“Life is a series of natural and spontaneous changes. Don’t resist them; that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like.” – Lao Tzu“Happy, happy, joy, joy Happy, happy, joy, joy Happy, happy, joy, joy, joy” – Ren & Stimpy
What a crazy year it has been thus far in the financial markets. After months of calm, steadily rising stock prices and interest rates pinned near historically low levels, Fed Chairman Ben Bernanke’s comments to Congress on Wednesday June 19 changed all that. To paraphrase the Chairman, at some point in the future, when things appear to be better than they are now, asset purchased by The Fed will begin to be reduced. He reiterated that inflation levels remain low, unemployment is above where they would like to see it, and there was no immediate need to start increasing the Fed Funds rate. But again, at sometime in the future – maybe not as far into the future as some had expected/hoped for – policy will change. And it was at about that time that the current market correction began to take shape.
I mention this not because it is something that will be important 25 years from now (or 25 months from now for that matter), but because it is the excuse that markets have been waiting for. The stock market indexes finally produced a greater than 5% correction while, at the same time, money began to leave the bond market as investors appear to have become cognizant of the idea that interest rates are not likely to stay at current levels forever. Imagine that.
Fortunately, here at Magellan Financial, we are investors, not traders. As investors the day-to-day movements of the market are interesting, but the focus is on what is happening in the big picture and how that will affect our client’s long-term financial concerns. The words of Chairman Bernanke concern us only in how they will affect market trends. We are concerned with where stock market valuations are heading as well as bond yields over years, not days. And with many stock market indexes trading around all-time high levels and bond yields moving higher, it feels like a good time to ask if we are on the verge of some longer term trends changes. But first, a look current market performance.
The first half of 2013 was very good to equity investors of U.S.-based stocks, with both the Dow Jones Industrial Average (DJIA) and the S&P500 posting all-time record highs for the second straight quarter. For the quarter, the Dow added 331 points to close at 14,909.6 for a year-to-date (YTD) return of 13.78% while the S&P500 closed up more than 37 point to close at 1606.09 for a 12.63% gain. Global indexes continued to lag with the MSCI EAFE turning in a 6-month return of just 2.18%. The debt markets sold off in June as bond yields continued to rise. The iShares Aggregate Bond Index ended the first half of the year with a loss of 2.46%. Commodity markets, with just a few exceptions, were down. Most notably, Gold and Silver lost 22.62% and 28.61% of their respective values, Sugar was down more than 22%, and Copper prices fell close to 11% from where they started the year. On the plus side were Cotton (+17.65%), Natural Gas (+27.12%) and Crude oil (+14.14%).
Where are we now?
In our Late May Market Update we discussed the coming correction in the stock market indexes and the three forms said correction would likely take. Of the four scenarios, we now believe that a “normal” correction has started. With the S&P 500 currently trading below its 50-Day Moving Average and the Weekly MACD indicating more market downside, the market technicals lead us to believe this current correction continuing from here. Really a matter of how deep of a correction it turns out to be. If the last few sentences were too wonkish for you, that’s ok. Here is the bottom line: we believe more short-term downside as the likely scenario for the stock market. We also see this as a standard, necessary countertrend to a stock market that we believe has not yet reached its ultimate peak for this cycle.
One question we periodically get from clients goes something like this: “Now that the stock market is once again at the same levels as March, 2000 and October, 2007, why should we remain in the market? Don’t you remember what happened the last two times we were here?” And from the monthly chart of the S&P500 below (chart #1) you can see the similarities are obvious. From a pricing standpoint we are just above the old highs; Relative Strength (RSI) is peaking; the market has been moving higher for years. The heart of the inquiry is really about what is going to happen longer-term, not next week.
Chart #1 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
And this is where things get murky. The question above is specifically about stocks and the stock market, but stock market pricing is about many different factors, including, but not limited to the bond markets, global bond markets, the currency markets, the global economy, commodity markets, U.S. employment, actions by The Fed (and the global equivalents of The Fed), corporate earnings, as well as sentiment (both investor and business). Not only was that a crazy long sentence, but it was a lot to take in. Here is a look at what we see as important in the second half of the year:
Economic factors: The U.S. economy has been growing at a moderate pace, but has been moving in the right direction for a number of years. Employment has been recovering from the Great Recession, but is not where anyone would like it to be. Corporate earnings have recovered, but revenue growth has stalled while the pace of earnings growth has slowed. Europe is improving, as the ECB has moved toward more stimulus-type policies. Over in Asia, Japan is in the middle of a grand economic experiment while China’s economy has been slowing.
Bond Markets: After 30+ years of interest rates moving down, U.S. Treasury Bonds have started to move off of the record-low yields, resulting in lower bond prices. The reaction has led to other interest rate sensitive arenas to lose value, including mortgage backed securities (CMOs) and Emerging Market debt. The more credit sensitive areas of the market have sold off as well. According to industry data, investors appear to be reacting by selling bond mutual funds and exchange traded funds (ETFs). You can find a more in depth look at Interest Rates here.
Chart #2 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
Commodities: The second quarter saw a hard selloff in both gold and silver, two commodities that have produced what we would consider extraordinary gains over the previous decade. But other areas have not done well either, most notably copper. Copper is important as it is an industrial material that is commonly used. Many see copper pricing as a look into the global economy as a whole, with higher copper prices equating to stronger demand, thus a stronger global economy. Lower copper prices are negative for global growth.
Chart #3 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
Currencies: In case you didn’t hear it from the talking heads, the U.S. Dollar has been strengthening against a basket of foreign currencies. But that doesn’t tell the whole story. For example, after decades of weakening vs. the Japanese Yen, we are seeing what we believe is a major shift in this relationship, due mainly to the economic policies in Japan under Prime Minister Abe. On the other hand, the U.S. Dollar has been slowly weakening vs. the Chinese Yuan, a situation that is not likely to change anytime soon. How the dollar trades against foreign currencies has real world effects on both multinational corporation’s profits, but also where global money flows for investment.
Chart #4 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
Actions by The Fed: Quantitative Easing (QE) continues on, but with the markets unsure of Chairman Bernanke’s timetable for slowly moving away from $85 Billion of monthly bond purchases. The winding down of this program can be seen either as a positive or a negative. On the sunny side, a lessening or discontinuance of this policy would mean that The Fed feels comfortable enough with the economy to back off the level of stimulus it has been infusing into the markets. On the cloudy side, there will less/not more stimulus for the markets, causing pricing of assets to be more dependent on economic factors, be they good or bad.
Inflation/Deflation: Currently the inflation rate is low and stable. The Fed has used the fear of deflation as justification for policy decisions over the past few years. Currently, the stimulus has not created a spike in inflation feared by many. Any drastic change to the current situation would have an effect on how the market prices stocks, bonds, and commodities.
Investor Sentiment: What we have observed is a mixed bag. The question referenced earlier gives credence to the reality of investor skepticism, as does the skittishness seen in the reported sentiment numbers. In general, the mood has been moving quickly from positive to negative. Because sentiment is a contrary indicator – as in, when “everyone” is happy with the stock market it is usually not good for the immediate future of equity prices – a mixed bag is a positive in our eyes.
What we have is a global economic mixed bag, essentially propped up by global central banks, with the United States appearing to be in the best situation, but not what we would consider to be outstanding. The list of countries with problems is long, for sure, and the commodity markets have reflected the current reality. The exception to this would be oil prices if political issues in Egypt put a strain on distribution. Back home, the bond market has become interested in life after QE at a time corporations are seeing slower growth. Not a disaster, but not the ideal.
Right now, in the fifth year of a bull market, we believe that there is more upside to the stock market after a period of correction/rest. Current valuations of the equity markets are not unusually high or unusually low, based on where we are in the interest rate/inflation cycle. But that is not really why we think there is more upside. For Magellan Financial, it all comes down to The Fed, stimulus, and market reactions to Fed policy moving forward.
What our own research has shown is that economic growth is not the major factor in determining how “the market” performs, but these other factors. For now, stimulus will continue, likely with continued outflows from bonds, but not necessarily substantially higher bond yields. For the equity markets, continued stimulus, lower commodity prices, stable bond markets, and minimal inflation are nirvana.
Going forward we will continue to watch the stimulus from central banks as well as how the markets react to eventual changes in policy. This is where we believe the first significant changes for the market will occur. We will leave the discussion as to when this might occur to the talking heads.
We will also be concentrating on inflation and/or deflation and its relationship to how the market values equities, bonds, and commodities as the implications can be significant. Generally speaking, when inflation increases the stock market will have a lower valuation on a price-to-earnings (P/E) basis. P/E will also decrease in an economy caught in a deflationary cycle. In a deflationary situation, bond yields have historically contracted (bond prices increase) while commodity prices decrease. Inflation causes increases in bond yields (lower prices) and commodity prices.
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Past performance is no guarantee of future results. Dividends are subject to change or elimination and are not guaranteed.
Stocks offer long term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investments that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than investments that are more diversified.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
The FDIC standard maximum deposit insurance amount per depositor per insured depository institution for each account ownership category is $250,000.
This and/or the accompanying statistical information was prepared by or obtained from sources that Magellan Financial, Inc (Magellan Financial, Inc is a separate entity from WFAFN) believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Additional Information is available upon request.
Jonathan D. Soden Robert I. Cahill
Partner Managing Partner
Ann L. Drescher Jeffrey T. Bogert