At the end of the third quarter the S&P 500 was perched at 16.44% year to date, a stark contrast to where we were at the same time last year at -8.68%. Driving this rally, as we have noted in a handful of these market commentaries, have been the policy measures made by central bankers around the globe. The Fed initiated a massive undertaking with so-called QE3 (or QE4ever as the financial wags put it) by pledging to buy a theoretically unlimited amount of federal debt. That followed on the heels of the aggressive measures announced earlier in the summer by ECB head Mario Draghi to “do what it takes” to shore up the Eurozone. What has ensued is what we refer to as a synthetic rally – a rally that is not being driven by fundamental economic drivers, but rather by policies meant to stimulate the economy.
So why is it important to recognize the difference between a synthetic rally and an organic growth-driven rally? In large part because of the unique nature of the unknowns. Investors, analysts and sundry financial experts alike are struggling to anticipate and make sense of what factors are really driving current market conditions during this policy driven period. With the announcement of QE3, one would have normally expected treasury yields to rise – however, yields have still not reached the already meager levels seen at the beginning of the year. This is a prime example of the lack of rhyme and reason that keeps market observers perplexed as they look for signs of transition back to organic growth and a more “normal” valuation-driven climate.
This transitional period will likely be fraught with the kind of volatility that investors have become (reluctantly) accustomed to over the past 4 years. Contributing to the turbulence will be an unhealthy admixture of political factors and wagers about the unknown, but inevitable, end of spoon-feeding by the Fed. Most immediately the passing of the 11/6 election and pending fiscal cliff loom large, but renewed inflation risk and sharply higher interest rates also lurk in the copses in the not-too-distant future.
A real growth period will announce itself by headline numbers like GDP and unemployment rates – but we may expect fleeting glimpses of the promised land via economic indicators such as consumer confidence and the various housing numbers which, as they start to rise, reflect and also encourage improvement in public sentiment. Current numbers are beginning to show some of these tantalizing glimpses, and that could turn into a high-likelihood case for 2013.
But even if that becomes our likeliest-case scenario we are mindful that the path is not paved nor the way smooth. Many variables remain to play out, starting with an election whose outcomes will very likely be dominating influences in the days and weeks after November 6.
With less than one month to go until Election Day the political narratives are in full swing. Dead-center in the crosshairs of the economic debate is the subject of taxes: what will happen to the Bush-era rates on income and capital gains, what about the payroll tax, Medicare contribution taxes and all the rest that no doubt have the CPAs and tax attorneys of the world busily at work helping their clients make sense of what might happen. The questions that tend to come our way, as investment advisors, is how changes in tax policy may impact investment portfolios and what action, if any, one should take.
Wagging the Dog
When it comes to decisions around taxes the fundamental tenet of our beliefs is this: taxes are the tail, investment policy is the dog. In other words, your investment policy should drive tax decisions; tax decisions, or reactions to changes in tax policies, should not drive investment policy. The tail should not wag the dog. If you have a taxable, non-qualified portfolio then when evaluating two alternative approaches, all else being equal it makes sense to opt for the one that is more tax-efficient. But first make sure that all else is equal. As in: if both alternatives are equally prudent in view of my long-term return objectives, risk tolerance and other relevant considerations, and alternative A is more tax-efficient than alternative B, then alternative A is the right choice. That’s how to make investment decisions around taxes. Pay attention to those operands “if, and, then” – because they matter.
Uncertainties and Probabilities
Here’s how not to make investment decisions around taxes: make decisions today, irrespective of whether they are in line with your investment policy, because of tax policy changes that might happen tomorrow. Right now there is a great amount of uncertainty. We don’t know who is going to win the presidential election, who will be in control of the Senate or the House of Representatives, or what margin of control the majority parties have to work with, or any number of other variables that will influence how tax policies are fashioned. We don’t know what dynamics will be at play as opposing sides try (or not) to reconcile their differences to avoid the “fiscal cliff”. The possible outcome generating much of the debate among investors about what to do is the long term capital gains tax, which could go back up to 20% from the 15% level that was established as part of the Bush cuts in 2003.
In our opinion there is a logical way to address this question, which is simply this: If your investment policy doesn’t contemplate any necessary asset sales that would trigger a long term capital gains tax event, don’t create asset sale mandates just to “lock in” a 15% rate. However if, in the context of your overall asset planning and income generating plans over the next twelve months or so, you identify asset sales that are likely to take place, and you are relatively indifferent as to the timing now or one year from now, then perhaps it makes sense to think about selling when you are certain about what the capital gains rate is rather than when you don’t know what it will be. That’s prudent, and that is wholly in line with investment policy dictating tax actions – the dog wagging the tail, as it should be.
Election season brings out the snake-oil salesmen and Chicken Littles of the world, running around with hyperventilating headlines about how the sky is falling and you have to act now. Nonsense. Successful investors are the ones who ignore the breathless hype and stay disciplined and patient.
Every month for the past three years, economists and financial professionals everywhere have waited with bated breath to hear the U.S. employment reports – economic indicators that offer insight into the current economic state of the country. Lately though, these reports have provided more confusion than clarity.
Payroll Processor Automatic Data Processor (ADP) reported on Wednesday that private businesses added 162,000 new jobs in the month of September – 9,000 more than the 153,000 that was expected by economists.
The Institute for Supply Management released a separate report illustrating that new orders in the non-manufacturing industry boosted the services sector to 55.1, the highest level since March. Unlike its manufacturing counterparts, companies in the services sector have remained stable despite the still-perilous situation in Europe, slowing growth in China and the looming U.S. fiscal cliff.
On Friday the Bureau of Labor Statistics (BLS) will release nonfarm payroll data, which includes government workers. Economists are currently predicting a rise of 118,000 for total nonfarm payrolls and unemployment to remain at 8.1%, an estimate that is unlikely to change despite the better than expected ADP report released this morning. Over the past couple of years ADP reports have not been especially helpful at predicting nonfarm payroll data – just last month large gains forecasted by ADP data missed by a long shot – a mere 96,000 jobs were added in August.
So what do these numbers mean for the economy as a whole? Not a whole lot. The discrepancies among economists’ expectations and actual numbers suggest that we are unsure of when the economy will start improving on the whole. That is not to say that the economy isn’t growing however – the steady improvement in ADP numbers and jobless claims (which clocked in at the lowest level since July) clearly indicate that the economy is improving, albeit slowly.
As the presidential debates get into full swing tonight the employment numbers could have a significant impact for both the candidates. Another disappointing jobs number could put Obama in the hot seat again – last month the unimpressive report fell in the wake of the Democratic National Convention and probably muted at least part of the “bounce” these conventions tend to produce. However, “Nobama” supporters take heed – should the Friday numbers significantly exceed expectations it could provide the President with a boost regardless of who is deemed to have won tonight’s debate. Wait and see.
We talk a lot about floors and ceilings these days – so much so that readers may be forgiven for thinking that we are carpenters. No – our floors and ceilings are of the electronic variety. Over the past several weeks we have seen the floor in action, with central bankers playing their now-customary role of shoring up support so as to prevent asset markets from falling further. First the ECB got its way when Germany’s constitutional court gave a thumbs-up to the European Stability Mechanism. Then the Fed chimed in with QE3, which could be more appropriately be called QE4ever. And in a “hey, what about me?” kind of way the Bank of Japan got into the act with its own new stimulus measures, as noted in last week’s Market Commentary.
This week we see the return of the ceiling, in a bit of tiresome déjà vu. Spanish bond yields are sharply up from their levels in recent weeks, Greeks are in the street protesting austerity, oil is dipping below $90 and stock markets are pulling back accordingly. Eagle eyes are trained on upcoming corporate earnings to see if the slow recovery is eating into the corporate bottom line. Gravity, in effect, is in full force.
The market’s inability to reach escape velocity and break through the ceiling is in no small part a recognition that the central bank policies put in place so far – including even Draghi’s perseverance in getting the ESM through Germany’s opposition – have not solved the problems. They have, to use a phrase we have often employed on these pages, just kicked the can down the road yet again.
But is there method in the madness? Is “kick the can” actually a strategy rather than a failure of vision? Maybe. Think about it this way: in its present floor-and-ceiling mode the stock market actually resembles a giant financial option. A basic call option has a floor, which is equal to the price you pay for that option. Your investment will never be less than that floor because the option has only two possible outcomes: to expire worthless; or to increase in value with the appreciation of the underlying asset.
The other thing about an option is that time is an ally. The longer time there is from today until the option expires the more value the option has, all else being equal. Why? Because the more time you give an asset to rise in price, the higher the probability that it will. If I buy an S&P 500 call option that expires next week then there are only a few trading days for the index to rise above the option’s strike price. But if the option expires two months from now than there are many more days in which that can happen. Statistically speaking my chances of winning are greater.
So it is for the synthetic floor the world’s central banks have put under the stock market. The floor may not be solving actual problems, but it is buying valuable time. Economic cycles come and go, and this anemic growth environment eventually will as well. If we have avoided another market meltdown by the time real growth kicks in again then the floor has been successful. Kick-the-can as a policy approach has worked.
That’s a big if, of course. There is already a growing body of doubt that any ongoing stimulus measures will accomplish anything. If investors believe there is no intrinsic value to the floor then the floor goes away and it’s watch out below. There are plenty of sharp curves ahead. But if nothing else, time is still probably on our side.
The aftermath since the Fed’s announcement of QE3 last week has been settled and somewhat unremarkable. As one would expect, investors have trimmed some of their equity positions after the initial rally following the announcement, but overall there has been no real drawback in risk asset markets. However, warnings related to future inflation expectations have surfaced among some observers, notably Richmond Fed Governor Jeff Lacker as the potentially unlimited expansion of the Fed’s balance sheet increases potential for future inflation.
Following the Fed’s announcement of QE3 last week and the European Central Bank’s (ECB) establishment of an open-ended sovereign debt buying program earlier this month, the Bank of Japan (BoJ) has thrown its hat into the ring with its own revamped monetary stimulus package.
Changes to the BoJ policy include an increase to the size of its asset-purchase program by purchasing about ¥10trillion ($126 Billion) in additional Short-Term Government Bills and Long-Term Government Notes (¥5trillion each), as well as extending its deadline by 6 months to the end of 2013. The hope of the BoJ is that the lower long-term interest rates resulting from these measures will weaken the appeal of the yen which tends to serve as a refuge in response to predicted economic turbulence around the world (though it should be noted that interest rates in Japan have been at extremely low levels for years as it is).
While a number of factors drive the persistently high value of the Yen – a perennial sore point for Japanese economic policy makers – the race for ever bigger quantitative easing measures exacerbates that tendency. The recent action by the BoJ, Fed and ECB have raised some concerns that central banks are engaging in “competitive easing” by pumping money into the home country’s (or region’s, in the case of the ECB) own economy despite whatever negative effects it could have elsewhere. These concerns are reinforced by this more aggressive policy by the BoJ, which comes as a surprise to many analysts who predicted that the more conservative BoJ Governor would delay any easing measures until late October.
The aftermath of QE3 also has an effect on the bond market but this is trickier to make sense of. Theoretically in a bond-buying exercise like QE one would expect to see bond yields fall as bond prices go up. Contrary to the theory, however, are the realities of present-day asset markets where QE induces interest rates to rise as investors sell out safe haven assets – this happened in both QE1 and QE2. However, QE3 has been something of a hybrid. Investors have – predictably – flowed into riskier assets, but there is no sustained upward trend in bond yields (as there was with QEs 1 &2). Yields on 10 Year Treasury Notes remain not far from historic lows and have not yet managed to surpass the already modest 1.97% yield seen at the beginning of 2012.
And so, the question remains that we posed last week: will QE3 work? And to follow that up with an even more ominous question: how bad will it be when interest rates really do start to rise, for real? We’ll be talking a lot about that in the weeks and months to come.