September 2013

………………Thoughts and Comments

Taking the Markets’ pulse

Part 1:  Corporate Economics

Second quarter earning are in and the results are far from impressive, but you wouldn’t know it looking at the market action.  The average growth rate of revenues in the S&P 500 (ex financials) was just over 2%, but this masks how much deviation there is – the median growth in revenues is just 0.3% (see chart 1).

Chart 1 – Data supplied by S&P Capital IQ


Net income (not impacted by shares outstanding) growth shows the same trend, only weaker; the average growth rate of net income was a -0.90% (see chart 2).

Chart 2 – Data supplied by S&P Capital IQ


Earnings per share grew at a similar rate to revenues, rather than net income, but notice that share buybacks increased, thus helping to elevate earnings per share, leaving a false impression of growth (see charts 3 and 4).

Interestingly, margins, which peaked more than a year ago, are still fairly strong, although they continue to fall slowly, although in a very choppy manner.   P/Es, on the other hand, are back close to multi-year highs, even with growth having consistently slowed for over a year now (see chart 5).

Chart 3 – Data supplied by S&P Capital IQ

Chart 4 – Data supplied by S&P Capital IQ

Chart 5 – Data supplied by S&P Capital IQ


From a sector point of view, technology was mostly weak and retail was really weak.  Banks did better thanks to trading and mortgages, but the biggest mortgage lenders all announced layoffs, saying mortgages were slowing.  Energy did well, although its expenses continued to rise.

Part 2: Government Factors

Today, it was announced that Larry Summers has withdrawn his bid to become the next Federal Reserve Chairman.  Conjecture, according to the Wall Street Journal, is that far-left leaning Congressional representatives hold him partially responsible for the banking crisis and so do not want him; they want Janet Yellen.

Apparently, the President, according to the Journal, doesn’t want Yellen because he doesn’t like to be told whom to pick and so he is considering former Fed Vice Chairman Donald Kohn instead.

The person chosen is likely to make little difference, as we expect that whoever that person is, he or she will want to continue the Quantitative Easing that is in now in its fourth iteration.  While we would not be surprised to see the Fed announce that they will begin tapering the QE from $85 billion per month to some slightly lower monthly figure this week, the impact will be to continue to manipulate the markets and print money.

Inflation is currently being offset by the fact that the entire world is struggling to grow and so everyone is doing what we are doing – depreciating their currencies so that they can sell products abroad.  Of course, this will only work for so long before it comes back to haunt everyone with higher prices and weaker economies.

At the same time as the Fed issue is forcing its impact on the markets, so is increasing government regulation.  New regulations are being advanced on coal, car mileage, drilling, banking, healthcare, minimum wages and employment, just to name a few – all  adding to the economic burden of companies, which becomes the economic burden of individuals.  Remember, one of the largest, most expensive sets of regulation, the new healthcare laws, start to impact the economy in November.

We are strong believers in some government regulation, without which there would be chaos.  But at the same time, too much regulation (the federal government has never found a rule, regulation or law that they didn’t think they could make better by expanding and complicating) can cause an equally harmful impact on the economy.  We are starting to see that now.

Finally, as part of this government-invoked chaos, we have the latest attempt by Congress and the President to come up with a budget and increased spending limits at the end of the month.  Likely, they will continue to kick the can down the road and come up with some short-term, temporary solution.

Part 3: Wall Street Impact

The vast majority of trading, as we have noted for several years, continues to be professional traders.  Using massive leverage and special rules that the exchanges have written for them so that they can continue to prosper, these traders continue to whip the markets around.

With the almost free money that is provided to them by the Fed (see Part 2), quick, violent moves in the market provide these people with their greatest profits; if the markets just sit there, they can’t make a profit – they need the volatility – and so they create it.

Market Strategy

So what does all of this mean to investors?

If we add up the pieces, we have the following equations:

Equation #1:

Fundamentals Are Too Expensive + Continued Fed Intervention + Traders Want Volatility = Markets Will Continue to be Volatile.

We note that it has been five years since a recession, which means the “economic expansion” is long in the tooth.  Given that the recovery has been so weak, however, and with so much government manipulation, this could continue much longer.  Yet, it has also been two years since we have had any correction of at least 10%  – two years in which growth has slowed, yet the S&P 500 is up 33%.

The argument for the stock market growth has been the strength in housing.  Yet, digging into the numbers determines that once again, this is due to Wall Street.  Most of the buying is being done by large funds that have decided that single family homes are now an asset class.  They have raised billions of dollars to purchase homes that they intend to rent.

The question is not whether they will make money – which we doubt given the prices they have paid for the properties. It is whether demand is as strong as it seems.  The fact that the banks all announced recent layoffs in the mortgage area seems to confirm that housing is not the broad positive economic development suggested.

Equation #2:

Leverage Is At Highs + Investors Have Increased Their Risk Profiles + Markets Are Not Pricing in Risk = Potential Losses Could Be Large

Many investors are buying stocks to replace their income that they cannot get out of fixed income.  Yet these are the investors least able to weather stock market losses.  At the same time, investor margin levels are back to 2008 highs.

The stock markets have not priced in any of the potential risk at this point.  While everyone knows many risks exist, stock prices are at highs.  At the same time, worries are quickly ignored and pullbacks are quickly replaced with higher prices.

For example, the stock market is up 160 points today because Larry Summers has removed himself as a Fed candidate and because the U.S. is not going to attack Syria over chemical weapons use.

But the markets never went down due to Summer’s potential nomination, and the S&P 500 is up 2.75% since the day the news broke that Syria was using chemical weapons!

All of this suggests to us that investors are getting complacent.

The Bottom Line….

The old story of the Tortoise and the Hare comes to mind.  The Hare is the trader, the Tortoise the investor.  The best way for the tortoise to make money is to 1) be long-term focused and; 2) to pay attention to fundamentals.  While the Hare has outperformed over the short run, he is becoming overconfident and thus careless.

The Tortoise, recognizing that the race is a long-distance marathon, not a sprint, bides his time and sticks to his strategy.  In that vein, we have been raising some cash in stocks in which we cannot justify prices, even over several years.  We plan to employ that cash when stocks become attractively priced, whenever that is.  As we are not market timers and do not believe that market timing works over time, we simply will stay focused on company fundaments.

We continue to believe that investors must be diversified by asset class, even though that has reduced returns.  The risks in the various markets are just too high, and until markets return to more normal environments, investors are far better off being less greedy and more patient than the other way around.  A fairly typical correction could easily wipe out most or all of the gains of the past two years, especially given the leverage involved in the markets.

Slow and steady wins the race, especially when it is an investment race.  See you at the finish line, Hare.

Alan E. Rosenfield,                                                                                                                       Managing Director


September 16, 2013


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