New Book. Restoration: God's Plan for America

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When Foolish Greed is Expensive

For quite some time I have been writing that speculators were creating a high risk situation for certain segments of the market. I have also consistently warned that chasing the “hot” stock is a sure way of losing money.

Well, the ‘correction’ in many of these previously hot stocks has recently taken place. Here’s some examples of declines from the high this quarter in just the last few weeks:

FireEye              69.5%

Twitter                46.5

Athena Health    46.0

BioMarin            30.0

NetFlix               27.9

SalesForce        22.7

Amazon             22.5

FaceBook          20.8

Tesla                 20.8

 

These losers are all multi-Billion dollar companies. They are not small caps.  These huge % declines occurred during a period when the general market rose slightly and high quality stocks beat the market.

Last post I wrote “Speculators have a tendency to move like a herd, when they exit, usually they all panic and exit at once.” Certainly looks like they all tried to get out of the above “hot” stocks at the same time. Those that bought in the last few months learned that greed is usually a foolish and expensive indulgence.

The good news is that declines in the above listed stocks did not affect WS Wealth Manager’s clients to any significant degree—most WS portfolios performed quite well. The bad news is that much of the money that came out of these stocks is now in the higher quality value stocks and shorter term fixed income securities that long term investors do and should own.

In the aggregate, markets are presently priced based on the assumption that poor economic performance in the last two quarters was due to bad weather.  This is an assumption and not a fact.  If the assumption is wrong and the economy continues to perform below expectations, there will likely be a correction. (Something we have not seen in two years.) But nobody knows for sure because the assumption is based on the future and very uncertain behavior of the global consumer.  We all hope that things are getting better, but hope is not a sound basis for making investment decisions.

So, we still have a lot of uncertainty and therefore still what I perceive as a somewhat dangerous market. Buy, Sell or Hold?  As frustrating as it can be, Hold and caution still seems the prudent course of action for retired or close to retirement investors.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Paradox of Uncertainty and Fed "Politics"

Janet Yellen, in her first public speech since becoming the Fed Chair, today expressed concern about the hardships of the unemployed and under-employed, and said the U.S. economy remains "considerably short" of the Fed's goals of maximum sustainable employment and stable inflation at 2 percent.

The "scars from the Great Recession remain, and reaching our goals will take time," she told about 1,100 people gathered at a downtown convention center in Chicago. "The recovery still feels like a recession to many Americans, and it also looks that way in some economic statistics."

One must ask the question, If the 'recovery still feels like a recession' to many, then why are people bidding stock prices upward? And, how much longer can that upward trend continue?


These are unanswered questions.


On thing appears to be certain. The first Liberal Democrat to be Fed Chairman in many years sounds quite political and seems to be willing to spend considerable public resources to lower unemployment levels beyond what many feel is prudent, even at the risk of higher than desired inflation. Obama himself probably could have given a similar speech. No mention of the devastating effect that low interest rates have on retirees who need fixed income from their savings.


The paradox of the current market is that many speculators feel the Fed is wrong. The stock market speculators are betting that the economy is improving much faster than the Fed believes.  


Whichever of the two are correct, it appears that we are likely to see a steeper yield curve with rising long term rates.  This would, in fact, indicate an improving economy, but also a harbinger of inflation and a stock market correction in response to increased buying of fixed income investments. 


The speculators aim to ride the market up and get out before it drops. A significant number of them will probably guess wrong and lose money.


Times like these dictate a bit of caution.

Options Expiration Dates Still Important

As I have indicated in the past, presently markets are heavily influenced by speculators. One of the most important tools used by speculators are options. And, options expire worthless after certain dates creating a lot of volatility.

The situation has not changed. Markets rose up until the days just after options expiration in January. That is exactly the same as what is happening today on 2/24/2014. (It is a clear sign that the market is dominated by speculators.)

But after reaching all time highs in January, market indexes fell by nearly 7% over the next two weeks. One cannot predict with certainty that the pattern will repeat, but it is important to remember that the markets are ignoring a lot of bad economic news.

It appears that speculators are still following the same “logic” that they have followed for a year: A) In a good economy, rising interest rates won’t matter and/or; B) In a poor economy, the Fed will continue or even expand its stimulus. I call this the “you can’t lose” belief.

History teaches that when a significant part of the market adopts this “you can’t lose” belief, it is a sign that there are very few buyers left and a market correction will likely come soon. It is particularly dangerous when those that believe the “you can’t lose” story are speculators. Speculators have a tendency to move like a herd, when they exit, usually they all panic and exit at once.  

Like all of history’s lessons, they are not right 100% of the time. And, the “soon” does not always mean next week, next month, or even next year.

So, we still have a lot of uncertainty and therefore what I perceive as a dangerous market. Buy, Sell or Hold?  As frustrating as it can be, Hold and caution still seems the prudent course of action for retired or close to retirement investors.

 

Stalemate....

Sometimes Mr. Market is depressed. Sometimes he is euphoric. And sometimes he is just downright confused.

I’ve warned in the past December that most stocks seemed to be a bit overvalued.  Come January 21, we saw a bit of a pullback. In fact, by February 3, we saw a drop of nearly 6%, both in domestic and international stock prices. 

Keep in mind that “markets” are made up of millions of investors but these millions can be placed into five major groups: Speculators, Institutional, Not Yet Retired Domestic Individuals, Retired Domestic Individuals, and Non-US Individuals. Each of these groups reacted a bit differently to the pullback.

All of the three groups of “Individuals” decided that the pullback was just the beginning of something worse and many sold off—so much that nearly $30 Billion was pulled out of equity mutual funds and ETF’s. To put this into perspective, flows into equity mutual funds in 2013 totaled about $130 Billion.  So $30 Billion out in only two weeks is a significant wave of selling.

Speculators, and Institutional Investors still confident that a “Buy the Little Dip” program would be successful (As it was in 2013) decided that 6% was enough for a “buying opportunity” and markets have recovered nearly half of the recent drop. Even bad economic news did not hold them back. No matter what bad news they hear, they seem to excuse it away……  It’s the weather. Or, some parts of the terrible employment report are good.  If it really is bad, then the Fed will step in and fix it. Since there are no other alternatives for making money thru investing, they convince themselves that the stock market must be on its way up. Keep in mind this is all “wishful thinking” and quite dangerous.

The truth….nobody is quite sure what, in fact, the near term future holds. The economy has been improving, but very slowly and only with the most massive global monetary stimulus experiment ever attempted.  And, the Fed is slowly unwinding that stimulus with the “Taper”.

So who is right..the pessimistic individuals or the optimistic risk taking hedge fund speculators and institutional investors?  Only time will tell for sure, but if you are part of the Retired Domestic Individuals Group, reasonable caution should be the order of the day.  Stay with a conservative asset allocation. (Not too hot and not too cold) and be particularly cautious with any excess cash.  If the speculators are right, you may miss some of the upside, but if they are wrong, you will have protected your nest egg. Sometimes doing nothing is exactly the right thing to do.

Keep in mind that speculators will exit the markets very quickly and “en masse” when they decide that “momentum” has turned to the downside. The longer we go without a healthy 10% correction, the more likely it will be larger than 10%. Remember the saying “Be fearful when others are greedy”. Well not everybody is now greedy, but a significant number are. So perhaps the appropriate saying for now is “Be careful when speculators are feeling greedy”. It is hard to make money in these types of market conditions but history teaches that it easy to lose money in times like these.

My best guess, markets will fluctuate and it is better than 50/50% that we will see better buying opportunities sooner than later.  Be patient and think long term---like 5 to 10 years out.

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Exceeding Expectations..

In past commentary, I’ve shared the proverbial description of the manic-depressive “Mr. Market”.  There are times when Mr. Market is depressed and he fears that things are not only bad, but they probably will get even worse. These are times when market prices are well below “fair value”.  Then there are times when Mr. Market is euphoric and is convinced that things are not only good, but likely to improve a lot.  These are times when market prices are well above “fair value”.

I warned back in May that it looked like Mr. Market was hopelessly euphoric and over optimistic in 2013. After a brief period in the summer and before the government shutdown, Mr. Market became a little less optimistic, but by the end of the year he again was back in that “Happy Days are Here Again” mood.

Let’s say from a “average” market index point of view, the market certainly exceeded expectations in 2013. This is not a bad thing.  But it is a bad thing if you catch Mr. Market’s disease.

Do not judge the value of your investments by one or two stock only market indexes like the S&P500 or the Dow Jones Industrial Average. The true value of your investments is based on the future income from interest or dividends and long term capital appreciation that your investments produce because of that future income. And, for stocks, that future income is all about how much profit the company can achieve. And here’s where it gets confusing…the value from long term capital appreciation has little to do with the stock market index daily quotations or fortune telling future predictions from market pundits on TV. In fact, one could argue that the long term future appreciation of your investments is actually negatively affected by markets that exceed expectations because of Mr. Market’s manic euphoria.  Risk is actually higher as prices rise.

You can always tell when Mr. Market is crazy on the optimistic side.  In the daily flood of news, there is always good news and bad news.  You can tell when Mr. Market is crazy on the optimistic side because the headlines tend to ignore the bad news and overemphasize the good news.

For example.  Recent news tells us that the economy grew faster than expected in the third quarter of 2013.  What few focused on was that most of the unexpected growth came because of increasing inventories and decreasing imports.  You see, business activity can increase if companies produce more than they sell---but only for a short period of time. Then they have to cut back. And, the way that GDP is calculated causes GDP to rise if imports go down relative to exports. But if exports stay the same and imports decline, it means that demand is actually declining. The media and pundits took the report to mean that the “economy is recovering”.  My take on the GDP report indicates caution in regards to future business activity and profits.

Another example.  Even though home sales are down, new building permits are up. The media and pundits took the report to mean the housing market is recovering. My take is declining sales is always an indication that caution is advised.

Another caution.  A great deal of the market’s rise for “hot” stocks is fueled with borrowed money. As I wrote in past commentary, Margin Loan activity is near record highs. That is always an indication that caution is advised.

Another caution. Markets are a pure auction. Around 50% of the participants think the market price will rise, so they are buyers.  Around 50% of the participants think the market price will fall, so they are sellers.  All it takes is for a very small percentage change toward buyers and prices rise.  These short term movements have little to do with known changes in future income—they are mostly based on “hunches” and “sentiment”.  Sadly, this “sentiment” is almost always wrong—history teaches that going against it tends to be more profitable that joining in with the crowd.

Another caution. Normally there is a lot of “tax selling” at the end of the year. Investors tend to sell their losers and offset the losses by selling some of their winners.  There has been a lower level of that activity this year because there has been fewer than normal “losers”. There is a significant risk that sellers engaged in “profit taking” after the beginning of the year may cause a stock market drop.

There are those that will tell you that the market always predicts the future rationally. My take is that statement is wrong.  The stock market does focus on the future, but it is seldom rational.  Mr. Market has a bad case of Manic-Depressive Syndrome. Mr. Market tends to see the future as he would like it to be. And, a rising market simply makes him think he is “smart” until he wakes up some day and becomes afraid that he has been wrong.

I am not being a pessimist. My opinion is that the economy seems to be recovering, albeit slowly and I’m quite optimistic about stocks—in the long run.  For those who already own a diversified portfolio, it is probably a good time to “hold”.  But most of the popular indexes are significantly overvalued—highly skewed by a few stocks that are ridiculously overvalued.  (Amazon for example has a Price/Earnings Ratio of 1360!)  And, for those with “new” money, I would recommend extreme caution. (If the market fell by 15%, I would probably be recommending a lot of buying.)

One way to explain my point is to think of investing as an ocean voyage.  At sea, one can always expect bad weather and big waves. A good ship is designed to take it.  So, think of a diversified portfolio of good quality investments as a super tanker in deep water, far from shore—properly captained, even bad storms are not too much of a risk.  But think of a portfolio with a lot of “new” money—coming out of a CD for example---as that same ship in harbor. Going to sea, leaving the relatively shallow harbor and attempting to navigate narrow channels can be risky. A wise captain will be cautious and will be reluctant to go to sea if the weather looks dangerous.

One can never be 100% sure about the weather or short term movements in the market.  Enjoy the relatively pleasant “voyage” in 2013.  But, be aware that we are overdue for bad weather.

Examples 2013 Capital Gain (UP) or Loss (DOWN) YTD:

10 year US Treasuries                DOWN 7.7%

Boeing                                      UP        80%

IBM                                          DOWN  2.7%

ATT                                          UP        4.4%

Caterpillar                                 UP        1.4%

McDonalds                               UP        10%

It has been many years since we last saw a substantial decline in the value of 10 year US Treasuries. These are supposed to be one of the lowest risk investments there is. One should always be careful when stocks are rising at the same time that US Treasuries are falling.  The drop in value of US Treasuries has also ‘exceeded expectations.

Making Sense of Employment Data

Lot's of information is reported regarding "employment".  Data comes from the government's BLS and some private firms like ADP.  There's the "unemployment rate" or the % of people looking for work that can't find it--a figure that can really be misleading as the number of people "looking" for work can change depending on economic conditions and outlook.  To make more sense of the unemployment rate, one must also look at the "labor participation rate" which gives the % of "potentially available" that are actually working. Again, it can be misleading as people retire at different ages.  In addition, people "drop out" when employment conditions are difficult and "return" when finding jobs becomes easier.

Perhaps the most meaningful data is from the BLS and shows the total number of full time jobs. See chart below:

The "take-away" here is that employment is improving, but is still significantly below the 122 million in 2007.   Almost 5 million fewer full time jobs now than in 2007, despite a growing workforce and trillions of dollars spent to "stimulate" the economy.

How this affects markets is that it creates "slack" in the labor market
and depresses labor costs---resulting in higher corporate profits but lower corporate revenues.  This is exactly what were are seeing during this and previous earnings seasons.  My take is that people are having increasing difficulty dealing with existing prices of many products and services, causing demand to be restrained, but because of low costs, corporations are able to increase profits, even with lower than expected sales.

This is not a trend that is sustainable in the long term and is one more reason why I recommend being very selective in what segments and companies to own in your portfolio. I tend to prefer companies that provide "essential" and "necessary" products and services that are less "price sensitive".  Every product and service is subject to declining demand with higher prices or slower economic growth; but some are more sensitive than others. 

Part of the market sees a continuation of corporate earnings growth, primarily because they believe that demand will soon accelerate as we get back to and rise above 2007 levels of employment.
Others see that with present rates of employment growth, those levels will not be seen until 2016 and that this slow rate of growth does not justify current stocks prices for many "hot" segment and stocks.

My "take" is that we should expect growth, but that continued stock price increases will increasingly require corporate profits that grow along with increasing revenue.