The Markets – Unplugged XVII

Markets Unplugged – XVII Conference Call

May 17, 2017

Welcome to our 17th edition 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 goals are 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’ve got something for everybody this evening. We’ll start our discussion by examining the importance of understanding the concept of “price” in the financial markets, how price is made, who makes it and how it might lead us to understanding the current psyche of investors, especially here in the United States. Next, we’ll delve into a review of Federal Reserve actions from our last conference call in November, and the associated economic data leading to possible future Fed actions. From there, we’ll venture overseas to examine the global economies and global market price action citing concerns and potential opportunities in the developed markets, and, also, the emerging markets. Next we’ll drill-down into an examination of some other broad asset classes like the U.S. dollar and commodities, and what price in these asset classes they may be signaling for our portfolios. And finally, we’ll comment on how the market may respond to the first year of a new presidential administration. That’s a lot to cover, so let’s get started with a discussion of why “price” may be the most important factor in securities analysis.

Price, certainly, is an underrated factor in mainstream security analysis. We emphasize price studies in our analysis, because price gives clues as to how investors are feeling and where they are putting their money; not just now, but maybe, in the future. And that’s why keeping an eye on changing prices is valuable for investors like us.

So, what is price? Price is the equilibrium between supply and demand; between buyers and sellers. In the financial markets, price reflects all the known and unknown information surrounding an issue. The back and forth between supply and demand is reflected in changing prices. Price is always right. And here is the example that makes this so: When an investor makes a purchase, they may have every reason in the world to believe that price should be doing what they want it to do. But when price is moving in the opposite direction of an investor’s decision, it doesn’t matter how right they think they are, the fact is, they are wrong, because they are on the wrong side of price. Price is always right. The old saying on Wall Street is: “Don’t argue with price!”

So the question is: “can analyzing changing prices provide clues behind investing decisions and provide a roadmap to finding future trends in the financial markets?”

How valuable might this be for our portfolios? I’ll show you how in a moment. But first, if you can, please grab a pen and paper and follow along with me, because this is our stock market lesson for the evening. Please write down, “if A=B and B=C, then A=C.” This formula is known as the transitive property in mathematics that I learned in 4th grade. I’ll show you why it’s also the formula that moves prices on Wall Street. Here is your first Question 1 – What moves price? The answer is money. Buying pressure, in the form of dollars purchasing a stock, for example, moves the stock price higher. The more money moving into a stock, the stronger the buying pressure; therefore, the higher the price. Selling pressure drives prices lower. Therefore, let’s label A= price (money). Question 2 – If money moves price, what or who moves money? The answer is that people move money; institutions like mutual funds, insurance companies, hedge funds and investment advisors, who work for you.

By the letter B, please write people. Our third and final question is this: what moves investors to risk their money, in hopes of making a profit in the financial markets?

Here’s a hint to this question: “I’ve got a real good feeling about this stock. This one is special; this one’s going to be different. ” What drives investors to feel this way? Emotions drive feelings, don’t they? By the letter C, please write emotions. Therefore, A (price) is moved by B (people) who are moved by C (emotions). Finally, if A=C, then price (A) is a result of people’s emotions (C). Emotions drive people to move money which causes price to change. Emotions move price. That’s why part of our in-house analysis, examines the interrelationships of price on charts, because the charting of price movement is a reflection of investors emotions. Why is it vitally important to track price? Price is a proxy for emotions. Emotions repeat themselves; therefore, following emotions in concert with price is valuable, since a repeat in emotions correlate with similar repetitions in price over many market and economic cycles. Prices, and therefore, markets, cycle between the emotions of fear and greed!

Do you remember Dr. Kildare, or George Clooney in ER, or House; all those great doctors in television shows? All those doctors seemed to be looking at their patient’s charts at the end of their hospital bed, when asking them how they were feeling. Did you ever notice that? Similarly, price changes on financial charts are like the EKG heartbeats for hospital patients. Prices reflect the financial health of the markets. So, what might the heartbeat of the U.S stock market be telling us about our patient Uncle Sam?

Continuing with our hospital analogy, let’s further put the stethoscope to Uncle Sam. When studying the stock market, as represented by the SP500, we can break the SP500 into 10 areas, or parts of the body, called market sectors.

Sectors reflect broad areas of the U.S. economy and are divided into two distinct groups, either “defensive or risk-off” or “offensive, or risk-on.” Sectors can reflect investor’s pessimism or optimism. Looking back to last year, two Conference Calls back, in the spring of 2016; America was uncertain about its future. Prices in the stock market reflected these feelings. The stock market was reflecting pessimism.

There was emotional uncertainty in the spring of 2016. The country was facing a choice for a new president, initially a choice among a dozen or more candidates between the two parties. “Defensive” sectors like utilities, consumer staples and energy performed well. Why are these sectors “defensive” in nature? Because no matter what may befall America, we still need the electricity and water those utilities provide. We need to consume food, and some need soft drinks, alcohol, or cigarettes. We need powder for baby’s bottoms and clothing to wear. These are the sub-industry groups that make up consumer staples, another “defensive” market sector. And of course, the energy sector remained popular, because we all drive cars, trucks and SUV’s. These sectors rewarded an uncertain environment and price rewarded investors that held these themes in their portfolios. From the beginning of 2016, up until the election in early November, the U.S. stock market was up just 2%, not including dividends. Pretty anemic performance compared to prior years, but price historically moves in a narrow range in times of uncertainty. Then, a change…

The election of our new president in November, gave rise to optimism. Price reflected a 180 degree turn, as the bottom half of the 10 SP500 sectors (those more risk oriented sectors) took the place of the “defensive” leaders we just mentioned.

The price change from early November to late January rewarded the industrial, materials, financial, health care and technology sectors; reflecting new optimism, a new beginning, and change!

A stronger heartbeat and rising prices in those sectors reflected the hopes of an infrastructure build-out, changes in health care, deregulation, a simpler tax code, and a stronger military. But, by late January 2017, uncertainty crept back into our sector analysis in the aforementioned industrial, materials and financial sectors. Price rotated back to “defense,” signaling waning optimism. And then, just a few weeks ago, in May, a subtle move back to rewarding the industrials and cyclicals, signaling a stronger industrial economy, perhaps and renewed optimism for the passage of government policy. Price is subtly telegraphing renewed interest in the infrastructure theme. What can we take away from these rotations among U.S. market sectors?: (1) with renewed pricing interest in mid-cycle leaders like technology, industrials and materials, price may be signaling that the stock market is willing to be patient with policy reform and may be discounting a stronger economy in the future, and secondly (2) the majority of sectors, on both the “offensive” AND “defensive” side of the ledger are currently within a few percentage points around the SP500 benchmark, meaning that the overall health of the stock market is in good shape. Thirdly (3), another important take-away, is that some diversification is being rewarded. Since the performance of the majority of SP500 sectors are within a few percentage points of one another, and positive performance is spread across a broad array of sectors, this validates the relative strength and balance in the broad economy.

The outlier among the U.S. market sectors is technology, which is responsible for a disproportional amount of the gains in 2017. Since diversification is prudent, for reasons we just cited, and we rarely recommend putting all our eggs in one basket, consider not getting too “hung up” on what your diversified portfolio achieves versus the SP500, especially when the performance of a benchmark may be the result of money piling into just one sector. Let’s switch gears and…

Let’s explore recent economic numbers in concert with recent Federal Reserve actions and see if we can draw some conclusions. Since our last Conference Call in November, the Federal Reserve Bank has raised interest rates for just the second time in the past 10 years. This rate hike is an effort to maintain credibility and honor its September 2014 promise for “Policy Normalization,” which calls for (1) increases in Short-term market interest rates, (2) reducing the size of the Fed balance sheet and (3) transforming the Fed’s asset holdings to a composition similar to those of pre- 2008. The stock market did not sell off in response to its most recent rate increase in March. So what’s price telegraphing by not selling off, like it did back in early 2016 when the last rate increase took place? Likely two messages: (1) rates are at such low levels; further Fed rate increases are not enough to de-rail corporate earnings. (2) Secondly, it may signal that monetary policy, whereby interest rates are raised or lowered to target inflation or ensure price stability, so prevalent during the Obama years, may now give way to fiscal policy as the main driver for the U.S. stock market. We use fiscal policy as the term for tax policies and government spending used to drive economic growth. If this is the case, monetary policy may not matter until fiscal stimulus produces robust economic growth.

At the point, of a real economic “take-off,” monetary policy may matter again, when companies and the consumer fight to borrow money, as a result of stronger economic conditions. But, this is not the case right now, as expressed by Fed Vice-Chairman Stanley Fisher, commenting on economic conditions last week, by saying that he is not worried at all by high stock valuations in the face of anemic GDP growth. He said that the tightening process will go on. Fisher was referring to GDP growth that came in at just 0.8% for Q1, 2017. Just last week, Commerce Secretary, Wilber Ross was quoted, saying that “3% GDP growth will not be achieved this year.”

There are other economic numbers that do not translate to robust economic growth: In March we saw a large drop in car and light truck sales and flat consumer spending. Personal income fell short of expectations at 0.2% vs. the consensus 0.3% in April and the March report was revised to 0.3% from 0.4%. Also, manufacturing retreated slightly as did construction spending. Nonfarm productivity dropped 0.6% last quarter. The job market has been strong, but wages for Americans have barely rebounded. The unemployment rate that hit a low of 4.4% in April, counts only workers who do not have a job but are still actively looking for one. It does not count the young people moving back in with their parents, workers who went on disability or older employees who opted for early retirement. Therefore, there is slack in the labor market which has contributed to sluggish wage growth even though unemployment is at 4.4%. For the Fed, that’s a disturbing data point when they’re trying to find reasons to raise rates. To conclude, Fed policy normalization may continue, but the current economic data does not, historically, present a case for sustained increases in interest rates.

On the positive side of the economic ledger, the U.S. economy has seen new single family home sales increase 16.6% in April, compared to March, the best increase since early 2008. And American consumers have come to life. Retail sales increased the most in April in over a year. Discretionary spending for eating out and taking vacations is strong. It’s not all doom and gloom and these numbers, of course, are constantly changing.

As we travel abroad, let’s examine what our in-house research is communicating to us for the first 5 months of 2017. We continue to witness strength in the overseas markets, perhaps, as a result of their quantitative easing programs that have been in place for the past few years?

In general, stocks overseas, like stocks here in the states, are ruling the roost. Specifically, international equities (the stocks of developed countries) are now slightly outperforming U.S. stocks and it’s the international small cap issues, with a growth style, that are leading the pack. Emerging market equites are, also, faring well.

The U.S. Dollar, since the beginning of the year, has been falling. Typically, rising U.S. interest rates strengthen the Dollar, because rising rates will attract foreign currency into the U.S. economy from investors seeking higher yields. That’s not happening, and it may be because the foreign equity and foreign debt markets are now attractive enough to lure money away from the U.S. Dollar. If the Trump administration makes good on its promise to reduce the trade deficit, that would reduce the supply of dollars in the world, therefore, strengthening the value of the U.S. Dollar. This has yet to be seen. A weak Dollar, coupled with what appears to be a recovery across the globe, should benefit U.S. and international multinationals; which many of you may own in your portfolios.

Let’s discuss commodities briefly. Commodities typically represent the inputs needed for growing global economies. Many commodities are priced in U.S. Dollars; therefore, we should see the weak dollar as a positive for the commodity sector.

This has not been the case thus far in 2017, except for gold, which has performed well. Commodities, for the better part of the past 12 months, have been in a trading range, their price moving in a lateral direction. Perhaps, one reason is that an oversupply of global oil is weighing on the energy sector, which makes up a large portion of the commodity index. But, what price is telling us is this: inflation is NOT a concern at this time.

And finally, according to Ned Davis Research, in a paper entitled, Presidential Cycles, he states that the SP500 can struggle in the first year of a new Presidential Cycle, given that it takes time for new policy initiatives to get passed and executed before their benefits may be realized.

But there is a silver lining for investors waiting for policy initiatives. According to The Stock Trader’s Almanac 2016 (Wiley & Sons), historically, stocks tend to perform better in periods of legislative gridlock. So while some of us may fret over what may or may not get done in Washington, know that the stock market likes legislative gridlock. At least with “gridlock” there is certainty that nothing will get done. And guess what? The stock market loves “certainty!”

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

Carl Perthel, CMT

May 17, 2017