The world no longer worries first and foremost about the products corporations make or the services they perform. Rather, it is focused on the amount of easy money the central banks can dish out. – John Mauldin, 8/17/13
Stocks had a strong five weeks going into last week as concerns over the Federal Reserve tapering had seemed to fade. Income-oriented securities such as bonds and REITs stabilized at lower levels, and some of the money that flowed out of those sectors has gone into more economically sensitive areas. Technology, biotechnology, aerospace/defense and media have been the best performers. Whatever you think of the long term implications of quantitative easing and other central bank actions, in the short run it has created an environment that is conducive to risk taking because credit continues to be plentiful. Any hint that the “punch bowl” is going to be pulled away gets met with selling, which frightens the Fed (because interest rates have already moved up enough to wipe out all of the profits on their bond buying operations) so they back off. Nothing emboldens a trader more than the idea that the guy on the other side of the trade has no good options.
That said, valuations have become less attractive with prices higher. One way of looking at valuation says that on the basis of very low borrowing costs, ample liquidity, and record high profit margins stocks are fairly valued. The counter argument says that massive liquidity, low rates, and high margins all occurring simultaneously is an aberration and the eventual loss of one or more of these pillars will bring considerably lower prices. Meggan Walsh of Invesco sums this up well:
“While we’re still finding attractive “appreciation” investments, they were more plentiful earlier in the current cycle. Today we see unattractive risk-reward profiles in more cyclical businesses. Much of our research focuses on “normalized earnings power” — what a company can earn across a full market cycle. We’re well past the early stages of this cycle, so it’s important to avoid paying for cyclically peak earnings or margins. But that’s fairly difficult now because US companies have efficiently managed their costs and balance sheets in recent years, leading to 30-year highs in operating margins.”
The cyclical nature of markets has been on my mind a lot lately, because I know we can’t stay in the currently favorable financial environment forever. Change will come, and it is hard to imagine that it will bring about an environment that is more favorable for risk assets than this one.
At the margin, investors are reducing interest rate risk in their bond portfolios and substituting credit risk. The idea is cyclically sound; interest rates are rising as the economy recovers and the demand for credit increases while default rates continue to be low as credit is still affordable and available. This trend becomes dangerous as it progresses, however, because at some point the economy peaks and then defaults rise and one’s bond portfolio moves in the same direction (lower) as one’s stock portfolio.
I am hearing a several fund companies recently stressing the attractiveness of European stocks. The arguments are as follows:
- Very reasonable valuation compared to the U.S. AND compared the average valuations for European stocks;
- Yields that are 80% higher on average than U.S. stocks (3.8% vs. 2.1%)
- Economic policies turning from austerity to growth
Europe is not going to sidestep any recession in the U.S. or Asia, because these countries are much more dependent on exports. Europe is a good story if (and only if) the global recovery continues because the yield and valuation advantages are real. Expect some relative outperformance near term, but the long run problems are real and could resurface as soon as we get into election season (which for Germany is September)
There are signs of stress emerging in stocks averages in terms of overall breadth. Few stocks are participating in the rallies. This has not reached levels that are alarming, but from a seasonal standpoint, you worry more about reversals than you would if you saw these same signs in March, for example.
Federal Reserve Policy
I believe the Federal Reserve will surprise investors next month by what they DO NOT do. Long term Treasuries are a “falling knife” right now, but I think they might be a very good investment in the next month or so.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money.