Markets Unplugged IX

Markets Unplugged – IX Conference Call

May 8, 2013

 

 

Welcome to our 9th Market’s Unplugged, our bi-annual Conference Call. On behalf of our team, it’s a pleasure to be sharing time with you this evening. Our goal is to provide timely market perspectives and where we think the markets may be headed, given the evidence presented to us by the markets themselves. Tonight we’ll start by examining why investor psychology is the main ingredient contributing to stock market “tops” and “bottoms” and why this is important for you to understand. After this discussion we’ll review the market’s response to monetary easing and how this might be affecting the stock market. We’ll review the current relationship between bonds, stocks and commodities and how these asset classes are affecting the stock market’s major sectors. We’ll comment briefly as to why the Federal Reserve Policy is a “doubled-edged sword” and finish with some observations on market seasonality for the next few quarters and how far we might go in the on-going cyclical bull market.  Let’s begin…

We are going to start with a short lesson in investor psychology. There are two Wall Street sayings, “Prices are made in people’s minds” and “Markets climb a wall of worry.” Both these messages correlate with investor psyche and provide pertinent information to help us understand where we are in the stock market right now. First, market participants don’t trade the financial markets; they trade what’s between their ears. Think about it. People trade their perceptions; what they think they see, not necessarily what is, but how they feel it is. Something moves market participants to buy or sell. Picture a chart of any market; let’s say the Standard & Poor’s 500 stock market index. Prices are labeled on the left side of the chart and time is labeled on the bottom of the chart.

In between price and time you would see a squiggly line. That squiggly line is “price.” It moves up and down over time, doesn’t it? That line reflects how money is moving.

Price reflects buyers and sellers coming to an agreement, right? So, who makes price? You make price. All active participants in the market place make price; mutual fund managers, insurance companies, portfolio managers, brokers and individuals. People make price.

Since the market is a zero-sum game; in other words, for every share of stock purchased, there must be a share of stock sold, price does not move up because there are more buyers than sellers.  Price moves up because there is more buying pressure; many buyers wanting something at the same time drives up prices. Anyone who has ever attended an auction has experienced people clamoring for an object as price is bid higher and higher. That’s exactly what happens when prices move higher in the stock market.

 

Since people move prices, what moves people? Well, people buy stocks when they feel there is an opportunity to make money after their purchase. Conversely, people sell to lock in gains or avert losses.  How do you feel after making money in the stock market? How do you feel after losing money in the stock market? I just asked you how you felt, not what you thought. When it comes to making and losing money, we feel, don’t we? Feelings connote emotions, don’t they? Most market decisions are based on emotions. Our lesson can be summed up like this: If money moves price and people move money, what moves people? Emotions move people. Therefore, if emotions move people, ultimately, emotions are the reason that money moves in the stock market, since people move money.

 

Worrying is a form of emotion, isn’t it? We’ve stated in past calls that price “climbs a wall of worry.” Certainly, there have been a lot of things to worry about since the market bottom in 2009; people losing their jobs, people losing their homes, failed businesses, a fragile banking system, bickering politicians, and yet, the stock market has moved higher. Prices have been climbing a “wall of worry.” Until, just last month, in April, we found ourselves back to price highs in the market indices we haven’t seen since 2007. What happens when prices come back to old highs, given our short lesson in investor psychology?

 

Initially, when prices come back to former highs, they stall at those highs for a while and then they fall back to lower levels. The primary reason for prices moving lower from former highs is emotion. Investors, who purchased stocks at nearly identical levels in 2000 and 2007, now find themselves back to the same price levels now, at “break even,” after years of waiting. Therefore, they have an emotional reason to sell, don’t they? These folks are thinking, “Finally, I’m back, just get me out!” We just observed this “get me out” price action over the past seven months, from last September until just recently as price kept bumping its head against 1570 on the SP500. So, where are we now?

Now we’re above 1570. What does this look like for us going forward?

Here’s where we are: Picture yourself in an airplane taking off on a cloudy day. As time passes and your plane continues to ascend you look out your window and all you see are clouds and grey skies. Suddenly, you break through the clouds and are surprised to see clear blue skies! That’s where we are right now in the U.S. stock market.

We’ve broken above the price ceiling in the market that has been intact since 2000 and 2007. Just recently, there have been only “blue skies,” once we started closing above 1580 on the SP500. In a “blue skies” environment there are no investors waiting to get out above the line of clouds at the old market highs. It doesn’t take much buying pressure to push prices up higher and higher when there is little or no resistance since there are no sellers waiting to “get out.”

 

Now once we’ve broken through the ceiling, it’s a sad fact, at this late stage in the stock market cycle, the investors who have been out of the market since the last bottom are the ones who are contemplating now as the time to start purchasing stocks. The cable and print media are now communicating that the economic weather is fine and getting better. The market participants who have missed the move the past four years hear that the markets are moving to new highs and now they feel it might be time to start investing again.  Why, after a +140% move off our 2009 stock market lows would an investor feel it’s now safe to get back in? It’s because the market is making new highs and the economic news is getting sunnier and brighter. Blue skies all around!

 

Here’s the reality. The best time, but the most difficult time psychologically to participate in the markets, is when economic skies are stormy, like they were in 2009. When economic skies are getting bright and sunny and markets are making new highs, like they are now, it’s easier to participate. But now is the time when market participants need to be wary.

Fortunately, there is one caveat to our weather report that positively affects the stock market, the economy and investors, even as blue skies persist. That caveat is the Federal Reserve and their power.

 

Remember, the stock market and the economy does not always move up and down together. Interest rates are the driving force that connect and disconnect the stock market and the economy. As the economy improves and business accelerates, the cost of doing business, i.e., the cost of money, increases. Interest rates are the cost of money. An increase in interest rates show a stronger economic environment, but over time, higher rates make it more expensive for businesses to make a profit.  As a result, the stock market and its issues will decline as rising interest rates cut into profit margins. Fewer profits equate to lower stock prices. That’s why we can have improving economic conditions like growth in manufacturing, increases in housing starts and rising consumer confidence, while the stock market can be stalling or even falling.

 

Again, here’s the positive for our current economic and stock market environment. The Federal Reserve is still implementing an “easy money” policy through buying mortgage backed securities and treasury bonds. Fed purchasing keeps interest rates low. Low rates assist businesses in borrowing money cheaply for expansion, aids consumers who can borrow money cheaply to buy the goods and services they desire and let’s federal, state and local governments pay their existing debt service at lower levels.  An unintended consequence of the Federal Reserve’s monetary policy is forcing investors, especially those looking for yield, into the U.S. stock market. Bonds pay very little interest. Conversely, stocks that pay dividends are now very attractive to money looking for yield, hence, the recent move in the major market indices since our last conference call in November. The Federal Reserve has stated that they intend to keep purchasing until 2015.

If their purchasing continues to keep a lid on interest rates, the stock market may find itself in a “blue skies” environment for a while longer. Money seeking yield will continue to move into the equity market. As the stock market continues to make new highs, the media will continue to communicate that news to a mass audience, many of whom have been out of the stock market since 2009. These potential investors represent the last group of individuals looking to invest. Low rates, improving business conditions, positive media coverage and new market highs will be the stimuli to induce more money into the equity markets, even after our +140% move. It’s possible a herd mentality could take over. History shows us that after the market “climbs a wall of worry,” it begins its final phase. The next and last phase in the stock market is when people who have been out of the stock market perceive the worst is over. The herd starts moving into the stock market. I believe the cattle drive has begun. But it will take a while to move the herd.

 

When the economy really starts to improve, forcing the Fed to cease “monetary easing,” it’s then that the stock market will fall back into the clouds. First, rates will have to rise as business conditions and the economy improves. Improving business conditions have been the objective for implementing stimulus programs: TARP, QE2, Operation Twist and QE3. Buying bonds to stimulate the economy has kept rates low so far. Therefore, keep an eye on interest rates.

The Federal Reserve policy is a “double-edged sword.” As long as the Fed can keep interest rates low, it’s blue skies for the stock market AND the economy. But once the economy really starts performing and the goals of all the Feds stimulus programs come to fruition, rates will start rising. Rising rates are the other edge to the sword and will eventually cut away at the stock market’s gains.

 

We monitor the asset class relationships between bonds, stocks and commodities to model the stock market and the business cycle. Currently, bond prices are being supported by Fed purchases; conversely, bond yields will remain low. With low yields in the bond space, money should flow into stocks. Dividend issues are already telegraphing this scenario. Dividend stocks have become a bond proxy. Dividend stocks are providing capital appreciation and cash returns for you. Out of the nine SP500 sectors, the two best performing sectors in the market this year are utilities and consumer staples. Both these groups are defensive and produce hefty dividends. The market is rewarding these sectors right now thanks to the Fed.

 

Following stocks, we will eventually see an upward move in oil and gas, precious metals like gold, industrial metals and agriculture related issues. We broadly label these issues as commodities. They’re the raw material inputs for the goods and services produced by manufacturers in concert with a strengthening economic environment. But, there are three headwinds facing commodities presently: the six-month “unfavorable” seasonal period in the stock market from May-October, which correlates positively with commodities.

In other words, commodities may be adversely affected over the next six months, along with the stock market, due to unfavorable seasonal factors.

Second, since commodities are priced in U.S. dollars and the U.S. dollar is rising, it will take more dollars to buy commodities.  An expensive dollar continues to be a deterrent for commodities. Third, the primary driver for commodity purchases, China, just had a new election last fall that occurs only once, every 10 years.  The seven newly elected Standing Committee Members of the Politburo in the People’s Republic of China are still sorting out their command economy. Although these are headwinds right now, down the road, commodities could be on the cusp of a cyclical bull market, once these factors sort themselves out. A new bull market in commodities would bring an end to the bull market in bonds.

 

Global equity markets and commodities have been range bound for almost 18 months. Resurgence in commodities will push global equity markets higher.

 

In the United States, the equity markets are over-bought in the short run. Even if we experienced a -5% decline in the SP500, we would still be near the “blue sky” line. May through October has brought a decline in the equity markets the past 3 years, coinciding with a negative commodities market in each of these 3 years. The commodity index (CRB) is -6.5% since February, while the SP500 is +6% over the same time. Therefore, it would not surprise us a bit to see a decline in the stock market at this time. In fact, it might be healthy. Longer term, we are bullish on the equity markets, given the evidence we’ve just presented. Thank the Fed for now.

 

I’ve been asked, “Are we still in a secular (long term) bear market?” The answer is “yes.” What we’ve seen the past 4 years is a short-term bull market, within a long term bear market.  A new long term bull market will not begin until stock market valuations become more favorable. Valuations will become more favorable if either price moves down while earnings remain steady, or if prices remain steady and earnings continue to improve. In the meantime, we still have some “snort” left in our current cyclical bull market move from 2009. Even with a pullback this summer, we expect to see “blue skies” by year-end.

 

Thank you for sharing your time this evening. I’ll turn the floor back over to our moderator, Amy Williard.

 

Carl Perthel, CMT

May 8, 2013