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Friday, May 22, 2015

Proactive in the Face of Volatility

Financial Review

Proactive in the Face of Volatility

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 53 = 18,232
SPX – 4 = 2126
NAS – 1 = 5089
10 YR YLD + .03 = 2.21%
OIL – .78 = 59.94
GOLD + 1.30 = 1,205
SILV - .03 = 17.11

Central bankers are speaking out. Earlier today, Mario Draghi, the President of the European Central Bank reiterated his call for euro zone countries to reform their economies, warning that future growth would remain modest. Draghi said: “It should…be clear that the argument that accommodative monetary policy constitutes an excuse for governments and parliaments to postpone their reform efforts is incorrect. Recently, economic conditions have improved somewhat in Europe…but growth is too low everywhere.”

This afternoon Federal Reserve chairwoman Janet Yellen delivered a speech in Rhode Island. Yellen said: “the U.S. economy seems well positioned for continued growth.” And she said: “If the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.”

The Fed has consistently stated that they would be data dependent, but today Yellen said “Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.” So, apparently data dependent is subject to interpretation.

Yellen expressed confidence that the economy will get better and the first quarter weakness was just a transitory problem and maybe even some statistical noise. When the Fed raises rates, Yellen promised to do it gradually.

So, what will it mean when the Fed raises rates? The Fed has held its target lending rate at zero for almost 7 years, during which time almost every financial asset has seen nifty appreciation as investors chased anything with a yield above zero. Bank of America and Goldman Sachs have recently come out with their predictions for the stock market when the Fed raises rates. BofA says that if the broader economy improve and the Fed raises rates, it will cause stock market volatility and borrowing cost instability; and if the broader economy does not improves, corporate earnings would suffer and you could not justify high priced stocks moving to even higher prices.

Goldman Sachs was even less optimistic; they say stocks are overvalued already, based on forward P/E projections, and the only thing keeping the market floating is stock buybacks and dividends. The thinking is that buybacks and dividends would dry up with higher rates. The more optimistic conclusion of the Goldman Sachs report, is that if the economy picks up, companies will abandon stock buybacks and instead invest in growing their companies.

Here’s the problem, and it is the same problem we’ve seen for a long time; the slack in the labor market means wage growth has flat-lined, and even slipped a little. Consequently, consumers have cut back a little on spending and increased saving, squeezing every dollar until the eagle grins.

Next, look at where the markets are right now. The S&P 500 index closed yesterday at its 10th record high of the year. The market is almost perfectly tracking last year, when the S&P notched its 11th record close on May 23.  The steady assault on record highs by the S&P has come amid a market sapped of volatility and volume. There hasn’t been a 1% decline from any given intraday high since May 11. In other words, a very tight trading range. The first half of the year has seen a very tight trading range. If the markets finish out the quarter about where we are, it would be the tightest trading range for the first six months of a year, percentage-wise, in market history. It feels a lot like the calm before the storm.

Recent market data may or may not repeat in the same way going forward. I do not know where the markets will go from here. I do not know if a Fed rate hike increase will slam the markets or if the markets will just keep slogging higher. And it does not matter. The Fed is not responsible for your portfolio, you are. If things go bad, you can’t blame the Fed. If things go swimmingly, you don’t have to pay the Fed a commission.

Will the markets soar to new highs or crash? I don’t know, you don’t know, and those that are foolish enough to say they know, well, they don’t know. What we can say with some certainty is that periods of extremely low volatility are quite rare. What will the market do? It will fluctuate. That is an old line attributed to J.D. Rockefeller, or J.P. Morgan, or Jesse Livermore, or Jay Gould; nobody knows for sure. This well-known prediction for investors is also the most humorously vacuous.

Still, it can be helpful. If you know that low volatility won’t last, you should ask yourself just how much volatility you can handle. If the markets correct violently, will you get out? Will you ride it out? Is your portfolio diversified in such a way that you can ride it out? And don’t make that mental mistake of reclassifying an investment if it doesn’t perform. If you bought something for capital gains or dividends or whatever, you should not reclassify it as something that might do well if we get another financial crisis. How much volatility can you stomach? Are you ready to take advantage of short opportunities?

And then remember that volatility can move both ways, up and down; it presents both challenges and opportunities. If the markets move higher from here, we could be looking at an overvalued, overbought market. Will you take profits off the table? Will you ride it out? In other words, what is your exit strategy? If you’re not clear on that, now would probably be a good time to look at some “what if” scenarios and make some decisions in advance. You can’t force the markets to move the way you want but you can control what you will do when markets move. When things get wild and wooly, proactive is better than reactive.

The Labor Department reports the Consumer Price Index gained 0.1 percent last month after increasing 0.2 percent in March. In the 12 months through April, the CPI fell 0.2 percent, the largest decline since October 2009. The core CPI, which strips out food and energy costs, increased 0.3 percent, the largest rise since January 2013. In the 12 months through April, the core CPI advanced 1.8 percent. In the last three months, core inflation advanced an annualized 2.6 percent, the most since August 2011. Costs may continue to firm as fuel expenses rebound, apartment rents climb and health-care services become more expensive. Such price pressures should help Fed policy makers gain confidence in their forecast that inflation will move toward a 2 percent goal as they consider their first interest-rate rise since 2006.Last month, gasoline prices fell 1.7 percent, food prices were unchanged, and shelter costs increased 0.3 percent. A rough gauge of housing costs known as owners’ equivalent rent, or OER, was up 2.8% in April, compared to April 2014. That’s the fastest year-over-year change since late 2007.

China’s stock market burst back to life this week, continuing a year-long rally in the world’s second-largest economy as Beijing steps up monetary easing and money floods in from overseas due to the new trading link with Hong Kong. The rally took a brief pause recently on worries it had gone too far and too fast, but it seems like the bulls have returned. The Shanghai Composite advanced 2.8% today, taking gains to 8.9% this week while Shenzhen rose 1.1% to bring its rally to a 12.2% gain over the past five days. The Shenzen may be the hottest stock exchange anywhere. Among the 1,721 stocks on the Shenzhen Composite Index, four have declined this year. The gauge has jumped 166 percent in the past year. The best performer is Beijing Baofeng Technology Co., a developer of online movie players, which has jumped 3,822 percent since its initial public offering two months ago. There are 103 stocks in the Shenzen that are up at least 500 percent, and those stocks now trade at an average 375 times reported earnings, with and average market cap of $3.5 billion.

As widely expected, the Bank of Japan kept its massive ¥80-trillion-yen monetary stimulus program intact today, and revised up its assessment of the economy, despite inflation still hovering around zero. Data last week showed GDP grew an annualized 2.4% in the first three months of 2015, as consumption climbed for a third straight quarter and companies boosted spending for the first time in a year.

The bird-flu outbreak is forcing some poultry companies to suspend operations and boosting prices for eggs and turkeys as supplies tighten. Egg companies — the sector hit hardest by the virus — and turkey producers are spending millions of dollars to try to contain the disease. With eggs in particular, the problem is greatly complicated by the way the American industry is concentrated in the hands of relatively few producers. The government has earmarked nearly $400 million to help compensate poultry farmers for culled birds, cleanup and disease testing. Avian influenza has resulted in the deaths or extermination of at least 39 million birds, more than double the previous major U.S. outbreak in the 1980s. Of that total, more than 32 million are egg-laying hens, accounting for about 10% of the U.S. egg-laying flock.

If you are planning to get away for the Memorial Day holiday, the best time to leave was Wednesday. AAA starts counting travelers for the summer’s first holiday weekend on Thursday, and they expect 37.2 million people to attempt the great escape — travel 50 miles or more from home — this weekend. That’s the biggest Memorial Day weekend mini-migration in a decade. About 33 million of them will drive. Today’s national average price of regular gas is $2.73 per gallon, almost a dollar less than the average price a year ago.

In 2002, nine million people between the ages of 7 and 17 played baseball in the U.S. By 2013, that number had dropped by more than 41%, to 5.3 million. This might be a good weekend for a game of catch. I’m just saying.

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