Is Good News Actually The Bad News

Published at Oct 13, 2013, 12:00 AM in wealth management by Buğra Bakan

“It’s quite exciting” said Sherlock Holmes with a yawn. – Sir Arthur Conan Doyle, A Study in Scarlet

As I was looking for a quote to start October’s market letter, I have stopped yawning when I saw this one liner from my favorite fictitious character, Sherlock Holmes. It captures the current market mood perfectly as I have never seen a market rally that is much hated, and much ignored.

Let’s look at the S&P 500 Index growth as of Oct 31, 2013:

Since March 9, 2009 bottom: 159.64%

Year to Date: 23.16%

Since 2012 Year High: 23.78%…and 12.74% above last all-time high.

Has there been a severe correction since March 2009? Nope, the deepest correction since then came in the summer of 2011 with a 17% loss. We have seen no 20% or more correction in the last 4.5 years.

Then have the markets been very volatile? The VIX index (one measure of volatility) sky rocketed to 60 in 2008, than spiked once more to 40s in the summer of 2011, which was during the above mentioned correction. Other than that, it has been hovering within the trading range of 10-20.

So you are saying we have seen a 159% percent gain in the last 4.5 years, without a correction of 20% or more, while one measure of volatility, the VIX index was within the 10-20 range for the most part? Yes.

Then why is everybody yawning and not excited?

My guess is that most investors are still heart-broken from the 2008-2009 trauma, and most of them rightfully so. If you haven’t kept faith and stayed invested (in risk managed portfolios), your investments still haven’t recovered from that period’s waterfall decline. I never get tired of throwing this fun little fact out there: when you lose 50% in year one, you have to make a 100% gain in year two to break even.

This is why Warren Buffet says “There are two rules to investing: 1 – Don’t lose money. 2 – Don’t forget Rule #1.”

If you generate 10% growth every year for 8 years and then lose 5% percent for 2, (assume a simple return with no compounding), then your average return for the 10 year period is 7%. So what I am trying to get at is, that even after 4.5 years, you may still be feeling the heat.

One other reason that may explain why many professionals haven’t been active in this rally, and why most mutual funds and hedge funds have been underperforming broad indexes is this: This uptrend entirely driven by the FED.

For many investors, this liquidity-driven rally of the FED has been creating a bubble and it is about to burst any day. It is not real, because it is not supported by economic fundamentals and so it can’t be trusted. According to them, the FED has been devaluing the dollar, which will create inflation; it will expose us to an alien attack, and therefore hard assets are the way to go (gold, commodities, real estate).

I have been writing against this trend ever since I have started publishing market letters in 2010, and so far I have been sleeping quite well. The defenders of the above faith has first turned blue waiting for this apocalypse, then black…that’s when I stopped watching. I can’t stand blood, except when it’s on Dexter.

The only real asset that has been a good investment lately has been residential real estate and apartment buildings. If you bought a house in the last couple of years, you have done well, and REITs had been going up until recently. A few months ago REITS topped and now it’s the residential real estate market that is blowing smoke from the exhaust pipe. There are two big market forces you can’t fight against; one is the market itself, which doesn’t care if you are right or wrong, and the second one is the FED, whose mandate is low inflation and full employment. In case you missed it, “YOU” are not on that list, and thus no one cares if you win or lose. As my grandfather used to say: “The bus won’t wait for you, so you have to go early and wait for it. After all, it’s bigger than you.”

Another saying is: “The mountain doesn’t come to you, you come to the mountain.” So if the FED and the market are the mountains, it is better to watch when and where they are going, not so much what you hoped to see. As famously said: hope is not a strategy.

While stocks have been rallying in spite of not getting much love, bond values have been dropping since late last year. In the short term, they may see a bounce back and possibly be oversold but the longer term trend is stocks’ likely outperformance of bonds to continue.

For some investment strategies, this rally has been a complete lost opportunity. If you allocate funds based on economic numbers, you have been sitting on the side lines or have been in bonds while waiting for the economy to turn around. Unfortunately for six years in a row, the growth rate of the US economy has been below the 1947-2013 average of 3.23% a year. Here is what real annual US GDP growth looks like:

2008 2009 2010 2011 2012 2013 Q1 2013 Q2 2013 Q3 -0.4 -3.1 2.4 1.8 2.2 1.1 2.5 2.8

The interesting thing, and most likely most frustrating for these folks waiting for the economy to turn, is that each time we got good news about the economy; it has caused a drop in the broad US stock market indexes. Case in point, as I am putting this letter together (11.7.13), the S&P 500 Index is down 1.32% precisely because unemployment and growth numbers came strong, which means the FED’s QE might be coming to an end. That has been the real threat to the Market. Quantitative Easing has been fuelling the markets and like any other sugar candy, it has to stop at some point. We need to get back on the veggie, fruits, nuts and fish diet (red meat ok here and there).

Good news becomes bad news for the markets, as it indicates possibly tapering; an end to the FED’s bond buying program.

So here comes the big question: Is good news really the bad news? If we won’t invest when the economic news is good, then when should we?

For those nervous types, who watch the market every day, yes it is bad news because of the reasons mentioned above: FED taking away the punch bowl is a sign that the party is over. But IF this will result in the economy improving, after the initial sugar low, which may last a quarter or two, we may start seeing the Earnings (E) portion of the P/E ratio expand. This would make the Price (P) portion look relatively smaller and cheaper, and attract more buying. At the end, the only for sure right answer to the question, why do stocks go up, is: because there are more eager buyers than sellers.

This, moving from the sugar to veggies, won’t be fun. It never is. But it is, a necessary correction and for long term investors, the ideal case scenario. Because if the economy doesn’t improve and Earnings don’t expand, I don’t know how much more the stock market can sustain this uptrend solely relying on the FED.

Currently, margin debt levels are high (borrowing and investing – bearish), mutual funds are invested (low cash – bearish), investors are optimistic (bearish) and early next year we will wake up to yet another debt ceiling and government shut down dog and pony show. All this may point out to a rally to the year-end…AND cut!

September and October are seasonally softer months of the year and broad stock indexes were up this year same period. This happened only 13 times before and 11 of those 13 cases; the following November and December were both positive months as well. So seasonality favors the stock market, but it never hurts to start keeping your investments a bit closer in the next couple of months.

One last thought before I send it to my good friend and Editor in Chief Greg Bronshvag. Are we due an economic recession?

Short answer is yes, we are always due a recession. You can’t grow to perpetuity, at least not in an economy governed and driven by earthlings.

But the 5 year growth, 2 quarter recession model (there is no such model but it is true that on average, every 5 to 7 years, the US economy dips into a recession) has happened over and over again in the past with one characteristic we have missed this time: a jump and above average economic growth right after recession. Yes we are in the 4th year of economic growth but they have all been sub-par years, heavily relied on the FED punch bowl (running out of analogies here) and yes it does make many people yawn. So I predict, the recession won’t come as scheduled and we will have a year with economic growth in 2014. Hope this was an enjoyable and informative read. Always, please feel free to reach out for questions and comments. Before now and my next market letter, you will be enjoying your family time around the Thanksgiving table. I wish you a great Thanksgiving and safe travels.

Next on Shield Wealth Newsletter

Hope you have enjoyed reading my Newsletter. Next month we will discuss investment opportunities outside of the US.

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