“We sail within a vast sphere, ever drifting in uncertainty, driven from end to end.” – Blaise Pascal
“The financial markets are generally unpredictable. So that one has to have different scenarios … The idea that you can actually predict what’s going to happen contradicts my way of looking at the market.” – George Soros
Admittedly, this is a hard letter to write. Here we are starting the 4th quarter with a stock market that has performed much better than most people expected – the major averages all with gains greater than 16% for the year – well above the previous all time high levels for both the Dow Industrials and the S&P500. The Nasdaq isn’t close to the March, 2000 highs, but not a rational human being could have expected that to happen this year. Bonds are generally down, but Magellan and almost everyone else has been expecting this for years. So why is this so hard to write? Uncertainty.
We enter October with a Federal Government that is shut down, a debt limit crisis that could happen in the middle of the month, no end to quantitative easing by The Fed, a good but not great economy, Syria, and on, and on and, on. On the positive side we have global economies that have been improving, most notably in Europe, corporate earnings that have been surprisingly strong, global coordination on Syria (at least on the surface), the U.S. and Iran talking after more than 30 years, improving but not stellar employment numbers, increasing U.S. energy production … All of this with U.S. stock indexes doing well.
In our minds it all comes down to one question: Are we picking up dimes in front of a bulldozer waiting to get crushed, or will this continue to be real?
From a pure technical perspective we see a market that has been making new highs, but appears to be a bit tired and ready for a rest, or dare we say possibly another, more severe correction. As we noted three months ago, relative strength was not following the markets higher. This has continued. Our conclusion in July was:
“… 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.”
And that is what happened, albeit not to the extent that we had expected. Instead, the correction was short and “V-shaped,” we hit new index highs, and nothing seemed to change.
Chart #1 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
Unfortunately investing is never quite so simple. As the George Soros quote above implies, financial markets cannot be predicted and forward looking scenarios are important. While we believe in technical analysis, this type of study comes down to a study of supply and demand. At Magellan Financial we believe you also need to understand the underlying fundamentals of the economy to comprehend how markets may react going forward.
At home we have an economy that is being driven by credit sensitive areas of the economy, specifically, automobile sales and the housing market. Historically low interest rates have enabled these two areas of the economy to thrive, producing jobs and economic growth. This has been a huge positive in digging our way out from the Great Recession. Going forward, however, we also know that higher interest rates can and probably will at some point become an issue for these two vital economic components.
With a possible end to quantitative easing in the coming months, longer-term interest rates have increased while short-term interest rates remain pegged close to zero. At some point we believe rates will hit a level where it affects the buyer. The level at which this happens it the great unknown.
Interest rates, and what the average investor can receive from their bond investments, also play a role in how stock markets are valued. With low interest rates, in theory, investors are more willing to pay a higher multiple (P/E) for equities; as rates move higher, multiples contract. Currently, one could conclude that equities are expensive, cheap or fairly priced, depending upon your method of valuing markets. Going forward, we think that an increase in interest rates will have a negative effect on stock markets, what is unsure is the timing and severity of those changes.
On a very positive note it appears that Europe has pulled through its recession and is showing signs of economic growth. This has been good for their stock markets, but it is also good for large U.S. multinational corporations that sell into these markets. Combine this with continued growth in Asia and South America, the revival of more balanced global economic growth should give global stock markets a boost in the coming years.
Chart #2 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
After a big move in the second quarter – due mainly to concerns of The Fed removing market support via bond purchases (Quantitative Easing) – bond yields have stabilized, albeit at much higher levels. As chart 4 shows, yields remain relatively robust but stabilized. In the coming weeks and months this chart has the ability to become very interesting, with the Federal Government currently shut down and a debt ceiling crisis looking like it could become a real thing. If/when that is resolved we can once again focus on the quantitative easing program.
Chart #3 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
Commodity markets are another economic variable that needs consideration. The movement of commodity prices gives a hint at what is happening economically on a global basis. When prices are moving down it can be a sign of a slowing economy and deflation; higher prices project growth and eventually inflation. Ideally commodities price like Goldilocks – not too hot and not too cold.
Copper – the economic barometer of choice for many – lagged for most of the first half of 2013 on fears that a slowing Chinese economy would be bad for global growth. Since then it has turned constructive, not into a definitive bull market. Stabilization is positive.
Chart #4 Courtesy of www.stockcharts.com. Indexes are unmanaged and you cannot invest directly in an index.
So what’s the, what’s the scenario?
That’s the million dollar question, right? Under normal circumstances, whatever that may be, this would not be a hard question to answer. Take away all the political nonsense and possible worst-case scenarios and we have a steady, more balanced global economy that looks sustainable. At home we have good, not great growth, but a burgeoning energy sector that is creating jobs today while laying the seeds for growth of the manufacturing base and sustainable economic output. At some point (hopefully sooner rather than later) The Fed will start to taper the bond purchases and end what is known as “Quantitative Easing.”
But these are not ordinary times.
Scenario #1 – Washington works out its issues doing minor economic damage, maintaining what can now be considered the status quo. Here we would expect markets to continue to be positive in the longer run. In the short-term, even without the drama of politics, the stock market indexes are starting to show some technical issues that suggesting either a continuation of the sideways markets of the past few months or an actual correction. And with economic growth still below 3%, we expect bond yields to stay in a trading range around the current levels. It may not come quickly or easily, but we think this is the likely outcome.
Scenario #2 – Washington has a major breakthrough, comes to a long-term solution to funding the Federal Government and entitlement reform. We are not expecting this to happen in October, but instead come about with the two sides negotiating over a few months. We have no opinion on how this would go or what the agreement would look like, just that any negotiated, long-term agreement would be positive. In the short-term we would expect equities to perform well, with bonds likely to see higher yields (and lower prices). Longer-term, we would expect a deal to be positive for the economy, more normalized interest rates and positive equity markets. Right now this seems like a fairy tale ending that is not likely to occur anytime soon.
Scenario #3 – Nothing gets resolved and the U.S. technically defaults before Washington settles on a solution. Quite frankly, we find it hard to believe that it will come to this, but it cannot be ruled out. While no one knows how it will play out in such a state of affairs, nothing good can come from it. The economy will be damaged as will the markets at home and abroad. It could be bad; or not so much. Really, it hurts just thinking about it.
Some of the greatest investors of our time are excellent poker players. This makes sense. Both deal in risk management and probabilities; both require reasoning skills and patience; both deal in uncertainties. In a game of poker you have some information available to make a decision, but not all the information available. An investor has access to reams of knowledge, but no guarantee of the final results. In either endeavor you can be right with your idea and strategy, but not get the outcome you expected, even in the best of times.
Which brings us back to this: Are we picking up dimes in front of the bulldozer waiting to be crushed, or is this for real?We believe the next few months will be a challenge for both the stock market and the bond market in all but the best-case scenario. There may be some short-term rallies, but we do not see the final quarter looking like the first few months of the year. What the resolution in Washington looks like will help determine how deep of a correction we get as well as how long it lasts.
We are still positive for the longer-term, knowing that the economy is slowly healing itself and looking sustainable. The United States has just surpassed Russia as the world’s largest energy producer, manufacturing continues to grow, and the housing sector continues it rebound. The seeds of economic growth have been planted. It will take some time, but we see a bright future that will ultimately reward the patient investor.
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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.
Investing in commodities is not suitable for all investors. Exposure to the commodity markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk.
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