“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes
Market Outlook October, 2012
The year 2012 has been quite an unusual ride for investors. After an impressive first half of the year, the expected summer doldrums turned into an unexpected stealth summer rally with the S&P500 rallying 80 points this quarter for a yearly return of 14.56% so far in 2012. The Aggregate Bond Index has slowly increased and has a yearly gain of 3.99%. Admittedly, we are a bit surprised.
On the surface these numbers are very encouraging. Hard to complain about markets that move slowly to the upside with little volatility (but weak trading volume, even for the normally bland summer months). On the surface everything appears to be a-ok. And a-ok it just may be, at least for a time.
“May you live in interesting times” is thought to be the English translation of a Chinese proverb, or curse, depending on your perspective. Regardless, it would be hard to argue that we are not in interesting times today. With the often reported issues surrounding Europe, the economic slowdown in China, and the U.S. Presidential election on the near horizon, there is never a dull moment. In the last few months unrest in the Middle East has reappeared. For the news and business networks this must feel like nirvana. CNBC Rejoice!!!
All of the above “issues” certainly present a risk to asset values in the coming months, albeit short-term in nature by our calculation. We see it happen every week. Bad news comes out of Spain one day and the global markets sell off. The next day a piece of good news hits the news wires and assets regain their previous values. Market action of this type is now expected.
Longer-term, these issues will get worked out one way or the other. Europe will either embrace greater fiscal unity or the Euro will implode; China will either stimulate their respective economies or will see stagnant or negative growth; we will have an election the first week of November that will help determine the path we take to resolving our fiscal issues; the Middle East will likely continue on as it has for centuries.
But these risks are the known unknowns. We are not sure how they will get resolved, but we know they are out there and we can get a grip on what is happening. When something happens (or doesn’t happen) one way or the other we are not caught off balance by the totally unexpected. Think of these as the front page stories of the newspaper you used to have delivered to your house. While interesting, all these issues can and have been discounted by the markets in one way or another.
Of great interest to us is the slowdown we have seen in both corporate revenue growth and earnings growth rate. In the second quarter growth rates flattened out due to European economic issues as well as U.S. Dollar strength vs. foreign currencies. Or at least that is the story told by most all multinational corporations when they reported earnings. The situation was seen as a quarterly glitch. Top line and bottom line growth would resume over the summer months.
Now, with reporting season ready to start on October 8 with Alcoa (AA), the story has changed once again. It appears that third quarter earnings will be less than impressive with revenues stagnant. As expected, the analyst community has lots of reasons (read: excuses) that include the Eurozone recession, China slowdown, and U.S. corporations holding back spending due to the “uncertainties” of the fiscal cliff. In other words, the known unknowns are leading us into the current earnings slowdown.
In the face of all of this terrible news – to the surprise of some – the markets have produced a stellar year thus far. The Dow, the S&P500, the NASDAQ, as well as bonds in general have definitely outperformed expectations. A decoupling of stock prices and fundamentals is upon us. As so often occurs, the markets have become irrational.
British economist John Maynard Keynes is considered to be one of the founders of modern macroeconomics, and best known for his ideas on the use of fiscal and monetary policies to stimulate the economy during recessions and depressions. His economic theory has become commonly known as Keynesian Economics. It is less commonly known that Keynes was a very successful speculator and investor, who ultimately traded himself to great wealth after nearly going bust during the 1929 stock market crash.
Over his investing career he learned many lessons regarding markets. During the aforementioned market crash he learned the painful lesson of irrational markets and the extent of irrationality that result from human emotions. From a practical standpoint, most investors embrace the “good” irrationality of markets moving higher and fear the “bad” irrationality of markets moving lower. Currently we are experiencing the “good” irrationality of higher equity prices that ignore poor earnings reports and discount global economic ambiguity.
In retrospect, our viewpoint last quarter of expecting little damage to result from the slowdown in earnings was conservative. We were on target with our assessment of the situation we faced, but wrong on the extent of the positive market reaction. What we missed was action by the U.S. Federal Reserve Bank (“The Fed”) to continue stimulus until further notice and the consequential continuation of market irrationality.
Looking ahead to the final three months of the year we are cautiously optimistic with the expectation of further advances in the stock market indexes. Will earnings come in lighter than we would like to see? Yes. Will there be bad news from Europe and China? Absolutely. Will the 2012 Federal elections definitively resolve our fiscal problems? We doubt it.
Beyond the next three months we can envision a scenario where the stock market averages reach or exceed their 2007 highs, not based on the flawed fundamentals, but based on the technicals. Below is a chart of the S&P500 going back to April, 2012. We have noted the classic cup-with-handle pattern and the breakout above resistance on September 6. We are currently (October 3) experiencing some consolidation with the belief that we will remain above 1420 and eventually continue to move higher. A move to higher levels, however, would not be a smooth ride but more two steps forward and one step back, likely coinciding with news events stemming from our three known unknowns. A break below the 1420 level would nullify this breakout, resulting in more consolidation or a market correction.
What Do We Do Now?
Assuming we are correct and the stock market continues to move in a positive direction, it is important to remember that the fundamentals are not in agreement with the market direction. Markets are not cheap and are getting less cheap as stock prices move higher. With The Fed’s September announcement of QE3 and low interest rates into 2015, there was a shift in the market environment that favors higher asset prices. And, while some very smart people have opined that this will all end very badly, we are not totally convinced.
We believe that the stock market will eventually head lower, as it has in the past. Corrections are a part of investing and we are in a secular bear market environment. With stock market indexes heading to the top of the range (roughly between 700 and 1550 on the S&P500) caution is a virtue. That doesn’t mean shun equities, just be aware of the situation and consider cautiously taking advantage of the irrationality.
The next correction, when it arrives will be different than the previous one. In 2008 the world faced one of the hardest financial crises of modern times as a number of major financial companies imploded. When it starts or what starts it is anyone’s guess. How it will play out will be determined by why the turn occurs. More than likely it will be from something that is currently unexpected, or an unknown unknown.
Income investing continues to be challenging. Because of the low-yield environment we continue to see investors who are taking on more risk than they realize as they chase yield. The average investor is frustrated with the returns they receive on their money markets and bank issued CDs. Over the past few years there has been a movement from these investment vehicles to other types of investments that offer a greater yield, but a much different risk profile.
At Magellan Financial we believe that income investment has changed and what has worked for the past 30 years is no longer applicable. A different approach must be taken. For more details, please refer back to our Market Outlook 2012.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
Market performance is no longer being driven by economic fundamentals but more by the quantitative easing policies being carried out by The Fed. The technical background of the market is strong and suggests that 2012 could be a year of extraordinary gains for the equity investor. We even see a possible melt up. As a result, we remain positive with an understanding that any growth in stock valuations is more likely to be a result of expanded price-to-earnings (PE) than top line or bottom line growth. And while we do not believe this can continue on forever, we do believe it can continue on for longer than logic dictates. After all, Keynes was correct – markets can stay irrational longer than you can stay solvent.
Past performance is no guarantee of future results. Dividends are subject to change or elimination and are not guaranteed.
Indices are unmanaged and you cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
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.
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