The Markets – Unplugged XV

Markets Unplugged – XV Conference Call

May 11, 2016

Welcome to our 15th presentation of Market’s Unplugged, our semi-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. We’ll start our discussion this evening examining the U.S. stock market’s price action and what it may be signaling in the quarters ahead. From there we’ll delve into a review of the U.S. domestic recovery, from our last conference call in November 2015, focusing on the Federal Reserve and the economic data that may be influencing their decision making regarding interest rates. Next we’ll drill-down into an examination of some other broad asset classes like commodities and the U.S. dollar and what they may be signaling for our portfolios. From there, we’ll venture overseas to examine the global economies and global market price action citing concerns and opportunities in Europe, Asia and the emerging markets. Finally, since it’s an election year, we’ll review the historical price implications of an election year, and examine how the stock market may react to a new presidential administration. That’s a lot to cover, so let’s get started by taking a step back. For those of you who attended our May call from last year you may remember us comparing the U.S. equity markets to “ocean tides.” The stock markets, like the tides, rise and fall. That analogy has resonated with many clients over the last year as we are constantly asked, “What’s the tide table telling us? Are the markets following the tide table right now?” The short answer is “yes.” To review briefly, the month of May transitions between high prices and low prices in the stock market.
Historically, on average, the high tide, or the highs in stock market prices peak around May and start receding between May and November. The tide goes out. On May 20th last year, the U.S. stock market, as represented by the SP500, reached its intraday high for the year at 2,134.71, meeting our expectations on the tide table. By August and September last year, right in the middle of the low tide season, if you remember, the tide went out dramatically, as the stock market witnessed its first greater than 10% correction in almost four years; again, following the tide table. Also, on last May’s call, we cited the likelihood of less than the “clear sailing” we had grown accustomed to since 2010, in large part because the Federal Reserve was not providing the tailwind for our sails, as they had for the previous 4 years. Price-wise we explained that the stock market had moved into a “trading range,” a marked difference from the easy climb quarter after quarter we had witnessed since 2010. And that’s where we continue to find ourselves, in a trading range. We stated last May, this change in the market’s personality, beginning in late 2014, was a consequence of “easy money” policies being discontinued by the Federal Reserve. You may remember, those “easy money” policies “back in the day” (cash for clunkers, cash for Home Purchases, quantitative easing one and two, Operation Twist) policies that kept interest rates low and drove investors into the stock market to find higher yield. Starting in 2015, a direct consequence of the U.S. Federal Reserve discontinuing these “easy money” policies has resulted in choppy seas over the past 12 months, but still we find underlying support in the stock market, because the low interest rate environment continues and the stock market still provides one of the best places to secure income.

Since late last summer, we’ve experienced some “sea sickness” during the months of August and September, and most recently in the months of January and February with price drops from peak to trough of 10-15%. Rough seas…yet, net-net, U.S. benchmark stock prices from May 2015 to now, as represented by the SP500, have barely moved, returning only +0.26% with dividends over the past 12 months. This bears repeating. The U.S. stock market has returned less than 1% over the past 12 months; heavy seas and not much headway for the stock market. But, here is some perspective, historically; volatility and low single digit returns typically follow long periods of rising price action; like the rising price action we witnessed from 2010-2014. In November 2011 in Market’s Unplugged IX, we stated, “A good example of the market’s overall “trendlessness” or sideways price action, occurred between 2000-2010. Stock market returns with dividends averaged less than +1.4% per year over that 10 year period.” That was right BEFORE U.S. Federal Reserve initiated those “easy money” policies. Again, that was 10 years averaging less than 1.5% a year. Continuing with our tide analogy, since last May, covering 1 full year of high and low tides in the stock market, over the past 12 months, what we have now is the high water mark at that 2,134 on the SP500 equity benchmark and the low water mark at around 1,810 which occurred in February 2016. These levels are where we expect the price tides to continue for the next few quarters.
Let’s switch gears and explore the economic data, to figure out why “tailwinds” have turned into “headwinds” over the past 12 months and examine if the change in wind direction and the increase in market volatility is cause for us to “batten down our hatches.”
On December 16th, 2015 shortly after our last conference call, after seven years of the most accommodative monetary policy in U.S. history, the Federal Reserve finally approved a quarter-point increase in its target funds rate. The new target went from 0.25 percent to 0.5 percent. By January, most pundits were anticipating another 3 to 4 rate hikes in 2016. As of today we have seen none. What happened? Well, the economy hasn’t lifted off, as many anticipated; therefore, the Fed has put interest rate hikes on hold.
First, let’s review why the Fed thinks the economy doesn’t warrant higher rates and secondly, explore why their “inaction” may benefit our portfolios. The Gross Domestic Product (GDP), which is one the primary indicators used to gauge the health of our economy, showed a weaker than expected number in April, ticking up only 0.5%, for the country’s slowest rate in growth in 2 years, according to the Bureau of Economic Analysis. Soft exports, weak business investment and a slowdown in consumer spending growth all contributed to this weak start to 2016. In the manufacturing sector U.S. manufacturers barely grew in April and there’s little sign of a broad pickup in business anytime soon, according to the survey from The Institute for Supply Management, which conducts this monthly study. They concluded that the April manufacturing index rose to 52.8 last month from 51.3 in March. The ISM index has hovered between 48 and 53 since last summer. So, there has been little change over the past year. Although readings over 50 indicate more companies are expanding instead of shrinking, manufacturers are clearly struggling to grow over the past 12 months.
On the service side of the economy, the ISM Non-Manufacturing Index edged up in its latest readings to 55.7 in April and that’s a positive, but the recent reading was below the index that stood at 56.9 in the same period a year ago.
The latest Producer Price Index, Retail Sales and Business Inventories all either came in below-consensus or contained negative revisions to prior reports. Housing starts and building permits issuance data from late April suggest that the construction sector is weakening in much of the U.S. This data marks sluggishness. Not recession, just a very soft economic recovery. These are the reasons why the Fed is not in a hurry to raise rates. But, that’s good for your portfolios and here’s why: A low interest rate environment is conducive to a strong stock market for this primary reason: corporations borrowing costs are cheaper when interest rates are low. By being able to borrow at low rates, companies can retire higher cost debt to shore up their balance sheets. Low rates allow companies to purchase raw materials on the cheap, manufacture their product with these less expensive inputs and sell their final product for a higher price to their customers, allowing them to make money. Also, low borrowing costs allow companies to hold inventory for longer periods of time. These are a few reasons why the companies in your portfolios applaud low interest rates. Low rates typically translate to higher profit margins which lead to increased earnings which, in turn, lead to a higher company share prices. Additionally, because rates are low, where else are investors going to go to find income? Competing investments like bonds and CD’s give an investor less bang for their buck, therefore, stocks and stocks that pay dividends are very attractive. So, let’s not bemoan the sluggish economy too much, since it does serve a beneficial purpose for our portfolios up to a point, thanks to low interest rates.
Our Market Barometer, which measures the relative performance of asset classes against each other, still has us leaning towards equities. We monitor industry group rotation. There are approximately 200 industry groups that comprise the 9 sectors that make up the SP500 benchmark. The latest evidence the market is presenting to us through our industry group modeling, shows money moving into late cycle leaders such as resource and basic industry groups. Historically, in past cycles when this type of rotation takes place, the evidence favors inflation. In the broader sectors, at this time, our research supports market weight or overweight in the area of consumer discretionary, transportation, industrials and materials. Utilities should continue to do well so long as interest rates stay low and the Fed does not start to escalate rate hikes. Also, in the defensive area, longer term, the fundamentals for healthcare are strong, supported by demographics, merger activity, research and development and the sector’s long-term earnings trends. But for the shorter term, expect some volatility in healthcare as the market deals with the uncertainty of future policy directives from a new presidential administration. Regarding style, mid and small cap stocks have made up ground on the large caps since the beginning of the year; therefore, on a relative basis, exposure distributed among each category may be prudent. “Value” versus “growth” gives the nod towards “value” issues. Value issues typically support lower valuations while growth stocks trade at higher multiples. For example, in the large company “value” space since the beginning of the year, companies that have consistently raised dividends for years and tend to have financial strength and stable earnings growth, all characteristics of “value,” have been outperforming the broader market by a wide margin. Where 2015 rewarded the growth category, the beaten down “value” category is now making a comeback and here are a few reasons why:
“Value” issues which do business outside the U.S., known as multi-nationals, are in a favorable position this year because the U.S. dollar has lost strength. A weaker dollar translates to higher earnings for these issues. Also, a weaker dollar makes the U.S. goods that these companies sell, more attractive to their global customers. U.S. goods are cheaper to purchase with a weaker dollar. Many of you have multi-nationals in your portfolios. A stable to weaker dollar works to your advantage. Also, “value” issues fall in line with energy companies, as well. And we’ve seen a rebound in energy issues, which make up part of the commodity space on our barometer. After a year and one-half of being beaten down, oil prices are rising, having come back to their inflation adjusted mean of $44 a barrel. Energies contain major integrated oils and gas companies, drilling and equipment services, refiners and the pipeline companies. These issues have price appreciation potential, and have been exhibiting strength such since mid-February. There are opportunities here.
Also, in the commodity space, let’s not forget industrial and precious metals. Industrial metals like aluminum, steel & iron and especially copper have come back to life. In the precious metal area, both gold and silver have been some of the best performing issues in 2016.
We still prefer U.S. Equities over International equities in developed nations, but not to the degree we did from our last conference call. There’s definitely a place for international equities from an asset-allocation standpoint. Also, emerging market equities (those issues in the up and coming global markets and economies) have shown relative outperformance over both U.S. equities and International equities of developed nations in 2016.
An investor shouldn’t discount the emerging market category for price appreciation. Again, from an asset allocation standpoint, exposure to emerging markets may be prudent for the investor with a longer term time horizon. But, short-term headwinds to be aware of in the emerging markets space include currency, commodity and interest rate risks, so expect volatility while holding the emerging markets.
Let’s briefly discuss some economic and market moving events that may present opportunities and concerns for the “overseas investor.” In the Eurozone, quantitative easing continues, which should prove successful in bringing that region out of the doldrums. Arguably, the premise of QE was supportive for U.S. stock prices from 2010-2014 and should hold true for Europe. Other global central banks, besides the European Central Bank, continue to implement “easy money” policies. The Bank of Japan, for example, in an effort to spur growth, recently moved to a “negative interest rate” policy, joining Denmark, Sweden and Switzerland. China’s efforts have included slashing interest rates, purchasing assets, and devaluing their currency, the yuan. The important take away is this: all global central banks, U.S. included, are coordinating their efforts to spur global growth. Given the interconnectivity of global economics, it’s a lot easier to accomplish monetary goals when major economies are on the same page.
Regarding the overseas markets, lower oil prices should prove a boost to those countries importing oil. Low oil prices will assist overseas markets (both developed and emerging markets) by allowing these countries access to more affordably priced inputs. On the flip side, higher oil prices, up to a point, are beneficial in this regard: higher oil prices lead to more of a stabilizing effect for governments that depend on energy exports, particularly in the Middle East and Africa, but let us not forget Brazil, Venezuela and Russia.
Certainly, oil revenues should translate into tangible benefits for the general population of these nations. Oil revenues will enhance basic economic and social services for exporting countries.
So, what does all mean for the “overseas” investor? Right now, the trend of the U.S. stock market versus Europe, Australia and the Far East still favors the United States, but not by too much. If quantitative easing in the Eurozone can accomplish its primary goal of spurring economic growth, if commodities continue to firm as a result of greater global demand, and therefore help commodity producing countries like Australia, Brazil and Canada and if negative interest rates can spur economic growth in Japan AND China can continue to successfully transition to a consumer driven economy, or a combination of these events, then the fortune for global economies versus the United States should tip the scales in favor of overseas markets. We are not there, quite yet, but we’ve been heading in that direction since the start of 2016.

Well, it’s not hard to find evidence that we are in an election year, is it?! How might the market respond for the rest of this year and in the first term of a new U.S. president?
According to The Stock Trader’s Almanac 2016 (Wiley & Sons), a bible for presidential cycles and the stock market, there have been only two losses in the last 7 months of election years. Regardless which Party is victorious, the last seven months in an election year, like the one we are in now, have seen gains on the SP500 in 14 of the 16 presidential election years since 1950. That’s a bullish scenario for the stock market until the end of this year. Since 1901 there have been 28 presidential elections.
When the Party in power retained the White House 17 times, the Dow was up 1.5% on average for the first 5 months of a new administration, compared to a 4.6% loss the 11 times the Party was ousted.

Presidential election years are the second best performing year of the 4-year cycle, producing losses of greater than 5% in only six of those 30 years.

Longer term, regarding new presidential administrations: major market bottoms have occurred within the first two years after a new administration takes the White House in 15 out of the last 18 presidential 4-year terms. That means, since 1941, spanning 18 administrations, looking ahead to the new administration in January of 2017, whether it’s a Republican or a Democrat, there is an 83% probability that the stock market could experience some kind of major bottom either in 2017 or 2018.

On behalf of our team, thank you for sharing your time with us this evening. We’ll catch up with you next time, in this format, the second Wednesday in November. I’ll now pass the microphone back over to our moderator, Amy Williard.

Carl Perthel, CMT
May 11, 2016