Download Issues Influencing the Markets

Third-Quarter 2013 Securities Market Commentary
The third quarter of 2013 was more productive than the second quarter, in both the stock and bond
markets. The Dow Jones Industrial Average returned 1.48%, the Standard & Poor’s 500 4.69% and the
NASDAQ Composite an impressive 10.82%. The broader bond market was less productive with the
Barclays Aggregate Bond Index virtually unchanged at a flat -0.01% return. Ironically, the asset class
which is often considered to be the ultimate safe haven, the long-term U.S. Treasury Bond (25 – 30 year
maturity), incurred yet another loss of 6.48% making for a colossal -19.06% year to date loss.
As outlined in last quarter’s market commentary, much of the volatility in both stock and bond markets
has been precipitated by comments from the Federal Reserve Bank chairman Ben Bernanke. While
testifying in front of Congress, Mr. Bernanke stated the Federal Reserve Bank was prepared to begin
“winding down” the economic stimulus plan in which the Federal Reserve Bank had been purchasing
$85 billion a month in U.S. Treasury bonds. Consequently, this triggered a knee-jerk reaction in the
equity markets as well as a meaningful decline in bond values which in turn caused higher interest rates
almost immediately. Accordingly, within weeks of Mr. Bernanke’s comments he reversed course, stating
that the Federal Reserve Bank had decided to postpone any scaling back of its current stimulus plan. It’s
very difficult to identify the reasons for this rather abrupt reversal. Whether it was due to the
pronounced reaction in the financial markets caused by his first remarks, or economic data that
indicated a further weakening in the economy or even the potential unintended consequences of the
new Affordable Care Act (Obama care). Whatever the reason, rarely is it wise to abruptly reverse course
on such widely followed public-policy. This often leaves the appearance of indecision or confusion to
the markets. Investors prefer even bad news over confusion or apparent inconsistencies which most
often leave financiers without a clear path or strategy to manage their portfolios.
It is inevitable that the Federal Reserve Bank at some point will begin to scale back its acquisition in
government bonds, causing yet another disruption in the stock and bond markets, precipitating higher
interest rates. I cannot see a scenario in which these less than desirable consequences can be avoided.
However, once we get the artificially manipulated markets behind us this will allow the markets to
return to a truly market-driven supply and demand oriented pricing structure. Investors will have an
environment in which prices are not manipulated, allowing them to establish a long-term strategy for
their portfolios.
Affordable Care Act
As of the writing of this letter, the Affordable Care Act is scheduled to go into effect within days. The
significant cost increases and lower benefits will, in my opinion, have a negative effect on the economy.
” IBM told its retirees in notices obtained by The Wall Street Journal that "Health care costs under IBM's
current plan options for Medicare eligible retirees will nearly triple by 2020, significantly impacting your
premium and out of pocket costs.” IBM is just one example, of corporations both large and small that
are incurring significant cost increases based on requirements by the new healthcare law. These
mandates will have two very unfortunate consequences. Significantly higher costs for healthcare plans
purchased by employers and in most cases, significantly higher costs for those purchasing healthcare on
their own. Companies as small as eight employees in Ohio, have experienced a 23% increase in premium
as of July 1 and are anticipating another 23% increase in December all based on mandates contained in
the health care legislation. It is important to realize these increases in costs were not to increase
benefits but merely pay the continuation of existing benefits. Obviously, one of the many unintended
consequences of this law will be to stop providing healthcare as an employer and simply pay the federal
penalty, which is in most cases much cheaper than the insurance premium. This forces its employees to
acquire health insurance on their own or they too will be subject to a fine from the government if they
choose to remain uninsured. These consequences are the exact opposite of the stated intentions of this
legislation.
Employment/Labor Force Participation
The federal unemployment rate experienced a modest decline to 7.3% from 7.6% last quarter, as
measured by U3, the national unemployment rate. The Bureau of Labor and statistics (BLS) also
calculates a broader measure of those underemployed or unemployed which makes up the U6. The U6
is comprised of the total unemployed, plus anyone marginally attached to the work force, including
workers employed part time for economic reasons and all persons marginally attached to the national
labor force. This broader indicator of unemployment is currently at 13.7% which is a modest decline
from 13.8% at the end of last quarter. All of this seems to be welcomed as positive news until one
reviews the footnotes explaining that some 600,000 people, have now fallen off the unemployment
polls with no way to track their employment status. Perhaps the most accurate indication of the overall
health of the job market may be found in yet another government statistic known as the Labor Force
Participation Rate. The current labor force participation rate is 63.2%, a decline of 3/10 of one percent
when compared to the June 30th reading at 63.5%. Three-tenths of one percent may appear to be a very
modest decline in such a broad statistic however, when you convert 3/10 of one percent into the
number of people that are no longer participating in the labor market, it is worrisome at best.
Consumer Confidence Index
U.S. consumer sentiment fell to a five-month low in September with Americans worried that higher
interest rates will put a damper on the housing market and overall growth, according to the most
recently released survey. The Thomson Reuters/University of Michigan's preliminary reading on the
overall index of consumer sentiment fell to 76.8 in September, the lowest since April and well below
August's 82.1 and the 82.0 reading economists had expected this month. It appears consumers are
already digesting the implications of rising interest rates on their family budgets. The most recent
survey also revealed that consumers fear higher interest rates will diminish the pace of economic
growth, as well as slow job creation. Any reluctance on the consumer’s part may have a sobering effect
on the economy moving forward. It is important to note, economists estimate that approximately 72%
of our economy is driven by domestic consumption; i.e. consumers’ willingness to purchase goods and
services.
Gross Domestic Product – GDP
The gross domestic product is the sum value of all goods and services produced within the economy
over a given time frame. The most recent estimate for the annualized growth rate for GDP is 0.79%,
declining from an already dismal 1.1% estimate as of June 30, 2013. A reasonable growth rate ranges
between 2 ½ and 4% per year for a healthy, expanding and sustainable economy. What is of greater
concern is the fact that economists estimate that a prolonged government shutdown would erode the
current growth rate at a rate of about 0.20% per month. As you can imagine, any prolonged government
shutdown may have a devastating effect on the domestic economy, considering the Federal government
constitutes approximately 20% of the entire domestic economy. Washington’s inability to put the health
of the U.S. economy ahead of partisan posturing, in anticipation of the 2014 midterm elections, may in
fact put this anemic recovery in jeopardy, sliding us back into a recession.
Technical Market Overview
A very widely used indicator for the overall direction of the stock market is the Standard & Poor’s 500
Index. The index consists of 500 publicly traded corporations as the name would suggest. 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 a confirmed upward trend. Although it must be noted that when the price of
the index is significantly higher than its average of the past 200 days, this may indicate an overheated or
overvalued environment; one that investors should be aware of. However, the relationship between the
current 200 day moving average and the price of the Standard & Poor’s 500 Index is a spread of
approximately 5.5%. This is a sustainable relationship between the indexes price and its average price
for the most recent 200 days. This indicates to me that the market has not yet begun to price in the
potential economic slowdown due to the federal government’s shutdown or to quantify the economic
impact of Obamacare. It’s important to note that historically, when the market ignores substantive
economic data and then alternately adjusts its outlook based on factors that had previously been
chosen to ignore, this often leads to a rather abrupt reduction in equity prices.
Issues Influencing the Markets
Government gridlock at the federal level is perhaps the most concerning systemic issue facing our
country. Inability or unwillingness, exhibited by both political parties to the extent they will allow the
government, to on some levels cease to function, is almost unfathomable. The real concern goes well
beyond the current economic shutdown to the much more meaningful negotiations (or lack thereof) to
raise the federal debt ceiling that must be completed by October 17 of this year. There’s an underlying
tone on Wall Street that politicians seem to routinely do these things and ultimately dodge the
proverbial bullet at the very last moment. However, with the historically unprecedented polarization at
the federal level, it seems that Wall Street’s becoming less and less convinced that there will be some
kind of last-minute compromise, where both political parties can save face. I believe these are all
precursors to what will be an extremely contentious and bitterly fought midterm election in November
2014. It appears as though the unwillingness to even discuss the issues at hand while declaring many
issues simply nonnegotiable, will serve no one well; particularly the individuals that openly and proudly
choose that path. As mentioned earlier in this letter, I think it is very difficult to quantify the economic
impact of the new national health care plan. There seems to be three major components of concern.
The numerous taxes incorporated in the legislation, the change in benefit structure and deductibles and
the costs associated with providing these benefits as an employer or the singular cost to acquire these
mandated policies as an individual. The impact on businesses to provide benefits to their employees
that the employees may or may not even want has yet to be calculated. Many people cannot use the
benefits because of their religious beliefs that go against what the health benefits offer. The potential
list of unintended consequences is almost bottomless. Significant layoffs have occurred in institutions as
renowned as the Cleveland Clinic and many other hospitals and healthcare facilities around the country
in an effort to deal with the economic impact of the new national health care mandate.
Looking Forward
The single most important event facing the markets is the impending negotiations to raise the federal
debt ceiling. The debt ceiling simply stated is the maximum lot of money the federal government’s able
to borrow to fund its operations. Without this latitude to borrow more money, the federal government
theoretically could default on its obligations. Experts would very quickly point out that the tax receipts
on the federal government are about $250 billion per month and its obligations for interest payments
are about $50 billion per month, making the fall in the classic sense very unlikely. However, when one
adds back in the entitlements such as Social Security, Medicaid, Medicare and the new subsidies for
Obamacare and other essentials such as military spending, it becomes much easier to see how a
“default” is a distinct possibility. The political hierarchy must reign in entitlement spending rather than
add to it if it ever intends to balance the federal budget. Based on current market behavior, it is quite
possible to see a sharp decline in stock prices if Washington remains on its current path. It is worth
noting that historically October is a difficult month for the stock market. Combine that with the
apparent inability of the government to manage its own spending and for politicians to act like
statesmen rather than political gang members and this may be a fall to remember.
Risk Management/ Portfolio Strategy
Due to the shift in Federal Reserve policy, the very same bonds that were very productive places to hide
from declining stock markets appear to have become “public enemy number one.” Longer maturity
government bonds I believe bring significantly more risk to a portfolio than the declining equities they
were used to defend against. For this reason, our models have considerably reduced our exposure to
investment options that focus on long-term government bonds. We continue to have potential exposure
to shorter-term government bonds and corporate bonds of all maturities, 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. Over the last several months 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 some benefits from doing so. 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 willingness to ignore riskier asset
classes often puts clients in a negative position portfolio wise. This requires using several years of rising
stock markets to get portfolio values back to the level they were at had they not been exposed to that
level of risk. This “chasing gains” strategy often introduces copious portfolio movement without
sustainable progress. That is to say exaggerated moves up and down without capturing enough gains
that the portfolio actually increases in sustainable value even over a long period time. I believe it is fair
to say that we should not expect bonds to be as productive or as good at mitigating risk in a portfolio as
they have been over the past 15 years. For this reason, it appears that equities will 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 just not as productive as we’ve all grown used to.
With the enhanced use of cash as its 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. There are many challenges
facing our country, our economy and our securities markets both stocks and bonds however, I remain
optimistic that we can conquer all those challenges. I remain positive and in fact excited about the
future as we move beyond what often seems to be insurmountable challenges that are ultimately found
to be manageable 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.
IBM to shift retirees to healthcare exchange due to rising costs
U.S. consumer sentiment sinks in September on interest rate fears
United State GDP Growth Rate