Fall 2014 – Newsletter
When everything seems to be going against you, remember that the airplane takes off against the wind, not with it. – Henry Ford
I once read that you attract what you fear, and if you consider the things you worry about the most, there might be something to it. Nevertheless, recent market volatility had some investors scared to death. And since we’re old enough to remember 2008, many wondered if this was the correction we’ve all been waiting for?
Let’s be clear, corporate profits are at record highs and the US economy is still growing at a measured pace. In fact, the U.S. has the highest entrepreneurship rate reported among 25 countries in North America, Europe, and Asia and no other country buys more than it sells to the rest of the world, with a net contribution of about three percent of the global economy. At the same time, jobless claims are declining, job openings are at a 13 year high, average manufacturing workweek is the highest it’s been since 1950 and stocks are not considered expensive by any historic measure.
Europe is in a bit of hot water, but as my grandfather was fond of saying: “tell me something I didn’t already know”. In any event, U.S. exporters aren’t heavily exposed to Europe, which accounts for just 15 percent of U.S. foreign trade. By many accounts, a slowdown across the pond wouldn’t necessarily be catastrophic to the U.S. economy.
China, on the other hand, has seen GDP growth drop to 7.3 percent, they have a looming shadow banking crisis on their hands and a potential real estate bubble. While Chinese real estate inventory levels are near a four-year high; transactions across major cities fell 19 percent year-on-year in the first six months of 2014. Good luck with that. Should housing prices continue to drop, highly leveraged real estate companies could be up the Yangtze River without a paddle.
So where does that leave us? It seems that the fundamentals in the United States are solid. Any time you create 10.3 million jobs in six years, have 55 straight months of private sector job growth, reduce the deficit from 9.8 percent of GDP to 2.8 percent of GDP in five years and extend the projected date for Medicare going broke from 2017 to 2030, things could be worse.
At the same time, the United States is producing so much oil and natural gas that Saudi Arabia is flooding the market in an effort to lower oil prices, maintain market share and make U.S. projects less profitable. Here’s what they may have missed: our companies make money if oil is over $50 to $60 a barrel and Saudi Arabia can’t stomach prices at that level.
Many cite geopolitical concerns as a reason to head for the hills, but if we’re being honest, few experts believe Putin would refuse to sell energy to Europe at the expense of his economic livelihood, particularly when energy accounts for roughly 70 percent of Russia’s annual exports. Many fear ISIS, although from our perspective, even if they took control of southern Iraq, which at the moment appears unlikely, they would continue their current practice of selling the oil in the black market at a discount.
The fly in the buttermilk is the scheduled end to Quantitative Easing in October. If you’ve ever seen a coffee drinker in the morning before they had their first cup of java, imagine how the market would react if their local Starbucks was closed. The last two times Quantitative Easing ended, the markets dropped by double digits and only recovered after another round of Five Hour Energy Drinks.
One might be led to believe that outside events impacted the markets in the past when the Federal Reserve ended its practice of buying bonds from the banks with money created out of thin air that somehow found its way into the market, and for good reason. When QE1 came to a conclusion in May 2010, there was a flash crash, Greek protests and reports that Portugal, Italy, Ireland, and Spain were in deep financial trouble, not exactly a winning hand.
When QE2 was terminated in June 2011, Congress was engaged in a bitter debt ceiling debate, the U.S. credit rating was downgraded and the EU debt crisis was in full bloom. All of these events create uncertainty, the sort of thing markets don’t like and may have played a large role in the pullback.
There’s only one problem: the market doesn’t do so well without the training wheels. To add some clarity, the S&P 500 hit an intra-day all-time high on September 19th, but dropped all the way to an intra-day low on October 15th, as the 9.9 percent selloff just missed the official correction mark of 10 percent.
At the precise moment that this was happening, when the Dow was getting clobbered for 450 some-odd points, media reports surfaced that Federal Reserve Chairwoman Janet Yellen expressed confidence in U.S. economic growth, even in the face of global economic headwinds, and the Dow cut its losses by more than half.
The very next day, on October 16th, the markets began free-falling once again, with the Dow sliding 170 points before another media report surfaced. This time, the president of the St. Louis Fed, James Bullard, suggested that the U.S. Federal Reserve should consider extending its bond-buying program (QE3) beyond October due to market volatility and worldwide economic uncertainty. What happened next? The markets went from losses of over one percent to closing even for the trading session and spiked higher over the next week.
The next time you hear somebody say “timing is everything”, tell them that story.
When my son was 8 years old, we let him run track. His mother and I had very successful track careers in college (or maybe it was just her), and genetics being what they are, we knew this would be his ticket. Before his first race they told him to stay in his lane when he went around the curve (remember, he was only 8). Well, he didn’t listen, got run over and laid on the track waiting for his mother to pick him up.
Having been raised by a man who thinks the problem with our country is that people are too soft, a common critique by older men who survived active military duty, I refused to let any of the mothers get near him. I made him get up on his own because I wanted to instill a sense of perseverance.
When the Fed came to the rescue of the market, it reminded me of the over protective parent who runs onto the field every time their child falls down. Aside from the unfortunate teasing that’s certain to ensue (children can be cruel), it has a way of handicapping the child. What happens when mommy isn’t there?
It’s not just the Fed coddling asset prices, but margin debt is at record highs. Investors have been using their stocks as collateral to (in many instances) buy more stock. Unfortunately, if the collateral declines in value, the borrower must come to the table with money, and if they get the funds by selling some of the collateral, you can see where this might become a problem. Again, there are only so many times you can engineer a profit before it works against you.
Legend has it that Kobe Bryant was a top NBA draft prospect in 1996, and because the Los Angeles Lakers had a low draft pick, they stood no chance of landing the future Hall of Fame player. Instead, they flew him to L.A. on a private jet, showed him the glitz and glamor of Southern California and convinced him to showcase ordinary talents for small market teams at the bottom of the standings that were more likely to draft him.
After his scripted mediocre pre-draft workout, the Charlotte Hornets drafted Kobe Bryant with the 13th pick and promptly traded him to the Los Angeles Lakers in exchange for the lower first round pick and a washed up center. As it turns out, Kobe Bryant has scored 31,700 points during his career, only 595 points less than the iconic Michael Jordan.
Today, however, Kobe Bryant is 36 years old and recently suffered both a knee and Achilles tendon injury. Aside from health concerns, Kobe’s larger than life presence, one bestowed upon him 18 years earlier, has made other superstars reluctant to join the team. Lo and behold, the Lakers missed the playoffs last year and won’t do any better in the upcoming season. The Lakers are indeed out of party tricks, even if they have five recent championship trophies to show for it.
Checks have been known to get lost in the mail, but the bills always get there on time. Should the Federal Reserve continue to print money, the market would likely react favorably, for a time. But with the Federal Reserve’s balance sheet leveraged at 77-1, knowing a 1.3 percent increase in interest rates would wipe out all of its capital, it’s unclear how long that option will be available or if it’s even wise to pursue.
I’m of the opinion that the economy can stand on its own two feet, that further easing would only make matters worse once the punch bowl is finally taken away – if it’s going to crash, go ahead and get it over with; at least this time it won’t catch us by surprise.
The end of the world is not upon us, but a correction? Your guess is as good as mine.
Securities offered through LPL Financial, Member FINRA/SIPC (http://brokercheck.finra.org/). Investment advice offered through Delancey Wealth Management, LLC, A registered investment advisor and separate entity from LPL Financial.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
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1 U.S. Leads Developed Economies In Startup Activity; Forbes; 6/29/14
2 Fed-driven ‘Locomotive USA’; CNBC; 10/27/14
3 U.S. jobless claims fall to lowest level in 14 years, CNBC.com; 10/16/14
4 Number of Job Openings Hits 13-Year High; Wall Street Journal; 10/7/14
5 Bureau of Labor Statistics
6 Global Growth Woes Threaten to Beset U.S. Economy; Wall Street Journal; 10/21/14
7 China GDP Growth Rate Is Slowest in Five Years; Wall Street Journal, 10/2/14
8 How Soon Will China’s Real Estate Market Bounce Back?; Forbes; 7/8/14
9 Bureau of Labor Statistics
10 The Budget Deficit Just Fell To The Lowest Point Of Obama’s Tenure; Business Insider; 10/8/14
11 2014 Annual Report of The Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds
12 Gloves off over oil: Saudi Arabia versus shale; CNBC; 10/17/14
13 4 reasons Russia will keep gas flowing; CNN Money; 3/2/14
14 ISIS Makes Up To $3 Million a Day Selling Oil, Say Analysts, ABC News; 8/2/14
15 Bullard’s surprise suggestion of continuing QE lifts markets; Market Watch; 10/16/14