Markets Unplugged XI

Markets Unplugged – XI Conference Call

May 14, 2014

 

Welcome to our 11th 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 reviewing where the markets have taken us since our last call in November 2013. We’d be remiss not to examine Janet Yellen’s current statements as the new U.S. Federal Reserve Chair. From there, as part of the educational portion of the program, we’ll comment on the once-every-four-year phenomena; the “mid-term election” market cycle and its possible implications for the broad market. After that, we will discuss the current inter-market relationships between bonds, stocks and commodities. We’ll examine the evidence pointing to possible inflation and analyze the state of the U.S. dollar, and finally conclude with what we might expect by year end.   

There’s a lot to cover, so let’s get started…

When we spoke in mid-November, last year, we had just started the beginning of what some call the “favorable” six-month window where prices historically rise. The stock market rose until the end of 2013 and turned in a very strong fourth quarter, relative to performance. But, since the beginning of 2014, stock market prices have trended sideways. Right now they are bumping their heads against the ceiling of 16,600 on the DJIA and 1890 on the SP-500.

The “sluggish” price action we’ve experienced in the equity indices since March is a microcosm of the overall equity price action we’ve experienced in 2014. Logically, one would expect a pause in rising prices in 2014, given that 2013 was a banner year, driven by smaller-cap momentum issues.  

Currently, both the SP-500 and DJIA-30 are holding their 50-Day Moving average levels; a line which offers price support in what we consider a “trading range” market. Not so with the less conservative, more speculative, momentum driven, mostly non-dividend paying NASDQ issues. The NASDAQ index is much weaker. The 26-week new-highs/new- lows ratio is still supportive and suggests the DJIA-30 and SP500 indices are in the process of consolidating. On the top-side of their range, prices are confined. Former owners at previous highs, going back to January, are selling to newer purchasers; therefore, there is not enough demand, or “buying pressure” to push through the “overhead supply” at the former highs. Old buyers are waiting to sell their issues as new buyers enter the market. This process of absorption may take some more time before the equity benchmarks can break out to new highs.

Digging a little deeper, as I watched the DJIA-30 drop 142 points or down almost -1.0% on April 27, I noticed Coke was up almost +1.4% and with McDonalds up almost +1.0%. Divergences like this catch my eye because it’s a window (a least for that day) into what “Mr. Market” is rewarding. I mention Coke and McDonalds because they are a proxy for big cap, multinational, dividend paying companies with sound business models that derive revenue from here in the U.S. and overseas. In fact, since early March, the DJIA-30 and the SP-500 (big cap indices) have had positive returns, while the high-flying NASDQ (QQQs) is negative. As the cyclical bull market matures (currently 62 months old last week), I believe we are seeing money move into higher quality issues.

For those of you who were around, or for you market historians, do you remember the term, “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.

Large capitalized, dividend paying issues should continue to be rewarded at this point in the market cycle. In 2013, it was the second and third tier issues and some of the newer Initial Public Offerings, especially in Q4, 2013 that were being rewarded with investor’s money. Not so, thus far, in 2014. And, speaking of dividends, boring old utilities remain the best performing sector so far in 2014. The “speculative” issues that were rewarded in 2013 have been punished in 2014 and money appears to be flowing towards conservative, well-established names that are able to pay investors a premium while they own them, in the form of dividends.  We look for more of the same through the end of the year.

Let’s switch gears, away from the market and talk about the Federal Reserve Bank.

Janet Yellen, the former Vice-Chair of the U.S. Federal Reserve bank has accepted the torch from former Chairman Ben Bernanke. At her first public media event in March as Fed Chair, Yellen’s honestly got herself in a bit of “hot water” as she alluded to not only raising rates but giving a time line for that event to happen. Honesty, relative to time lines, is not always the best policy as a Fed Chair. Her comments roiled the stock market. Initially, investors who were afraid that the morphine drip of “easy money policies” would be ending soon now faced the fear of the Fed actually raising rates!

Since that meeting in March, the equity markets have calmed down and seem to be embracing the Fed’s tapering policy. Tapering means that the U.S. Federal Reserve Bank will put less money into the economy by not purchasing bonds and mortgage backed securities.

Since the economy has been improving, there is not as great a need to “print money” and inject it into the financial system.

Tapering is a result of the success from the quantitative easing programs administered by the Fed since 2009. QE seems to be achieving the Fed’s desired objectives of re-vitalizing the U.S. economy and assisting in job creation.

Let’s fast-forward six weeks to Yellen’s second meeting before Congress last week. Yellen stated that she expects economic growth to accelerate this year despite the anemic first quarter but the recent housing market slowdown, in her words, “could prove more protracted than currently expected.”  And unlike last March, Yellen declined to be specific about when the Fed will begin to raise its benchmark short-term interest rate, now near zero, despite being pressed repeatedly by Congress Committee Chairman Kevin Brady. Since this meeting the stock market has responded favorably by not selling off. In fact, in the past few days it is poking its head to marginal new highs. There appears to be the feeling that despite the historically upcoming “unfavorable” months between May-October that befall the stock market each year, this year may be different, thanks to a coherent Federal Reserve policy.

Ms. Yellen summed up her meeting by commenting, “I have no doubt that if growth in the economy picks up…then long-term unemployment will come down too.” We shall see… 

And now, true to form, I’m going to attempt to educate by providing a short lesson that melds politics, human psychology and the stock market in order to put the next 6 months into perspective. So here goes…

Of course you know that 2014 is a “mid-term” election year? And you might ask, why does this matter to me as an investor in the stock market? Well, here are a few observations: Charles Dudley Warner, an American essayist and editor, once said, “Politics makes strange bedfellows.”

Therefore, regarding the stock market, relationships with one’s bedfellows’ which would normally be in concert and harmony, are made strange, by things of a political nature. The second year of the four year presidential term often highlights politics and “disharmony.”

In The Stock Trader’s Almanac, 2004 (Wiley), Yale Hirsch notes that based on his studies, “Presidential elections every four years have a profound impact on the economy and the stock market. Wars, recessions and bear markets tend to start or occur in the first half of the term and bull markets, in the latter half.”

In Hirsch’s 2014 edition he notes: “So many bear markets seem to occur in midterm years, very often bottoming in October. Also, major military involvements began or were in their early stages in midterm years, such as World War II, Korea, Vietnam, Kuwait and Iraq.” I would note that Russian President Vladimir Putin’s foray into the Crimea and east Ukraine more recently are prime examples of military involvement; once again, this event occurring in a “midterm” election year.

Another scholarly observation regarding “midterm” years comes from Dr. Marshall Nickles, professor at Pepperdine University, who studied stock market movements from 1941 to 2004. Dr. Nickles determined that in the 16 quadrennial cycles (just a fancy word for presidential administrations) studied from 1941-2004, the stock market declined from its previous peak 12 out of the 16 times, or 75% of the time, in the “midterm” election year. Why might this be the case? Let’s look into the psyche of a President.

Whether a president is newly elected or as an incumbent, whether they are a republican or a democrat, they’re inclined not to ride in on their “white horse” and “save the day” until the last two years of their administration, leading up to their party’s election. Therefore, the first two years for any president are a time to “pay up” on the promises that got them elected.

And since the goal of every president is to get re-elected, why not wait for a few years to fix matters, should there be a problem. When does fixing stuff matter most to a president…you guessed it…before the next election!

Good deeds, quantitative easing’s, whatever, occur in the back half, or the last two years of a presidential administration—not the first two.

So what’s the lesson for us as investors and managers of money? If volatility enters the stock market before this year’s November elections, don’t be surprised. Historically, it’s in the cards. As pointed out in the Wall Street Journal from April 5th, Sam Stovall, the chief equity strategist for S&P Capital IQ and the Street’s leading curator of midterm stock market data, Mr. Stovall relays to us that the markets, on average, tend to climb back to break-even relatively quickly, following pullbacks.

I simply point out these observations to present the other possible scenario even if the Federal Reserve is correct in its assessment that the economy is on better footing.  

Given that the stock market is trying to break through to new all-time highs and that its valuation measure, its price-to-earnings ratio, is near the top end of its range, one might expect some sort of summer malaise that generally occurs in the months from late spring to early fall. Markets typically don’t continue to move up in a straight line and we have not seen nary a 10% correction since 2012. This type of rising price action in the stock market, without a 10% pullback for this length of time, is highly unusual.

Regarding our in-house research…

Our asset class barometers study the correlations between bonds, stocks and commodities. By studying correlations, we can follow where money is flowing in the financial markets. Our models signaled strength in commodities back in December.

Stock groups that represent the commodity asset class are oil and gas issues, synthetics, chemicals, agricultural chemicals, industrial and precious metals. Commodities typically follow industrial and transportation stocks higher. We saw good moves in the industrial and transportation sectors last year. Of the 16 Basic Materials sub-industry groups that represent commodities, this month’s analysis is showing positive price action in all 16 groups as of May 1. 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? 

I’m often asked, “Could inflation be in the cards?” The federal government statisticians would say, “No.” Of course, their public calculations do not include (the rising cost of) food and energy. Did you know that 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 inflation 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 seen 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. 

On the currency front, a falling U.S. Dollar is assisting the strength in commodities since most commodities are priced in U.S. Dollars. Currently, the beneficiaries of a weak U.S. Dollar are large U.S. multinational corporations and U.S. businesses that sell abroad.

You see, profits derived overseas are accentuated when the profits in the foreign currency are brought back onto U.S. balance sheets. The foreign currency is “translated” back to U.S. dollars. Because the U.S. Dollar is weak, relative to the foreign currency, more dollars are derived on the balance sheet after “dollar translation.” More dollars translate to higher profits for the multinationals that provide the goods and services sold abroad.  Bottom-line, those household names like Johnson & Johnson, Microsoft, McDonalds and Coca-Cola make greater profits when the U.S Dollar is weak because they derive a great deal of their revenue from overseas markets. A weak U.S Dollar is another reason why we’ve seen strength in the large cap indexes in 2014.

Once we get through the “midterm” election season, we anticipate stock prices to steady themselves and rise going into the end of the year. 2015 is the third year in the Presidential Cycle and typically bodes well for stocks. We’ll speak more to year-end price action at our next Conference Call on November 12th.  Until then, we wish you a joyful and adventurous summer.

On behalf of our team, thank you for sharing your time with us this evening. I’ll pass the mike back over to our moderator, Amy Williard.

Carl Perthel, CMT

May 14, 2014