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