Wednesday, February 5, 2014
The first month of 2014 has proven to be:
a) A normal pause in an ongoing bull market
b) The result of the Fed’s reduction in bond purchases (tapering)
c) All about the growing weakness in emerging markets
d) The beginning of the next great bear market
e) All of the above
f) None of the above
US Stocks were lower: The Dow Jones Industrial Average (DJIA) fell 5.3%, the S&P 500 lost 3.6%, The Russell 2000 fell 2.8%, and the Nasdaq Composite lost 1.7%. Real Estate, Utilities, and Health Care are the best performing sectors in 2014 while Energy, Consumer Discretionary, and Consumer Staples have been the weakest.
International stocks followed US stocks lower with the Emerging Market Region significantly underperforming: The Dow Jones Global Ex-US index fell 4.3%, the European-heavy STOXX 600 pulled back 1.7%, the Developed Market Region fell 3.6%, and the Emerging Market Region lost 6.9%. Looking at major international markets, the Japanese Nikkei is down 8.5% with only Russia (-9.2%) and Turkey (-8.8%) underperforming the Nikkei among the major international markets.
Bonds have rallied: as stock markets pulled back, investors once again turned to bonds. The Barclays Aggregate US Bond index is up 1.48% for 2014 erasing a sizable portion of the loss incurred by this key bond index in 2013. The US 10-year Treasury yield continued to fall closing Friday at 2.645% down from 3.03% at the end of last year. The most interest rate sensitive bond sectors like long government, long corporate, and preferred stock have been the best performing sectors in 2014.
Commodities continue to remain weak overall: The Dow Jones UBS Commodity index gained 0.3% in January primarily on the strength of Natural Gas (+17.9%) and Heating Oil (+6.6%). Gold added 3.5% to finish January at $1245.60 per ounce while WTI Oil fell 1.1%. I believe Natural Gas and Heating Oil have rallied as demand in January surged due to the bitter cold that has swept over much of the country. Gold rallied, in my view, on the general fear of some investors, and WTI Oil has lagged because of concerns about global growth.
Given all that we know today, the answer in my opinion is: A—a normal pause in an ongoing bull market.
Let me provide you a list of some of the key data that I base my opinion on.
1) The first estimate of the real 4th Quarter Gross Domestic Product (GDP) came in at 3.2%. The number would have been higher except for a significant pullback in government spending (a good thing in my view). Additionally, the Price Index (my preferred measure of inflation) grew at a subdued 1.3%. While growth should be better, the economy is still moving forward despite government-induced structural headwinds.
2) Government spending as a percent of the economy has fallen significantly over that past three years. This is important because I firmly believe that the government does not utilize dollars as efficiently as the private sector, and when government spending grows, the output of the private sector falls.
3) The trouble with emerging markets has been underway for more than a year. This is not a new phenomenon; however, some countries like Argentina and Venezuela have reached tipping points where government policies require change or else hyperinflation will set in and severely hurt the middle class. My relative strength data has signaled that emerging markets were underperforming developed markets since September 2011.
4) The jobs picture remains ok. I did not say great because there remains a lot of trouble with the longer-term unemployed and the increasing numbers of workers who have given up looking. However, with the recent termination of permanent long-term unemployment benefits as part of the budget deal early this month, expect to see a number of people move back to the employment rolls. Additionally, with the economy continuing to grow at a steady basis, look for job growth to continue as well.
5) Housing is in a long-term positive trend. Shaking off the housing bubble in 2008 has taken years to accomplish, but that is what has happened. Like other markets, this recovery will not be in a straight line upward, but a positive trend is in place.
6) The energy revolution has taken hold. This is and will remain one of the most important factors of long-term growth in the US economy. Energy creates jobs both in the oil sector but also in manufacturing sector where low energy prices can make a huge difference in manufacturing costs. Lower energy prices mean more money in the pockets of consumers and that helps everyone. Energy has the potential to be a positive force force in long-term economic growth over the next twenty or thirty years.
With the positives comes the negatives, and how these negatives work out can help determine how quickly markets get back in a winning direction.
At the top of my list of concerns is a dysfunctional Washington. I just have not seen enough out of our political leaders to give me confidence that they will tear down some of the barriers to strong economic growth. My concerns deal with the impact of rising premiums and deductibles resulting from Obamacare on the average American family’s budget, no Keystone Pipeline, the never-ending stream of regulations foisted on the private sector, and the potential battle of the debt ceiling later this month. Much of this has been underway for several years and the private sector has withstood the challenge, so I anticipate 2014 will be the same.
I have delayed publishing my Market Update and Commentary by about a day due to the market turmoil yesterday (Monday). The DJIA was off 326 points and registered a 2.1% drop. The S&P 500 fell 2.3%, the Nasdaq fell 2.6% and the Russell 2000 dropped 3.2%. That is volatility! It has pushed most indexes down more than 5% for the year. Most of the reporting is suggesting that the drawdown continues to focus on fears of a global growth slowdown. Emerging markets are contributing, but even here in the US, a key manufacturing indicator showed an unexpected reduction in the rate of growth for January. The Employment Situation report coming out this Friday will again take on extra significance due to this perceived contraction of growth expectations.
International stocks currently rank number two of the six asset classes. However, I strongly advise against owning the Emerging Market region and suggest continued focus on the Developed Market region—especially Europe.
Finally, after the big sell-off to start out the week, there have been some pundits suggesting that the Fed should either suspend the purchase of bonds (suspend tapering) or even go back and buy bonds outright and reverse the past two policy moves by the Fed. In my opinion this would be a terrible mistake because the Fed would be signaling investors that they believe our economy is too weak for more normalized monetary policy. Therefore, I do not believe the Fed will change its current course and continue reducing bond purchases.
My next Market Update and Commentary will be published around February 17th.
Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
NTrust Wealth Management
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Emerging market investments involve higher risks than investments from developed countries and involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation. The main risks of international investing are currency fluctuations, differences in accounting methods, foreign taxation, economic, political, or financial instability, and lack of timely or reliable information or unfavorable political or legal developments.
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Posted by Paul Merritt at 1:29 PM