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