Tuesday, November 18, 2014

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

October was clearly a volatile month. Although the stock market had been soft during the latter part of September, it really became unpredictable during October. This is not terribly unexpected, but at the same time it does not happen on a regular basis. As corporations start to announce earnings, the traders that make their living in volatility hedge their bets against whatever the companies will eventually announce. At one point during the month, the broad market was down to almost 10%. It got so bad that I even wrote an interim blog Conundrum where I indicated that even though the market was volatile, the underlying fundamentals were intact and there was no reason to abandon the market due to this volatility.

Looking back at that period in the middle of October, it was a scary time for many investors. However, having watched the markets for close to 40 years, these volatile times are not a rarity. Once volatility begins, it is important to understand why, and whether it is something you need to be afraid of or should just ignore.

As the end of the month rolled around, it was clear that my message to investors in “Conundrum” was correct. After all was said and done, the market rallied back to fully recover its 10% decline and actually ended up positive for the month of October. Who would have ever thought in the extraordinary volatility of mid-October that we would actually end the month in a positive light?

For the month of October, the Standard & Poor’s Index of 500 stocks was up 2.4%. The NASDAQ Composite grew 3.1% and the Dow Jones Industrial Average was up 2.2%. Even the beleaguered Russell 2000 was up a stunning 6.6%, which was the best of all the indexes. The S&P 500 is up 11% for the year as of the end of October and up 17.3% for the 12 months ended October 2014. The NASDAQ Composite was up 11.9% for the year 2014 and 19.6% for the year ended in October. The Dow Jones Industrial Average is up 6.9% for 2014 and up 14.5% for the 12 months ended October 31, 2014. In contrast, the Russell 2000, which has been extraordinarily volatile, is only up 1.9% for 2014 and only up 8.1% for the 12 months ended October 31, 2014.

Just so you have a basis for comparison, it is also interesting to see that the Barclays Aggregate Bond Index was up 1% for October and continues to be up 5.1% for 2014, but only up 3.9% for the one year ended October 31, 2014. While many people hide out in bonds in order to avoid volatility, we are almost certainly in a rising interest rate environment.

When interest rates rise, bonds move down. The Federal Reserve has already announced that they will begin increasing interest rates in 2015, and it would not surprise me to see rates move up faster than most people expect. As I will illustrate below, the economy is quite good and it is only a matter of time before the Federal Reserve begins moving interest rates up to offset an economy that might end up being “too hot.”

I recently spoke at a seminar on investing and thought I would go back over the years and illustrate why market timing is an absolute waste of time. When I first became active in investing in 1987, we were all crushed by the market crash on October 21, 1987. In fact, I saw many so-called experts using this time during October 2014 to surmise that the market would go down as much as it did in 1987. On that day in 1987, the Dow Jones Industrial Average went down 22% in one day. For those of you who are not familiar with this time, that was 22% in just one trading day - not a week, month, or year. Please look at the chart below illustrating this dramatic activity.

At that time, there were many forecasters that predicted the world as we know it would clearly end with the stock market sell-off. Many proclaimed that the financial world would never be the same and clearly a Great Depression was upon us, as they braced themselves for long bread lines and mass hysteria…

I have identified on the chart below when the stock market crash of 1987 occurred. On that fateful day, the Dow Jones Industrial Average ended down at a level of 1738. Today, the Dow Jones Industrial Average is 17,380. That means that the market has gone up tenfold since 1987. For those of you interested in statistics that is 1,000% higher than it was in 1987.

I only remind you of the 1987 crash because it was clearly on display in mid-October as the reporters on the financial news channels were exclaiming all the negatives that were set to occur. However, they missed many very clear signs that the economy was strong and earnings were stronger. Not a single day passes that I do not hear that the market will crash because it has gone up so much and so quickly. While certainly nobody knows what will happen over the short-term, I do know you can predict what the market will do over the long-term based upon interest rates, earnings, and the economy. If all three are intact as they are today, it is much more likely that the market will move higher rather than lower.

I started this blog by quoting Peter Lynch, who was maybe the most famous investor of our lifetime. Peter Lynch managed the Fidelity Magellan fund through some of its most successful years. I have read all of his books and enjoy his writing. The most important thing I like about his writing is his simple way of understanding the futility of trying to time the market. His philosophy is to buy good companies and the market will take care of itself. One of the most famous quotes relates to his position that you cannot predict the economy, interest rates, and the stock market. As Peter Lynch said, " If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes." I also enjoy the following because it is so true - “It’s only three dollars a share, what can I lose?” to which Peter Lynch replies, “Three dollars for every share you buy.”

While it gives me great pleasure in writing the words that my blog of October 15th was correct, I do not find joy in seeing my clients make moves that are not beneficial to their investment future. I wish I would have kept track of how many clients called indicating their concerns that the market was headed for a major correction. Despite very few of them actually making any moves after speaking with us about the markets, it still bothers me that clients are not evaluating true economic data, and choose instead to give weight to some of the ridiculous proclamations of so-called knowledgeable people in the financial press. If you are ever having a hard time evaluating data, please give us a call as we certainly would love to discuss it with you.

While writing this, I am reviewing the financial and economic issues in the US today. Clearly, there is no indication of a weakening economy when you read that the durable manufacturing is up 6.42% over the last one year, and capacity utilization borders on a full capacity 80% with a reading of 79.3% for September of 2015. Manufacturing is extraordinarily strong and that is a positive. Also, exports increased 4.5% over the last one year, even in face of a dollar that is strengthening dramatically due to the strong US economy. We hear so much about employment and the employment participation rate that it obscures the actual facts. While it is clear that there are way too many people living off government subsidies, employment has dramatically improved over last year.

Over the last two-year period, we have added almost 4 million new jobs. This is a significant number since this is 4 million people that can now contribute to the economy by buying goods and services, which improves gross domestic product. Virtually every aspect of employment has improved over the last year, although I don’t believe the unemployment rate is truly 5.8%, as the government reports. While certainly better, who knows exactly how good it is at the current time. But what I do know is that these previously unemployed 4 million Americans will now be contributing to improve the economy.

It is amazing to see consumer confidence up 30.52% over the last 12-month period. Standing at a percentage in October at 94.5% tells you that most people feel good about the economic future. Also, the index of leading indicators is up a robust 7.3% over the last 12-month period. Anyone reading the almost rosy economic statistics at the current time could tell it is highly unlikely a major negative economic swing could be occurring.

Earnings for the third quarter of 2014 were up almost 10% over the identical quarter in 2013 and interest rates continue to be zero or lower and as illustrated above, the economy continues to be strong. It is interesting to note the rate of inflation was recently announced at an annualized 1.7%. However, many of the people reading this posting today have funds in money market accounts earning zero and CDs earning less than 1%; having money in cash today means that every single day you are losing money to inflation as the cost of living grows.

I have indicated in multiple postings that the market will reverse when one or more of the indicators of interest rates, earnings, and the economy change. Currently, all three are positive and are increasing. When I wrote the blog “Conundrum” in mid-October, I had absolute confidence whatever was happening would not affect the stock market in a dramatic way. You may rest assured though that I have no pretense about predicting market crashes. No one can, no one will, and it is unlikely that I will even try.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Tuesday, November 11, 2014

Broadway Junkie

I realize that I have not written my investment report for the month of October, which was a very volatile month on the stock market, but intend to do so later this week. In the meantime, I thought I would give you an update on my recent trip to New York, which is a lot more entertaining. Suffice it to say that the month of October, even while extraordinarily volatile, ended up being an excellent month for the financial markets. Also, November has started out strong, so we are progressing nicely into the most successful part of the year for the stock market, which is the November through May financial year. As I mentioned, I will cover each of these items at a later time.

About this time last year, I wrote 48 hours in The Big Apple. This year I made another trip to the Big Apple, not only for the Baron Investment Conference but also to attend as many Broadway plays as I could during a three day weekend. To see four Broadway shows and get the most value for my money, I attended a play on Thursday, Friday, and Saturday night, along with a matinee on Saturday afternoon. Flying back to Atlanta early Sunday morning, I knew it would be a busy weekend but well worth it.

While I was there, I also had the opportunity to visit the 9/11 museum. If you have not been and ever get the opportunity to do so, you should certainly make a trip down to Lower Manhattan. They have recently opened the museum and the new 1 World Trade Center is open for business (picture below). While certainly not as impressive as the preceding twin towers, it is still pretty overwhelming if you have never seen it up close and personal.

For those of you who are not familiar with the site, they now have built two fountains that encompass the actual footprints of the towers that were destroyed in the terrorist attack. In between the two reflecting fountains, the memorial space is completely underground, while the wall that kept the Hudson River out of the original World Trade Center is exposed. Although I was very impressed by its beauty, it brought back all of the ugly memories of that fateful day, and you may rest assured, “I will never forget”- not in this lifetime!

On Thursday night, I went to see a musical that I had never seen before (which is unusual) - Beautiful: The Carole King Musical. Although I am very familiar with Carole King, I did not know she wrote “Up on the Roof” for The Drifters, one of my favorite groups in the 1960s. And who could ever forget, “(You Make Me Feel) Like a Natural Woman” by Aretha Franklin, another famous song from that era. Surprisingly, the show was excellent, and since I was so familiar with the music (from my college years), I guess it really hit close to home. Carole King’s famous album Tapestry has set kinds of records and to this day, it is one of the highest grossing albums by a female performer and one of the overall best-selling albums of all time.

During the day on Friday, I attended the annual Baron’s conference, which is always a treat. Not only is the financial part of the conference good, but it is held at the Metropolitan Opera House and always features big-name entertainment to break up the monotony of discussing the stock market. For lunch, I was somewhat surprised to see they had the entire New York Symphony Orchestra performing. There were at least 50 musicians and 20 singers to perform the songs from the famous Show Boat musical composed by Jerome Kern. While certainly beautiful and Broadway related, it is just not my cup of tea. After a short while, I left that venue and headed over to see country star Carrie Underwood perform. Given her relatively short time in the limelight, she really is an excellent performer. The concert was all Broadway mixed with Hollywood- laser lights, the entire works... And yes, it is true… she is pregnant, and it shows.

After lunch and additional meetings at the conference, they announced the famous entertainer slated to perform that afternoon. You may recall last year, the entertainment was Barbra Streisand and her orchestra. I was thinking to myself that they would never be able to outdo that one, but sure enough they did.

Ron Baron was as excited as the rest of us to announce that the entertainment for the afternoon would be Paul McCartney. And believe it or not, I sat in the very first row, less than 10 feet from one of the greatest musicians of all time. Having grown up in rural Southwest Virginia, to a very humble life, I would have never dreamed I would be afforded this opportunity. Due to their influence on my during my high school years, no one was more famous to me (and many others) than The Beatles. For years we could not believe the success and the honors that The Beatles accumulated in the United States. Who would have ever thought that forty years later I would actually be within 10 feet of Paul McCartney? He performed many of the original songs, including “I Want to Hold Your Hand” and “Hey Jude”. I can report that even today, Paul McCartney at age 72, sings as well as ever. It was certainly a thrill beyond belief to see him perform so up close and personal.

After the Paul McCartney concert, I rushed back to Broadway to attend the performance of Motown. I was lucky enough to have a seat in the first row, directly in front of the stage. In fact, the conductor and I shook hands prior to and after the performance. I will not bore you with the details of revisiting the Motown play, since I discussed it last year, however, the reason I like Broadway so much is because of the sheer talent you can see up close and personal. Here, classic performers are just extraordinarily talented, young kids. They do not make millions of dollars like the stars, and in fact, are probably lucky to make $1,000 per week. It is the truest form of entertainment and by far my favorite.

I even love the old playhouses on Broadway, with their uneven floors, seats too close together, and inadequate restrooms. When they built the Marriott Marquis in Times Square, they had to tear down many of the original playhouses. This caused such a public outrage that the city of New York made all of the original playhouses “historic buildings”. Due to this historic designation, apparently playhouses cannot be renovated or updated. And despite everything wrong with these venues, I truly love them and hope they never change.

On Saturday afternoon, I went to my 11th viewing of the Jersey Boys – and am already looking forward to my 12th. This is sheer energy and talent with a bunch of unknown actors, singing songs that were recorded almost 40 years ago. There is nothing more enjoyable than to see the story unfold, surrounded by the fabulous music of The Four Seasons.

There is one scene in the musical where the character playing Frankie Valli does a solo version of “Can’t Take My Eyes Off of You”. At the end of the song, the 2,000 people in attendance all stood at once to applaud; and I have never witnessed a time when the audience’s reaction was not the same after this song. The only time I have seen anything comparable to this reaction on Broadway, was when I saw Michael Crawford and Sarah Brightman perform The Phantom of the Opera in 1990. In the original run of the Phantom, these two best known performers literally brought the audience to their feet when they sang the lead song. I know it is an exaggeration, but I still believe it to be true: the house shook. I have seen Phantom of the Opera at least 10 times and that was by far the best.

Finally, on Saturday night I attended the most recent version of Les Miserables. I have actually seen Les Miserables nine times, in nine different versions - including 3 times in London, once in Atlanta, and now 5 times in New York. This was an updated version and the production was pretty spectacular. Once again, young kids expressing enormous talent and no big-name performers. As the performance progressed, all I could think about was how poorly the movie was in relationship to this. It seems pretty silly that the movie was made with million-dollar actors, none of which could really sing, and here before me were these amazingly talented, young kids performing extraordinary songs while earning virtually nothing.

In summary, this was definitely a whirlwind tour of the Big Apple this trip. Four Broadway plays, Carrie Underwood, Paul McCartney, and most importantly the 9/11 museum. You could not have squeezed in an additional event over the two and a half days I was in New York.

I have been very lucky to go to a lot of wonderful different places in my lifetime. Many cities, events, and some of them truly as spectacular as this weekend was in New York. However, there is nothing that brings me more joy and as much pleasure as when I hear the flight attendent announce, “Ladies and gentlemen, we have started our descent in preparation for our arrival at Hartsfield International.” Even after an exciting, chance of a lifetime weekend, “There’s No Place Like Home.”

(Ava as Dorothy from The Wizard of Oz and her friend as the Wicked Witch of the East)

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Friday, October 24, 2014


From the Desk of Joe Rollins

Transcribed Thursday, October 16, 2014

The stock market has sold off for the last three weeks for a lot of different reasons, which I would like to try to explain from my point of view. Anytime there is a large movement in the market, I attempt to analyze the underlying issues to determine if the issues are real issues or issues just perceived by the public. There is absolutely no question that when the market goes down, everyone feels pain. The question for us, as investors, is whether we need to change what we are doing or whether we should maintain our positions and wade through the downturn.

First, this may be hard to absorb, but the market movement has actually not been as bad as the public perceives. The S&P is down only 8.5% from its all-time record high. You have to have a movement of 10% or greater to realize a correction; we have not reached that level yet. I realize that we could reach that level, but as of Thursday morning, the market is holding strong at that percentage.

There is no question in my mind that the major driver of the downturn is the fear of the Ebola virus and it’s potential to spread. While watching the news at 4:30 a.m. yesterday morning, it was announced that the most recent Ebola patient was allowed to fly on a commercial airline with the permission of the CDC. Almost immediately after that announcement was made, the Dow futures dropped over 100 points. The panel of commentators on the financial show all expressed fears that an Ebola epidemic would cause the public to limit their actions insofar as going out or traveling. In other words, they are afraid that people will stop going to movie theaters, stop going shopping (which in turn they forecast as negative news for Christmas sales), and they would certainly stop flying. But when you consider that there are only two people in the United States, of which we are currently aware, to have contracted the virus from a population of over 300 million, that seems to be a fairly extreme position in my opinion.

The other major driver is that the price of crude oil has dropped from over $100 per barrel down to about $80 per barrel. The argument here is that a lack of demand for oil signifies an economy in a downturn. If there is no demand for oil, either the consumers cannot afford it or businesses are suffering so much that there is no demand for fuel for trucks and other industries. While certainly that might be the case in Europe, there is no evidence that is the case in the United States. In addition, the strengthening dollar, as I will discuss below, has an effect on the price of imported oil, making it more expensive. Consequently, oil production in the United States is more attractive, since there is not the high cost of transportation from the Middle East. Frankly, our energy prices are not a negative to me; in fact, it all sounds fairly positive.

We have been talking for years about the very important economic effect of higher production of energy in the United States. It has been somewhat surprising that that this additional production of crude oil did not lead to lower prices for consumers years ago. In fact, we expected to see lower prices much sooner than now.

So is this reduction in crude oil prices due to oversupply and economics of demand/supply, or is it in fact due to the upcoming recession either in this country or in Europe? Certainly there is no evidence of the downturn in the economy in the United States, so you have to think that it is mainly due to supply and reductions in demand.

It appears to me that the fair price for oil is somewhere around $90 per barrel and it must be realized that the price of oil can only go down so much. When the price of oil reaches a level of the cost of production, the wells will just be capped. When you use fracking to extract oil from shale, your cost of production is much greater than under normal extraction techniques. Therefore, it does not seem that the price of oil could fall much lower than it is today.

The positive spin on the low price of oil is that this is a huge benefit for the consumers. If consumers have lower gasoline prices and lower commodity prices, that is good for everyone. Virtually every industry uses energy in some form or another, and lower prices are good for everyone.

The other major concern is the strengthening dollar. Once again, this should not be much of a surprise to anyone. The 10-year treasury bond in Germany is at 0.8%, less than 1%. It should not surprise anyone that people from Europe are investing their dollars in the United States, where the interest rates are much higher, even at the miniscule rate of 2% annually for a 10-year treasury bond.

It is true that when the dollar strengthens, U.S. companies that sell products to international consumers are less competitive while selling outside of the United States. Many of the S&P 500 companies receive a significant portion of their revenue base in a foreign currency. While it is true that these prices will definitely go up and make them less competitive in other countries, it also positively impacts all assets held in the United States based on U.S. dollar terms. It also brings back money from overseas to the United States, which also increases the value of the dollar. Of little notice is that many companies hedge their currencies. Much of the manufacturing takes place outside of the United States, and then products are shipped to other countries outside of the United States. In return, this (in dollar terms) should not greatly affect profits of corporations.

The other major concern that is affecting the market is the deterioration in the European economies. For many years, the European Union has been fighting over whether they should stimulate their economy with government support, or whether they should allow economies to sink or swim based upon their own momentum. The cost of government in Europe is well over 50%, and therefore it is hard to affect pricing when the government controls so much of the economy.

In France, Italy, and the smaller European countries, they are begging the government to stimulate the economy, while Germany refuses to participate. Of all the European countries, Germany has the tightest grip on their economy and is scared to death of inflation. European economies are basically functioning at a breakeven GDP, there is certainly no evidence that those countries will spiral down into a major recession. While European economies are weak in comparison to that of the United States, it is hard to imagine that this would have a long-term effect on the U.S. economy.

I have written many times in these blogs that you can expect a 10% down movement in equity markets, either up or down, at any time. Over the last 50 years, there have been 30 times when the markets have moved at least 10%. With that being said, it is not an unusual circumstance. That does not mean that we do not take this movement seriously. We watch it every day and study the fundamentals to determine whether a change needs to be made in our basic investment philosophy. For the period ended September 30, 2014, the S&P was up 19.7% for the one year period. Therefore, even with a 10% move down, the S&P would still be up almost double digits over the last year.

In analyzing the fundamentals, it is important to make sure that something has not changed that we need to address. I constantly review economic reports and earnings to determine whether some adjustments need to be analyzed. It is just unusual to see a movement this large without some sort of economic reason. Certainly, if you are in the camp that you believe Ebola is going to develop into a pandemic throughout the United States, then of course, there is your economic reason. The effect of lower oil prices, the stronger dollar, and the mild economic weakness in Europe certainly would not have the same negative economic ramifications.

What is interesting is that all the economic fundamentals are clearly intact. I have been watching corporate earnings very closely over the last couple weeks, and all of them appear to not only be strong, but above expectations. Interest rates have fallen to 2% on a 10-year treasury bond, which in return helps all aspects of the economy. Now consumers are realizing lower mortgage payments, and every facet of credit is cheaper due to the lower rates. The economy recently appears to be on track for 3% GDP growth, which by no definition would indicate any type of weakness. Therefore, the three components that we analyze to determine whether stock prices are reasonable are all intact: earnings are great, interest rates are low, and the economy is stable and growing. Therefore, fundamentally, there is no change from our opinion that stock prices should move higher.

An explanation is needed to understand the fundamentals of momentum traders. The so-called “fast money” moves strictly on momentum and not on fundamentals. They move a market in the direction of what the trend is, either up or down. When you see the large volume that occurred in the markets on Wednesday, October 15, 2014, you realize the fast money, or momentum traders, were involved. Due to the huge volume that occurred, it could only be them trading in such enormous share volumes.

This is not to say that these momentum traders would not have an effect on the overall market at the end of the day. On the other hand, it does prove that it does not reflect fundamentals. Therefore, it is probably not relevant for future stock prices.

The conundrum for investors (such as us) is whether we should make a large fundamental change in our positions to accommodate a short-term scare or momentum traders changing the direction of the overall market. The fear, of course, is that being uninvested, the momentum traders could shift gears and the market could go up as much as it is down over the same relevant time period.

When momentum traders sell the market, they usually do so with a technique known as shorting the indexes. Along with any other investors, the traders only have so much capital to work with, and therefore are limited as to how much they can move the market. It is inevitable that at some point they would have to cover the shorts, meaning they would buy the indexes to cover the shorts. This unwinding of the shorting technique creates upward pressure on the market, which is positive. Since the moves by the momentum traders are designed to make short term profits, none of these transactions will happen in the long-term.

In summary, after a review of all the fundamentals and the underlying economy, we have made an election to hold our position and watch it for a few more days. That does not mean we will not change our opinion tomorrow, but today (Thursday, October 16th) it appears that the fundamentals are intact. Interest rates tend to be low and the threat of Ebola is so small that it is virtually meaningless. Of course we would be more than happy to notify you if our thoughts change.

If you are still feeling uncomfortable regarding the movements in the equity market, even after reading this, then please give us a call and we would be happy to discuss it with you and update your portfolio to reflect any conservative path you would prefer to take. In the meantime, as I write this post, the market has rallied back to breakeven, which is a positive compared to the last several weeks.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Thursday, October 9, 2014

There Must Be a Pony in Here Somewhere!

I know the title of this blog may sound confusing, but I will explain it later in greater detail. However, I wanted to begin by saying how happy I am that we finished the third quarter financially unscathed, and express how much I am looking forward to the fourth quarter.

We just experienced a quarter that had at least six ongoing wars (Syria, Afghanistan, Libya, Iraq, Israel and Palestine), an invasion by superpower Russia into Ukraine, an outbreak of an infectious disease in Africa, a total lack of confidence in the United States government and the executive branch, and we still finished essentially breakeven. I would say that’s not too bad! Oh, and let’s not forget the political unrest in Hong Kong and the ISIS beheadings – need I say more? Historically the third quarter is always the worst quarter of the year financially, principally due to the fact that many stock market traders do not work during the summer months. Due to the low volume and vacuum of traders, even the smallest move can have an enormous effect on stocks.

For that same reason, the fourth quarter of the year is generally considered the best. It is a time when all the traders come back to the floor, and a flood of new money comes into the stock market by way of pension plan investments. While somewhat scarce in the third quarter, the fourth quarter tends to evoke a frenzy of trading. There have been many studies that indicate if you stay in the market from November through May, and leave the market June through September, you will have captured all of the gains in history. Maybe it’s a mere coincidence or maybe it’s just the nature of human beings trading in a competitive market. Whatever the reason, the fact that we got through the third quarter essentially breakeven is pretty good and very exciting for the upcoming quarter.

Before addressing the seemingly inane title above, I wanted to provide you with the finishing results of the third quarter. For the quarter ended September 30, 2014, the Standard & Poor’s Index of 500 stocks actually had a gain of 1.1%. For the year, the S&P 500 is up a very satisfying 8.3%. While September was down and extraordinarily volatile, the fact that the major market index ended up positive for the quarter illustrates the underlying strength of the equity markets.

For the third quarter, the Dow Jones Industrial Average was up 2.0%, and reflects a 4.7% gain for 2014. The NASDAQ Composite was up 2.2% for the third quarter and is up 8.6% for the year. Even the much maligned Barclays Aggregate Bond Index finished marginally higher for the quarter and up 4% for 2014.

As I have pointed out before, the Russell 2000 Small-Cap Index is continuing to get crushed this year. For the third quarter of 2014, it was down 7.4%, incurring a stunning 6.1% loss in the month of September alone. For no reason that I can discern, this index is down 4.4% for the year. Rather than try to be a hero, I have sold virtually all of our small-cap index funds and will look to reinvest again at the beginning of next year. There is certainly no reason for this broad-based sell off of the small-cap index, but you cannot just stand in front of a moving train… you need to get out of the way and let it settle.

While attending public speaking events, I am often asked why we do not invest in gold and precious metals. The principal reason is that there is no way to evaluate what a fair price is for gold. If there was ever a quarter that justified an increase in gold prices, it would have been the third quarter of 2014, inundated with its many crises. However, surprisingly gold was down a stunning 9.0% for the month, and now shows negative returns for 2014. Although many have been taught that you should invest in gold during world crises, it is proven here that any type of quantitative analysis is not followed by fundamental performance. Thus our decision to steer clear of such investments...

September was a particularly bad month for virtually all of the financial markets with equities, bonds, precious metals, natural resources, etc. all ending with losses for the month. Often when I see these types of months, I wonder whether this is a fundamental economic change or if the lack of volume exaggerated the losses and therefore really does not mean much. However, the foundation is set for higher stock prices going forward. As the title of this blog indicates, there certainly must be a pony in there somewhere.

I am often reminded of the joke that President Ronald Reagan always referenced. It certainly was not a joke that was created by him, but overnight the term became an international sensation. Looking back, it is hard to believe that it has been close to 30 years since Ronald Reagan was president and used this joke to illustrate the difference between an optimist and a pessimist. For those of you that do not remember the joke, I will quote it in its entirety to illustrate how clever it really is:

“The joke concerns twin boys of five or six. Worried that the boys had developed extreme personalities -- one was a total pessimist, the other a total optimist -- their parents took them to a psychiatrist.

First the psychiatrist treated the pessimist. Trying to brighten his outlook, the psychiatrist took him to a room piled to the ceiling with brand-new toys. But instead of yelping with delight, the little boy burst into tears. "What's the matter?" the psychiatrist asked, baffled. "Don't you want to play with any of the toys?" "Yes," the little boy bawled, "but if I did I'd only break them."

Next the psychiatrist treated the optimist. Trying to dampen his outlook, the psychiatrist took him to a room piled to the ceiling with horse manure. But instead of wrinkling his nose in disgust, the optimist emitted just the yelp of delight the psychiatrist had been hoping to hear from his brother, the pessimist. Then he clambered to the top of the pile, dropped to his knees, and began gleefully digging out scoop after scoop with his bare hands. "What do you think you're doing?" the psychiatrist asked, just as baffled by the optimist as he had been by the pessimist. "With all this manure," the little boy replied, beaming, "there must be a pony in here somewhere.”

This joke illustrates how I feel today. With so many negative occurrences in the world, it is hard to illustrate the positive that is occurring financially. While watching TV the other morning as the stock market futures were trading at an essentially breakeven level, it was announced that a nurse in Spain had contracted Ebola; almost immediately, the stock market futures sold off 100 points.

With close to 6 billion people on Earth, for the US market to react in this fashion just illustrates that there is little common sense or common logic being exercised in investing. As I have written so many times in so many ways - interest rates, earnings, and the economy hold the key to stock performance. When you have the trifecta of these economic indicators, as we do now, it forebodes a higher stock price in the coming months.

In an attempt to find the pony, you need to look closely in order to find the positive news regarding the stock market. You should actually be happy with all the negative publicity and criticism you see of stock investing in the newspapers and in the media, as the publicity actually might keep stocks from getting too far ahead of themselves. Every paper you pick up talks about over-extended investors and unrealistic valuations. Quite frankly, stock market tops are generally not made with negative stories dominating the media today.

Stock market tops are achieved when economic and market sentiment is overwhelmingly positive. When you see the stock market mentioned in a positive light on the cover of a major news publication, then you need to worry. Today however, the opposite is true. The majority of the headlines are negative and the media is focused on pointing out the negative.

Stock market tops are not reached when the economy is accelerating. Even though we had a negative GDP in the first quarter of 2014, the second quarter GDP rebounded nicely and ended with a sterling increase of 4.6%. It looks like the third quarter GDP might be in the 3.0% to 3.5% range and similar returns are expected in the fourth quarter. In fact, economists are forecasting the GDP to be even higher in 2015 than in 2014. It would be very unusual for the markets to top until the economy starts to turn down. Nothing we see today would reflect that reality.

The other major component of stock market performance is interest rates. The Federal Reserve has already announced that interest rates will not increase until 2015. There is no question that the Federal Reserve would have to move interest rates if inflation were to pick up or the economy were to accelerate out of control. Neither is the case today. The second quarter inflation report is up only 1.7% on a year-to-year basis. That is much lower than the 2.0% that is desirable by the Federal Reserve. In fact, the Federal Reserve would like to have inflation higher not lower, as it is today. I believe there is little chance that interest rates will increase over the next seven to eight months, and therefore, there are plenty of opportunities for stocks to improve during that time frame.

The most important component of stock prices is earnings. Earnings have been nothing short of spectacular and appear to be accelerating. The current forecast for the next four quarters for earnings are increases of 11.7%, 11.8%, 14.7%, and 16.7%. It is hard to even imagine that the extraordinary, record earnings that we are realizing today are projected to go up by double digits over the next four quarters. Stock market tops do not happen when earnings are accelerating. Stock market tops happen when earnings are declining or when a recession is in sight. Neither of those conditions exists today.

Therefore, in summary, it looks like, “Virginia, there might just be a pony in your Christmas!”

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Wednesday, September 10, 2014

Time Passes By

I recently just passed my 65th birthday and I am starting to realize as I get older how quickly time passes. It is actually hard to believe that the firm started in my living room in 1980 has just past its 34th birthday. I never had any intentions of being an employer, I just wanted to prepare tax returns correctly and that was the reason for establishing the firm. I saw so much that I disliked in large accounting practices, but mainly I disliked seeing my clients mistreated. Therefore, the origin of the practice began in a small bedroom in Fairburn, Georgia, and now 34 years have passed so quickly.

Below are two pictures from Ava’s first day of school at age two and age three. Not that it has anything to do with what I am writing, but if I do not put a picture of Ava in the blog, I am heavily criticized. It seems like only yesterday she was born, and now three and a half years old, she is probably at the peak of her intellectual ability.

The main reason why I wanted to make this point is because over the last year we have enjoyed extraordinary success by investing. For the one year period ended August 31, 2014, the Standard & Poor’s index of 500 stocks is up a sterling 25.3%. The NASDAQ Composite is even better at 29.1% and the Dow Jones Industrial is up 18%. Given that the rate of inflation is currently around 2%, there are very few times that you can enjoy a rate of return 10 to 12 times the rate of inflation. It is been an extraordinary year by virtually anybody’s standards.

I am asked almost every day, “When should I expect the large market crash?” During the month of July, when the market was volatile and traded to the downside, there could not have been more market forecasters predicting the ultimate demise of the financial markets. Do not get me wrong, there are plenty of reasons in the geopolitical arena that would lead to this conclusion. It is almost a war everyday throughout the rest of the world, and frankly things do not appear to be getting any better in the Middle East. Yes, a major war with Russia would have a terrible effect in Europe; however, I question whether it would have much effect on the United States.

As I wrote in the July blog, I did not think that the market volatility was much to be concerned about, especially since the fundamentals were still exceedingly strong. Also, I argued that earnings were great, interest rates were low, and the economy appeared to be on the upswing, and therefore, I did not anticipate a major move to the downside in the financial markets in July. I guess I was right!

The month of August was quite an excellent month for investing. The S&P 500 was up 4% in August, and is up 9.9% for the year 2014. The NASDAQ Composite was up 4.9% in August and up 10.5% in 2014. The Dow Jones Industrial Average was up 3.5% in August, and remains up at an excellent 4.7% in 2014. As comparison, the Barclays Aggregate Bond Index was up 1.1% in August, but still up an impressive 4.7% in 2014 for bonds.

Many times a week, I meet with you (clients) and I am always blown away by how impersonal and uninformed the financial advice is that others receive elsewhere. I guess there must be a chart out there somewhere that says if a person is of a certain age, they require a “set” combination of stocks and bonds, notwithstanding any other information. It is amazing to me that someone who has never met a client and knows nothing about their financial life, needs, or what their time horizon is, can recommend any type of investment protocol.

As a matter of fact, we have some clients come in and they have never actually spoken with their financial adviser. They deal with a salesman who sends some money off to some unknown location for investing. I often ask them if they had ever talked to the person who invests their money. Often times, the answer is no – they do not even know who that person would be. The big difference between the way we do things and the way other people invest money is that we attempt to fully understand the client’s needs and invest with knowledge, not off an investors’ chart that probably has not been updated in decades.

A thought popped in my mind the other day, my first recognition (of any type) of interest in the financial markets began in 1980. At that time, we were enjoying a new administration with Ronald Reagan during a time when America felt good about itself. We had gone through serious inflation during the 70’s and interest rates were totally out of control. I vividly remember when the 10-year Treasury rate nudged up against 16% in 1981. It is important that you understand how much interest rates affect financial markets. I am enclosing a chart below that illustrates the 10-year Treasury beginning in 1980 up to today.

In reviewing the report, you will note that interest rates topped out around 16%, and are now currently down approximately to 2.4%. However, if you draw a straight line, you will note that for the last 34 years, the trend in interest rates has always been lower. Therefore, unless you have a financial adviser that is as old as I am, they have never witnessed a negative bond market in their LIFETIME!

Even though interest rates in 2014 have been stubbornly low, this has been good for the financial markets, however bad for savers. Interest rates paid at banks are virtually zero, and if anything will continue to go lower – not higher. However, we know that the party is beginning to end. We know that interest rates will go up in 2015, we just do not know when. When interest rates start to move higher, there will be a large number of investors who are currently invested in bond funds, that will see a negative rate of return on an investment they were told was solid.

Maybe for the first time, a lot of financial advisers will see a negative bond market and really not know how to advise their clients. As we have for the last several years, we have avoided bonds since we anticipate the trend in bonds to be negative; no one knows the exact date or time, we think it is coming. In the meantime, since equities have been performing beautifully, there is no reason to take the risk that I believe bonds are today. This also goes for bond-like investments, such as real estate and some forms of utility stocks. Many of these financial instruments trade much like bonds, and will be adversely affected, as will bonds, when interest rates go up. Therefore, we have been trimming back our exposure in bonds and focusing more on investments in equities.

There is no question that the government’s manipulation of interest rates is helping the financial markets. Even through the U.S. Treasury at 2.4% is extraordinarily low, it is not as low as the 10-year German equivalent treasury. That current rate is 1%. Likewise, how could a country as economically unstable as Spain issue bonds with lower interest rates than the United States if it were not for government market manipulation? All of this is to say that governments can hold down interest rates for a while, but at some point market pressure will require higher rates. When those higher rates come, the principal of bonds will be endangered. Beware… you have been warned!

I saw an interesting article in Barron’s this weekend where they were analyzing market tops. The one that caught my interest was the market top of 2000, as compared to today in 2014. The most interesting aspect of this chart where, for the most part some are provisioned similar ratios existed, the huge differential was in the amount of the 10-Year Treasury. In 2000, the 10-Year Treasury was 6.2%; 4.7% in 2007; and 2.4% in 2014. Arguably, when interest rates are as high as they were in the prior years, an investor would have an incentive to move from equities into interest rate instruments. Today, moving from equities to the 10-Year Treasury would not be beneficial, since the 10-Year Treasury barely exceeds the rate of inflation today; much less over a ten year period.

Therefore, even though the markets rallied significantly during the month of August, I maintain my position that stocks will continue to trend higher as the year progresses. While it certainly may not be as dynamic as August, I do anticipate them to increase. It certainly would not surprise me to see a 3-4% additional gain between now and the end of 2014. Yes, there will be scary days and geopolitical events will shake our confidence, but do not read the front page of the New York Times to get your financial news. If you analyze interest rates, earnings, and the economy, you will know a lot more about the financial news than most people giving advice on TV.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Wednesday, August 6, 2014

Reversification - Good News is Bad News for Security Prices, Stocks, and Bonds...

Had the month ended on the 30th rather than the 31st, July would have actually been a very nice month for investments The month was moving along at a fairly nice clip until the last day of July, when virtually all the major market indexes were down at least 2% or greater. The violent selloff at the end of July resulted in all of the major market indexes in a loss position for the month, but certainly did not reverse all of the very nice gains the markets have realized for all of 2014. One day does not make a trend.

For the month of July, the Standard & Poor’s Index of 500 stocks lost 1.4%. This is a result of the 2% loss on the last day of the month essentially throwing the index into a loss position for the whole month. For the first seven months of 2014, the S&P 500 Index is up 5.7%, and the one year total return, ended July 31, 2014, on this index is 17%.

I read many scathing reports that the Dow Jones Industrial Average’s large losses wiped out all of the profits for the year, but clearly those newspapers did not take dividends into consideration. The Dow lost 1.4% during July, is up 1.2% through the end of July 2014 and 9.4% for the one year ended in July. The NASDAQ Composite lost less at only .8% for the month of July and is up 5.3% for all of 2014, and up 22% for the one year. And for those who thought that abandoning stocks and going into bonds would be safe in July, the Barclays Aggregate Bond Index was down 0.3% in July and is up 3.5% for the year 2014; for the one year period, it continues to be up 3.6%.

As one would expect, the more aggressive NASDAQ Composite is up the most for the one year period and the less aggressive bond index trails along with a 3.6% increase. Because the headlines attempted to make the sell-off a much bigger event than it really was, I thought I would try to help put the entire matter into perspective in this posting.

I rarely take more than a few days off at the time, but this last weekend I decided to make a trip to Florida to pick up our newest puppy. As many of you know, we have always maintained a fair number of dogs, so with this new addition we currently have three dogs and one cat. Since our oldest mother dog is gaining in the age category, we elected to buy Ava a new puppy so she would have the opportunity to grow up with one. And because we had to go to South Florida anyway, we decided to help the economy and drop in on Disney World. As you can see from the attached pictures, both the trip to Disney World and the purchase of the puppy were a big hit with Ava.

While I was gone, the markets elected to interpret very good news negatively. The word reversification is basically used to describe when good news is bad news for the markets. Despite sounding like an oxymoron, you have to interpret the way the market views these sorts of things. I will explain in greater detail momentarily, but the economic news was excellent for the month of July.

Despite positive economic news, geopolitical events were bordering on catastrophic. With essentially a Civil War in Syria, the start of a possible Civil War between Libya and Iraq, Russia’s attempts to overtake Ukraine, and the never-ending war between Hamas and the Palestinians against the Israelis, I, quite frankly, found the loss in July to be very much muted.

And of course they had to throw in a little scary economic news, which in reality was not very scary. Some totally insignificant bank in Portugal failed and the government had to bail it out. And in addition, Argentina, the perpetual defaulter, once again defaulted on their nationally issued bonds. If you ever need to illustrate that socialism does not work, just take a quick look at Venezuela and Argentina – or even Cuba for that matter. I find it quite interesting that we long for socialism in this country, yet every time it has ever been practiced it has failed. The failure of the bank in Portugal and the default by Argentina are relatively minor items that should not warrant any type of financial scare, but unfortunately traders viewed it as 2008 reincarnated, and decided to sell and get out of the way rather than actually think about it.

As I have indicated on many occasions, stock prices should be controlled by corporate earnings, interest rates, and the general economy. In all truthfulness, all three of those were quite excellent during the month of July. In fact, economic news was so good that the traders just assumed that the improving economy would clearly force the US Federal Reserve to increase interest rates sooner rather than later. I find it somewhat baffling that although the Federal Reserve has basically indicated that interest rates would not increase prior to mid-2015, traders begin to react to this at least one year in advance.

Some of the more basic economic news was very positive. During the month, the second-quarter GDP was announced at 4% and the first quarter GDP was revised higher from a -2.9% to a -2.1%. As I have previously posted, this rebound in GDP was well forecasted. The first quarter GDP was a very difficult weather-related quarter and certainly should not be deemed normal as the quarters progress.

I am sticking with my projection that the GDP for the third and fourth quarters will be in a 2.5% - 3.5% range. As the employment index indicated on Friday, the economy is improving. Everywhere we look the economy is firming up, so the massive sell-off that occurred at the end of July was certainly not warranted. The trend in employment continues to be very strong, with approximately 2.3 million new jobs created over the last year. Certainly, much improvement is necessary going forward, but solid progress has been demonstrated.

The most important consideration in stock prices is earnings and earnings growth. Currently, it appears the earnings growth for the second quarter to be an increase of 11.8% on a year-to-year basis. I am completely blown away by seeing the excellent corporate earnings that are being reported daily in the financial news. But even more impressive is the expected earnings growth coming up. It is fully expected that the third-quarter earnings growth may be as great as the projected growth of 13.5% and the fourth even better while projected at 15.1%. If the economy continues to remain in an uptrend, these higher earnings will almost unquestionably increase stock prices.

Sometimes you really just need to get a grip on reality! Stock prices do not just crash and burn when earnings are accelerating and interest rates are practically zero. Of course, there can always be a decline of 5 to 10% at almost any time for any reason, good or bad, but no long-term negative trend should develop in the face of increasing earnings. If there were alternatives for investing then maybe, but there are not so right now is an extremely favorable time for investing in stocks.

All of the additional financial information about the economy continues to be strong. Consumer spending rose in the second quarter at a solid 2.5% which was largely driven by large ticket items, principally cars and trucks. The consumer confidence index in July hit 90.9% - a stunning 12.2% increase over this same index last year. It is just hard to reconcile the confidence that consumers are showing against the negative outrage with traders on Wall Street. With such consumer confidence, you should see higher GDP in the quarters ahead.

Other economic indexes remain strong - we're seeing capacity utilization in the manufacturing industry almost at full capacity, many positive attributes from oil drilling, and for the first time in 40 years, the exporting of oil overseas. Very few people understand the potentially huge economic benefits of the United States actually exporting oil resources to foreign countries. If widespread exporting of oil was permitted by our government, it could change the economic landscape of many countries and shift the economic strength back to the United States.

With so much positive news economically and so much bad geopolitically, it is difficult to know what to believe. Here we are today, a little over halfway through the year, and the S&P 500 continues to be up nicely at 5.4% for the year. We certainly expected the market to be choppy during 2014, so it would be more shocking if we did not see any loss months during the year. However, with earnings accelerating, the economy strengthening as noted herein, and interest rates likely to be near zero for at least another one to two years, there is no reason why stocks should not continue to be the best place to invest for months, if not years, to come.

I am often questioned, on a day like July 31st, with the major market indexes down 2% and even bonds being crushed that day, where these potential traders invested their money after selling that day. It is highly unlikely that any long-term investor traded anything on this given day, while traders like to move the market so that they can take advantage of weak spots. I can almost guarantee you that none of these traders will be in cash for very long.

If you look at the major market indexes from that Thursday, you will note that everything was down: stocks, bonds, convertibles, and essentially every other type of security. When you see a market sell-off with such magnitude, you can rest assured that it was a traders' day and not representative of the economic data. As illustrated above, economic data continues to be strong and earnings are excellent. As we go forward, you will see those traders reinvest and push markets higher; it is not a matter of if, but a matter of when.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Thursday, July 10, 2014

Lions, and Tigers, and Bears. Oh my!!

When you have a three year old, sometimes you find yourself doing things you have not done in a really long time. For me, it was watching the Wizard of Oz in high definition with Ava the other night. It was a real eye-opener to say the least. Having been 20 years since I last watched it, I guess you could say I was truly shocked to see how poor the quality of the filmmaking was as compared to today. You could actually see the painting strokes on the scenes along with the superficial stunts performed by the actors. If you compare it to today’s movies generated with high resolution computers, it is almost embarrassing.

I only point this out to illustrate the difference between the way things used to be built in America and the way they are built today. In the time period which the Wizard of Oz was filmed, I am sure it literally took hundreds of people to make and paint the scenes. The vast majority of the movie was made on a soundstage, and it clearly looked as such. With today’s computer graphics, one person rather than hundreds could do a better job. So much for manual labor...

Back in Detroit’s heyday, Henry Ford would mass-produce automobiles with literally hundreds of men on the floor assembling a single part. Although the cars were manufactured quicker than ever, the quality suffered. The standards of automobiles in America were deemed inferior to internationally produced cars.

Today’s cars are no longer being produced with masses of employees, but rather with robots. Cars are better and cheaper today than ever before. It no longer takes hundreds of people to produce a car, but rather a few people and hundreds of good robots working side by side.

Although hundreds of people unfortunately lost their jobs in the automobile industry, many jobs were actually created for the very high skilled engineers who could produce robots far superior in building cars than humans. Like many aspects of the economy, machines are replacing people and brains are replacing hard labor - even the Scarecrow saw that coming... And as the economy progresses, so does the market.

Last month I wrote about the old Wall Street saying, “Sell in May and Go Away.” I was relatively confident that the markets would rebound in June, and they did. For the month of June, the Standard & Poor’s Index of 500 stocks was up 2.1% for the month and is up a very satisfying 7.1% for the year 2014. The Dow Jones Industrial Average was only up 0.8% for the month of June, but was up 2.7% for the year 2014. The NASDAQ Composite was up 4% in the month of June and 6.2% for the year-to-date. The Russell 2000 Index rebounded and was up a sterling 5.2% in June and 3.1% for the year.

As could be expected, the Barclays Aggregate Bond Fund was absolutely flat for the month of June, but is still up 3.9% for the year 2014. Since virtually all assets advanced in June, it was still a very good month to be invested. Some people are put off by the volatility of the market, but when you are long-term investors, you look at long periods rather than weeks, days, or months.

Much can be illustrated by the one-year total return of the major market indexes. The S&P 500 Index is up 24.6% for the one year period ended June 30, 2014, and the NASDAQ composite is up 31.1%, the Dow Jones Industrial Average up 15.6%, and the Russell 2000 Index is up 23.5%. Regardless of which of those you selected, each would have a very satisfactory return for the one-year period ended June 30. It continues to baffle me why people remain in cash.

In my January 2014 blog, "I Was Wrong, But In A Good Way", I forecasted that, based upon my analysis of earnings and other variables affecting stock prices, the S&P 500 Index would be up between 13% and 14%. Given that this index was up 7.1% for the first six months of 2014, I find this forecast to be right on target thus far. I could go on and on discussing the many aspects of this market, but will do my best to keep it to a minimum.

It was recently announced that the first quarter GDP lost a surprising 3%. I predicted that the net GDP would be hurt due to the severe weather in the United States, and I was right. The good news is that this index looks to the past and really has nothing to do with the future. There was a lot of built-up demand that we are now seeing which will improve the GDP for the second quarter of 2014.

Despite poor sales in Q1 due to the inclement weather nationwide, retail sales have rebounded in the second quarter, and automobile sales continue to be very strong. The manufacturing index is now close to 80%, which in many circles is deemed to be full capacity for manufacturing. Exports have picked up and are rising at a percentage point higher than imports for the year. Employment continues to be on the upswing, and unemployment ratios continue to decline. Oil production in the U.S. has exploded; notwithstanding a president I feel fights progress at every turn.

There is much commentary in the financial news regarding the fact that the participation rate of employment is virtually the same today as it was one year ago. This means there are the same number of people looking for jobs today than there were exactly one year ago. I can only assume that millions of people have quit looking. However, there are 2 million more people working today than in 2013. Many of these jobs are undoubtedly part-time and less than desirable, but they are still providing a source of employment for individuals who are in need of a job. In order for the economy to rally, working individuals earning salaries and buying consumer goods are needed to drive the GDP higher.

It would not surprise me at all to see the GDP for the quarter ended June 30 to rebound to a + 2% ratio. Furthermore, I see the GDP in the third and fourth quarter of 2014 accelerating too close to 3%, making the GDP for the year quite satisfactory. The annual GDP is the average of all the four quarters, so coming off a negative quarter makes an exceptional annual GDP unlikely. However, earnings of major corporations are greatly improved when the GDP is better.

As I have often mentioned in these blogs, the most important item that affects the level of stocks is earnings. I expect earnings for the second quarter to be higher than the first quarter by a 6% to 8% ratio. And it would not surprise me if earnings even went up double digits in the third and fourth quarters.

Coupled with interest rates that are incredibly low and an economy that is clearly improving, these higher earnings will lead to higher stock prices as the year goes on. Hardly a day goes by where I am not questioned on how I feel about the market setting a new high almost daily. The fact that we have had 32 new highs for 2014 must be put into perspective, as the S&P 500 Index is only up 7.1%. When you realize that many of these highs are only incremental gains of a few points, you realize that these new highs are merely an academic term, and not a forecast of the future.

I believe the stock market will continue to move higher – not straight up, but rather a choppy incremental struggle to gain ground. There are many people that are forecasting a negative market. You have to have both people buying and selling in order to create an equitable market, and we as investors do not fear that participation as this is what makes the markets work.

As the economy continues to get better, it is almost inevitable that interest rates will be going up in 2015. While the interest rates on bonds have actually decreased in the first six months of the year, I don’t believe there is anyone who thinks they will continue to trend down in a higher economy. At some point the bond market will follow this upward trend making lower bond values inevitable.

We have an unusual occurrence right now with the ten-year treasury in Germany yielding 1%. A similar ten-year treasury in the United States is yielding 2.5%. It is not unexpected, nor should it be a surprise to anyone, that people who are invested in Germany are converting their Euros to United States Dollars and buying up available ten-year instruments that double their return. Essentially we have a shortage of bonds and an abundance of money chasing them.

Europe is finally doing the right thing and stimulating their economy by reducing their interest rates - improving their overall economy. Corporate profits in Europe are already starting to improve, and emerging-market stocks are finally showing life. While we have been primarily invested in United States for the last five years, I can see us diversifying into the overseas markets which, by historical standards, are cheap. This will most likely consist of countries where the stimulus of their economy will improve corporate profits, therefore creating higher stock prices.

So in response to all of the critics - no, I am not discouraged at all. I do not expect to move out of equities until we see the following - earnings declining, the economy drifting lower, or interest rates going higher. It is not necessary for all three to occur for us to shift our investment philosophy, as something such as decreased earnings alone may prompt this. However, I currently see all three major market drivers moving higher, which to me dictates the need for a fully invested portfolio of equities and strong international companies in order to produce a safe and secure financial retirement.

Summer is the perfect time of year for you to come in and meet with us to review your portfolio and discuss your financial goals for the future. And for those clients reading this post who have huge sums of uninvested cash, earning essentially zero, now is the time to put that money to work.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Friday, June 6, 2014

Sell in May and Go Away...Wrong

I would like to discuss why it would be a bad idea for you to sell now and go away for the rest of summer. The talk on Wall Street for many years is that most of the money is made in the period between October and the following May; the thought is that by avoiding the volatility and losses of the summer, you will actually end up much better than remaining invested June through September. I believe this year we might have an argument to stay fully invested for the summer, which I hope to explain later in this post.

If you followed the maxim of "sell in May and go away", you would have missed out on what ended up being quite a good month. For May, the Standard & Poor's 500 was up 2.3%, and up a total of 5.0% for the first five months of the year. While certainly not the fiery results of 2013, still quite good. The Dow Jones Industrial Average was up 1.1% for the month of May and sits nicely for the year, up 1.8% The NASDAQ Composite had an excellent month, up 3.2%, but has suffered more losses than the other major indices putting it at 2.0% for the year.

The Russell 2000 (small cap) index continues to struggle. While up 0.8% for the month of May, it is still down 2.0% for 2014. The Barclay's Aggregate Bond Index was up 1.1% for the month of May and sits even higher at 3.8% for all of 2014. All in all, May was a great month with all major indices and even bonds posting higher returns.

May was a very good month for the Rollins household as well - there was the always exciting end of the school year/beginning of summer, and both of my children celebrated their birthdays. Joshua turned 19 this May and his little sister Ava turned 3. Despite writing some of the most interesting and provocative posts known in the financial world, virtually the only blogs anyone ever comments on are the ones that include pictures of my children. In fact, I am often criticized because there is not a picture of them in every blog I write. So I thought I would briefly divert your attention from the financial news with these pictures (Josh & Ava attending a recent Braves game, another ball to add to Ava's collection, and me & Ava celebrating her BIG 3).

And now back to it...We continue to see high volatility in the underlying small-cap stocks, and to a lesser degree, the NASDAQ Composite stocks. Since the middle of March, these indexes have been punished pretty much on a daily basis. As I mentioned in my last posting, I do not believe for a second that there is anything underlying fundamentally negative about small cap or over-the-counter stocks. I think this all relates to a normal rotation with professional trades switching from one segment of the market to another.

Seemingly during this time frame, small cap stocks have suffered since there has been a rotation out of the smaller technology stocks and more importantly the biotechnology stocks into either bonds or large cap stocks. Given the potential for profits in these small cap stocks, I am a long way from wanting to give up our positions. I think we will ride them out for a few more months and see exactly what happens.

It is also interesting to note the economic news during the month. The original forecast of the GDP for the first quarter of 2014 came in at a 0.1% gain - that is about as close to breaking even as you can actually get. However, just last week they announced a slight revision of their GDP calculation to recast the first quarter GDP to -1.0% growth. It was astonishing to see the articles written by traditional newspapers regarding this negative GDP growth for the quarter. There were even publications that were thoroughly examining the definition of a recession and back-to-back negative GDP growth.

I wish people would exercise some common sense when it comes to basic economic reasoning. There is virtually no one skilled in the science of economics that believes the country is in a recession. In fact, most economists are calling for the GDP growth of close to 3.0% for all of 2014. I certainly see GDP growth in the quarter we are currently in at 2.5% at trending higher. For anyone to assert the U.S. economy is falling into recession clearly is not viewing the economic conditions correctly.

Actually, I would be somewhat shocked if the GDP for the second quarter of 2014 was not in the 2.5% range. It is inconceivable to me that with car sales up drastically, home construction on the upswing, and manufacturing operating at near full capacity, that we could not reach that 2.5% level. Additionally, consumer confidence and consumer spending continues trending higher, which could be a sign of an even higher GDP for the rest of the year. As any student of basic economics knows, if economic activity grows, clearly profits will rise, leading to higher financial markets.

As for the value of the market pricing today, it is fairly clear to me that with little moving in the market for 2014, the market is essentially priced the same as it was at the end of 2013, except now the earnings are higher. As I mentioned in my previous post, the three components - higher earnings, better economic activity and low interest rates - are all intact. Therefore, no change is warranted to our basic investment philosophy at this time.

When it comes to interest rates, if you have not refinanced your mortgage, you are missing out on a fabulous opportunity. Interest rates are currently at some of the lowest levels of all time. This may be the last time you can refinance at such low rates. Just in the last week, I have seen the ten-year treasury move from 2.4% to 2.6%. I think it is finally starting to loosen up and the bond market is realizing that economic activity is on the uptrend. While certainly higher interest rates do not look good for the bond market, they clearly support a higher stock market.

As we move forward into the summer, it would not surprise me to see the market move higher. Given the extreme volatility we have noticed in 2014, it would not even surprise me to see the market jump up 5% or 6% in one month alone. While withstanding all the negative publicity we are reading, I personally still think the trend in the markets bode well for a low double digit return for 2014.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Wednesday, May 14, 2014

A $17 Billion Solution!

The month of April was a mixed performance for the major market industries. While the S&P 500 actually ended up 0.7% (less than 1%), the NASDAQ Composite lost two full percentage points (-2%). The Dow Jones Industrial Average was up 0.9%, but the Russell 2000 Index lost a healthy 3.8% during the month of April. For the year, the S&P was up 2.6% at the end of April, the NASDAQ Composite was down 1.2%, the Dow Jones Industrial Average was up a marginal 0.7%, but the Russell 2000 for the year was down 2.8%. Surprisingly, the Aggregate Bond Index was up .9% during the month of April, and year-to-date gains are 2.8% for this broad index.

While certainly nothing spectacular happened during the month of April, underneath the broader index there was a major sell-off in small and mid-cap stocks, which I would like to discuss since many of our clients hold these mutual funds. It is certainly surprising that the Bond Index continues to rally in the face of what I suspect will be an increase in interest rates as the year progresses. Within the broad spectrum of investments, I fear bonds the most. We know at some point the Federal Reserve will further reduce their buying of bonds in the open market and begin to increase interest rates. When this happens, it is likely just a matter of when, and not if, many bond funds will lose money.

Often times, things occur in financial markets that there is no explanation for and you just have to accept it as the reality of a willing participant. However, this sell-off of small and mid-cap stocks of nearly 15% in the last 30 or 40 days has been pronounced and has made me really wonder whether there was something deeper going on in the markets that I had not noticed.

While the broader large-cap stocks have been relatively stable, the small-cap and medium-cap stocks have been unfairly punished. The S&P 500 is up 2.3% for the year 2014 through May 9, 2014. While certainly not a sterling gain, it is still acceptable considering the huge 32% gain we enjoyed during 2013.

Some small-cap funds have sold off in excess of 15% in this relatively short period of time and I wanted to do some research to see if I could make sense of this bloodbath that occurred. Both small-cap and mid-cap (mid-cap to a lesser degree) stocks provide a truer reflection of the U.S. economy, compared to the larger companies contained within the S&P 500. These huge large-cap stocks have operations around the world and function in many companies, many currencies, and deal with the economies of the world, and to a lesser degree the U.S. economy.

In contrast, the small and mid-cap stocks are generally U.S. based companies that reflect only the U.S. economy. Virtually every economist is forecasting the U.S. economy to improve throughout the rest of the year. Even though the first quarter of 2014 has recorded a GDP growth of virtually zero, most economists are blaming that on severe weather. Even the Federal Reserve is projecting the U.S. economy to have close to a 3% GDP growth in 2014. While I am not as optimistic as that, I still think 2.5%-2.8% is a realistic calculation of GDP for 2014.

If the first quarter GDP growth was virtually zero, then by definition the economy would have to accelerate quite rapidly in the following three quarters to reach a 2.5% GDP for all of 2014. In my opinion, that is exactly what will happen. After seeing the severe damage that the harsh winter did to businesses, it is not unrealistic to assume a significant improvement in the economy is imminent.

If that is the case, why have mid and small-cap stocks been so unfairly punished? Ever since the GDP was announced for the first quarter, there has been a substantial decline in these stocks based upon the assumption that GDP growth would still be timid or negative. Knowing that there is no substantial support for that opinion, I was perplexed that this sell-off occurred so quickly and dynamically in a relatively short period of time.

Every week I study the financial statistics in Barron’s. I look at both the performance of various financial instruments as well as the momentum of individual sectors and try to determine what is affecting them. This sell-off is even more mind-boggling when you see that economic statistics continue to remain strong. The 2014 first quarter earnings were up and once again set an all-time record for corporate earnings, leaving no justification for the sell-off based on earnings and the economy as a whole. When you have all three positive attributes as we have today - very low interest rates, earnings that are accelerating as well as an economy that appears to be on the uptrend and increasing- stock prices should be higher not lower. Therefore, I found it more surprising than ever to see this large sell-off in the small and mid-cap stocks.

When I searched Barron’s looking for a solution to the conundrum of positive attributes with lower stocks, I came across a very interesting financial fact. As of April 30, 2014, there was a short interest in the Russell 2000 ETF of almost 156 million shares. To most people this would seem like a meaningless number, but when you multiply out the value of that ETF, you find out this is over $17 billion. And even more surprising, that entire ETF only has $27 billion in assets. Therefore, currently 63% of this very important ETF has already been shorted. A technical explanation of shorts is very important to understanding this analysis.

When you short a stock, essentially you sell a stock you do not even own. The financial markets allow this treatment since it tends to keep the market regulated and gives a ready seller the opportunity to sell with a ready buyer. The major difference in buying a stock long and shorting the same stock is the amount of risk taken. Risk, for the average investor, would never allow one to short stocks as the risk involved is unlimited.

If you buy a stock for $10, the most you could lose is $10. However, if you short a stock for $10, your loss could be exponential. The stock could increase to $20, $30, $40, etc. Therefore, shorting a stock is the riskiest form of investment and is usually isolated among very sophisticated investors or hedge funds that specialize in this aggressive yet risky form of investing.

If you really want to know why the small-cap stocks took such a major downturn, this would be my explanation. Hedge funds as an industry have struggled over the last few years to compete with the large gains realized by the broader passively invested indexes. If you are charging the outrageous fees that hedge funds charge, then by definition you have to take risky bets to increase your returns. It seems that as an industry many have decided to short the small-cap stocks all at the same time. When you have a 63% short ratio on only one ETF that specializes in the Russell 2000, you can see the enormous downward pressure they create on this individual index. Even during the month of April, these shorts increased by an excess of $2 billion.

While this may explain why the stocks underperformed when the financial conditions did not warrant such an under-performance, there is actually a bright future for the index. People who short stocks eventually have to cover those shorts. When they do so, they have to purchase the index in order to cover a short. Therefore, at some point you will see a mad rush for the shorts to get out of their positions by purchasing the same index that they previously sold.

This built up demand could cause the index to move up very quickly when you many not see any reason for a quick move to the upside. When shorts all rush out the door at the same time, it becomes a game of chicken. Which fund will elect to be short if everyone else is covered and the index is moving up quickly? I think the bottom is near and the index should move higher from here.

With all this said, it appears that nothing in the economy or the valuations of business has led to this swift sell-off. From the research, it looks to me that traders alone are pushing the index down for their own special benefit. Since this move is short-term and we are long-term investors, I do not anticipate any changes in our allocation to these indexes over the near term. While we will certainly watch them closely and look for any inconsistencies in performance given the change in economy, I cannot see any change that warrants us moving or changing our long-term investment horizon at the current time.

While the market has certainly been volatile, none of this could be unexpected given the huge gains that we enjoyed in 2013. Even the small-cap index is up over 130% over the last five years and moved over 30% higher in 2013. While you would certainly expect there to be a sell-off as investors reallocate resources to other sectors, I currently am not convinced this move is warranted.

There may also be a hidden explanation as to why the bonds are rallying. Even with the almost assurance that the interest rates will increase as the year progresses, I cannot help but think that the shorts, which sold stock they did not own, may have parked that money in bonds as a safe haven until they cover these positions. If that is the case, the move up in bonds and the move down in small and mid-cap stocks is a false alarm and as an investor, you should always fear such swift movements that are not supported by economic reality.

As the economy strengthens throughout the year, I would expect the small-cap and mid-cap U.S. stocks to perform at even a higher level than the large-cap international stocks. Since we hesitate to make short-term moves, I suggest we wait this one out and see what happens in the next month or so.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Wednesday, April 23, 2014

Volatility Rules the Day – Don’t Lose Sight of the Big Picture

My apologies for falling behind in keeping you updated on the current status of the financial markets – such is the course of business during tax season. First, I would like to comment on the quarter ended March 31, 2014, and then bring you up to date on the current volatility that we are seeing in the financial markets during the month of April.

For the first quarter ended March 31, 2014, the S&P 500 was up a very satisfying 1.8 %. However, the Dow Jones Industrial Average was down 0.1% and the NASDAQ Composite was up 0.8%. Interestingly, the small cap Russell 2000 stock was up 1.1% for the quarter and the Barclays Aggregate Bond Index was up equal to the S&P with a 1.8 % gain. While certainly not a sterling quarter, it was still very satisfying as some type of normal correction was expected coming off the huge gains we enjoyed in 2013.

Even with the lackluster first quarter, the major financial indexes continue to post very robust numbers. For the one year ended March 31, 2014, the S&P 500 was up 21.9%, the NASDAQ Composite 30.1%, and the Dow Jones Industrial Average 15.7%. One misconception regarding the Barclays Aggregate Bond Index, although it had a profitable first quarter in 2014 (as mentioned above), it actually had a negative return of .5% for the one year period ended March 31, 2014.

During 2013, the S&P Index was up greater than 32%, which was an outstanding year by anyone’s definition. The fact that the first quarter return was somewhat lower should be neither surprising nor unexpected. When you have a large run up in the markets, you are eventually going to get some sort of correction in order for the other financial assets to catch up. The normal rotation out of one sector into another creates quarters where some of the returns cannot really be explained.

Who would have ever guessed that the bond index would have been up in the first quarter of 2014 when virtually every economist in the world expects interest rates to go up during 2014? My suspicion really is that bonds have been a safe haven from volatility - short-term traders go into bonds as they rotate out of one sector into another.

While there is hardly any economic justification to bonds decreasing in yield during the quarter, it is exactly what they did. The 10-year treasury bonds began the year at roughly 2.9% but ended the quarter at roughly 2.7%. As you know when bond yields go down, bond values go up - so for the quarter, not only did you earn the return of the interest rate on the bond, you also got some appreciation in the underlying principal of the bond.

As we began the second quarter in April, the market was hit with a great deal of volatility. There was great outcry in the financial media that surely the next correction was underway. Hard hit particularly were small cap stocks that tend to go up the most during good times, but correspondingly go down the most during bad times. In particular, we saw a large sell-off in the NASDAQ Composite during the first several weeks of April, along with virtually any of the stocks invested in biotechnology or the science of biotechnology.

The financial gurus that forecast the market were arguing that surely the economy must be slowing and falling into another recession. However, as I write this document on April 22, 2014, the S&P Index is up 1.84% for the year and therefore is actually up from the end of March through the first three weeks of April. As I have mentioned in many previous postings, a correction of 10% in the market at any time would or could be expected. The fact that the market has corrected less than 10% certainly qualifies as a normal correction within an upward trending bull market.

I try very hard to evaluate the upward flow of information in the financial markets based upon hard statistics, not the general consensus expressed over the airways by the financial media. I actually like to look at the indexes to see if the trend is up or down, and whether any correlation can be drawn from these economic statistics and how they will affect the stock market going forward. No one can properly evaluate how the public will respond at any time, but I think a much better indicator of future market performance is whether the economic statistics support the market or whether it is a negative trend.

I have reviewed the economic statistics as of the end of March and find them almost universally higher year over year. Global manufacturing is up close to 5% and capacity utilization is approaching 79.2% with this most current reading. As many of you know, full capacity utilization is considered to be 80%, and therefore we are nearly bordering on full capacity in the manufacturing sector. Other industries that are higher year over year are manufacturing, non-durable manufacturing, personal income, personal savings, non-residential investment, and residential investment. In fact, every economic index in investment statistics reported in Barron’s for this week of March shows a positive return year over year.

Further, if you look at every important consumption indexes, you see that they are also higher. Auto sales are up, consumer spending is up, factory shipments are up, personal consumption is up, retail store sales are up, and wholesale sales likewise are up. None of the indexes that I have mentioned above show a negative year over year trend.

It is important to note that inflation continues to be very mild at a current rate of 1.5% annualized and even employment is trending up as well, although only marginally so. Construction contracts are up double digits, residential spending is up double digits, and the home price index correspondingly is also up double digits. Consumer confidence is up an impressive 33% year over year and the index of leading indicators is positive.

One of the three components of higher stock prices is the general overall trend in the economy. What we know from the indexes above, the economy continues to expand; while certainly lackluster, the trend is definitely up instead of down. The other two components of higher stock prices are earnings and interest rates. While I could certainly write many pages on the trend in interest rates, what we know for sure is that interest rates are low and, if anything, trending down (defying logic). As mentioned above, the 10-year treasury fell during the month which is a positive indicator for home purchases and refinances. Currently, CDs are paying practically zero and money markets are paying zero or less. If you combine the 1.5% inflation noted above with the current rate of return of money market accounts, anyone holding cash is suffering an economic loss because their investment is not keeping up with the rate of inflation.

The big unknown, of course, is corporate earnings. What we know about earnings, as of today, continues to be very positive. Earnings on the S&P 500 for the fourth quarter of 2013 were 22% higher than in 2012. Earnings are expected to grow 7.6% for the first quarter of 2014, and anticipated earnings for the remainder of the year are somewhere in the neighborhood of 12-14% growth. Even with the harsh winter the United States suffered and the drag it had on earnings, it appears that the first quarter of 2014 will set once again a record for total absolute earnings in the history of the financial markets.

The only remaining argument for lower prices would be current valuations. Currently, based on trailing earnings, the S&P 500 has a P/E Ratio of 17.45 times earnings. The estimated 2014 P/E ratio is 16, 14 for 2015, and 13 in 2016. As you can tell, earnings are expected to accelerate and bring valuations to lower levels. All of this is put into perspective when you consider that the 25 year average on the P/E ratio for the S&P 500 is 18.7 times earnings. Remember that this is an average - many times it trades much higher than that and often times much lower. By the definition of fair valuation, it appears valuation and therefore value is a long way from being extended.

I try to evaluate financial markets based upon hard economic data, not the whims of market forecasters or financial media. Based on all of the information that I have presented above, I personally see nothing that would indicate a sharp market sellout or anything that would affect the trend of positive earnings for the remainder of 2014. While I always say you can expect a market correction of 10% at most any time, there does not need to be any financial reason for that correction.

The most important considerations for stock valuation are earnings, interest rates, and current economic circumstances. At the current time, since all three are positive, I feel comfortable in forecasting that the stock market will be higher at the end of the year than it is today.

This does not mean that there will not be higher volatility and much debate regarding the proper value of stocks; however, when all three trends are positive, common sense will likely prevail and stocks will likely drift higher as the year progresses. Those of you that try to time the market, be aware that the market can correct 10% either up or down in a relatively short period of time. However, if you are not invested the possibility of you trending upward is essentially zero.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins