Posts filed under ‘Financial Markets’
“Patient” Prick Proves More Pleasure than Pain
I will be the first one to admit I hate needles. In fact, I’ve been known to skip my annual flu shots out of cowardice simply to avoid the harmless prick of the syringe. The mere thought of a long needle jabbing into my arm, or other fleshy part of my body, has had the chilling effect of generating irrational decisions (i.e., I forgo flu shot benefits for no logical reason).
For months the talking heads and so-called pundits have speculated and fretted over the potential removal of the term “patient” from the periodically issued Federal Open Market Committee (FOMC) statement. Since the end of 2014, the statement read that the Fed “can be patient in beginning to normalize” monetary policy.
For investors, the linguistic fear of the removal of “patient” is as groundless as my needle fears. In the financial markets, the consensus view is often wrong. The stronger the euphoric consensus, the higher the probability the consensus will soon be wrong. You can think of technology in the late 1990s, real estate in the mid-2000s; or gold trading at $1,800/oz in 2011. The reverse holds true for the pessimistic consensus. Value guru, extraordinaire, Bill Miller stated it well,
“Stocks do not get undervalued unless somebody is worried about something. The question is not whether there are problems. There are always problems. The question is whether those problems are already fully discounted or not.”
Which brings us back to the Fed’s removal of the word “patient”. Upon release of the statement, the Dow Jones Industrial index skyrocketed about 400 points in 30 minutes. Considering the overwhelming consensus was for the Fed to remove the word “patient”, and given the following favorable factors, should anyone really be surprised that the market is trading near record highs?
FAVORABLE FACTORS:
- Queen Dove Yellen as Fed Chairwoman
- Declining interest rates near generational low
- Stimulative, low oil prices that are declining
- Corporate profits at/near record highs
- Unemployment figures approaching cyclical lows
- Core inflation in check below 2% threshold
While the short-term relief rally may feel good for the bulls, there are still some flies in the ointment, including a strong U.S. dollar hurting trade, an inconsistent housing recovery, and a slowing Chinese economy, among other factors.
Outside the scandalous “patient” semantics was the heated debate over the Fed’s “Dot Plot,” which is just a 3rd grader’s version of showing the Fed members’ Federal Funds rate forecasts. While to a layman the chart below may look like an elementary school dot-to-dot worksheet, in reality it is a good synopsis of interest rate expectations. Part of the reason stocks reacted so positively to the Fed’s statement is because the “Dot Plot” median interest rate expectations of 0.625% came down 0.50% for 2015, and by more than 0.60% for 2016 to 1.875%. This just hammers home the idea that there are currently no dark clouds looming on the horizon that would indicate aggressive rate hikes are coming.
Source via BusinessInsider
These sub-2% interest rate expectations over the next few years hardly qualify as a “hawkish” stance. As I’ve written before, the stock market handled a 2.5% hike in stride when the Fed Funds rate increased in 1994 (see also 1994 Bond Repeat or Stock Defeat?). What’s more, the Fed Funds rate cycle peaked at 5.0% in 2007 before the market crashed in the Great Recession of 2008-2009.
Although volatility is bound to increase as the Federal Reserve transitions out of a six-year 0% interest rate policy, don’t let the irrational fear of a modest Fed hike prick scare you away from potential investment benefits.
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.
March Madness – Dividend Grandness & Volatility Blandness
March Madness has arrived once again. This NCAA basketball event, which has been around since 1939, begins with a selection committee choosing the top 68 teams in the country. These teams are matched up against each other through a single-elimination tournament until a national champion is throned. The stock market does not have a selection committee that picks teams from conferences like the SEC, Big East, Pac-12, and ACC, but rather millions of investors select the best investments from asset classes like stocks, bonds, real estate, commodities, venture capital, and private equity.
In the investment world, there are no win-loss records, but rather there are risk-return profiles. Investors generally migrate towards the asset classes where they find the optimal trade-off between risk and return. Speculators, day-traders, and momentum traders may define risk differently, but regardless, over the long-run, capital goes where it is treated best. And over the last six years, the U.S. stock market hasn’t been a bad place to be (the S&P 500 has about tripled).
Why such outperformance in stocks? Besides a dynamic earnings recovery from the 2008-2009 financial crisis, another major factor has been the near-0% interest rate environment. When investors are earning near nothing in their bank and savings accounts, it is perfectly rational for savers to look for riskier options, if they are compensated for that risk. In addition to loose central bank and quantitative easing policies fueling demand for stocks, rising dividends have increased the attractiveness of the stock market. In fact, as you can see from the chart below, dividends have about doubled from 2008-2009 and about tripled from the year 2000.
Source: Buy Upside
Stock prices have moved higher in concert with rising dividends, which, as you can see from the chart below, has kept the dividend yield flat at around 2% over the last few years. Treasury bond yields, on the other hand, have been on steady declining trend for the last 35 years. So, while coupons on newly issued bonds have been declining for virtually the last three and a half decades, stock dividends have been on a steadily upward moving rampage, excluding recessions (up +13% in the most recent reported period).
Source: Avondale Asset Management
Declining interest rates have made stocks look attractive relative to investment grade corporate bonds too as evidenced by the chart below. As you can see, over the last half-century, corporate bond yields have predominantly offered higher income yields than the earnings yield on stocks – that is not the case today.
Source: Calafia Beach Pundit
What does all this stock dividend, earnings yield stuff mean? In the grand scheme of things, income starving Baby Boomers and retirees are slowly realizing that stocks in general stack up favorably in an environment in which interest payments are going down and dividend payments are going up. One of the areas highlighting the underlying demand for stocks is the Volatility Index (VIX) – a.k.a., the “Fear Gauge.” Despite Greece, Russia, ISIS, the Fed, and the Dollar dominating the headlines, the hunger for yield and growth in a declining interest rate environment is cushioning the blow during these heightened periods of volatility (see also A Series of Unfortunate Events).
Since the end of 2011, the monthly close of the VIX has stayed above its historical average of approximately 20 only two times (see chart below). In other words, over that timeframe, the VIX has remained below average about 95% of the time. When the VIX has spiked above 20, generally it has only been for brief periods, until cooler heads prevail and bargain hunters come in to buy depressed stock bargains.
Source: Barchart
I’m not naïve enough to believe the bull market in stocks will last forever, but as long as interest rates don’t spike up and/or corporate earnings crater, underlying demand for yield should provide a floor for stocks during heightened periods of volatility. We may be in the midst of March Madness but volatility blandness is showing us that investors are paying attention to dividend grandness.
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 IC Contact page.
NASDAQ Redux
The NASDAQ Composite index once again crossed the psychologically, all-important 5,000 threshold this week for the first time since the infamous tech-bubble burst in the year 2000. Of course, naturally, the media jumped on a non-stop, multi-day offensive comparing and contrasting today’s NASDAQ vs. the NASDAQ twin of yesteryear. Rather than rehash the discussion once again, I have decided to post three articles I published in recent years on the topic covering the outperformance of the spotlighted, tech-heavy index.
NASDAQ 5,000 Irrational Exuberance Déjà Vu?
Investors love round numbers and with the Dow Jones Industrial index recently piercing 17,000 and the S&P 500 index having broken 2,000 , even novice investors have something to talk about around the office water cooler. While new all-time records are being set for the major indices during September, the unsung, tech-laden NASDAQ index has yet to surpass its all-time high of 5,132 achieved 14 and ½ years ago during March of 2000.
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NASDAQ and the R&D Tech Revolution
It’s been a bumpy start for stocks so far in 2014, but the fact of the matter is the NASDAQ Composite Index is up this year and hit a 14-year high in the latest trading session (highest level since 2000). The same cannot be said for the Dow Jones Industrial and S&P 500 indices, which are both lagging and down for the year. Not only did the NASDAQ outperform the Dow by almost +12% in 2013, but the NASDAQ has also trounced the Dow by over +70% over the last five years.
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NASDAQ: The Ugly Stepchild
All the recent media focus has been fixated on whether the Dow Jones Industrial Average index (“The Dow”) will close above the 13,000 level. In the whole scheme of things, this specific value doesn’t mean a whole lot, but it does make for a great topic of conversation at a cocktail party. Today, the Dow is trading at 12,983, a level not achieved in more than three and a half years. Not a bad accomplishment, given the historic financial crisis on our shores and the debacle going on overseas, but I’m still not so convinced a miniscule +0.1% move in the Dow means much. While the Dow and the S&P 500 indexes garner the hearts and minds of journalists and TV reporters, the ugly stepchild index, the NASDAQ, gets about as much respect as Rodney Dangerfield (see also No Respect in the Investment World).
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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.
Ceasefires & Investor Quagmires
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (March 1, 2015). Subscribe on the right side of the page for the complete text.
Considering the following current event headlines, who would have guessed the stock market is trading near record, all-time highs and the NASDAQ index breaking 5,000 for the first time since the year 2000?
- Russia Lies Over Ukraine Ceasefire
- ISIS Beheadings and Jihadi John
- Strong Dollar, Weak Global Economy
- Fed’s Yellen: Rate Rise & Inflation
- Iranian Negotiations & Nuclear Weapons
- Grexit: The Likelihood of Greece’s Exit from the Euro
- The Chinese Bubble Pops
- Ebola and the Fear Epidemic
After reading all these depressing stories, I feel more like taking a Prozac pill than I do venturing into the investing world. Unfortunately, in the media world, the overarching motto driving the selection of published stories is, “If it bleeds, it leads!” Plainly and simply, bad news sells. The media outlets prey on our human behavioral shortcomings. Specifically, people feel the pain from losses at a rate more than double the feelings of pleasure (see Controlling the Lizard Brain and chart below).
This phenomenon leaves Americans and the overall investing public choking on the daily doom and gloom headlines. Investor skepticism caused by the 2008-2009 financial crisis is evidenced by historically low stock ownership statistics and stagnant equity purchase flow data. Talk of another stock bubble has been introduced again now that the NASDAQ is approaching 5,000 again, but we are not seeing signs of this phenomenon in the IPO market (Initial Public Offering) – see chart below. IPOs are on the rise, but the number of filings is more than -50% below the peak of 845 IPOs seen in the late 1990s when former Federal Reserve Chairman Alan Greenspan made his famous “irrational exuberance” speech (see also Irrational Exuberance Deja Vu and chart below).
Uggh! 0.08% Really?
Compounding the never-ending pessimism problem is the near-0% interest rate environment. Times are long gone when you could earn 18% on a certificate of deposit (see chart below). Today, you can earn 0.08% on a minimum $10,000 investment in a Bank of America (BAC) Certificate of Deposit (CD). Invest at that rate for more than a decade and you will have almost accumulated a $100 (~1%) – probably enough for a single family meal…without tip. To put these paltry interest rates into perspective, the U.S. stock market as measured by the S&P 500 index was up a whopping +5.5% last month and the Dow Jones Industrials climbed +5.6% (+968 points to 18,133). Granted, last month’s S&P 500 percentage increase was the largest advance since 2011, but if I wanted to earn an equivalent +5.5% return by investing in that Bank of America CD, it would take me to age 100 years old before I earned that much!
Globally, the interest rate picture doesn’t look much prettier. In fact, the negative interest rate bonds offered in Switzerland and other neighboring countries, including France and Germany, have left investors in these bonds with guaranteed losses, if held to maturity (see also Draghi Beer Goggles).
Money Seeking Preferred Treatment
Investors and followers of mine have heard me repeatedly declare that “money goes where it is treated best.” When many investments are offering 0% (or negative yields), it comes as no surprise to me that dividend paying stocks have handily outperformed the overall bond market in recent years. Hard to blame someone investing in certain stocks offering between 2-6% in dividends when the alternative is offered at or near 0%.
While at Sidoxia we are still finding plenty of opportunities in the equity markets, I want to extend the reminder that not everyone can (or should) increase their equity allocation because of personal time horizon and risk tolerance constraints. Regardless, the current, restricting global financial markets are highlighting the scarcity of investment alternatives available.
As we will continue to be bombarded with more cease fires, quagmires and other bleeding headlines, investors will be better served by ignoring the irrelevant headlines and instead create a long-term financial plan with an asset allocation designed to meeting their personal goals. By following this strategy, you can let the dooms-dayers bleed while you succeed.
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 BAC, 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.
Is Good News, Bad News?
The tug-of-war is officially on as investors try to decipher whether good news is good or bad for the stock market? On the surface, the monthly January jobs report released by the Bureau of Labor Statistics (BLS) appeared to be welcomed, positive data. Total jobs added for the month tallied +257,000 (above the Bloomberg consensus of +230,000) and the unemployment rate registered 5.7% thanks to the labor participation rate swelling during the month (see chart below). More specifically, the number of people looking for a job exceeded one million, which is the largest pool of job seekers since 2000.
Source: BLS via New York Times
Initially the reception by stocks to the jobs numbers was perceived positively as the Dow Jones Industrial index climbed more than 70 points on Friday. Upon further digestion, investors began to fear an overheated employment market could lead to an earlier than anticipated interest rate hike by the Federal Reserve, which explains the sell-off in bonds. The yield on the 10-Year Treasury proceeded to spike by +0.13% before settling around 1.94% – that yield compares to a recent low of 1.65% reached last week. The initial euphoric stock leap eventually changed direction with the Dow producing a -180 point downward reversal, before the Dow ended the day down -62 points for the session.
Crude Confidence?
The same confusion circling the good jobs numbers has also been circulating around lower oil prices, which on the surface should be extremely positive for the economy, considering consumer spending accounts for roughly 70% of our country’s economic output. Lower gasoline prices and heating bills means more discretionary spending in the pockets of consumers, which should translate into more economic activity. Furthermore, it comes as no surprise to me that oil is both figuratively and literally the lubricant for moving goods around our country and abroad, as evidenced by the Dow Jones Transportation index that has handily outperformed the S&P 500 index over the last 18 months. While this may truly be the case, many journalists, strategists, economists, and analysts are nevertheless talking about the harmful deflationary impacts of declining oil prices. Rather than being viewed as a stimulative lubricant to the economy, many of these so-called pundits point to low oil prices as a sign of weak global activity and an omen of worse things to come.
This begs the question, as I previously explored a few years ago (see Good News=Good News?), is it possible that good news can actually be good news? Is it possible that lower energy costs for oil importing countries could really be stimulative for the global economy, especially in regions like Europe and Japan, which have been in a decade-long funk? Is it possible that healthier economies benefiting from substantial job creation can cause a stingy, nervous, and scarred corporate boardrooms to finally open up their wallets to invest more significantly?
Interest Rate Doom May Be Boom?
Quite frankly, all the incessant, never-ending discussions about an impending financial market Armageddon due to a potential single 0.25% basis point rate hike seem a little hyperbolic. Could I be naively whistling past the graveyard? From my perspective, although it is a foregone conclusion the Fed will have to increase interest rates above 0%, this is nothing new (I’m really putting my neck out there on this projection). Could this cause some volatility when it finally happens…of course. Just look at what happened to financial markets when former Federal Reserve Chairman Ben Bernanke merely threatened investors with a wind-down of quantitative easing (QE) in 2013 and investors had a taper tantrum. Sure, stocks got hit by about -5% at the time, but now the S&P 500 index has catapulted higher by more than +25%.
Looking at how stocks react in previous rate hike cycles is another constructive exercise. The aggressive +2.50% in rate hikes by former Fed Chair Alan Greenspan in 1995 may prove to be a good proxy (see also 1994 Bond Repeat?). After suffering about a -10% correction early in 1994, stocks rallied in the back-half to end the year at roughly flat.
And before we officially declare the end of the world over a single 0.25% hike, let’s not forget that the last rate hike cycle (2004 – 2006) took two and a half years and 17 increases in the targeted Federal Funds rate (1.00% to 5.25%). Before the rate increases finally broke the stock market’s back, the bull market moved about another +40% higher…not too shabby.
Lastly, before writing the obituary of this bull market, it’s worth noting the yield curve has been an incredible leading indicator and currently this gauge is showing zero warnings of any dark clouds approaching on the horizon (see chart below). As a matter of fact, over the last 50 years or so, the yield curve has turned negative (or near 0%) before every recession.
Source: StockCharts.com
As the chart above shows, the yield curve remains very sloped despite modest flattening in recent quarters.
While many skeptics are having difficulty accepting the jobs data and declining oil prices as good news because of rate hike fears, history shows us this position could be very misguided. Perhaps, once again, this time around good news may actually be good news.
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.
Inflating Dollars & Deflating Footballs
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (February 2, 2015). Subscribe on the right side of the page for the complete text.
In the weeks building up to Super Bowl XLIX (New England Patriots vs. Seattle Seahawks) much of the media hype was focused on the controversial alleged “Deflategate”, or the discovery of deflated Patriot footballs, which theoretically could have been used for an unfair advantage by New England’s quarterback Tom Brady. While Brady ended up winning his record-tying 4th Super Bowl ring for the Patriots by defeating the Seahawks 28-24, the stock market deflated during the first month of 2015 as well. Similar to last year, the stock market has temporarily declined last January before surging ahead +11.4% for the full year of 2014. It’s early in 2015, and investors chose to lock-in a small portion of the hefty, multi-year bull market gains. The S&P 500 was sacked for a loss of -3.1% and the Dow Jones Industrial index by -3.7%.
Despite some early performance headwinds, the U.S. economy kicked off the year with the wind behind its back in the form of deflating oil prices. Specifically, West Texas Intermediate (WTI) crude oil prices declined -9.4% last month to $48.24, and over -51.0% over the last six months. Like a fresh set of substitute legs coming off the bench to support the team, the oil price decline represents an effective $125 billion tax cut for consumers in the form of lower gasoline prices (average $2.03 per gallon nationally) – see chart below. The gasoline relief will allow consumers more discretionary spending money, so football fans, for example, can buy more hot dogs, beer, and souvenirs at the Super Bowl. The cause for the recent price bust? The primary reasons are three-fold: 1) Sluggish oil demand from developed markets like Europe and Japan coupled with slowing consumption growth in some emerging markets like China; 2) Growing supply in various U.S. fracking regions has created a temporary global oil glut; and 3) Uncertainty surrounding OPEC (Organization of Petroleum Exporting Countries) supply/production policies, which became even more unclear with the recent announced death of Saudi Arabia’s King Abdullah.
Source: AAA
More deflating than the NFL football’s “Deflategate” is the approximate -17% collapse in the value of the euro currency (see chart below). Euro currency matters were made worse in response to European Central Bank’s (ECB) President Mario Draghi’s announcement that the eurozone would commence its own $67 billion monthly Quantitative Easing (QE) program (very similar to the QE program that Federal Reserve Chairwoman Janet Yellen halted last year). In total, if carried out to its full design, the euro QE version should amount to about $1.3 trillion. The depreciating effect on the euro (and appreciating value of the euro) should help stimulate European exports, while lowering the cost of U.S. imports – you may now be able to afford that new Rolls-Royce purchase you’ve been putting off. What’s more, the rising dollar is beneficial for Americans who are planning to vacation abroad…Paris here we come!
Source: XE.com
Another fumble suffered by the global currency markets was introduced with the unexpected announcement by the Swiss National Bank (SNB) that decided to remove its artificial currency peg to the euro. Effectively, the SNB had been purchased and accumulated a $490 billion war-chest reserve (Supply & Demand Lessons) to artificially depress the value of the Swiss franc, thereby allowing the country to sell more Swiss army knives and watches abroad. When the SNB could no longer afford to prop up the value of the franc, the currency value spiked +20% against the euro in a single day…ouch! In addition to making its exports more expensive for foreigners, the central bank’s move also pushed long-term Swiss Treasury bond yields negative. No, you don’t need to check your vision – investors are indeed paying Switzerland to hold investor money (i.e., interest rates are at an unprecedented negative level).
In addition to some of the previously mentioned setbacks, financial markets suffered another penalty flag. Last month, multiple deadly terrorist acts were carried out at a satirical magazine headquarters and a Jewish supermarket – both in Paris. Combined, there were 16 people who lost their lives in these senseless acts of violence. Unfortunately, we don’t live in a Utopian world, so with seven billion people in this world there will continue to be pointless incidences like these. However, the good news is the economic game always goes on in spite of terrorism.
As is always the case, there will always be concerns in the marketplace, whether it is worries about inflation, geopolitics, the economy, Federal Reserve policy, or other factors like a potential exit of Greece out of the eurozone. These concerns have remained in place over the last six years and the stock market has about tripled. The fact remains that interest rates are at a generational low (see also Stretching the High Yield Rubber Band), thereby supplying a scarcity of opportunities in the fixed income space. Diversification remains important, but regardless of your time horizon and risk tolerance, attractively valued equities, including high-quality, dividend-paying stocks should account for a certain portion of your portfolio. Any winning retirement playbook understands a low-cost, globally diversified portfolio, integrating a broad set of asset classes is the best way of preventing a “deflating” outcome in your long-term finances.
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.
Draghi Provides Markets QE Beer Goggles
While the financial market party has been gaining momentum in the U.S., Europe has been busy attending an economic funeral. Mario Draghi, the European Central Bank President is trying to reverse the somber deflationary mood, and therefore has sent out $1.1 trillion euros worth of quantitative easing (QE) invitations to investors with the hope of getting the eurozone party started.
Draghi and the stubborn party-poopers sitting on the sidelines have continually been skeptical of the creative monetary punch-spiking policies initially implemented by U.S. Federal Reserve Chairman Ben Bernanke (and continued by his fellow dovish successor Janet Yellen). With the sluggish deflationary European pity party (see FT chart below) persisting for the last six years, investors are in dire need for a new tool to lighten up the dead party and Draghi has obliged with the solution…“QE beer goggles.” For those not familiar with the term “beer goggles,” these are the vision devices that people put on to make a party more enjoyable with the help of excessive consumption of beer, alcohol, or in this case, QE.
Source: The Financial Times
Although here in the U.S. “QE beer goggles” have been removed via QE expiration last year, nevertheless the party has endured for six consecutive years. Even an economy posting such figures as an 11-year high in GDP growth (+5.0%); declining unemployment (5.6% from a cycle peak of 10.0%); and stimulative effects from declining oil/commodity prices have not resulted in the cops coming to break up the party. It’s difficult for a U.S. investor to admit an accelerating economy; improving job additions; recovering housing market; with stronger consumer balance sheet would cause U.S. 10-Year Treasury Note yields to plummet from 3.04% at the beginning of 2014 to 1.82% today. But in reality, this is exactly what happened.
To confound views on traditional modern economics, we are seeing negative 10-year rates on Swiss Treasury Bonds (see chart below). In other words, investors are paying -1% to the Swiss government to park their money. A similar strategy could be replicated with $100 by simply burning a $1 bill and putting the remaining $99 under a mattress. Better yet, why not just pay me to hold your money, I will place your money under my guarded mattress and only charge you half price!
Does QE Work?
Debate will likely persist forever as it relates to the effectiveness of QE in the U.S. On the half glass empty side of the ledger, GDP growth has only averaged 2-3% during the recovery; the improvement in the jobs upturn is arguably the slowest since World War II; and real wages have declined significantly. On the half glass full side, however, the economy has improved substantially (e.g., GDP, unemployment, consumer balance sheets, housing, etc.), and stocks have more than doubled in value since the start of QE1 at the end of 2008. Is it possible that the series of QE policies added no value, or we could have had a stronger recovery without QE? Sure, anyone can make that case, but the fact remains, the QE training wheels have officially come off the economy and Armageddon has still yet to materialize.
I expect the same results from the implementation of QE in Europe. QE is by no means an elixir or panacea. I anticipate minimal direct and tangible economic benefits from Draghi’s $1+ trillion euro QE bazooka, however the psychological confidence building impacts and currency depreciating effects are likely to have a modest indirect value to the eurozone and global financial markets overall. The downside for these unsustainable ultra-low rates is potential excessive leverage from easy credit, asset bubbles, and long-term inflation. Certainly, there may be small pockets of these excesses, however the scars and regulations associated with the 2008-2009 financial crisis have delayed the “hangover” arrival of these risk possibilities on a broader basis. Therefore, until the party ends or the cops come to break up the fun, you may want to enjoy the gift provided by Mario Draghi to global investors…and strap on the “QE beer goggles.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions , 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.
Supply & Demand: The Lesson of a Lifetime
Between all the sporting events, road trips, and parties, I had a difficult time balancing my academic responsibilities just like any other college student. Nonetheless, after a few jobs and a few decades post my graduation, it is refreshing to see my economics college degree was able to teach me one valuable lesson…”supply & demand” actually works.
Emotions and animal spirits can separate fact from fiction in the short-run, but over the long-run, the economic forces of “supply & demand” will ultimately determine the direction of asset prices. If you can think of any bubble market, ranging from tulips and tech stocks (see Bubbles and Naps) to commodities and houses, sooner or later new supply will enter the market, and/or some other factor, which will prick the demand side of the bubble equation.
The same economic rules apply to currencies. Gut-based, day-traders may be skeptical, but economics’ longest enduring axiom shined last week when we saw the Swiss franc spike +20% against the euro in a single day. On the heels of a weakening euro currency and heightened demand for the franc, the Swiss National Bank (SNB) decided to remove its artificial peg to the euro. Effectively, the SNB has been selling francs and buying $490 billion in reserves (the majority of which is in euros and U.S. dollars). As a result, exports of Swiss army knives, watches, and industrial equipment will be more expensive now, which could potentially crimp demand for the country’s goods and services. The SNB, however, could no longer afford to buy euros and dollars to artificially depress the franc. Swiss bankers were very worried about the possible amplified costs of a currency war in the face of this week’s expected European Central Bank (ECB) announcements on quantitative easing (QE) monetary stimulus, so they decided to allow the franc to free-float versus global currencies.
Another asset class heavily impacted by volatile supply-demand dynamics has been the oil market. Weaker demand from Europe/Russia combined with the higher supply from U.S. shale has created a recipe for a crude price collapse (> -50% declines over the last year). Thus far, OPEC (Organization of Petroleum Exporting Countries) has remained committed to maintaining its supply/production levels.
Interest Rates and Supply-Demand
Not every asset price is affected by direct supply-demand factors. Take for example the stock market. I have been writing and commentating about the fascinating persistence and accelerated decline in global interest rates recently (see Why 0% Rates?). Near-0% rates are important because interest rates are just another name for the “cost of money” (or “opportunity cost of money”). When the Prime Rate was 20% in the early 1980s, the cost of money was high and a 16% CD at the bank looked pretty attractive relative to rolling the dice on volatile/risky stocks. Any economics, finance, or accounting student knows through their studies of the “time value of money” that interest rates have a tight inverse correlation to asset values (i.e., lower interest rates = higher asset values, and vice versa).
More practically speaking, we see stock prices supported by the lower borrowing costs tied to low interest rates. Just look at the $500,000,000,000+ conducted in share buybacks over the past 12 months (chart below). Economics works quite effectively when you can borrow at 3% and then purchase your own stock yielding 6% (the inverse percentage of the current 16x P/E ratio). What makes this mathematical equation even more accretive for corporate CFOs is the 6% rate earned today should double to 12% in 10 years, if a company resembles an average S&P 500 company. In other words, S&P 500 earnings have historically grown at a 7% annual clip, therefore the 6% earnings yield should double to 12% in about a decade, based on current prices. This basic arbitrage strategy is a no-brainer for corporate execs because it provides instantaneous EPS (earnings per share) growth with minimal risk, given the current bullet proof status of many blue-chip company balance sheets.
Source: Financial Times
I have provided a few basic examples of how straightforward supply-demand dynamics can be used to analyze market relationships and trends. Although supply-demand analysis is a great rudimentary framework at looking at markets and various asset classes, unanticipated exogenous factors such regulation, terrorism, politics, weather, and a whole host of other influences can throw a wrench into your valuation conclusions. Until rates normalize, the near-0% interest rates we are experiencing now will continue to be a significant tailwind for stock prices. As interest rates have been declining for the last three and a half decades, it appears I still have time before I will need to apply the other important concept I learned in college…mean reversion.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions , 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.
Stretching the High Yield Rubber Band
The 10-Year Treasury note recently pierced below the all-important psychological 2% level (1.97%), which has confounded many investors, especially if you consider these same rates were around 4% before the latest mega-financial crisis hit the globe. Some of the rate plunge can be explained by sluggish global growth, but the U.S. just logged a respectable +5.0% GDP growth quarter; corporate profits are effectively at all-time record highs; and the economy has added about 11 million private sector jobs over the last five years (unemployment rate of 10.0% has dropped to 5.6%). So what gives…why such low interest rates? Well, as I noted in a recent article (Why 0% Rates?), there is a whole host of countries with lower rates, which acts like an anchor dragging down our rates with them. Scott Grannis encapsulates this multi-decade, worldwide rate decline in the chart below:
It should come as no surprise to many that these abnormally low rates have had a massive ripple effect on other asset classes… including of course high-yield bonds (aka “junk bonds”). It doesn’t take a genius or rocket scientist to discern the effects of an ultra-low interest rate environment. Quite simply, investors are forced to hunt for yield. When a Bank of America (BAC) customer is forced into earning less than 1/10th of 1 cent for every dollar invested in a CD, you can easily understand why the smile in their CD advertisement looks more like a grimace. Rather than accept $8 in annual interest on a $10,000 investment, post-crisis investors frightened by the stock market have piled into junk bonds. If you don’t believe me, check out the analysis provided by the Financial Times (data from Dealogic) in the chart below, which shows about $1 trillion in U.S. high-yield debt issuance over the last three years. Europe has experienced an even more dramatic growth rate in junk issuance compared to the U.S.
Stretching High-Yield Band
A rubber band can only stretch so far before the elasticity forces it too snap. We are getting closer to the snapping point, as more complacent investors lend money to riskier borrowers and also accept more lenient terms from issuers (e.g., cov-lite loans). Although default rates on high yield bonds remain near decade lows (1.1% through November 2014), high-yield investors keep on inching towards an ultimate day of reckoning. Thanks to a continually improving economy, Fitch Ratings is still projecting a benign default rate environment for high-yield bonds in 2015 – somewhere in the 1.5% – 2.0% range (see chart below). However, high-yield credit spreads did widen in 2014 with the help of crude oil prices getting chopped by more than -50% over the last year. Given the energy sector accounts for about 17% of the high-yield market (Barron’s), it would be natural to expect a larger number of energy company defaults to occur over the next 12-18 months, especially if crude oil prices remain depressed.
Source: Fitch Ratings
While it makes sense for you to hold a portion of your portfolio in high-yield bonds, especially for diversification purposes, don’t forget the power of mean reversion. The uncharacteristically low default rates will eventually revert towards historical averages. Stated differently, the increased risk profile of the high-yield bond market continues to stretch, so make sure you are not overly exposed to the sector because this segment will eventually snap.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions (JNK, HYG), and BAC, 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.
After 2014 Stock Party, Will Investors Have a 2015 Hangover?
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (January 2, 2015). Subscribe on the right side of the page for the complete text.
Investors in the U.S. stock market partied their way to a sixth consecutive year of gains during 2014 (S&P 500 +11.4%; Dow Jones Industrial Average +7.5%; and NASDAQ +13.4%). From early 2009, at the worst levels of the crisis, the S&P 500 has more than tripled – not too shabby. But similar to recent years, this year’s stock bubbly did not flow uninterrupted. Several times during the party, neighbors and other non-participants at the stock party complained about numerous concerns, including the Fed Tapering of bond purchases; the spread of the deadly Ebola virus; tensions in Ukraine; the rise of ISIS; continued economic weakness across the eurozone; the decline of “The Fragile Five” emerging markets (Brazil, India, Indonesia, Turkey and South Africa), and other headline grabbing stories to name just a few. In fact, the S&P 500 briefly fell -10% from its mid-September level to mid-October before a Santa Claus rally pushed the index higher by +4% in the last quarter of the year.
Even though the U.S. was partying hardy in 2014, it was not all hats and horns across all segments of the market. Given all the geopolitical trepidation and sluggish economic growth abroad, international markets as measured by the Total World Stock ETF (VT) gained a paltry +1.2% for the year. This dramatic underperformance was also seen in small capitalization stocks (Russell 2000 Index ETF – IWM), which only rose +3.7% last year, and the Total Bond Market (BND), which increased +2.9%.
Despite these anxieties and the new Federal Reserve Chairwoman Janet Yellen removing the Quantitative Easing (QE) punchbowl in 2014, there were still plenty of festive factors that contributed to gains last year, which should prevent any hangover for stocks going into 2015. As I wrote in Don’t Be a Fool, corporate profits are the lifeblood for stock prices. Fortunately for investors, the news on this front remains positive (see chart below). As strategist Dr. Ed Yardeni pointed out a few weeks ago, profit growth is still expected to accelerate to +9.3% in 2015, despite the recent drag from plummeting oil prices on the energy sector.
Source: Dr. Ed’s Blog
While a -50% decline in oil prices may depress profits for some energy companies, the extra discretionary spending earned by consumers from $2.24 per gallon gasoline at the pump has been a cheery surprise. This consumer spending tailwind, coupled with the flow-through effect to businesses, should provide added stimulative benefit to the economy in 2015 too. Let’s not forget, this economic energy boost comes on the heels of the best economic growth experienced in the U.S. in over a decade. More specifically, the recently reported third quarter U.S. GDP (Gross Domestic Product) statistics showed growth accelerating to +5%, the highest rate seen since 2003.
Another point to remember about lower energy prices is how this phenomenon positively circulates into lower inflation and lower interest rate expectations. If energy prices remain low, this only provides additional flexibility to the Federal Reserve’s monetary policy decisions. With the absence of any substantive inflation data, Chairwoman Yellen can remain “patient” in hitting the interest rate brakes (i.e., raising the Federal Funds rate) in 2015.
Geographically, our financial markets continue to highlight our country’s standing as one of the best houses in a sluggish global growth neighborhood. Not only do we see this trend in our outperforming stock indexes, relative to other countries, but we also see this in the rising value of the U.S. dollar. It is true that American exports become less competitive internationally in a strong dollar environment, but from an investment standpoint, a rising dollar makes U.S. stock markets that much more attractive to foreign investors. To place this dynamic into better perspective, I would note the U.S. Dollar index rose by approximately +13% in 2014 against a broad basket of currencies (including the basket case Russian Rouble). With the increasing likelihood of eurozone Quantitative Easing to take place, in conjunction with loose monetary policies in large developed markets like Japan, there is a good chance the dollar will continue its appreciation in the upcoming year.
On the political front, despite the Republicans winning a clean sweep in the midterm elections, we should still continue to expect Washington gridlock, considering a Democrat president still holds the all-important veto power. But as I have written in the past (see Who Said Gridlock is Bad?), gridlock has resulted in our country sitting on a sounder financial footing (i.e., we have significantly lower deficits now), which in turn has contributed to the U.S. dollar’s strength. At the margin however, one can expect any legislation that does happen to get passed by the Republican majority led Congress will likely be advantageous for businesses and the stock market.
When Will the Party End?
What could cause the party to come to a screeching halt? While I can certainly point out some obvious potential negative scenarios (e.g., European financial mayhem, China economic speed bump, interest rate spike), history shows us it is usually unforeseen events (surprises) that cause significant downdrafts in stock market prices. The declines rarely come from factors you read in current newspaper headlines or hear on television.
Just like any party, this year is likely to include high points and low points in the financial markets – and of course some lull periods mixed in as well. However, with the economy improving and risk appetites increasing, we are bound to see more party poopers on the sidelines come join the celebration in 2015. It will be a while before the cops arrive and stop the party, so there should be plenty of time to prepare for any hypothetical hangover.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions (including BND), but at the time of publishing SCM had no direct position in VT, IWM or 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.
