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1 Neuro Approach INVESTMENT NEWSLETTER RBC Dominion Securities Inc, 2701 Highway 6 Vernon, BC V1T 5G6 Ph: (250) 549-4084 Fax: (250) 545-4139 October 2014 Website: rbcinvestments.com/terry.curran E-mail: [email protected] Written by Dr. Terry Curran, MD, CIM, Investment Advisor Table of Contents: 1. 2. 3. 4. Markets May Head Higher, But………….pg 1 The Many Uncertainties ……………..….pg 2 The Many Certainties ……………………pg 5 Conclusion ………………………………pg 6 Markets May Head Higher, But…. The extreme market volatility we saw in September and October has been well documented in several prior reviews on “Seasonality of the Markets.” The TSX peak-to-trough decline over Sept/Oct was a negative 11.4% and the S&P500 was down 7.4% (but with intra-day it was down 9.5%)! Remarkably, over the last week the markets have recovered about half of that loss, which verifies for me that the Herd Reflex and the R emotional brain are leading markets these days! As we enter the seasonally positive period of November – April (also known as the “Halloween Indicator”) investors must now balance the contrasting viewpoints of what history projects for this favorable time period with what the fundamentals are currently saying. The historical calendar slant is very positive for this time period as historically the 6 months after the November mid-term election (i.e. start of Year 3) is the strongest 6 month period of the whole 4 year Presidential Cycle. The two supporting features for this unusual strength is firstly the remarkable “seasonal benefit” where markets are typically strong most years from November to April and secondly, the very well studied and consistent Four Year Presidential Cycle overlay. History has shown that Year 1 & 2 of every Presidential Cycle are repeatedly weak for the equity markets (the average decline is 21% going back to 1934) as that is when the bad news must be dished out by governments. But starting in Year 3, after the mid-term elections in November, incumbent governments refocus on getting reelected, which often equates to announcements about lower IR, lower taxes, increased government spending programs, increased deficit spending or whatever it takes to boost consumer spirits/spending as well as corporate spending and hiring. This in turn helps the incumbent party get re-elected. Sy Harding’s research on this cycle reveals that from 1934 to 2006 there was an average 50.5% gain from the Year 2 low (such as was seen Oct 15, 2014) to the high in Year 3. Amazingly, this happens regardless to whether it’s Democrats or Republicans in charge, booming or weak economic times, rising or declining IR, or rising or declining inflation! And the strongest market gains are frequently in the November to April time span of Year 3. Kelly Bogdanov at RBC (Oct 21, 2014) updated this research recently and found that after the midterm elections the markets soar an average of 48.5% from the lows in Year 2 to the highs in Year 3. Additionally, the markets were higher on all 20 of these time periods since 1934 and in 19/20 rallied by more than 25%! That’s a pretty good track record folks and has my emotional R brain ready to jump full force into equities. BUT #1… I am really not a pessimist, but rather I believe that we are currently going through uncharted and uncertain times right now (i.e. “a once in a century event”) and I am not sure if the past conventional trends apply during this particular Nov 2014 – April 2015 cycle? For example – maybe the “Year 3 incumbent government stimulus benefit” has already happened? We have had an incredible market run over Year 1 & 2 of this cycle already, 2 and most importantly, this was at least 80% government “induced” re the QE programs, the continued zero interest (or ZIRP), the running up of huge deficits, vast government aid programs, etc. So how does Mr. Obama repeat or up the ante in Year 3, I ask myself. As well, I worry that we have not witnessed a typical 15 – 20% correction over Year 1 or 2 that was supposed to happen based on history. What makes me nervous is that Sy Harding looked at the two times when governments primed the pump throughout the full 4 year cycle and did not get the 20% correction in Year 1 & 2 (which happened 16 out of 18 cycles from 1934 to 2006 in his study). Those two times occurred with President Regan in 1980 and President Clinton in the late 1990s. Regan subsequently suffered through the 1987 stock crash in Year 3 and Clinton had the bursting 2000 tech bubble in Year 4. Consequently my logical L brain is asking if we are not setting ourselves up for another Regan or Clinton repeat in 2015? BUT #2… Another major concern for me is that the fundamentals tell me that the markets remain expensive, especially based on the current tepid recovery and possibly slowing global economy? This by itself hinders my L brain from going all in! So even though the historical seasonal benefit and the Presidential Cycle is encouraging me to be all in for the next 6 months, I feel compelled to weigh the uncertainties against the certainties as we move through the uncharted waters that we currently find ourselves in, e.g. US QE stopping, and ECB starting, the weakest economic recovery ever, massive record government debt levels, etc. The Many Uncertainties 1. The QE3 Stops In October The unconventional QE 3 program is slated to stop this month. This massive buying of government bonds (and mortgages) has gradually forced investors out of bonds and into higher risk assets such as equities. The intentional motive here was to boost equity markets so as to make investors feel wealthy and confident. This in turn was supposed to lead to more spending and economic activity (the jury is out on whether it worked). What we know is that when QE1, QE2, and Operation Twist were stopped the markets tumbled over fears that “the Fed no longer had our backs” and that the economy/markets could not go it alone. On reviewing the current economic backdrop with the stoppage of QE3 we see that some aspects of the economy have improved over the last 2 years (unemployment level, company earnings) but many others have not and there are now new risks on the horizon, such as weakening global growth, especially in China and the EU, multiple wars, Ebola, etc. Additionally, I worry about the “Liquidity Risk” when QE stops at the same time as corporate share buy backs are tumbling and consumers are still being frugal? Richard Koo has warned us that no papers have been written on the giant unconventional QE experiment, nor how the final exit strategy plays out. Nobody knows what will happen over the next few weeks when QE3 stops! That’s uncertainty and my L brain says sit on your thumbs and wait to see how it plays out. 2. The Global Economy Remains Weak The IMF recently cut its global 2014 forecast from 3.7% to 3.3% over concerns of slowing growth in the EU, China, Japan, and several BRIC economies. The IMF also warned about leverage use and stated that the “global recovery is precarious.” In fact many of these global economies are already in a recession or on the brink of a recession, e.g. most of the EU including Germany, Italy & France as well as Japan, Brazil, Russia and several other emerging countries. Several years ago it was the Emerging Markets that were the big global engines coming to the rescue of over indebted industrialized economies – but that has now changed. In 2007 the emerging economies GDP averaged 8.7% and today it is less than 4%! The world’s second largest economy – China, is now also slowing. If we remove China from the GDP calculation then EM growth becomes an anemic 2.5% (B. Milner G&M). So EM will not be a big help in the near term. There are many reasons for the slow growth globally, but increasing global debt and 3 demographic headwinds are the main culprits. Dr. Stacey Hunt has shown that when a countries total debt exceeds 275% of its GDP we see a weakening of growth. Right now the US aggregate debt is at 334%, the Eurozone is at 460% and Japan is at a whopping 655%. These are all higher than 2008 levels! Personal debt has decreased over the last few years, but government debt has soared. Yes, the US is doing much better relatively speaking, but over the last 5 years the US average GDP growth comes in at a paltry 2.2% versus the historical average of 3.9% per annum from 1791 – 1999 (Hoisington). In fact, this is the only bull market recovery out of 16 since 1938 without a single year above 3% GDP growth! That’s slow, that’s uncharted, and that’s worrisome in my books. And although the US economy is very domestic/consumer oriented – it’s stock market is not. At least 45% of the S&P500 revenues come from outside of the US and I believe the ongoing global slowdown will affect the US if it persists. Additionally, the rising US dollar will also be another headwind for these multinational US companies once they convert back into US dollars. I don’t think the markets have factored this in. I agree with Stephen Roach’s recent comments that “secular stagnation is gripping most developed economies” and the US will have trouble side stepping this, I believe. The main problem going forward is that debt and demographics take a long time to change. 3. The Oil/Commodity Signal The price of oil and several other commodities such as copper and iron ore are down significantly over the last year (oil is down 25%, iron ore is down 30%). Although there are conflicting views on the cause, this is a strong signal to me that the global economy is in a weakening trend. To explain the drop in oil prices some argue it is excess oil production, but this does not explain why most commodities are down around the globe. The strong US dollar is certainly playing a role and is hurting most commodities. Yes, there are some benefits to lower gasoline prices (see later) but the overall picture coming from commodities is one of a weakening global economy and declining commodity prices are reflecting this weak demand. 4. Financial Engineering is a BIG Risk Readers all know from prior reviews that this has been one of the weakest economic US recoveries ever. Yet paradoxically the equity markets have had one of the best bull runs ever. This combination is not uncommon over a short period (as the equity markets are forward looking), but rare over such a protracted period. A recent Bloomberg report revealed that from March 2009 to June 2014 the S&P500 increased 4.7% on average every quarter, which was almost 5 times faster than the GDP growth. The report went on to say that this was “the biggest gap since at least 1947.” Lance Roberts in a September report referred to the “accounting magic” that US corporations are now incorporating into their reports. Since 2009 the reported earnings have increased by 262% in the US – which is “the sharpest post-recession rise in reported EPS in history” – yet revenues for sales are only up 23%! Over the last 2 years the S&P500 stock market is up about 45% with 70% of this coming from P/E multiple expansion, 15% from margin expansion, but only 15% from sales growth. Financial engineering and accounting magic have created a huge disconnect here. So what is behind this disconnect between GDP and the stock markets? Well, it comes down to clever “financial engineering” at the corporate level and government level. A report by Michael Lewitt reveals that in 2014 S&P500 companies have spent 95% of their earnings on stock buybacks and dividends! So that leaves only 5% for capital expenditures, R&D, and hiring! These smoke and mirrors accounting practices work because stock buybacks reduce the share count so then the earnings per share (EPS) improve and the stock moves higher. The CEO/CFOs love this as their remuneration is tied into EPS and stock prices. The fact that since 2009 earnings have grown at an annual rate of about 14% yet sales have only grown at a third of that pace exposes the use of “financial engineering.” Financial engineering has allowed corporations to minimize or even hide their weak sales growth – that is until 4 recently. You can fudge earnings, but it’s very hard to fudge sales. Again, another symptom of the uncharted times we are living in, which greatly elevates the risk level. This quarter bellwether companies IBM, Coca Cola, and McDonalds (about 12% of the DOW) all disappointed the markets and their stocks got clobbered. The common criticism was that of weak sales growth and excessive share buybacks. IBM for example has had flat revenues for 6 years, but until recently its stock has soared. IBM has spent $140 billion on share buybacks and dividends since 2000! That buying has tripled its debt level. Maybe more focus on R&D or acquisitions would have been prudent in hindsight? Another bellwether stock that is still hiding its flat sales yet managing to juice its EPS through enormous stock buybacks is Caterpillar (CAT). Yet its Capex spending has collapsed over the last several years. When will the markets see this? Some very bright investors are shorting CAT and I suspect they will be successful. 5. Bond Market Sees Uncertainty As an aside, I also wonder if weak sales from these bellwether companies - McDonalds (worst same store sales in 10 years) and Walmart (lowered its sales outlook for 2014) is not also a reflection of the status of the US middle class and the frugality they are enduring due to poor wage gains? To allow for this massive buyback process, the S&P500 companies in aggregate have raised almost $1.3 trillion in 2014 through new bond issuances to help pay for the buybacks. Hence US corporate debt levels are now at record levels. This will have to be refinanced down the road and at higher IR I suspect. Finally, one has to mention the fact that the US Gov/Fed is also performing its own act of financial engineering. Through the QE program and ZIRP it’s managed to rack up massive debt with minimal side effects thus far. Because of this manipulation, one wonders if we can now trust and rely on the traditional yield-curve recession indicator? Historically, all US recessions since WWII have been preceded with a flattening and then inversion of the yield curve. I wonder if this indicator is still valid with the current Fed Financial Engineering? Or is it another manipulated indicator like corporate EPS creating the illusion that all is well? The bond market signal is one of slower global growth. Despite the QE taper, the 10 year US bond yield has dropped significantly this year as investors poured dollars into bonds (for safety), which drives yields down. Normally when the economy is growing and rebounding, the bond markets anticipate an increase in inflation and interest rates and bond yields typically rise. This has not happened in 2014 and in fact most economists got this call wrong in their mid 2014 predictions expecting the 10 year yield to rise to 3% - instead it has dropped to 2.3%. To me this is another sign that the bond markets are not buying into “all is well” after the QE taper. Another indication of fluctuating levels of confidence (and R brain emotional activity) was the recent panic equity sell off days in mid October when the 10 year US Treasury went on one of its wildest rides ever. Over a few hours the yield went from 2.21% to 1.86%. That’s rare! 6. The Deflation Uncertainty Deflation (or decreasing prices of goods/services) is never good for economies, nor the stock markets. All one has to do is reflect on Japan’s 20 year struggle with falling inflation, deflation, tepid GDP, and soaring debt to get an indication of why governments fear deflation. The most recent inflation number for Europe was a paltry 0.31%. Many are now worried that the EU could follow the same economic path as Japan! The EU is struggling with many of the same problems that plagued Japan for years – soaring debt, weak banks, weak growth, and significant demographic headwinds. All of these problems are deflationary and none are quick fixes. Most expect the ECB to react any day and start their own full blown QE program. Adding to these global deflation worries is the fact that China and the US are also dealing with very low inflation. The US core inflation rate is now 1.7% vs the historical average of 3.8%. The macro concern is what happens to these economies when 5 the next recession hits as recessions are deflationary, which could tip many countries into outright deflation. recovery has ever occurred in the US without a robust housing recovery. We are still waiting to see this. 7. The Middle Class Uncertainty Other headwinds covered previously include frothy valuations, record profit margins, and record high leverage by investors. These are all mean reverting at some point and will challenge equity markets going forward. A big challenge facing the US middle class is one of significant income inequality and poor wage growth. A recent ECB report revealed that the top 1% of Americans now control 35% of the US wealth. A more dated study by E. Wolf from 2012 revealed that the richest 5% of Americans control 88.9% of the nation’s health! That’s a very lopsided distribution of wealth and unhealthy for any democracy. Jeff Gundlach has referred to the middle class in the US as being “hollowed out” as wages/salaries as a percentage of GDP remain at record lows. Since 2009 the rich have gotten richer (top 5%) and the poor have gotten poorer (bottom 95%). Because of this imbalance, I worry about how the US can sustain its growth if the middle class is fragile (especially as the rest of the globe stagnates)? There is no doubt that the US is seeing some growth and jobs are happening, but I fear that the gains are not being realized by the part of the middle class that can help the US economy going forward. Tyler Durden recently reported that since December 2007 there have been 5.5 million jobs created in the US in the 55 – 69 age group. But in the core 25 – 54 year old age group there has been a loss of 2.04 million jobs! These 25 – 54 year olds are the folks that buy new homes, visit Walmart, Target, and McDonalds. The problem is that the 55 – 69 age group are savers – not spenders and will contribute little to the US economy in the near term. This job discrepancy also likely explains in part why the US retail sales remains weak despite “job gains.” 8. Other Uncertainties I have covered the demographic headwinds and the tepid US housing recovery in prior Newsletters and Generic E-mails and so I won’t repeat here. But it is hard to get a sustainable recovery when new home builds are only running at 50% of the historical trend. The most recent volume of “applications for home purchases” plunged to the lowest level since 1995. No prior sustained B. The Many Certainties Several valid bullish arguments brought forward by the bulls needs to be reviewed here as they have continued to carry the markets higher and could carry the markets higher yet into 2015. #1. The Year 3 Presidential Cycle: This was covered in the intro and for me is one of the main reasons to have equity exposure for the next 6 months. The question is how much? I think finding the balance between the uncertainties and certainties will help with this decision. #2. The Recession Risk is Low: By virtually all measures the risk of a recession in the next 6 – 12 months is very low (not impossible – just low). The stated “safe guard” to this insight is that any market correction occurring now would most likely be in the 10 – 15% (rarely 20%) range and only last 3 – 5 months. The theory is that the more traumatic bear market corrections (or 20% plus) “only” occur during recessions, and these are more protracted lasting 1 – 2 years. This gives great comfort to the many bulls (e.g. David Rosenberg) who are happy to remain overweight in equities as despite some short term volatility (e.g. Sept - Oct) the upward market trend should be supported by the lack of a recession in the next 6 – 12 months. In fact, the three main “provokers” of recessions and bear market corrections are 1. rising oil prices, 2. rising interest rates, and 3. an inverted yield curve. None of these seem to be in the cards for the next 3 – 6 months. Oil prices are currently declining, which is good for consumers as it is a 6 tax break. Interest rates (globally) are rock bottom and the yield curve remains steep (although one could argue that Government “financial engineering” has manipulated the yield curve making its prediction usefulness weaker this time around). just fine but the pessimist says that the US will be affected by the global slowdown. We will see. #4. Lower Commodity Prices are a Tailwind: Supporting evidence for the low recession risk are the most recent leading economic indicators (LEI), which continue to show economic growth as does the 3 month rolling Chicago Federal National Activity Index (FNAI). The only thing that scares me about this viewpoint is that virtually 100% of economists see no recession risk and my logical L contrarian brain sees this opinion in itself as a risk! Oil and gasoline is a huge tax on the US economy and so with oil having dropped from $110/barrel to $80 barrel many are expecting that consumer spending will surge going forward. This is also a big positive for energy dependent manufacturing businesses, which could translate into more hiring and wage increases. In addition to oil, many other commodities are also down in 2014, such as corn, cotton, and iron ore, which also helps business input costs and ultimately the economy. #3. The US Economy is Doing Just Fine: #5. The “TINA” Certainty: The bulls main argument is that despite many other economies suffering through recessions and declining growth the US economy continues to grow and create jobs. And because 70% of the US economy is domestic consumer based it should be “pretty immune to any global setbacks.” Many believe that equities will continue to see an advantage over most other assets as “There Is No Alternative.” Bonds are yielding very low returns and after inflation you are negative on many. And by going longer on the term (or duration) to seek higher yields you run the risk of capital loss should IR spike. The other alternative is cash and this again is a poor option because of the low interest rates. Additionally, as long as IR and inflation remains low, equities often do well in this environment. We are seeing steady US job creation averaging 220,000/month over the last 12 months and the unemployment rate is now only 5.9%. The broader U6 unemployment has dropped to 11.8% indicating that jobs are being created, but I note that prior to the recession it was 8.9%. Additionally, the US jobless claims (i.e. firing rate) – a leading indicator, is now at the lowest level since 2000! Other positives for the US economy are the persistent very low IR and low gasoline prices. In fact, many are calling for a “stellar” holiday season in retail sales because of the dollars saved on gasoline prices (however, I would have thought that this gasoline “benefit” would have showed up in McDonald or Walmart sales by now as well?). Other positives touted by the bulls include soaring auto sales and an increase in Merger & Acquisitions activity. All positives for the market. Although it is possible that the US can maintain its “island of prosperity” status, I wonder how the US middle class will step up to this challenge if wages remain flat and jobs continue to go to only those age 55 and up? The optimist says the US will do CONCLUSION One of the most important investing decisions is finding the correct balance between risk and reward. Ideally we would always like low risk exposure and lots of rewards when investing in equity markets. However, the reality is that this balance or relationship between risk and reward is in constant flux and like a pendulum swings from one extreme to the other. Although I believe that much of the time the markets are fairly efficient and balance risk and reward pretty accurately, there are times when markets become very inefficient and badly balanced. The clear obvious examples would be the outrageously overpriced market tops of 2000 and 2008 (i.e. high risk – low reward) and outrageously underpriced bear market lows of 2001 and 2009 (risk low – reward high). In hindsight 7 these risks and opportunities seem very obvious and some smart money investors with great foresight did very well – but unfortunately most did not. However, I believe the odds of identifying these imbalances can be identified in real time but this requires deep thought and lots of patience. The most important issue is finding a way to balance the L & R brain’s input to your investing decision. It is when the risk vs reward aspect becomes very asymmetrical that smart investors can both make lots of money or equally important, protect lots of money. This is the time when the L brain must override the R brain. I think we are now at one of the extreme ends of the pendulum swing. I currently see the level of risk very high and the reward potential very low. In fact, it has been this way for 16 months and the R brain investors have not seen this because of the smoke and mirrors created by the corporate and government financial engineering eluded to earlier. The logical L brain currently acknowledges the huge disconnect of stretched valuations at a time when we have the weakest US economic recovery ever. It is also fully aware that you can’t fudge sales, and the current P/S on the S&P500 is now higher than 2000 and 2007! The L brain also sees the tremendous demographic headwinds and mounting global debt that must come to roost at some point. Equity markets are ignoring these risks. Finally, the ending of QE3 at a time of declining share buybacks presents a significant liquidity risk to the markets that has my L brain on vigilant alert! The competing emotional R brain senses that the animal spirits are on fire as reflected in the markets steady climb and is now doubly “reassured” by the rapid rebound from the most recent correction, i.e. “it was just a minor dip and a buying opportunity.” It also acknowledges that we are now entering the most favorable 6 month period of the whole 4 Year Presidential Cycle! My balanced “hemispheric” approach will start by seeing how the next two weeks play out with the QE stoppage and the conclusion of the 3rd quarter Earnings season. If there is no major correction, then it is quite possible that history will repeat and the markets will climb higher into early 2015! The Presidential Cycle, soaring animal spirits, and the strong Herd Reflex are very powerful market movers. However, I strongly feel this could set the scenario for another market bubble, especially if we continue to see a global economic slowdown as indicated by slumping commodity prices even if the US continues its tepid recovery. If the ECB joins the “full QE program” like the US did (and I expect it will) then this increases the odds of a bubble for sure. Today’s surprise stimulus by the Bank of Japan will also add to the bubble creation. My plan of action is to continue with our Defensive Investing Strategy with some minor adjustments. I feel that this is the most logical path forward when the risk/reward is so asymmetrically slanted towards risk! To benefit from the market rise I plan to add some tranche positions in low Beta dividend stocks that have recently gone on sale and some country specific ETFs, such as Europe and select Emerging Markets. Additionally, I also plan to start taking profit on some of our winners that have seen tremendous growth over the last couple of years and are now overvalued. I will also continue to hold a high cash position, but will put more of this cash in our “cash substitute” investments that have worked very well over the last 16 months. At times like now I am always reminded of famed Jeff Gundlach’s quote that “you make 80% of your money in 20% of the time in investing and you have to be patient.” ________________________ I am very happy to report that we have added a new associate, Val Rybka, to our team. Val has many years of experience in the financial industry and will be helping Terry and Sharon with her invaluable expertise going forward. ------------------------------------------------------------------* Please feel free to pass this no obligation, free Newsletter on to any colleague you feel might be interested. * We also provide a bi-weekly Generic NeuroApproach E-mail to all clients. If you would like to receive this no obligation e-mail, please e-mail my assistants at [email protected] or [email protected] 8 PLEASE FEEL FREE TO CONTACT US: RBC Dominion Securities Inc. 2701 Highway 6 Vernon, BC V1T 5G6 Toll Free: 1-800-663-6439 Direct Ph: 250 549-4084 Fax: 250 545-4139 [email protected] [email protected] [email protected] Disclaimer: Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. 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