Markets Unplugged X

Markets Unplugged – X Conference Call

November 13, 2013

  

Welcome to our 10th Markets 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 the timely topic of debt, its effect on society and examine four possible solutions that could put this country back in the black, not to be confused with AC/DC’s album from 1980.  After this discussion we’ll move on to the market’s response to monetary policy since our last Conference Call in May. We’ll examine where we are regarding our financial barometers and where we see “the sweet spot” for investors. We’ll briefly examine stock sector relationships and speak to Dow Theory and why this theory may be important for the continuation of the “bull market.” Then we will turn our eyes overseas to discuss Europe and finish by noting where we are in the market’s seasonal cycle.  There is a lot to cover, so let’s get started…

With our law makers meeting in less than 3 months to discuss the debt ceiling, again, we’re going to examine the subject of debt; its definition, its components,   possible solutions to overcoming indebtedness and most importantly, what our central bank is trying to do to mitigate our debt problem.  First off, debt is something, typically money, that is owed or due. Debt is not necessarily bad, as I recently explained to my college- aged children. Most folks have to secure debt to buy a house, a car or other “big ticket” item. I told my kids, “You can finance debt, pay it off over time and improve your credit rating.”  That’s a good thing!

If a business incurs debt; for example, borrowing money to build a plant or buy equipment, than the expected return later comes from the goods and services produced as a result of building the plant or purchasing the equipment. That’s also a good thing! The difference between the sale of what is produced and the debt it took to produce it, if sold at a higher price, is a profit. Welcome to capitalism!  

Conversely, in most cases with government borrowing, borrowing is for consumption, NOT for production. Therein lays the rub. Government consumption, without the production motive creates a liability.  The word “liability” in most phases of our life doesn’t have a positive connotation, does it?  Liability is expressed in the business headlines with phrases like “debt vs. GDP.” Liability, on the consumer level, could be tied to the phrase “the U.S. debt clock,” which illustrates the extent of government debt as it relates to how much each U.S. citizen owes to pay the debt off.  If you take it one step further and include non-government debt like mortgage, credit cards and other consumer debt, like the HVAC unit I just purchased, then determining where and how you go about paying down large amounts of money get one’s anxiety levels up,  doesn’t it?  No wonder the law makers in Congress don’t want to tackle this problem. It’s depressing! It’s overwhelming! Just recently, The Heritage Foundation came up with an analogy that was summarized by a Washington Post article on September 11, 2013 titled, “What If a Typical Family Spent like the Federal Government? It’d be a Very Weird Family.”  

The Post article sums it all up with, “The U.S. federal government really does resemble your typical money-printing family that owns lots of tanks, operates a giant insurance conglomerate, can borrow money at extremely low rates and is assumed to be immortal.”

 So, what are the solutions to the debt problem that the government has been debating?

Likely, there would be four solutions and they don’t come without their own set of vexing consequences. (For further study, see Investing in the Second Lost Decade, by Martin J. Pring, Joe Turner & Tom Kopas; Publisher: McGraw Hill (2012); Chapter 1).

(1) Our law makers can reduce the deficit by raising taxes, cutting spending or a combination of both.  The vexing issue for the law makers here is “going on record” with a vote and perhaps up-setting part of their constituency by making a decision that may not appeal to a special interest. (2) The government could write-down or default on some of its debt but that would likely result in receiving a lower credit rating, besides upsetting countries like China and Japan, among others, who hold our debt. (3) How about growing the economy by changing current policy or implementing new policy decisions?  Law makers could draft “manufacturing friendly” government regulations that could put some wind in the economic sales. The preferential tax treatment for U.S. multinationals to move off shore is attractive. Maybe a change in the tax treatment for large corporations could draw businesses offshore back home, along with thousands of lost jobs? Committing to a change in business policy to spur growth could tie the “production motive” to our debt problem. (4) And finally, what our government does, and this is very popular with central banks around the world, is to “print money” and inflate our money supply.  

As explained by David Glasner on his blog, “Uneasy Money (commentary on monetary policy in the spirit of R.G. Hawtrey); http://uneasymoney.com/2011/08/21/yes-we-can-and-must-inflate-our-way-out-of-debet/),” the premise behind this solution goes something like this: printing money will force rising prices that will encourage production, enhancing incentives for businesses to increase output, hire more workers and take on new investment versus holding on to cash. The prospect of rising prices, in turn, is supposed to encourage households to increase purchases of consumer goods instead of paying down debt.  Theoretically, this stimulus to output, when the economy is beset with chronic unemployment and idle capacity, tends to induce further increases in output. Increases in output would therefore produce further positive expectations. Couple these expectations with rising real interest rates and that will spur businesses to new investments now, rather than wait for rates to move higher later. Arguably, inflating our money supply to spur the economy to new heights has achieved a mixed outcome thus far and the jury is still out on whether it has produced favorable results.

 Shortly after our last Conference Call in May, Chairman Bernanke alluded to “tapering;” in other words, slowing down the printing of money by pulling back on the purchase of treasury bonds and mortgage backed securities. Shortly after making this statement, at the next Fed Meeting, the Fed decided to take no action, rather, deciding to wait and see what action Congress would take regarding the debt ceiling deadline. What we might be seeing here is the Fed laying the debt issue back in the laps of Congress before it decides to move ahead on its next monetary policy decision. Therefore, we believe that it is highly doubtful that any change in Fed policy will occur while Ben Bernanke is still Chairman.

In the meantime, maybe Congress will contemplate policy initiatives that will provide guidelines to American businesses that will put us on a path to grow our economy. These are the important issues Congress and the Federal Reserve are facing in the months to come. The main takeaway for you is to understand the role of the Federal Reserve in the debt process, because Fed policies directly affect movements in stock prices and your portfolios.

Arguably, the markets upward momentum since the 2009 bottom has been tied to the Federal Reserve’s actions regarding stimulus; the market moves up when it thinks money is “loose” and down when it hears a stimulus program is ending, or just recently, when tapering is beginning.  The volatility we’ve experienced in the equity markets since our last Conference Call in May validates these observations. The equity market’s price action in the SP500 rose and fell 7 times, in a very tight trading range, coinciding with Federal Reserve rhetoric since early May. In fact, we are only +4.5% higher on the SP500 since our last Call in May. Compare that to the price move of +18% from last year’s November Conference Call to May of this year. Both periods are 6-month periods…+18% vs. +4.5%. The point is, the market has lost a lot of its upward momentum, coinciding with the talk of “tapering” in the past 6 months.

Even though the equity markets have slowed their rate of trajectory, there is no real evidence, outside the talk of “tapering,” that the markets are going to do anything but continue to grind higher. Remember our past discussion on financial barometers and the relationship between bonds, stocks and commodities? Nothing much has changed.

We are still witnessing weakness in bonds, strength in stocks and tentative strength in commodities. The price action in these three asset classes fits the classic rotation of money seeking yield.  With bonds still producing very low yields, and therefore smaller amounts of income, stocks should continue to attract investors. Many stocks pay solid dividends that “yield hunters” seek, and if stocks should move up in price, all the better it is for investors to capture capital appreciation. Commodity issues like the energies, metals and agriculture tend to follow stocks higher as the general business environment improves. These issues fall under the sector, Basic Materials, because they are the basic inputs and the foundation of manufacturing when the economy starts to expand.

There are a few reasons to believe we are on a path to economic recovery. Transports often lead the rest of the market in both directions. Truckers and railroads, both strong currently,  get an early look at changes in the amount of raw materials and supplies carried to manufacturers and the amount of finished goods moving from manufacturers to wholesalers and retailers, here and around the world. Transports made new highs in their averages last week.  Talk of the “transportations” brings us back to Dow Theory. Basically, a Dow Theory Confirmation occurs when both the Dow Jones Transportation Index and the Dow Jones Industrial Average’s reach new highs together or in close proximity to one another.

A Dow Theory confirmation will validate the continuation of the on-going “bull” trend in the equity markets. Well, it just so happened that a Dow Theory Confirmation occurred in late September. Since late September, both indexes had fallen back together, but by late last week, they again confirmed each other, both reaching new highs with the “transports” leading the way.

Regarding the business cycle ((Sam Stovall, S&P Guide to Sector Investing; Publisher: McGraw-Hill (1995)), our sector work puts us in an Early Expansion phase based on the price action of the 212 sub-industry groups we follow.

Early expansion is characterized by a (1) a pick- up in the economy, (2) consumer expectations are rising, (3) industrial production is growing and (4) interest rates bottoming, while the yield curve is starting to get steeper. Historically, successful sectors at this stage include transportation and technology. Next, Middle Expansion starts with rewarding the Industrials, known as Capital Goods and Services. The recently reported business fundamentals that support our technical research are as follows:

Employers added 204,000 jobs in October, the Labor Department reported last Friday, far more than expected and the latest sign that the economy was building momentum even as the government shutdown took hold. These job gains far surpassed the 120,000 that economists had forecast.  Jumping over to the manufacturing sector, manufacturers added 19,000 jobs in October, the third monthly gain in a row and the most since February. ISM manufacturing and service-sector reports both signaled faster growth in October. Meanwhile, the U.S. economy expanded at a 2.8% annual rate in Q3, the Commerce Department reported last Thursday. All this is good news for the economy.

But the other side to this coin is: should the economy improve too quickly at some point, and the Fed not “get out in front of it” by slowing down QE3 stimulus, the Fed could face the potential problem of inflation down the road. Arguably, that’s not an issue now, but at some point it may be.

The morphine drip of “easy money” will dissipate as the economy picks up steam and the giddy equity market that has been pleasured by “loose money” will have to go through some sort of withdrawal. Good fundamental news regarding higher employment, increased gains in manufacturing and an expanding economy, supported by higher stock prices in the transportation and industrial stocks could signal a better economy ahead.

Part of our research and analysis examines equity prices as a proxy for what the economy may have in store for us because stock market pricing leads the economy. In past Conference Calls, we’ve discussed the importance of this premise that stock market pricing leads economic numbers. Why is this important?  Because the stock market is NOT the economy. That’s why stocks and market averages (pricing) can lead, or turn up, in poor economic environments (e.g., 2009) and conversely, stocks and the market can turn down when economic numbers are robust (e.g., 2007).

Let’s jump across the pond and visit Europe for a moment. In a surprise step last week, the European Central Bank, the ECB, cut interest rates to a new low to help the region’s faltering economy. The euro sold off, but stocks largely ignored the easing move. The ECB, vowed to keep liquidity flowing until at least 2015. While the ECB doesn’t have a formal dual mandate to support employment as well as stable prices, like our Federal Reserve, the 12.2% jobless rate is likely to be a part of its decision to cut rates. 

Cutting rates will stem the euro’s climb. A cheaper European currency will make exports more competitive.  Exports will assist a fairly healthy Germany and help out its sick sister countries like Italy and Spain. The ECB has not reached a point where it will have institute QE like the U.S. or Japan.

I’ve am often asked, “Carl, are we still in a secular (long term) bear market?” The answer is “yes.” But that doesn’t mean we can’t make money. Although we are 55 months into this cyclical bull market, within the longer term (secular) bear market, equities are still the “sweet spot” until the Fed changes monetary policy or until the economy really starts to become robust.

Neither looks likely over the next six months, although “tapering” is on the table and the economy appears to be moving forward as we noted a few minutes ago. Also, we’ve just entered the historically “favorable” 6-month period on Wall Street where we should expect higher stock prices until the spring, right around the time the new Fed Chair Woman, the accommodative, Janet Yellen, will take over the reins at the Federal Reserve.

Until our next Conference Call in the spring, enjoy the upcoming Holidays! It hard to believe they’re here already. On behalf of our team, thank you for sharing your time with us this evening.

 

Carl Perthel, CMT

November 13, 2013