Fed taper worries crept back into the market, giving the Dow its second-worst week of the year. Through the close Friday, the Dow fell 1.5%, the S&P dropped 1.1%, and the Nasdaq was lower by 0.8%. Gold showed a little life, rising 0.2%. Meanwhile, oil prices fell 0.9% to $106 per barrel. The international Brent oil, which is used for much of our gas here in the east, closed lower to just under $107.
Source: Yahoo Finance
While the talks of a reduction in stimulus by the Fed played a large part in the decline in the markets this week, there were several other stories that added to the downward pressure. These were also stories that are making us cautious on the direction of the stock market in the longer term.
First, this week we heard increasing chatter out of the regional Fed presidents on the prospects for a pullback in the Fed’s stimulus programs, perhaps as early as September. Most notably, Charles Evans of the Chicago bank indicated a taper was “Quite likely later this year” and possibly occurring in September. This is notable because Evans has been one of the largest advocates for more stimulus, so it is very telling if he thinks a pullback is possible.
Even with these Fed presidents signaling a taper on the horizon, we don’t feel it will happen in the coming months. Maybe by December, but as we’ve discussed often, we just don’t seem to be nearing the targets they laid out (higher inflation, higher employment) to trigger a reduction.
While the Fed and their stimulus was the focus of the market, some other stories caught our attention. The P/E multiple (price to earnings ratio, which is the current stock price divided by its annual earnings per share) of the overall stock market reached its highest level since 2009 and is above its 10-year average. This indicates to us that stocks are not as cheap as many believe.
The P/E ratio has been moving higher as many investors expect higher corporate earnings growth later in the year. Indeed, Factset has reported estimates of 4.3% earnings growth in the third quarter (which was a reduction from the estimates of 6.7% at the end of June). This would be a significant increase from the 2.1% growth we’ve seen this quarter.
As for other earnings stats this quarter, 90% of S&P 500 companies have reported so far, with 72% of companies beating earnings estimates while 54% have beaten revenue expectations. Keep in mind, these expectations have been steadily lowered, so the bar to beat was very low.
The other story making us cautious this week was an article (Link and Link) on record high margin levels in the stock exchange (margin is basically borrowed money used to buy stocks). Margin levels tend to get overly high near tops in the market. The following decline is often very sharp since investors have to sell their stock holdings to pay back the cash they borrowed.
First, this week we heard increasing chatter out of the regional Fed presidents on the prospects for a pullback in the Fed’s stimulus programs, perhaps as early as September. Most notably, Charles Evans of the Chicago bank indicated a taper was “Quite likely later this year” and possibly occurring in September. This is notable because Evans has been one of the largest advocates for more stimulus, so it is very telling if he thinks a pullback is possible.
Even with these Fed presidents signaling a taper on the horizon, we don’t feel it will happen in the coming months. Maybe by December, but as we’ve discussed often, we just don’t seem to be nearing the targets they laid out (higher inflation, higher employment) to trigger a reduction.
While the Fed and their stimulus was the focus of the market, some other stories caught our attention. The P/E multiple (price to earnings ratio, which is the current stock price divided by its annual earnings per share) of the overall stock market reached its highest level since 2009 and is above its 10-year average. This indicates to us that stocks are not as cheap as many believe.
The P/E ratio has been moving higher as many investors expect higher corporate earnings growth later in the year. Indeed, Factset has reported estimates of 4.3% earnings growth in the third quarter (which was a reduction from the estimates of 6.7% at the end of June). This would be a significant increase from the 2.1% growth we’ve seen this quarter.
As for other earnings stats this quarter, 90% of S&P 500 companies have reported so far, with 72% of companies beating earnings estimates while 54% have beaten revenue expectations. Keep in mind, these expectations have been steadily lowered, so the bar to beat was very low.
The other story making us cautious this week was an article (Link and Link) on record high margin levels in the stock exchange (margin is basically borrowed money used to buy stocks). Margin levels tend to get overly high near tops in the market. The following decline is often very sharp since investors have to sell their stock holdings to pay back the cash they borrowed.
As for other economic data on the week, the results were mostly positive. The service sector in the U.S. picked up strength, coming in above expectations. The trade deficit improved sharply as higher oil exports and fewer oil imports helped narrow the gap. Also, weekly jobless claims improved, pushing the four-week average to the lowest level since 2007, although the JOLTs report (which gives a more thorough view of the employment picture) showed the increases in employment have not been as strong as thought.
One last item we’d like to mention, this week Japan had the dubious honor of crossing the ¥1 quadrillion in debt level. Although it is only 10.7 trillion in dollar terms (which is still an extremely high number), terms like “quadrillion” were unthinkable not too long ago. It does cause us to worry about the debt levels around the globe and the trajectory we are on.
Next Week
Next week looks to be a little busier. All eyes will continue to be on the Fed, so the speeches from several regional Fed presidents will be closely followed. On the economic front, we will get info on retail sales, inflation at the producer and consumer levels, industrial production, and housing. There will be a few corporate earnings reports, but the pace of the releases has declined steadily.
Investment Strategy
As we discussed above, we are very cautious on the outlook for the market. The biggest issue to watch for is the pullback in stimulus from the Fed. Since the stimulus programs fueled the rise in stocks, it is only natural to see them move lower on the prospect of a taper, just like we saw with the taper rumors in June.
The thing is, we don’t think they will be tapering in the near future. This may play out again like June, where the market drops on expectations of a taper, only to rise again when the market sees it no tapering imminent. In fact, the technicals right now show we may be due for a short-term pop.
With the market being so focused on the Fed for direction, plus the other concerns we addressed above, we prefer to find undervalued individual names to invest in, rather than the overall market. Technical analysis helps us find those undervalued names while the fundamentals tell us how strong the company is and if it’s worth an investment. We would avoid stocks in sectors with a strong correlation to interest rates. Our timeframe is shorter (looking out a couple weeks or months), so we can keep one foot out the door in case the market turns abruptly.
As for gold, it continues to hang around this current level. If the Fed does announce a pullback in its money-printing stimulus program, gold may move lower. It may be worth a nibble here, but caution is still warranted.
We like other commodities for the long term, especially due to weaker currencies around the globe. A slowdown in global growth seems to be weighing on commodity prices here, so buying on the dips may work with a longer time horizon.
As for bonds, this area continues to receive much attention as yields keep rising (so prices are falling). A short position (bet on the decline in prices) has done very well here but serves only as a nice hedge, not intended to be a loner term investment.
TIPs have performed poorly recently, but are an important hedge as we still expect inflation to increase down the road. Municipal bonds are in the same boat, but will work for the right client. We keep a longer term focus with these investments.
Finally, in international stocks, we are still not interested in developed markets and not totally sold on emerging, either.
Please note, these day-to-day and week-to-week fluctuations have little impact on positions we intend to hold for several years or longer. Our short and medium term investments are the only positions affected by these daily and weekly fluctuations.
This commentary is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Past performance cannot guarantee results.
One last item we’d like to mention, this week Japan had the dubious honor of crossing the ¥1 quadrillion in debt level. Although it is only 10.7 trillion in dollar terms (which is still an extremely high number), terms like “quadrillion” were unthinkable not too long ago. It does cause us to worry about the debt levels around the globe and the trajectory we are on.
Next Week
Next week looks to be a little busier. All eyes will continue to be on the Fed, so the speeches from several regional Fed presidents will be closely followed. On the economic front, we will get info on retail sales, inflation at the producer and consumer levels, industrial production, and housing. There will be a few corporate earnings reports, but the pace of the releases has declined steadily.
Investment Strategy
As we discussed above, we are very cautious on the outlook for the market. The biggest issue to watch for is the pullback in stimulus from the Fed. Since the stimulus programs fueled the rise in stocks, it is only natural to see them move lower on the prospect of a taper, just like we saw with the taper rumors in June.
The thing is, we don’t think they will be tapering in the near future. This may play out again like June, where the market drops on expectations of a taper, only to rise again when the market sees it no tapering imminent. In fact, the technicals right now show we may be due for a short-term pop.
With the market being so focused on the Fed for direction, plus the other concerns we addressed above, we prefer to find undervalued individual names to invest in, rather than the overall market. Technical analysis helps us find those undervalued names while the fundamentals tell us how strong the company is and if it’s worth an investment. We would avoid stocks in sectors with a strong correlation to interest rates. Our timeframe is shorter (looking out a couple weeks or months), so we can keep one foot out the door in case the market turns abruptly.
As for gold, it continues to hang around this current level. If the Fed does announce a pullback in its money-printing stimulus program, gold may move lower. It may be worth a nibble here, but caution is still warranted.
We like other commodities for the long term, especially due to weaker currencies around the globe. A slowdown in global growth seems to be weighing on commodity prices here, so buying on the dips may work with a longer time horizon.
As for bonds, this area continues to receive much attention as yields keep rising (so prices are falling). A short position (bet on the decline in prices) has done very well here but serves only as a nice hedge, not intended to be a loner term investment.
TIPs have performed poorly recently, but are an important hedge as we still expect inflation to increase down the road. Municipal bonds are in the same boat, but will work for the right client. We keep a longer term focus with these investments.
Finally, in international stocks, we are still not interested in developed markets and not totally sold on emerging, either.
Please note, these day-to-day and week-to-week fluctuations have little impact on positions we intend to hold for several years or longer. Our short and medium term investments are the only positions affected by these daily and weekly fluctuations.
This commentary is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Past performance cannot guarantee results.
