Download October 2014 - Markets May Head Higher, But

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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,
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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
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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
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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
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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
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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
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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.
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and may trade in any of the securities mentioned
herein either for their own account or the accounts
of their customers. RBC Dominion Securities Inc
and its affiliates also may issue options on
securities mentioned herein and may trade in
options issued by others. Accordingly, RBC
Dominion Securities Inc. or its affiliates may at any
time have a long or short position in any such
security or option thereon.
RBC Dominion
Securities In.* and Royal Bank of Canada are
separate corporate entities which are affiliated.
*Member-Canadian Investor Protection Fund.
RBC Dominion Securities Inc. is a member
company of RBC Wealth Management, a business
segment of Royal Bank of Canada. ®Registered
trademarks of Royal Bank of Canada. Used under
license. © 2013 Royal Bank of Canada. All rights
reserved.