Finance, Insights

Too Good to be True

PaulNolte-2“Wishin’ and hopin’ and thinkin’ and prayin’” is not only the lead into a song, but also the strategists’ playbook for figuring out the next Fed move. The White House is wishin’ the economy picks up some real steam, as President Obama indicated in the State of the Union. Investors continue hopin’ the Fed keeps rates l“Wishin’ and hopin’ and thinkin’ and prayin’” is not only the lead into a song, but also the strategists’ playbook for figuring out the next Fed move. The White House is wishin’ the economy picks up some real steam, as President Obama indicated in the State of the Union. Investors continue hopin’ the Fed keeps rates low to help boost stocks ever higher. Everyone is thinkin’ they know what exactly will happen in the months ahead. And whatever happens, we’re prayin’ it all comes out just fine. The “glass is half full” group saw the employment report as further evidence of a very robust economy. Jobs were created at the fastest pace in years and wage growth for the month was also very good. Combined with the weekly jobless claims, any thought of recession remains many months away. The “glass is half empty” crowd saw a higher unemployment rate (as more people are coming into the workforce) and wage growth that remains at roughly 2%, which is still on the lower end of the historic range. Additional worries about layoffs in the energy sector (that are higher paying jobs) and a strong dollar that encourages buying overseas products, continue since the worrywarts fear any hike in interest rates will tip the US back into a recession. Following her visit with Putin last week, Angela Merkel is chatting with Obama this week as the world is hopin’ for some resolution to the situation in the Ukraine. Investors need more than just hope for stocks to continue their trek to new all-time highs.

The markets have taken the long way back to beginning year levels. The Dow has moved just under 4000 points since the start of the year, with nothing to show but an upset stomach. Many of the indicators we regularly review are stuck in middle, neither wildly overbought nor oversold. When markets are as volatile as they have been without a clear trend in place, many of the technical indicators are fairly useless, save for some very short-term trading. The daily swings in the markets have masked some already stunning moves in various sectors. Interest rate sensitive investments, from utilities to REITs have done very well as investors clamor for any investment that pays a decent income. However, this yield chasing has put many of these stocks into very high valuation levels that are not likely to be sustained in the months/years ahead. If/when interest rates do finally rise, these investments are likely to suffer as well. One other note on corporate earnings announcements, the stronger dollar is hurting corporate earnings. For many multinational companies, the stronger dollar means overseas earnings are translated back into fewer dollars. This may be a temporary condition as the dollar is not likely to continue straight up, but a warning to investors that overall earnings growth is likely to slow.

The “bad” in the very good employment report is that bond prices declined as expectations for a Fed rate increase rose. Will higher wages translate into more spending, as is hoped and begin a virtuous circle of corporate investment and hiring. If spending rises, companies will need to hire more people who can then also buy goods/services, forcing companies to produce more, requiring more hiring. The bond market worries that this cycle of events will put pressure on the Fed to continue raising rates well beyond the one that is expected mid-year. Trying to extrapolate one good (or bad) report has made all of the markets extremely volatile.

The markets may be in the very early stages of rotating away from interest rate sensitive sectors into stocks that benefit from a growing economy. Utilities have dropped 5% over the last two weeks while energy and basic materials have gained over 3%. What may be nothing more than a bounce after fairly heavy and intense selling, the energy related stocks have been captive to the falling prices for crude oil. IF energy prices moderate, the stocks should do well. IF interest rates also moderate, investors will move away from higher yielding investments. Finally, IF the dollar slows its ascent, international investments will do well. As we mentioned last week, a more diversified portfolio should do better over the coming year or two than one focused exclusively on the large US companies. We are seeing some very early signs of the shift, but additional time is needed to feel better that the change has indeed taken place.

The bond market is beginning to show signs that rates are indeed going higher. This statement is not without caveats as there have been plenty of head fakes in the last five years. For now, we continue to invest in 7-10 year maturities while reducing interest rate “exposure” in the equity holdings. Volatility is not going away soon. Sometimes, the best thing to do in this type of environment is to stick with quality and hold through the storm.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.