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Third-Quarter 2014 Securities Markets Commentary
Securities Markets Indexes performance
The third quarter of 2014 returned a more modest performance than the vigorous one we observed for
the second quarter. To start, the Standard and Poor’s 500 returned .61% for the third quarter resulting
in a year-to-date return of 6.7%. If we include dividends the returns are 1.12% for the quarter and 8.34%
year-to-date. The Dow Jones Industrial Average saw a 1.28% return for the quarter and a 2.81% return
year-to-date. The NASDAQ Composite returned 1.93% for the quarter and 7.58% year-to-date. Next, the
Barclays Aggregate Bond Fund saw a quarterly return of .27% and a year-to-date return of 3.84%. The
Dow Jones Corporate Bond Index was down slightly, contracting -.13% in the quarter and lowering the
year-to-date return to 5.19%. Finally, the Investor’s Business Daily Mutual Fund Index, which again
tracks twenty of the top US growth mutual funds, was down the third quarter -2.8% and year-to-date is
down -.13%.
Domestic Developments
The past several months have witnessed the reemergence of the Ebola virus in western Africa and now
in the United States. Thomas Eric Duncan, a Liberian man, travelled from Monrovia to Dallas and started
exhibiting symptoms several days later. Mr. Duncan became the first person in the United States to die
of Ebola owing partially to a delay in hospital identification of the virus and also a lack of the promising
Zmapp drug. Thus far the American public has remained calm as patients carrying the virus are brought
into the country one by one. This calm could, however, break into panic should any American citizens,
who have not been to Africa, become diagnosed with the deadly virus. To this point the threat of Ebola
outbreak has had little or no impact on the securities markets, leading one to believe the markets are
confident that the government can manage/contain this extremely serious public health situation.
In domestic economic news re-incorporating a company overseas in order to reduce the tax burden on
income earned abroad, known as corporate inversion is a strategy receiving much attention by
Washington policymakers. This strategy is most often used by companies that receive a significant
portion of their income from foreign sources, since that income is taxed both abroad and in the country
of incorporation. Companies undertaking this approach are likely to select a country that has lower tax
rates and less stringent corporate governance requirements. After the inversions of pharmaceuticals
Abbvie and Mylan earlier this year and the proposed merger of Burger King and Canadian coffee chain
Tim Horton’s, treasury secretary Jacob Lew decided finally to stem the flow of American corporate tax
dollars by adding more rules to the tax code. The new rules, made effective in late-September, will make
an inversion deal more difficult and supposedly less profitable. We can only speculate as to the
unintended consequences of the actual effects of the new rules will have. The mergers and acquisitions
departments of major law and accounting firms may certainly expect rather robust demand for services
as the new regulations unfold. On a positive note, the administration has stated it is open to talking
about restructuring the current tax code to make the need for inversion unnecessary. Time will tell.
The housing market unfortunately is continuing its stagnation. The flight of cash-paying investors from
the market caused housing sales to slip in August 1.8% from July. The market is also down 5.3% from
August of 2013. Economists blame the homebuyer exodus on the possibility of rising interest rates and
an undersupply of cheaper “distressed” homes available on the market. To fill this void left by real
estate investors the market will have to fall back to the ordinary consumer and first time home buyers.
The catch, however, is that credit remains tight thereby leaving these buyers without the necessary
mortgages that enable them to purchase homes. While the government encourages lenders to loosen
credit standards it appears that the housing market for the latter half of 2014 may continue to languish.
It is worth noting that the tight credit environment is a direct consequence of the Dodd-Frank act that
was put in place after the implosion of the credit markets in 2008. These regulations subject banks to
steep penalties for investing in subpar mortgages without adequately describing what the government
views as a subpar mortgage. This lack of clarity leaves the banks no choice but to lend only to borrowers
with credit scores that are beyond question by any regulatory agency.
Healthcare spending, tracking along with robust GDP growth, was up in the second quarter after the
surprising drop in the first. The anomaly of the early healthcare spending contraction may be explained
by the still incomplete implementation of the Affordable Care Act, and the fact that aging baby boomers
are healthier than previous generations. Further, the number of insured increased in the second quarter
as they received coverage following the enrollment deadline of March 31st.
International Developments
In international developments the newest Middle East extremists ISIS continue to occupy the world
headlines. Following the widely broadcast beheadings of American journalists James Foley and Steven
Sotloff, a broad international coalition has been assembled to stop the would-be-caliphate. The coalition
includes several Mideast nations worried that the revolutionary fundamentalists could ultimately
threaten their already-shaky political positions. Key targets of American-led airstrikes will be ISIScontrolled oil fields, the group’s principal source of revenue. ISIS is in control of nearly 60% of Syria’s oil
fields, though they are not operating them at full capacity. It is widely believed their crude is being
smuggled through to Turkey and sold there on the black market. Optimistically the united front facing
ISIS will succeed in if not destroying them, then reducing them into smaller less effective bands of
radicals instead of the pseudo-nation-state they have now become. But considering that this is the
morass of the Middle East where tribal factions do constant battle with various religious zealots,
optimism must give way to realism as we consider an unstable region for the foreseeable future.
A freedom seeking grass roots movement has sprung up in Hong Kong. Students, youth, and poor Hong
Kong citizens have begun protesting China’s control of local elections. Just as in all communist regimes,
Hong Kong does have elections but all the candidates are chosen by the Communist Party in Beijing.
Fueling the protestors’ fire has been the lack of response from Beijing to the plight of the lower and
middle classes on the island. While the business tycoons and the extremely wealthy of Hong Kong
benefit from the quasi-capitalist/communist governance the younger generations are not enjoying
prosperity and now attempt dissent under the watchful eye of dictatorial Beijing. Let us hope the
protestors’ civil disobedience will not meet the same fate as those killed at Tiananmen Square in 1989.
Hopefully some impact can be made on Hong Kong’s Government, as well as their business
establishment, as the protest brings to light the freedom-crushing consequences of their current
policies.
Consumer Confidence Index
The University of Michigan report on consumer sentiment for the month of September was up to 84.6.
This is an increase from June’s 82.5 and is the highest it has been since July of 2013. The number is less
than three points away from the non-recessionary average of 87.4 and is well above the recessionary
average of 69.3. Again, the majority of our gross domestic product is based on domestic consumption so
the improving trend in consumer confidence bodes well for the economy in the future.
Gross Domestic Product – GDP
Real GDP for the second quarter grew by a robust 4.6%. Bouncing back from the dire 2.1% contraction of
the first quarter this expansion tracks even higher than the Bureau of Economic Analysis’s two earlier
estimates. The decidedly potent performance was boosted by strong business and corporate investment
combined with moderate consumer spending. As stated, consumer healthcare spending was up the
second quarter and should continue to increase this year, albeit modestly. Economists have tempered
expectations for steady growth in the third quarter, likely in the 3% range. The advance estimate for
third quarter GDP will be released October 30th.
Employment/Labor Force Participation
Taken as a whole, employment numbers for the third quarter tell two different stories: the good news of
lower unemployment, but the bad news of lower rates of labor force participation. First the
unemployment numbers: the U-3 measurement, the official unemployment rate, dropped to 5.9% in
September after the addition of 248,000 payroll jobs. In June this number was 6.1%. The more inclusive,
and therefore more instructive, U-6 measurement dropped down to 11.8% from where it had been in
June at 12.1%. Even though the U-6 has dropped it remains alarmingly high and is still a cause of
concern to the market(s) and to Federal Reserve Chair Janet Yellen. Furthermore the Labor Force
Participation Rate (LFP) has fallen to a number not seen since the waning days of the Carter
administration. The LFP rate simply calculates the percentage of able-bodied workers actually
participating in the labor force. The number as of September was 62.7%. This is the lowest LFP rate since
1978. So the curious phenomenon of lower unemployment coupled with lower labor force participation
continues. This discrepancy may be explained by the inability of the employment rate (U3) to track
unemployed persons once they are no longer eligible for unemployment insurance, thus leaving a
significant percentage of the labor force not being tracked other than the much broader LFP. Some
economists put partial blame on retiring baby boomers but that only explains a piece of the puzzle.
From what the numbers tell us we may surmise that long-term unemployed continue to drop
completely out of the workforce (the same problem identified in the second quarter). This, then, is an
indication that the economy is still suffering from the 2008 recession. This elusive recovery has been a
slow, sometimes painful process for the American worker.
Technical Market Overview
The Standard & Poor’s 500 remains firmly above its 200 and moving average indicating this long-term
indicator has been unaffected by the recent selling pressure experienced in the market. However, it is
important to realize that it takes a prolonged and significant downtrend in the indexes to cause
significant deterioration in the 200 and moving average as this indicator has a bias toward the longterm. Long-term valuations have become quite rich by historical standards causing the value-oriented
investor to take a more cautious approach to the equity positions in their portfolios. As discussed last
quarter the number of stocks in the S&P 500 achieving new all-time highs at the same time the S&P 500
index itself set a new high watermark has deteriorated significantly from earlier in the year. This
deterioration in the breadth of the market may be another early indicator of an overdue market
correction. As of the writing this letter it has been 719 trade days since the market experienced a 10%
correction, making this the fourth longest uptrend since 1926. I believe these factors combined with the
historically weak equity performance in October may indicate a near-term correction.
Looking Forward
As I mentioned last quarter, many of the issues facing our country and in fact the world have caused
significant downtrend in the markets precipitating a flight to quality in either cash or government bonds.
The markets continue to be optimistic and march almost unabated to new highs. This may be the
collective wisdom of investors deciding what’s important and what’s not; what may have an impact on
corporate earnings or the economy; and what is merely emotionally and psychologically uncomfortable
but is economically unimportant. Or it may be the market is so fixated on earnings a mere 12 weeks out
that it is become so myopic as to discount events such as Ebola and its potentially devastating effect on
our country. As the crisis surrounding ISIS seemingly grows by the day with promises of terrorist attacks
and unspeakable violence on our shores, it is in large part ignored by the markets.
As mentioned last quarter many if not all of these scenarios historically would have invoked a much
more abrupt and longer-term response by the markets withdrawing into a more and more defensive
posture. With the combined psychological impact of issues like the Ebola virus and the emergence of
ISIS and the seasonal selling pressure often experienced in the month of October very well may be the
catalyst for, in my opinion, a long overdue correction. Having said that, markets often exhibit
remarkable resiliency to geopolitical events and even indisputable negative economic situations that
seem to be entirely disregarded until such events can no longer be ignored. Unfortunately when the
market(s) finally digests/consider such events it often contracts rather violently and over a short period
time rendering many defensive strategies less effective, leaving them little time to respond.
Risk Management/Portfolio Strategy
The decision-making process that I use in identifying and making on-going investment choices to meet
your portfolio objectives, and are consistent with your risk profile, includes the use of a sophisticated
computer modeling system that analyzes price trends and many factors at any point in time. It is
important to understand that a model at any moment in time reflects all of the continuous inputs, and is
an observational process, not a predictive one. This means that models I look to do not predict what the
market will do, but rather simply observe what a market is doing and respond to it accordingly. A model
may respond to inputs by, for example, taking a defensive position among available alternatives, but
that is a result of the model having observed enough negative price movement to cause a defensive
response, which can then become a part of my decision-making process. Portfolio losses may be
incurred until such time as a model, or models, have observed enough negative price movements to
cause a defensive response. The same is true as new upper trends emerge. A model must observe
upward price movement before it responds by reducing exposure to defensive investments and
increasing exposure in the appreciating asset classes. What this means is that a model will not normally
leave the market prior to the market peaking and beginning a downward trend, nor will it enter markets
on the day the market bottoms. That is the objective in using a modeling system as a resource. The
adaptive nature of the modeling process aids me in reducing risk/equity exposure in a portfolio, as well
as in responding to emerging up-trends in a way that adds meaningful value to a portfolio. Of course,
there is no investment process or strategy, or any computer modeling system that can eliminate losses
or guarantee positive results. However, the computer modeling system that I use is a valuable resource
in both implementing and carrying out the risk management/portfolio strategy I undertake in the
management of your portfolio. I would welcome the opportunity to review your portfolio with you any
time. If you have questions or wish to make an appointment, please contact my office.
Performance Disclaimer
No investment strategy or methodology can guarantee profits or protect against losses. Investment
risk includes the uncertainty and volatility of potential returns for a portfolio or an individual
investment over time. Investment risk is inherent in every individual portfolio, and no computer model
or modeling program used or relied upon in making investment choices for a portfolio can eliminate
risk. A computer modeling program may not reflect actual risk and return parameters applicable to
any particular portfolio or investor. Actual investment decisions made on the basis of a computer
generated model or modeling program may be materially different from expected or intended results,
and any computer modeling program is subject to errors in the program and system failures at any
time.
Sources
https://www.google.com/finance (indexes)
http://www.bea.gov (GDP)
http://www.bls.gov (employment statistics)
Luay al-Khatteeb, Will U.S. Airstrikes hurt ISIS’ oil riches?, CNN (Sept. 25, 2014),
http://edition.cnn.com/2014/09/22/business/isis-oil-luay-al-khatteeb/
Karma Allen, Economists slash Q3 GDP forecast, but see steady growth ahead, CNBC (Sept. 29, 2014),
http://www.cnbc.com/id/102037335#.
Matthew J. Belvedere, 3 bear market red lights flashing: David Darst, CNBC (Oct. 8, 2014),
http://www.cnbc.com/id/102069891.
Nicholas Bequelin, What’s Wrong With Hong Kong?, Foreign Policy (Sept. 19, 2014),
http://www.foreignpolicy.com/articles/2014/09/19/what_wrong_with_hong_kong_three_reasons?wp_
login_redirect=0.
Te-Ping Chen, Isabella Steger, and Fiona Law, Hong Kong Tycoons Visit Beijing as Students Boycott
Classes, Wall Street Journal (Sept. 22, 2014), http://online.wsj.com/articles/hong-kong-tycoons-visitbeijing-as-student-boycott-starts-1411366778.
Manny Fernandez and Dave Philipps, Death of Thomas Eric Duncan in Dallas Fuels Alarm Over Ebola,
New York Times (Oct. 8, 2014), http://www.nytimes.com/2014/10/09/us/ebola-us-thomas-ericduncan.html.
Mark Landler, Obama, in Speech on ISIS, Promises Sustained Effort to Rout Militants, New York Times
(Sept. 10, 2014), http://www.nytimes.com/2014/09/11/world/middleeast/obama-speechisis.html?_r=0.
Kimberly Leonard, What’s Behind the Slowdown in Health Care Costs, U.S. News & World Report (Sept.
26, 2014), http://www.usnews.com/news/articles/2014/09/26/whats-behind-the-slowdown-in-healthcare-costs.
Ben Leubsdorf, Health-Care Spending Picks Up, Wall Street Journal (Sept. 12, 2014),
http://online.wsj.com/articles/health-care-spending-picks-up-1410463798.
John D. McKinnon and Damian Paletta, Obama Administration Issues New Rules to Combat Tax
Inversions, Wall Street Journal (Sept. 22, 2014), http://online.wsj.com/articles/treasury-to-unveilmeasures-to-combat-tax-inversions-1411421056.
Jim Michaels and Katherine Lackey, Video purports to show 4th Islamic State beheading, USA Today (Oct.
3, 2014), http://www.usatoday.com/story/news/world/2014/10/03/alan-henning-beheaded-islamicstate/16661899/.
Josh Mitchell, Job Growth Rebounds, but Wages Lag, Wall Street Journal (Oct. 3, 2014),
http://online.wsj.com/articles/u-s-job-growth-rebounds-in-september-1412339557.
Josh Mitchell, U.S. Home Sales Falter as Investors Pull Back, Wall Street Journal (Sept. 22, 2014),
http://online.wsj.com/articles/u-s-existing-home-sales-fall-1-8-in-august-1411394672.
Jethro Mullen, U.S.-led airstrikes on ISIS in Syria: What you need to know, CNN (Sept. 24, 2014),
http://edition.cnn.com/2014/09/23/world/meast/syria-isis-airstrikes-explainer/.
Samantha Sharf, U.S. GDP Grew 4.6% In Second Quarter 2014, Up From Earlier Estimates, Forbes (Sept.
26, 2014), http://www.forbes.com/sites/samanthasharf/2014/09/26/u-s-gdp-grew-4-6-in-secondquarter-2014-up-from-earlier-estimates/.
Doug Short, Consumer Confidence Drops, Advisor Perspectives (Sept. 30, 2014),
http://www.advisorperspectives.com/dshort/updates/Conference-Board-Consumer-ConfidenceIndex.php.
Michael Singh, The Real Middle East Crisis is Economic, New York Times (Aug. 19, 2014),
http://www.nytimes.com/2014/08/20/opinion/the-real-middle-east-crisis-is-economic.html.