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Second–Quarter 2013 Securities Market Commentary
The second quarter of 2013 was significantly more challenging to both the stock and bond markets’. The
Dow Jones Industrial Average returned a mere 2.27%, the Standard & Poor's 500 Index 2.36% return and
the NASDAQ Composite Index returned 4.15% for the quarter. Bonds suffered an even more challenging
quarter with the Dow Jones Corporate Bond Index declining -3.5%. Similarly, the Barclays Aggregate
Bond Index incurred a loss of 3.18%. Finally, what is widely considered to be the pinnacle of safety,
long-term U.S. treasury bonds (25-30 year maturity) suffered losses in excess of 9% during the second
quarter.
The impetus for the tepid returns in the equity markets and negative returns for the bond markets were
both precipitated by comments from Ben Bernanke, the Federal Reserve Bank chairman. In testimony to
the U.S. Congress, Mr. Bernanke stated that the Federal Reserve Bank may begin to "wind down" its
quantitative easing policy before the end of 2013. Quantitative easing is a form of economic stimulus in
which the Federal Reserve Bank purchases about $85 billion a month of U.S. Treasury bonds, creating a
market for bonds yielding an artificially low interest rate; rates much lower than the bond market would
normally demand. This artificial market stimulus/manipulation has allowed both the stock and bond
markets to "float" on a sea of the liquidity, which is essentially manufactured by the Federal Reserve
Bank. Mr. Bernanke may argue that this massive infusion of cash was needed to stabilize our economy
as well as a global economy after the economic crisis of 2008. This excess liquidity allowed capital for
businesses to reestablish themselves after the devastating economic downturn.
The real dilemma for the Federal Reserve Bank and Mr. Bernanke is how do you stop this artificial
market support without causing the rather violent price disruption that occurred based on statements
as benign as "may begin to wind down before the end of 2013". The markets have become intoxicated
with an environment in which the Fed fixes all things by simply infusing more cash into the economy. As
the Federal Reserve Bank ultimately decides that the economy is strong enough to sustain economic
growth without "help" from the Federal Reserve Bank and in fact begins to reduce its intervention in the
securities markets, it is quite conceivable that both the stock and bond markets may decline rather
precipitously.
Another trigger that would force the central bank to stop artificially depressing interest rates would be a
resurgence of inflation. Simply stated, inflation is caused by too many unearned dollars chasing too few
goods and services. The U.S. Department of Agriculture estimated that a total of 101,000,000 people
currently participate in at least one of the 15 food programs offered by the agency, at a cost of $114
billion in fiscal year 2012. According to the Bureau of Labor Statistics (BLS), there were 97,180,000 fulltime private sector workers in 2012. In other words, we now have more people receiving federal
assistance via food stamps than we have citizens working at full-time private sector employment. With a
population of 316.2 million people we now have nearly a third of the U.S. population receiving
assistance in the form of food stamps. However, this does not take into consideration that much of our
population is receiving more than one form of federal assistance, unemployment insurance, or social
security disability benefits to name just a few. These "unearned" dollars whether deserved or not
significantly increases the possibility of inflationary pressures. With no goods or services being produced
to receive these dollars, the effect on the overall value of the dollar is diminished, causing all dollars to
have less purchasing power in the marketplace. The central banks historic tool to deal with inflation is
raising interest rates. By doing so, this increases the cost to buy items such as cars by making the loan
payments higher and causing fewer consumers to qualify for loans. This in turn causes less demand and
ultimately causes prices to fall. The scenario of rising interest rates is a painful economic solution to
rising prices that are often caused by shortsighted economic policies put in place for political reasons.
There are currently very few economic signs of systemic long-term inflation however, if the central
banks economic policy of low interest rates and "easy money" persist for a longer time than is an
absolute economic necessity, history indicates inflation is most often the very undesirable consequence
of these policies.
Technical Market Overview
The 200 day moving average is a long-term trend indicator that is often useful in determining the longterm direction of a specified market. If today's average price of the previous 200 days is higher than the
previous day’s average price of the prior 200 days, then the trend remains positive. All of the major
equity indexes remain above their 200 day moving average. However, the exaggerated levels seen as of
March 31 with the S&P 500 being approximately 10% above its 200 day moving average have now
declined to a level of about 5% above the long-term 200 day moving average. As stated in last quarter's
letter, such exaggerated levels may indicate “a near term down trend is often imminent “. As mentioned
in the first paragraph, we did in fact experience a rather significant short-term downtrend. With the 200
day moving average currently in a more modest, sustainable level it doesn't appear as though this
market is fragile from a technical analysis perspective.
Issues Influencing the Markets
Issues such as Cyprus and the European debt crisis have not occupied the headlines during the second
quarter of 2013 however, that is not to imply that those issues are completely resolved and will not at
some point serve to once again cause investors to reevaluate the future for the global economy. In the
second quarter, China reported a slowing in the rate of growth for the gross domestic product. This
report caused the markets to momentarily reevaluate the impact on the global economy from the
deceleration in the rate of growth in China's economy. This data did not cause a significant correction in
stock and bond prices and this disappointing economic data was not impactful for more than one or two
days.
Consumer Confidence Index
The Thomson Reuters/University of Michigan's final reading on the overall index on consumer sentiment
was 84.1 points, just slightly below a near six-year high of 84.5 in May. This indicates a significant
increase from the index of 72.3, the index level as of March 31, 2013. This widely followed barometer of
the consumer's attitude of their current economic situation and perhaps more importantly their
expectations for their future, is signaling a very optimistic outlook by the U.S. consumer. This may be in
part responsible for the recent increases in new home construction and robust sales of existing homes.
It is interesting to note that the most recent retail sales numbers ending June 30th came in at a very
disappointing 0.4%, obviously not showing the same optimism that was indicated in the University of
Michigan's sentiment index. As with all financial data, it cannot be viewed in a vacuum and must be
assessed with broad economic data, rather than choosing a single data point to form an opinion.
Unemployment / Labor Force Participation
The unemployment rate remained the same at 7.6% as measured by U3 the national unemployment
rate. The broader U6 has risen from 13.8% at the end of the first quarter to 14.3% as measured by the
broader measurement known as U6, which includes people working part-time that are unable to obtain
full-time employment. U6 also includes people that are considered “under-employed.” Underemployed refers to those working in jobs that are well beneath their skill levels, or have much greater
levels of education than can be utilized in their current positions because of economic reasons. Another
way to analyze the job market is through a statistic compiled by the US Bureau of Labor Statistics (BLS)
that is known as the labor force participation rate. The labor force participation rate measures the
subset of Americans who have jobs or are seeking a job, are at least 16 years old, are not serving in the
military and are not institutionalized; in other words, all Americans who are eligible to work every day in
the U.S. economy. The current labor force participation rate is 63.5% increasing a modest .2% from the
March 31st measure at 63.3%. This modest increase in the labor force participation rate is more than
offset by the .5% increase in the U6, indicating a very stagnant job market that is stabilized at a
historically unacceptable level.
Gross Domestic Product-GDP
All indications are that GDP grew at a very disappointing rate of less than 1% for the second quarter,
making this the third consecutive quarter of economic growth of less than 1%; with the most dismal
forecast coming from Barclays Bank by recently reducing its GDP estimates from 0.6% to 0.5%. A healthy
growth rate for the U.S. economy has historically ranged between 2.5 and 4%. As one analyzes the
consistently disappointing growth rate in GDP it’s easy to understand why the unemployment numbers
continue to remain stubbornly at levels never seen before and certainly not for this length of time.
Overregulation through government agencies such as the EPA and other intrusive regulations in virtually
every industry in our economy have caused an economic burden that our economy is simply not robust
enough to carry.
Looking Forward
As we are now halfway through 2013 I believe the biggest uncertainty facing the U.S. economy and its
markets is the implementation of the Patient Protection and Affordable Care Act (Obamacare). The
many unforeseen economic consequences that it will almost certainly bring, very well may serve as yet
another financial milestone around the U.S. economy’s monetary neck. As mentioned last quarter, the
Sec. of Health and Human Services (HHS) Kathleen Sibelius recently stated that ”she underestimated
how long the politics of health reform would last and didn’t anticipate how much confusion the slow
rollout of the legislation would create.” The HHS recently decided not to implement the employer
mandate for businesses with more than 50 employees on January 1, 2014. This clearly was an admission
that the consequences of such implementation would have onerous consequences on the economy with
many small businesses choosing to reduce its work staff from full-time to part-time employees to avoid
the new mandate. However, for businesses with less than 50 employees the new regulation still applies
causing an unnecessary burden on even smaller businesses. The economic consequences in this
legislation are largely unknown and unfortunately what is known is not positive. The original
government estimates done by the Congressional Budget Office (CBO) were that this plan would reduce
deficit spending by $100 billion per year. Within the last two weeks the CBO the same government
agency revised their economic forecast to an increase of $170 billion in the federal deficit to fund what
was supposed to have generated a surplus of $100 billion. Most recent projections now indicate that
spending for 2013 through 2019 have increase by a $124 billion beyond their original estimates.
Risk Management/ Portfolio Strategy
As of the writing of this letter, the U.S. stock market indexes are either at or slightly above their all-time
highs. It is critical that corporate earnings meet or exceed Wall Street's expectations for the current rally
to continue. These historically high equity prices, combined with the markets concern regarding the
Federal Reserve banks continued willingness to support the economy through its policy of buying U.S.
government bonds, leads the securities markets at an inflection point. We find ourselves at a point in
which the market will decide whether to focus on corporate earnings rather than the government's
willingness to artificially depress interest rates. The corporate earnings are at or above Wall Street's
expectations and if the markets choose to focus on earnings as its primary motivation, equity markets
may continue to move forward. However, if the markets primary focus is on Federal Reserve policy, it
appears as though Mr. Bernanke is in fact beginning the process of phasing out systematic purchasing,
of U.S. government bonds, then I believe that bonds and particularly long-term U.S. government bonds
will decline in price and equities may decline as well.
For these reasons we have changed the composition of our models to emphasize cash (money markets)
as our defensive investment options rather than U.S. government bonds. It appears to be a foregone
conclusion that at some point the Federal Reserve policy will have to stop its plan of systematic bond
purchases. Once this artificial buying pressure is no longer available, bond prices will decline causing
increased yield in the bond market. This increase on interest rates may have a negative effect on
corporate earnings due to increases in borrowing costs for corporations both in the bond market as well
as through commercial banks. The ramifications of this policy shift has already caused a short term
uptick in mortgage interest rates; which may ultimately cause a slowing in the pace of new home
construction and existing home sales.
It is important to realize that we have not changed modeling technology or the method by which it
makes its investment selections; we merely have changed the range of investment options it has to
choose from. Over the first half of 2013, many of the U.S. bond trades were productive at the outset
only to find that before the end of that minimum hold period, bond prices began to decline in
anticipation of the Federal Reserve Board's policy shift. For this reason, we believe that bonds,
particularly long-term government bonds, are less capable of bringing risk reduction to a portfolio and
may in fact bring equal if not greater risk than conservative equity investments.
It should be noted, that with cash as the primary defensive investment option in the models, when a
cash trade is recommended, there is no minimum hold. As market conditions change, the models will
have the potential to respond more quickly, rather than waiting till the end of a minimum hold to expire
before the model generates a new trade recommendation. This increased flexibility may be
advantageous in uncertain markets, such as the environment we are now in.
As always, our investment philosophy first and foremost is focused on risk reduction/mitigation. For this
reason, our returns are not equal to that of pure equity indexes, such as the Standard & Poor's 500
Index or the Dow Jones Industrials. Our goal has been to achieve reasonable risk, adjusted rates of
return, rather than introduce risk at levels that will perform equal to an index that is 100% exposed to
stocks, regardless of market conditions. In the past, our portfolio composition in most cases has been a
blend of both stocks and bonds. With the recent shift in the Federal Reserve policy, the bond market
has become significantly less productive causing a reduction in our investment returns. For this reason,
as mentioned above, we have significantly reduced our potential exposure to long-term U.S.
government bonds in an effort to participate in more productive investment options. We believe the use
of cash in the portfolios will give us a very viable option in declining equity markets, without the risk of
participating in a declining bond market as well. I remain optimistic that our modeling technology will
continue to serve us well as the markets move forward. If for any reason you wish to have greater risk
exposure in your portfolio in an effort to participate more fully in the rising equity markets, please
contact my office for an appointment and we will revisit your risk profile in adjust your portfolios
accordingly.
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
http://www.businessinsider.com/economists-cut-q2-gdp-forecasts-2013-7
http://www.bls.gov/news.release/empsit.t15.htm
http://www.reuters.com/article/2013/06/28/us-usa-economy-sentiment-idUSBRE95R0MA20130628
http://www.sca.isr.umich.edu/fetchdoc.php?docid=24774
http://cnsnews.com/news/article/101m-get-food-aid-federal-gov-t-outnumber-full-time-private-sectorworkers
http://finance.yahoo.com/blogs/daily-ticker/reason-not130747610.html;_ylt=AsAxXuy0CbChiOBXtDWf4saiuYdG;_ylu=X3oDMTNycmNzbThmBG1pdANGUCBUb
3AgU3RvcnkgTGVmdARwa2cDMTBhZTcwM2YtZGVjYS0zYmEzLTgzYWYtMWI5NWRlYmE1MGYyBHBvcw
MxBHNlYwN0b3Bfc3RvcnkEdmVyAzAzM2Y2MDQwLWVlMjItMTFlMi1iZWJmLTg2NTU2MDY4YjE5Zg-;_ylg=X3oDMTFkcW51ZGliBGludGwDdXMEbGFuZwNlbi11cwRwc3RhaWQDBHBzdGNhdANob21lBHB0A3
BtaA--;_ylv=3
http://www.sca.isr.umich.edu/fetchdoc.php?docid=24774