Markets Unplugged VII

Transcript for May 9, 2012 Conference Call

Welcome to our 7th 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 you with a timely market perspective and where we think the markets may be headed, given the evidence presented to us by the markets themselves. Since no one is able to predict the future, we feel the best method to evaluate the market is to examine the current evidence. Evidence is a theme we will be citing for you this evening. The financial markets, like life, are about relationships. Tonight, we’ll examine the equity markets relative to their inter-relationships between headline news, economic policy, business cycles, industry sectors, asset class rotation and market seasonality. So let’s get started…

Our first observation is… the stock market is NOT the economy. Let’s think about it. The stock market is a marketplace where buyers and sellers come together to trade something. Buyers and sellers come to a consensus based on price, for a financial instrument; a bond, shares of stock, or perhaps, bushels of wheat. The stock market may react to economic news, but price does not always reflect the economy. In fact, the market, or price, is often a leading indicator of the economy. Here are two fairly recent examples to explain this dichotomy.

In our first example, let’s travel back to fall of 2007. SP500 equity prices are rising. The economy shows great strength. Housing is overly healthy, the unemployment rate is near all-time lows and interest rates are near historic lows.

One naturally thinks the market and the economy are both healthy. Yet, over the next six months, leading into 2008, while economic numbers remain healthy, the stock market turns south. Prices turn down. Eventually, the equity markets plummet over 50% in the next 17 months. The evidence of weak economic numbers lagged the stock market highs in 2007 by almost a year. And if you were to go back and re-examine the news, it was 11 months from the market highs to the headlines of a banking crisis in 2008. Lehman Brothers filed for bankruptcy in September of 2008, almost a year after stocks peaked. General Electric later reported they almost missed their payroll that month. Those were dark days. Economic news was even worse at the stock market bottom six months later. But something unexpected happened; the economic news that was dire and getting worse was disregarded by the stock market as stock indices started their current rise over +100% from market lows in March 2009. This “cyclical bull” has now entered its fourth calendar year.

If the economic news at the bottom in 2009 was horrible and deteriorating week by week, why did the market go up? Here’s the reality, but the tough part to act on: At the market bottom in 2009, stock prices turned up while economic numbers showed weakness. At the market top in 2007, stock prices turned down while economic numbers showed strength. In both examples, stock prices lead the economic news.

Here’s what’s important: stock prices reflect a future belief or value as to what the economy may bring us. This is the reasoning behind the Wall Street aphorism, “buy on the rumor and sell on the news.” By the time the news is out, the markets have already priced it in. To go along with that, my favorite saying is “the headlines are the hind lines.” Government statistics, company balance sheets, and news headlines report on what has already happened. Have you ever noticed why prices in your favorite issues rise BEFORE good earnings news, or perhaps FALL before bad earnings news, only to rebound higher once the bad news hits the headlines! Relative to price, the economy and the news is measured after the fact. Since price leads the economy we will continue to experience disconnects at market turning points. Therefore, please remember this; price will turn IN THE DIRECTION of future economic reports, BEFORE the reports are released. The stock market LEADS the economy; the stock market is NOT the economy. That concludes the stock market education portion of our presentation. If you didn’t get all that don’t worry, a transcript for this evening will be available to you soon.

When we ended our last conference call, six months ago, the news was reporting dire consequences for the stock market and the economy. Another observation regarding news headlines is this: markets climb a “Wall of Worry.” When economic, political or geopolitical issues are perceived to have adverse effects on consumer and investment sentiment, especially after large declines, markets often do an “about face” and rise, reflecting investor confidence that these issues will be resolved at some point. This happened last October before our November Conference Call. Simply put, a “wall of worry” exists when markets go up on less than stellar or bad news.

At the time of our last call, the headline news was ominous. We were just coming off a -19% decline in the indices from last summer. We had just experienced a downgrade in the U.S. debt rating; Europe was emulating the United States in 2008, Greece being the prime example, while unemployment was at 20 year highs. Bad news was everywhere. In the market’s defense, at that time, we cited that “historically, the next six months (should) provide investors with an opportunity to take advantage of positive seasonality,” based on the six month market cycle and the presidential cycle. Indeed, the SP500 is up + 13% since our bullish comments from six months ago. If you remember, I likened the markets to the tides and tried to give you some perspective as to why these tides occur with some regularity.

We stated that high tides, or rising prices, historically occur between November and April, while low tides or falling prices historically occur between May and October. Let’s examine the evidence. In the last three years, the autumn high tide produced gains of +14% in 2010, +15% in 2011 and +15% in 2012; rather consistent high tides during the November-April six month period. Regarding low tides, or price declines, in the May-October period, we have seen consistent low tides; -16% in peak to trough in 2010 and -19% in 2011. The 2012 low tide six month period is upon us.

As we see it, current headwinds in the coming months are not too different from what we have seen the past few years during low tides: weakness in the housing sector, economic slowdown in Europe and Asia, Mid-East uncertainties, increases in inflation including food and especially energy, budgetary concerns and most recently, tax provisions setting to expire at year end. Like the past two years, these factors potentially set-up another similar spring-summer season of the Fed adhering to a low interest rate environment, which should assist the U.S. economy. In all likelihood, expect the Fed to let economic numbers deteriorate, along with stock prices, BEFORE doing “what is necessary” to support a weakening economy.

The Fed’s action has assisted you personally as holders of U.S. equities. While some may argue the merits of Fed stimulus regarding the economy, real results appear to be stimulating the stock market. Which begs the question, are the stock market rallies based on an improving economy, or on investors’ beliefs that the Fed will “backstop” bad economic news? And at what point does the Fed stop being accommodative? This perception reminds us a bit of the Greenspan “put” in the late 1990’s where investors had the misplaced belief that the Fed was able to rescue their investments under any adverse economic circumstances.

But for now, the mood of investors, at least here in the U.S., is somewhat complacent after the recent rise of over +20% in the equity markets from our October 2011 lows. Current headlines seem to communicate the message that there is no real need to worry. As contrarians, we are more inclined to question when everyone else is satisfied.

We’ve had over three wonderful years of rising prices. Although we have yet to reach former all-time highs of 1,565 in the SP500 and 14,165 in the DJIA, we have been heading that way. From our March 2009 lows, we are up over +100%.

For those of you have tuned in before, you know that we’ve labeled this 3-year price rise as a “cyclical” or short-term bull market within a “secular” or long-term bear market. Cyclical bulls are characterized by rising prices lasting, on average, 30 months. Psychology moves from gloom, to complacency, to outright excitement. Perhaps some investors who own Apple, Inc. fall into the downright “excited” category? In cyclical bull markets, price-to-earnings ratios, or valuations, expand. Presently, the valuation of the SP500 adjusted price-earnings ratio, using the more stringent Shiller P/E methodology, matches our current levels with bull market tops seen in 1900, 1937 and 1968 before market declines. We mention this to put our current market environment into perspective. We have come a long way in a short amount of time and we are over-valued. Ideally, going forward, we would like to see a slower price ascent, coupled with the strong corporate earnings we have experienced the past few years. This would be a cheerful recipe for less price volatility, with a contracting P/E, resulting in lower valuations, as we continue to work our way through the secular bear market that began in 2000.

Turning directly to our economy, the U.S. business cycle was derailed last summer with the uncertainty presented by the downgrade in U.S. debt by our own Standard & Poor’s rating agency. Added uncertainty presented itself, again with Greece, last summer, while the Eurozone and Asian economies continued to struggle. According to the International Monetary Fund, Europe’s GDP ($17.5 trillion U.S.) makes that region the largest economy in the world. Europe’s slowdown has adversely affected the U.S. manufacturing sector.

Presently, our work shows the United States slipping back from the start of a “middle expansion” phase last summer, to somewhere between a “late contraction” to “early expansion” phase. Our current position is characterized by strength in the financial, consumer discretionary and technology sectors since the start of 2012. Our former leaders from a year ago, the industrials, materials and energy sectors have cooled off as a result of less consumption from Europe and Asia. If we are to move forward, we need to see growth in the transportation, industrial and material sectors. We’re going to need help from Asia in order for this to happen, as it appears that Europe is on its heels.

Domestically, the transportation group needs to re-assert itself. Even though the major indices, like the Dow Jones Industrial Average, are making new 52-week highs, the transportation average is lagging. Transports often LEAD the broad market indices in both directions. Railroads and trucking get an early look at changes in the amount of raw materials and goods that are carried to manufacturers and the amount of finished products moving from manufacturers to wholesalers and retailers; ultimately, ending up in my attic or basement. Once the transportation average starts leading the major indices, we’ll have a shot at the 2007 highs in the broad market. That is an “if” not a “when.” So, keep your eyes on the transportation average for an upside confirmation.

Although we expect the seasonal six month “soft patch” to kick in, as usual, we are bullish on equities for the rest of the year and anticipate positive performances in the indices by year end. Income from stock dividends and capital appreciation can be found in an equity allocation, more so than bonds. Should global economies pick up again, commodities will bolster the rise in equities. We are in favor of waiting for better opportunities to purchase in the late summer to early fall, once the bearish seasonal cycle ends. Let’s be realistic and examine the evidence: After a better than +20% move higher in only seven months, the markets are over-bought. We need a pause to refresh. March and April may be the start of a healthy pause having gone up only +2% in the past two months. One could argue that a pullback in the market averages would be healthy at this juncture, given the markets extended position.

Election years, where we find ourselves now, are traditionally up years. According to Stock Trader’s Almanac (2012), the SP500 will average a positive +4.5% in the last 8 months of an election year, over 67% of the time; not bad odds. Given where we are now in the market averages, even with a price decline in our low tide May-October time frame, before positive seasonality kicks in again, around November, that gives us a decent year in the markets. Let’s count our blessings.

Carl Perthel

May 9, 2012