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The Core of the Matter

By: Beese Fulmer
Monday, October 15, 2012

Year-to-Date Results

The third quarter was another good one for stock market investors. So far this year, May has been the only negative month for equities. The S&P 500 Stock Index, the most widely tracked stock benchmark among investment professionals, enjoyed a total return of 6.35% during the third quarter and gained an impressive 16.4% through September. The S&P 500 is a capitalization-weighted index, meaning that a company’s weight in the index is the result of its stock price times its number of shares outstanding. Apple is the largest company in the index at 4.4% of the total market cap, and it comprises 22.4% of the Information Technology sector. Exxon Mobil is the second largest company in the S&P at 3.25% of the total, and it makes up 30% of the Energy sector. Although there are 500 companies in the index, the ten largest equal 20.94% of the total market cap. Here’s something to think about: The average market cap of the stocks in the index is $24.62 billion, while the market cap of Apple is $546 billion! Size matters--so much so that the return for the unweighted S&P through September is a more-modest 11.6%.

The NASDAQ Composite Index is an even broader-based capitalization-weighted index that includes over 3,000 securities ( both U.S. and non-U.S. companies) including American Depositary Receipts (ADRs), common stock, limited partnerships, ordinary shares, REITs, shares of beneficial interest, and tracking stocks. It spiked 6.2% in the quarter and sports a three-quarter tally of 19.6%. Its gains have been even more impacted by Apple’s meteoric rise of nearly 70% (it is responsible for 9.3% of the total).

The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks and is the most recognized stock benchmark for the general public. The higher the price of the stock, the more importance it has in the average. It has actually advanced in 11 of the last 12 months—a feat not accomplished since the 1950s—and tacked on a gain of 5% during the quarter, bringing its year-to-date total to 12.2%. In summary, these benchmarks have already garnered remarkable return numbers for most years, and we’ve still got a quarter to go!

Some Context

That being said, analysts are calling this the “feel-bad” rally because retail investors continue to pull money out of equity mutual funds and deposit dollars into bond funds. Have flash crashes, botched initial public offerings, and insider trading scandals scared off many folks too close to retirement to take a flyer on stocks? Perhaps. We listened to a market analyst yesterday who pointed out that about 70% of the daily trading on the exchanges is being done by hedge funds, exchange-traded funds, and high-frequency traders, whose holding periods can be measured in seconds rather than quarters or years.

Indeed, the Wall Street Journal recently reported that, according to Lipper Analytical Services, investors have pulled $137 billion out of U.S. stock mutual funds so far this year, while increasing their holdings of bond funds by $267 billion. As for stocks, investors are choosing to own either individual securities or exchange traded mutual funds which hold U.S. stocks. If you read between the lines, mutual fund investors are so worried about losing money that they want a stock or stock fund they can trade at a moment’s notice rather than wait for a traditional fund company to redeem their shares. So much for conviction!

Looking at our material on the S&P 500 sector returns for this year, you will see that five of them have outperformed the index while five have trailed it. In general, the numbers seem to indicate we’re experiencing a “risk on” stock market rally in a “risk off” economic environment. Interestingly, the two sectors at opposite ends of the risk spectrum have turned in the worst performance so far: Energy is up just 7.6%, while the defensive Utilities sector brings up the rear with a gain of only 4.3% through September—a puzzling development in a world searching for yield. If you think about the real economy, though, the Energy sector might be reflective of slowing global GDP growth, while the underwhelming return for the Utilities sector probably has much to do with fear about the potential tax increases on dividends coming should the Bush tax cuts expire as part of our January 2013 fiscal cliff debacle.

For the 30-stock Dow Industrials, it’s not surprising that 15 stocks have outperformed the average while 15 have trailed. What is surprising is that five of the underperformers have actually declined so far this year: Hewlett-Packard (-34%) is a woeful turn around waiting for the turn, but McDonald’s (-8.5%), Intel (-6.5%), Boeing (-5%), and Caterpillar (-5%) are more indicative of a slowing global economy. The NASDAQ market’s return has been powered by Apple, as we mentioned, but also helping the cause have been Microsoft (+17% and 5.5% of the index), Oracle (+23% and 4%), and Google (+17% and 3.7%).

Our take on the quarter is that most investors’ portfolios are constructed around their goals and objectives rather than by cap weighting or industry. That’s the way we manage assets for our clients. As people approach retirement they are less enthused about taking risk, and in this environment of zero-percent interest rates, dividend-paying stocks are providing much of the income our clients need but can’t get from the fixed-income segment of their account. Many names in the Consumer Staples, Energy, Utilities, and Health Care sectors—brand-name stocks—have been providing and even raising those dividends for decades. That they trail the performance of the more volatile “risk on” names over a certain period should not cause long-term investors much concern.


Without a doubt, THE event of the third quarter was the September 12-13 meeting of the Federal Open Market Committee. Financial markets were on high alert anticipating what moves Fed Chairman Ben Bernanke would make regarding monetary policy. In the weeks prior to the meeting, most pros assumed the Fed would take some action but figured the Chairman would wait until after the election, so as not to appear “political.” Well, a couple of things happened to change the Fed members’ minds (all of whom, according to CNBC’s Larry Kudlow, have been appointed by Mr. Obama and are known to be “easy money” advocates). First, the Romney/Ryan team has made it clear that if they win the White House they are going to pursue a pro-growth policy to pull us out of our economic malaise, and an easy-money monopoly will not be welcome at the Fed. If you’re Mr. Bernanke, what’s the risk of appearing political when you’re going to get canned if your guy loses the election? Second, and probably much more impactful on Mr. Bernanke, was the August employment rate reported on September 7. The Labor Department announced that just 96,000 jobs had been created, far short of the expected 125,000. It was the fourth month out of five that saw sub-100k job growth. The unemployment rate “fell” to 8.1% from 8.3% due to a statistical oddity: 368,000 more people simply left the labor force; if you’re not looking, you’re not counted! The labor participation rate, which measures the number of working-age Americans in the labor force, has fallen to 63.5%, and that is a 31-year low.

Even though two rounds of Quantitative Easing and an additional “Twist” have done little to help the unemployed, on September 13, Mr. Bernanke decided to put the pedal to the metal of the QE express, vowing to buy an additional $40 billion in mortgage-backed bonds in addition to the $45 billion in bonds the Fed is already purchasing each month. And this time, there is no stated end date for the money printing. The Fed will print until the unemployment rate hits 6% and predicts it will need to keep rates low until at least mid-2015.


Easy money and low rates, two tools of financial repression we’ve written about before, have so far accomplished the following: savers have lost about $1 trillion in interest over the last three years; median household income continues to fall and is down more than 8% from 2007; the economy grew at just 1.3% in the second quarter; 46 million people live in poverty and are receiving food stamps, which now costs taxpayers over $70 billion a year. Meanwhile, the Fed’s balance sheet has ballooned from about $800 billion prior to the crisis to more than $3 trillion; the Fed is buying nearly 70% of the bonds the Treasury floats in order to ENABLE the government to run trillion-dollar deficits year after year--pushing the debt total higher by nearly $5 trillion in just four years. To be fair, stock prices are higher, but so are commodity prices. So far, though, Mr. Bernanke’s “wealth effect” strategy has not worked; Baby-boomer savers, 75 million strong, have seen their interest income disappear while their cost of living has risen, and they are leaving stocks on a monthly basis in search of yield. Someone commented recently that Mr. Bernanke’s desired “wealth effect” has run smack into the baby boomers’ desired “income effect.” It’s a darn good observation. In addition, although the stock market HAS gone up, even the wealthy have begun to keep an eye on their bank balances; so, absent robust consumer spending, businesses are not hiring or expanding. To make matters even more problematic for business owners, another branch of the government is burying them in new regulations, and years after the legislation was passed, we can’t find a businessman that understands the full implications of ObamaCare. Furthermore, $1.5 trillion of the liquidity the Fed has bequeathed to the banks is sitting on deposit at the Fed earning a risk-free return of 0.25%. That’s right--the Fed is actually paying banks to keep their money on hold, and the members wonder why the banks aren’t lending. Why make a loan that might fail? The money is getting printed, but it is slow getting into the real economy.

Mr. Bernanke defended his fleecing of savers a few days ago by saying everyone benefits from a growing consumer economy. What he fails to acknowledge, though, is that the baby-boom generation has largely moved past the consumption period of their lives that young families experience. They are downsizing; they want to sell their accumulation of stuff (including homes) to young people who can’t get jobs and establish households of their own. Heck, even the birth rate has dropped to a level not seen in decades—no job, no marriage, no children! (It’s a reassuring display of common sense.)

Looking at the Rest of the Year

The talking heads on the business channels believe that the next leg up for the stock market will be when the retail investor comes back to the stock market. We agree that folks in bond funds will be in a pickle when rates begin to rise. But investors are taking Mr. Bernanke at his word that he will not raise interest rates until 2015 or later--even if unemployment drops and the economy improves—and they feel more confident owning bonds with low yields rather than invest in a stock market that could suddenly decline following a three-year rally. If you think about it, the Fed, by buying all of these bonds the Treasury is issuing, is doing exactly the same thing!

In an effort to keep it real, let’s be honest: Financial repression rewards debtors at the expense of savers. And who is the biggest debtor in the world? Answer that question and you’ll know why Mr. Bernanke sticks with a policy that hasn’t accomplished his stated goals. It’s because those aren’t really his actual goals. Unfortunately for Mr. Bernanke--and we’re sure he knows this and is probably dismayed by the part he’s playing--he has been forced to participate in the president’s grand wealth “redistribution” scheme. If his plan eventually works (the economy will gradually regain some sort of momentum) and interest rates begin to go up, the Fed will have another set of problems: How to keep the banks from lending too much too quickly and igniting inflation, and how to sell off its own portfolio of bonds without taking a big loss. We’re in uncharted territory here, folks, which is why Fed critic James Grant opined recently that we are all “lab rats” in Dr. Bernanke’s economic experiment!

By the time you receive this, we will be deep into earnings-reporting season. Most analysts expect a decline in corporate profits, so it will be interesting to see how stocks react to that news. And a few weeks after that, we have a little thing called an election taking place on November 6. We know our readers have diverse views about politics. Our view on most things political is that we have watched our clients do wonderful things over the last 32 years with the wealth we’ve helped them grow. None of them pay too little in taxes, and all of them have exhibited better judgment about their finances than the folks in Washington. As a result, we are always anxious for them to keep as much of their money as they can. We’ll leave it at that. (Written 10/3/12)

Sources for this Outlook include, but are not limited to: Barclays Research, Bureau of Labor Statistics, The Washington Times, Investor’s Business Daily, The Wall Street Journal, Bloomberg News, CNNMoney, CNBC, Standard & Poor’s, NASDAQ, Morgan Stanley& Co., The New York Times, and the investment blogs The Big Picture and ZeroHedge.

We hope you enjoy this issue of our Investment Outlook. If you know of anyone whom you think might benefit from our investment management services, we would be pleased to add them to our Outlook mailing list as a way of introduction. Client referrals are our most valuable source of new business; they are especially gratifying because they mean you are pleased with the job we are doing for you.

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