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  • Volume I, Issue 9

LGR Financial Newsletter

Volume I, Issue 9 (Released On April 10, 2014)

Hello all! I would just like to say that I will continue to send the newsletters by email for the immediate future, but my hope is that you will continue reading my newsletter in the new blog format.

This week the S&P 500 and DJIA reached a new high, and when any new high is reached it becomes important to ask the question: “what’s next?” This Issue is designed to help us answer that question together because, in all honesty, neither I nor anyone in the financial sector know for sure what’s going to happen next.  All we can do is collect as much information as possible and try to come up with a well-informed analysis.

On the docket for this Issue: a summary of the market’s performance, my portfolio update, a market update (focusing only on the biggest news stories), and a write-up on market timing. The major write-up this week will include a lot of charts that present some truly fantastic visual representations of data I talk about. Just to get it out of the way now, the data shows a very scary picture of financial markets at this point, although it doesn’t have to end up as bad as the data would have one believe (and it probably won’t be! due to Fed intervention of course). Also, nothing is “certain” when it comes to the stock market, so although the data I present shows a lot of bearish conditions underlying the current bull market, at best this data is probably useful for helping you make a prediction with 60% (or perhaps more depending on your trading horizon) accuracy. However, being right 60% of the time is very good when it comes to the stock market (considering 90%, or more, of short-term to intermediate-term traders lose money) and many industry professionals only have a “batting average” of 60% anyway.  Bottom line: better than throwing darts.

In short, in my write-up on market timing I focus on data that will help you predict future market direction as accurately as most industry professionals.  As always, I appreciate all feedback and any recommendations for topics.

 

Summary of Market’s Performance This Week:

(MARCH 31 – APRIL 04)

As mentioned above, both the S&P 500 and the Dow Jones Industrial Average (DJIA) reached new highs this week; the S&P 500’s new high was 1,897.28 (just shy of 1900!), and the DJIA’s high was 16,631.63. Both the S&P 500 and the DJIA peaked on Friday then headed much lower, to end the week with only modest gains, while the NASDAQ Composite was the worst performer of the group and had its biggest daily decline since February 03, 2014. The DJIA outperformed the other two major indexes for the week, rising 0.55%; the S&P 500 was not far behind though, with a gain of 0.40%. The NASDAQ Composite declined for the second week in a row, this time by 0.67%. When looking at the daily performance of all three major indexes, it is important to note that Friday was the worst trading day and all three suffered severe declines on that day; with the S&P 500, DJIA, and NASDAQ Composite sliding 1.25%, 0.96%, and 2.60% respectively. Biotech companies dragged the NASDAQ Composite lower, with the Nasdaq Biotechnology index falling 4.1% to its lowest close since January 6 on Friday (WSJ, Link #1). Keep in mind what I mentioned in my last issue: the indexes usually move together, so the NASDAQ Composite’s continuing decline could be an early warning signal for more weakness to come for the other two major indexes following Friday’s decline.

In contrast to Biotech: Telecommunications and Consumer Staples have outperformed other sectors recently, as they “benefited over the past month as hedge funds and other investors have pulled back from biotechnology and other so-called momentum plays” (WSJ, Link #1).

 

Portfolio Update:

(MARCH 31 – APRIL 04)

This was a much better week for my stimulated stock portfolio. The value increased 0.94% this week, which was great to see because the benchmark index that I compare my portfolio’s returns to (the S&P 500) only went up 0.40% and outperformance is my goal.

Ironically, many of my top performers were Biotech companies, and that shows the importance of stock picking and how beneficial it can be when one picks companies that outperform their peers. I currently own four companies in Biotech, and the Healthcare sector has the second highest allocation of capital in my portfolio (the sector currently accounts for 15.25% of the portfolio and I own shares of five companies in the sector). Three of the four Biotech companies I “own”; Questcor Pharmaceuticals, Inc. (NASDAQ CM: QCOR), Amgen, Inc. (NASDAQ GS: AMGN), and Gilead Sciences, Inc. (NASDAQ GS: GILD) significantly outperformed the NASDAQ Biotechnology industry with weekly returns of 9.26%, -1.19%, 5.32% respectively versus the NASDAQ Biotechnology index’s return of  -1.66%. Only one of my Biotech stocks, Novo Nordisk A S (NYSE: NVO), underperformed the index, with a weekly return of -2.15%, but that stock has been a leader in the industry with a Year-To-Date return of 19.70%, and my position is currently up 8.15%.

Three other high performers in my portfolio this week: Smith & Wesson Holding Corporation (NASDAQ GS: SWHC); Sturm Ruger & Co., Inc (NYSE: RGR); and Companhia Vale do Rio Doce (NYSE: VALE) with weekly returns of 4.19%, 5.74%, and 5.85% respectively. This is the second week VALE earned status as one of my best performers, and VALE’s return of 5.85% this week follows the stock’s 4.91% return last week. (That’s 10.76% in two weeks.)  JP Morgan recently “lowered its 2014 ore price forecast by 6% to $118 per ton,” mostly due to expectations of lower demand from China, but JP Morgan still likes VALE and believes the company will “generate positive cash flow even at the lower iron ore price” (Barrons.com, Link #2).

Finally, overall my top performer this week was Questcor Pharmaceuticals, Inc. (NASDAQ CM: QCOR) with its weekly return of 9.26%.

 

Market Update

(MARCH 31 – APRIL 04)

My Market Update will be short, deservedly so after last week, because I want to focus on a Write-Up.

Economic Data:

Economic data varied this week, showing positive numbers for some countries and negative numbers for others, but overall I would say that it could have been better.

The Purchasing Managers’ Index (PMI) data compiled by the Hong Kong and Shanghai Banking Corporation (HSBC) showed that China’s manufacturing industry contracted in March, with 48.0 vs. 48.5 expected, signaling the “sharpest fall of output since November 2011” (Forexfactory.com, link #8). China’s PMI numbers have been declining steadily for at least 5 months now, and this is the third month in a row that the numbers have indicated that the country’s manufacturing industry has contracted. This conflicted with China’s “official manufacturing PMI” reading of “50.3 in March,” which “beat expectations for a modest decline to 50.1, and is up from a reading of 50.2 in February” (Forexfactory.com, Link #3).

The US trade balance came in at -42.3B vs. -38.3B expected, per the Commerce Department.  (Trade balance is defined as the “difference in value between imported and exported goods and services.”) Exports fell by a larger than expected amount in February. More specifically, the trade gap widened “to the highest level in five months as exports of fuels and capital equipment dropped” (Forexfactory.com, Link #3). The median forecast in a Bloomberg survey of 69 economists called for a further reduction to $38.5 billion. This is all on the export side, however, as imports were little changed.  The deterioration in exports may further depress economic growth in the first quarter, which was already suffering from slowdowns in consumer spending and manufacturing caused by unusually harsh winter weather. However, expectations are that the drop in exports will probably not be sustained as economies overseas (including the euro area) improve. (Bloomberg, link #9)

Unemployment data for this week was poor, with a larger than expected number of unemployment claims (326K vs. 319K expected), and unemployment data for the month was mixed. On the positive side, the Labor Department announced on Friday that unemployment “figures for the [past] two months were revised up by a combined 37,000” while “the unemployment rate held steady at 6.7%” (WSJ, Link #4). The unemployment rate actually edged slightly higher than what it was at in February (6.6%), and it failed to stay completely as analysts had expected it to remain at 6.6% (Forexfactory.com, Link #3). The U.S. economy still has not achieved the breakout performance expected by many economists, and latest figures demonstrate a slow grind: Private-sector payrolls hit a record 116.09 million, passing the peak set in January 2008, but they are far below where they would be if the labor market’s trajectory weren’t interrupted. And government jobs remain well short of their high point.  Still, after months of worry over a December/January slowdown, the March report was reassuring. “There is improvement, but it’s gradual,” said J.P. Morgan Chase economist Michael Feroli” (WSJ, Link #4).

News Stories:

High-speed trading, also known as high-frequency trading (HFT), is a form of automated trading that uses algorithms to basically make a large number of trades in very short periods of time and take advantage of arbitrage in stock prices.  How is it possible for HFT firms to make so much money?  Is it because of their algorithms (as they claim) or because they are acting on illegally obtained information? A year ago the FBI launched an investigation into whether HFT firms are engaging in insider trading by “taking advantage of fast moving market information unavailable to other investors,” and the investigation has “picked up speed in recent months” (WSJ, Link #5).  The FBI is looking at whether HFT firms are trading ahead of other investors based on information that other market participants do not know, including the practice of placing a group of trades and then canceling them to create the false appearance of market activity. “Such activity could be considered potential market manipulation by encouraging others to trade based on false orders.” The FBI is also looking at whether HFT firms place orders to conceal transactions based on illegal tips.

Not to be outdone, New York Attorney General Eric Schneiderman is investigating whether HFT firms have gained advantages that aren’t available to regular investors, such as access to superfast data feeds (WSJ, Link #5).  It is unclear as of yet whether these investigations will be fruitful, but I think it is very unlikely that HFT will cease altogether. In fact, we should look to the impact stopping HFT would have on the stock market, because in recent years it has accounted for an increasing percentage of the total trades on all major stock exchanges, and provides investors with necessary liquidity.

As I’m sure most of you know, the new CEO of General Motors, Mary Barra, appeared before a House subcommittee on Capitol Hill to answer questions about why the company waited 10 years before recalling cars with faulty ignition switches. The ignition switch that, “according to documents submitted by GM to lawmakers,” apparently “would have cost just 57 cents” has been linked to the tragic deaths of 13 people in traffic accidents, and is now going to cost the company significantly more (CBS New York, Link #6). Thankfully the problem is being handled, and since February 2014 “GM has recalled 2.6 million cars over the faulty switch” (CBS New York, Link #6). Mary Barra offered her sincerest apologies, but that will not be enough for most people and GM will most likely receive very heavy fines, especially considering the fact that Toyota recently settled for $1.2 billion after the U.S. government investigated whether Toyota cars had a defect that caused them to accelerate unexpectedly.

As discussed last week, this Wednesday Amazon “unveiled a set-top box for streaming video and games,” and by doing so they entered a highly “competitive market dominated by Apple Inc., Roku Inc., Google Inc. and others” (WSJ, Link #7). The set-top box, named “Fire TV,” is Amazon’s first step into new markets through a device that delivers streaming content straight to televisions across the country. Strategy Analytics, a powerhouse market researching company, announced that “sales of streaming media devices such as Roku are expected to grow 24% this year,” and currently Strategy Analytics has “Apple today [leading] the market, followed by Roku and Google” (WSJ, Link #7).

Do you think Amazon can compete in this extremely competitive market? One thing that my coursework at Boston College has taught me is the importance of turning data into useful information. Through its normal business operations Amazon has collected a large amount of data on consumers’ preferences regarding streaming devices. Amazon Kindle VP Peter Larsen said as much at a presentation in New York: “We hear about what’s working and we hear about what’s not working” (WSJ, Link #7). If Amazon harnesses data on sales, there is every reason to believe they can successfully leverage data on streaming.

Goldman Sachs Group Inc. will soon sell a trading business on the New York Stock Exchange (NYSE) to Dutch firm IMC Financial Markets. Goldman bought Spear Leeds & Kellogg when it was the largest so-called specialist firm on the NYSE, a major force in U.S. equities trading. Its traders, called specialists, provided quotes for buyers and sellers of stocks throughout the day to facilitate trades, capture the spread between bids and offers on thousands of trades a day and “were obligated to step in with their own capital when there were big imbalances” (WSJ, Link #8). As far as investments go, this one was terrible. Less than 15 years ago, in 2000, Goldman Sachs paid $6.5 billion for the business, “which included a division that puts buyers and sellers together on the floor of the NYSE” (WSJ, Link #8).  Now computerized trading has made the “floor-based model” obsolete.  The current negotiations for the sale are at a mere $30 million, representing a 99.54% decline in value – does that define “nuisance value” for Goldman? The deal reflects “the dramatic changes that have transformed U.S. markets since Goldman made the initial deal” (WSJ, Link #8). The decline reflects the market’s transformation in the last decade with the advent of computerized stock quotes.

Interesting news coming from Turkey, where the government decided to “[lift] its block on access to Twitter on Thursday, a day after the country’s top court ruled the ban—imposed by the government in March just ahead of crucial local elections—was unconstitutional” (WSJ, Link #9). Ironically, Turkey is actually “one of Twitter’s top 10 markets with more than 12 million users, although many people were still employing technical workarounds to access the site late into the evening” (WSJ, Link #9). The lifting of the ban will significantly help to free up access to information in the country.

IPO News:

GrubHub Inc., the company whose website allows people to order food from various local restaurants and then generates revenue from charging restaurants a commission, made its stock-market debut on Friday. The stock did extremely well, rising 30.77% to close at $34 after being initially priced at $26.  Analysts loved the company’s rapid revenue growth and emergence as the leader in a potentially huge market. GrubHub estimated in its SEC filings that Americans spent about $67 billion on delivery and pickup meals at mom-and-pop restaurants in 2012. GrubHub’s revenue rose 67% to $137.1 million in 2013. (WSJ, Link #10)

GrubHub’s IPO proves that fast-growing Internet-based companies can still perform well in their IPO, after so many others have struggled this year. In the past two weeks “Candy Crush” game maker King Digital Entertainment Inc., wellness-website operator Everyday Health Inc. and education-software maker 2U Inc. “slipped below their IPO offer prices at times on their respective first day of trading” (WSJ, Link #10).  GrubHub’s initial success indicates the problems with King and 2U were company, not market, based.

 

Write Up On Market Timing:

As mentioned in the introduction: when the market reaches a new high it is important to take a step back and re-evaluate our positions.  How likely is it that the market will continue higher from here? Well, these past 12 months have seen a lot of new all-time highs, giving me plenty of time to think what exactly is driving the market higher and when we should expect a major correction to finally occur.

I want to be ambitious here: I want to identify data that should help explain the market direction moving forward. I will also discuss how to approach “market timing” as a decision. I would love to talk more in-depth with anyone who has any questions after they have read this write-up.  Disclaimer: Just as past results are no predictor of future performance, the conclusions I draw are simply forecasts of what “should” happen based on the data.

Economic Backdrop: Mixed for stocks (short-term bearish but long-term bullish)

The Federal Reserve is expected to allow interest rates to rise as soon as six months after the Fed’s monthly security purchasing program (Quantitative Easing or QE for short) ends. The Fed announced that it will continue to decrease the amount of bonds, and other assets, it buys next month by another $10 billion, to $55 billion in total, despite the still shaky growth we are currently seeing in the U.S. economy. If the Fed continues to taper at the expected rate ($10 billion per month), we would expect an interest rate hike to happen at around mid-2015. When Janet Yellen announced this more definitive date for an interest rate hike, there was a sell-off in the stock market, although the majority of market participants expected an interest rate hike.

The current market environment, therefore, could be summed up as follows: any data giving a hint of the Fed providing more “easy money,” in the form of more QE, is good for the stock market; any data suggesting that the Fed would continue to taper as expected or raise interest rates at all, or even sooner than expected, is bad for the market. This means that any bad economic data indicating any slowing or stagnation of the U.S. economy would be good news for the stock market, because it would cause the Fed to slow their rate of tapering or lengthen the time before they raise interest rates. On the other hand, any good news for the economy is bad news for the market because it would cause the Fed to continue to taper at the same pace, with the expectation of an interest rate hike in the not so distant future.

Why is this scenario long-term bullish for the stock market? Current estimates are that although short-term interest rates will eventually rise, they will still be below long-term averages; meaning that in the long run we can still expect “easier money.” However, in the short term the market reacts negatively to any mention of interest rate hikes, no matter whether the market should have expected those hikes to begin with. Therefore, moving forward, expect that a mention of interest rate hikes made by FOMC officials, the Federal Reserve (in their statements), or Janet Yellen will cause a negative move by the stock market.

Looking at the Past to Predict the Future: What happened the last time the S&P 500 did so well? (not looking good short term to intermediate term)

What does past market data tell us?  The S&P 500’s close on Monday, March 31st, marked the “sixth consecutive quarter the S&P 500 closed higher” (Yahoo Finance, Link #11). I looked at the following chart, which shows the S&P 500’s performance the last five times it had positive returns for six quarters in a row.

image

As you can see, “in the five previous instances in which stocks moved higher 6 straight quarters, the return in the following quarter was negative, sometimes by a lot” (Yahoo Finance, Link #11). Looking at the bottom column entitled “% positive,” there is an indicator for how likely it is for there to be a decline in the indicated time period. Therefore, based on the historical data, we can say that that there is an 80% likelihood that the S&P 500 will decline next quarter, there is a 40% chance that the S&P 500 will decline in the next six months, and there is a 60% chance that the S&P 500 will decline in the next year. Obviously, we choose to focus on the longer-term data (the return over the one year) and we see that magic number (60%) again. Now I think you all might begin to see why professionals have a “batting average” of around 60%….

Looking at the Past to Predict the Future: What is different about this time? 

What is different about this time? Well, investors currently have more debt/margin than they have had at any point in approximately the last 35 years. The following chart is not new, in fact I provided it in a Newsletter about a month ago, but the situation has gotten worse since then and now investors have more debt than they had during either the tech bubble in 2000 or June 2007 (our most recent market meltdown).   Read that last sentence twice.

image

As you can see from the chart above, investors currently have less available cash (more negative net worth) than they had in either 2000 (when the tech bubble took place) or June 2007 (when the most recent financial meltdown took place). Additionally, investors have higher debt balances than they had during either of those two time periods. It is easy to see how having high debt balances and more negative net worth effects the stock market (when one looks at the chart of the S&P 500 at the top of the chart), so we are definitely in extremely dangerous territory right now.

In situations like this, when investors have no free cash and they want to raise liquidity, the only way to raise cash is to sell positions which obviously would trigger a major selloff, as everyone tries to raise cash at once.  This is how margin calls happen.

When these events all happen at once, industry professionals call it a “fire sale,” and the stock market suffers a very quick and violent downturn. However, obviously all these events have to happen at the same time, and much less drastic situations are also possible (and much more likely given the fact that the Fed seems VERY willing to intervene if another market meltdown seems imminent).

image

When looking at the graphic above, one should understand that “The higher the line, the more money is in equities vs. in money markets” (Geoff - Four Pillars Report). Right now, the ratio of “Equity Fund and ETF Assets” to “Money Markets” is at the highest point that it has ever been since 1984.  This chart shows you that investors have a much larger amount of money in the less-liquid parts of the stock market than they do in money markets. This is significant because “money markets” are defined by Investopedia.com as “segment[s] of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year” (Investopedia.com, Link #12).

This provides further evidence to support my conclusion above: investors will need to sell equities to raise cash quickly to pay off debt.

image

The graphic above shows a more interesting and detailed version of the second graphic in this post (that is hopefully easier to understand).

Relating The Macroeconomic Backdrop To The Current Market Environment: How Did This All Happen?

How was all of this allowed to happen? Quite simply because of the Federal Reserve’s “easy money” (dovish) policies. The FOMC allowed interest rates to remain near zero for quite a long time, following the financial meltdown in 2008, to try and boost aggregate demand in our economy by allowing people to borrow money at cheap interest rates and then spend that money and help boost demand for goods and services (through increased consumer spending). That strategy has clearly worked, as our economy has definitely improved since 2009, but it might not have worked quite as well as some Fed officials hoped. Regardless, those low (near zero) interest rates have allowed investors to put larger and larger amounts of money into the stock market, by borrowing money to chase a higher return from the stock market. That has led to the current situation where debt balances are extremely high. I’m sure now you see why investors are so worried about interest rates rising!

For the record, on many official documents and websites the current short-term interest rate in the U.S. is shown as “<0.25%”… Amazingly enough, some people have talked about how the Fed (or the ECB in the Eurozone) should cut interest rates further. I’m not quite sure how that would work, but the “law of diminishing returns” is definitely in affect at this point and that is also why people believe that “easy money” no longer stimulates our economy as effectively as it once did.

How Are We Doing Timing-wise?

I can answer in two words: not good.  I recently received a link to an article that all of you should probably check out, it can be found by following this link: http://www.safehaven.com/article/33230/the-64-month-bubble-pattern

The article talks about how “All the ‘name-brand’ market bubbles in history have lasted 64 months from initial growth to blow-off top. This includes the 3 biggest bubbles in modern market history:

◾the Dow into the 1929 peak

◾the Nikkei into the 1989 peak

◾the Nasdaq 100 into the 2000 peak.”

This is quite a crazy concept, but it is definitely something that everyone should be aware of (although I have never seen any other mention of it before), because our current bull market in the S%P 500 will reach month 64 this upcoming June. The writer of the article, David Nichols, has his own website and clearly he has done some research into the topic, because he has some great charts of how the 64 month pattern has played out in previous bubbles that have taken place throughout history. I encourage all of you to visit the link I gave above to take a look at the charts of past bubbles, and the 64 month pattern, because they really are fantastic to look at.

The author does note, however, that the market could still see some big run ups before beginning to decline in June or July of this year, so he’s not calling for an immediate flight to cash just yet.

Interestingly enough, the person who sent me the link to the article, Geoff, the investor who writes the “Four Pillars” newsletter and is one of the main writers for a blog named the Forbes Magazine “Favorite Trading Blog” (Billcara.com), actually agrees with the 64 month time-frame. Please see the graphic below of Geoff’s own chart for the S&P 500, and when looking at the chart you can see that the S&P 500 is already late for setting what Geoff calls the index’s “Yearly Cycle Low” and “Four Year Cycle Low.” Geoff says that cycles in the market have become extended in time due to QE, which is why the market completely passed his “timing band” and may not even decline in June or July as David Nichols predicts. Regardless, David Nichols is one of quite a few well-known investors who believe that the market is currently over-priced and in need of a correction.

image

Follow this link to see another report from an investor predicting a market decline in the near future: http://blogs.marketwatch.com/thetell/2014/04/03/sp-500-will-peak-around-1900-to-1950-then-drop-30-saxo-bank-strategist/

Full Disclosure: I received the “Four Pillars” newsletter, with the link to the article about 64 month bubbles, on March 26, 2014.

 

My Opinion:

I definitely think that the market is currently overvalued, and that investors are currently over-extended when it comes to their positions in U.S. equity markets, and I believe that the market will probably experience a correction in the near future (of 10-15%). However, I am not quite so sure that the market is currently in a bubble, and I am not so certain that the “bubble” will pop in June or July as David Nichols predicts. I may be inexperienced, compared to these other market timers, but it just seems to me as though this “bubble” is a bit too predictable. When talking to people, who experienced the events personally, about past bubbles I always got the sense that “no one expected it to happen,” and right now it seems to me that too many people are speculating about how the market “might be rolling over.” One thing that I believe to be true about the stock market is that generally when everyone expects something to happen it generally doesn’t happen. I am not so sure that market sentiment is at the point that everyone believes the current bull market will last forever, and because of that I am a little bit more cynical about the prospects of a “bubble popping” in the next few months. However, if the market does experience a huge run up over the next few months then that could definitely lead to the overzealous sentiment of investors that seems to lead to major market corrections.

Additionally, while the S&P 500 seems to be trading at a pretty high trading multiple (P/E ratio), it does not seem as though this current bull market is overvalued enough to warrant a major market downturn (like that happened when many of the past bubbles popped). Again, if the market experiences a major run up over the next few months I would need to re-evaluate my position.

Also, I do not think the Fed will sit idly by and let a bubble pop, so soon after the 2008 financial crisis, so I would expect intervention from the Fed to minimalize potential losses if the market does take a big downturn (which would prevent another major financial crisis).

Now would be a good time for a targeted exit from well-performing equities.

If you have any questions about this Issue of my Financial Newsletter please fill out the form below. I also appreciate receiving any comments you might have about what you just read, and I encourage you to send me ideas for topics that you would like to see me write about in the future. Thank you for reading!

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