Bull market prolonged by sluggish economic recovery – it has more upside potential

Posted by Shyam Moondra

In recent months, the “overheated” bond market has declined with a sharp increase in the yield of the 10-year Treasuries, while the stock market has traded in a narrow range. The bulls are frustrated because the broader stock index DJIA is not moving up faster with heavy volume and the bears are disappointed because the market is not having the expected big correction of 10-20% even after a long bull-run over the last seven years. That leaves the stock market in a limbo and many investors are not sure how to trade, which is apparent from the declining trading volume.

Below is a synopsis of various economic and political factors that suggest that the stocks still have an upside potential and we might see DJIA surpassing the 19,000 mark in the coming months:

·         The economy has been recovering from the financial crisis of 2008 at a tepid annual rate of 1-3% (historically, post-recession recovery rate of 4% is not uncommon), which has prolonged the recovery period beyond the usual four to five years. An over-heated economy coupled with out-of-control commodity markets are a pre-requisite for an impending recession; however, at the present time, we have neither and as such we could see continuing sluggish economic recovery for another couple of years.

·         The jobs numbers have been good but not very strong and, therefore, even after seven years of recovery, we are still not close to the full-employment level (i.e., unemployment rate of 4.5%). As a result, the wage inflation has thus far been negligible, which has allowed the corporations to keep their costs down and allowed FED to defer any increases in the funds rate, thereby continuing with their accommodative monetary policy.

·         The inflation continues to be very low and within the FED’s targeted range, thanks to the decline in oil prices. Given that commodity markets are not over-heated (even after seven years of economic recovery), it’s reasonable to assume that inflation will remain in check for the foreseeable future. Low inflation is always good for the stocks.

·         In recent weeks, the bond market has declined (after an extraordinary bull run that created the bond bubble) with the interest rates spiking up but they still remain below historical levels. Given lower inflationary pressures, the FED is expected to increase the funds rate in small increments starting this year; however, the market has already discounted the first couple of small increases that are likely to take place in September and December of this year. The market will wait and see how these increases continue next year in terms of their magnitude and timing before reacting to interest rate increases. Since next year we have the presidential election, the FED is unlikely to change policies drastically and give the perception of taking sides; therefore, the FED will continue its slow and steady approach at least through 2016. For now, so far as the interest rates are concerned, the stock market has a green light to continue its upward march. As the bond bubble bursts, some of that money could end up in stocks and help with the bull-run.

·         The stock market recovery has also been slow coincident with sluggish economic recovery, which explains why even after seven years of a bull run, the market is not overheated and the stock valuations are quite reasonable. The forward PE of 15.94 for DJIA, 17.81 for S&P 500, and 19.45 for NASDAQ are not excessive and they are much lower than what they were at the market peaks of 2000 and 2007 (when they were in the high-20’s to 90’s range). Also, the current common stock dividend is higher than a year ago and is very attractive compared with the bond yields. Therefore, a case could be made that bonds have room to go down more and stocks have room to go up more.
 

·         The auto and housing sales continue to be very strong, mostly because these markets were hurt really badly by the financial crisis and there was a huge pent up demand built up over the last few years. The current strong demand for auto and houses mean that economy will continue to grow in the foreseeable future and the stock market will keep going up with them.

·         In recent years, European countries have taken unprecedented austerity programs to cut government spending, which, in the near-term, has proven to be painful and it has even slowed down economic growth; however, those sacrifices are beginning to pay off and it is expected that the European economy would start picking up the pace in the coming months. The QE program recently started by the European Central Bank will also help revive the EU economy. Also, strong dollar is increasing the European exports to the U.S., thereby giving a boost to their economy. In the intermediate-to-long term, strong European economy will spur global growth which will also benefit the U.S.
 

·        We have just begun the presidential election season and this time financial markets would be   more sensitive to who is elected as the President than ever before. President Barack Obama is viewed by many, perhaps unfairly, that he is anti-business. Therefore, businesses may favor a business-friendly Republican in the White House, who might reduce taxes, streamline government regulations, and spend more on military.

·         Some of the specific sectors that could be the leaders in the next phase of the bull-run for the stocks could include banks, military system manufacturers, and technology companies.

Given that interest rates are likely to go up this year and next, the banking sector would see their interest spread increase and thus help boost their profitability. The bank stocks, which have gone up in the last couple of weeks, will benefit from interest rate increases and may lead the new bull phase of the stock market. Many banks are currently selling near or below their book values; they could easily move up to at least 1.2 to 1.4 times their book values, assuming we would see more increases in their dividends and buybacks of their own shares in the coming months. If a Republican wins the White House in 2016, it’s safe to assume that bank regulations emanating from Dodd-Frank bill would be scaled back, which will greatly reduce banks’ operating costs and make it possible for them to take greater risks than they are able to do now by lending more to small businesses that could help create more jobs

Recent geopolitical developments such as Russia’s illegal annexation of Crimea, China’s aggressive policies in the South China sea, and the turmoil caused by the Islamic militants in the Middle East and Africa have prompted countries around the world (including the U.S.) to increase the budgets for their defense departments. The U.S. military systems manufacturers are likely to see increased demand for their products and services worldwide over the next several years and thus could become one of the leading sectors to push the stock market up. Given that Republicans favor strong defense, if a Republican is elected as the next President, the stocks of the defense manufacturers would get a big boost.

Although NASDAQ set a new record high last week (beating the last record set back in 2000), the forward PE is only 19.45 compared with 90 in 2000. This suggests that the technology sector could also be one of the leaders that will take the broader stock market to new record high levels in the coming months.

Given that the current stock valuations are not excessive and that we will continue to have low interest rate/low inflation environment for the near-term, the stock market has more room to go up at least for the rest of this year and early next year. At some point in 2016, depending on if a pro-business candidate is elected as the President and depending on inflation situation and how aggressive the Fed is on increasing interest rates, it is possible that we may finally see a correction that many bears have been expecting. But for now, the stock market may continue its slow upward march towards DJIA of 19,000.

DISCLAIMER: The blogger is long in the sectors mentioned in this blog.

To taper, or not to taper – that is the question

Posted by Shyam Moondra

The biggest uncertainty in the financial markets right now surrounds the question of when would Federal Reserve Board (Fed) start winding down (i.e., taper) the Quantitative Easing (QE) program in which the Fed buys treasuries and mortgage-based securities at a rate of $85 billion a month. This unprecedented monetary program was designed to keep the long-term interest rates low, which, in turn, would stimulate economy, especially the housing sector. The Fed was forced to undertake this aggressive approach because the Congress and President Barack Obama were deadlocked on providing stimulus to economy on the fiscal front. The QE has had some success in giving a boost to economy via housing boom and in bringing down the unemployment rate to 7.4% from the peak of 10% at the height of the 2008-2009 financial crisis. The critics of the QE program have argued that easy money would recreate bubbles (e.g., in the housing and bond markets) and also increase inflationary pressures. While low interest rates have created a bubble in the bond market and boosted interest-sensitive stocks such as utilities, inflation continues to be in check (in fact, some fear that we may be in a prolonged deflationary environment similar to the one that Japan had during the 1990's).

Ben Bernanke, the Fed Chairman, has indicated that the goal of the QE program is to bring down the unemployment rate to 6.5% at which time the program could be terminated. The low interest rates and low inflation have boosted the equity prices; DJIA as well as the broader index, S&P 500, have both set all-time records. However, the key question now is when would the Fed start tapering the QE program. The Fed is expected to first reduce their purchases from the current rate of $85 billion a month and then start selling what they already purchased to bring down their balance sheet to more traditional levels. The whole process of tapering and selling their holdings could take years to complete.

It is generally believed that when tapering begins, interest rates would go up and stock prices would go down. The financial markets are beginning to show increased volatility as the possible tapering moment gets closer. The increase in interest yields on bonds and decline in stock prices in the last week reflect the uncertainty as to exactly when the QE tapering would begin. Bernanke is on record saying that the Fed could begin tapering when the unemployment rate goes down to 7% (currently at 7.4%). Many investors believe that tapering decision could be made as early as next month when the Federal Open Market Committee (FOMC) would meet. However, given that unemployment is still not at the level the Fed desires (next unemployment report is due on September 6, 2013) and inflation continues to be within the Fed's target range, the FOMC may decide to defer the decision on tapering to their next meeting in December. If a decision is not announced after their September meeting, the stock markets could soar to new record high and long-term interest rates could get a reprieve from recent run-up.

Given how sensitive financial markers are to the timing of tapering, it may be better if the Fed pulls back from its recent policy of transparency and not be so open on what their plans are. Below are some principles that the Fed could adhere to:

• Tapering and unwinding of their balance sheet should be done in a very gradual fashion, spread over several years. This would minimize severe volatility in the financial markets.

• The Fed should bring their transparency down a notch and not talk about their plans publicly. They should not pre-announce when they would begin tapering and at what rate. If investors don't know, they wouldn't react and that will help minimize volatility and reduce chances of flash crashes in the financial markets. If the Fed tapers gradually without public fanfare, it's possible that it might have very little negative impact on economy, to the point that people might not even notice that taper has already begun.

• The Fed should give out information on tapering and unwinding of their holdings after the fact and only in less dramatic way (e.g., making a vague reference in their meeting notes rather than Bernanke talking about it prominently at a press conference). The less the information given out in a low-key fashion, the better it would be.

Regardless of what the Fed decides on unwinding QE, the long-term prospects for the stock markets continues to be positive. Yes, the interest rates would increase, but given we are so far down from the normal interest rate levels that existed prior to the financial crisis of 2008, one should exercise caution in not overstating the impact of rising interest rates. In any case, given record cash hoards on the corporate balance sheets, their capital expansion plans may not be negatively affected by higher interest rates. Second, the end of QE would also signify significant improvement in the job market, which means increased consumer spending. Since consumer spending accounts for two-thirds of economy, corporate profits would increase even more from their current record levels. Also, higher interest rates would finally burst the bond bubble and some of that money would end up in stocks. Therefore, the recent decline in the stock prices caused by uncertainty surrounding the timing of tapering, could in fact be a good buying opportunity for the long-term investors.

DJIA down 550 points – Hysterical reaction by investors to Federal Reserve policy creates a huge buying opportunity

Posted by Shyam Moondra

The DJIA has gone down by 550 points in just two days, the largest two-day decline this year. Last Wednesday, Federal Reserve announced that, for now, they would continue to buy mortgage-based securities and Treasuries at the rate of $85 billion a month; however, the Fed also said that they were prepared to phase-out the QE program later this year if the unemployment rate fell to around 7% from the current 7.6%. The Fed announcement also pushed the yield on 10-year Treasuries to 2.42%, the highest since 2011. The announcement was hardly a breaking-news; everybody understood that if economy strengthened, the Fed would phase-out QE to ensure that inflationary expectations did not get out of control. It's almost as if the investors had already decided to dump both stocks and bonds regardless of what the Fed said. The expiration of stock options this week may have also contributed to this unexpected market crash. Interestingly, gold, silver, and oil prices also crashed, suggesting a total panic among the investors. They would rather hold on to cash and earn close to zero interest or less than the inflation rate, thereby losing ground in terms of real value.

When faint-hearted investors panic, smart investors aggressively move in and start buying good quality stocks at fire-sale prices. The crowd is so much focused on the tapering of QE and rising interest rates that they are completely ignoring the reasons behind the Fed's QE policy. As the Fed Chairman Ben Bernanke explained in his press conference on Wednesday, if the Fed started to taper off QE it would be because of improving underlying fundamentals of economy. An improved economy means higher sales and profits for corporations and that, in turn, means higher stock prices. Since corporate balance sheets are the strongest ever (with the current cash hoard of $5 trillion), they don't really need to borrow much to support their capital investment programs and are thus relatively unaffected by higher interest rates. Also, as Bernanke pointed out at his press conference, increase in mortgage interest rates would not necessarily reduce the demand for housing because the increase in monthly payments would be relatively small. Let's not forget that the current levels of interest rates are no where near the normalized levels that existed before the 2008 financial crisis. Therefore, investors' worries over increasing interest rates are somewhat overblown.

The current stock valuations are very attractive. The WSJ reports that the current estimates of forward PE for DJIA is 13.62, S&P 500 is 14.88, and NASDAQ is 16.22. It's hard to imagine a huge selloff at such low PE ratios at a time when economy is strengthening. If economy continues to improve, as the Fed expects, corporate profits will also increase and these estimates of PE's could in fact prove to be too conservative. At previous market peaks, we have had PE ratios in the high 20's to low 30's range. While no one expects that we would get back to those levels any time soon, the current PE ratios are hardly excessive to have triggered a huge selloff.

This is the time to buy stocks of high quality companies that are positioned to experience growth in revenues and profits as the economy improves. The current market crash may have created one of those rare opportunities for the long-term investors who tend to buy and hold stocks. Also, as the interest rates rise, the bond bubble will finally burst and some of the bond money will end up in equity funds, creating one of the greatest rotations of recent times. In fact, the DJIA could very well hit 18,000 within a couple of years.

This is not the time to panic - this is the time to buy quality equities for the long-term.

Is stock market bottoming out?

Posted by Shyam Moondra

There were several instances when it looked like the stock market had bottomed out but then came more bad news and the market headed lower again. However, the behavior of the market in recent days suggests that DJ may have already hit the bottom at 7,773 on October 10, 2008.

It seems that the market is being hit repetitively by the same old bad news, leaving the valuation at a level as if we are headed to the 1930's era depression. The recession has come fast and furious but it's unlikely that it will last long for the following reasons:

1. In a concerted effort, the governments of major economic powers have been reducing interest rates to the levels not seen for decades, pumping liquidity into the markets at an unprecedented rate, and increasing expenditures via stimulus packages that will eventually revitalize the global economies.
2. The credit crisis is easing, as is evident from the inter-bank Libor rate that has come down to the levels not seen since 2005.
3. The latest housing data suggests that the housing market may be stabilizing. Recent positive actions by several major lenders will reduce the number of home foreclosures, which will help revitalize the housing market.
4. In general, the corporate balance sheets are very strong with unprecedented levels of cash. This explains why corporate bankruptcies are far fewer than seen during the past recessions.
5. The corporations were quick to adjust their inventories when the credit crisis first became evident. The current extremely low inventory level suggests that the industrial production may be ready to bounce, which will boost the employment.
6. The current stock valuations seem ridiculously low when compared with the valuations at the bottom of the past severe recessions.
7. The collapse of the prices of oil and other commodities is a welcome news for the consumers. The lower commodity prices will dampen inflationary expectations that will free the FED to reduce interest rates even more. Low inflation and low interest rates are generally good for the equity markets.
8. The incoming Obama administration is poised to cut taxes for the middle-class and small businesses, aid the ailing auto industry, and invest in alternative fuel research and development and infrastructure projects. These initiatives will boost employment and consumer confidence.

The current stock market is being driven more by fear rather than the economic reality. In this kind of market, as Warren Buffet said, investors need to be greedy.

FED should buy stocks to stabilize the markets

Posted by Shyam Moondra

It's amazing to see how people have become used to the DJIA declining 500+ points a day. The ramifications are far reaching; the crash of financial and housing markets will inevitably lead to declining living standards and increasing poverty around the world. While people enjoyed the fruits of globalization when things were going great, now they must share the pain when the sky is literally falling down.

The question is what can we do now? The government has many other tools at its disposal that it can use to build up the investor and consumer confidence. One thing the federal government could do is to buy the stocks in the open market which will surely move the market up and improve the investor sentiment. At the current fire-sale stock prices, the tax-payers will eventually reap huge profits in a year or two when the stock markets reflect the true value of the corporations. Those profits could then be used by the new president to invest in education, health care, and infrastructure improvements.

Here is a list of what the government should do:

1. FED and Treasury Department should buy stocks of major blue-chip high quality stocks in the open market at the current outrageously low prices.
2. Extend FDIC insurance to all deposits regardless of the amount.
3. Close-down weaker banks immediately, so that banks can start freely lending money among themselves.
4. FRB should immediately lower funds rate by another 0.5%.
5. FRB should extend credit to corporations and small businesses to avoid layoffs.
6. Implement $700 bi bailout without any delay.
7. Treasury Department should also buy foreclosed houses on sale and sell later when the housing market recovers, as was done during the last depression.
8. President Bush should coordinate actions with EU, Japan, and China, and convince oil-rich countries to use their sovereign funds to invest in American companies.