Archive for January, 2014

Batting .333 Isn’t Bad for Baseball

Thursday, January 23rd, 2014

indu

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I thought we’d change things up and look at a graph of the Dow Jones Industrial Average in today’s blog. This is the most widely reported of the various stock market Indices – which makes it psychologically important for the retail investor and company 401k participant.

As you look at this graph, you can see that over the past year, the index has moved up steadily, with only one trip to the 200-day moving average, and on the far right you’ll see that we are at the 50-day moving average with today’s sell-off.

This all looks pretty healthy, and if you are under-invested, a bit of weakness that consolidates last year’s gains giving you an opportunity to buy something is a good thing.

However, let’s take a look at the Year-To-Date graph:

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What I find striking about this graph is that the market as represented by this index has been down 2/3 of the trading days this year, yet it is only down a bit more than 2% YTD. To me, this means one of two things: there are significant levels of investors “buying the dips” when the market is down, trying to get some money put into the market, or there are significant disparities between the market sectors.

If we look at the volume section of the above graph, you see that we have had three days where buying volume exceeded the YTD average and the On Balance Volume indicator that I’ve superimposed over the volume bars is in a downward trend. I don’t think this explains the minor pullback in the index in the face of such a losing record in YTD performance days.

So, let’s check out this YTD Sector analysis:

sectors-ytd

Strong performance in the Health Care and Utilities sector with barely positive performance in Technology and Financials are offset by dismal performance in Consumer Cyclical, Materials, Energy and Consumer Staples.

Traditionally, the Health Care and Utilities sectors – along with the Consumer Staples sector – are considered the defensive areas of the market. Investors shift money into them in advance of a soft economy because their earnings tend to not be impacted to the same degree as other industrial sectors of the economy if we are heading into a slow-down.

The cyclical sectors like Industrials, Cyclicals, Materials, and Energy are tied more closely to the performance of the economy – and right now investors are forecasting a bad year economically in spite of the news being reported on TV as to how strong everything is and how much stronger 2014 looks compared to last year.

It is strange to see the Consumer Staples stocks not up along with their defensive cohorts – but maybe investors are shunning all things Consumer based upon the trends of the Labor Force Participation Rate:

labor-force-participation-rate

This is one of the most concerning economic issues, in my opinion. People continue to leave the work force (early retirements, disability, stay-at-home parent, move back in with Mom and Dad, etc.) because they are unable to find work.

People leaving the workforce has a direct impact on the number of consumers with disposable income – so potentially investors are punishing both Consumer Cyclical stocks along with Consumer Staples based upon the perception that earnings from companies focused on selling products to consumers will be negatively impacted by a shrinking workforce. Not sure, just a thought, but something is sending these sectors down.

This chart also bodes poorly for Social Security and Medicare forecasts – when there are fewer workers paying into these systems it moves the date when they exhaust their trust funds move even closer. Right now Social Security is projected to be solvent until 2033 and Medicare until 2026 – but those can be revised to sooner dates if the money flowing into the programs is less than forecast. Now, I know I will get some emails because technically there is no money in the trust funds, only IOU’s from the Treasury Department – but let’s just leave that issue aside for this blog post. This is not weighing on the market right now, but its something we need to keep in mind as we look at long-range investment plans.

My opinion on all of this is that after a big up-year in the market last year, it is good to consolidate those gains and visit a moving average line. That serves two purposes – (1) it allows those who are under-invested an opportunity to buy something, and (2) it scares away the short-term players who heard the market was performing well and they decided to get in at the top, then sell now when we are 2% below the top. The former are healthy for the market because they represent real demand – the latter are unhealthy for the market because they add to pricing distortions moving up days higher and down days lower based upon whims to get in or out.

If we break the 50-day moving average and head toward the 200-day moving average, this represents a buying opportunity AS LONG AS the current earnings estimates for companies remain solid. If we begin to see companies slash their earnings forecasts for 2014, we could be in for a tough year. As this earnings season progresses, it is the weakest one we’ve had in a few years – fewer companies are beating their earnings estimates this quarter so far than at anytime since the 2008 market crash. Earnings appear to be weakening indicating that the economy may not be as strong as we hear reported on TV, just as noted above.

Given the sentiment in the market based upon price performance, I’d say a trip to the 200-day moving average is very possible. For the S&P 500, that would be a bit under a 7% correction from today’s prices – definitely not the end of the world but it would frighten a number of folks who haven’t seen a pull back like that in a while. However, unless we get some sort of indication that a recession or negative economic or geopolitical (or even Washington political) event is drawing down upon us, there is no reason to believe that any pullback will be anything other than temporary. If we start to see our macro indicators flash warning signs that something is afoot, it will be our cue to raise some cash. I haven’t posted those indicators in a couple of months so I’ll try to put those together in a couple of days for your review here on the blog.

Given the big run-up in equities last year, we have been working on rebalancing client portfolios. The equity positions have grown outsized relative to the bond positions for clients that have portfolio allocations that include bonds. We have been paring back the over-weight equity positions and buying bonds with those profits – a pretty standard rebalancing between asset classes – and ultimately de-risking portfolios.

Our fixed income strategy for clients who own individual assets (ie, not solely mutual fund portfolios) is to focus on individual bonds that are laddered out to seven years with a weighting toward the front end of the ladder. We want to own a diversified mix of corporate, government agency, and taxable municipal issues – all high quality – so that we are prepared for any increase in interest rates that would allow us to reinvest maturing bonds at ever-higher yields.

We are also utilizing some adjustable rate fixed income mutual funds in both our individual issue portfolios and our mutual fund portfolios.

The biggest risk in owning bonds right now is that yields will rise. Check out this long-term chart (below) so you can see the 30-year decline in bond yields that fueled the biggest bull market any of have seen in our lifetime (and its been the bond market bull, not a stock market bull).

treasury-yield

When I look at this chart, I see yields bottoming last year and the beginning of a move higher. When yields move higher, bond prices fall – and traditional bond mutual funds are hit hard. That is why I have written on the blog over the past 18 months or so about our effort to lower duration in our bond fund portfolios to reduce the interest rate risk that can devastate bond funds. We now have a 2.5 year duration in our bond fund portfolios and are locking in maturity values with individual bond portfolio holdings where appropriate.

Risk management is always a key factor in portfolio management – and when clients have blended portfolios of stocks and bonds they intend the bond portion to be their “safe” money that diversifies away the volatility and risk of loss from their portion of their portfolio invested in stocks. As an investment manager, you must not allow a potential bond bear market to crush the “safe” money and foil the clients’ objectives.

Can we see a move back to those lower yields from last year? Definitely, particularly if we see a slower economy as a couple items above indicate is possible. But ultimately, the risk is to tilted to higher yields and prudence dictates we act accordingly.

As things progress with the markets, I’ll be back with updates on both the technical and fundamental aspects of investing. If you have any specific topics you’d like me to address as we are kicking off the year, feel free to email me and I’ll post entries dealing with those topics.

Remember, batting .333 isn’t bad for baseball, but a .667 losing record in days performance is a pretty lousy way to kick off a year as a stock market investor.


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Mark

Year-End Wrap-Up and Thoughts on the Year Ahead

Tuesday, January 7th, 2014

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With a Federal Reserve-induced wind at its back, the US stock market sailed into year-end to close out 2013 with an outstanding performance. In fact, US stocks had their strongest year since 1997, with the S&P 500 closing the year right at its all-time high. Over 90% of the companies in the index had positive returns for the year, with about half the gains for the year coming in the last quarter.

In the last quarter of the year, the most aggressive stocks in the index moved well ahead of the defensive stocks, demonstrating investor’s general penchant for assuming risk based upon their belief that the Federal Reserve will continue printing money, and that new money will flow into the stock market pushing stock prices even higher.

Other asset classes faired much worse. Foreign stocks significantly under-performed the US markets, with a blended return of 8%. The Aggregate Bond Index lost nearly -3%, its first loss in 14 years. Gold lost -28%, which was its worst year in nearly a quarter of a century. Given the general view with investors that the Federal Reserve can print money forever without inflation being a threat, Gold was definitely the whipping-boy of the 2013 investment markets.

In looking at the market’s sector performance for 2013 we see that Consumer Discretionary, Healthcare, Industrials, and Financials were the leaders, each up by more than 30%. Following closely behind were Technology, Consumer Staples, and Energy, which were each up more than 20%. At the bottom were defensive sectors Materials, Utilities and Telecom, which were up less than 10%.

Fully diversified portfolios that include all asset classes for risk management purposes were positively influenced by the US component but held back by the allocations to other asset classes. However, in reviewing historical asset class performance, this is the first time since 1997 and 1998 that the US markets have been the top performing asset class. Having a diversified portfolio, over the long-term, provides for much better performance than an S&P 500 centric portfolio. It allows investors to spread the risk of financial loss over a wider array of asset classes, it ensures investors include the top performing asset class in their mix, and it provides for a more consistent risk-adjusted return over the long-term.

Valuations have been pushed toward historic highs, meaning that the US stock market is expensive compared to other asset classes, with the exception of bonds that have been on a 30-year bull market. In 2013, the riskiest stocks with little or no earnings pushed the index to its highs as Federal Reserve policy encouraged investors to assume ever-greater levels of risk.

The riskiest stocks have had a rocky beginning to 2014, but that does not mean we have seen investors get religion. We saw a similar Federal Reserve policy push the US housing market higher before greed brought it to a crashing halt – the question we all need to ponder is whether the same thing can happen to the stock market.

As we look to 2014, even though we have started the year with several down days in a row, investors are still as a whole very bullish on the stock market. As long as the Federal Reserve is printing money, the US economy is growing slowly, interest rates remain low, and inflation is not a concern, the stock market should continue to move higher as investors are in the mood to assume risk.

Unfortunately, corporate earnings are projected to grow less this year than last and the expansion of market multiple (i.e., the ratio of stock prices to company earnings – or how many years of earnings an investor willing to pay for a share of stock) is unlikely to expand at the same rate as 2013, so we probably will not see the same rate of return in 2014 as in 2013. However, 1997’s 33% return was followed by 1998’s 28% return, so anything is possible when you are dealing with an extraneous market force like the Federal Reserve’s money printing influencing investor psychology.

At some point, earnings and valuation will matter to investors and the stock market will go down. Much like a housing market that pushed home prices higher based upon little fundamental relationship with value, the stock market will at some point realign with mean valuations either through a correction or by moving into a trading range that will keep prices flat for a period of time until earnings catch up.

Until then, you have to…


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Mark