Posts published in December 2013
There are but a couple trading days left in 2013. This has been a good year to be an equity investor, particularly an investor in U.S. equities. In fact, the real stomach-churning roller coaster ride this year was not in stocks, but in fixed income instruments. A somewhat off-the-cuff utterance of the word “taper” by soon to be outgoing Fed Chairman Ben Bernanke in May sent bond markets into a tizzy. The rate on the 10-year Treasury note soared from 1.5% in early May to graze 3% by September. That’s just about where the rate is now, as the year draws to a close. With the QE taper now officially underway, if still only modestly, the direction of bonds is likely to continue weighing on Wall Street minds as the New Year gets underway.
U.S. Equities: American Pie
The banner year in stocks was most concentrated in U.S. equities. As of the December 26 close the Russell 3000, a broad all-cap benchmark, was up just over 33% for the year to date. That represents the strongest calendar year performance since the post-recession recovery year of 2003. Most major asset classes got a share of the love, with small cap growth leading the way. The Russell 2000 Growth index clocked in at 43.08% as of the 12/26 close.
Among industry sectors the notable laggard was utilities, with a comparatively modest gain of just under 12% as the year comes to an end. This traditionally defensive, dividend-oriented sector had a good start to the year, but ran out of gas when interest rates started to trend upwards in May. On the other end of the performance spectrum, the healthcare, industrials and consumer discretionary sectors are closing out 2013 ahead of the pack.
After flagging somewhat in the first half of December, U.S. equities enjoyed a good old fashioned holiday rally on the back of a string of promising macroeconomic data points. Employment and GDP data in particular look stronger than they have in years. The data were instrumental in giving the Fed confidence to start reducing QE by $10 billion, and that was the move that sent the year-end bulls into the streets.
Non-U.S. Equities: Emerging Malaise
The notable wallflower at this year’s equity party was emerging markets. This asset class has not fared well over the last couple years, but 2013 was a particularly bad year. The MSCI Emerging Markets Index was down by -3.2% as of the 12/26 close. Traditional growth engine economies in Asia and Latin America have had trouble keeping up the levels to which investors have become accustomed in recent years. Tepid growth in Europe and (until recently) the U.S. has proved troublesome for these still export-dependent economies. Although emerging markets stocks look attractive by traditional valuation measures, and may benefit from the uptick in U.S. economic growth, this remains in our opinion a sector that continues to merit caution.
Developed non-U.S. markets mostly fared better than their emerging cousins, with the Eurozone showing the best regional performance. The MSCI EAFE index was up 21.3% as of 12/26, with the EMU index showing 27.7% for the same period. The laggard was the Pacific ex-Japan region, which managed to eke out a 4.5% gain. Non-U.S. markets broadly suffered from currency trends mostly working in favor of the U.S. dollar for much of the year.
Fixed Income: The Big Question
Market chatter continues to fixate on the beleaguered fixed income markets. A scan of the Barclays U.S. fixed income indexes reflects a sea of red, from governments and agencies to corporate investment grade and municipals. The notable exception is high yield, which as an asset class tends to trade in closer correlation with equities than with other fixed income styles. Not surprisingly, the hardest hit sectors are long-dated Treasuries. The 20+ year sector leads on the downside with a -13.6% performance year to date. Rising interest rates have a sharper impact on long-dated issues, all else being equal.
The good news for bondholders, such as it may be, is that the rate trend for 2014 may be less steep than it was this year. A level of 3.5% for the 10 year note seems to have emerged as a kind of consensus among market watchers for an upper limit in 2014 (though of course that does not rule out the possibility for rates to go higher). Even with the faster pace of economic growth, there is not much fundamental economic pressure pushing rates up. Inflation remains below the Fed’s 2% target – in fact that fact alone will probably keep any talk of orchestrated rate hikes off the table for a long time to come. We expect to see rates generally trend upwards, and have measurably reduced the target duration levels of our strategy models accordingly.
And so we ring out 2013. We will of course be back with more research and commentary as the New Year gets underway, with insights on whatever twists and turns the capital markets have in store. Meanwhile, we wish all of you a happy and healthy holiday, and a prosperous 2014.
There was an interesting article in the Wall Street Journal this week, which perhaps slipped under the radar amidst all the frenzied taper talk. That piece was about a company called Genscape. There is a connection between that article and the big story of the week. Success in the capital markets comes from information: what you know, and when you know it. Increasingly the tools are available – for those willing and able to pay – to know things before they happen.
Insider Trading Done Legally
Kentucky-based Genscape uses cutting edge surveillance technology to piece together nonpublic data about things like oil supply, electric power production and retail traffic. It then sells this data to investment and trading companies that pay dearly for the privilege of knowing something important before anyone else does. The annual bill for intel on the oil supply alone can run a Genscape client to over $500,000. Technically there is nothing illegal about what Genscape does, nor are the investor clients in clear violation of any SEC-defined insider trading rules. The practical effect, though, is that someone who is able to shell out half a million a year will have very accurate figures about oil supply trends two days before the U.S. Energy Information Agency releases that same information to the public. Two days, of course, is a lifetime in the capital markets spacetime continuum.
Frozen Orange Juice, Anyone?
Of course, traders have looked for unfair advantages over their rivals since the dawn of time and markets. In the classic 1982 film “Trading Places,” the nefarious Duke brothers hatch a plan to corner the market in frozen orange juice, only to find themselves outplayed by Eddie Murphy and Dan Aykroyd, who manage to get their hands on the orange juice crop data first and send the Dukes to the poor house. We could laugh at that, because it was such a ridiculous and far-fetched scheme. But with today’s ultra-sophisticated surveillance technology, you don’t need Clarence Beeks, the bumbling gumshoe who procured the crop report, to get that inner edge. You need Genscape, and, for a price, you can have it.
A Genscape for the Fed?
In a market hardwired to react to Fed events, one can only imagine how many propeller-heads are toiling away at their predictive analytical models, trying to write that Holy Grail of algorithms that would accurately predict what will come out of those monthly Board of Governors meetings. Sound impossible? Not really. The surveillance includes infrared technology, antenna stations, videotapes, satellite imagery, and quantitative methods that crunch the data and arrive at the answers to questions as varied as how much a retail chain made in Black Friday weekend sales (before the retail chain itself even knows), or how much coal is being shipped to electrical grids in the Midwest. It is far from inconceivable that a perfectly legal, insider report on the outcome of a Fed deliberation could be in the hands of Goldman Sachs and JP Morgan traders on the Monday before the Fed’s Wednesday post-meeting conference.
There Will Still Be Uncertainty
However much they seek certainty, though, the profiteers from insider information will always have to contend with uncertainty. Consider what happened this week. For the last two weeks, all the talk has been of how badly markets may react to a December taper. Then the taper comes, and markets enjoy their biggest rally in weeks. If you knew the taper was coming, would you also be able to predict that exact outcome? As sophisticated as they are, predictive analytical models will still dwell in the realm of probability, not certainty.
Last week we wrote about the strange relationship between economic news and recent market performance. Major stock indexes were turning sour ahead of a possible Fed taper in mid-December, even as the economic news looked more promising than it has for a number of years. The sourpusses have continued to hold the upper hand this week. As of the Thursday close the S&P 500 was down by just under 1% for the month to date. Hey, wait a minute! Isn’t the “month to date” of which we speak December? Isn’t there some kind of a special thing that happens this time of year, a little good cheer to close out the calendar?
In search of lost Decembers
Marcel Proust apparently could reconnect to the distant times of his childhood by smelling the aroma of a madeleine soaked in tea. We’re not nearly as poetic, but we do remember the markets of Decembers past and indeed the memories are, for the most part, good ones. Since 2000 the S&P 500 price return for the twelfth month of the year has been negative only three times out of 13, up to the end of calendar year 2012. The average return for the ten positive Decembers is 2.1%, a good-sized holiday present indeed. Theories abound as to why December may be a better month on average for stocks than others. One thought, which makes sense to us, is that brokers and portfolio managers hasten to dress up their portfolios with whatever assets are in favor, providing momentum for companies and industry sectors that have shown recent outperformance.
Actually, there is not much momentum leadership going on at all these days. For industry sectors, the only truly consistent trend over the past several months has been utilities, and that is a negative trend (utilities are up by a bit over 11% this year, substantially less than half what the S&P 500 has gained year to date). Others, from consumer staples to industrials and financials, have had their day in the sun, but in general the trajectory has grown more directionless in recent weeks. The money movers seem to be in no particular rush to spruce up their portfolios with crowd-pleasing names. Perhaps they’re not feeling the pressure quite so much, given how well the broader market has done this year.
There is no “average December”
Of course, just because the average performance for the month is good doesn’t mean it will be thus every time. Every December – for that matter any defined period of time at all – has its own unique aspect. There are many factors that influence the short-term direction of the market, and hanging your hat on some “effect” theory for predicting the performance of any specific December is probably unwise. It may well be that there just isn’t much more goodness to extract from this current, long-standing rally. The trailing twelve month return on the S&P 500 has not been negative for one single day since the beginning of 2012, which is extraordinary. A pause for profit-taking surely should not come as a complete surprise.
Month not over yet
Finally, lest we forget, we’re not even at mid-month yet. Two weeks is a long time in this world – enough time for anything to happen. We’re keeping an eye on lots of different moving parts including, of course, next week’s Fed confab. But whether or not we get a late December effect tailwind, we’ll take 2013 as a whole over most of the other calendar years the 21st century has served up thus far.
Just in time for the holidays, recent headline economic news should bring on a rush of good cheer. Nonfarm payroll gains have topped the critical 200,000 level for three of the past four months, while the unemployment rate has fallen to 7%. GDP was revised upward for the third quarter to 3.6%, the highest it has been for two years. Inflation is nowhere to be seen. The housing recovery continues apace. These all make a reasonable case for a return to more normal levels of growth than we have seen for a while.
Good news. Except, that is, for the folks who are too busy throwing a “taper tantrum” to notice.
The $85 billion question
The market opened sharply higher today, largely on news of the jobs numbers, but prior to that the S&P 500 had lost ground for five days in a row. The building signs of economic growth took traders to the dark place where fears of a reduction in the $85 billion monthly bond purchasing program trump all else. The Fed meets again on December 17-18, and taper fears are running high. Nor are stocks the only asset feeling the chill. It is a rare sight to see bonds underperforming stocks on a day when stocks are down, but that has happened several times recently. Even though the Fed has no intention of raising rates any time ahead as far as the eye can see, and there is little in the way of fundamental upward pressure on rates, the equation “taper = rising rates” is lodged firmly in the mind of the market.
Six of one, a half dozen of the other
So are the taper fears grounded, or is this just another irrational outburst from the denizens of Prozac Market, kicking and screaming their way to rehab? Will the Fed actually start tapering and, if so, will that necessarily be a bad thing? These are hard questions to answer, because the answer largely depends on whether the recent growth trend has durable traction. The dismal scenario that keeps the Board of Governors members up is the combination of anemic growth and ultra-low inflation. That’s the combination that has people tossing around terms like “lost decade” and “Japan 2.0”.
But if 3%-plus GDP and below-7% unemployment are in fact the new normal, then the assumption is that a healthier inflation rate of 2 – 2.5% will follow in due course. Under those conditions, the QE training wheels should be able to come off without major disruptions. So the Fed’s dilemma is about how much trust to put into the growth story, and whether the data are strong enough to justify a December taper.
The cautious Fed
The deliberating style of this Board of Governors is cautious, and caution will continue to be the watchword. That caution was in full view in September, and it came through loud and clear in the recent confirmation hearings of soon-to-be chairwoman Janet Yellen. A read of the tea leaves still probably points to a higher likelihood of no taper action in December. But the growth numbers do matter. At the very least, we should expect to see something in the meeting minutes that incorporates the growth scenario into future intentions. In an ideal world, the Fed could communicate these intentions in a way that makes clear that (a) tapering policy does not equal rate hike policy, and (b) they will turn the spigot back on if future economic conditions so warrant.
But we don’t live in an ideal world, and chances are that we’ll have to endure more taper tantrums as the weeks continue. At some point, though, we would expect that the good growth numbers, should they continue, will gain the upper hand in the market Zeitgeist.