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

Is the Stock Market Too High?

A question that often comes up after the stock market has had a significant increase in value is: “Is the stock market price too high?” The corollary of this question may be: “Is the stock market too low, or under-priced?” Current economic data indicates that the economy grew more than expected in the second quarter. Instead of rising only about 1%, the government’s original estimate, it rose in excess of 2%. Housing start numbers came out this morning showing an increase in July over June of an estimated 50,000 (896,000 vs. 846,000). Consumers are spending more, initial job claims for last week dropped to 335,000 (the lowest since November
2007), employers added 162,000 new jobs last month, and the value of homes has increased. This is all good news, but there is some bad news, too. Retail earnings for companies like Macy’s, McDonald’s, Wal-Mart, and others that target lower- and middle-income people dropped. Manufacturing growth and factory orders are down. The Federal Reserve is indicating it is going to reduce, then eliminate, the stimulus it has been giving the economy within the next year. So how do you judge the stock market? Many say the “old ways” are out. But if the “old ways” are out, then how do you determine if this is a buying or selling opportunity? Let’s look at 
the old methods of making decisions. When we invest in stocks we are investing to capture the earnings and earning potential of a company. The price earnings ratio (P/E) is a significant way of looking at individual stocks and the broad market. It takes the price of a stock and divides it by the earnings of the stock. This gives us an understanding of how an increase or decrease in the price of a stock is determined, based on earnings of the stock. Using the S&P 500 as an example, the P/E is 18.62 vs. 15.89 a year ago, which appears to be a big increase in price vs. earnings in one year. We cannot stop at this point, because what we really want to know is how much will we earn between this year and next? The forward P/E, which looks at estimated earnings for the coming year, is 15.40, lower than the ratio was (15.89) last year. This appears to be a bullish sign for stocks because it indicates that current prices are not out of line with the norm. Another piece of information to examine is the percentage of dividends paid to the price of the stock. For the S&P 500, the current dividend rate is 2.04% vs. 2.07% a year ago, which seems to be a small dip. When we examine what is really happening, we must take into account the price gain from a year ago. If we had $100,000 in the S&P 500 one year ago, our annual dividend would be about $2,070 (2.07%). Between last year and this year our, account would have grown by 17%, the rise in the S&P 500 during the one year period. Now our account would have $117,000, earning 2.04% for an annual dividend of $2,387 or $317 more than last year. All of this indicates that, as earning on stocks have grown, the prices have risen and the companies have been paying increasing dividends. This seems to me to be a rational way to look at the stock market, even if I’m using the “old ways.”
Ed Mallon

Expectations

We all have certain expectations and so does the market place. As each year progresses, expectations arise about the future inflation rate, the growth of the economy, consumer spending, and other such areas of interest. Based on these expectations, investors make decisions about what investments they want, when, and how. As real results come in, the expectation is compared to the result. Generally, if the result meets or exceeds expectations the response is good. If the result falls short of the expectation, the response is not good. Last week, a report was released showing that consumer spending, a key ingredient in moving the economy, did not meet expectations and the market dropped. The market moved lower due to fear that consumers had curtailed their overall discretionary spending for everything except automobiles. This week, a report was released indicating that consumer prices were rising and exceeding expectations, moving the market up. The market rose because higher prices are apparently taking hold, thus increasing the possibility of added profits for companies. Currently, we are at the end of a quarter, with a half year behind us and a half year to go. Earnings from various companies are very important to the market at this time as analysts attempt to figure out what will happen for the balance of the year. We closed the second quarter with both stocks and bonds down for the month of June. As of this writing, stocks have staged a dramatic recovery and bonds are moving into positive territory. This is all good news, but the markets are very susceptible to wide fluctuations, and earnings reports will continue to come in between now and early August. At this time, the economy appears to be growing stronger, the Federal Reserve will reduce purchases on bonds, and the U.S. deficit for the current fiscal year, which ends on September 31, will be substantially lower than expected. This is good news for the U.S. economy and the stock market. We as investors need to remember that short term shifts in investments will occur, and we must be patient and look at the long term. To me, the long term looks extremely good.
Ed Mallon

Double Down!

The month of June was unkind to both bonds and stocks, as both lost value during the month. From the beginning of May until last week, Barclays index, which tracks investment grade bonds, was down 3.77%. Some people are referring to this as a “blood bath”, which it certainly is not.
Back in 1994, we had what has come to be known as the “bond massacre” when bond values dropped 5.3%. Bonds, like stocks, do go up and down, but bonds pay interest, which helps offset losses. The reason for owning bonds is that, over the long-term, they are more stable and can offset significant losses in stocks. The portion of the bond market that was most adversely impacted was United States government notes with maturities of 10 years or longer. These bonds were down an average of 10.8% during that same period. The long-term investor knows that a knee-jerk reaction is not the best investment move. As occurs quite often with a big selloff, the pendulum swung back, with bond interest rates falling later in the month and the value of bonds beginning to grow, although not back to where they had been at the beginning of May.
While it is unusual, stocks and bonds can rise or fall at the same time. Such was the case in June as stocks also fell. Using the S&P 500 as our measurement, the index fell from 1666 on May 21st to 1573 on June 24th, a drop of 5.6%. It recovered to 1606 by the close of the stock market on June 28th. In many respects, the second quarter of the year returned the gains of the first quarter. What precipitated this selloff of both bonds and stocks was an assessment by the Federal Reserve Board that the economy was getting stronger and would be growing significantly in 2014 and 2015. In May, I indicated that I thought the market was ready for a 10% correction but not a bear market. Some bonds have produced that correction, as have some stocks. The long-term outlook seems bright.
Ed