INDEBTED SERVITUDE?

The stock market surged to new all-time highs in the first quarter but the rally was largely confined to the month of February. The Dow Jones Industrial Average posted a price gain of 4.6% for the period, but, as of January 19, the venerable index was down for the year in very choppy trading that continued into early February. A short-term low, however, on Ground Hog Day was followed by a sprint to the aforementioned record highs on March 1 as the market registered gains in fifteen out of eighteen trading sessions.

In fact, there were twelve consecutive up days from February 9th to February 27th – one of the longest such streaks on record. Alas, the high on March 1 was followed by a correction that included a streak of eight consecutive down days, likewise one of the longest such streaks on record. The market giveth and the market taketh away….

Despite another increase in the federal funds rate on March 15, yields on ten-year Treasury notes actually fell about five basis points during the quarter. We have long opined that the sport known as “Fed Watching” is largely a waste of time. Why spend hours parsing the speeches of members of the Fed’s Open Market Committee or the minutes of that august body’s meetings when the market itself tips the Fed’s hand long before the actual announcement? Mister Market – a sobriquet coined many years ago by Jim Grant – sees all and knows all. Speaking of which, the decline in ten-year yields is a sign that Mister Market may be anticipating that the Fed is getting a bit ahead of itself. More on that subject anon.

Meanwhile, commodity prices parted company with stocks by tumbling 3.4% during the period as measured by the Commodity Research Bureau’s composite index. The rout in that sector was largely led by crude oil, which pulled back after a sharp rally last year that resulted from an OPEC agreement on production cuts. We shall be keeping an eye on commodity prices in the weeks ahead as they have a history of being a leading indicator for risk asset prices as well as the economy in general.

On the economic front, GDP turned in yet another lackluster performance during last year’s fourth quarter as the annualized growth rate came in at 2.0%. With initial claims for state unemployment insurance benefits recently at the lowest levels in decades, one would hope that first quarter growth will be reported to have been at higher levels. The manufacturing sector, however, has not been helping out very much as industrial production (a statistic compiled by the Fed’s staff) was reported to have been down slightly in January and unchanged in February. Housing activity, moreover, has been relatively good, but, here too, this sector is not really helping to fire gains in overall final demand. Finally, personal income growth in January and February was reported to have grown at a healthy annual rate near 5%; yet personal spending grew only 0.2% and 0.1% in those months, respectively.

We sense that there is a thread that links this disappointing data and that thread is the four-letter word, “debt.” It has been our opinion for years now that lackluster global growth and the deflationary pressures attendant thereto can be largely attributed to the enormous amount of debt that has accumulated at virtually every level of society from student loans to the obligations of sovereign states.

The fact that strong growth in personal income has not been accompanied by a strong increase in personal spending could be an indication that consumers need the funds for purposes other than consumption. We contend that debt service requirements are siphoning away a significant part of income gains in the current environment. This also helps explain why a stronger jobs market has not led to strong housing demand. Many prospective home buyers are simply not in a position to take on additional debt service.

Over the years these pages have described the machinations of the ”virtuous cycle” of economic activity that typically begins near the bottom of a recession when the Fed aspires to stimulate growth by loosening the monetary spigot. The hope is that the increased wherewithal in the system props up risk asset prices, thereby lifting animal spirits of investors, business people and consumers. Lower interest rates and more readily available credit help to stimulate housing activity and business spending. These, in turn, lead to a better jobs market and increases in disposable income. Income gains lead to higher consumer spending, which is followed by additional increases in production and the cycle eventually becomes self-sustaining.

The momentum typically continues until stopped by something. Sometimes that “something” is an exogenous event that creates fear amongst investors, consumers and/or the business community. More often, however, the “something” is Fed tightening – the proverbial taking away of the punch bowl when the party gets going too good.

One might think that we are currently some distance from the party being so good that the Fed needs to clamp down but, beginning in late 2015, the central bank made the first of three small increases in the federal funds rate. In an historical context, seventy-five basis points doesn’t look like much of a “tightening” at all. One must consider, however, that never before in our nation’s history have interest rates been as low as they have been in recent years.

We suspect that the “virtuous cycle” has not been hitting on all cylinders in this recovery because of the enormous worldwide debt service burden. While seventy-five basis points is nominally a relatively small increase by historical standards, it represents a quadrupling from where the program began. Over the past twelve months, ten-year treasury yields have increased by sixty basis points. Once again, that doesn’t sound like much in nominal terms but it is a 33% increase.

Hence, even what appear to be relatively small increases in interest rates are having a substantial impact on the debt service requirements for debtors with adjustable rate loans.

The bottom line is that the economy’s sensitivity to rising interest rates is as high as it has ever been due to the substantial impact on debt service costs in a debt-laden world. Unless inflation were to accelerate and thereby make servicing the debt somewhat less painful, it should not take much tightening to have a profound impact on the economic cycle.                                                                                                                  

Weaver C. Barksdale, CFA

Tug of War?

There was no “October Surprise” in the fourth quarter but there were plenty of fireworks in November and December as the stock market established new record highs in a sprint to the finish line. The closing high on the Dow Jones Industrial Average occurred on December 27 at 19,945, tantalizingly close to the 20,000 level. The venerable index closed with a price gain (no dividend reinvestment) of 7.9% for the quarter and a stout 13.2% for the year.

It was, however, the November-December sprint that made all the difference. At the close on November 4, the Dow was up a mere 2.7% for the year. Of the remaining thirty-eight trading sessions, twenty-seven registered gains. The Dow Transports, which had been badly lagging the Industrials for some time, also made new highs, thereby confirming the bullish trend. The financial stocks also performed well during the period – another bullish confirmation.

If it was the best of times for stocks, it was the worst of times for bonds as interest rates moved up across the yield curve, thereby precipitating price declines of 10.4% and 5.3% in the thirty-year and ten-year Treasury futures contracts, respectively. The market, as it always does, correctly anticipated the Fed’s move on December 14 to bump the fed funds rate up another one-quarter of one percent. We have for a long time questioned why so many expend so much effort parsing every word of every comment uttered by Fed officials when all they need do is look at market yields. That, however, is not as much fun and would wipe out the cottage industry of Fed watchers.

Commodity prices, a good leading indicator for both stock prices and the economy, were up 3.3% for the quarter, with crude oil leading the way with an 11.4% increase. Precious metals, however, were weak as gold prices slumped 12.4%. Gold often moves inversely to investor confidence while the dollar is more directly related. Hence, it is no surprise that the dollar rallied 7.5%. The buck bull market, however, is getting long in the tooth and a pullback appears in order whilst the precious metals appear to be oversold and probably poised for a bounce.

Like stock and commodity prices, the economy snapped out of the doldrums as real GDP was reported to have grown at a 3.5% annual rate in the third quarter. The fourth quarter, however, didn’t appear to be quite as strong based on the data released thus far. Industrial production was flat in October and down slightly in November. Retail sales were strong in October and weak in November, although the holiday season looked reasonably healthy overall.

Housing starts were likewise stronger early and weaker later. Home sales typically pick up when interest rates start to rise as potential buyers move to lock in lower rates. Higher rates eventually dampen enthusiasm in the sector but we are starting this cycle from historically low levels so it could take some time for interest rates to be a deterrent. Credit availability (or more precisely, the lack thereof), however, is a different question and that could become a negative more quickly than in previous cycles.

Despite the record levels in stocks, the leading indicator composite index has been weak of late and could be pointing to trouble down the road. Meanwhile, the inflation indices, after a long period of deflation, have moved up and are at or near the Fed’s target levels.

In the sporting news, pigs flew, hell froze over and multiple longstanding curses were broken as the Cubs not only made the World Series for the first time since 1945 but also won it for the first time since 1908. Such an occurrence would appear to open the door to many possibilities, but we wouldn’t bet on Vandy winning the college football national championship anytime soon.

In the span of a year, the Fed has raised the funds rate twice by a total of one-half of one percent. The amount is not nearly as consequential as the trend, which is now clearly up as the economy is at or near full employment. Meanwhile, the incoming administration is advocating serious fiscal stimulus in the form of tax cuts and infrastructure spending.

Ours is not the task of deliberating the virtues and vices of monetary restraint and/or fiscal stimulus but to try to assess the fallout from what appears to be an incipient policy tug of war between the White House and the Fed.

Our confidence about the near-term is reasonably high as it appears likely as noted above that the markets that have been strong (stocks, commodity prices and the dollar) are due for pullbacks while rallies should be expected in the markets that have been weak (bonds and precious metals). These moves, moreover, are not likely to be protracted in either magnitude or time. The bull trend in stocks, for example, while much closer to its end than its beginning, appears to have some more room on the upside before the bears gain control. Relative weakness in the financial stocks is likely to precede any such occurrence and that is not in evidence at present.

Meanwhile, on the economic front, the effects of fiscal stimulus are likely to show up before the effects of monetary restraint if tax cuts are passed quickly and made retroactive to the beginning of the year. That would result in withholding tax table adjustments that would immediately put more money in the pockets of the workforce.

Monetary policy, on the other hand, works with a long and variable lag. Should the central bank remain on course with pulling in the reins, the full effect on the economy would not show up until the second half of the year.

The bottom line is that the word, stagflation, which has not been used to describe the economic environment for many years, might come to be uttered more frequently in the months to come.

Weaver C. Barksdale, CFA

"Inflation is like toothpaste. Once it's out you can hardly get it back in again." Karl Otto Puhl

Is there an “October Surprise” in store for this year? No, we’re not referring here to election year politics but instead to the global economy and, especially, the world’s financial markets. Things have been awfully quiet of late. True, the major stock market indices in the U.S. were able to reach all-time record highs in August but volatility has largely been absent from the headlines for quite some time.

During the third quarter, the Dow Jones Industrial Average, for example, traded in a rather narrow 800-point range. The Dow closed out the period with a 2.1% price gain but finished well below the August highs. In September the venerable index successfully tested support at the 18,000 level on a couple of occasions. Hence, said level appears to be important and a failed third test could lead to a sharp selloff, whereas another successful test could send stock prices soaring again to new record highs. This situation should be resolved in the near future.

Interest rates rose across the yield curve as speculation of another tightening of the monetary policy screws by the Fed reared its ugly head yet again. Pronouncements by various central bank officials clearly indicate dissension in the ranks amongst the doves and the hawks. The odds appear slightly in favor of the hawks at this point but the only thing we are prepared to rule out is an October Surprise from the Fed. Our confidence arises from the fact that the Federal Open Market Committee doesn’t meet again until November. Q.E.D.

Commodity prices generally declined during the quarter although crude oil appeared to find support at the $40 per barrel level. Both the PPI and CPI remained in the doldrums as the former was unchanged for the past twelve months while the latter climbed a meager 1.1% for the same period.

Once again we were informed that the past isn’t what it used to be as GDP growth for the fourth quarter of 2015 was revised downward from a meager 1.4% annual rate to a paltry 0.9% rate. Things were even worse in the first quarter of 2016 as the growth rate for that period was revised from 1.1% to 0.8%. In comparison the 1.4% growth rate for the second quarter (revised upward from 1.1%) appears positively robust. As is the case with Vanderbilt football, low expectations make for easier comparisons.

Jobs growth slowed in August and September and the unemployment rate edged back up to 5%. These statistics, however, are somewhat misleading. The slower jobs growth is due largely to a dearth of skilled workers and the unemployment rate moved up because the labor force grew as previously discouraged job seekers decided to look for work again. That is a positive sign and fits with the historically low rate of claims for state unemployment benefits that has prevailed for several months.

Alas, the healthier jobs situation has not yet shown up in other areas of the economy. Retail sales and industrial production declined in August and the housing sector has shown some softness of late. Here, too, however, the statistics don’t tell the whole story as services now comprise the lion’s share of the economy and that area remains relatively strong.

In the sporting news, the Cubs completed the regular season with, mirabile dictu, the best record in all of baseball. It was, in fact, the North Siders’ best season since, well, long before we were born. Unfortunately, such a record has not been associated with postseason success in the era of the playoffs. To the contrary, the team with the best regular season record has gone on to capture the World Series title on average about one year in eight. Those are not good odds for a team that has not appeared in the World Series since 1945 and has not won it since 1908.

At this seemingly critical junction (for all of us, not just the Cubs), the central bankers find themselves between the proverbial rock and a hard place. They are expected to foster a climate of noninflationary growth and, in the role as lender of last resort, be on alert for any cracks in the financial system that could turn into large fissures.

The tools at their disposal are to some degree impaired by the historically low level of interest rates. Furthermore, monetary policy affects the general economy with long and variable lag times. Imprecision is not friendly toward good policy making.

To compound this problem, global debt levels are at record highs in both nominal and relative terms. Yes, these levels now well exceed those that obtained before the financial crisis that precipitated what is now called the Great Recession. Said debt burden has a lot to do with the sub-par economic growth throughout much of the world at present. Rising interest rates would serve to increase the burden of servicing the debt.

Like monetary policy, inflation also operates with long and variable lag times. Despite the massive intervention by the world’s central banks in recent years, there has been scant inflation in evidence and actual deflation has appeared in some areas. Yet, as Herr Puhl pointed out many years ago, once inflation appears, it is too late. As they used to say in the old horse operas, inflation must be “headed off at the pass.”

We noted above that there are signs that the U.S. economy is at or near full employment. The hawks on the Fed believe that there is little slack in the system whilst the doves believe that there is more room for growth without exacerbating inflationary pressures. There are, moreover, other considerations including the apparent fragility in many European economies and their banking systems and the possibility of the same in China, where the statistics are (ahem) somewhat less reliable.

Everything considered, it appears dicier to us to raise rates than to stand pat and risk inflation getting out of the tube down the road. Happily, for us and the rest of the world, the decision is not ours to make. (And Joe Maddon doesn’t appear to need our help with the Cubs, either.)

Weaver C. Barksdale, CFA

Going Global?

The stock market started the new year by stumbling out of the gate and falling flat on its face. The Dow Jones Industrial Average dropped 6.2% in the first week of trading – its worst start to a year ever. By the close on February 11, the venerable index had dropped over 10% for the year and almost 15% from the all-time high established in May of last year.

 A rally thereupon ensued that carried the Dow to a closing level on March 31 that represented a price gain of 1.5% for the quarter. While that return might be nothing to write home about, the market’s wild ride was headline news as over half of the trading days during the period witnessed intraday moves of 1% or more. Can you spell v-o-l-a-t-i-l-i-t-y?

 Despite being scorned by many a pundit looking for higher interest rates in 2016, Treasury bonds rallied yet again as yields on long-term government debt fell during the first quarter. A widely anticipated second increase in the federal funds rate by the FOMC never occurred. More on that subject anon.

 Commodities were again the biggest losers during the period as the Commodity Research Bureau Index dropped 3.3 percent. There were, however, a few exceptions. After being down over 30% in February crude oil managed to rally in the second half of the quarter to pull even for the year. Gold, moreover, was the biggest winner as, contrary to industrial metals, it jumped 15% due in large part to a flight to safety on the part of foreign investors.

 In keeping with recent trends, economic growth remained relatively lackluster although the U.S. economy looks pretty healthy in comparison to many others around the world. Fourth quarter real GDP registered a meager 1.4% gain as the manufacturing sector exhibited weakness late in the year. In January, however, industrial production jumped 0.9% before falling back 0.5% in February.

 New orders for durable goods tend to be highly volatile on a month-to-month basis and that has held true of late; yet the trend has been noticeably to the downside. Retail sales proved to be disappointing as well with declines in both January and February. Housing activity, meanwhile, has been relatively flat in recent months.

 The brightest star in the economic firmament continues to be the jobs market. After a brief jump in unemployment claims late last year, that measure moved back down early in 2016 to levels implying moderately strong growth in payrolls. Cue the payroll reports which indeed saw appreciable gains in all three months.

 Inflation remains remarkably muted as the latest year-over-year changes for the PPI and CPI were 0.0% and 1.0%, respectively. While still below the Fed’s target rate of 2%, they are now much closer to said target than the negative readings that prevailed throughout much of last year.

 Over the years, Fed watching has become something of a major industry as analysts and scribes parse every pronouncement by Fed officials, governors and regional bank presidents in hope of discovering clues to the never ending question, “How now, interest rates?” A number of the regional bank spokespersons have lately been opining that the employment statistics, among others, appear to be sufficiently strong to justify getting ahead of the inflation curve by allowing the funds rate to move higher. However, as Lee Corso might say, “Not so fast, my young friends,” as he forsakes the hawks’ mascot’s head and dons that of the doves.

 Fed Chairman Janet Yellen has recently put something of a kibosh on the plans for higher rates, at least for the time being. Citing a host of troubling deflationary tendencies in the global economy, Ms. Yellen made it clear that Fed policy will likely remain steady as she goes until more data with stronger growth implications become available.

 Why the foot dragging? We noted above that gold rallied sharply in the first quarter in response to a flight to safety. This was not the only indication that fear of loss is now, on the margin, edging out fear of losing out in a rally.

 Risk assets other than large cap stocks are giving signals of renewed reluctance by investors and speculators alike to assume risk. We have already mentioned the ongoing bear market in most commodity markets. Furthermore, commodity prices have a long history as leading indicators for the general economy and other risk assets as well.

 One of the biggest beneficiaries of the bull market that started seven years ago has been the market for art. Alas, Christie’s and Sotheby’s spring sales this year were down 35% and 50%, respectively. Other collectibles have taken a hit as well. Sales at the Scottsdale classic car auction were down 15% - the first decline since 2010.

 In Japan and much of Europe there is over $7 trillion in sovereign debt that is trading at negative yields. In other words, investors are so worried about risk that they are willing to pay the government to keep their money safe for them.

 Bull markets, of course, are known to climb walls of worry, so there has been plenty of fuel to drive stock prices higher since mid-February. A closer look at the numbers, however, reveals that the market’s gains have been Pyrrhic in character as the higher the large cap indices have gone, the fewer the number of stocks that are participants.

 What does it say when a defensive group like the Dow Utilities is making new highs for the cycle while a more aggressive group like the financial stocks is underperforming? (See charts below.) Large cap indices like the Dow are within shouting distance of the all-time highs established last May. If this is a bull market, new highs should be in the offing. If, however, it is only a bear market rally, a move below the 15,500 support level on the Dow would be expected. There is much at stake here and Chairman Yellen has chosen wisely to keep the powder dry at this juncture.

                                                                                                         Weaver C. Barksdale, CFA

Conundrum Redux

Cash was king last year. Despite yields well south of 1%, cash and cash equivalents held their own in an environment wherein inflation was conspicuous by its absence. No such claim can be made for any other class of investments (no, we don’t accept contemporary art as an investment class).

Although things could have gone either way with the stock market, selling late in the year eliminated any chance of price gains for the Dow and the broader indices. The Dow Industrials fell 2.23% (before dividend reinvestment) while the S&P 500 edged lower by 0.73%.

This occurred following a fairly spirited rally from the August lows at 15,355 that saw the Dow make several valiant efforts to break back above the 18,000 level. Alas, each subsequent attempt failed at a lower high and lack of breadth helped pull prices lower as the year came to a close.

Despite much wailing and gnashing of teeth about potential Fed tightening during the year, as well as the actual event on December 16th, Treasury bonds and notes fared reasonably well with only modest price declines. Corporate bonds, however, suffered from spread widening and the high yield sector, especially extractive industries such as mining and petroleum, was hit hard by fears of a repeat of the debacle in 2008.

The Commodity Research Bureau’s Index, moreover, fell 23.4% in what was largely an across the board rout of all things taken from the earth. Gold fell 11.6% but the biggest loser was crude oil, which tumbled 32.3%.

The economy continued to limp along at a relatively slow pace during the final months of the year. Housing starts showed some oomph in November, but retail sales were up a disappointing 0.1% and 0.2% in October and November, respectively. There appears to have been some improvement in December as Christmas sales were relatively strong and auto sales, led by SUV’s, moved higher as the price for gasoline continued to drop.

Employment increases were impressive during the fall months, but wage gains were muted and the unemployment rate remained stuck at 5%. Unemployment claims ticked up a bit, but we wouldn’t read much into that as they are often volatile during the holidays.

There were notable signs of distress emanating from the manufacturing sector. The effects of a stronger dollar were felt as industrial production dropped in every month from August through November in large part due to a slump in exports. The ISM Index dropped below the key 50% level that demarcates growth from decline.

In the sporting news, the Cubs, after a storybook season during which they achieved the third best record in baseball while playing in the most competitive division, managed to lose the pennant in typical Cubbie fashion by dropping the NLCS to a team against whom they went 7-0 during the regular season. Oh well, there’s always next year.

At the end of the college football season, the Vanderbilt squad had exactly the same number of wins (four) as they have uniforms. At least one member of the Commodore Nation would be happier with more of the former and fewer of the latter. After all, one helmet, one pair of pants and two jerseys is all that Alabama requires.

Before penning this epistle, we reviewed our letter from this time last year and were sorely tempted to reprint most of it as little has changed in the intervening months as far as the economic and market outlooks are concerned. A year ago we discussed the fact that the economy was muddling along at a low pace relative to past expansions but the good news was that growth should continue unless something came along to stop it. In past cycles that something has more often than not been Fed tightening.

Despite much spirited debate about the advisability of tightening, the Fed last year delayed taking any action until their December meeting, when they announced a 0.25% increase in the Federal funds rate. Hence, growth continued to stumble along throughout most of the year. With the deed having been done, the question now is how much further will the Fed pull back on the credit reins.

In the past, the first move was typically followed relatively quickly by several more. In fact, many analysts are calling for a 1% funds rate no later than mid-year. That doesn’t sound like much and, by past standards, it isn’t. We must bear in mind, however, that what happens on the margin is most critical. We are witnessing a shift from the most extraordinary easing in history to a tightening. Modest though it may be by past standards, it is a risky bet in a world where deflationary pressures remain in evidence and massive amounts of debt are choking global growth. So, indeed, the FOMC once again finds itself in a conundrum.

We also mentioned last year that the virtuous cycle of growth can also be altered by factors that are exogenous to the economy. These tend to occur less frequently than central bank tightening, but they can be powerful, especially over short periods of time. These are typically unexpected events that precipitate a crisis in financial markets – a large default, a major bank failure, or a crash in a foreign market – factors that can be lumped together in the category of “things that go bump in the night.” The volatility in the Chinese stock market that precipitated the summer selloff in U.S. markets is an example.

So once again we begin a new year in an environment where growth can continue or falter. National election years tend to be about average as far as stock market returns are concerned (2008 was an unfortunate exception). But how can the economy founder with all of the election spending sloshing around? So relax and enjoy all of the posturing, propaganda and poll proliferation. But for safety’s sake, keep an eye on the Fed and a finger to China’s pulse.

Weaver C. Barksdale, CFA

 

BEST WISHES FOR A HAPPY AND PROSPEROUS NEW YEAR FROM EVERYONE AT BARKSDALE AND ASSOCIATES!

Lack Of Participation

It was open season on risk assets, especially stocks and commodities, during the third quarter. The major equity indices fell 7% or more during the period, so it was painful being long anything other than volatility. The latter was greatly in evidence, especially on August 24, when the Dow’s daily range was greater than 1000 points.

The selloff was the first correction of 10% or more (measured from the May highs to the August lows) since 2011. The market then spent most of September backing and filling after the August 24 rout that was precipitated by a debacle in Chinese stocks. Hence, the question is whether the correction was sufficient to dispel extreme bullish sentiment and avoid a bubble or was it merely a shot across the bow in advance of more trouble ahead. Stay tuned….

As bad as the period was for stocks, it was far worse for commodity prices, which fell almost 15% during the quarter based on indices of a variety of commodities. Most of the damage was done by crude oil, which fell over 20%, and industrial commodities such as copper. The weakness in said products reflects the worsening situation in the world’s largest consumer of industrial commodities, China, and is a better indication of the real condition of the Chinese economy than any of the statistics emanating from Beijing. Furthermore, commodity prices have long been an important leading economic indicator for all advanced economies and the only one that is available in real time and not subject to revision.

Speaking of which, we learned once again that the past isn’t what it used to be as GDP growth in 2013 and 2014 was revised downward to 1.5% from 2.2% and to 2.1% from 2.4%, respectively. Growth in the second quarter rebounded sharply from the first quarter’s decline but initial data from the third quarter suggest that there was only modest follow through.

The ISM survey has dropped near the key 50% level that demarcates growth (>50%) or decline (<50%) in the manufacturing sector. Industrial production was up 0.6% in July but fell 0.4% in August. Housing starts, which were strong in the spring, have leveled off of late. The composite index of leading economic indicators fell 0.2% in July and eked out a mere 0.1% gain in August.

One key leading indicator, however, initial claims for state unemployment benefits, fell to its lowest level in forty years during July, which is a positive as lower claims typically indicate stronger growth and a better jobs market. Curiously, however, recent employment gains have been lackluster. More on this anon.

It’s a shame that we can’t harvest all of the hot air created in the debate about what the next move by the Fed will be and put it to some useful purpose. Chairman Yellen adamantly maintains that a tightening will occur before the end of 2015 despite the fact that inflation, as measured by most of the various price indices, is still not near the central bank’s long-term target of 2%. The latest year-over-year changes for the PPI and the CPI are -0.8% and 0.2%, respectively. The same measure for the Personal Consumption Expenditure Price deflator is 0.3%. Verily, inflation is most notable by its absence.

In the sporting news, long-time readers of this missive must surely be wondering why there has been no mention of the recent success of a certain team in the NL Central Division. Given the history of that organization, complete with disgruntled billy goat owners, black cats and sundry other hexes, we choose not to jinx them by reporting on their astounding progress. They shall remain unmentioned until it is all over.

Meanwhile, we note with dismay the proliferation of exceedingly gaudy college football uniforms. Recruits apparently find them to be sick (sic). That’s pretty much how we feel about them but there is no doubt a huge dichotomy between our definition of the word “sick” versus that of the younger generation. Vanderbilt, for example, has four different uniforms (which is one more than the number of wins last season) all of which are adorned with likenesses of anchors (their nickname is the Commodores). One of these features pants that display the slogan, “Anchor Down.” We suppose that’s appropriate for a team with one of the worst offenses in Division I.

We noted earlier that low unemployment claims (they have been below 300,000 for seven consecutive months) should be followed by strong gains in jobs growth. Alas, the latest household survey indicates that only 47,000 jobs have been added since May - a paltry sum by any reckoning. Meanwhile, the latest payroll survey was disappointing and the data for prior months were revised downward. What gives?

No doubt the problem involves some complexity but a large part of it may be explained by the chart below. The lackluster nature of the current recovery has been widely discussed. Despite massive monetary stimulus on a scale never imagined heretofore, the “virtuous cycle” of economic growth has somehow been short circuited. Said cycle involves the sequence of higher employment leading to gains in disposable income, which, in turn, leads to growth in consumer spending. The greater spending leads to production gains that result in even more hiring. And the beat goes on.

In the current expansion, potential hirees have stopped seeking employment. Hence, a lower level of unemployment claims has not been followed by a surge in payroll growth because an increasing number of workforce participants are dropping out. Wage growth has also been lackluster, so the net result is that the virtuous cycle is not hitting on all cylinders. Now we have news that a profit squeeze in some areas is resulting in sizable layoffs. Should that trend develop further, the claims data may begin to climb back toward 300,000 and the threat of recession will grow. Hence, any move by the Fed to tighten may in retrospect prove to have been ill advised.

CHINA : Fragile - Handle with Care

The Dow Jones Industrial Average rallied to a new all time record high closing level of 18,312 on May 19 only to drop back and close the quarter at 17,619, a -0.1% decline for the period. The May high followed suit with other recent highs by occurring on declining volume with fewer individual stocks making new highs. This is an indication that the bull market’s momentum may be beginning to ebb.

 It is also discomfiting to the bulls that the Transportation Average last made a new high in November of last year. A sell signal from the Dow Theory has yet to be generated but this non confirmation suggests that such a signal might not be too far down the road.

 While returns in the equity sector were mixed, there were negative returns across the yield curve in the bond market as investors once again began to anticipate (jump the gun?) that the Fed will initiate a round of interest rate increases in the months ahead. The futures contract on the thirty-year Treasury bond fell almost 12 points during the period, thereby implying a yield increase from 2.14% to 2.67%.

 Commodity prices continued to rebound from last year’s sharp decline as the CRB Index rose to 227.17 from 211.86 largely due to an extension of crude oil’s price rally. West Texas Intermediate Crude increased from $49 to $58 per barrel during the quarter.

 The precious metals didn’t join the party as gold dropped from $1200 to $1170 per ounce. The dollar, which has largely moved inversely to commodity prices over the past few years, continued to do so by losing almost 3% of its value in terms of an index of trade-weighted foreign currencies.

 Returns in most risk asset prices, however, paled in comparison to the gains realized in the art market, especially modern and contemporary art. The record price paid for any painting at auction was achieved by a Picasso work that was hammered down at $179.4 million. That set the tone for what was a record amount of sales overall at the spring auction. Break out the bubbly but beware of the bubble.

 Plagued by abominable winter weather throughout much of the nation, first quarter real GDP growth was a very disappointing -0.2%. The economy should have rebounded nicely in the second quarter as the weather improved, but the jury is still out as the data released thus far have been mixed. Housing starts perked up and, after being flat in April, retail sales jumped sharply in May.

 On the other side of the coin, industrial production slumped -0.3% in April and -0.2% in May, presumably as a result of undesired inventory accumulation in the weak first quarter. Those anticipating quick action by the Fed might want to pause and consider because this indicator is compiled by the Fed’s own bean counters.

 Initial claims for state unemployment benefits fell below 300,000 and held there throughout the quarter. This typically portends improvement in the jobs market in the following weeks but the employment statistics didn’t completely jibe with the claims data. Payroll growth slowed in the spring and previous gains were pared back somewhat due to revisions. Wages also continue to lag. Hence, it appears that the recovery, albeit extant, is continuing to sputter instead of hum.

 Meanwhile, inflation remains conspicuous by its absence. The first quarter’s GDP deflator was an annualized 0.0% and the latest year-over-year changes for the PPI and CPI were -1.1% and 0.0%, respectively.

 We have noted heretofore in these pages that, if there is to be some sort of problem in the U.S. financial markets in the short to intermediate term, it is more likely to come from without rather than from within the domestic economy. The news media have been buzzing almost daily of late with a list of the usual suspects. Greece is the word (yes, pun intended) most prominently mentioned but Puerto Rico, Spain, Portugal, Ireland and Italy are also among the potential trouble spots for financial malaise. China, however, appears to us to be the most likely culprit as it is currently experiencing the largest bubble.

 The Chinese have often been described as “inscrutable” - a condition no doubt fostered by their predilection for “painting the tape” where economic statistics are concerned. They are the quintessential Cordon Bleu chefs in the methodology of book cooking.

 To impart the impression of growth during the late Great Recession, the Chinese central planners engaged in a vast number of construction projects involving manufacturing facilities, living spaces, office buildings and the like. A considerable amount of apparently shaky debt was required to finance these programs but it was thought to be worth it to help keep the population employed and not rioting in the streets. The problem is that there now exist huge tracts of what are essentially ghost towns throughout the country. Anecdotal evidence suggests that this is a large and widespread phenomenon.

 Meanwhile, beginning in the spring of last year, the Chinese stock market took off on an historic bull run that saw the Shanghai Composite rise by a factor of 2.5 times into mid-June of this year. Then, in very short order, it declined over 30%.

 Perhaps the most disturbing aspect of this is the fact that the majority of the trading has apparently been accounted for by small retail investors, many of whom are poorly educated. In addition, margin debt has soared. Some analysts estimate that the total margin debt could be as high as five million yuan, which would be in the vicinity of 20% of the total market value of Chinese stocks. That is a far larger percentage than has ever been witnessed in any other market throughout history.

 Frothy prices for contemporary art, extreme bullish sentiment, and poor market breadth may be reasons for investors to be concerned about U.S. equity market valuations. Yet, instead of asking, “How now, Dow Jones?,” it is probably more apropos to ponder, “What now, China?”

 Weaver C. Barksdale, CFA


CONUNDRUM

March madness. Nope, we’re not talking college hoops here. Instead we are describing the behavior of the U.S. stock market last month. In short, the best thing to have been long was volatility. Of the twenty-two trading days during March, sixteen registered triple digit changes in the Dow Jones Industrial Average. The bears had a slight edge as nine of the sixteen sessions experienced price declines.

Most of the major indices either established or approached new all-time record highs on March 2, the first trading day of the month. The rarefied air apparently wasn’t to investors’ liking as it was generally a very bumpy downhill ride from there. Sic transit gloria. Nonetheless, the NASDAQ composite was able to finish the quarter with a price gain (not including dividend reinvestment) of 3.5%. The S&P 500, on the other hand, netted a paltry 0.4% gain while the Dow Industrials suffered a 0.3% decline.

Following the time tested baseball strategy of shuffling the batting order when results aren’t favorable, the folks at Dow Jones decided to juice up the venerable industrial average by giving AT&T the heave-ho (and not for the first time) and bringing Apple into the fold. In the past, this has been the kiss of death for the stock being added. For example, RCA (which was a high tech stock back in the day) was added in the late 1920’s after a spectacular run in that decade, but soon thereafter experienced an equally spectacular decline. (We’ll resist making any allusions to one bad apple spoiling the bunch.)

Although a Dow Theory sell signal has yet to be generated, there are some thought provoking non-confirmations to consider. The Dow Transports peaked on November 28 of last year at 9310.22. They closed at 8741.41 on March 31 – a loss of more than 6% despite a huge decline in fuel costs. The Dow Utilities peaked at 657.17 on January 28 and closed out March at 587.08 – a loss of more than 10%.

Bullish sentiment indicators are near record levels (which is a bearish indicator) but the Timex market has kept on ticking albeit with a much more irregular pulse. Bulls can take heart from the fact that April has been the best month for market gains since 1950 with an average return of just under 2%. Ah, spring, the time of year when a young man’s fancy turns to thoughts of…stock speculation.

While all of the machinations described above were occurring in the equity sector, interest rates continued the trend that has been in place since 1982. They declined…again. Yes, despite all of the chatter by the collective talking heads regarding the inevitability of Fed tightening, nothing of the sort occurred and the yield on the ten-year Treasury note fell from 2.17% to 1.93% during the quarter. Yields did rise, however, in the corporate bond sector, especially in the high yield arena; but that is more a manifestation of investor risk tolerance (more specifically, the lack thereof) rather than a widespread anticipation of the Fed applying the brakes (about which there will be more anon).

Commodity prices continued to drop but at a greatly reduced pace versus the second half of last year. In fact, crude oil and gold have experienced a bit of a bounce of late even though it ultimately might prove to be of the “dead cat” variety. The dollar was in the midst of a parabolic rise until the last week of the quarter, when it experienced an overdue correction. Nonetheless, we suspect that this is merely a hiccup in a long-term bull market for the buck.

The economy expanded at a less than sparkling 2.2% annual rate in the fourth quarter of 2014 after showing promise of stronger growth in the prior two quarters. The atrocious weather in the first quarter no doubt sapped some strength from economic growth in that period. Industrial production was up a meager 0.2% and 0.1% in January and February, respectively. Housing starts dropped sharply in February due largely to the poor weather conditions while retail sales that month fell 0.6% - the third consecutive monthly decline.

Payrolls continue to grow at a healthy, albeit not robust, pace while the unemployment rate has fallen to 5.5%. Yet wage gains continue to lag and the economy is not likely to kick into a higher gear as long as this condition obtains.

The “conundrum” to which our title refers is the one faced by our nation’s central bank. Over the past year the Fed cut back on and eventually eliminated the stimulus plan dubbed QEII. Having thus taken the foot off the accelerator, the question now before the money maestros is whether or not to begin applying the brakes. The evidence in favor of doing so would include the aforementioned payroll gains and the record high in stock prices. While the Fed’s mandate has nothing to do with “irrational exuberance”, various members have opined on the subject in the past.

One can certainly argue that record highs in stock prices are not inherently a sign of a bubble. On the other hand, recent IPO activity has been somewhat reminiscent of the dot-com hysteria that preceded the bubble popping back in 2000. To wit, an offering was proposed by one Bigfoot Project Investments – a company organized for the purpose of funding efforts to track down Sasquatch. (No, we are not making this up.) This sounds more like a Kickstarter project to us but any way you size it up, it is proof positive that fools and their money are soon parted.

Yeti sightings notwithstanding, the evidence against the Fed’s initiating a tightening policy appears to outweigh the evidence in favor of doing so by a fairly sizable margin. The central bank’s mandate does include promoting a healthy economy whilst   keeping demon inflation at bay. When we last looked, moreover, signs of inflation were exceedingly scarce. The latest year-over-year change in the Consumer Price Index was 0.0%. The collapse of energy prices since last summer has a lot to do with the weakness in the CPI , but, factoring out food and energy prices, the CPI rose 1.7% - still below the Fed’s target of 2%. Furthermore, it should be noted that most consumers’ perception of inflation is influenced largely by what they see at the gas pump and the grocery store.

There are inflation hawks, however, who believe that the Fed should head off inflation proactively because once it appears, it is likely too late to contain it. History suggests that this argument has merit; yet there are other factors that do not support tightening, chief among which is the dollar’s rapid rise in recent months.

The large whooshing sound in the currency markets of late is the manifestation of capital flowing out of low interest rate countries into the U.S. True, yields on U.S. Treasury securities are at the lowest levels in a couple of generations, but they are still higher than the yields in many other markets. In Switzerland, for example, government securities have negative yields (i.e. investors are paying the government to keep their money). If the Fed were to proactively raise domestic interest rates in this environment, capital inflows would accelerate, and that could be self- defeating.

We’d much rather be a fly on the wall at Federal Open Market Meetings than a participant at the table trying to fathom a solution to the conundrum. It is inevitable that interest rates will begin to rise in the U.S. at some point, but it doesn’t necessarily have to happen in the near future. In the long run, rates will move up; but, as Keynes once remarked, we are all dead in the long run.

 

Weaver C. Barksdale, CFA

Economists are paid to pretend they understand ... things so that people will think that the world isn't riding a wild horse, when in fact it is. - Mark Helprin

The Timex stock market. It takes a licking and keeps on ticking. To wit, the Dow dropped from 17,279 on September 19 to 16,461 on October 22 – a 4.7% decline in a little over four weeks that totally eradicated the market’s gain for the year to that point. No problem. Over the ensuing six weeks the Dow rallied over 9% to a new all-time record high. But then it gave back almost 5% over the next seven trading days. No sweat, for the venerable index soared almost 6% over the following six sessions to another record high of 18,083 on the day after Christmas. Yes, Dow Jones, there is a Santa Claus.

The rarefied air proved to be too much again as the market fell back slightly over the last few days of 2014. The net gain for the year (excluding dividend reinvestment) was 7.52%, which definitely qualifies as not too shabby at all in a world of moribund inflation. But hold the phone because stock returns during the year paled in comparison to the returns from long-term Treasury bonds. The nearest Treasury bond futures contract enjoyed a price gain of 12.7% as yields fell during a year in which the vast majority of prognosticators was calling for exactly the opposite. Nothing new about that.

Among the losers during 2014 were a host of commodity prices. The Commodity Research Bureau Index plunged 17.9% for the year. The carnage was widespread in industrial commodities but the energy sector was hit hardest. West Texas Intermediate Crude Oil reached a peak over $110 per barrel in June before plummeting over 50% by the end of 2014 as OPEC steadfastly refused to cut production in order to support crude prices.

Speaking of losers, the Vanderbilt football team managed to eke out only three wins during the season and two of those were against lower division opponents. As a result, the offensive and defensive coordinators were sacked. The no longer lovable but still losing Chicago Cubs also effected a coaching change as they lured the successful manager of the Tampa Bay Rays, Joe Madden, to the North Side. Good luck with that. All of these machinations will probably end up being as useful as rearranging the deck chairs on the Titanic.

The economy began 2014 with a thud as first quarter real GDP fell 2.6%. Like the stock market, however, the economy snapped back from the skid and finished the year in a sprint. Second quarter growth was a stout 4.6% and the third quarter turned in a sparkling 5.0% gain led by an increase in personal consumption spending (apparently mostly on the new iPhone). Fourth quarter data has yet to be reported but another above trend result is anticipated.

Much of the improvement in the previously becalmed recovery has emanated from employment growth. Unemployment claims, a leading indicator of employment conditions, fell from 339,000 at the start of the year to less than 300,000 by the end of 2014. That level has been associated in the past with monthly jobs growth above the trend growth rate of the labor force. Heretofore, the decline in the unemployment rate was largely attributable to a decline in the labor force participation rate. In other words, frustrated job seekers gave up looking for new jobs.

The better news on the employment front, however, has been tempered by what appears to be a “profitless prosperity” in that wage gains have remained relatively paltry. The latest data show a 1.7% year-over-year gain in average wages. That is not materially better than the rate of inflation so it is questionable if consumer spending can continue at a pace sufficient to sustain above trend growth in real GDP unless there is greater improvement in wage growth in the months ahead.

For many years (alas, a great many) these pages have included references to what we call the “virtuous cycle” (as opposed to the “vicious cycle” known all too well by many, especially Commodores and Cubs fans). The virtuous cycle begins with jobs growth that leads to an increase in disposable income. The higher disposable income leads to gains in consumer spending that, in turn, results in higher production levels and, eventually, even greater jobs growth. This is the sweet spot of any economic expansion and it appears to have finally taken hold last year.

Once the virtuous cycle gets underway, it tends to be self-perpetuating. Ultimately the cycle can lead to either cost push and/or demand pull inflationary pressures. That is the point where the Fed takes the punch bowl away before the party gets going too good. Rising interest rates eventually signal the death knell of the cycle and a slowdown or recession ensues.

At present we are experiencing real GDP growth rates well above the long-term trend. Considered alone that might prompt the party poopers at the Fed to become more stingy about supplying liquidity to the financial system. In fact, the central bank has moved to reduce liquidity growth by eliminating its program of buying fixed income securities in the open market. They have done so, however, in a manner designed to avoid putting upward pressure on interest rates.

There has been much speculation in the media about when the Fed might begin to raise interest rates and much discussion within the Fed itself on the same topic. Most pundits, moreover, now believe that any upward pressure on rates will occur later in 2015 if at all this year. One of the supporting factors for this is the fact that the rate of inflation is well below the Fed’s target of 2%. No doubt the aforementioned collapse in commodity prices and meager wage growth are also important considerations influencing the central bank’s policy decisions.

Hence, the virtuous cycle would appear to have plenty of life left in it. As Lee Corso might say, however, “Not so fast my friend.” While the Fed historically has been the agent of undoing for the virtuous cycle, there are other factors that can have an impact and these are known as “exogenous variables” (which can largely be characterized as “things that go bump in the night”). These are sometimes referred to as Black Swans – unusual events that can disrupt financial markets and, hence, economic growth.

While the U.S. recovery at long last seems to be gaining momentum, the rest of the world’s economy is struggling. Japan and Russia are in recessions and Europe is battling substantial deflationary forces. In the past, the U.S. economy has often been the locomotive that pulls the rest of the world along with it and that may very well happen again.

For it to happen, the Timex market needs to keep on ticking. While the Dow and S&P 500 established new all-time highs late last year, the collective world stock market, ex the U.S. components, finished well below the peak set in 2007.Credit spreads have been widening and the precious metals have recently gained ground despite the blood bath in other commodities. This, along with the dollar’s ascent of late, is indicative of a flight to safety – risk aversion by the world’s investors. The hope is that those seeking to avoid risk will be proved wrong and the virtuous cycle will remain intact and lead the rest of the world out of the doldrums. The coming year should prove to be very interesting, indeed.

 

Weaver C. Barksdale, CFA

"As for foreign exchange, it is almost as romantic as young love and quite as resistant to formulae." - H. L. Mencken

As it has done so often since the cycle low in March of 2009, the stock market rallied following a correction in the dog days of August and the Dow Jones Industrial Average as well as the Standard and Poor’s 500 Index established all-time record highs in September. The recovery, nonetheless, was rather labored and the Dow’s net gain for the quarter was 1.3% without dividend reinvestment.

 Despite continued widespread concerns about the inevitability of rising interest rates, yields in the fixed income sector were up only modestly and the ten-year Treasury note futures contract thereby suffered a 0.7% decline for the period. Credit spreads, however, widened out, so returns in lower rated issues were disappointing.

 The biggest loser, however, was the commodities sector as the CRB Index posted a whopping 9.6% decline in the third quarter. Oil prices have led the way south but industrial commodities were part of the carnage as well.

 The big winner for the period was the oft-maligned U.S. dollar, which appreciated 7.6% against a basket of currencies including the euro, yen, Swiss franc, and others. More on this development anon.

 Real GDP was reported to have expanded at a 4.6% annual rate in the second quarter following the poor weather induced decline in the year’s first quarter. Whether such a pace can be sustained for the remainder of the year appears doubtful but there is at least a chance of matching the long-term trend growth rate near 3%.

 To wit, initial claims for state unemployment insurance benefits declined below the 300,000 level – a development suggesting that jobs growth could approach or surpass the growth rate of the labor force. To this point the decline in the unemployment rate, which now stands at 5.9%, has been as much a function of declining labor force participation as it has been jobs growth. This is the reason why income growth has remained muted, and, unless this situation changes, future GDP growth could prove to be lackluster, much as it has throughout the recovery thus far.

 Industrial production declined slightly in August but the supply managers’ survey continues to hold well above the 50% level, thereby indicating that the manufacturing sector is still growing. Housing starts, however, have been essentially flat albeit rather volatile on a month-to-month basis. It is difficult for the economy in general to exhibit strong growth without the participation of that critical sector.

 As indicated earlier, interest rates have been buffeted by the hot air emanating from the mouths of Fed watchers but the net result to date is that the Treasury yield curve has lifted only modestly above the lows for the cycle. Still, one cannot ignore the fact that the rate of monetary creation, while still rising in absolute terms, has dropped dramatically in recent months. In monetary matters, what occurs on the margin is paramount.

 In the sporting news, the Chicago Cubs failed to make the World Series for the sixty-ninth consecutive year. Speaking of losers, the Vanderbilt Commodores football team returned to their usual form (this is known as regression to the mean) after three consecutive seasons of bowl appearances. Only a missed last second field goal by UMass kept Vandy from going 0 for September.

 In other news, we have learned that a major solar flare in 2012 came very close to disabling a large number of communications satellites as well as the power grid. There is supposedly a 12% chance that those most unpleasant events could occur over the next ten years, so give your mother a call today.

 The Sun is not the only source of unpleasantness. The reported cases of unruly passenger behavior by 170 airlines (who knew there were that many?) have grown from 339 in 2007 to 8217 last year. Fly the friendly skies, indeed.

 September 19 was the day that the Dow established a new record closing high at the 17,279.74 level. On the New York Stock Exchange that day there were actually more declining stocks than advancing ones. This development is known as negative divergence and historically has been a warning that the market is running out of steam.

 Among the other signs of potential trouble are near record levels of bullish sentiment, high levels of margin debt and a record IPO to the tune of $25 billion by China’s Alibaba. (The reader can no doubt guess who the forty thieves might be.)

 As mentioned heretofore, the dollar advanced sharply last quarter. The foreign exchange markets are affected by all sorts of machinations and phenomena, so we are not pounding the table about a possible explanation for the dollar’s rapid ascent of late. Nonetheless, it is not unreasonable to think that at least part of the buck’s rally can be attributed to a flight to safety. Europe is barely growing, Japan’s economy has turned down and the Chinese financial system and economy bear a strong resemblance to a house of cards.

 Also noted above, commodity prices peaked in the spring and took a tumble in the third quarter. Meanwhile, yield spreads have been widening. The Russell 2000 made a high on March 4. The NYSE Composite made a high on July 3. Hence, over the last several months the markets have exhibited a move away from riskier assets toward those deemed to be safer. It appears that it is only a matter of time before the Dow and S&P come under pressure.

 The good news is that we have seen this before on several occasions since the market low in 2009. In every instance there was a moderate correction followed by a move to new highs for the cycle. The bad news is that all of that activity occurred while the Fed was injecting enormous amounts of liquidity into the financial system. Today, instead, the Fed is draining said liquidity on the margin.

Our initial thought was to include a chart of commodity prices with this letter but we have chosen not to do so because it is unpleasant and we have had a tendency to harp about commodity prices over the years. Hence, with our favorite season upon us, we are instead attaching a photograph recently taken in the high country of northern New Mexico.

 Enjoy the autumn weather and the confluence of baseball, football, hockey and basketball in October. And please note that we have carefully avoided any reference to the word, “Fall.”

   -  Weaver C. Barksdale, CFA

MC Photo.jpg

Not So Easy Does It?

The good news is that risk assets of all flavors have posted gains for the year to date. The bad news is that said gains in the financial markets have been a tad on the lean side. The Dow Jones Industrial Average, for example, which ended the quarter within a whisker’s width of an all-time record high, posted a price gain of 1.5% (before dividend reinvestment) for the first half of 2014. This was bested by a 1.7% price gain for the ten-year Treasury note futures contract despite earlier widespread concern that interest rates would rise this year.

 Commodity prices, moreover, were the big winners with crude oil leading the pack with a 31% gain for the first half. Gold posted a 7.2% return while industrial metal prices were mixed. The really smart money, however, was in contemporary art, a sector that experienced record auction prices for objects that purport to be, well, art. Who wouldn’t prefer owning one of Jeff Koons’s inflatable this, that, or t’others to a mundane scrap of paper representing fractional ownership of a corporation?

 The economy bounced back from the stunning 2.9% drop in GDP of the first quarter, although the data reported thus far do not suggest that it was an outsized bounce. The purchasing managers’ survey showed improvement even though the industrial production reports for April and May were a wash with the former down 0.6% and the latter up by the same amount. Unemployment claims, while bouncing around a bit per usual, were essentially flat at a level that implies continued moderate (but below trend) growth in employment. Housing starts improved somewhat, but, here as well, results have been relatively flat going back to last year. All in all, the sub-par expansion appears to be moving along at a somewhat disappointing pace that is unlikely to accelerate without a more rapid rate of job creation.

 The inflation indicators, which had spent quite some time well below the Fed’s 2% target rate, have recently bounced up to meet said target. Kudos to the central bankers for avoiding deflation. If they are equally successful at avoiding excessive inflationary pressures down the road, we will be pleasantly surprised (no, make that stunned).

 In other news, we note that the Japanese have proposed a new national holiday to be dubbed, “Mountain Day.” If instituted said holiday would be the nation’s sixteenth such celebration. Why so many? Japan’s white collar workers have long refused to take their allotted vacation days for fear of getting behind and losing face. Hence, the government must force them to take time off lest the number of stress-related deaths grow even larger.

 There are reports that the French national railway system (SNCF) has spent billions to purchase new rolling stock for passenger trains. Alas, it turns out that the new cars are too tall for the existing station platforms. The answer, of course, is to throw even more money at the problem by lowering said platforms. In America we prefer direct injections of money into the economy, about which we shall have more to say anon.

 In the sporting news, Wrigley Field turned 100 in April. To celebrate the occasion as only the Cubs could do it, the team blew a three-run lead and lost to the Diamondbacks, a squad that this season appears to be worse than even the woeful Cubbies. It could not have gone more true to form if it had been scripted.

 Considering all of the abuse hurled in the direction of various Vanderbilt athletic teams in these pages over the years, we feel compelled to note that this year’s baseball team won the College World Series, thereby securing the school’s first national championship in a revenue sport…ever. A certain curmudgeon was in the stands in Omaha with tears of disbelief in his hoary eyes as he watched the Commodores emerge victorious. They might not have been the best team (Virginia gets our nod on that score) but they were definitely the grittiest.

 We have an abiding interest in economic and market cycles and in various indicators that are designed to give one a leg up in divining the ebbs and flows thereof. We have a special affinity for some of the more esoteric indicators that, while not of rigorous analytical origin, are nonetheless interesting by their very nature. Among these is a measure of animal spirits known as the Hemline Indicator. The idea here is that rising hemlines are indicative of rising expectations that, in turn, produce higher stock prices. When hemlines plunge, or so the thinking goes, stock prices follow suit.

 Ever vigilant for insights to aid our readership, we recently visited a mall to do some window shopping in the name of research. Of course, we totally dismissed ogling the displays in the windows of Victoria’s Secret as we did not wish to appear “creepy” to our fellow mall walkers. (Well, okay, we did take just a quick peak.) What we saw in the more mainline retailers’ windows, moreover, was rather astonishing. Next to a mannequin sporting hot pants (Buy! Buy!) was another outfitted with an ankle-length skirt that featured a slit up to the hip (Sell! No, wait! Buy! No, uh…).

 As disconcerting as those observations were, the worst was yet to come. We have seen hot pants and slit skirts before and have even commented upon same in these pages. In the very same window, however, was something we have never encountered – a mannequin wearing a skirt that was scooped to mid-thigh in front and dropped to mid-calf in back. Good grief, what is one to make of THAT?

 Completely disillusioned by the esoteric, we decided to return to the mainstream and take a gander at the City Hall Indicator. This is based on the hoary adage, “You can’t fight City Hall.” In the economic and financial arenas, City Hall is the Federal Reserve and going against the grain of their current policy is usually unproductive at best. Easy money typically leads to higher risk asset prices and tight money usually produces bear markets in same.

 We have noted in recent missives that our central bankers, in their tireless efforts to take away the punch bowl before the party gets going too good, decided late last year to begin tapering the monthly purchases of government and mortgage bonds that had been swelling the Fed’s balance sheet. Said swelling had kept downward pressure on interest rates and injected excess liquidity into the financial system for quite some time. No doubt the positive returns in risk asset prices since the lows in the spring of 2009 have resulted from the Fed’s largesse.

 A look at our chart of M1 and M2 growth suggests that the word tapering was carefully chosen. There was little apparent change in the growth rate of the monetary aggregates earlier in the year, but, as the process has continued to unfold in recent months, there has been a noticeable, albeit not drastic, slowing of money growth.

 If expanding reserves were good for risk asset prices, logic suggests that slowing reserve growth would take at least some of the steam out of the markets. One must be aware, however, that changes in monetary policy tend to work with a lag, sometimes a rather long one. It is also important to note that the majority of the Fed’s key decision makers still appear to be more concerned with the risk of deflation than inflation, although the balance of power may be shifting toward the latter. Hence, the continuation of the tapering program is not writ in stone.

 We advise enjoying your summer but keeping an eye on the Fed and, perhaps, a finger on the trigger. And, if you are of a mind to do so, pray for the Cubs. Only Divine Intervention can save them at this point.

 Weaver C. Barksdale, CFA

Tension On The Tape

The financial markets spent the first quarter performing their version of “Much Ado About Nothing”. After stumbling out of the gate with a 7% decline over the first twenty-two trading sessions of the new year, the Dow Industrials spent most of February and March backing and filling before a sprint to the finish line left the venerable index just shy of its all-time record closing high. And therein lies the rub….

 The Standard and Poor’s 500 was able to surpass its old closing high and the Dow Transports were able to post a new high as well. The Industrials’ inability to follow suit has, for the nonce at least, set up the possibility of a sell signal from the Dow Theory.

 A substantial majority of forecasters has been calling for higher interest rates in 2014 but the market itself paid no heed as prices edged up and yields declined a bit over the course of the quarter. This occurred despite all of the ballyhoo about the Fed’s “tapering” of its monthly open market purchases of government and mortgage-backed bonds. Even the news that global debt surpassed the $100 trillion mark (billions and billions sold!) was largely ignored. In fact, investors’ (or should it be speculators’?) demand for lower quality debt continued unabated. The lessons about reaching for yield from 2007-2009 have been largely forgotten.

Commodity markets presented a varying picture as agriculture and livestock prices rose while the metals were mixed. Copper, the metal with the PhD in Economics, sold off for the period as a whole but was able to end with a rally. Energy prices were up across the board.

The latter no doubt was due to a prolonged stretch of unseasonably cold weather that fueled demand for energy products while serving to reduce economic activity overall. When conditions improved in the second half of the quarter, there was a snap-back in the general economy. Production fell in January by 0.3% but jumped 0.6% in February. Unemployment claims moved up to 348,000 during the January deep freeze but fell back to 311,000 at the end of March. Finally, the commodity price index dropped to 278 on January 21 before rallying to close near 305 on March 31.

In the sporting news, despite serious concerns about disruptions from protests and/or terrorist activity, the Winter Olympics came off with barely a glitch. Well, there was the problem in the opening ceremonies when one of the Olympic rings refused to open properly on cue. We hope that whoever was responsible for the mishap has plenty of warm clothing as we understand that it can get rather chilly in Siberia.

 While the Olympiad was spared disruption, the ongoing crisis in Ukraine is drawing attention (and tension) from all corners of the globe. Russia’s provocative occupation of the Crimea has led to a potentially explosive situation.

 In other news, there are reports that North Korea is developing a smart phone (better late than never?). We are wondering if it will have an app for launch codes. They do so love to shoot missiles into the ocean.

 Our last bit of miscellany for this issue is that researchers are said to be working on a wristwatch that purportedly will be able to predict one’s lifespan by analyzing clues contained in the epithelium of one’s skin. Apparently the epithelium knows all (please don’t tell the NSA).

 “Tension on the tape” is an expression oft employed by the late Ed Hart, an analyst for the former Financial News Network back in the day. Mr. Hart would opine that such a situation obtained whenever the market was “burning and churning” like it did during the first quarter – a lot of minor fluctuations within a generally flat trend. The suggestion was that, when the tension reached sufficient potency, it would propel the market out of the trading range in one direction or the other. We employ it here because the stock market’s inability to sustain its early downtrend coupled with its failure to break out to new highs in convincing fashion last quarter has left many pondering the old question, “How now, Dow Jones?”

In our last missive we noted that the stock market was exhibiting some of the signs of a bubble top. January’s sell-off let some of the air out of said bubble and, after the market bounced off support in February, it looked like all systems were “go” for a move to new highs. As noted heretofore, a number of stock indices were able to move to higher ground. As they did so, however, fewer and fewer individual stocks were making new highs – definitely a sign of market halitosis (bad breadth).

 Furthermore, as the rally proceeded, most of the indicators of bullish sentiment reached even higher levels than were in evidence at the end of December. Sentiment indicators are contrarian – the idea is that if the overwhelming majority is bullish, they have already acted on that sentiment and there isn’t enough “fuel” left to push the market higher. Hence, the market literally ran out of gas.

 After last year’s strong gains, it could be that we are in for an extended period of backing and filling. At this juncture it is difficult to tell if this is the pause that refreshes after a long bull run from the lows in 2009 or a case of exhaustion to be followed by a sizable correction.

 The Fed has started to ease back on monetary stimulus on the margin. In past cycles that has been a clue to start heading for the exits. Yet at present the central bank really isn’t making credit scarce so much as it is merely mopping up some of the excess liquidity left over from what was by far the greatest monetary expansion in history.

 Furthermore, economic growth appears to be picking up somewhat. Commodity prices, like stock prices, are pushing against upside resistance. If the commodities can break through, then stocks may well follow.

 On the other side of the ledger, the financial stocks have been lagging the general market for some time (see chart below). That typically leads to trouble for the general market but the lead time can be long and variable.

Instead of trying to pick the trend, perhaps the best play now is to go long volatility. In this scenario one makes money no matter in which direction the break of the trading range occurs. There are, of course, no free lunches so one can lose money if the trading range extends. As Ed Hart was also fond of saying, “We shall only know in the fullness of time.”

 

Weaver C. Barksdale, CFA

Bubble Bath?

Anyone who started out 2013 with a case of triskaidekaphobia (fear of the number thirteen) was likely to have ended the year with triskaidekaphilia unless, of course, they were of the ursine persuasion. The Dow Jones Industrial Average soared almost 27% before dividend reinvestment - an impressive achievement given all of the uncertainty about monetary and fiscal policy and an economy that looked fragile at best through much of the year. Then again, the hoary adage that “bull markets climb walls of worry” encourages one to wish for more of the same in the coming year.

Alas, the glad tidings did not extend to most other investment arenas. The precious metals were the mirror image of the stock market as gold suffered its largest decline (-28.7%) since 1981 and silver plunged 36.6%. Commodity prices in general were down for the year as the CRB Index fell five percent. There were exceptions, however, as crude oil prices registered modest gains. Copper prices, while down for the year as a whole, were able to hold above critical support at the $3.00 level and stage a rally in December.

In the fixed income sector, Treasury yields rose across the board as bond prices fell in anticipation of stronger economic growth and an end to the Fed’s massive stimulus program. The high yield sector, however, took its cue from the roaring stock market and posted modest price gains as yield spreads dropped to near record low levels.

After rather feeble growth in the first half of the year, real GDP spurted 4.1% (annual rate) in the third quarter. The stronger growth appears to have continued into the fourth quarter albeit at a somewhat slower pace due to the government shutdown in October. Auto sales were the strongest since 2007 and housing activity continued to move erratically higher.

The most critical component of the economy - the jobs market - also showed growth but at a pace that is not consistent with 3% GDP growth, much less 4%. Non-farm payrolls gained a little over 200,000 in October and November - a level more in keeping with GDP growth with a 2% handle. The most sensitive

indicator of employment conditions - weekly new claims for state unemployment insurance benefits - was quite volatile during the fourth quarter. The influence of the shutdown was apparent when claims spiked to the 370,000 level in October after beginning the quarter at 300,000. Following the shutdown they dropped temporarily below 300,000 before moving back up again to around 340,000.

If the economy has truly moved to a higher rate of growth, claims should fall back to and below the 300,000 level in the coming weeks. If that does not occur, we would expect first quarter GDP growth back in the 2% area.

Although inflation, as measured by the CPI, remains below the Fed’s purported target rate of 2%, the central bankers nonetheless elected to start tapering the monthly purchases of government and mortgage-backed bonds from $85 billion to a mere $75 billion. Hence, the rehabbing economy is going to go through a measured withdrawal rather than a regimen of cold turkey. We suspect that it will take a year or more for the Fed to reduce the bond purchases to zero. Meanwhile, wonder of wonders, Congress passed a budget and the President signed it. No doubt said budget does very little to address long-term problems but, hey, this is the first sign of cooperation since Ronald Reagan and Tip O’Neill got together for cocktails back in the ’80’s. It must have been the holiday eggnog this time around.

In the Sporting News, the Titans failed yet again to make the playoffs and, along with several other NFL teams, decided to fire their coach. Mike Munchak, however, needn’t be overly concerned about long-term unemployment. NFL coaches play a continuous game of musical chairs and fired coaches always seem to pop up somewhere else in short order. In the college ranks, the formerly hapless Vanderbilt Commodores, however, have a different problem. After back to back nine-win seasons for the first time in history, it seems that just about everyone is after their coach. 

In science news, it turns out that Chicken Little was right. A large bolide (meteor) exploded over Russia last year causing multiple injuries from broken glass. While NASA and others have identified thousands of Earth-orbit crossing asteroids (very large space rocks) similar to the one suspected to have led to the extinction of the dinosaurs, there are millions of these smaller sized rocks out there that could hit us at any time. We expect legislation any day declaring the planet’s surface to be a Hard Hat Area.

What do Ben Bernanke and the late Don Ho have in common? They share an affinity for the tune, “I’m forever blowing bubbles.” Well, okay, so the actual name of the song is “Tiny Bubbles.” That might have been okay for Mr. Ho but Mr. Bernanke did things on a much larger scale during his tenure as Fed Chairman.

Lately there has been a growing debate about whether the stock market is at or approaching bubble status, a debate no doubt fueled by last year’s outsized gains and the fact that the Dow, for example, is up 155% since the low in March of 2009. The bulls, on the one hand, suggest that current valuation levels are not excessive based on historical averages. The bears point to sentiment indicators that are at or near record bullish levels. Contrary opinion, in their view, would imply that a substantial correction should ensue.

Sentiment indicators reflecting the opinions of market analysts hold little currency with us (to paraphrase Grouch Marx, I wouldn’t want to belong to a club that would take me as a member). We are much more persuaded by data based on where one puts one’s money. Along these lines one of the most troubling indicators is the all-time record high level of NYSE margin debt. Bubbles require air and debt is a vehicle for producing a lot of air. It has equal puissance as a vehicle for deflation. Hence, with equity prices being supported by an enormous amount of debt, there is at least a risk of a rapid deflation of stock prices.

Stocks, moreover, are not the only asset class to have attained record levels:

The Scottsdale and Monterey classic car auctions totaled a record $535 million in 2013 (the 2003 total was $73 million);

A 59.6 carat pink diamond sold for a record $83 million; Two NYC taxi medallions sold for a record $2.5 million;

France’s oldest charity wine auction raised a record $6.8 million;

A record $474,000 was paid for a case of red burgundy wine (that equates to $300,000 per gallon, and we gripe about $4.00 gasoline).

We could go on and on but feel assured that the reader has gotten the point by now.

Hence, while the potential exists for the bubble to burst, it is not clear what might precipitate said bursting. The usual suspect is the Fed, which has a history of following overly generous monetary expansion with overly stringent monetary policy. The rather frothy price gains noted above appear to suggest that recent monetary policy might have been overly stimulative, but what has been a boon for various asset classes has yet to translate definitively to the economy in general. The central bank, therefore, is much more likely to be overly cautious this time around as it begins to rein in money supply growth.

The word “taper” was chosen very carefully. The initial $10 billion cut in monthly bond purchases appears to be a relatively modest step toward reining in credit growth. While the economy can be very sensitive to any kind of change on the margin, the first sign of renewed economic weakness in the months ahead will likely bring an end to or at least a pause in the tapering process. The hope is to let some air out of the bubble in a controlled manner and avoid a puncture that could result in a sudden deflation.

Meanwhile, best wishes for a happy and prosperous new year, and be especially careful around sharp objects. 

- Weaver C. Barksdale, CFA

“Every bull market has a copper top”

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“Every bull market has a copper top.” - Old Wall Street Adage

“Does she or doesn’t she?” was the question posed by Clairol ads in the days of yore. Nowadays the most popular question posed by the financial media is, “Will they or won’t they?” The “they” in question are the members of the Federal Reserve Board and the “will or won’t” refers to action taken to taper or eliminate the current round of Quantitative Easing – some $85 million per month in purchases of government and mortgage-backed securities. On September 18 it was announced that “won’t” is the operative word, at least until the October meeting.

In times even more olden than the Clairol ads, Groucho Marx hosted a television game show entitled, “You Bet Your Life.” At the start of every show a “secret word” would be revealed to the audience. If one of the contestants mentioned said word on the air, they would win $100 – a not inconsiderable sum back in the day. The word “won’t” had a similar salutary effect on September 18 as the Dow rallied to a new all-time record high. As we noted in our last missive, this “junkie” stock market quite likes its monthly monetary “fix.”

Once the news was out, however, the market closed the month by selling off in seven of the last eight trading sessions. Earlier in the quarter stocks had rallied into early August and then had fallen back in a Dog Days correction before the rally to historic highs commenced. It seems that 15,000 has been something of a magnet for the Dow of late, much like 12,000 was way back in, um, last year. In any event, the net for the quarter was a 1.5% price gain that brought the year- to-date return less dividend reinvestment to a handsome 15.5%.

“Won’t” in this context, of course, is a four-letter word for the crabby sorts over in the fixed income sector who much prefer hard money and hard times. Hence, the misanthropes pushed market interest rates higher despite the Fed’s intention to keep them low. This was, however, insufficient to deter Verizon from bringing to market the largest corporate bond offering on record – a whopping $49 billion that was almost three times larger than Apple’s $17 billion issue in April.

Commodity prices rallied during the quarter and produced a 3.6% return, thereby dwarfing the results in the financial sector. A possible fly in the ointment was that commodity prices did not rally back to record highs as stock prices did. In fact, most commodity prices topped out two years ago – a subject that we shall opine upon anon.

Once again the revisionist historian Beltway bean counters have changed the past. Back in April they told us that first quarter GDP growth was an annualized 2.5%. In July they informed us that, no, it wasn’t 2.5% but 1.1%. Hmm. At the same time they announced that second quarter growth was 1.7%, a number that has since been revised to 2.5%. Yet again we say “hmm” because those percentage errors represent a heckuva lot of beans. Maybe they should consider a name change from the Bureau of Economic Analysis to the Lost and Found Department. And to think that the financial press is bemoaning the fact that the government shutdown is depriving them of more of this quality data. For our part, all that we will miss is the comic relief.

Some of the other, uh, data indicated that a rebound in production occurred late in the quarter after a bit of a slump in the spring. This appears a bit curious given that personal spending has been pretty weak of late. Then again, a large part of that upward revision to second quarter GDP was accounted for by an increase in inventories. That typically is not a good thing unless consumer spending is on the verge of an upturn. Alas, that doesn’t appear to be very likely. Despite the elation on Wall Street, Main Street is still feeling some pain as personal income growth has been meager and sentiment measurements are reflecting consumer reticence.

There may be a ray of sunshine in the offing, however, as initial claims for state unemployment insurance benefits have recently fallen to multi-year lows. This is an important leading indicator for both the jobs market and the general economy. The $64 question (yet another prehistoric game show) is whether this decline is the result of a bona fide cutback in layoffs or if instead it is reflecting the declining labor force participation rate resulting from job seeker frustration.

In the sporting news, the Cubs should consider changing the name of their stadium form Wrigley Field to The Revolving Door as dozens of different players were shuffled in and out of the lineup during the season to no avail. The string of consecutive years without a World Series appearance has now stretched to sixty- eight. The only solace is that their woeful 66-96 record was actually three games better than the crosstown rival White Sox’s. Pale Hose, indeed.

These pages have long noted the importance of commodity prices as leading indicators; hence, the market adage cited earlier. Our praise for market- determined indicators stands in sharp contrast to our disdain for statistics provided by bureaucrats. Copper has been hailed as “the metal with a Ph.D. in Economics” because the trend of copper prices historically has peaked before business cycle downturns and turned up before economic recoveries.

We bring this up because, as noted heretofore, commodity prices, including copper, have not achieved new highs this year despite many stock indices having done so. In fact, copper topped out in 2011 just under the $4.50 per pound level and recently has been trading just above the $3.00 level that appears to be an important support area. Given copper’s history, one would presume that stocks are at or near a peak from which a correction of at least moderate proportions might be expected.

To this we say, maybe, maybe not. Two years is an awfully long lead time and makes us wonder if some sort of disconnect has occurred. Although there are a number of reasons to suspect that a stock market correction could be at hand,

there are also reasons to question that copper’s efficacy as a leading indicator may be waning. The deindustrialization of America has been occurring for several decades. Ours is now a predominantly service-based economy wherein industrial commodities like copper have reduced relevance.

A close look at what is called the Dow Jones Industrial Average is revealing. Last month the venerable index was revised with Goldman Sachs, Visa and Nike being added while Bank of America, Hewlett-Packard and Alcoa were deleted. Following this change, thirteen of the Dow’s thirty components are either service-based, retail or financial companies. There are only maybe ten or eleven companies left in the Dow that are consumers of copper in any significant way.

Does a metal that appears to have a greatly reduced relevance in a post-industrial economy have any relevance as an economic indicator? Perhaps less so than in the past but we are not quite ready to entirely dismiss copper’s puissance. It certainly is relevant for China, a place where stuff containing copper is still being made. This is important because the Chinese hold an enormous amount of U.S. government debt paper. If China catches cold, there is a chance we could get pneumonia. Furthermore, the Chinese banking system is, if anything, more highly leveraged than our own was before the late unpleasantness. Hence, should copper drop significantly beneath the $3.00 support level, it might be a good idea to look for a solid piece of furniture under which to duck.

- Weaver C. Barksdale, CFA