Good US Consumer

Stocks haven’t had the greatest start to 2015.  Regardless, economic fundamentals are seemingly still solid.  Here are 3 charts indicating consumption could be tailwind in spite of the latest retail sales report:

1. The most apparent, oil is cratering and along with it gas prices, giving consumers more funds to spend on retail items they likely don’t need:
   
2. Wages are likely heading higher, so consumers can use that extra income to get that totally unnecessary Apple Watch.
   
3. And less of that increasing income is going to service debt, so maybe sometime soon Americans can go back to the good old days of maxing out their credit cards!
   

Of course none of this means stocks can’t go down.  But historical returns suggests a drawdown of greater than 20% is highly unlikely.

*Please see the important disclosures that apply to this commentary HERE.  The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Stocks Should be Okay as Long as Economy is Expanding

• According to the chart below, since 1954, economic expansions tend to be a good time to be invested in stocks (SPX = S&P 500*):

• Some observations:
• As the numbers show, we are about 62 months through this one
• It’s right around the average and median since 1954
• Further, there were 4 expansions longer than this once
• The market return has been greater than average, though the market did have a lower bottom than any market prior
• Valuation level was also at a relative low:
  
• And regardless, there have been 2 expansions where the returns were higher
• Anyway, all this says to me that we aren’t in unprecedented territory in terms of length or stock growth in this expansion…
• And while we might be long in the tooth, nothing in the data indicates we are at extreme levels
• But what if the expansion is ending…
• Maybe the expansion ended this month and we didn’t realize it for 6 months (recessions are usually decided after the fact).  Highly unlikely with GDP coming in at 4.2%, but even so the first 6 months of a recession haven’t been destructive for stock market returns, assuming you hold throughout:
  
• Ok, we likely aren’t in a recession now, but what if we start a recession in 6 months?  After all, the common mantra is that markets lead the economy.  Again, while the returns are likely negative:
  
• Altogether Now:
• Expansions yield solid returns for stocks
• It’s likely we are still in an expansion (note: ISM has been in recession once with ISM at 59 or higher):
  
• Even if we are going into a recession, the months leading up to a recession haven’t had a HUGE drawdown (> 25%), despite a likelihood they will be negative
• Thus, as it’s highly probable the economy is expanding there are potential equity returns that outweigh the risk of a drawdown…
• And as a result waiting to pair back your equity exposure until you are certain the economic fundamentals have deteriorated is likely prudent

*Please see the important disclosures that apply to this commentary HERE.  The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Recessions Matter

Despite the lack of correlation between equity markets and economic growth, de-risking before a recession can help investors avoid large losses. 

Sorry for the delay, but have been out of the country only to return and have a presentation to put together.  Luckily the presentation yielded much commentary level material.  The first of which I want to cover is why recessions matter.

Most probably view this as common sense, but the reality is often times the market and the economy don’t run in sync.  For example, the market bottomed in Q1 of 2009, but the economy was still very weak.  Recently, GDP growth for much of 2013 was lower than that of 2012, but the market basically doubled its return in 2013 from 2012. 

Anyway, by and large is that economic forecasting shouldn’t be a huge factor in determining how you allocate your portfolio.  Aside from being terribly unreliable, even when they are spot on the market may behave in an unexpected way.  I agree with that for the most part, except when it comes to recession forecasting.  Here I walk through why:

1. A reduction in corporate profits often leads or coincides with recessions.
2. As one would expect, profit growth is highly correlated with the S&P 500.  Also, that larger market declines happen when earnings fall at or around recessions:
3. Thus, it follows that if economic growth is positive, as it is projected to be, earnings should grow and subsequently the market.
4. But more importantly, if you have a beat on when the economy will slow (and that is very hard to do) you can get out in front of a fall in corporate profits and the subsequent fall in the market.

The takeaway is to use economic forecasts as part of your risk control strategy to move out of stocks before they have a large move down.  But don’t have it be your only piece and certainly don’t go risk heavy because the economic growth is expected to rip as there are other factors at work.  This is a drawn out way of saying “win by not losing big” and seeing storm clouds on the horizon can help with that.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market The Dow Jones Industrial Average is a widely watched index of 30 American stocks thought to represent the pulse of the American economy and markets. 

2013 and Beyond – The Bad, and The Ugly

Negative ETF Ranking - 2013
9	-1.37% - shares International Treasury Bond ETF (IGOV)
10	-1.83% - iShares S&P GSCI Commodity-Indexed Trust (GSG)
11	-1.98% - iShares Core Total Aggregate U.S. Bond ETF (AGG)
12	-2.00% - iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
13	-3.44% - iShares National AMT-Free Muni Bond ETF (MUB)
14	-3.64% - iShares MSCI Emerging Markets ETF (EEM)
15	-6.09% - iShares 7-10 Year Treasury Bond ETF (IEF)
16	-6.73% - iShares Emerging Markets Local Currency Bond ETF (LEMB)
17	-28.33% - SPDR Gold Shares Trust (GLD)

Shockingly, not every asset class went up last year.  I say shocking because usually when stocks are hot nobody really cares what anything else is doing.

Last post I covered the ETFs that finished in the black last year and what we should expect moving forward.  This time I will cover the ETFs that finished in the red in 2013 (with the help of this file).  Again, when looking forward I am using this thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

I will again mention the caveat that what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned and when things change portfolio and thesis adjustments will be made accordingly…

And now, the ETFs that had negative returns in 2013…

• IGOV – 2013:  International treasuries almost finished positive, but alas they finished with every other fixed income asset class.  They did finish the second half of the year very strong with the help of a weaker dollar.  Moving Forward:  While the US is pulling in the reins on QE – pushing our yields higher and bond prices lower – other countries are expected to remain easy or possibly become more accommodative (see Japan’s “success” with their own QE).  This would push their yields lower (or stable) and prices higher, but also cause their currencies to fall and thus washing out any positive.  Thus, an investment that is USD hedged could provide some boost.
• GSG – 2013:  The commodity chart looked a lot like USO last year, but worse as it includes agriculture and precious metals.  Commodities look to be in a range, and while that’s subjective the alternating black (Q1, Q3) then red quarters (Q2, Q4) would appear to validate that.    Moving Forward:  see USO (note: energy and industrial metals make up the bulk of index).
• AGG – 2013:   The pulse of the US bond market had its first negative calendar year return since inception and didn’t break its intermediate-term trend for the last eight months of the year.  Interestingly though it only had one negative quarter (Q2).  Moving Forward:  Assuming interest rates to continue to rise in 2014 it should yield another negative year for bonds.  While it appears interest rates may have hit a secular bottom in 2012, it’s important to remember that bonds hedge against a decline in risky assets (note: this has held as of late with equity markets off their highs and AGG moving up) and that they present much less risk (unless they are high yield or high duration) in terms of large capital loss.  Finding a balance between rising rates and the portfolio hedging benefits fixed income brings should be the goal.
• LQD – 2013:  See AGG, though the Investment Grade Corporate Bond LQD did break its intermediate-term downtrend at the end of the year.  Moving Forward:  See AGG.  There doesn’t appear to be much room for investment grade spreads to compress any further, so outside a 2008 credit event I would think they will have a high correlation with Treasuries.
• MUB – 2013:  Munis were hit harder than their taxable counter parts in 2013 with Detroit’s bankruptcy taking center stage.  While they did recover in the later part of the year, MUB like AGG finished the year below its intermediate-term trend for the last eight months.  Moving Forward:  Quick math, 3% yield on MUB equates to a tax effective yield at the 40% bracket of 5.00%.  AGG has a yield of 2.32%.  So if you are in a higher tax bracket, pick out some attractive munis, ladder them by maturity, hold to maturity, and you get a decent yield with not much interest risk. Note: as interest rates rise prices do fall, so prepare to watch your values drop, but if you hold to maturity you get the face value back.
• EEM – 2013: While EEM finished with two positive quarters and the last three months above the intermediate-term trend (barely), it still couldn’t overcome a poor start to the year as money moved out of Emerging Markets when our interest rates moved up.  EEM is also over 60% below its 2008 peak.  Moving Forward:  Even more so than developed markets, emerging markets appear to have an attractive relative valuation to our market.  Much of this is likely due to some longer-term demographic and geo-political issues and is especially true of the ones that got beat up last year (Russia, China).  Further, a sharp rise in US interest rates could continue the capital flow out of emerging markets.  Thus, while there are opportunities for upside until the trend reverses it’s hard to have much conviction.
• IEF – 2013: See AGG.  Moving Forward:  See AGG, though I think it makes sense to take a more tactical (over and under weighting when the market dictates) approach to the 7 – 10 year Treasury space.
• LEMB – 2013:  See EEM; rising domestics rates equates to capital moving from emerging markets local currency bonds back into US markets.  Moving Forward:  See EEM and IGOV.  While rising domestic rates would continue to be negative for emerging market bonds, a USD hedged exposure could be a nice boost.
• GLD – 2013: The gold chart for the year went pretty much straight down.  You can take your pick why: higher interest rates, decrease in systemic risk probability, lower inflation.  But at the end of the day you see three out four negative quarters, the whole year below the intermediate term trend, and down nearly 30%.  Moving Forward:  All three items I listed for gold’s 2013 decline are still in place.  Maybe one of those reverses and this turns into a great contrarian trade, but until the trend changes it’s difficult to allocate dollars to gold.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

2013 and Beyond – The Good

2013 is a wrap!  What a year it was if you invested solely in US stocks.  Just a guess, but I would wager some investors probably will think now is a good time to get undiversified.  That could work in 2014, maybe even longer, but ultimately other asset classes will begin to outperform and a diversified portfolio will provide good relative returns with lower volatility. 

But that discussion is for another day.  Below are some observations on ETFs (listed at the top) we look at that yielded positive returns last year.  I used this file to help make those observations.  For each ETF, I summarized 2013, and then outlined what should happen moving forward, based on the following thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

Will all that happen?  Probably not, but these are my conclusions based on the current environment.  Of course as the markets and facts change so will the above thesis; in other words, as I have pointed out before, nothing is static.

Making predictions is a futile business, so what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned, with the caveat that when things change portfolio and thesis adjustments will be made accordingly… 

• IWM – 2013:  US Small Cap stocks were best in show and never came close to breaking their intermediate-term uptrend (roughly 10% above the 10-month moving average).  Small Caps leading Large Caps is a good sign to market observers, though they also lagged a bit (still up over 8%) in Q4 and is something to keep an eye on.  Moving Forward:  This equity market segment seems relatively pricey to others and above average.  While the environment is conducive toward continued appreciation, I prefer higher quality companies with strong balance sheets that tend to land in the large cap space (SPY) in case some of those conditions reverse or something unforeseen happens.  Still, the trend in US stocks (this includes SPY) is overwhelmingly positive and as a result our risk metrics have not been triggered, in fact IWM and SPY are far from them.  So until the environment changes or the risk metrics tell us otherwise it’s difficult to go against the market.
• IVW – 2013:  Growth had little difference from the Value stocks ETF, thus if you were invested in stocks it really didn’t matter much.  Moving Forward:  see SPY/IWM.
• SPY – 2013:  The S&P 500 ETF that everyone looks at really ripped and was up over 30% on a total return basis.   Q4 was also the strongest quarter of the year and the index hit its high in the last week of the year.  Like IWM, SPY never came close to breaking its intermediate-term uptrend.   Moving Forward:  See IWM, though valuations are more reasonable than small caps and probably at their average.  I will again note, I prefer the quality companies moving forward that capture part of the up move, but also avoid some of the down move in the event the market reverses course.  Lastly, a major fundamental equity concern is what happens as interest rates rise; however, in this environment rising interest rates have historically been a benefit to stocks.
• IVE – 2013:  see IVW.  Moving Forward:  see SPY/IWM.
• EFA – 2013:  Investing in developed international market stocks netted 20%+ though still had a decent lag relative to domestic stocks.  The ETF is also still below its 2007 peak, but it’s close to making a new high on a total return basis.  Moving Forward:  Looking at prior returns and research, these markets tend to be a better relative value than our own stock market.  What this doesn’t mean is that outperformance will happen overnight.  Further, the trend is NOT your friend.   What it does mean is that there are some opportunities here, especially as growth in those economies picks up. 
• USO – 2013:  This is the first significant relative underperformance as the oil ETF’s return was a tad under 6%.  Moving Forward:  Typically cyclical commodities tend to rally more late equity cycle (see big Oil rise in 2007 and 2008 before it cratered), so assuming the equity market rally still has legs, I would expect the lag to continue.  Further, many investment based countries (e.g. China) are trying to shift to a more balanced economy.
• HYG – 2013:  Only bond asset class up for the year, which isn’t surprising given high yield is more correlated with equities and has minimal duration risk.  Moving Forward:  Environment should still be supportive.  However, while spreads (the difference between Treasuries and a similar high yield bond) have been narrower before, I do wonder how much juice is left in the squeeze?  Just be careful as high yield bonds won’t provide a hedge if riskier assets stumble.
• IYR – 2013:  Logic would dictate real estate would perform better given a big bullish economic story last year was the increase in home prices, but IYR barely finished the year in the black.  The chart looks eerily similar to the Treasury ETF, so there appears to be a correlation with interest rates.  Plus REITs outperformed stocks every calendar year since 2009 except last year, so maybe much of those gains were priced in.  Moving Forward:  The correlation between real estate and stocks broke down for much of 2013, but did move together prior to that.  Still, steadily rising interest rates with minimal inflation should result in lackluster performance and a loose correlation with bonds. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

The 10-2 Indicator Says No Recession, Market Collapse

A popular indicator is the 10 Year Treasury yield less the Two Year Yield.  When the number is positive or upward sloping, that is typically indicative of a growing economy.  The short version is that the Fed heavily influences the short-end of the curve, so when investors are confident about the economy they sell the long-bond pushing the yield up. 

Now the Fed can and will, as evident by quantitative easing (the Fed buying longer dated bonds), control the long-end too.  Thus, even though we have an upward sloping curve now there is still some heavy Fed influence as they are keeping short-term rates very low.  Further, the drawing down of quantitative easing (no longer buying longer dated bonds) expected Q1 next year should push up the long-end of the yield curve.

Still, even with that caveat I found the chart below pretty fascinating.  The blue line is the 10 Year yield less the 2 Year yield and the red line is the S&P 500.  

A few things stick out:

1. A negative sloping yield curve has ALWAYS led to a recession.  There all no false positives.
2. We have never had a recession since 1976 (from when the data was available) where the yield curve did NOT turn negative beforehand.
3. The last two major markets tops in 2000 and 2007 coincided with a negative yield curve.
4. We don’t have anything close to a negative curve now.  In fact, the slope is moving higher.  

While the sample size is small and everything works until it doesn't, it bares extremely well for the economy.  This has important stock market implications.  I have noted before that even if earnings lag (say the economy is weaker than expected or the record high profit margins come down) we can still have multiple expansion to push the market higher given short-term valuations are not at extreme levels.  That isn't to say the market can’t or won’t have a hiccup or pullback around 20% or so, just that a larger bottom doesn't appear to be in the cards unless that 10-2 indicator reverses. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Getting Fresh with the Markets – Part 2

While I highlighted JP Morgan’s sexy charts in my last post, now it’s time for my sexy charts.  It’s really a whole document, which you can find uploaded here. 

Aside from being more colorful and handsome, my weekly charts attempt to capture the movements of multiple markets, how they are performing relative to other markets, and if they are more risky based on a historical metric I use, among other data.  In short, I use it to identify trends in broad based ETFs, so that we can apply that to our portfolio construction, accordingly.

So here is a quick summary based on weekly data at the close of November 15^th and monthly data as of October 31^st: 

• It’s really amazing how the risk indicator has worked with domestic investment grade bonds.  In October bonds rallied but failed to pierce the risk indicator.  Since then bonds have moved down; though, did rally last week.
• And bonds have by and large had a positive return over the last 12 weeks.
• Another thing to note is the AGG (Aggregate Bond US Bond Index) chart.  Look at that fall!  But how much is AGG down over the last year?  -1.71%.  So really not that big of a deal in my mind.  To me this indicates that even in rising interest rate environments (when interest rates rise bond prices fall), there is little risk of huge portfolio loss from holding bonds.
• Note, the duration (a measure of a bond’s sensitivity to interest rate changes) of the AGG is still under 5, so it’s not like there is huge interest rate risk holding AGG.  This is different for longer dated bonds though.
• Munis still continue to suck wind against corporates, despite their recovery over the last 3 months.
• High yield has been relatively immune to the rise in interest rates.  This isn’t surprising as high yield is usually negatively correlated with Treasuries. 
• A recent trend of late is the outperformance of SPY (large caps) vs. IWM (Small Caps), which are actually flat over the last month.  I wonder if this is the sign of a tired rally as typically riskier flare leads.
• Alternatively, Growth has outperformed Value over the last few months, which may be a short-term move, but is a directional change at least for the time being.
• Developed Market stocks are up, but are still underperforming SPY over the past 12 months (and every other period listed).
• Emerging Market stocks are all over the place.  I love their valuation, but to me still seems like the trend is against them.
• Commodities in general seem to be consolidating, though Oil looks could be in a downtrend.
• The same goes for Real Estate.  In my opinion, rising rates are probably more hazardous to IYR (Real Estate ETF) than to AGG.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Getting Fresh with the Markets – Part 1

I have mentioned this before, but JP Morgan’s Guide to the Markets is really full of awesome charts, graphs, and data.  The edition for Q3 (note all data as of 10/31) can be found here.  Below are some of things I found of interest and how they affect your portfolio:

• From the market bottom in March 2009, the S&P 500 is up 174% and 23% above the prior 2007 peak.
• Best sector YTD is Consumer Discretionary, which is bullish given its cyclical nature.  Further, it’s trailing and forward PEs are still below historical norms.
• Most valuation levels on the markets seem reasonable, thus it doesn’t seem that valuation will dislodge the rally.  Though there is the exception of Shiller Price to Earnings Ratio, but even he admits this isn’t a short-term metric.
• One big market worry is profits as a % of GDP.  This is at an all-time high.  So if this reverts and profits are hurt this could affect the market or on the other hand valuations could keep rising.  This undoubtedly ties to the poor employment picture.
• Interesting to note that when yields are below 5% and interest rates go up, generally stock prices have a positive return.
• Corporate balance sheets are very strong with higher % of cash and lower % of leverage.
• The earnings yield is the reverse of the P/E ratio, in other words, earnings divided by price: by this measure, the markets are cheap.  Further, even if we get to the average valuation level on the earnings yield ration markets have historically followed with positive moves.
• Consumer balance sheets are improving and debt payments as a % of personal income look to be close to an all-time low.  The household deleveraging cycle may be over, and consumers may begin to have disposable income, something which the economy has missed dearly.
• To me employment still looks ugly. Much of the drop in the unemployment rate is a result of people dropping out of the work force. On the other side of that equation, I also read elsewhere the following: if all 3M open positions in the US were filled, unemployment would drop into the mid 4% range. This is largely due to a skills gap.
• Inflation as reflected by the CPI is still tame, so the Fed is really under no pressure, and can be accommodative, which is bullish for stocks.
• Our oil imports our dropping, though we are the largest consumer.  We also produce 12% of the world’s oil, second only to Saudi Arabia, and are expected to surpass them in 2015.
• Looking at the long-run chart on interest rates, it’s tough to tell if we have bottomed.  Though I will say on a subjective note that the current interest rate move up has felt different. 
• While the spread (the difference between two bonds with similar maturity) on high yields makes them look rich, municipal bonds look attractive. 
• While domestic stocks have blown through their 2007 peak, Developed and Emerging Market stocks have not.  This indicates that while the trend still favors the US, on the long-term basis these markets might be more attractive.  Emerging Markets in particular; however this was the case last year at this time, and those who made that bet – we didn’t – have been very disappointed this year.
• Consumption in Emerging Markets is on the rise while US consumption is falling.  This is good for a more balanced world economy.
• Europe still has some gaudy unemployment numbers, particularly in Spain and Greece where they eclipse 20%.
• US stocks have crushed every broad asset class YTD.
• 2013 should be the first year since 2005 since domestic equity funds will have positive fund flows.  Glass half full - more flows from retail investors can push the market higher.  Glass half empty -- retail investors don’t really move the market as evidenced by negative flows since 2009 despite a huge bull market. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

30 Minutes to Understand the US Economy

I cheated this week and am making one longer commentary, as opposed to two shorter ones.  This is due to my own personal time crunch, and the depth required for this subject.

Further, I am using Google Docs. for the deeper dive into this piece, and can be accessed here.    What is contained there is my summary notes of the 30 minute embedded video Ray Dalio put together entitled “How the Economic Machine Works”. 

Dalio runs the world’s largest hedge fund, the $120B Bridgewater Associates. This is the most simple and succinct explanation of how money and credit are used in transactions, the sum of which is our economy: why we have booms and busts, where we are at in the current cycle, what’s likely to happen moving forward, etc.  Dalio boils this all down to the most basic fundamentals, and makes everything easy to understand.

While I don’t believe these views are mainstream economic thought, they are much in line with my beliefs on how the economy works, and provides a practical means to explain what has happened in the past.  Those who follow a similar viewpoint have been right more often than their peers.  So click the link, use my outline to follow along, and in 30 minutes, you will better understand what makes our economy tick and destroy those who challenge you at cocktail parties.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

QE Taper or Not… and What Happens if it Does Occur?

When will the Fed taper its purchases of Treasuries and mortgage backed securities as part of its Quantitative Easing?  That seems to be the biggest discussion going on at all the hottest clubs.  The chief economist from my favorite econ research team (Goldman) said “A September tapering is certainly possible”.

In an economic sense, QE is more debated than JB at the Heat Game 7.  Regardless of whether QE works, is destructive long-term, neither, or both, I want to focus on its impact on equity markets where I see 3 common reasons why it’s bullish:

1. Higher earnings of companies through refinancing as interest rates are pushed down.
2. Low bond yields force investors into higher yielding assets (e.g. stocks), which in turn forces up stock prices and valuations.
3. QE creates liquidity (e.g. I hold a bond, the Fed buys it, I now have cash), which has to be put somewhere.  One of those places is the equity market.

Ipso facto, QE tapering would be bearish for equities.  I do believe that is a risk, but at least for now under the current facts and circumstances – facts and circumstances which can and do change – I am less concerned, and here is why:

1. Econ Data Still Not There:  from the same article “I think that is going to depend on the data… Chairman Ben S. Bernanke expresses caution over trimming the program too soon… The likelihood that the economy will continue to grow about 2 percent over the next couple of quarters with inflation ‘well below’ target will probably stay the Fed’s hand until December”.
2. Closer to End of Recovery Cycle: Cullen Roche at Pragmatic Capitalist elaborates on the last bullet: we’re in the backstretch of the recovery, unemployment is still way too high, corporate revenues are starting to falter.
3. Tapering Not Huge Anyway: if they do taper, consensus isn’t exactly a large change to the Fed’s balance sheet.
4. Good Economic News Drives This Decision: as insinuated earlier, if the Fed is tapering then economic data is good.  If economic data is good, then stocks should do well.   

That last bullet is the key.  If economic data falters as the Fed tapers their purchases then equity markets will be in trouble.  A good article at Learning Bonds points out that fact QE and equity prices is even a conversation points to artificially inflated equity values.  Thus, if data comes in weak stocks would be more likely to revert to their fundamental value. 

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

In Retrospect, What Did QE1 and QE2 Bring?

Again, I hope to get to some economic charts shortly, but for now let’s focus on asset prices.  The Big Picture posted some great charts on the previous QEs and Operation Twist (OT) and how various asset classes reacted.  Since I am not sure if I can post them (please check out the link), here is summary:

• Yields.  It’s interesting that yields rise after QEs.  They do drop drastically before QEs though.  Markets are basically buying the rumor and selling the news.  The same could be said about OT, while yields have gone lower it wasn’t until earlier this year.  I don’t think it was coincidence QE3 rumors started then.  I can’t see a divergence between the 10 and 30 year.
• Stocks.  Equity prices did rise rather nicely.  However, it does appear that there is a near-term pullback in prices at first.    Again, it appears investors start buying QE before it even happens.
• Commodities.  Prices rise pretty much throughout QE and on the rumor.  Like equities, there appears to be a selloff at the launch before a nice move higher.  

Also, from those charts I took a look at some numbers and came up with the following chart:

One thing that jumped out was that stocks and oil didn’t have as big a jump after QE2 as they did in Q1.  This would be concerning now given that the QE3 has already seen about the same rise.  Still, the highs and lows are relatively subjective.  Further, maybe the open-ended nature or current economic conditions would generate higher returns than QE2.

Gold and commodities appear to have the most upside, as rose by close to the same amount both QEs and have barely got off the ground this round.

QE3 – A Quick Thought

On September 13^th the Fed statement was extremely accommodative.  Here are some highlights:

1. Extending language "exceptionally low … federal funds rate are likely to be warranted at least through mid-2015"
2. New round of QE to MBS (not Treasuries) & rolling maturing MBS from previous asset purchases "purchasing additional agency mortgage-backed securities at a pace of $40 billion per month... maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities... increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year"
3. Extending operation twist "continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June"
4. Asset purchases appear open-ended (as opposed to a set $ amount) "outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability". 
5. Fed officials also upgraded their economic forecasts significantly.

So that was the announcement.  The takeaways?

• There also isn't a consensus this is actually economically stimulative.  I myself wonder how will lowering already low mortgage rates will help stimulate demand?  I will post on this shortly after I look into some data.
• Even if it doesn’t help the economy, does that mean QE is meaningless?  No.  If it follows the past QEs stocks and commodities should have a nice go of it.
• So if we assume it doesn’t help the economy, how can it help stocks?  Multiple expansion. 
• One measure of stock value is Price/Earnings.  So if Price is $100 and Earnings are $10 then P/E = 10.  If we assume QE doesn’t affect the economy then earnings stay at $10, but QE does help a stock’s P goes to $110.  The P/E is now 11, however fundamentals remain unchanged.  
• The open ended comment essentially assures Treasury yields shouldn't have a large move up and volatility in that market should be muted.
• Treasury and agency spreads should narrow further.
• The Fed won't be tightening until there is a dramatic change in the economic data.  
• Is the Fed now out of bullets?

In my next post, I want to touch on what happened to various asset prices the last two times we have QE.

Where we are at now, US Economy

With the massive amount of data available it can be hard to get a grasp on what is going on.  I tend to look more at the big picture and trends, as opposed to the data points.  So here it goes:

• GDP growth is slow – 2% for Q1 and 1.70% for Q2 (revised up today).  Year end estimates are in the 2% range.
• Employment isn’t good.  But hey, doesn’t look like mass layoffs are coming up soon either.
• Housing starts have bottomed and are in an uptrend.  Maybe even prices (?) have bottomed.  Just don’t expect a massive V recovery in either.  
• Real income growth is weak and still below the 2008 peak.
• Retail sales were up, but that was after a decline.  It’s not clear whether the trend will move down, sideways, or reverse back to up. 
• Industrial production continues to expand and is in an uptrend.   The ISM Index indicates a slight contraction. 

So the bad news is I wouldn’t expect a massive jump in GDP.  None of the above metrics (or any others) seems to indicate that.  This is because employment is terrible and income growth is weak.  Without higher incomes, there is less demand; less demand equals lower revenues, which in turn leads to lower employment.  This is why I am opposed to deficit reduction now.

On the plus side, nothing appears to be rolling over.  Retail sales were close, but the most recent jump at the very least gave pause to its recent moves down.  Hopefully this actually reverses the trend going forward.  Housing is now a tailwind as opposed to a headwind.  And manufacturing, while not roaring, is chugging along.

Ultimately, this is indicative of a slow growth economy, but not one that is cratering or in recession; although, the latter is more semantics at this point than anything.    

A Note on Unemployment

The employment picture is a huge economic headwind.  That is why each report gets so much attention.  Lack of employment = continued weak demand.  If the employment situation improves, consumption should pick, balance sheets will heal faster, the economy will improve, and then you get a positive feedback loop.  With that in mind, let’s take a look at the most recent report…

The Good:

• We added 163k jobs
• Better than consensus (100k forecast)
• The stock market appeared to like the number
• Indicates we aren't in a recession

The Bad:

• Other aspects of the report were more negative
• Unemployment actually rose to 8.30%
• U6, a broader range of unemployment rose to 15%
• Revisions in prior months and seasonality 

What it Means:

Nothing.  While I just said the report gets attention, it’s one report.  The trends remain not good and the employment picture is still poor.  Calculated Risk has some fantastic graphs that illustrate this:

• Deepest job loss and slowest job recovery in Post WWII recessions (here)
• Long-term unemployment, while decreasing, is still elevated (here)
• Note, if this doesn’t decrease it could indicate a more secular employment problem
• People ages 25 to 54 are underemployed relative to prior levels (here)
• People still aren’t participating in the labor force as they have in the past (here)

So to conclude, it’s good we are moving in a positive direction, continuing to heal, and seemingly not in a recession as of now.  Still, the report is not a game changer and does not augment the underlying key theme – the employment situation as a whole is weak.

Focus on the trends, not one reading.