The Markets – Unplugged VIII

Transcript for November 14, 2012 Conference Call

Welcome to our 8th 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 what are the market’s financial barometers and how can they help us navigate the current business cycle. After that discussion we’ll comment on the Federal Reserve’s role as a Central Bank, give you an update on the U.S. and global equity markets since our last call, briefly discuss the results of our U.S. elections, examine price “seasonality” over the next six months and finish with a discussion of where we might be in the cyclical bull market. So, let’s begin…

Most investors liken the markets to the weather; ever present and for the most part, unpredictable. And it’s true, nobody knows for sure what the weather is going to be exactly from one day to the next, and nobody knows exactly where the financial markets will be from one day to the next. Regarding the financial markets, we analyze the evidence the markets present us each day and derive a thesis on where price might be headed. We attempt to identify trends to the upside, corrections to the downside and turning points at each juncture. While the weather exhibits seasonal patterns; spring, summer, autumn and winter, the financial markets exhibit historical patterns, as well, during its seasonal cycle, which we’ll call the business cycle.

Relative to the weather, a barometer is an instrument that measures air pressure and therefore the daily nature of the weather. We attempt to measure the stock market in a barometric fashion, as well. Our barometer reflects changes in circumstances or opinions. Therefore, since “price” is a true reflection of market opinion, “buying and selling pressure,” the market’s barometric pressure, is reflected through price movements. Our market barometer measures the price pressure in the relationship between bonds, stocks and commodities during a business cycle. The business cycle is similar to the seasons. It’s a move through economic contractions and expansions. So, to sum up, our roadmap through the markets is measured through the changes in price pressure among the markets three main asset classes: bonds, stocks and commodities.

Let me paint you a picture comparing the four seasons to a typical business cycle. Price movement in bonds, stocks and commodities move like the weather through spring, summer, autumn and winter. A recovery, in a new business cycle, is like the springtime. Where we are used to seeing daffodils around our neighborhoods, in the financial markets we see bond prices popping up. As our earthly season progresses and spring matures, trees become green and leafy. In our market season, as the business cycle progresses, our portfolios become greener with profits from rising stock prices. Therefore, after bonds pop, the equity markets are the next to bloom. Both bonds and stocks mature as spring turns to summer. Finally, in mid to late summer, commodities like oil and gas, material and metals will shine like the warm summer sun. Commodity prices will rise, following stocks and bonds. All three asset classes are bullish near the height of a typical business cycle. It’s like the summer solstice.

But the hot summer sun and the heat of an economic expansion doesn’t last forever. And like the change in seasons, the barometric pressure of our asset classes’ decline as the economic climate gets cooler. Why does the business climate change, and like the temperature from summer to autumn, gradually cool off? It’s because the heat of the economic expansion drives up the cost of money and therefore, interest rates. As rates rise, our daffodils start to wilt; bonds move lower with rising interest rates. Barometric pressure decreases as money moves out of bonds and tries to find yields in the stock and commodity markets. These moves last for only a while, but eventually, even our green, leafy trees in rising stock prices turn to yellow and orange with the change of the season, adversely affected by the rise in interest rates, putting a chill on the business climate. Autumn has arrived. Money is harder to borrow for businesses. Expansion slows and inventory becomes increasingly expensive to hold. Therefore, the barometric pressure drops even further. Commodities, those raw inputs for the goods and services being sold, lose their luster as the business climate turns colder. As raw materials become more expensive and prices rise, consumer demand recedes. At this point we head into winter. All three asset classes are falling and a low pressure system finds its way into the business cycle. The business cycle begins a downturn, which may be mild or turn into a full blown recession. So there you have it. Bonds lead us out of a business contraction. Business expansion follows, characterized by rising stock prices and rising commodity prices. At the business cycle peaks, all three asset classes are moving higher together. The first sign of cooler weather is characterized by weakness in bond prices, followed by falling stock prices and finally, falling commodity prices. Here the business cycle begins to move from expansion to contraction.

Therefore, price relationships between bonds, stocks and commodities are akin to barometric pressure and weather patterns. The business climate, like the weather, can be measured in barometric terms by examining the “buying and selling pressure” between these three asset classes.

Let’s see how this metaphor coincides with the existing domestic and global business climate. As they have for the past few years, the Federal Reserve continues to control the business climate through monetary policy, which is the regulation of the money supply and interest rates. Remember our analogy above regarding interest rates? Rising rates are the catalysts that transition summer to autumn. The higher interest rates move, the chillier the business climate becomes. By keeping rates low, the Fed is trying to exert a high pressure system on the business cycle, with the goal of extending the “summer” season. It’s our feeling that no one, ultimately, can control the weather and it’s only a matter of time that the warmth of the sun, through a loose monetary policy, turns into the heat of inflation, ultimately leading to a cold winter in the financial markets. But, that change in the business climate is not yet upon us. With the re-election of President Obama, we can further expect an accommodative weather man in the form of Ben Bernanke over the course of the next year. He’ll continue to lead the Fed in trying to keep the cost of money low by creating more money at the printing press through bond purchases and therefore, try to extend the ride on this “easy money” wave through “The Endless Summer.” That’s a surfer reference, if you didn’t catch it…

We postulated at the end of the last Conference Call in May that the “soft seasonal patch” would kick in from May to November. True to form, the DJ Industrial average has exhibited negative performance over the “unfavorable” six month period, down -4.86% since May 1. May to June saw pull back of -10% in the indices. We are still in “pull-back” mode, most recently since mid-September. So, true to form, the market is acting out, as we pointed out to you last May, co-inciding with the unfavorable season. Unlike the aftermath of the first two monetary stimulus programs from our “weatherman” Ben Bernanke, the equity markets did not continue to rise after the implementation of QE3 in mid-September. We feel that the markets are adjusting from an over-extended position created by the summer run-up in price. The run-up in price was spurred by investor perception that U.S. and European Central Banks were standing by to assist the global markets should economic trouble present itself. This is a continuation of the “stimulus theme” since 2010, only this time, the markets have gone down, not up, since the announcement of another stimulus package.

Still, regarding the U.S. weather report, the financial markets through the lens of price action in the bonds, stocks and commodities are still telling us that the U.S. economy and equity markets are under a high pressure system. Bonds are still in an uptrend. Stocks are consolidating within an uptrend, and have yet to break key support levels. These are positive conditions. Commodities, on the other hand continue to languish, which casts some cloud cover. Overall, it’s still summertime according to the market barometer. But the weather can change…

Historically, economic performance, here and abroad, is driven by demand for inputs like copper and oil. When there’s demand in these two groups, economic performance is robust, coinciding with higher equity prices. Since October, copper and oil have been weak. Additional cloud-cover, prior to the negative price action in commodities, showed itself in the third quarter earnings reports. 33% of U.S. companies missed their earnings targets and 66% of these companies did not beat their revenue projections. The 66% number means that companies are over-estimating their top-line growth; in other words, they aren’t selling as much as they originally thought they would for the last quarter. These conditions are bearish for the stock market in the near term, as money continues to find a safe haven in bonds. Money has been flowing into the bond market since March 2009. Ultimately, we believe, market participant’s search for yield will lure investors away from bonds and back into equities that pay dividends or into financial instruments that mimic bonds and have attractive yields.

Many folks don’t realize that global equity markets have been in a bear mode since late 2010; that’s 2 years!; down as much as negative -25 to -30%, while the U.S. equity markets have risen +10 to +20% over the same time period. But recently, Asian markets Ex- Japan have broken their downtrend and moved to the upside on an absolute and relative basis. Europe has shown price improvement, but Asia is stronger on a relative basis. A strong Asia should lead to firmer commodity prices and consequently, firmer equity markets around the globe. Mexico, Australia, Singapore and India are pockets of strength around the globe.

Stronger global equity markets should benefit large U.S. multi-national companies.

On a sector level, here in the United States, we have been troubled with a falling transportation index at a time when the industrial index was rising. This is known in market parlance as a “non-confirmation.” A bullish market signal occurs when the transportation average and the industrial averages are moving higher, together. Since transportation issues move raw materials and finished goods and services to wholesalers, retailers and ultimately consumers, we want to see a stronger transportation average. While the industrials are up for the year, transportations are unchanged.

How about some positive news? Housing starts, a very long term leading indicator, reached new recovery highs in October. Our sector work has shown upgrades in sub-industries like residential construction, lumber and general building materials since the beginning of the year. Financial sub-groups like surety & title, mortgage investment and credit services have all moved higher in the past year. Even Savings & Loans have bottomed. Since it was the financial and housing sectors that led us down in 2008, a turn for the positive in these two groups sheds light on the potential for a healthier economy. Combine these groups with stronger consumer sentiment and there is the real possibility for an improvement in the velocity of money between banks, businesses and consumers. These synergies would accelerate an economic recovery.

We would be remiss, not to comment on gold, which is up over +10% on the year. It has been the best performing asset class since the start of the secular bear market in 2000. Although gold has moved down since October, it looks ready to steady itself and challenge its February and October highs. Gold is seen as a store of value around the world in this era of central bank printing press frenzy. The bottom line for gold is there is greater demand than supply for this precious metal.

The U.S. elections are over. Over three billion dollars ($3 Billion) as spent and we end up right where we started off; a Democratic President, a Republican House and a Democratic Senate. In a research meeting last week, Gordon Lamb put it succinctly, when I asked him about the election. He said, “The Democrats won and the Republicans lost. Now comes the time for the Republicans to try and work with this President, because if there isn’t real progress on the issues confronting Capitol Hill in the next two years, then Republican heads, in Congress, will roll.” That makes a lot of sense to me.

The confirmation signal for the start of the market’s “favorable” six-month seasonal period, which usually occurs by early November, has not yet signaled. Nevertheless, based on our historical model, we expect the current market environment to steady itself based on our market barometer.

We’re still in a “secular” or long-term bear market, which started in March 2000. Shorter term “cyclical” bull and bear moves occur three to four times within an average secular bear market. Since 2000 we have experienced only two cyclical bull and bear moves. That leaves room for at least one more move to the downside, if not two. Sorry to give you that news, but that’s just the nature of a secular bear market.

Most bear markets occur within the first two years of a new Presidential cycle. That places the odds for the next move down somewhere in 2013-2014. Should our favorable time period kick in as we expect, we do not anticipate trouble in the equity markets until the spring time. That happens to be when we will be speaking to you next over this forum. Until then, enjoy your holidays and the profits the markets have given you this year.

Thank you for sharing your time this evening. I’ll turn the floor back over to our moderator, Noreen Miyake – Char.

Carl Perthel

November 14, 2012