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