Posts filed under ‘Financial Markets’
Extrapolation: Dangers of the Reckless Ruler
The game of investing would be rather simple if everything moved in a straight line and economic data points could be could be connected with a level ruler. Unfortunately, the real world doesn’t operate that way – data points are actually scattered continuously. In the short-run, inflation, GDP, exchange rates, interest rates, corporate earnings, profit margins, geopolitics, natural disasters, financial crises, and an infinite number of other factors are very difficult to predict with any accurate consistency. The true way to make money is to correctly identify long-term trends and then opportunistically take advantage of the chaos by using the power of mean reversion. Let me explain.
Take for example the just-released October employment figures, which on the surface showed a blowout creation of +271,000 new jobs during the month (unemployment rate decline to 5.0%) versus the Wall Street consensus forecast of +180,000 (flat unemployment rate of 5.1%). The rise in new workers was a marked acceleration from the +137,000 additions in September and the +136,000 in August. The better-than-expected jobs numbers, the highest monthly addition since late 2014, was paraded across television broadcasts and web headlines as a blowout number, which gives the Federal Reserve and Chairwoman Janet Yellen more ammunition to raise interest rates next month at the Federal Open Market Committee meeting. Investors are now factoring in roughly a 70% probability of a +0.25% interest rate hike next month compared to an approximately 30% chance of an increase a few weeks ago.
As is often the case, speculators, traders, and the media rely heavily on their trusty ruler to connect two data points to create a trend, and then subsequently extrapolate that trend out into infinity, whether the trend is moving upwards or downwards. I went back in time to explore the media’s infatuation with limitless extrapolation in my Back to the Future series (see Part I; Part II; and Part III). More recently, weakening data in China caused traders to extrapolate that weakness into perpetuity and pushed Chinese stocks down in August by more than -20% and U.S. stocks down more than -10%, over the same timeframe.
While most of the media coverage blew the recent jobs number out of proportion (see BOOM! Big Rebound in Job Creation), some shrewd investors understand mean reversion is one of the most powerful dynamics in economics and often overrides the limited utility of extrapolation. Case in point is blogger-extraordinaire Scott Grannis (Calafia Beach Pundit) who displayed this judgment when he handicapped the October jobs data a day before the statistics were released. Here’s what Grannis said:
The BLS’s estimate of private sector employment tends to be more volatile than ADP’s, and both tend to track each other over time. That further suggests that the BLS jobs number—to be released early tomorrow—has a decent chance of beating expectations.
Now, Grannis may not have guaranteed a specific number, but comparing the volatile government BLS and private sector ADP jobs data (always released before BLS) only bolsters the supremacy of mean reversion. As you can see from the chart below, both sets of data have been highly correlated and the monthly statistics have reliably varied between a range of +100k to +300k job additions over the last six years. So, although the number came in higher than expected for October, the result is perfectly consistent with the “slowly-but-surely” growing U.S. economy.
Source: Calafia Beach Pundit
While I spend much more time picking stocks than picking the direction of economic statistics, even I will agree there is a high probability the Fed moves interest rates next month. But even if Yellen acts in December, she has been very clear that this rate hike cycle will be slower than previous periods due to the weak pace of economic expansion. I agree with Grannis, who noted, “Higher rates would be a confirmation of growth, not a threat to growth.” Whatever happens next month, do yourself a favor and keep the urge of extrapolation at bay by keeping your pencil and ruler in your drawer.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
More Treats, Less Tricks
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (November 2, 2015). Subscribe on the right side of the page for the complete text.
Have you finished licking the last of your Halloween chocolate-covered fingers and scheduled your next cavity-filled dental appointment? After a few challenging months, the normally spooky month of October produced an abundance of sweet treats rather than scary tricks for stock market investors. In fact, the S&P 500 index finished the month with a whopping +8.3% burst, making October the tastiest performing month since late 2010. This came in stark contrast to the indigestion experienced with the -8.7% decline over the previous two months.
What’s behind all these sweet gains? For starters, fears of a Chinese economic sugar-high ending in a crash have abated for now. With that said, “Little Red Riding Hood” is not out of the woods quite yet. Like a surprising goblin or ghost popping out to scare you at a Halloween haunted house, China could still rear its ugly head in the future due to its prominent stature as the second largest global economy. We have been forced to deal with similar on-again-off-again concerns associated with Greece.
The good news is the Chinese government and central bank are not sitting on their hands. In addition to interest rate cuts and corruption crackdowns, Chinese government officials have even recently halted its decades-long one-child policy. China’s new two-child policy is designed to spur flagging economic growth and also reverse the country’s aging demographic profile.
Also contributing to the stock market’s sugary October advances is an increasing comfort level with the Federal Reserve’s eventual interest rate increase. Just last week, the central bank released the statement from its October Federal Open Market Committee meetings stating it will determine whether it will be “appropriate” to increase interest rates at its next meetings, which take place on December 15th and 16th. Interest rate financial markets are now baking in a roughly 50% probability of a Fed interest rate hike next month. Initially, the October Fed statement was perceived negatively by investors due to fears that higher rates could potentially choke off economic growth. Within a 30 minute period after the announcement, stock prices reversed course and surged higher. Investors interpreted the Fed signal of a possible interest rate hike as an upbeat display of confidence in a strengthening economy.
As I have reiterated on numerous occasions (see also Fed Fatigue), a +0.25% increase in the Federal Funds rate from essentially a level of 0% is almost irrelevant in my eyes – just like adjusting the Jacuzzi temperature from 102 degrees down to 101 degrees is hardly noticeable. More practically speaking, an increase from 14.00% to 14.25% on a credit card interest rate will not deter consumers from spending, just like a 3.90% mortgage rising to 4.15% will not break the bank for homebuyers. On the other hand, if interest rates were to spike materially higher by 3.00% – 4.00% over a very short period of time, this move would have a much more disruptive impact, and would be cause for concern. Fortunately for equity investors, this scenario is rather unlikely in the short-run due to virtually no sign of inflation at either the consumer or worker level. Actually, if you read the Fed’s most recent statement, Fed Chairwoman Janet Yellen indicated the central bank intends to maintain interest rates below “normal” levels for “some time” even if the economy keeps chugging along at a healthy clip.
If you think my interest rate perspective is the equivalent of me whistling past the graveyard, history proves to be a pretty good guide of what normally happens after the Fed increases interest rates. Bolstering my argument is data observed over the last seven Federal Reserve interest rate hike cycles from 1983 – 2006 (see table below). As the statistics show, stock prices increased an impressive +20.9% on average over Fed interest rate “Tightening Cycles.” It is entirely conceivable that the announcement of a December interest rate hike could increase short-term volatility. We saw this rate hike fear phenomenon a few months ago, and also a few years ago in 2013 (see also Will Rising Rates Murder Market?) when Federal Reserve Chairman Ben Bernanke threatened an end to quantitative easing (a.k.a., “Taper Tantrum”), but eventually people figured out the world was not going to end and stock prices ultimately moved higher.
Besides increased comfort with Fed interest rate policies, another positive contributing factor to the financial market rebound was the latest Congressional approval of a two-year budget deal that prevents the government from defaulting on its debt. Not only does the deal suspend the $18.1 trillion debt limit through March 2017 (see chart below), but the legislation also lowers the chance of a government shutdown in December. Rather than creating a contentious battle for the fresh, incoming Speaker of the House (Paul Ryan), the approved budget deal will allow the new Speaker to start with a clean slate with which he can use to negotiate across a spectrum of political issues.
Source: Wall Street Journal
Remain Calm – Not Frightened
Humans, including all investors, are emotional beings, but the best investors separate fear from greed and are masters at making unemotional, objective decisions. Just as everything wasn’t a scary disaster when stocks declined during August and September, so too, the subsequent rise in October doesn’t mean everything is a bed of roses.
Every three months, thousands of companies share their financial report cards with investors, and so far with more than 65% of the S&P 500 companies reporting their results this period, corporate America is not making the honor roll. Collapsing commodity prices, including oil, along with the rapid appreciation in the value of the U.S. dollar (i.e., causing declines in relatively expensive U.S. exports), third quarter profit growth has declined -1%. If you exclude the energy sector from the equation, corporations are still not making the “Dean’s List,” however the report cards look a lot more respectable through this lens with profits rising +6% during the third quarter. A sluggish third quarter GDP (Gross Domestic Product) growth report of +1.5% is further evidence the economy has plenty of room to improve the country’s financial GPA.
Historically speaking, October has been a scary period, if you consider the 1929 and 1987 stock market crashes occurred during this Halloween month. Now that investors have survived this frightening period, we will see if the “Santa Claus Rally” will arrive early this season. Stock market treats have been sweet in recent weeks, but investors cannot lose sight of the long-term. With interest rates near generational lows, investors need to make sure they are efficiently investing their investment funds in a low-cost, tax-efficient, diversified manner, subject to personal time horizons and risk tolerances. Over the long-run, meeting these objectives will create a lot more treats than tricks.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Out of the Woods?
In the middle of the 24/7 news cycle, many investors get distracted by the headline du jour, much like a baby gets distracted by a shiny new object. While investor moods have been swinging violently back and forth, October’s performance has bounced back like a flying tennis ball. So far, the reversal in the S&P 500 performance has more than erased the -9% correction occurring in August and September. Could we finally be out of the woods, or will geopolitics and economic factors scare investors through Halloween and year-end?
Given recent catapulting stock prices, investor amnesia has erased the shear horror experienced over the last few months – this is nothing new for emotional stock market participants. As I wrote in Controlling the Lizard Brain, human brains have evolved the almond-shaped tissue in our brains (amygdala) that controlled our ancestors’ urge to flee ferocious lions. Today the urge is to flee scary geopolitical and economic headlines.
I expanded on the idea here:
“When the brain in functioning properly, the prefrontal cortex (the front part of the brain in charge of reasoning) is actively communicating with the amygdala. Sadly, for many people, and investors, the emotional response from the amygdala dominates the rational reasoning portion of the prefrontal cortex. The best investors and traders have developed the ability of separating emotions from rational decision making, by keeping the amygdala in check.”
Evidence of lizard brains fear for flight happened just two months ago when the so-called “Fear Gauge” (VIX – Volatility Index) hit a stratospherically frightening level of 53 (see chart below), reached only once over the last few decades (2008-09 Financial Crisis).
Just as quickly as slowing China growth and a potential Fed interest rate hike caused investors to crawl underneath their desks during August (down –11% in four days), while biting their fingernails, investors have now sprung outside to the warm sunshine. The end result has been an impressive, mirror-like +11% increase in stock prices (S&P 500) over the last 18 trading days.
Has anything really changed over the last few weeks? Probably not. Economists, strategists, analysts, and other faux-soothsayers get paid millions of dollars in a fruitless attempt to explain day-to-day (or hour-by-hour) volatility in the stock markets. One Nobel Prize winner, Paul Samuelson, understood the random nature of stock prices when he observed, “The stock market has forecast nine of the last five recessions.” The pundits are no better at consistently forecasting stock prices.
As I have reiterated many times before, the vast majority of the pundits do not manage money professionally – the only people you should be paying attention to are successful long-term investors. Even listening to veteran professional investors can be dangerous because there is often such a wide dispersion of opinions based on varying time horizons, strategies, and risk tolerances.
Skepticism remains rampant regarding the sustainability of the bull market as demonstrated by the -$100 billion+ pulled out of domestic equity funds during 2015 (Source: ICI). The Volatility Index (VIX) shows us the low-hanging fruit of pessimism has been picked with the metric down -73% from August. With legislative debt ceiling and sequestration debates ahead in the coming weeks, we could hit some more choppy waters. Short-term volatility may resurrect itself, but the economy keeps chugging along, interest rates remain near all-time lows, and stock valuations, broadly speaking, remain reasonable. Investors may not be out of the woods yet, but one thing remains certain…an ever-changing stream of fearful headlines are likely to continue flooding in, which means we must all keep our lizard brains in check.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
E.M.s Want Cake & Eat It Too
Since the end of 2010, the emerging markets (E.M.) have gotten absolutely obliterated (MSCI Emerging Markets index –25%) compared to a meteoric rise in U.S. stocks (S&P 500 index +60%) over the same period.
Source: Financial Times
Slowing global growth, especially with resource-hungry China going on a crash diet, has caused commodity-exporting emerging markets like Brazil to suffer economic starvation. Rising inflation, expanding debt, decelerating Chinese growth, collapsing commodity prices, and political corruption allegations are all factors pressuring the Brazilian economy. Weak emerging market economies like Brazil are contributing to global GDP forecast reductions. As you can see from the chart below, global GDP growth rates have been steadily declining since 2010, and the IMF recently lowered their 2015 forecast from +3.5% down to 3.1%.
Source: Financial Times
Beginning in late 2008, when Ben Bernanke first announced his QE 1 (Quantitative Easing) money printing binge, the U.S. dollar remained relatively weak against other global currencies for years. The weak dollar provided a nice tailwind to U.S. exporters (i.e., American manufactured goods were more cost competitive for foreign buyers).
Multinationals loved the export lift, but emerging international politicians and investors cried foul. They complained the U.S. was starting a “currency war” by artificially deflating the value of the U.S. dollar, thereby making international markets less competitive. At the time, the thought process was the emerging markets (e.g., China, Russia, Brazil et.al.) would be disproportionately impacted because their economies are export-driven. In a 2010 article from the Guardian (World Gripped by International Currency War) Brazilian finance minister Guido Mantega explicitly stated, “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.”
This “currency war” griping stayed in place until the end of 2013 when the Fed announced its plans to begin “tapering” bond buying (i.e., pull away the financial punch bowl). We all know what has happened since then…the U.S. dollar has spiked by about +20% and the Brazilian real has depreciated by a whopping -37%. This is good news for emerging markets like Brazil, right? Wrong!
A few years ago, emerging market investors were initially worried about the depressing effects of a strong currency on exports, but now that emerging market currencies have depreciated, fears have shifted. Now, investors are concerned whether E.M. countries can pay off foreign borrowed debt denominated in pricey U.S. dollars (paid with vastly weaker E.M. currencies). Moreover, with foreign governments holding dramatically lower valued currency, investors are worried about the ability of these E.M. countries to raise additional capital or refinance existing debt. SocGen’s head of emerging market strategy, Guy Stear, summed it up by noting, “Prevailing risks of a deterioration of the external financing environment and disruptive capital flow and asset price shifts that increase volatility in the respective bond and currency markets, make a rapid rebound in EM growth over the next months unlikely.”
So which one is it…do E.M. investors want a weak currency to power exports, or a strong currency to pay down debt and raise additional capital? Unfortunately, investors can’t have their cake and eat it too – you can’t have a depreciating and appreciating currency at the same time.
While anxiety has shifted from strong emerging market currencies to the issues associated with weak currencies, India is one E.M that has reaped the rewards from a declining rupee (-20% since 2013). In other words, India is benefiting from a stronger trade balance via a boost in exports and reduction in imports – interestingly, the U.S. has experienced the exact opposite. Regardless, eventually, other emerging markets will benefit from these same positive trends as India – that will finally be a tasty slice of cake.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including EWZ, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Oxymoron: Shrewd Government Refis Credit Card
With the upcoming Federal Reserve policy meetings coming up this Wednesday and Thursday, investors’ eyes remain keenly focused on the actions and words of Federal Reserve Chairwoman Janet Yellen.
If you have painstakingly filled out an IRS tax return or frustratingly waited in long lines at the DMV or post office, you may not be a huge fan of government services. Investors and liquidity addicted borrowers are also irritated with the idea of the Federal Reserve pulling away the interest rate punch bowl too soon. We will find out early enough whether Yellen will hike the Fed Funds interest rate target to 0.25%, or alternatively, delay a rate increase when there are clearer signs of inflation risks.
Regardless of the Fed decision this week, with interest rates still hovering near generational lows, it is refreshing to see some facets of government making shrewd financial market decisions – for example in the area of debt maturity management. Rather than squeezing out diminishing benefits by borrowing at the shorter end of the yield curve, the U.S. Treasury has been taking advantage of these shockingly low rates by locking in longer debt maturities. As you can see from the chart below, the Treasury has increased the average maturity of its debt by more than 20% from 2010 to 2015. And they’re not done yet. The Treasury’s current plan based on the existing bond issuance trajectory will extend the average bond maturity from 70 months in 2015 to 80 months by the year 2022.
If you were racking up large sums of credit card debt at an 18% interest rate with payments due one month from now, wouldn’t you be relieved if you were given the offer to pay back that same debt a year from now at a more palatable 2% rate? Effectively, that is exactly what the government is opportunistically taking advantage of by extending the maturity of its borrowings.
Most bears fail to acknowledge this positive trend. The typical economic bear argument goes as follows, “Once the Fed pushes interest rates higher, interest payments on government debt will balloon, and government deficits will explode.” That argument definitely holds up some validity as newly issued debt will require higher coupon payments to investors. But at a minimum, the Treasury is mitigating the blow of the sizable government debt currently outstanding by extending the average Treasury maturity (i.e., locking in low interest rates).
It is worth noting that while extending the average maturity of debt by the Treasury is great news for U.S. tax payers (i.e., smaller budget deficits because of lower interest payments), maturity extension is not so great news for bond investors worried about potentially rising interest rates. Effectively, by the Treasury extending bond maturities on the debt owed, the government is creating a larger proportion of “high octane” bonds. By referring to “high octane” bonds, I am highlighting the “duration” dynamic of bonds. All else equal, a lengthening of bond maturities, will increase a bond’s duration. Stated differently, long duration, “high octane” bonds will collapse in price if in interest rates spike higher. The government will be somewhat insulated to that scenario, but not the bond investors buying these longer maturity bonds issued by the Treasury.
All in all, you may not have the greatest opinion about the effectiveness of the IRS, DMV, and/or post office, but regardless of your government views, you should be heartened by the U.S. Treasury’s shrewd and prudent extension of the average debt maturity. Now, all you need to do is extend the maturity and lower the interest rate on your personal credit card debt.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
The Bungee Market
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (September 1, 2015). Subscribe on the right side of the page for the complete text.
Are you an adrenaline junkie? You may be one and not even know it. If you are an investor in the stock market, you may have noticed a sinking feeling in your investment portfolio before a sharp bounce-back, much like a bungee jump. Before the recent drop of -6.6% in the Dow during August, some stock investors got lulled into a state of complacency, considering a tripling in stock prices over the last six years.
Almost any current or future news headline has the capability of potentially triggering a short-term bungee jump in stock prices. Now, worries over the health of the Chinese economy and financial markets, coupled with concerns of an impending rate hike by the Federal Reserve have created some tension for global financial markets. The slowdown in China should not be ignored, but as famed investor Bill Nygren pointed out, its impact should be placed in the proper context. China only represents 15% of global economic activity and U.S. exports to China only account for 0.7% of our GDP.
- 5% market corrections, 3 times per year on average (“correction” = price decline);
- 10% market corrections, 1 time per year on average; and
- 20% market corrections, 1 time every 3.5 years on average.
Welcome Back Volatility! Mini Flash Crash
- Economic growth revised higher (Q2 GDP raised to +3.7% from +2.3%)
- Unemployment rate continues to drop ( at 5.3%, a 7-year low)
- Interest rates near historic lows (3.95%, 30-year mortgage rate), which will remain massively stimulative even if the Fed modestly increases short-term rates
- U.S. corporate profits are near record highs (despite dampening effect of the strong U.S. dollar on exports)
- Reasonable valuations (improved after latest index price declines)
- Housing market on a steady recovery (existing home sales at multi-year highs and pricing up +6% vs. July of last year)
- Massively accommodative central banks around the globe (e.g., European Central Bank and People’s Bank of China)
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
The Art of Catching Falling Knives
“In the middle of every difficulty lies an opportunity.” ~Albert Einstein
It was a painful week for bullish investors in the stock market as evidenced by the -1,018 point drop in the Dow Jones Industrial Average, equivalent to approximately a -6% decline. The S&P 500 index did not fare any better, and the loss for the tech-heavy NASDAQ index was down closer to -7% for the week.
The media is attributing much of the short-term weakness to a triple Chinese whammy of factors: 1) Currency devaluation of the Yuan; 2) Weaker Chinese manufacturing data registering in at the lowest level in over six years; and 3) A collapsing Chinese stock market.
As the second largest economy on the planet, developments in China should not be ignored, however these dynamics should be put in the proper context. With respect to China’s currency devaluation, Scott Grannis at Calafia Beach Pundit puts the foreign exchange developments in proper perspective. If you consider the devaluation of the Yuan by -4%, this change only reverses a small fraction of the Chinese currency appreciation that has taken place over the last decade (see chart below). Grannis rightfully points out the -25% collapse in the value of the euro relative to the U.S. dollar is much more significant than the minor move in the Yuan. Moreover, although the move by the People’s Bank of China (PBOC) makes America’s exports to China less cost competitive, this move by Chinese bankers is designed to address exactly what investors are majorly concern about – slowing growth in Asia.
Although the weak Chinese manufacturing data is disconcerting, this data is nothing new – the same manufacturing data has been very choppy over the last four years. On the last China issue relating to its stock market, investors should be reminded that despite the massive decline in the Shanghai Composite, the index is still up by more than +50% versus a year ago (see chart below)
Fear the Falling Knife?
Given the fresh carnage in the U.S. and foreign markets, is now the time for investors to attempt to catch a falling knife? Catching knives for a living can be a dangerous profession, and many investors – professionals and amateurs alike – have lost financial fingers and blood by attempting to prematurely purchase plummeting securities. Rather than trying to time the market, which is nearly impossible to do consistently, it’s more important to have a disciplined, unemotional investing framework in place.
Hall of Fame investor Peter Lynch sarcastically highlighted the difficulty in timing the market, “I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
Readers of my blog, Investing Caffeine understand I am a bottom-up investor when it comes to individual security selection with the help of our proprietary S.H.G.R. model, but those individual investment decisions are made within Sidoxia’s broader, four-pronged macro framework (see also Don’t be a Fool, Follow the Stool). As a reminder, driving our global views are the following four factors: a) Profits; b) Interest rates; c) Sentiment; and Valuations. Currently, two of the four indicators are flashing green (Interest rates and Sentiment), and the other two are neutral (Profits and Valuations).
- Profits (Neutral): Profits are at record highs, but a strong dollar, weak energy sector, and sluggish growth internationally have slowed the trajectory of earnings.
- Valuation (Neutral): At an overall P/E of about 18x’s profits for the S&P 500, current valuations are near historical averages. For CAPE investors who have missed the tripling in stock prices, you can reference prior discussions (see CAPE Smells Like BS). I could make the case that stocks are very attractive with a 6% earnings yield (inverse P/E ratio) compared to a 2% 10—Year Treasury bond, but I’ll take off my rose-colored glasses.
- Interest Rates (Positive): Rates are at unambiguously low levels, which, all else equal, is a clear-cut positive for all cash generating asset classes, including stocks. With an unmistakably “dovish” Federal Reserve in place, whether the 0.25% interest rate hike comes next month, or next year will have little bearing on the current shape of the yield curve. Chairman Yellen has made it clear the trajectory of rate increases will be very gradual, so it will take a major shift in economic trends to move this factor into Neutral or Negative territory.
- Sentiment (Positive): Following the investment herd can be very dangerous for your financial health. We saw that in spades during the late-1990s in the technology industry and also during the mid-2000s in the housing sector. As Warren Buffett says, it is best to “buy fear and sell greed” – last week we saw a lot of fear.
In addition to the immense outflows out of stock funds (see also Great Rotation) , panic was clearly evident in the market last week as shown by the Volatility Index (VIX), a.k.a., the “Fear Gauge.” In general, volatility over the last five years has been on a declining trend, however every 6-12 months, some macro concern inevitably rears its ugly head and volatility spikes higher. With the VIX exploding higher by an amazing +118% last week to a level of 28.03, it is proof positive how quickly sentiment can change in the stock market.
Not much in the investing world works exactly like science, but buying stocks during previous fear spikes, when the VIX level exceeds 20, has been a very lucrative strategy. As you can see from the chart below, there have been numerous occasions over the last five years when the over-20 level has been breached, which has coincided with temporary stock declines in the range of -8% to -22%. However, had you held onto stocks, without adding to them, you would have earned an +84% return (excluding dividends) in the S&P 500 index. Absent the 2011 period, when investors were simultaneously digesting a debt downgrade, deep European recession, and domestic political fireworks surrounding a debt ceiling, these periods of elevated volatility have been relatively short-lived.
Whether this will be the absolute best time to buy stocks is tough to say. Stocks are falling like knives, and in many instances prices have been sliced by more than -10%, -20%, or -30%. It’s time to compile your shopping list, because valuations in many areas are becoming more compelling and eventually gravity will run its full course. That’s when your strategy needs to shift from avoiding the falling knives to finding the bouncing tennis balls…excuse me while I grab my tennis racket.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including emerging market/Chinese ETFs, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Investors Take a Vacation
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (August 3, 2015). Subscribe on the right side of the page for the complete text.
It’s summertime and the stock market has taken a vacation, and it’s unclear when prices will return from a seven month break. It may seem like a calm sunset walk along the beach now that Greek worries have temporarily subsided, but concerns have shifted to an impending Federal Reserve interest rate hike, declining commodity prices, and a Chinese stock market crash, which could lead to a painful sunburn.
If you think about it, stock investors have basically been on unpaid vacation since the beginning of the year, with the Dow Jones Industrial Index (17,690) down -0.7% for 2015 and the S&P 500 (2,104) up + 2.2% over the same time period (see chart below). Despite mixed results for the year, all three main stock indexes rebounded in July (including the tech-heavy NASDAQ +2.8% for the month) after posting negative returns in June. Overall for 2015, sector performance has been muddled. There has been plenty of sunshine on the Healthcare sector (+11.7%), but Energy stocks have been stuck in the doldrums (-13.4%), over the same timeframe.
Source: Yahoo! Finance
Chinese Investors Suffer Heat Stroke
Despite gains for U.S. stocks in July, the overheated Chinese stock marketcaused some heat stroke for global investors with the Shanghai Composite index posting its worst one month loss (-15%) in six years, wiping out about $4 trillion in market value. Before coming back down to earth, the Chinese stock market inflated by more than +150% from 2014.
Driving the speculative fervor were an unprecedented opening of 12 million monthly accounts during spring, according to Steven Rattner, a seasoned financier, investor, and a New York Times journalist. Margin accounts operate much like a credit card for individuals, which allowed these investors to aggressively gamble on the China market upswing, but during the downdraft investors were forced to sell stocks to generate proceeds for outstanding loan repayments. It’s estimated that 25% of these investors only have an elementary education and a significant number of them are illiterate. Further exacerbating the sell-off were Chinese regulators artificially intervening by halting trading in about 500 companies on the Shanghai and Shenzhen exchanges last Friday, equivalent to approximately 18% of all listings.
Although China, as the second largest economy on the globe, is much more economically important than a country like Greece, recent events should be placed into proper context. For starters, as you can see from the chart below, the Chinese stock market is no stranger to volatility. According to Fundstrat Global Advisors, the Shanghai composite index has experienced 10 bear markets over the last 25 years, and the recent downdraft doesn’t compare to the roughly -75% decline we saw in 2007-2008. Moreover, there is no strong correlation between the Chinese stock market. Only 15% of Chinese households own stocks, or measured differently, only 6% of household assets are held in stocks, says economic-consulting firm IHS Global Insight. More important than the question, “What will happen to the Chinese stock market?,” is the question, “What will happen to the Chinese stock economy?,” which has been on a perennial slowdown of late. Nevertheless, China has a 7%+ economic growth rate and the highest savings rate of any major country, both factors for which the U.S. economy would kill.
Source: Yardeni.com
Don’t Take a Financial Planning Vacation
While the financial markets continue to bounce around and interest rates oscillate based on guesswork of a Federal Reserve interest rate hike in September, many families are now returning from vacations, or squeezing one in before the back-to-school period. The sad but true fact is many Americans spend more time planning their family vacation than they do planning for their financial futures. Unfortunately, individuals cannot afford to take a vacation from their investment and financial planning. At the risk of stating the obvious, planning for retirement will have a much more profound impact on your future years than a well-planned trip to Hawaii or the Bahamas.
We live in an instant gratification society where “spend now, save later” is a mantra followed by many. There’s nothing wrong with splurging on a vacation, and to maintain sanity and family cohesion it is almost a necessity. However, this objective does not have to come at the expense of compromising financial responsibility – or in other words spending within your means. Investing is a lot like consistent dieting and exercising…it’s easy to understand, but difficult to sustainably execute. Vacations, on the other hand, are easy to understand, and easy to execute, especially if you have a credit card with an available balance.
It’s never too late to work on your financial planning muscle. As I discuss in a previous article (Getting to Your Number) , one of the first key steps is to calculate an annual budget relative to your income, so one can somewhat accurately determine how much money can be saved/invested for retirement. Circumstances always change, but having a base-case scenario will help determine whether your retirement goals are achievable. If expectations are overly optimistic, spending cuts, revenue enhancing adjustments, and/or retirement date changes can still be made.
When it comes to the stock market, there are never a shortage of concerns. Today, worries include a Greek eurozone exit (“Grexit”); decelerating China economic growth and a declining Chinese stock market; and the viability of Donald’s Trump’s presidential campaign (or lack thereof). While it may be true that stock prices are on a temporary vacation, your financial and investment planning strategies cannot afford to go on vacation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
F.U.D. and Dividend Shock Absorbers
As the existential question remains open on whether Greece will remain a functioning entity within the eurozone, investor anxiety and manic behavior continues to be the norm. Rampant fear seems very counterintuitive for a stock market that has more than tripled in value from early 2009 with the S&P 500 index only sitting -3% below all-time record highs. Common sense would dictate that euphoric investor appetites have contributed to years of new record highs in the U.S. stock market, but that isn’t the case now. Rather, the enormous appreciation experienced in recent years can be better explained by the trillions of dollars directed towards buoyant share buybacks and mergers.
With a bull market still briskly running into its sixth year, where can we find the evidence for all this anxiety? Well, if you don’t believe all the nail biting concerns you hear from friends, family members, and co-workers about a Grexit (Greek exit from the euro), Chinese stock market bubble, Puerto Rico collapse, and/or impending Fed rate hike, then here are a few confirming data points.
For starters, let’s take a look at the record $8 trillion of cash being stuffed under the mattress at near 0% rates in savings deposits (see chart below). The unbelievable 15% annual growth rate in cash hoarding since the turn of the century is even scarier once you consider the massive value destruction from the eroding impact of inflation and the colossal opportunity costs lost from gains and yields in alternative investments.
Next, you can witness the irrational risk averse behavior of investors piling into low (and negative) yielding bonds. Case in point are the 10-year yields in developing countries like Germany, Japan, and the U.S. (see chart below).
The 25-year downward trend in rates is a very scary development for yield-hungry investors. The picture doesn’t look much prettier once you realize the compensation for holding a 30-year bond (currently +3.2%) is only +0.8% more than holding the same Treasury bond for 10 years (now +2.4%). Yes, it is true that sluggish global growth and tame inflation is keeping a lid on interest rates, but these trends highlight once again that F.U.D. (fear, uncertainty, and doubt) has more to do with the perceived flight to safety and high bond prices (low bond yields).
In addition, the -$57 billion in outflows out of U.S. equity funds this year is further evidence that F.U.D. is out in full force. As I’ve noted on repeated occasions, when the tide turns on a sustained multi-year basis and investors dive head first into stocks, this will be proof that the bull market is long in the tooth and conservatism should be the default posture.
Dividend Shock Absorbers
There are always plenty of scary headlines that tempt investors to bail out of their investments. Today those alarming headlines span from Greece and China to Puerto Rico and the Federal Reserve. When the winds of fear, uncertainty, and doubt are fiercely swirling, it’s important to remember that any investment strategy should be constructed in a diversified manner that meshes with your time horizon and risk tolerance.
Consistent with maintaining a diversified portfolio, owning reliable dividend paying stocks is an important component of investment strategy, especially during volatile periods like we are experiencing currently. Sure, I still love to own high octane, non-dividend growth stocks in my personal and client portfolios, but owning stocks with a healthy stream of dividends serve as shock absorbers in bumpy markets with periodic surprise potholes.
As I’ve note before, bond issuers don’t call up investors and raise periodic coupon payments out of the kindness of their hearts, but stock issuers can and do raise dividends (see chart below). Most people don’t realize it, but over the last 100 years, dividends have accounted for approximately 40% of stocks’ total return as measured by the S&P 500.
Source: BuyUpside.com
Markets will continue to move up and down on the news du jour, but dividends overall remain fairly steady. In the worst financial crisis in a generation, dividends dipped temporarily, but as I explain in a previous article (The Gift that Keeps on Giving), dividends have been on a fairly consistent 6% growth trajectory over the last two decades. With corporate dividend payout ratios well below long term historical averages of 50%, companies still have plenty of room to maintain (and grow) dividends – even if the economy and corporate profits slow.
Don’t succumb to all the F.U.D., and if you feel yourself beginning to fall into that trap, re-evaluate your portfolio to make sure your diversified portfolio has some shock absorbers in the form of dividend paying stocks. That way your portfolio can handle those unexpected financial potholes that repeatedly pop up.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and SPY, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on ICContact page.
Will Rising Rates Murder Market?
After an obituary of Mark Twain had been mistakenly published in the United States, Twain sent a cable from London stating, “The reports of my death have been greatly exaggerated.” Similar reports about the death of the stock market have been prematurely published as well. If you were to listen to the talking heads on TV or other self-proclaimed media pundits, the prevailing opinion is that rising interest rates will murder the stock market. In reality, the benchmark 10-Year Treasury Note has risen a whopping 0.23% so far this year. Could this be a start of a more prolonged increase in interest rates? It is certainly possible. Most investors have a very short memory because we have seen this movie before. It was just two short years ago that we witnessed a near doubling of 10-Year Treasury yields exploding from 1.76% to 3.03% in 2013. Did the stock market crater? In fact, quite the contrary. The S&P 500 index catapulted higher by a whopping +30%.
Even if we go back a litter further in recent history, interest rates were quite a bit higher. For example in early 2010, 10-Year Treasury yields breached 4.0%. Where was the Dow Jones Industrial index then? A mere 11,000 vs 17,850 today. Or in other words, when interest rates were significantly higher than today’s 2.40% yield, the stock market managed to climb +62% higher. Not too shabby, eh? As I have talked about in the past (see Don’t Be a Fool, Follow the Stool), there are other factors besides interest rates that are contributing to positive stock returns – primarily profits, valuations, and sentiment are the other key factors in determining stock prices. Suffice it to say, over the last five years, stocks have survived quite well in the face of multiple interest rate spikes; the 2013 “Taper Tantrum”; and the subsequent completion of quantitative easing – QE (see chart below).
Underlying Chart: Yahoo Finance!
Yield Curve on the Side of Bulls
Despite the trepidation over a series of potential Fed rate hikes, stocks continue to grind higher. If the fears are based on the expectation of a slowing economy on the horizon, then we would generally see two things happening. First, rising short-term interest rates would cause the yield curve to flatten, and then secondly, the yield curve would invert (typically a leading indicator for a recession). Currently, there are no signs of flattening or inverting. Actually, the recent better than expected jobs report for May (280,000 jobs added vs. estimate of 226,000) created a steeper yield curve – long-term interest rates increased more than short-term interest rates. Just as I wrote in 2009 about the recovery (see Steepening Yield Curve Recovery), right now the bond market is flashing recovery…not slowdown.
In the face of the mini-interest rate spike, bank stocks are also signaling economic recovery – evidenced by the 2.75% surge in the KBW Bank Index (KBX) last week. If there were signs of dark clouds on the horizon, a flattening yield curve would squeeze bank net interest margins and profits, which ultimately would send bank investors to the exit. That phenomenon will eventually happen later in the economic cycle, but right now investors are voting in the opposite direction with their dollars.
The media, economists, strategists, and other nervous onlookers will continue fretting over the Federal Reserve’s eventual rate increases. As long as dovish Janet Yellen is at the helm of the Fed, future rate increases will be measured, and rather than murdering the stock market, the policies will merely reflect a removal of the economy from artificial life support.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on ICContact page.
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