Daily Bullets ………..For April 15, 2014 (Happy Tax Day)

·         Housing sentiment still flat……Homebuilder sentiment moved up slightly in March to 47, still in flattish pattern the past few months. Reason? Tighter credit, tight supply of buildable lots. Pent up demand for housing is increasing based on household formations and deep supply reductions of past several years. Link: http://money.msn.com/business-news/article.aspx?feed=OBR&date=20140415&id=17526384

·         Shiller positive on housing…….Nobel economist and housing guru Robert Shiller said this morning he sees more momentum in housing market than the stock. While mortgage rates have moved up, affordability is still good. He believes it is possible home prices could rise 25% in next 3-4 years. Link: http://finance.yahoo.com/news/more-momentum-housing-stocks-shiller-141805700.html

·         10-20% correction: Stovall…… Sam Stovall, equity strategist for Standard & Poors, believes we could see a 10-20% market correction by the end of June. Why? Statistically speaking the market has not had a true correction (down 10-20%) in 2.5 years, way beyond the historic average of about every 18 months. His call is purely statistical in nature. Market corrections are normal and necessary to cleanse excesses and imbalances in the markets. Link: http://finance.yahoo.com/news/odds-favor-10-20-stock-195801126.html

·         Big banks need more capital: Yellen……Fed Chair Janet Yellen speaking at a bank conference this morning stated big banks rquire more capital to withstand periods of financial stress. One implication of this: perpetuates the “risk averse” mentality among bankers that could act as a drag on loan growth and, therefore, act as a drag on the economy. Link: http://money.msn.com/business-news/article.aspx?feed=AP&date=20140415&id=17525691

·         Obamacare may help bonds…..Bloomberg News has an interesting analysis that supports the view that Obamacare may actually be favorable for bonds because it will reduce the rate of health care inflation. Lower inflation would be favorable for bond prices because interest rates would not rise as fast. The irony is longer term rates could rise even if inflation remains low because of credit demands for funding expanding federal deficits. Link: http://money.msn.com/business-news/article.aspx?feed=BLOOM&date=20140415&id=17526095

·         CPI picks up a bit…..Labor Department report this morning that CPI increased 0.2% in March, up from 0.1% in February. Core CPI was also up 0.2% in February and increased 1.7% for 12 months. This may raise concern that inflation is “accelerating”. We hardly view 1.7% as heated inflation and we believe inflation will remain relatively subdued. Link: http://money.msn.com/business-news/article.aspx?feed=OBR&date=20140415&id=17525585

 

Daily Bullets………..For April 14, 2014

• Good news on retail sales!.... March retail sales up 1.1% were much better than expected. The strength was across the board, driven by strong demand for autos, furniture, clothing, building materials, etc.  The really positive aspect is the breadth and reflection that economy and consumer spending, are performing well, and perhaps better than many expected. This supports our long-held outlook for the economy in 2014, unfolding as we anticipated, which has positive implications for stocks. Article link: http://money.msn.com/business-news/article.aspx?feed=OBR&date=20140414&id=17521612
• Another positive sign for U.S. economy…..Job outlook: Reuters reports this morning that U.S. consumers are growing more confident about the job market as the estimated chance of finding a new job increased to 49.0% up from 46.1% in February. This is another reflection of improving consumer sentiment generally and has positive implications for both economy and consumer spending. Article link: http://money.msn.com/business-news/article.aspx?feed=OBR&Date=20140414&ID=17522768&topic=TOPIC_ECONOMIC_INDICATORS&isub=3
• “It can’t be done with current information at hand”…. Jim Cramer has an interesting article out this morning questioning why certain sectors in the market are behaving the way they have been in this recent market pullback (today notwithstanding). His ultimate conclusion is: you can’t determine from available data (as to why sectors such as machinery have done well if investors are concerned about the economy). Hmmm….. Could it be that fundamental investors, or what we would refer to as “strong hands”,  are looking through the near-term noise and are focused on what continues to be pretty solid economic fundamentals, particularly for the U.S.? We think so. Article link: http://money.msn.com/top-stocks/post--why-is-this-market-so-hated-and-feared
• More easing ahead for ECB? ……We note over the weekend, it was reported that Eurozone banks will only pay back 6 billion (Eurodollar) of their crisis loans, which is below the 8 billion that was expected. The implication is Euro bank liquidity is not improving as rapidly as hoped for. Should this be any big surprise? We think not. It reflects more of the same for Europe: recovery will continue to be slow, ECB policy will remain highly accomodative. Article link: http://money.msn.com/business-news/article.aspx?feed=OBR&Date=20140414&ID=17522672&topic=TOPIC_ECONOMIC_INDICATORS&isub=3
• Lower federal deficits…..CBO this morning is reporting it expects U.S. federal budget deficits to be nearly $300 billion lower than previously expected. CBO now expects federal deficit to reach a low-point of $469 billion, or 2.6% of GDP in 2015, then gradually rise to over $1 trillion in 2024. This has positive implications for interest rates near term, as it indicates that marginal demand for credit by U.S. government should ease somewhat in next year or two. It has negative implications for the longer term as funding of increased Federal deficits could place upward pressure on interest rates and remains a long-term structural problem for the U.S. Fortunately, our economy is large and resilient enough to handle a lot of this future financial “pressure” but it is problematic nonetheless. Article link: http://money.msn.com/business-news/article.aspx?feed=OBR&Date=20140414&ID=17522837&topic=TOPIC_ECONOMIC_INDICATORS&isub=3

 

 

 

Daily Bullets….April 11, 2014

As we review the daily news, we see articles that we believe have particular significance for the financial markets and our investment policy. We highlight some of these for you in this column. Our goal is to post daily on these items, but we know realistically there may be days where it is not feasible. Please let us know if you have comments or questions !

 

·         Yesterday………….Dow down 267 yesterday. Why? Necessary and overdue adjustment to what was becoming a short term overbought condition reflected in speculative froth in pockets of the market such as biotech, social media, and stocks with nose-bleed valuations. Could this be the start of a bondfide “correction” (meaning 10-20% decline)? Possibly. But more likely it’s another in a steady series of periodic downward “adjustments” of 5-8%, of which there have been seven since March 2009 (or about every 6-7 months).  Article link:
http://finance.yahoo.com/blogs/breakout/market-nose-dive--major-indices-shed-recent-gains-200646218.html

·         And Today………….Today, through mid-day, market continuing its moderate pullback based on concerns over an earnings report from JP Morgan, follow through from yesterday’s declilne, and perhaps some concern over today’s PPI number. Article link: http://money.msn.com/business-ews/article.aspx?feed=OBR&date=20140411&id=17500759

 ·         Consumer sentiment improving……….The Thomson Reuters/U- Michigan's preliminary April consumer sentiment index came in at 82.6, the highest since July, and up from March final reading of 80.0. Both current conditions and expectations improved. This is in contrast to mixed retail sales readings we’ve seen lately  but is positive for the overall economy and supports the thesis for moderate but steady economic growth and consumer spending, the “goldilocks” environment favorable for stocks. Article link: http://www.bloomberg.com/news/2014-04-11/wholesale-prices-in-u-s-rise-more-than-forecast-on-services.html

·         U.S. Wholsale prices:   Wholesale prices in the U.S. rose in March. Excluding food and energy, the index increased 1.4% year to year following a 1.1 percent year-to-year gain in February. The 0.5% month-to-month advance in the WPI was the biggest since June. Despite what appears to be some acceleration in WPI, 1.4% continues to be very moderate inflation and well below the Federal Reserve’s target inflation of 2%. For a variety of reasons both cyclical and secular, we continue to see inflation remaining fairly subdued in 2014, which is favorable for financial assets. Article link: http://www.bloomberg.com/news/2014-04-11/wholesale-prices-in-u-s-rise-more-than-forecast-on-services.html

 

 

 

Q2 Investment Strategy Meeting Summary

We held our Q2 investment strategy meeting on March 28. The general investment landscape has not changed significantly since our December meeting. The outlook for U.S. equities remains positive. U.S.  economic and corporate earnings growth both remain healthy in 2014. After a weather-impacted Q1, we expect U.S. real GDP growth to accelerate to 2.5-3% by second half-2104. We see corporate earnings rising 8-10% and we expect inflation to remain subdued. While we expect the Federal Reserve will continue its taper of quantitative easing, we do not expect the process to be overly disruptive for financial markets.

There is some evidence of increased environmental risk reflected in recent pockets of speculative froth (particularly social media) and recent extremes in investor sentiment readings. There has also been considerable discussion recently in the media about the 5-year anniversary of the current bull market. The average bull market since 1945 has been about 4.5 years in duration. We acknowledge this “birthday” has significance, however, we continue to remain positive on underlying fundamentals that should support higher equity prices. Geopolitical factors, particularly Crimea and Ukraine, have also increased environmental risk somewhat. We are watching these developments, but as of now we do not expect a major impact on U.S. equities.

With respect to international investments, we continue to see a mixed picture. We think there is increasing risk of a further slowing in China’s economy that will have repercussions for global economic growth, particularly for emerging market economies. Europe has exited its long recession, however the growth outlook appears anemic and the recovery remains fragile.  For these reasons we continue to overweight U.S. equities in our investment strategy.

We still believe the secular bull market in bonds ended in July 2012 and that bond yields will most likely continue on a gradual upward path.  As we stated in our December commentary, the potential for rising interest rates renders bond investments less attractive. In order to reduce interest rate sensitivity in your portfolios we have focused on reducing durations by maintaining long and intermediate bond exposures at the minimal end of our allocation range.

With respect to changes in our investment models, within our U.S. holdings, we shifted more of our allocations towards value both in large and small cap equity exposure. We reduced weightings in our models to both international equities and REITs, and are now slightly underweight a normal allocation in those areas. Within natural resources, we added exposure to timber and forest products as we believe there is increasing potential for rising timber prices over the next couple of years. There were no significant changes in our fixed income weightings or holdings.

 

Rising Bearish Sentiment Brings Some “Good News”

In wake of stock market sell-off of the past few days, there is increasing evidence that small investors are getting scared. The Associated Press this morning reports that “the number of small investors who say they feel bearish soared this past week” and “some stock funds have been hit with their biggest withdrawals since 2012”. Here is the link to the AP article:

http://money.msn.com/business-news/article.aspx?feed=AP&date=20140201&id=17312155

 

 It may sound illogical but it is actually a good sign. As we’ve noted previously, the stock market has not had more than a 10% correction since mid-2011. This is longer than the statistical norm for time intervals between “corrections” which, since 1945, have occurred on average about every 20 months and average about 13% decline. The fact that small investors are getting nervous and pulling out is positive in that it relieves some of the extreme positive sentiment that is associated with rising markets, particularly a rise like we saw in 2013 (which was up 30%, about 3x the long-term average annual return).

 

We think the underlying fundamentals for U.S. companies remain sound based on improving economic growth and higher earnings in 2014. At about 15x 2014 earnings, valuation is “neutral”, no longer “cheap” but not excessive either. In addition, as we’ve mentioned previously, the financial arbitrage that currently exists between the cost of debt and equity capital is also providing support for equity valuations.

 

This morning’s auto sales and factory order data were lower than expected, partly contributing to today’s sell off, but we note this data bounces around significantly and does not move in a linear fashion. We don’t read much into the softer data. There may also be some investor concern with Janet Yellen taking over as chief honcho at the Federal Reserve, however our expectation is she will maintain a gradualistic approach towards unwinding of the quantitative easing program of the last five years. Concerns over slowing growth in China are legitimate, however, with over $3.5 trillion in monetary reserves, we think China has the financial wherewithal to engineer a “soft landing” for its economy. We continue to believe the best opportunities remain in U.S. stocks, in which we remain overweighted.

 

Our strategy of diversification among multiple asset classes is an important way in which we aim to provide not only asset growth but also reduce portfolio volatility, an important aspect of achieving improved risk-adjusted returns. Corrections and market pullbacks are normal, and in many cases, necessary, as they relieve extended positive sentiment and allow the market to “recuperate” technically. We expect this correction will prove to be another normal mid-cycle correction in an ongoing secular bull market.

 

China Ripple Effect

We mentioned in our recent Q1 investment commentary that we believed, moving into early 2014, the risk of a market pull-back or correction had increased for a number of reasons: 1) the market’s extraordinary gain in 2013, 2) concerns over initiation of Federal Reserve taper, 3) concerns over slower growth in China, 4) divergences in certain technical market indicators, 5) having gone over two years without a correction of 10% or more, which is about twice the statistical norm.

Over the past seven trading sessions, the market measured by the S&P500 has declined about 3.5%. The reason? China. Investors have become more concerned that growth in China may be slower than previously expected. This has a potential “ripple effect” particularly to emerging market economies which are more heavily dependent economically on China. We believe these issues will prove transitory, or an “adjustment”, in the overall global growth outlook, and should not have too great an impact on U.S. companies. If the Chinese economy does slow to a degree much greater than expected, it could have some impact on U.S. corporate earnings to a greater degree than we now expect.

With respect to our investment strategy, we continue to remain more heavily weighted in U.S. stocks. In international stocks, we do have exposure to EAFE, a broad international index, but we are underweighted in emerging markets equities. We believe fundamentals for U.S. stocks remain generally positive: earnings growth is expected to accelerate in 2014; U.S. corporations continue to hold record levels of cash; M&A activity should remain strong in 2014; inflation remains subdued. Positive investor sentiment has become somewhat more of a concern but at 14.8x 2014 earnings, valuation is not excessive.

As we always do, we are keeping a close eye on developments in China and emerging markets.  We  have not changed our view that the risk of a 10% or greater pullback in the U.S. stock market has increased. However, we would view such a correction as a normal “adjustment” within a longer term bull market, and as of now, we are taking no specific actions to change investment allocations or strategy. As a reminder, an important way in which we aim to buffer client portfolios from market volatility is through our strategy of asset class diversification. This diversification helps to reduce sensitivity to changes in equity prices and, thereby, reduce portfolio volatility with the ultimate long-term goal of improved risk adjusted return.

Notes From Our First Quarter Investment Strategy Meeting

We held our first quarter investment strategy meeting on December 30, 2013. 2013 was an extraordinary year for the stock market reflected in a total return for the S&P500 of about 30%. There are only a handful of years in the past 60 which have seen gains of this magnitude. The stock market overcame an amazingly high “wall of worry” in 2013. These worries included things such as the debt ceiling, the Syrian conflict, Federal Reserve policy, slowing corporate earnings, slowing growth in China, and continued government policy uncertainty, to name but a few.  

What drove the market up this “wall of worry”? Several factors: capital seeking higher return alternatives to bonds; improving outlook for the economy and corporate earnings; and “financial engineering”. With regard to this last point, the current low cost of debt is providing an opportunity for corporations and investors to improve their investment returns by using low cost debt to make acquisitions and buy backs shares. This is similar to what occurred in the 1980s and we believe will provide a positive backdrop for stocks in 2014.  

We remain positive on the outlook for stocks. Fundamentals for equities, particularly the economy and corporate earnings, remain generally positive. Of increasing concern, however, is valuation. With the S&P500 now trading at about 15 times 2014 earnings, stocks are no longer “cheap”. This raises a bit of a cautionary flag that a) valuation may not be the driver of stocks prices it has been heretofore and b) market risk has increased. Another concern is the fact that the market has not had more than a 10% correction since mid-2011, which implies the odds of a correction in 2014 have increased.

The investor “conundrum” continues for the bond market. We believe returns on bonds, which have averaged 5-6% over the past several decades, will be considerably lower going forward.  We believe the secular trend in interest rates is now up, as opposed to the last thirty years, in which the secular trend had been down. We expect this new secular trend will keep pressure on bond returns. We expect interest rates will rise in 2014 in a gradual but steady fashion.

With respect to portfolio changes following the meeting, we further increased exposure to large and mid-cap stocks. We believe quality, dividend-paying stocks continue to offer value and attractive risk/reward. We further increased exposure to technology stocks as we view the sector as undervalued. We reduced exposure to REITs but increased our exposure to energy. Within bonds, the most notable change was the elimination of our position in preferred stocks and the addition of a position in high-yield corporate bonds as a way of reducing duration while maintaining a high income stream. We also raised our exposure to short-term bonds to reduce duration and interest rate risk.