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