echoes Oscar Hammerstein II, “…he (Old Man Market) keeps on rolling along.” Hence, the old market axiom, “Don’t fight the Fed!”

Of course, the “Ben Franklin Approach” to making a decision would suggest you take a piece of paper and draw two columns; one labeled “Pro” and one labeled “Con.” Franklin would advise you to tally the number of reasons under each heading, and compare the totals on each side to determine which side to bet on.  In the above scenario, I count 8 cons versus 1 pro. Cons win, right? But since the U.S. Federal Reserve Bank is under the “Pro” column, is that enough for me to discount the astute Mr. Franklin and his methodology? I mean, come on, we are talking Ben Franklin here!

Year-to-date 2014, 9 out of the top 20 stocks in the SP500 garnering the best performance are energy issues. Late last year (Carl’s Corner, December 1, 2013) and in subsequent “Corners,” we commented to be on the lookout for “outperformance” in the commodity patch, with the premise that basic materials, like the energies, may be the next group to move higher.

The premise of this remark cited inter-market analysis, i.e. examining the relationships between the three major asset classes: bonds, stocks and commodities. Mentioned previously, as bonds move to the downside, stocks will move higher, followed by commodities. Asset class rotation along these lines has been playing itself out over the past three years.  Commodities are the last asset class to shine before all three classes move lower. Commodities are shining thus far in 2014. The energy sector is the #2 performer year-to-date, while the materials sector stands at #4.

This past week, Q1, 2014 GDP, already at -1.0%, was surprisingly revised down to -2.9%. The market response…it closed up! In Q1, 2011, GDP was negative by half this figure and the SP500 declined -19% less than three months later. The Fed responded to the 2011 GDP decline by implementing “Quantitative Easing 2 (QE2).” The GDP disappointment of 2011 not only became a distant memory, but fueled a cyclical bull market. Is the market now remembering the Fed’s QE 2 response in 2011 and simply not responding negatively this time around in 2014? It’s hard to believe in the midst of Federal Reserve tapering that the market would shrug off last week’s contracting GDP number. Unless the market believes that next quarter’s positive Q2, 2014 GDP estimates will render Q1, 2014 an anomaly.

How about the “tapering” of corporate stock buybacks? U.S. corporations have purchased $5 Trillion of their own stock since 2009. In an uncertain economic and public policy environment, it made more sense for corporations to play it safe. Rather than invest money in Research & Development, corporations bought back company shares, bolstering their own share prices. One wonders how long corporate stock buybacks will remain in effect before corporations make the alternative decision of choosing to spend money on creating new jobs and/or investing in capital expenditures. Certainly, United States GDP will be enhanced over the course of time with corporations making the latter choice. But when?

Carl Perthel, CMT

 

*** Carl’s Corner for May 1, 2014 ***

Judging by yesterday’s equity market price reaction to the FOMC statement, it would appear that the Fed is still providing the assurances needed to keep investors pleased while communicating that the economy is picking up.

The “sluggish” price action we’ve experienced in the equity indices this past month is a microcosm of the overall equity price action we’ve experienced in 2014. One would expect a pause in rising prices to digest last year’s gains after a banner 2013. Currently, both the SP-500 and DJIA-30 are holding their 50-Day Moving average lines; a line which offers price support in what we consider a “trading range” market. Not so with the NASDAQ.

As I watched the DJIA-30 drop 142 points or -0.91% on April 27, I noticed Coke was up +1.36% and McDonalds was up +0.88%. Divergences like this catch my eye because it’s a window (a least for that day) into what “Mr. Market” is rewarding. Coke and McDonalds are big cap, multinational, dividend paying companies with sound business models. In fact, since early March, the DJIA-30 and the SP-500 (big cap indices) have had positive returns, while the high-flying NASDQ (QQQ) is negative. As the cyclical bull matures (currently 62 months old next week), I believe we are seeing money move into higher quality issues. For those of you who were around, or for you market historians, remember the “Nifty 50” after the expansive cyclical bull-run leading up to the 1972 market top? The Nifty 50 was characterized by mega-cap, dividend issues, just like the aforementioned Coca-Cola and McDonalds. Speaking of dividends, utilities remain the best performing sector out of the nine SP500 sectors in 2014.

Standard and Poor’s Capital IQ (quantitative) research department posted a chart in April, showing the Average Monthly SP500 % Price Changes from 12/31/45 to 3/28/14. The chart supports the statistically valid supposition that more than 97% of all stock market returns occur between the months of November and April each year, on average. In addition, this chart emphasizes “mid-term” election year performance, between May-October, as being extremely bearish. 2014 is a “mid-term” year. Historically, the equity market hits a low point every four years in the first (post-election) or second (mid-term) year. Please contact me at carl@aamg.com and I will forward you this poignant piece of historical evidence.

Could inflation be in the cards? The federal government statisticians would say, “No.” Of course, their calculations do not include (the rising cost of) food and energy. Inflation gauges are changed every decade or so by government statisticians. Compliments of Shadow Government Statistics (http://www.shadowstats.com/alternate_data/inflation-charts); their work concludes that the 1990 (now defunct) based gauge puts inflation at +5% and the 1980 based inflation gauge at +9%. I bring this to light as we’ve seen our “in-house” relative strength model comparing manufacturing inputs (PPI) to consumer staples on the rise since last December. PPI normally leads inflation. Additional support regarding signs of rising prices comes from the April report at the Department of Labor (Bureau of Labor Statistics). On an unadjusted basis, the producer price index for final demand moved up +1.4% for the 12 months ending in March, the largest 12-month advance since a +1.7% increase in August 2013. Lastly, on April 17, Bloomberg news reported that the U.S. sale of $18 billion in five-year Treasury Inflation Protected Securities (TIPS) drew the strongest demand ever from a class of investors that includes foreign central banks.  Indirect bidders bought 58.4% of the securities at the TIPS sale. That compared with an average of 42.3% at the past 10 auctions. These early signs of inflation are positive because they reflect a stronger U.S. economy.

Our inter-market barometers study the correlations between bonds, stocks and commodities. By studying correlations, we can follow where money is flowing in the financial markets. In our December and January Notes we posited that commodities (oil and gas, synthetics, chemicals, agricultural chemicals, industrial and precious metals), which are the next group to follow stocks higher, might find “good footing” in the quarters ahead. Of the 16 Basic Materials sub-industry groups we follow each month, this month’s analysis is showing positive price action relative to 2013 in all 16 groups. Stronger basic material sub-groups normally translate to improving economies here and abroad. Stronger economies have been a goal for the U.S. Federal Reserve Bank and other central banks around the world since 2009. Maybe the time is now?

See you next month.

Carl Perthel, CMT

 

*** Carl’s Corner for April 2014 ***

Carl’s Corner celebrates its one year anniversary with this, our April 2014 issue. If you would like to contact Carl Perthel, CMT, please email him with your comments or questions at carl@aamg.com. For further information on AAMG investment services and benefits, please email us at info@aamg.com.

The “big” news item driving price action this month was Chairwoman Janet Yellen’s remarks regarding Fed tapering. Yellen’s “frankness” on March 19th at her first news conference as the Fed Chair was a surprise and to her credit, as it was in stark contrast to the obfuscation that typically accompanied her two predecessors, Messieurs Greenspan and Bernanke.  But, her candid remark about the Fed raising rates “six months” after the end of tapering (i.e. March, 2015) spooked the equity markets. And you know from previous discussions in Carl’s Corner, the equity market has needed its “easy money” fix to feel good for years. Just look at the market jubilation and rising prices after major quantitative easing (QE) programs were announced since 2009. Withdrawal from easy money is one thing, but now Yellen’s talk of actually raising rates is down-right frightening for a stock market used to stimulus.

We’ve remarked in the past that QE is a “double-edged” sword. On one side of the blade, quantitative easing has contributed to the rise in equity prices by providing low rates and monetary assistance since the 2008 credit debacle. The back side of the blade works to the detriment of rising equity prices. When QE accomplishes its objective to stimulate the economy, easing will taper and then disappear. This side of the sword is the current “flight path” of the Federal Reserve.  When the economy fully recovers, market mechanisms will drive up rates independently of the Federal Reserve. Business should expand. Expansion brings a clamor to borrow money for new plant and equipment as well as money to meet the higher wage demands of new hires.  Expansion also increases borrowing to cover the costs of inventory held to meet the expected rise in consumer demand. If businesses’ borrowing costs increase, then profit margins are squeezed.  Earnings will shrink and stock prices will decline. It’s the nature of the business cycle. And it’s here the Fed will consider raising rates.

Five years ago, in March 2009, the stock market troughed and started a cyclical bull market in equity prices while the economy was otherwise in an economic miasma.  Since 2009, quantitative easing, while keeping rates low, has incentivized money to seek yield in the equity markets and driven stock prices higher. Bonds yields, as a result, have been dismal over the same period. Now after five years and a +170% move higher in equity prices, the economy is starting to show some signs of life.

In past Corners we explain why the economy and the stock market are two separate entities. Since the equity markets lead the economy, this begs the question, “how much higher can stocks move now, given improving economic conditions? Has the equity market fully priced in the economic “good news” that may lie ahead of us?” That’s been the quandary for the equity market in Q1, 2014.  The word quandary reflects the stark difference in the price action in the SP-500 from Q4, 2013 when compared to Q1, 2014. The last quarter of 2013 saw a +10.51% rise (SP-500 equity benchmark), while Q1, 2014 has seen just the opposite; a very small rise. One quarter does not make a trend, but it begs the question whether further upward moves in price will occur while facing a number of fundamental headwinds: (1) record margin interest recorded by investors as reported by the NYSE; (2) a 60 month old bull market (compared to an “average age” bull market, historically lasting 50 months); (3) slower U.S. GDP growth year-over-year; (4) a Shiller CAPE P/E ratio of 25.95 (higher than its historical average, signaling  “rich” stock valuations in the SP-500); and (5) an historically negative second year (2014) within a presidential administration cycle, equating historically to a negative year for stock market performance returns.  Certainly, these are all reasons to remain cautious. Price action in Q1, 2014 has been exactly that– cautious. Consequently, the most defensive sector of all, utilities, is the top performing sector in Q1, 2014.

This does not mean that money cannot be made in the equity markets. As Jim Cramer of “Mad Money” fame says, “There is always a bull market somewhere.” Our in-house research continues to focus on our financial barometers that center around the asset allocation cycle and the Intermarket relationships between bonds, stocks and commodities. Initially, our models showed potential favorable moves in the energies, agriculture and materials in Q4, 2013, which we reported to you in our December Corner, four months ago. Strong moves in these sectors continued in March, with grains and energy leading the way. Since the beginning of the year grains, gold and the overall commodity index have led the way compared to all other sectors and the SP-500 index, except utilities. Typically, a move in these commodity related groups is accompanied by higher input costs down the road, leading to higher inflation and economic expansion.

At a recent investment committee meeting for one of the charitable foundations we support, I was asked my opinion of inflation. I told them I was befuddled as to why the federal government does not currently count rising food or energy prices in its computation of inflation. Compared to past computations (before they were changed in recent years), inflation is higher now than is currently being reported.  I will speak more to that in next month’s Carl’s Corner.

Carl Perthel, CMT

 

*** Carl’s Corner for March 2014 ***

While February is, on average, the weakest month in the positive consecutive six month “favorable” season (running from November-April each year), this year it showed strength. And while January usually shows strength, this year January was weak – an about face. The good news for the “bulls,” regardless of history, is that the major market index (SP500), broke to new highs a few days ago, a happy prelude to the stock market’s 5 year cyclical “bull” anniversary from the March 2009 bottom.

Last month we alluded to less “bad news” in the media and pondered whether the “wall of worry” mindset that moves markets higher might be fading in the rear view mirror. Not only do sentiment indicators show much investor optimism in the equity markets, but investors are showing their confidence, as well, by borrowing against their stock portfolios. According to reports from the NYSE, margin debt in December hit an all-time high of $444 billion, up 35% from the year earlier. An investor increasing their margin debt is akin to borrowing more money against one’s current portfolio balance. Borrowing more money is a bet on stocks continuing to rise. Then again, borrowing against the portfolio might be borrowing to buy other consumer oriented items or pay down personal debt. Regardless, it is a classic example of spending money that one does not physically possess. Historically, large margin interest borrowing occurs after investor fear has subsided and signals a wave of investor optimism, typically close to near-term topping action in the stock market. For further discussion please view “Markets Un-Plugged IX” under Past Market Views (http://www.aamg.com/markets-unplugged-ix/).

Cyclical bull markets typically last in the neighborhood of 50 months. Our current cyclical bull reaches the ripe age of 60 months next week. It takes time for perception to change – which is often the reason individual investors enter stock market purchases too late in the cycle. Therefore, the risk to the market is “Johnny-come-lately” investors entering the market well after a protracted move. The SP500 has experienced a protracted move of +175% over the past 59 months. These “late to the party” investors were termed “bag-holders” by the late, great market analyst, Joe Granville.

Janet Yellen has taken over as the new Federal Reserve Chairperson. Overall, the stock market is responding favorably to Fed “tapering.” Ms. Yellen stated that the Fed will hold rates near zero well after the unemployment rate falls below 6.5 percent. The recent spate of bad weather, according to Ms. Yellen, was the contributing factor to poor economic numbers that have some analysts questioning the trajectory of tapering. Since economic numbers are lagging in nature, we will have a better handle on the data points in April.

The Fed has stated that “tapering” is flexible and will be handled accordingly, in light of changing economic conditions. A weak economy would argue for mitigating tapering. At this juncture, the Federal Reserve “backstop” remains in place. Current Fed policy favors the stock market.

We noted in the December edition of Carl’s Corner that commodities (metals, energies, agriculture) were starting to strengthen. Improvements in commodity related issues generally correlate to improvements in international economies. We witnessed month-over- month gains of +10.30% in Silver, +9.41% in Grains, +6.90% in the Material sector, +6.27% in Gold, +5.12% in the Energy sector, and +6.88% in the general commodity index for February 2014. The SP500 achieved a February return of +4.31%. The outperformance of these commodity related indices versus the SP500 in the month of February may bode well for growth internationally. Both the commodity and the international markets have suffered severe downturns in price since late 2010. While the U.S. stock market has achieved double-digit returns to the positive since late 2010, major international equity markets have achieved double digit losses. An upturn in the commodity patch may go a long way to reversing the 3 year downtrend in the international equity markets. Historically, commodities are the best performing asset class (versus bonds and stocks) in a secular bear market. The SP500 has been in a secular bear market since March 2000. A move higher in commodities typically follows a “bull” move in stocks; like the one we have witnessed since March 2009.

Technically speaking, the stock market is not quite in sync. Although the SP500, NASDQ and the small cap Russell 2000 have broken to new highs, the Dow Jones Industrial Average and the Dow Jones Transports have not. Nevertheless, the trends on all these indexes are positive. It’s when all the indexes have broken to new highs and moving higher that corrections likely begin. Therefore, until then, don’t fight the trend. Get concerned when there is nothing left to worry about.

Carl Perthel, CMT

 

*** Carl’s Corner for February 2014 ***

At this month’s Fed Meeting, the Fed voted to taper QE stimulus by an additional $10 Billion per month. Bond buying by the Fed for February 2014 will be reduced to $65 Billion. Should the Fed come through on its reduction targets, tapering may end by autumn 2014.

The Fed Meeting highlighted data points showing improvement in the labor markets, while yesterday’s news showed GDP at a solid 3.2% for the quarter. In addition, consumer spending improved in February. This good economic news validates the Fed decision to taper “easy money.” But, as we noted in the November, 2013 Carl’s Corner, the economy is NOT the stock market. What shall happen if the economic “wall-of-worry” seen in 2013 disappears and gives way to a “smiley face” in 2014? Can the markets continue to rise without that “wall of worry” as they did in 2013?

The equity markets increased over +30% last year on EPS growth of only +5-6%. Could 2014 earnings already be priced into the market? The SP500’s current P/E ratio (of 17 or so) reflects high profit margins and will be tough to improve upon, while QE tapering may foster investor concerns that the Fed will not be around to the degree it has been in the past should volatility set in. A primary concern for 2014 is that downturns in the stock market during a Presidential cycle normally occur in the first or second year of a new administration (89% of the time since 1941). The year 2013 was the first year of a new presidential cycle, therefore, 2014, given past evidence, points to a “rocky” year relative to the past 5 years of Fed “hand-holding” since we did not see an inkling of a decline in 2013— I point out these “non-smiley-face” observations in an effort to keep readers honest; not to scare them.

Based on our in-house research, we pointed out in December’s Corner that Farm & Construction Machinery was improving and that may signal improvement in the global economy going forward. To validate an improving U.S. and global economy, this month our industry group model shows improvements in cement, general building materials, residential construction and global shipping; all economic bell-weathers which, perhaps, validate the Fed’s decision to continue to taper. Strength in these groups bodes for stronger economies down the road.

Two groups we have not seen moving to the fore in a long while are resorts and lodging. Both exhibited strength this past month. The rise in consumer spending this past month may coincide with strength in these two groups. Of course, for those who can, travel to resort destinations is a favorite for many over the holidays. We’ll have to wait to see if this is not just a seasonal move. But should the economy and jobs continue to improve, Americans may let loose their tight fists holding those dollar bills.

From a technical perspective, 2013 did not see the equity benchmark SP500 move down to its 200 Day Moving Average (DMA) all year. It has been quite a while since that has happened in the stock market. The 200 DMA is what one might call an “institutional” line in the sand; representing “fair value,” and is typically a point where Wall Street computer algorithms issue purchase orders for their firms.

The 200 DMA on the SP500 is at 1700. Taking the last impulse wave higher, starting in June 2013 (at about 1550) to year-end 2013 and then anticipating a normal pullback of 50% from the December 31, 2013 high (at 1850),  we end up right at 1700; our current 200 DMA. Therefore, please keep an eye on the 200 DMA in 2014 (1,850 high-1,550 start = 300 points times 50% = 150 points. 1,850 – 150 = 1,700 objective).

The move down in stocks since the beginning of January has money rotating back into treasuries; just when you thought money had given up on fixed income for good, five weeks ago!

See you next month.

Carl Perthel, CMT

 

*** Carl’s Corner for January 1, 2014 ***

In last month’s Carl’s Corner, we observed that the Farm & Construction industry group, a subset of the Industrial sector, was showing signs of improvement, along with the Energy sector. We stated that signs of strength in these groups could portend a bullish move in the Basic Materials sector; a sector that is comprised of industry groups which are “building blocks” for the general economy.  Oil, gas, synthetics, agricultural chemicals, basic chemicals, precious metals and materials like steel, iron, aluminum and most importantly, copper, comprise  Basic Materials.  Indeed, the Basic Materials sector outperformed the SP500’s 2.53% return for the month of December, 2013. The Materials sector achieved +4.24% returns. “Dr. Copper” doubled the SP500 return for December at +6.04%.  These observations are important for the economy and the stock market, should this trend continue. Why?

Basic materials are the inputs for manufactured goods that are produced to satisfy consumer demand. I will leave it to Investopedia’s definition of copper to explain my case: [the bullish move in copper is most important because] “copper is the base metal that is reputed to have a Ph.D. in economics because of its ability to predict turning points in the global economy. Because of copper’s widespread applications in most sectors of the economy – from homes and factories, to electronics and power generation and transmission – demand for copper is often viewed as a reliable leading indicator of economic health. This demand is reflected in the market price of copper. Generally, rising copper prices suggest strong copper demand and hence a growing global economy.”

Since the stock market is not the economy, but a leading indicator of economic activity, the beginning of a bull market in the Basic Materials sector would signal an end to a broader move in the overall stock market since Basic Materials are one of the last sectors to outperform among all sectors. The general market often “tops out” before the end of a “bull run” in the Basic Materials sector. The last example of such a move came in 2008 when the Basic Materials sector peaked in July of 2008, eight months after the stock market top in October of 2007. A positive turn in Basic Materials, albeit good for the economy, is a warning that the 57 month “cyclical” bull market, which began in March of 2009, is starting to show its old age.

It should come as no surprise that the economy is starting to improve, since the Federal Reserve Bank of the United States has thrown everything at it except the kitchen sink; and by that, I mean TARP, QE2, Operation Twist, QE3, etc. What might be more surprising is why it has taken so long to show signs of improvement?  We will leave that question to another time.

These aforementioned programs were started in 2008 under the pretense of staving off another 1930’s type of Depression. These programs resulted in a massive injection of new money (printed money). Since markets are driven by supply and demand, any purchasing demand, artificial or otherwise, will boost buying pressure and cause a rise in prices. An intended consequence of the 2008 credit crisis and the purchasing of bonds and mortgage-backed securities by the Federal Reserve were to hold down interest rates to enable an economic recovery. Conversely, an unintended consequence of holding down interest rates in the bond markets caused money to find higher yields somewhere else. Money found yield in the U.S. stock market. Many fine companies were issuing stocks that paid higher dividends than the bond market was providing. Hence, a flow of money out of bonds and into stocks, leading to a robust rise in equity prices.

To summarize, money is moving through a rotation process: (1) Money clamored into bonds for reasons of safety during the credit crisis from mid-2007 to early 2009. (2) In early 2009, money slowly started to rotate back into stocks. This move began the current “cyclical bull” in equities. Money was capturing dividend yield and anticipating an eventual economic recovery in business and industry. (3) Now, as the economy improves, money appears to be moving into commodity related issues (Basic Materials).  Should manufacturing, housing, employment and GDP continue to improve, expect Materials and Energy to out-perform. Should the economy really start to “heat up” again, the cost of money (rising interest rates), will eventually choke off demand, squeeze earnings and drive down company profits, causing the stock market to turn down. After stocks fall and demand decreases, commodities will weaken and fall on the heels of the stock market. After that, a bear market in all three asset classes (bonds, stocks and commodities) will occur and we will wait for a new cycle to begin.

We still have a way to go in the U.S. equity markets, but we are late in the game, given the current evidence from the price action in Basic Materials.

Happy New Year!

Carl Perthel, CMT