Time for a Stock Market Correction?

bullsvsbearThe overall calm, positive performance of financial markets in 2014 took a hit on July 31st when stocks declined 2-3% and fixed income and alternatives lost about 1%. Markets have been about flat since then, yet talk about a stock market correction of 10% or more has escalated.

There’s lots of reasons why some believe a correction could happen:

  • Valuations of stocks are high. The current P/E ratio of the S&P 500 is 15.7- higher than the 10-year average of 14.1
  • Improving U.S. economic conditions have brought concerns about the Fed raising rates quicker than many investors anticipated
  • Europe’s prolonged economic slump is making deflation a concern
  • Economic sanctions against Russia could negatively impact consumer demand in many countries
  • Geopolitical unrest in Iraq, Gaza, Syria, Ukraine, etc. could explode

Yet, at the same time, there are many reasons why some believe the bull market should continue:

  • The U.S. economy is the best in years: new jobs are up, unemployment is at 6.1%, job openings are at a seven-year high, housing is up again after a slow start in 2014, car sales are at post-crisis high, and consumer sentiment is up
  • There has been a huge recovery in American corporate revenue and profits since the 2008-2009 crisis. Yes, lower borrowing costs helped. Second quarter earnings, with nearly 90% of S&P 500 companies having reported, are on track to grow 8.4% this year
  • For a variety of reasons, companies are continuing to buy back large quantities of stock
  • Market peaks have occurred historically when P/E ratios are 25 times earnings or more
  • Geopolitical worries have boosted the allure of “safe” bonds. With U.S. 10-yr bonds at 2.4% and German 10-yr bonds at 1%, stocks continue to be very attractive

Overall, it has been suggested that we are in a “Goldilocks” economy. One that is “not too hot, not too cold.” Stimulative policies, created by Fed Chairman Ben Bernanke and now Janet Yellen have created a great environment for stock growth. However, when investors get nervous about the Fed’s ability to keep the “temperature just right” we have seen big swings. May and June 2013 saw 5-6% drops when the Fed first started talking about “tapering” the QE program. Now, with the economy doing better and inflation nearing 2% targets, investors are concerned that the Fed will start to raise interest rates and change our “just right” conditions. That’s a huge challenge for the Fed. A perceived major misstep or miscommunication by the Fed could again shake the markets.

Yes, at some point we will have a correction in the stock market. History tells us they come along regularly (27 corrections of 10% or more since 1945). Yet, a priori, the reasons were enigmatic. Hence, trying to time the start and finish of such events is useless.

We have a saying at DWM: “There are many variables you cannot control. Long-term success, on the other hand, relies on managing the variables you can control, including reviewing your risk profile and asset allocation, reducing expenses, diversifying portfolios, minimizing taxes, and staying invested.”

The Debt Limit and Beyond

sterner queenMaybe we need a stern, bossy matron in D.C. to “kick some butt.” Barron’s pointed out Saturday that back in 1975, the Australian government shut down in 1975 over a budget impasse. Queen Elizabeth II (queen of Britain and Australia) came in and fixed the problem. She and the local governor-general fired the prime minister, passed a temporary funding bill, and held elections to replace the culpable Parliament. Australia hasn’t had another shutdown since.

Since that time, our American politicians have shut down our government 18 times. This time, the stock market seems to be treating the shutdown like the boy who cried wolf. Investors have seen this show before and the markets haven’t dropped. In fact, it appears that the current debacle in D.C. has some convinced that QE “tapering” is even further off, and therefore, it’s “a great time to buy.”

As we have pointed out in previous blogs, one of the greatest assets, if not the greatest, we have in America is the fact that Treasury debt is the only risk-free asset in the world. It’s the backbone of the world’s financial system. China and others invest their money in Treasury bills. Today, the U.S. dollar is not even close to being unseated as the world’s primary reserve and trading currency. Can you imagine how the world would be viewing our mess in Washington if the worldwide currency was not U.S. dollars? We certainly wouldn’t be borrowing 10 year money to finance our deficits at 2.70%. We might be paying twice that rate and increasing our annual deficits commensurately.

We’re all hoping that an agreement is put in place by October 17th. If not, the government loses its borrowing authority and it can only pay out the cash it has on hand. By the end of the month, that would mean the U.S. could miss a bond payment, which would create a huge mess. The banks rely on treasuries to trade with each other overnight. If you take away trust in the financial system or U.S. debt, it would be, as Joe Nocera on NPR Saturday expressed, “cataclysmic”. In Mr. Nocera’s worst-case scenario: “The banks would freeze up. There will be no borrowing. It’ll be like Lehman. The stock market will go down. It has the potential to be a real disaster.”

Certainly, we all hope and expect that our government will pull us through this short-term mess once again in the next couple of weeks. However, at some point in time, people worldwide may stop trusting the dollar. At that point, it will lose its advantage as the world’s only risk-free currency. Then, America will be on the same slippery slope as many countries around the world are today.

Yes, wouldn’t it be nice to have a stern, bossy matron to “kick some butt” in D.C.? If she isn’t coming soon, perhaps, as NYT writer Thomas Friedman and the Rootstrikers group have suggested, we should push for a third major political party. Two days ago, a Gallup poll showed 60% of Americans, disgusted with Washington, would support this option. Let’s hope it happens, sooner rather than later.

What’s Next for the Economy and Markets?

crystal-ballTough question. A more relevant question would be: “How do I obtain long-term investment success?” We’ll discuss both today.

First, the economy and the markets are not correlated over the short-term. Last week’s overall market selloff again demonstrates this. Yes, over the long-run, there is a correlation between GDP growth and corporate earnings. But data demonstrates that over the short-term, there is no correlation.

Second, it is imperative to filter the noise of the media and put the current situation in broader context, than to guess about the future. Our economy is still recovering from the 2008 credit crisis. Similar crises were followed by weak GDP and job growth. The Fed confirmed last week that we are following this historical pattern. Since September 2012, when the latest QE program started, the unemployment rate has fallen from 7.8% to 7.6%. The Fed expects GDP to increase 2.3-2.6% this year. Inflation is up only 1.05% year over year.

Of course, these results, and the stock markets, have been influenced by easy money policies. Since 2008, the fed funds rate has been near zero. Hence, the Fed has employed additional policies to boost the economy. The most significant has been QE. The Economist on Friday described Chairman Bernanke’s tough assignment: “In a zero-interest rate environment, the central bank can influence monetary conditions more through words than through actions.” Mr. Bernanke’s comments last week, which pointed to the path that actions were “data dependent” were interpreted (perhaps incorrectly) by many investors to mean greater “hawkishness” (tapering was about to start). Virtually all markets tumbled.

The economic data doesn’t support a change in the bond-buying policy. Unemployment is still at 7.6%, labor participation rates are near 29 year lows, inflation expectation are falling, and perhaps, most importantly, there has been no substantial improvement in job growth:

chart

Yet, despite the weak pace of overall growth, the recovery in the last four years seems to be getting smoother. The housing market is up, the energy sector is booming, auto sales are improving, household finances are looking healthier and consumer confidence is at a five-year high. The Fed has increased its 2014 growth forecasts to 3% to 3.5%, from a March forecast of 2.9% to 3.4%. So, we’re making progress, but will it continue? And, if so, when will tapering start?

We agree with Yogi Berra, who said: “It’s tough to make predictions, especially about the future.” We humans are not so good with making accurate predictions. However, these days, you can generally find an opinion to confirm almost any point of view. In fact, studies have shown that the most confident, specific forecasts are a) most likely believed by readers and viewers, and b) least likely to be correct.

We prefer to focus on the long-term. People seem to lose sight of their financial future in the midst of all the noise. Most of us have a long-term investment horizon- perhaps 20, 30 years or more. During that time, we can expect bull and bear markets, volatility and short-term market swings. Emotional reactions to short-term events and media noise can cause you to miss market rallies and doom you to long-term investment failure.

You need a disciplined investment strategy and perhaps a full-time professional investment adviser to help you with it. Your asset allocation needs to represent the three asset classes; stocks, bonds and alternatives, with further diversification within each asset class. Your portfolio needs to be reviewed continually and rebalanced regularly. You need to make your capital work for you all the time, and not leave money sitting in cash. Over time, asset allocation, diversification, rebalancing and mean reversion will all work in your favor.

So, we won’t focus on predictions. Instead, what we will do is to help you establish and maintain a long-term probability-based investment approach that should reap dividends and investment success for you for years to come. Give us a call. We’d be happy to chat.

Quantitative Easing: QE 4ever?

QE (2)We are all in the midst of one of the biggest global financial experiments ever conducted: Quantitative Easing. Since the world financial crisis in late 2008, the Fed and other central banks have employed this technique in an effort to stimulate the world economy. QE has certainly has had an impact. It has reduced home mortgage rates to all-time lows and helped push the stock markets to all-time highs. Yet, QE is not an elixir. QE can’t cure all the ills of a moribund world economy. Furthermore, QE could ultimately cause major damage to the U.S. and world economy.

Last week, a good friend and client suggested that an update on QE might be appropriate for our readers. Good idea DD; thanks for the suggestion.

Quantitative Easing is an unconventional monetary policy used by central banks to stimulate the economy when conventional monetary policy isn’t working. Historically, the Fed has principally stimulated the economy by lowering short-term (fed funds) rates and cooled down the economy by raising short-term rates. However, by late 2008, the Fed funds rate was as low as it could go-effectively at zero. The Fed needed another tool. QE, last used in the U.S. from 1932-1936, got the call.

QE has the same effect as printing money. The central bank buys treasury and agency bonds from commercial banks and other private institutions (using electronic transfers), thereby creating money and liquidity. The purchases raise bond prices and reduce their yields, thereby reducing long-term interest rates. Interest rates on 10 yr. U.S. Treasuries have fallen from roughly 3% to 2% since QE started. Lower treasury rates mean lower home mortgage rates, which has certainly helped the housing industry get back on its feet.

Many investors, uncomfortable with lower returns on fixed income, started loading up on stocks and riskier debt. Since the start of QE, there has been an 85% direct correlation between the amounts of money added to QE and the rise in the stock markets. During 1Q2013, the move to riskier assets intensified. The result -stocks hitting all-time highs. Furthermore, increasing stock values have been shown to affect both consumption and investment decisions, which helps the economy as well.

Other developed countries have also adopted QE to stimulate their economies. The UK started in 2009. The European Union started in 2011. And Japan, which used QE in 2001-2006, started a new round of QE last year. In total, about $10 trillion has been invested by central banks world-wide in QE programs.

There are two major concerns with QE. First, many believe that QE will ultimately cause inflation-perhaps hyperinflation. With the money supply expanding faster than the real economy, one would expect inflation to occur. This hasn’t happened yet. Fortunately, the U.S. dollar continues to be the world’s reserve currency. Hence, events in Cyprus and other parts of Europe cause investors to dump the euro for dollars. Certainly if China and/or Saudi Arabia would ever drop the dollar or dump U.S. Treasuries, we could certainly see a run on the dollar and perhaps hyperinflation. However, that scenario, if it does occur, is likely years or decades away.

The second concern of QE is the impact when it starts to unwind. At their FOMC meeting in March, the Fed signaled that it would keep its ultra-easy money policy for now. They will continue this at least as long as the unemployment rate is above 6 ½%. As it approaches this level, it is expected the Fed will taper off QE. However, Chairman Bernanke made it clear that the Fed would discontinue QE long before it would raise the fed-funds rate. And it promised to keep the fed-funds rate at current levels until 2015.

So, the net effect is that once there is a substantial improvement in the economy, QE will stop. This will likely result in higher interest rates and higher inflation- both of which could slow economic growth. As a result, some are calling for the Fed to start unwinding QE now. With the unrest in Europe and around the world currently, perhaps the impact of unwinding of QE now would be less damaging to the U.S. economy than it will be in the future.

Rest assured, DWM is following QE very carefully. This experiment has already had a huge impact on the U.S. and world economy and undoubtedly will for years to come.