Archive for October, 2014

The End of QE

Wednesday, October 29th, 2014


In spite of the Federal Reserve’s forewarning weeks ago that they were planning to end their bond buying monetary stimulus activity known as Quantitative Easing (QE), when they formally ended it today the stock market sold off.

If you look at the graph above, you can see the big swoon down at 2pm when it was announced. The market then fretted for a bit and the buy-the-dippers came in and pushed the market back up to almost break-even on the day.

What does it all mean? The QE activity was a way for the Federal Reserve to increase the money in circulation by buying government bonds from the Wall Street banks and crediting them with the payment for the bonds using newly created money.

This new money was supposed to do two things: (1) provide liquidity for banks to increase credit to stimulate the economy; and (2) generate a wealth effect by increasing the value of the stock market. They certainly accomplished point two but it doesn’t seem that they were able to accomplish point one.

Now that this newly created money will not be a stimulus to the investment markets, the stock market will have to move higher the old fashioned way – based upon earnings growth and a sound economy.

Tomorrow’s announcement of 3rd quarter GDP will be the first major economic announcement and stock market investors will be paying close attention to it. A solid number will ease their minds and allow the market to move higher – a weak number will have the opposite impact.

It will be interesting if we start to see a rotation out of the top 50 largest companies in the S&P 500 (these are the stocks that have seem the most buying interest during the QE cycle as they are also the most liquid and easiest to accumulate) and into small cap/mid cap and the smaller blue chips.

Traditionally, earnings growth in these companies has been higher than in the top 50 companies and earnings growth is rewarded by investors with P/E expansion and higher stock prices. If so, then the beta driven market we have seem the past few years will revert to an alpha driven market and reward investors who do their homework accordingly.

In a beta driven market, index funds are the winners because money flows into the largest companies simply because they are the largest companies. In an alpha driven market, money flows into the companies with the best investment fundamentals.

Our core investment methodology is an earnings growth-based analysis. I for one welcome this as fundamentals like earnings and valuation will matter again and investors will see the benefits of active portfolio management.

For index fund investors and portfolio managers that have benefited from mimicking the index holdings over the past few years, this is the end of the world as they know – but I feel fine.


A Look at the Energy Sector

Monday, October 27th, 2014


If I were to be asked what the most successful sector of our economy were in recent months, I’d say that it was the Energy sector. The companies are making boat loads of money, the process (whether you agree with fracking or not) being used is extracting oil from fields that a decade ago were considered unretrievable, and in the distant future our country could conceivably be energy independent – we have already topped Saudi Arabia as the top oil producer in the world. Being energy independent is a hugely critical component of improving our national security and economic sustainability.

Then, you look at the graph above – and you see that over the past three months, the stocks of the companies in the energy sector have been by far the worst performers in the stock market.

Take a look at a selection of well-known energy companies stock price performance over the past three months:


If that isn’t an ugly chart I don’t what one is.

So is there a strategy here? Yes – at some point, these companies become a screaming BUY – the question is when. To determine that, you have to figure out where the bottom in the price of oil will be.

Realistically, you want some sort of fundamental reason and some technical reason to hang your hat on.

From a Fundamental perspective, I listened to a news conference by an OPEC Oil Minister (from Abu Dhabi, maybe) and he said that oil would bottom near $78 per barrel based upon their analysis. Today it closed around $80.60 – so we are pretty close from a fundamental perspective.

For the Technical perspective, lets look at a graph:


This is a ten-year graph of West Texas Intermediate Crude. You can see I’ve annotated it with a horizontal line a bit below $80 per share. You can see that the line originates in the early/mid 2000’s as a resistance level which was ultimately broken to the upside in the big oil boom, then again broken to the downside in the big oil bust, then has acted as support in recent years.

Based upon these two factors, we are likely fairly close to a near-term bottom in oil prices which should put a floor under the prices of oil stocks and present a buying opportunity.

However, there is never a guarantee – so our strategy is to start adding to shares of some of our favorite companies, and if they go down, buy some more. It’s not rocket science, but it is a proven strategy that has worked over the decades when shares of companies so significantly underperform the rest of the stock market.

We have started to nibble on some shares and will likely continue to add them at these reduced levels – its not likely to be a big winner in the near-term but in the fullness of time buying shares of a quality company like Apache at $73 when they were just at $105 several weeks ago will pay off for our clients.


ISIS Rockets Hit US Embassy in Baghdad

Wednesday, October 22nd, 2014

For the first time in a long time, Baghdad MAY have some impact on our markets here at home.

The Stock Market was down today ostensibly because Oil fell below $81 per barrel. However, what is not really being widely reported is that rockets fired by ISIS have hit the US Embassy in Baghdad. I have news alerts set to keep me informed about topics that could impact our management of stocks and bonds; one of those hit mid-day and I’ve been watching things since and have been surprised by the lack of coverage of this story by our news sources here.

You will probably recall that when this embassy was being built, it was touted as the most advanced US Embassy anywhere in the world, with the most security and most sophisticated weaponry around.

I don’t know what our government’s response will be, if any. However, if this situation escalates, it will not be good for the stock market – it will however be good for the bond market.

Check out this graph of today’s action in the S&P 500:
This story hit YouTube (uploaded by Iraqis) about the time that the market started downward. It might just be a coincidence but I think it bears watching – an attack on a US Embassy is the same as an attack on US soil. If we get drawn further into this situation, look for further volatility in the stock market and for bond yields to fall as investors make a flight for safety.

As things unfold, I will keep you up-to-date here on the blog.

But, not to make lite of the situation, I really want to watch this video:


Down the Valley of the Shadow

Wednesday, October 15th, 2014


‘Over the Mountains
Of the Moon,
Down the Valley of the Shadow,
Ride, boldly ride,’
The shade replied,—
‘If you seek for Eldorado!’
–Edgar Allan Poe

I don’t post a lot about the Treasury Note market – its the largest most liquid market in the world and as such it doesn’t move a whole lot during the course of the day.

However, check out the chart above of the yield on the 10-year Treasury note – that big valley in the middle of the chart is absolutely frightening. Kudos to Charlie from our staff here at the bank for bringing this to my attention. The question the two of us have is why didn’t the stock market drop 1,000 points?

To give you a feel for what this chart is saying, the yield on the 10-year note fell from roughly 2.2% to 1.85% almost instantaneously. The implication there is that a huge buyer came into the market, driving up the price (supply/demand dynamics at work) which drove down the yield.

For that to happen, either the buyer would have had to have been sitting on a bunch of cash earning nothing (doesn’t seem reasonable) or they were sitting on stocks that they had to sell to generate the cash to buy the notes. Well, since the stock market didn’t drop with the yield, that didn’t happen either.

Was it something synthetic? A derivatives contract or some futures contract? Did one of the big Wall Street Banks do something crazy or make a trading mistake?

What has me baffled is that after that spike down you see, the yield stayed low until close to the close of the market where you see it moved back up toward where it started the day, down only 2%. Did the Federal Reserve or the US Treasury come in and start selling bonds to drive the yield back up?

I am not sure we will ever know the answer to these questions, but whatever happened it is not the sign of a healthy market absent of manipulation. If something from the shadows can make this happen in the treasury market which is significantly larger than the stock market, how much manipulation is there is the stock market that is out of your control?

I’ll leave you with that as I ponder more of Poe’s poem:

By Edgar Allan Poe

Gaily bedight,
A gallant knight,
In sunshine and in shadow,
Had journeyed long,
Singing a song,
In search of Eldorado.

But he grew old—
This knight so bold—
And o’er his heart a shadow—
Fell as he found
No spot of ground
That looked like Eldorado.

And, as his strength
Failed him at length,
He met a pilgrim shadow—
‘Shadow,’ said he,
‘Where can it be—
This land of Eldorado?’

‘Over the Mountains
Of the Moon,
Down the Valley of the Shadow,
Ride, boldly ride,’
The shade replied,—
‘If you seek for Eldorado!’


Columbus Day Thoughts

Monday, October 13th, 2014

It’s Columbus Day and we are closed but I saw the article below in Bloomberg and thought it was a nice supplement to my post last week.

It does a
Nice job showing the extent of the correction and how it’s masked by the capitalization weighted S & P 500 Index:

THE CORRECTION IS ALREADY HERE – Bloomberg: “For most American stocks, the correction has arrived. While gauges such as the Standard & Poor’s 500 Index cling to gains for the year, declines that exceed 10 percent are spreading in the broader market. In the Russell 3000 Index, for example, 79 percent of companies are down that much from their highs … Concern the rate of global growth is slowing and the Federal Reserve is preparing to raise interest rates has pushed the S&P 500 down 5.2 percent from its September record.

“The 1,700-stock Value Line Arithmetic index, which strips out weightings related to market value to show how the average U.S. stock has fared, is down 10 percent since July. Three weeks of declines have broken the almost unprecedented calm that had enveloped markets for most of 2014. Eight trading days into October, the S&P 500 has posted six single-day moves exceeding 1 percent. The market went without any swings of that size for 62 days in May, June and July, the longest stretch since 1995. At the same time, the 5.2 percent decline that started in September is only slightly bigger than the last two retreats that exceeded 3 percent, in April and August. Both gave way to larger advances. At about 15 times forecast earnings, the S&P 500’s valuation has climbed 40 percent from the bottom in 2011, data compiled by Bloomberg show.”


Friday, October 10th, 2014


The Semiconductor stocks were absolutely crushed today, taken out back and shot. The chart above shows that the SOX index was down almost 7% today based upon a forecast by Microchip Technologies – a bell weather in the industry – that said the cycle is over and a bear market for tech looms large. Their stock was down 12.5% today – a horrid day for an otherwise reliable investment.

But this raises the question “what is really happening in the market?”

To understand what the typical company in the S&P 500 is doing, I like to look at the graphs of the number of companies trading above their 50-day and 200-day moving averages.

Here is the graph of those trading above their 50-day moving averages:


This graph is telling you that of the 500 companies followed by the index, only 145 of them are trading above their 50-day moving average, down from nearly 450 this summer.

Here is the graph for the 200-day:


You can see a similar thing here, with only 268 trading above their 200-day average compare to 450 this summer.

What these graphs are telling you is that most of the companies in the index are in correction mode.

The S&P 500 Index is an interesting thing – it is down a bit under 6% from its high – but most of the companies being traded are off SIGNIFICANTLY more than that. The reason for this is because the index is a cap weighted index and the top 50 companies in it have provided all of the upside to the index this year with the bottom 450 providing the downside.

Things are even uglier in the NASDAQ which is down roughly 10% from its high.

Corrections like this generally shake out the weak hands and provide opportunities for everyone else.

We raised cash at the top of the market and will have it to buy shares of our preferred companies significantly lower than they were trading just a couple of weeks ago. This is a good position to be in so we are not too upset by this volatility – its part of investing in the stock market and part of the process of managing your risk.

Next week, I will be discussing what some of the economic indicator graphs I follow are telling us about the possibility for a recession. With the 10-year treasury interest rate being pushed lower by the record amount of money flowing into bond funds, and Germany (Europe’s economic engine) staring a recession in the face – we want to make sure that the current pullback is temporary and not something that could turn into a much larger event.

More next week!


Another Triple Digit Loss for the Dow

Wednesday, October 1st, 2014


Double Click the chart above for a view that is not distorted

A big loss in the markets today as investors have begun to worry about international crises (protests in Hong Kong, Russia cutting off the natural gas supply to Europe, ISIS), the potential for falling corporate earnings, rising interest rates, a slowing US economy, a near-recessionary European economy, a continuing slow Chinese economy, and Ebola in Texas.

All of that, combined with it now being October – the month when most crashes seem to occur – has spooked investors who are selling shares of stock and raising cash. As most of you know that have been reading this blog over the past four weeks or so, we raised roughly 5% cash in client accounts back when the S&P was trading at record highs. I’ve explained our logic in previous posts, so I won’t bore you with that, but now that we have a roughly 4% correction in the S&P 500 under our belts I thought it would be instructive to see what the market is telling us.

So, lets look at the graph above in detail, from top to bottom:

> The Relative Strength Indicator (RSI) has dipped below the 30 level, indicating that on a short term basis, we are nearing an oversold point and are due for a bounce higher

> The purple area graph is showing you that the S&P 500 has gained about 14% over the trailing 12 months – well above the S&P 500’s historic average return of 8.98% since the beginning of 1957 when the index was created. Under the theory of mean revision, a bit of a pullback is not out of the question.

> The pink area graph is showing you that the S&P 500 has underperformed the NASDAQ Index by about 1% over the past year. Indicating that as we move into this correction, NASDAQ Index will likely go down more than the S&P 500 Index.

> The price graph for the S&P 500 Index shows us that over the past year, we have had four previous instances where the index has dropped to the 100 day moving average (the pink dotted line), closed below it, then moved higher – and no instances where it has dropped all the way to the 200 day moving average (the solid green line). We are due for a trip to the 200-day moving average – the market will tell us if that will be this time or not.

> The Volume bars show that on recent sell-off days, volume is above its moving average (the thin blue line). The black line above the volume bars is an indicator of supply and demand, and it shows that demand is waning.

> The turquoise area chart is a money flow indicator and it shows that money is flowing out of the market. The accumulation/distribution line above it (the black line) confirms this indicator as it is heading down as well.

> We next have two short-term indicators of market direction (Full Stochastics and Commodity Channel Index). Both indicate that on a short term basis, the market has moved down too fast and is due for some of the selling pressure to subside and the market to bounce higher – confirming the reading of the Relative Strength Indicator.

> And finally we have the two intermediate term indicators of market direction (the Moving Average Convergence Divergence indicator and the Know Sure Thing indicator). Both of these show that on an intermediate term basis, the market is in a downtrend. These can turn higher if we get a few days where the selling pressure subsides, but as of right now, they are saying to be careful of any move higher because it is just selling relief and not a change in intermediate term trends.

To give you a feel for how tough it was over the past couple of days in the market, take a look at this Market Capet:

The purpose of the Market Carpet is to give you a visual feel for what is happening in the market. This one shows you what is happening in the S&P 500 – you can see that predominantly the market is red with only a small section being green. That one quadrant that is green is made up primarily of utility stocks with a couple of companies with specific good news thrown in. That is an indicator of an unhealthy market and also goes along to support the intermediate indicators discussed above.

All in all, this is what we had a feeling about when we raised cash. The market had not made any sort of major move down in a very long time, corporate earnings had started softening, geopolitical news was negative, and October was on the horizon. We are very fortunate to have raised cash so that our clients won’t be hurt by this correction. When our indicators show we have bottomed, we will begin to buy our favored companies at prices well below where they were trading a couple weeks ago so that over the long term, our clients will benefit from this pullback.