Oct 22, 2013

3rd Quarter 2013

The third quarter of 2013 was marked by lackluster earnings, concerns about the Fed

from both a succession planning and near term policy standpoint, continued middling

employment growth, geopolitical uncertainty, a rip-roaring auto market, and another

debt ceiling fight in Washington. We also received a creative English lesson as to the true

meaning of the phrase “Red Line,” which might be this generation’s version of “It depends

on what the meaning of the word ‘is’ is.” In spite of the many concerns, the S&P 500 still

managed to rise 5.2% in the quarter for a 19.8% increase for the year, while the Barclay’s

Aggregate was up 0.6% in the quarter but has declined by 3.5% (2% net of dividends) for

the year.

Domestic View and Equity Markets

Earnings growth continued to slow in the quarter for much of the S&P 500, yet investors

didn’t seem to care as they piled money into equity funds at the expense of fixed income.

Sales growth was even weaker than earnings growth, posting an increase of 1.2% in the 2nd

quarter. Valuations need to be watched in this environment. When stock prices rise faster

than earnings, stock valuations are expanding. While valuations aren’t in the “red zone,”

they are getting extended at roughly 16x earnings.

Soft wage growth, high unemployment, high fuel costs, and a favorable currency situation

have made it more attractive for companies to migrate their manufacturing back to the US.

Major manufacturers that are on-shoring operations have reached 21%, compared with

10% last year, according to a study by The Boston Consulting Group. More than half of

manufacturers with sales exceeding $1 billion intend to shift work, or will evaluate shifting

work, from China to the U.S.

Market prognosticators continually attempt to find historical patterns in the markets to

predict what might happen in the future. Many are now focusing on 1954, which was the

first year in which stock prices exceeded their 1929 highs after the Great Depression, as a

comparison to 2013. In the chart below you can see the high correlation (.95) between the

two years. The biggest difference is the magnitude of increase, with stocks rising 30% in the

first three quarters of 1954 versus 19% so far this year.


S&P 500 1954 versus 2013

Just in Case You Were Wondering

The world’s most famous index, the Dow Jones Industrial Average, changed constituents this quarter. The index dropped Hewlett Packard, Alcoa, and Bank of America, replacing them with Goldman Sachs, Nike, and Visa. A question we often receive is why we don’t use the Dow as a benchmark. We can’t think of a single firm that uses the Dow as a benchmark because one of the requirements of a benchmark is having the ability to replicate the benchmark by investing in its holdings. Although the 30 stocks in the Dow are highly liquid and part of many other indices, the Dow is price-weighted, which mean it is virtually impossible to replicate in a portfolio. A price-weighted index is one
in which the higher the price of a stock, the bigger impact it has on the index. In an actual portfolio, it’s the number of shares combined with the stock price and dividends which determine the value. A capitalization-weighted index, such as the S&P 500, more readily lends itself to replication.

The Fed

Will the Fed ever be out of the news? The two biggest items of note swirling around the Fed this quarter have been tapering and succession. Heading into the Fed’s September meeting, the majority of market participants anticipated that the Fed would begin tapering or slowing its monthly purchase of bonds from $85 billion per month to a modestly lower value. Many Fed members, including Chairman Bernanke, had suggested that a tapering would be a probability, and in fact the Fed had
signaled through its various market communication tools that a tapering would occur. Investors were surprised and markets soared when the Fed decided to keep its existing program in place, citing a recent softening of economic data.

In our view it would appear that the Fed’s historic accommodations have been met by a fiscal tightening coming from Washington and the economy itself. Real wages haven’t increased at all over the past five years; federal spending has declined slightly due to the sequester and the pull back from Iraq; significant tax increases kicked in this year; interest rates have risen; and the cost of living continues to increase. All of these factors have created a de-facto tightening of fiscal policy, occurring while the Fed attempts to provide a looser monetary policy. While not new, the tightening and the accommodation are conspiring to offset each other.

Fed succession has been a hot topic of conversation ever since President Obama announced that Chairman Bernanke would not be coming back for another term. Speculation has been focused on two candidates: Former Secretary of the Treasury, Lawrence Summers, and current Vice Chairwoman of the Federal Reserve, Janet Yellen. Mr. Summers was viewed as being more hawkish towards inflation, while Ms. Yellen was considered to be more dovish towards inflation. In the old days, before 2008, a more hawkish chairperson would have received better acceptance from the bond market as the expectation would be a more vigilant fight against inflation. In today’s world, where the markets are addicted to the stimulus provided by the Fed, the threat of a hawk heavily concerns the bond market. When Mr. Summers recently withdrew his name from consideration, the bond (and stock) markets viewed the news positively as the assumption was that the Fed’s monetary accommodation would remain in place. In the long run ignoring (and trying to ignite) inflation could be a risky strategy, but for now it seems to be welcome medicine to the market.

The Economy

US economic data continues to be mixed, but with a slightly positive bias. GDP for the 2nd quarter came in at 2.5% and is estimated to increase by less than 2% in the 3rd quarter. Pending home sales have softened significantly from the spring as mortgage rates (see chart below) have climbed from a low of 3.3% in late 2012 to 4.3% today.


A statistical oddity makes it challenging for the Federal Reserve to decide whether to start scaling back its bond-buying program based on unemployment data. US joblessness dropped to 7.3% in August because people gave up their search for work. The proportion of working-age people holding a job or looking for one has fallen to its lowest level in 35 years. The Fed could be in a position where the unemployment rate is low, but the number of working adults hasn’t progressed.

Global Perspectives

Europe finally appears to be gaining some traction, a nice switch from the past half-decade or so. The Eurozone PMI rose to 51.5 in August, the fastest rate of expansion since 2011. The services index also posted a positive number at 50.7, its first increase in 18 months. Germany, Italy, and Spain are actually growing, while the declines in France are moderating.

In Asia, Japan continues its impressive recovery as loosening monetary policy combined with massive rebuilding after the 2011 earthquake and tsunami have helped fuel the Japanese economy. GDP growth for the 2nd quarter was 3.8% while capital spending rose for the first time in six quarters. The biggest question is whether a pick-up in demand will force Japan to reduce its $800 billion in holdings of US debt. If so, it could put additional pressure on our Fed to defend rates.

China, which has been struggling for the past two years, is finally showing signs of a rebound, which is positive for the

other emerging markets as well as the Eurozone. The Chinese PMI is now back above 50. Overall it appears that most of the world’s major economies are experiencing a modest recovery.

A Civil War in Syria nearly pushed the world to the brink and has tested the resolve of our leadership. After issuing a red line warning, the Administration punted to the UN when a defiant Syria chose to cross that line. In a Clinton-like “define is” response, President Obama said: “I didn’t set a Red Line on Syria, the world did.” George Orwell would have loved this doublespeak.

Bonds and Debt

Bond yields began jumping in late spring based on the anticipated tapering by the Fed. The yield on the 10-year treasury peaked at just over 3% in early September after hitting a multi-generational low of 1.3% in July of 2012. While investors will eventually appreciate the accompanying higher yields on new fixed income investments that should generate better income, the result has been a difficult 14 months for bonds. Since peaking when bond yields troughed, the Barclay’s Aggregate bond index has declined by nearly 5%, which is the first decline since 1994.

Washington Policy

Politicians have been bickering over the budget deficit, Obamacare, and whether to continue to fund the government or not. Sounds a lot like the summer of 2011, but in fact it is occurring as we go to press. The House has passed one budget resolution, the Senate another, and they can’t seem to agree, or possibly don’t want to agree. The last time we had a debt crisis the markets got whipsawed. Our guess is that unless the government goes into an extended shutdown, markets will have a slightly negative bias around the news. Given this is the 17th showdown on funding the government in the past 30 years, and all 17 have resulted in a funding bill passing, we are confident that this too shall
pass and an agreement will eventually be reached.

Are we the only ones who find it unusual that the President is willing to negotiate with both Russia and Iran, but not the United States Congress?

Obamacare Update

The much ballyhooed (or maligned) rollout of Obamacare has been abysmal so far.  After spending somewhere in the neighborhood of $6 billion to launch the website (about 3000x more than EBAY spent on their initial launch), it has been a failure.  The website doesn't work, and the people responsible, well, won't take responsibility.  We are trusting social security numbers and other personal data with a website that doesn't work.  Anyone want to guess where the next big cyber-security threat will occur?
Does anyone else get concerned when the people who are proposing to takeover 1/6 of the US economy can't launch a working website after working on it for three years? 
The American people have digressed into a populist mentality, and Obamacare is the most recent of what should prove to be the takeover of many industries in an effort to "level the playing field."  Unfortunately, the Administration doesn't recognize that its tax and spend policies, combined with aggressive Fed intervention, are responsible for increasing the divergence in wealth between the 1% and the 99%. 
“Freedom is never more than one generation away from extinction. We didn’t pass it to our children in the bloodstream.  It must be fought for, protected, and handed on for them to do the same, or one day we will spend our sunset years telling our children and our children’s children what it was once like in the United States where men were free.”

- Ronald Reagan.


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