Government Shutdown: Our View

October 7, 2013

The failure in Washington is disappointing, if not a surprise. However, history tells us it is not necessarily a bad thing for investors. The 16 government shutdowns over the past 37 years, which have ranged from one to 21 days, have not been particularly negative for stock market investors, averaging only a 2% decline for the S&P 500. More importantly, from a longer-term perspective, they preceded above-average returns. The S&P 500 Index has risen 11% on average in the 12 months following the shutdowns, compared with 9% for all periods. Notably, in the last government shutdown 17 years ago in late 1995, the S&P 500 rose 21% in the subsequent 12 months.

As the government shutdown began on the morning of October 1, stocks actually rose after falling modestly in the preceding days. That reaction makes sense, since selling stocks into short-term political uncertainty has been costly for investors in recent years.

Of course, the shutdown is not the only issue facing investors from Washington. We are also approaching a breach of the debt ceiling on October 17, leading to the remote-but-heightened threat of default on some U.S. obligations if lawmakers fail to increase the limit on total U.S. federal government debt. Fear over the threat posed by the debt ceiling seems well contained at this point. For example, the VIX, often called the “fear gauge,” is currently around 16 and not at the 48 level seen in August 2011, when the debt ceiling was last the subject of a battle in Washington and stocks fell 17%. Also, default concerns currently seem minimal with the discount on the one-month T-bill at just six basis points versus 17 basis points at the peak of fear in early August 2011. Perhaps this is because the economic and fiscal backdrop in the United States, and especially Europe, is much improved relative to the 2011 episode.

While it is good news that the markets have been relatively steady, without a negative market reaction there is less pressure on politicians to compromise. Furthermore, the longer the shutdown goes on and the closer we get to the debt ceiling deadline, the more the market is forced to make politicians act. We continue to monitor events closely and believe this is not a time for indiscriminate selling but rather a time to look for opportunities to buy on weakness.


The Eurozone Crisis Drags On

August 28, 2012

Europe is nearly through its August holiday and the only evidence of progress in the debt crisis has been press releases and sound bites from vacationing heads of state. Recently, however, the German weekly newsmagazine Der Spiegel reported that the European Central Bank (ECB) is once again debating a plan to cap interest rates in countries like Spain and Italy by buying unlimited amounts of their bonds.

The ECB, of course, immediately denied the report, as the plan’s potential to saddle German taxpayers with huge debt makes it a political non-starter for the EU’s most powerful member. Just to underline how Germany doesn’t (at least publically) approve, both the German Finance Ministry and the Bundesbank made it clear that any such plan is unacceptable, which didn’t stop the Spanish and Italian bond markets from rising on the news, thereby lowering interest rates.

Meanwhile, the Eurozone economy, as expected, contracted in the second quarter, with Germany positive, France flat, and most of the remaining countries negative. Less government spending, lack of hiring and worsening consumer sentiment led to a consensus estimate from economists of further contraction in the third quarter followed by weak growth in the fourth.

None of that is good news for the American economy or American investors. Europe as a whole is our largest trading partner, so slack demand across the Atlantic means lowered demand here, slower job growth, and lower profits for many American companies, particularly those with a large percentage of their business overseas. (Think Coca-Cola, Microsoft and General Motors, just to name a few.)

Compounding the problem is the continuing uncertainty as the Euro crisis drags on, month after month, with stalemate, and often economic impotence, built into the structure of the European Union itself. Don’t look for a resolution any time soon.

As always, the best defense is a diversified portfolio and the advice of a smart, experienced financial advisor.


Feeling bad, but still prosperous

August 16, 2012

The U.S. stock market, as measured by the S&P 500, has had an outstanding year so far, posting gains of 12.8 percent through August 10. Yet, there are plenty of reasons to feel pessimistic about the future: unemployment is at 8.3 percent, Europe continues to fumble for an answer to its debt crisis, and growth in emerging economies is slowing. How can stocks, which are supposed to trade on future earnings, be doing so well when the financial press is full of caution? We believe the answers to the apparent disconnect lie in the financial reports of U.S. companies for second quarter 2012.

For those watching closely, there has been a lot of good news for stocks. Of the companies in the S&P 500 that have reported second quarter earnings, more than 70 percent have beat Wall Street’s earnings estimates. That means that companies are making more money than analysts expected. As analysts adjust their future estimates to include the recent good news, prices of stocks rise. While earnings are surprising to the upside, revenue—or how much companies sell—has been surprising to the downside. Almost 60 percent of S&P 500 companies missed their Wall Street revenue targets. Companies are making more money than expected, but with fewer sales.

Companies are able to generate more profit per sale by controlling costs. Another way of putting this is that companies are squeezing more and more out of their employees; in economics parlance we call this productivity gains. Productivity gains are good, because it means that each employee produces more, which generally leads to higher wages and more disposable income. Higher disposable income in turn leads to more spending, which leads to higher revenue for companies. You get it—a virtuous cycle of growth. Yet while productivity is rising among those employed, we have a large pool of unemployed workers and that means that wages aren’t rising; try negotiating a raise when there are 3.5 job-seekers for every 1 job opening. Without rising wages, disposable income is stagnant, which means people aren’t buying more things, and that largely explains the missed revenue numbers.

The fact that we haven’t been able to enter the cycle of virtuous growth is part of the reason why the recovery has felt uninspiring. That said, even in this weak environment, companies continue to increase profitability as they squeeze workers for more output without increasing their wages. But, the current state can’t go on forever. Companies will eventually start hiring and that will result in higher wages. Either there will be virtuous growth OR companies will start to put up disappointing earnings. We don’t know which scenario will play out, but we are hoping, along with the rest of the country, for the former.


Will it be a “bearish” summer?

June 15, 2012

Lately, the weaker-than-expected economic data globally and the deepening of the European sovereign debt crisis have prompted market observers to sound the warning bells for a bear market. Some are comparing the current downdraft to what happened in 2010 and 2011, implying much further downside. Others—including international policy makers—have compared the current environment to the summer of 2008, likening the fall of Lehman Brothers to a Greek exit from the eurozone and emphasizing the unknowable “unknowns” and the spillover effects that could follow such an exit.

It seems as though a bearish sentiment has become increasingly pervasive. The American Association of Individual Investors’ sentiment survey has shown a significant increase in bearish sentiment in recent weeks. From our perspective, this level of bearishness is in sharp contrast to the year-to-date total return of 2.6% in U.S. equities! So the question is…whether such bearishness is warranted.

We are highly skeptical of the “doom-and-gloomers” or any forecaster with a strong view of how markets will perform in the near future. Markets and the events that shock markets are nearly impossible to predict on a consistent basis. A broader review of the economic data seems to indicate that while the U.S. economy might be in another “soft patch,” there is still meaningfully positive growth and that growth is likely to continue.

The media is focusing on Europe as the potential catalyst to knock the United States off its path of positive growth; we view this as unlikely. While peripheral Europe has serious solvency and liquidity issues, core Europe is growing and is not in recession, which gives Germany and France room to act to stabilize the economy. Political actions are almost as difficult to predict as the markets; however, the cost of a eurozone breakup would be much greater than the cost of a bailout to the core European countries. So if core Europe acts rationally, it’s difficult to imagine that the European Union would break up, even if it means large additional bailouts or, more likely, major structural reform.

Furthermore, Greece is relatively insignificant. A Greek exit could send a troubling message and start the game of “who’s next,” but on its own, it is a non-event. And, we believe that a Greek exit is unlikely. Returning to the Drachma doesn’t solve any of Greece’s problems; in fact, it enhances them by leading to potential hyperinflation and restrictive capital controls, making an exit even more unlikely. 

So while it might feel reminiscent of the summers of 2008, 2010 and 2011, it’s the summer of 2012. The situation today is materially different from those of previous years. The United States is growing, core Europe is creatively (if too slowly) dealing with the problems of the peripheral countries, and central banks around the world are working to coordinate and promote growth. Overall, the data indicates a heightened level of concern, but nothing that should distract us from staying focused on the long term.

Wealth Enhancement Group


Perspective: JPMorgan’s big losses

May 15, 2012

JPMorgan Chase’s surprise $2 Billion loss is exactly what’s not supposed to happen anymore, but we are not surprised. Before 2008, big Wall Street banks had a great deal going with the American people. If the banks bet big and won, their employees were paid handsomely; if they bet big and lost, well then, American taxpayers were on the hook. The Volcker Rule, part of the sweeping Dodd-Frank bank reform measures that were passed in response to the financial crisis, was supposed to change that by taking the ability to make big, short-term bets on risky assets away from banks that are considered “too big to fail” and, therefore, implicitly backed by taxpayer money. However, the Volcker Rule won’t take effect for another two years, and this recent blunder by JPMorgan will be additional ammunition for bank critics who want to impose more regulation.

These big bets, though, tend to be really profitable. The highly skilled traders that banks can attract, coupled with their knowledge of the markets and technological prowess, means that banks’ trading desks can win more often than Main Street investors. Given that greed tends to rule (and greed is not always bad), it’s no surprise to us that JPMorgan found its way back into the business of betting its own money in a big way. These bets have been very profitable and, up until the surprise announcement, had been almost a bragging point for JPMorgan’s revered CEO Jamie Dimon.

But there is no return without risk, and the risk finally caught up with them. Dimon attributes the loss to “many errors, sloppiness and bad judgment.” He makes it sound as though taking risk doesn’t always lead to some unexpected losses, and if they could have had “more control” over the risk they were taking, the losses wouldn’t have occurred. That’s just not true. The lesson here is that when big bets are taken, both big gains and big losses are possible, regardless of how good you are at managing risk.

 

Wealth Enhancement Group

 

The opinion voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The opinions expressed in this material do not necessarily reflect the views of LPL Financial. To determine which investment(s) may be appropriate for you, consult with your financial advisory prior to investing.

Economic Update: The View From 3 Months In

April 24, 2012

Except for those who are still unemployed, 2012 has been a good year so far. The U.S. economy is recovering slowly, and there are many indications it will continue to recover. Markets are up, with the Dow reaching the 13,000 milestone last seen in 2007. Greece hasn’t defaulted. Even unemployment is showing signs of improvement.

The U.S. picture
The consensus prediction is for 2% to 3% economic growth in 2012. That’s better than the 1.7% of 2011, but too slow to quickly cut unemployment from 8.3% to a more acceptable level.

Job creation, nevertheless, is increasing. December, January and February added 244,000 jobs a month, the most since before the Great Recession. Many experts think that productivity growth is maxed out and more hiring is inevitable. Businesses are investing in new equipment after spending the last two years increasing production by working off spare capacity.

Consumers are spending and borrowing again, even for big-ticket items like cars. February auto sales were at the highest since 2008. Housing starts show signs of recovery, spurred by continuing record-low mortgage rates.

So what gives us pause? Oil. Should tensions with Iran turn to war, higher gas prices would dramatically cut consumer spending, and slow the U.S. economic recovery as a whole.

Europe and Asia
Europe appears to have avoided a severe financial crisis, and while its recession is expected to be mild, the United States is feeling the effects. Banks with exposure to European debt, and the global economy as a whole, may be affected if debt restructuring doesn’t go smoothly.

China’s growth is slowing, impacting the global economy and the recovery of almost every nation. Can the Chinese avoid a hard landing on one hand, and avoid inflationary over-stimulation on the other hand? We’ll see.

What we think
We’d summarize the first quarter and the outlook going forward with two words: wary confidence. There might be some slowdown and market volatility. Oil prices will affect the economy. Fixed income has been a haven for investors, but that may be changing. Interest rates are likely to rise, and the 30-year bull market in bonds will become more bearish. And, as always, a diversified portfolio is a prudent hedge against unpredictable events and a good long-term strategy for investors.

 

Wealth Enhancement Group

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Ahhhh, 13,000!

March 1, 2012

“After bouncing up and down around the 13000 level for a week, the Dow Jones Industrial Average finally closed above that psychologically important mark for the first time since May 2008.”

That’s what The Wall Street Journal says in its online edition about the February 28 market close. But is closing above 13,000 really psychologically important?

The short answer is that for the pros, no, it isn’t. They’re busy drawing conclusions from the facts hiding behind the milestone. The twin specters of U.S. recession and European debt collapse are fading. The Dow is up 22% since October and 6.4% since the beginning of 2012, the strongest rise to start the year since 1998. Will it continue?

On the plus side, there’s another bailout for Greece, rumors of a renewed Federal Reserve bond buyback should the economy show signs of weakness, declines in borrowing costs for Italy and Spain, and a 12-month high in the Conference Board’s index of consumer confidence. On the minus side, the slowing growth rate of corporate profits, fears that China’s real estate bubble will pop, rising oil prices, and the plain fact that stocks have been rising for five months and could be due for a correction.

So the answer to “Will it continue?” is, as usual, maybe.

And if 13,000 isn’t psychologically important for the pros, is it for the Main Street investor? Probably it is. Consider the five-month run-up that led to 13,000. In the past few weeks it has finally brought the Main Street investor creeping back into the market.

Here are some ways the average investor can avoid letting the psychological component override the facts: 

  • Pay attention to valuations, the most fundamental measure that moves stocks.
  • Remain focused on broadly diversified portfolios with exposure to multiple asset classes.
  • Focus on long-term goals and stay invested.
  • Avoid the “herd mentality” of jumping on the most recent investment bandwagon.

 

James Copenhaver, Director of Investment Management

 

Sources: Optimism Drives Dow Past Milestone; Main Street’s $100 Billion Stock-Market Blunder

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.