Fed Takes Action

As the economy has grown stronger, the Federal Reserve has been discussing when to reduce its bond and mortgage purchases. For about 15 months, the Fed has been purchasing about $85 billion each month and has acquired approximately $3 trillion in these investments. The purpose was to add liquidity to the economy, which resulted in lower mortgage interest rates, lower long-term bond interest rates and a booming stock market. The Fed indicated this afternoon that they will taper off these purchases by about $10 billion, bringing them down to about $75 billion monthly. Tapering will reduce the flow of cash from the Fed but will also allow them to adjust upward easily if the economy shows signs of souring. If tapering does not disturb the economy, it will likely be followed by additional cuts until all purchases are stopped. The long-term impact of this change will likely be an increase in longer-term interest rates and slowing of the rise in stock prices.  I had not personally expected the change until March of 2014, once Janet Yellen was in place as the new Fed Chairman. The change is likely to be the last major action by the current Fed Chief, Ben Bernanke. At the same time that they announced the tapering of purchases, the Fed also indicated that short-term rates would remain close to zero until after the unemployment rate goes below 6.5%.  This information means that short-term rates will be likely to stay at zero until late 2015 or early 2016.

Ed Mallon

Market Turning Down

During the past number of market sessions, we have seen some profit taking on stocks and repositioning of bonds, which has moved the stock market down. The result is confusion on the economic front. The good news, announced on Thursday, was that in the third quarter the economy grew at a rate of 3.6%, rather than the 2.8% originally reported. Business inventories, at $116.6 billion--the largest accumulation of inventories since the first quarter of 1998--accounted for most of the growth. This growth is in sharp contrast with domestic demand that rose only 1.8% rather than the expected 2.1%. As a subplot, consumer spending dropped to 1.4%, the lowest since the fourth quarter of 2009. Retail spending, so far in the fourth quarter, does not seem to be picking up as we go into the biggest shopping period of the year. Retailers may have to take major markdowns before the holiday season is over, to align inventories with consumer spending. Corporate profits, after tax for the third quarter, dropped to 2.6% from 3.5% in the second quarter. If heavy discounting of inventories takes place, corporate profits may drop further. Expectations of advancing corporate profits have kept the recent stock rally going. The reality of what might happen to corporate profits is setting in and moving the market downward.

All is not lost. It appears this will be a correction and not a bear market. One of my favorite indicators is the number of initial jobless claims. I have not reported on that in a while. Last week, jobless claims were at 298,000, the lowest number we have seen in years, and the third weekly drop, which is also impressive. Not long ago, I was wishing for the claims to drop below 400,000! With all of this information, I am maintaining my position that the Federal Reserve will not reduce bond purchases before March of 2014. The liquidity level of the economy should remain constant, which is good.  The economy surprised experts in the second quarter, growing more than 2% after original estimates of 1%. Again in the third quarter, the economy grew at 3.6% after the original estimate of 2.8%. Who knows? Perhaps it will do so again in the fourth quarter.

Ed Mallon 

Change Afoot!

At this time of year, I look both back and forwards. In looking back, I see that we are better off, overall, this year than we were a year ago, from a financial perspective. Looking toward next year, I believe we will be better off than we are today. That being said, some interesting things on the horizon could have a significant impact on financial matters. If the agreement with Iran goes through, it could mean significantly lower oil prices for Eastern and Western Europe. This would be good for their economies and also for world economies as discretionary income would grow. The new Fed Chairman, likely to be Janet Yellen, will bring a softening to monetary changes that will be enacted by the Fed during 2014. This should result in less shock to the financial system as the stimulus is discontinued, and should reduce the risk of a major market correction.  The big unknown on the negative side is what Congress will do about the budget and deficit reduction.  I am guessing that the Republicans will not want a repeat of October as we head into an election year. We will see.

Thanksgiving is my favorite holiday. I wish each of you peace, joy and the blessing of living in a country like the United States of America!

Ed Mallon 

Market Conditions

There was a front page article in the Wall Street Journal this morning about “Mom and Pop” now entering the stock market, after an absence since 2008. It seems that by the time “Mom and Pop” enter the market, it’s at the top! I can’t say I completely agree with this but it does reflect how fast the stock market has gone up this year and the amount of new money being invested. According to Warren Buffett, a simple way to look at the market is to measure the ratio of the aggregate value of the stocks in the Wilshire 5000 to the U.S. GNP. If this ratio is under 100% stocks seem priced to buy. If it is over 100% stocks are pricey and will likely come down. According to this idea, back in 2009, when the ratio was 76%, it was a time to buy. As of September 30^th the ratio was 109%. Does this mean that stocks are headed for a tumble?

There are many ways to look at the stock market none of which has proven infallible. The market is based on what a willing buyer will pay a willing seller. We all know the stock market goes up and down and it is difficult to determine when it will do either. The best way to address this issue is to have a diversified portfolio of stocks and bonds that have a relatively low correlation to each other. As an investor you do not want to be “chasing” yield, but to set your investments in accordance with your risk tolerance. I am sure that Warren Buffett is not selling most of his investments in fear of a downturn in stock values, but he may be limiting new purchases until such time as he feels that there are better values.

Ed  

The After Glow

We all watched as the government shut down and witnessed how dysfunctional Washington has become. During this time the stock market held up rather well while interest rates on bonds tended to go up. As bond interest rises the value of the bonds decline. The impact on the bond market was reversed once a deal was struck. Bond interest rates have come down to a point we have not seen since mid-May, in some cases. For now, the Federal Reserve(Fed) continues to purchase about $85 Billion of mortgages and bonds each month to assure liquidity and continuing expansion of the economy. At some point in the future, the Fed will reduce and then eliminate their purchases. When this happens it is expected that bond interest rates will go up and the value of bonds will go down. It is likely that this reduction in purchases will not take place until mid-January when the new Chairperson of the Federal Reserve takes over. For now, there is a lull in the bond market. To counter the potential increase in interest rates, it seems wise to move bond investments into shorter duration bonds that pay little but have a lower risk of principal devaluation. For those portfolios that are largely in bonds, like a Conservative portfolio with 80% in bonds, there will likely be a reduction in earnings and negligible gains in principal by using this strategy. My guess is that this will all be played out during the next 12 to 18 months, after which time investment grade bonds should stabilize and become the sound investment that they are intended to represent. For now, I see an opportunity to rebalance portfolios to reduce the chance of principal loss in bonds.

Ed

Budget, Debt, Fed

The preoccupation in the stock and bond markets at this time is with what is happening in Washington. The mixed economic reports that came out last week indicate that the Federal Reserve will likely make no changes to their bond and mortgage buying program until very late this year or early next year. This has sent bond prices up as yields have fallen. At the same time, the equity markets are justifiably worried about what Congress is going to do to resolve the budget and Federal debt ceiling issues. If the debt ceiling issue is not resolved, the government will run out of funds by the latter part of October. Currently, the concern is with a budget resolution by October 1^st, the beginning of the next fiscal year. The lack of a resolution will result in closure of non-essential government services and the inability to pay Social Security and Military Pension benefits. The repercussions of this inaction would have a detrimental effect on the entire economy. This concern has lead to a downturn in the stock market. The short-term outlook is cloudy. In the long term, I believe the stock markets in the U.S. will do well if the economy continues to grow. Stocks trade at a multiple of earnings. On a trailing 12 month basis, the market’s current price-to-earnings ratio of about 19 is a third above its long-term average. This has occurred because earnings growth has been tepid while stock prices have gone up significantly. The expectation is that we will see greater earnings growth in the future. Shutting down the government could change this assessment. Bond markets will have to adapt to increasing interest rates over the next year or so, but should subsequently be fine.

Ed

From Damascus to Jerusalem

With all that is going on in Syria, I’ve been asking people how far they think Damascus, Syria, is from Jerusalem? One great answer I received was “it must be either very close or far away.” Apparently we are not much for geography in the United States. Most of us recognize that the Middle East is a very dense area of the world, but just how dense? In answering my basic question you can look in the New Testament, where Saul, soon to be Paul, has an encounter on the road from Jerusalem to Damascus. This indicates that, even 2000 years ago, it was possible to travel between these two cites on foot. The answer to my question is 135 miles. But this belies the question of density in the Middle East. Some interesting distances: between Damascus and Cairo, Egypt: 382 miles; Nicosia, Cyprus: 204 miles; Tel Aviv, Israel: 133 miles; Amman, Jordan: 109 miles; and Beirut, Lebanon: 55 miles. These are all capital cities in the Middle East and they are very close to each other. The fallout of the civil war in Syria on the countries surrounding it has lead to disruptions, as millions of people have fled from Syria to these nations. Any action that is taken in Syria will undoubtedly have repercussions on countries in close proximity, and we just don’t know where this may lead. Generally, this type of tenuous situation is not good for stock markets. The stock markets in the U. S. have shown no apparent significant downturn--yet! The Middle East still supplies about one-third of the oil that is used in the U.S. A disruption to the supply line, or worry about such a disruption, could send oil prices skyrocketing. Such an event would have a negative impact on the growth of the U.S. economy, with more consumer dollars going for gas and less for consumer products. While we are in the stages of becoming self-sufficient in energy, our infrastructure, to make this possible, is not yet fully in place. Today, on the front page of the Wall Street Journal, it was reported Secretary of State John Kerry, in London, 2855 miles from Damascus, in an off-the-cuff remark, suggested that President Bashar al-Assad could avert an attack by promptly handing his chemical weapons to the international community. Moscow, 2184 miles from Damascus, declared its support and quickly got Damascus on board. In Washington, DC, 5877 miles from Damascus, the vote on action in Syria became muddled. No matter the outcome, the Middle East does have an impact on the markets and citizens of the U.S.   

Ed Mallon