FINANCIAL REVIEW

Mangled Expectations

Sinclair Noe — November 3, 2014

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Financial Review
DOW – 24 = 17,366
SPX – 0.24 = 2017
NAS + 8 = 4638
10 YR YLD + .01 = 2.35%
OIL – 2.03 = 78.39
GOLD – 7.60 = 1166.30
SILV – .03 = 16.25

No milk and cookies today, however the Dow and S&P hit intraday record highs.

Construction spending fell 0.4% in September to a seasonally adjusted annual rate of $950 billion. Spending fell 0.6% for nonresidential projects and dropped 1.3% for public construction projects, but rose 0.4% for residential projects.

The National Association of Realtors reports first-time buyers’ share of home sales has hit a 27 year low of just 33%; normally it would be closer to 40%.

The final reading of Markit’s manufacturing purchasing managers’ index was 55.9 in October, down from the flash reading of 56.2 and well below September’s 57.9.

The Institute for Supply Management said its manufacturing index jumped to 59% from 56.6% in the prior month; new orders, production, and the employment gauge all moved higher.

Last week the Federal Reserve officially ended the Quantitative Easing plan, which has been around in various forms for about 5 years. The dollar reached multi-year highs against both the yen and euro; last week the Bank of Japan announced a surprise stimulus plan, called QQE2; on that news the stock markets hit a new high on Friday and global markets rallied.

This week the European Central Bank will meet, and if history is any guide, the ECB won’t do anything extra, although we must throw in the caveat that any action or inaction will be data dependent. For many, the ECB meeting on Thursday will be the main money event, despite the fact that it is not likely to be one of action or suspense. Eurozone inflation picked up a tiny bit to 0.4%, so policymakers have a reason to hold back.

The question is: what happens next? And the answer is nobody knows. Earnings reporting season rolls on with what I guess is good news, but the reality is that earnings reports are now an exercise in obfuscation and mangled expectations. One thing we are seeing is that most earnings per share growth is not organic, but the result of buybacks and other financial engineering feats.

Fund managers have been playing catch up with the S&P 500 index after trailing the rally. The good news is they are sitting on about $4.7 billion in fresh cash. Declines in small caps and technology companies have left fewer equities beating the index than any time since 1999. The average stock measured by the Value Line Arithmetic index is up 4.4% this year, half as much as the S&P 500. About half of the stocks in the Nasdaq Composite Index have fallen at least 20 percent from their 52-week highs, while more than 40 percent of the Russell 2000 are stuck in bear markets. The S&P 500 is a market value weighted index; each stock’s weight is proportionate to its market value; therefore, if you have a few of the mega caps performing well, it skews the results. The S&P 500 is masking what’s going on underneath the surface.

The only way you’re going to pick up performance is by being fully invested. And yesterday’s winner’s aren’t necessarily today’s performers, and vice versa. Consumer discretionary stocks led the S&P 500 with a 322% gain from the bear market’s bottom through 2013, but for 2014, the results have been just under 2%. The S&P 500 Energy Index, which beat all but one industry during the first six months of 2014, dropped as much as 20% from its June high as money flowed out of commodity shares amid a collapse in oil prices. The group is now the worst performer, losing 1.6% this year.

Utilities, those boring, old dividend paying, non-growth companies that have gone nowhere forever, have gained 20% this year as investors seek safe-haven stocks. The only group that has posted better returns is health care, which jumped 21%. The selloff we saw in October got a lot people too defensively positioned. In the next two months, we’re will likely see people add a lot more risk.

And while we’re on health care, a new study from the McKinsey Center for US Health System Reform shows competition and choice will expand as we head into 2015. According to the McKinsey study, “In the 41 states releasing exchange participation carrier data, the number of health insurers increased by 26% between 2014 and 2015. In the 19 states with complete fillings, the number of products grew 66%. While 65 percent of existing policies will see an increase in premium costs for 2015, the medium increase will be just 4%. When was the last time we saw insurance premiums experience an annual increase of less than 5 percent?

Last week’s report on third quarter GDP was decent; thanks in part to increased military spending, which is no way to grow an economy. Fourth quarter GDP is expected to be a little less, but it could turn out just fine. According to Gallup, Americans’ daily self-reports of spending averaged $89 in October, versus $87 in September. Spending last month is similar to what it was in October 2013 ($88), but it remains well above the lower levels Gallup measured from 2009 through early 2012. Although consumer spending was generally stable in October, it remains higher than the levels found during the depths of the recession and its immediate aftermath.

Today the automakers reported their strongest October sales in a decade. October auto sales increased 6.1 percent to 1.28 million vehicles; on a seasonally adjusted annualized basis, that works out to 16.46 million vehicles. Ford, Chrysler, and Nissan topped sales estimates, while Toyota matched. GM and Honda missed estimates, and that might have something to do with 1,722 claims for injuries and deaths associated with faulty ignition switches at GM, and also exploding airbags at Honda.

And there are other factors at work in the economy; mainly oil, light sweet crude, also known as West Texas Intermediate dropped under $80 a barrel after Saudi Arabia reduced the cost to US customers. Saudi Arabian Oil Co. cut prices for all grades to the US. OPEC output rose to a 14-month high in October, and the Saudis are looking to make sure they maintain market share, and the best way to do that is to cut prices, especially when they are supposed to be part of a coalition against terrorists in the Iraq, Syria region. Demand for imports in the US has fallen as the shale boom moved the country closer to energy independence.

The $80 per barrel level was an important technical level of support, and now it is broken. Cheap oil is a big boom for the economy, but not necessarily the best thing for the environment. The UN yesterday issued its fourth and final installment in the IPCC’s climate assessment and the synopsis is that climate change is happening, it’s almost entirely man’s fault, and limiting its impacts will require reducing greenhouse gas emissions to zero this century.

According to the DHL Global Connectedness Index, we are more connected now than any time since 2007. Globalization plods along, at a slow, yet relentless pace. For the past couple of decades, globalization has been largely driven by trade, investment, and other interactions between developed countries and developing ones. Now the action is among the developing countries and formerly developing countries. Still, the overwhelming majority of commerce, investment, and other interactions still occur within, not between, nations. The report finds South-to-South trade is now growing faster than South-to-North or North-to-South; while North-to-North trade “has basically stagnated.”

This coming Friday we’ll get a better read on the economy with the monthly jobs report. It is anticipated that the economy added 225,000 net new jobs in October. The economy has gained an average of 227,000 jobs per month this year, up from a 194,000 average last year. The unemployment rate fell to 5.9% at the end of September, down from 7.2% a year earlier.

Today, the US Treasury said it plans to issue $232 billion in net marketable debt in the fourth quarter of this year; that’s the lowest level since 2007. Next quarter, the Treasury plans to borrow $209 billion. Budget deficits have been falling since 2009, and the 2014 deficit was 2.8 percent of gross domestic product, according to the Congressional Budget Office. That is down from 9.8 percent of GDP in 2009.

Investors submitted bids for $5.54 trillion of government debt at auctions this year, or 3 times the amount sold. The bid-to-cover ratio is higher than the 2.87 last year. Even with the end of unprecedented bond purchases from the Federal Reserve, demand for US Treasuries looks as strong as ever. The willingness of foreign central banks, insurers and pensions to pick up the slack as the Fed tapered out of QE, suggests there’s plenty of buyers to keep US borrowing costs low.

Bill Gross, the former bond king from Pimco, and now the chief bottle washer at Janus Capital says deflation is a “growing possibility” as governments worldwide are struggling to create inflation and stimulate growth. Gross is still publishing his investment outlook newsletter, where he says central banks around the world have made “a damn fine attempt” at fueling inflation, yet their efforts have pushed up financial assets, rather than prices in the real economy.

Gross writes: “The real economy needs money printing, yes, but money spending more so, and that must come from the fiscal side –-from the dreaded government side –- where deficits are anathema and balanced budgets are increasingly in vogue. Until then, the possibility of deflation is a challenge to wealth creation.”

And he adds: “Stopping the printing press sounds like a great solution to the depreciation of our purchasing power but today’s printing is simply something that the global finance based economy cannot live without.”