Monthly Archives: January 2014

Macro Focus — A Changing of the Guard at the Fed

Fri, JAN 31st, 2014

I find the below table, put together by the folks over at Strategas Research, very interesting.

There have been fourteen chairmen since the Federal Reserve was sanctioned by Congress in December 1913 to stabilize the banking system [and thus the economy]. From the below data, Paul Volcker was arguably the best chairman in terms of absolute stock market performance [CAGR]. I say this because even though his annual returns aren’t the highest of the group they are very impressive and over a much longer period of time [Hamlin’s number beat Volcker’s, but he was only running the show for about two years]. It is also worth noting that Volcker’s brash policies broke the back of pesky inflation — which plagued the economy and markets all throughout the 1970s peaking at ~13.5% in 1980/81 — and helped set the stage for economic growth. He did this by first hiking aggressively the federal funds rate from August of 1979 through 1981 [from 11% to 20%] before pivoting in 1982 steadily dropping rates in order to help grease the gears of the economy. As a result, great stock returns followed as inflation came down and real economic growth went up. This created a virtuous cycle that persisted for years.

Greenspan and McChesney Martin hold the longest tenures [each at nearly nineteen years] and both have laudable stock market CAGRs over this exhaustive period. Impressive, to be sure.

More recently, Ben Bernanke’s +5.2% CAGR looks mediocre at first blush. Nevertheless, I place him as likely the greatest central banker in the history of the Fed. First, let us agree that a Fed chairperson’s greatness should not be measured by stock market returns alone. Second, returns over Bernanke’s eight years are quite misleading in my view and do not fully capture his positive contribution to both the real economy and financial markets. For if it were not for Bernanke’s courage and diligence in deploying progressive, unorthodox monetary policy over the past several years the U.S. financial system [and thus the economy] may not have made it through the crisis. Some may call this hyperbole, and that’s fine. We can never truly know what would have happened had we charted a different [policy] course. But those same skeptics must also recognize that had it not been for Bernanke’s bold policies the economy and markets would be far behind where they are today, at the very least. Mr. Bernanke’s last five years in office [2009-2013], the direct period beholden to these intrepid policies, show a stock market CAGR of closer to +19%! With context to his spot on the table, this five-year performance number vaults him to second place. I assert that this is a germane lens through which to view Bernanke’s most critical body of work. Indeed, it is a reflection of the vast strides the economy and the business cycle have taken post-crisis.

Across these fourteen Fed shepherds the mean chairmanship has lasted about seven years; the median is five years; and the mode is bimodal [i.e., not unique] at three and eight years. It will be interesting to see what Janet Yellen is able to do as she officially begins her work as the first chairwoman of the Fed. I suspect that a big part of her legacy will be in her first act — how deftly she manages the exit from the extraordinary monetary policy of her predecessor.

I ponder these things as Ben Bernanke wraps up his final day at the helm after eight years. It was a wild ride to say the least. In financial markets there were ups, then [dramatic] downs, and finally a return to [dramatic] ups. And in close correlation the economy grew, then broke, then gazed into the abyss only to be pulled back from the brink, and has since recouped all of its lost output [though we remain below our economic potential]. Banks, at the heart of the crisis, went from complete disasters to the healthiest they’ve been in years. Meanwhile, politicians controlling fiscal policy have made smooth economic progress nothing short of a major challenge. This made Bernanke’s job increasingly difficult.

Along the way Ben attracted many critics and amassed a legion of supporters. Monetary policy is now on the path to normalizing and his chairmanship has officially ended. I suspect that only time will provide the truest bench from which his legacy is to be judged in the court of public opinion.

I thank Bernanke for his service to the economy.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200
jware@albionfinancial.com

FedChairs

Market Surveillance — Emerging Economies Upset Stocks

Fri, JAN 24th, 2014

With equity markets turning sour this week investors have two real choices: 1) PANIC, or 2) breathe.

At this point we don’t yet have  a “correction” on our hands. A correction is generally defined as a -10 to -19% sell-off in the market [bear markets are -20%+]. The current -3% is barely akin to a pull-back [defined as -3 to -9%]. But is this pull-back setting up to be a full-fledged correction? Maybe. Maybe not. Either way, I believe this recent selling is chiefly predicated upon a few items:

1) Recent news out of China [a January PMI that missed the mark; SEC battles with the Big-4 US accounting firms’ Chinese arms; and a ~$496M Chinese trust investment on the brink fanning the flames of systemic debt fear, probably the largest cause of recent anxiety]; and also the rocky emerging market currency behavior of the past couple of days [Turkish Lira, Argentine Peso — both suffering from policy problems, but the latter is experiencing dollar-reserve issues as well]. Taken together, this recent volatility and uncertainty in emerging markets and their currencies are impacting sentiment on U.S. stock markets.

2) Given the increasingly accepted general outlook for 2014 that the U.S. economy is getting better and that the Federal Reserve is on track to normalize monetary policy, rates seemingly have nowhere to go but up. Thus a major related undercurrent in the marketplace in recent months has been — in classic Wall Street fashion — traders overplaying their hand, this time on the short side of the U.S. Treasury market. To wit, short positions in this market have grown quite large, according to data from Stone & McCarthy Research. As a result it appears that, following a big run in the stock market and a big sell-off in the Treasury market, weaker-than-expected Chinese PMI data and a potential credit flap were enough to trigger a flight to quality back into safe haven assets. This lead to serious short-covering in Treasurys and sent markets spinning. This hedge fund driven market flush scenario is of course but a theory, though it’s one that seems to make sense when looking at recent price action and correlations.

3) In my view there remains a meaningful lack of conviction in equities [a contrarian indicator]. Over the past several months everyone has been talking about how “bullish” investors are. That this market has now become too frothy because there are simply no bears to be found … an imbalanced market now top-heavy as everyone crowded to one side [optimism]. This level of bullishness, the thinking goes, is what often shapes market tops. My position is that this consensus sentiment analysis is incorrect and lacks appreciation for a critical nuance. What I have seen [and continue to] is a more bifurcated sentiment landscape. On one side are core equity holders who have conviction in stocks [and have been this way for some time]. On the other are “nouveaux bulls” who just recently came to the party. They have been dragged kicking and screaming into this market. They are, in my opinion, better described as fully invested bears [FIBs for short].These guys lack true conviction; they still dislike and distrust stocks and are gone at the first signs anxiety. And there are a large number of these folks given the variety of conversations I have with investors, including other professional analysts. To be sure, this type of stock ownership is not indicative of ‘too much bullishness.” Fair enough, but why is this important in the context of the recent pull-back? Because I believe we are seeing many of these skittish FIBs now exiting the market after the recent rally. They are trimming positions, cutting exposure and generally taking profits on the first signs of bad news. This retreat back into their bear caves is healthy for the market.

Indeed, this was probably needed after such an impressive rally.

By my count, over the past twelve months we’ve had three different notable pull-backs while the market has moved roughly +30% higher. Each one had their reasons, so to speak, and I don’t see anything out there that suggests that this one is somehow more concerning or fundamentally different from the others. So, how long does this one it last? I don’t know. How low does it trade? Haven’t a clue. Nevertheless it’s worth noting that the majority of the recent pull-backs have been both short and shallow. This is likely a function of money wanting to get into stocks after years of receiving negative real returns in cash and paltry yields in fixed-income. Stocks have crushed other asset classes for nearly five years in spite of rampant fear and loathing; suffice to say, those under-invested used those dips as buying opportunities. Unless we see some grave deterioration in economic fundamentals, I suspect this time is no different.

So, how are we handling this pull-back? For now, we are prudently and carefully watching from the sidelines. We aren’t selling into it. Our macro baseline for both the US economy [it’s doing OK and growth is broadening out] and the stock market [we’re still in a bull market that’s going higher] remain firmly intact. We are closely watching U.S. corporate earnings season, and so far things on this front are tracking along fine.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200
jware@albionfinancial.com

Market Surveillance — 2014 Begins

Tues, JAN 14th, 2014

Happy New Year! I has been nearly 12-months since I lasted blogged. 2013 was defined as a year of change for Albion’s website. Now that the site has been completely refreshed, it is our intent to periodically update the blog in 2014, and beyond, with real-time economic, market and investment insight. We hope you find it both informative and entertaining. Cheers!

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We are 9 trading days into the year. The S&P 500 is in a state of churn, though on a vector that is slightly lower than the 2013 close. This has provoked many to proclaim a tough year ahead for stocks [citing the “first five days” rule]. While I am not typically one who affords much attention to silly market “rules”, this one has received an undue amount of press. Indeed, it is out there festering within the mouths’ of the pundits, salivating over any whiff of a correction or bear market. OK. You can have your little five day rule, Super Bowl and lipstick indicators, too, but consider this: According to the folks over at Strategas, market internals so far in 2014 are off to a solid start with Low Quality beating High Quality, Cyclicals outperforming Defensives, Small-Caps besting Large-Caps, and High Beta edging out Low Beta. Too, recent price action from the Transportation and Shipping stocks, as well as from Financials, Building Product companies and Industrials augur well for underlying market fundamentals, and act as read-through commentary on the general economy.

A brief note on the short-run technicals, with respect to S&P levels there is some minor resistance near 1850 and support around 1820.

In Europe it’s a similar story as Small-Caps continue to set the market’s pace; Banks seem a bit healthier and recent government bond auctions from Spain, Portugal and Ireland were met with strong demand and thus lower yields [the Spanish 10-year bond clocked in @ 3.75%!]. At the index level, the climate looks promising as credit and sentiment gradually improves and the European Central Bank [ECB] remains in “whatever it takes” uber-dove policy mode. At the sector level, European bank stocks have broken out on sturdy breadth, which may be a good signal for slowly improving risk appetites. Valuations in Europe remain attractive.

Japan is mixed. The weak yen is being driven by extremely loose monetary policy, which should continue through 2014. With the U.S. Federal Reserve now tapering, the BoJ is unquestionably the king of kings among the most accommodating global central banks. This is helping to boost exports and corporate profits. Inflation figures, including key readings of expected inflation, are turning up after nearly two decades trapped in the jaws of deflation [though admittedly, we have seen head-fakes before]. For now, these are all positive items. On the other hand [my apologies to Harry Truman], Japan’s fiscal policy seems to be tightening some, most notably with a scheduled two-tiered increase in the national consumption tax. However, I cannot help but wonder if this looming rise is more of an effort to pull forward some level of aggregate demand ahead of the tax increase thereby further stoking the coals of inflation [and hence prodding evermore consumption]. Of course, growing tax collections, in theory, certainly help the highly-indebted Japanese government achieve better fiscal stability, but so too does higher inflation. The other arrows in Shinzo Abe’s policy quiver – chiefly trade reforms and government spending on infrastructure – lie somewhat dormant for now.

Meanwhile, emerging markets as a whole are still reporting superior rates of economic growth verses the developed world, yet many stock bourses within these economies have performed noticeably worse. Part of this divergence is a reflection of policy challenges — particularly in China, and particularly regarding debt in the system — as well as structural global economic re-balancing in a post-crisis world. The other element in play is U.S. monetary policy, which has been perceived [and rightly so] as less dovish over the past 6 months. The result has been a reversal of steady “hot” money flows out of these markets and back into more stable markets whose growth and return profile has become increasingly more attractive. Those developing economies with large trade deficits [particularly when backing out FDI] and whose reliance on foreign borrowing is highest have the most to lose under this new paradigm of rising U.S. interest rates. In Brazil, preparations for the 2014 World Cup and 2016 Summer Olympics has driven infrastructure spending. But social unrest remains elevated, demand from China [their largest export market] has cooled, and inflation is running too high. Russia and India are facing vastly different, but equally daunting, political and economic hurdles. Elections this year in India, Brazil, Turkey and South Africa, to name a few, will be crucial in establishing the near-term direction of these regions.

Nevertheless, global growth — the summation of the developed and developing world — should be higher in 2014 than 2013. Indeed, about 75% of world GDP [U.S. + Europe + China + Japan] is either stable or picking up.

So, in getting back to U.S. equities …

Talks of another stock market bubble continue to swirl about. And in a post-bubble world where the market continuously reaches new highs, I understand the avidity of those attempting to call the next top. I argue, however, that while indeed absolute price levels of the Dow Jones Industrials and S&P 500 are at record highs [though, the latter is still short of an inflation-adjusted high] underlying valuation of the market – by far the most important gauge – is reasonable on known information [i.e., not cheap and not expensive]. Put differently, absolute price level alone is not a good predictor of future returns. Yet when one looks out into 2014 and into 2015 a sensible argument can be made that we have more room to go as I expect both the corporate profit cycle and macro economy to continue along their expansionary paths. The allure of equities become particularly engaging when paired with the dearth of compelling investment alternatives and against the low inflation and interest rate backdrop. Understanding this key point is important in recognizing our present location on the bull market road map. The core ingredients that determine equity prices — P/Es, inflation and interest rates — remain supportive of the market at current levels.

Moreover, in performing a thorough valuation analysis one must carefully take note of the components that make up the market’s overall position. High-beta stocks, including many cyclical names, are actually trading below their historical P/Es. Meanwhile, more defensive stocks with higher yields – the favored group during periods of macro stress – remain above their long-run P/E averages as they persist in working off this premium now that the Fed is beginning to dial back QE and the economy picks up momentum. To be sure, this type of valuation inversion is not symptomatic of an overheated stock market. Instead it demonstrates a still-restrained risk appetite. There is no excess of excess, broadly speaking. Not in the economy, not in stocks. In fact from my perch many investors currently own stocks with great resentment. They are shareholders with one foot out the door lacking a true sense of conviction. These invested bears, as I prefer to call them, throw off false readings in the widely referenced investor sentiment surveys and will be gone at the first signs of turbulence. This is neither the texture nor tone of bull markets with too much euphoria.

Finally, a study of long-run stock market data tells us that protracted bull markets – those that extend 5 years or more – generally do not end simply because valuations are perceived as stretched. To wit, valuations can stay elevated for a lot longer than people realize. What usually ends the party is a recession, a brawny Fed tightening cycle [no, tapering QE does not qualify] or some black swan event [i.e., exogenous shock]. At present, we don’t see a recession given the economic data, nor do we expect any time soon for the Fed to embark upon a classic tightening of monetary policy by raising the federal funds rate target *though, this would become a risk if we suddenly get money velocity in the economy*. As for black swans, by definition they are events that are completely unknowable so I will not venture a guess as to the likelihood of one swooping down and *goosing the market.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200
jware@albionfinancial.com

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