First-Quarter 2014 Securities Markets Commentary
The first quarter of 2014 presented many challenges to the domestic securities markets. These challenges manifested themselves in flat to mildly negative performance in virtually all domestic securities markets for both equities and bonds. The Standard & Poor 500 index returned a meager 1.29% for the first quarter of 2014, with the Dow Jones 30 Industrials offering investors an even more unimpressive return of -.72% for the quarter. The NASDAQ offered investors another lackluster performance of .53% for the quarter. Bonds were somewhat more productive with the Dow Jones Corporate Bond index producing a 2.70% return and the broader Barclays Aggregate Bond index returning 1.39% for the quarter.
Chairwoman Yellen’s first quarter at the helm of the US economy has proven quite interesting. In her statements around mid-first quarter she served notice that fed policy would be decided on an “as needed basis” rather than her predecessor’s policy of sharing economic targets that would cause a shift in policy from the Federal Reserve. This new, less predictable and less transparent policy caused both equity and bond markets to retreat. After the markets’ unfriendly response to Chairwoman Yellen’s new policy, she returned to the podium just before the quarter’s end with a much more conciliatory tone, reassuring the markets that she was committed to low interest rates and to an accommodating monetary policy well into the future. This reassuring tone was well received by the markets as they stabilized and established a modest term upward trend. It is worth pointing out, however, that Ms. Yellen’s comments are difficult to reconcile with her policy of reducing the Fed’s intervention in the bond markets to artificially depress interest rates (QE3), and that by doing so she has essentially raised interest rates—the very thing that the markets most feared. The Federal Reserve Bank now believes the economy is stable enough to “stand on its own” rather than depend on continued monetary stimulus. It appears, at least at this moment, that the market(s) tends to agree with the Fed’s modestly positive appraisal of the economy.
The markets were forced to contend with challenges from beyond our shores. Underdeveloped countries such as Turkey and Indonesia embarked on a campaign to raise the value of their currency relative to the US dollar. This fairly aggressive strategy caused our securities markets to decline rather abruptly for a short period.
As you all know the US endured an uncommonly bitter winter. The economic implications of such a harsh winter affect everything from retail sales and new housing starts to energy prices. This could not have been at a less opportune time as our economy struggles to gain traction. The financial consequences of this harsh winter in the US are being felt around the world, slowing our production for export while reducing demand for imported goods. Fortunately as spring approaches it appears that this winter’s chilling economic effects are already thawing.
Currently the most significant challenge our markets face is the provocative invasion of the Crimean peninsula by Russia. This extraordinarily bold, and in fact illegal, invasion has raised tensions throughout the Ukraine while causing markets around the world to slide precipitously. The invasion is especially disquieting because Crimea is home to integral pipelines supplying much of Europe with heating fuel. Add on top of this Crimea’s geographical position on the Black Sea as a pivotal trading port and we begin to see the true scope of Russia’s gamble. The cavalier way in which Vladimir Putin has chosen to ignore the US and the EU may foretell further aggression toward the entire Ukraine. With Russia being a significant energy producer any sanctions leveraged against them may cause a global upheaval in energy prices. The underlying fear appears to be that the ex-KGB Putin is on a misguided quest to reassemble the shattered Soviet Union. Unfortunately this Russian aggression very well may continue for the foreseeable future and will likely remain a volatile situation for Europe and the rest of the world.
Consumer Confidence Index
According to the Thomson Reuters/University of Michigan survey, consumer confidence declined in March to the lowest level in four months to 79.9 from 81.6 in February. This indicates that US households may be slow to increase their spending after enduring increased expenses over the harsh winter. Consumer confidence is a valuable forward-looking indicator because approximately 72% of our Gross Domestic Product is based on domestic consumption.
Gross Domestic Product-GDP
Real GDP was 2.4% annualized for the fourth quarter of last year (the most recent data) which is down from 4.1% annualized growth the third quarter of 2013. Economists attribute this surprising deceleration in growth rate to the economic impact of last winter. Unusually bad weather conditions had a devastating effect on retail sales, transportation costs, increased utility expenses, and a general slowing of manufacturing production due to underperforming infrastructure.
Employment/Labor Force Participation
The most recent unemployment numbers indicate a modest increase in the unemployment rate (U-3) to 6.7% from 6.6%. This modest increase can be attributed to two factors. First, people rejoining the active search for employment because some extended unemployment benefits are no longer available therebygiving long-term unemployed no other option but to reenter the labor force. The second factor may be the job creation simply was not sufficient to absorb the influx of people rejoining the active search for long-term employment. These two situations combined to show a slight increase in the percentage of people looking for jobs that are unable to find them. A broader measure of unemployment according to the Bureau of Labor Statistics is the U-6, the total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force. This broader measure of unemployment is currently 12.7% down from December 2013’s rate of 13.1%. As telling as these numbers are I think the most accurate representation of the employment environment is Labor Force Participation Rate (LFP). The labor force participation rate is simply the percentage of people old enough to be in the labor force that are not in college, not in the military, not disabled and not formally retired. As of the end of March 2014 the number is 63.2% of the eligible workforce is currently employed, or expressed another way 36.8% of the potential workforce is currently unemployed. As dismal as that number sounds LFP rate experienced an increase since December 2013 when the percentage was 62.8% of the workforce was employed.
The two graphs are as of 12/31/2013
The above graphs reveal a startling depiction of the bleak environment faced by the long-term unemployed. The most recent downturn in equity prices was due to disappointing job creation numbers which came in between 150,000 and 190,000 jobs in the most recent reporting period. Economists believe that in order to affect the LFP rate approximately 350,000 to 400,000 jobs must be created in the same reporting peroid. Obviously there’s much work left to be done.
Technical Market Overview
The Standard & Poor’s 500 index is quite possibly the most followed stock market indicator in the world. The index consists of 500 publicly traded corporations as the name suggests. They range in size from small companies to large-cap companies, across a broad range of industries and economic sectors. The 200 day moving average is simply the average price of the index for the most recent 200 days. If today’s average price is higher than the previous days average price this is considered confirmation the market is in a confirmed upward trend. Although it must be noted that when the index is price is significantly higher than its average the past 200 days this may indicate an overheated or overvalued environment, one that investors should be aware of. Currently we are experiencing stagnation in price movement, indicating the market is finding few reasons to move significantly higher. This indicates to me that the market may be beginning to “price in” the potential economic impact of the Federal Reserve Bank’s policy of reducing economic stimulus (rising interest rates) or to quantify the economic impact of the implementation Obamacare as well as the geopolitical tensions outlined above. Based on the relatively flat performance numbers discussed in the first paragraph of this correspondence it seems that, for whatever reason, the market has lost its upward momentum. This may just be a temporary lull wherein the market digests various factors it now deems important, or it may be the beginning of a normal correction in equity prices. Furthermore, it is important here to note that, historically, when the market ignores substantive economic data and then alternately adjust its outlook based on factors previously ignored, it often leads to a relatively abrupt reduction in equity prices.
Looking Forward
In my last commentary for the final quarter of 2013 I concluded there were three fairly obvious challenges for both the stock and bond markets as we move into 2014. The first challenge is the above-mentioned policy change by the Federal Reserve Bank as it pertains to its monetary policy. As discussed in some depth above, the speed at which Chairwoman Yellen reduces the capital being infused into the bond market will be of paramount importance to both stocks and bonds. This delicate balance I believe holds the future health of our economy in the balance. However, if Chairwoman Yellen is unsuccessful in her balancing act, we have the potential to experience a very difficult year both in stocks as well as in bonds. For this reason, as our defensive tool, we have adjusted the composition of our models that manage many of your portfolios to have a greater likelihood to move into money market accounts rather than bonds. For the first time in many years we had the potential to see reasonable interest rates paid on money market accounts based on rising interest rates as the Fed allows the markets to price money. As of the final quarter of last year we reduced the amount of potential exposure to long-term government bonds from the inventory from which our models can choose. This is all in an effort to insulate the portfolios from the possible, if not probable, declines in the long-term government bond prices over time.
Secondly, the implementation of the Affordable Care Act (Obamacare) even with postponement of some of the law’s most potentially negative financial aspects, has the potential to have a decidedly negative effect on unemployment, health care availability, as well as overall health care costs. When the administration created exemptions or postponed the date by which many major corporations are required to comply with the law, it became abundantly clear that the administration was aware of the negative political and economic consequences of this legislation. The administration and media now boast of seven million citizens enrolled in Obamacare. But experts maintain that over five million of these enrollees previously had insurance and lost it precisely because of Obamacare’s mandatory minimum coverage for things like maternity and pediatric care for which many have no need. I find seven million enrollees suspect, because we have no figures as to how many of the “newly insured” have in fact paid premiums for their policies. Obviously if the premiums are not paid there is no coverage. As we approach the midterm elections we have experienced even more delays in implementing politically unpopular aspects of the Affordable Care Act law. I believe this to be a brazen political play to avoid the potentially negative impact on the balance of power in both the House and Senate. The known consequences remain somewhat unclear and the unintended, unknown consequences may be of even greater import.
Finally, the midterm elections may have more effect on the markets than they usually do because of the stark contrasting philosophies between the political parties. Even after the claimed victory of seven million new insured it seems that many of the president’s own political party have gone to great lengths to distance themselves from him because of the political repercussions they fear from their support of the Affordable Care Act (Obamacare). The wide range of issues that have far-reaching economic consequences to our country include: our seemingly endless federal deficit, entitlement programs, the role of federal government in healthcare and a muddled foreign policy just to name a few. Amnesty for those in our country illegally is a topic that deeply divides our political parties as well as many Americans. This will undoubtedly be a theme in the midterm elections in November and most certainly a major political issue for the next presidential election in 2016. So many Americans are apathetic about politics and indifferent to the blatant political posturing. Yet that apathy often subsides when there is a real economic impact on an individual or his or her family.
Risk Management/ Portfolio Strategy
As mentioned above bonds were the best performing asset category in the first quarter of 2014. However, I believe reduced exposure to investment options that focus on long-term government bonds will bring the best balance between risk and return. We continue to have potential exposure to shorter-term government bonds and corporate bonds of all maturities, along with convertible bonds, inflation protected bonds, high-yield bonds and even foreign bonds in some cases. We believe these other bond options offer a reasonable risk reward investment option.
Reiterating an earlier point, we have increased the likelihood of moving into a cash position by increasing the model sensitivity to a declining stock market environment. We are quite comfortable with this change in model composition and have already seen benefits from doing so during the last two quarters. It is of paramount importance that you understand we have not changed the way the models work, the mathematics driving the decision-making process or any aspect the modeling process whatsoever. We have merely adjusted the investment options the models have to choose from, not the methods by which they are chosen. I continue to believe it is an advisor’s responsibility to manage risk in a client’s portfolios rather than expose clients to investment options that may not be risk appropriate to simply outperform a specific benchmark or index.
This “chasing gains” strategy often introduces volatile portfolio movement without sustainable progress. I believe a process by which an investor truly establishes how much risk they are willing to accept in a portfolio and then focuses on extracting as much profit from that risk profile as the markets make available is far wiser and more emotionally comfortable for most investors.
It appears that equities may be the primary source of profits as opposed to the environment in which we could make money either in stocks or bonds over the last several years. That is not to say that bonds, other than long-term government bonds, will not be productive parts of a portfolio, rather they are just not as productive as we’ve all grown accustomed.
With the enhanced use of cash as a defensive option this allows our models to be more adaptive as the markets change direction and resume their upward trend as abruptly as the market declined. This increased flexibility may allow us to more quickly respond to rising markets. With the potential of rising interest rates as discussed in some depth above, money market funds offer appealing characteristics. Stable principle and the potential for increasing yields on your money market accounts are attractive qualities as we wait for the equity markets to resume their upward movement. There are many challenges facing our country, our economy and our securities markets. I remain optimistic that we can effectively deal with those challenges. I am in fact excited about the future as we move beyond what often seem to be insurmountable challenges that are ultimately found to be surmountable after all. As always, feel free to contact my office with any questions regarding your portfolio or its performance.
Disclaimer Notice
No investment strategy can guarantee profits or protection from losses as securities are subject to market volatility. The analysis, ratings and/or recommendations made by the Edgetech Analytics, LLC computer models do not provide, imply or otherwise constitute a guarantee of performance. No guarantee is offered by Edgetech Analytics, LLC regarding the accuracy, market predictive powers, suitability or profitability (either expressed or implied) of any information provided. Indices are unmanaged and direct investment in them is not possible. Actual investment performance of any trading strategy may frequently be materially different than the pursued results.
Sources
Google Finance (for price history of S&P 500 and other indexes) - finance.google.com