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Off to a Fast Start

SPXstart Off to a Fast Start

Price Source: Bloomberg

Although we have not quite finished the first quarter, it is obvious that the broad market is off to a fast start this year. A great deal of that performance was attributable to the stellar rise of Apple shares but there has also been a healthy serving of general improvement in the economic prospects both in the US and Globally.

The question one has to ask is: how much longer can the market run?

To answer that, one must consider what is driving the market. And, in general, the drivers are generally positive and sustainable. Of particular interest is the strength in Housing and Banking for which we can take XHB (chart) and IYF (chart) as proxies. If these two related sectors are showing signs of recovery, there is hope that the great American Consumption Machine can be cranked up to its former glory.

Looking at the S&P 500 earnings breakdown, the only “fly in the ointment” is the estimate that cashflow is due to drop (down 10.9%) even though earnings are still bounding forward (up 8.8%) in 2012. However, one should note that much of the discrepancy will be due to banks writing back unused loan loss reserves (a plus for earnings but a non cash item) and increased dividend payouts (negative for cash flow but a good thing for shareholders). These are to be expected and even welcomed as the recovery slowly gathers some momentum.

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SPXEEO Off to a Fast Start

The forecasts for 2013 and 2014 are probably too “straight-lined” to take seriously at this point. Around half the earnings on the S&P 500 are derived outside the US so they are still susceptible to troubles in Europe or China. However, it is fair to say that most of the potential bad news appears to be in the market. It will take a serious shock event (Iran, perhaps?) to knock the markets at this point.

So, for the next few weeks, there is little reason to be concerned that the main indices have burst out of the gates a bit faster than in the past few years. The Fund King System numbers are running in the teens for most risk assets with some sub sectors reaching into the 20’s and 30’s.

The Meaning of 7.5% Growth

China recently announced that the target for economic growth has been lowered from 8% to 7.5%. For most countries, this would hardly rate more than a line or two buried deep in the middle of the paper. However, for China, the 8% growth rate is deeply symbolic. The 8% rate has been a key metric against which the Communist Party has measured itself in this latest 10 year political cycle. Anything below 8% growth is cast as the equivalent of a recession. The success of one party rule in China hinges on the ability of that party to deliver the economic goodies.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.

Tablets and Cellphones

What is the market saying about the tablet/cellphone wars?

Are you holding out for the Ice Cream Sandwich version of the Android operating system? Does the acronym LTE excite you? Do you think that Microsoft might finally get things right with Windows 8 running on an ARM chip? Do you think Apple at $500 a share is merely a milestone? Will Amazon surprise us all with new and improved Kindle offerings?

Here are a few of the main companies in the tablet/smartphone wars and how they rate currently. It is interesting to note that while we have seen very impressive performance from Apple, they are not the only ones in the running.

Samsung Electronics (+27.92%, Company Info) The massive Korean conglomerate is both supplier and competitor to Apple and most of the key players in the IT/Cellphone/Consumer Electronics field.

Hon Hai Precision (+25.65%, Company Info) In the news recently for its Foxconn subsidiary, the main contract assembler Apple and most other name brand consumer electronic companies.

HP (+14.27%, Company Info) After some serious strategy wobbles, HP is promising to redouble its efforts.

Apple (+13.22%, Company Info) It’s the biggest stock in the S&P 500 and the excitement building around the iPad3 is driving component makers in Asia into frothy territory.

Microsoft (+11.77%, Company Info) Windows 8 in two flavors and compatibility with ARM chips. Could 8 be the lucky number for a company that has struggled with mobile versions of its main operating system over the years?

Google (+10.98%, Company Info) In addition to the Android platform, the company is trying to acquire Motorola Mobility.

Dell (+9.63%, Company Info) Dell’s forays into tablets have not panned out so far.

nVidia (+2.8%, Company Info) Primarily a high end graphics chip designer, nVidia is taking its engineering expertise into the smartphone arena with “Tegra” chips that boast up to 5 “cores”.

Motorola Mobility (+1.93%, Company Info) The “pioneer” of the mobile phone is trying to make a comeback under the RAZR badge.

ARM (+0.46%, Company Info) ARM designs the RISC chips that sip power compared to mainstream CPUs from AMD and Intel, a critical factor for battery powered devices.

Asustek (-0.27%, Company Info) is a threat on both the ultrathin laptops and tablet space.

Sony (-7.17%, Company Info) The company has made a concerted effort to produce a competitive tablet. Can they still bring out the old Sony magic?

Amazon (-18.13%, Company Info) Although the Kindle Reader in all its forms is a tiny, loss-making part of the Amazon retailing empire, the Readers are cheap and popular.

HTC (-28.08%, Company Info) Despite its success with Android based handsets, it has weathered a fair bit of legal strife, primarily from Apple.

What should you conclude?

As we climb the “Wall of Worry”, there are other trends which are not dependent on Central Bankers and European Politicians.

Volatility

One of the lessons we have learned from the Fund King System is that cycles do exist and participating in them can have a significant impact on downside protection and long term returns. The timing and the magnitude are not perfectly predictable but one need only be ready for the next wave and jump on when it becomes evident.

With Greek mobs burning buildings to celebrate the deals being struck to tame the Greek Sovereign Crisis, one can sense that the market has fully discounted nearly every ugly outcome from this real life financial tragedy. A Eurozone recession, bank bailouts, austerity programs and at least one or two exits from the Euro are “baked in” to the market.

As a result, the most watched measurement of volatility, the VIX, is at a very subdued level.

VIX Volatility

Source: Bloomberg.com

So this week, we think it is worthwhile to look at the risks in the market to see what might drive the VIX to much higher levels.

The two big macro risks which spring immediately to mind are a military strike against Iranian nuclear facilities and an inflationary spike in the US.

Military Strike Against Iran

Even though the US and EU have been tightening the sanctions regime on Iran of late, the Islamic Republic appears to be forging ahead with its “peaceful” nuclear enrichment program. The leadership of Iran protests that nuclear weapons are not the goal while Israel is playing the “bad cop” to the Obama administration’s “good cop”. There are a few points (as highlighted in the Wall Street Journal) that make an Israeli airstrike in the coming months credible:

  1. Syria, Iran’s ally and Israel’s neighbor, is embroiled in near civil war conditions,
  2. the rest of the Arab world would not mind seeing Iran’s influence in the Middle East taken down a peg,
  3. Israel does have the airforce and bunker busting ordinance to inflict serious damage on Iran’s nuclear enrichment facilities,
  4. Israel has a track record of attacking nuclear facilities in Iraq and Syria when development seemed to threaten its existence.

The risk of a strike is low (Stratfor seems to think it very unlikely) but not low enough for investors to ignore. Iran’s most likely response will be to mine the Straits of Hormuz to choke off a significant amount of the world’s daily oil flow and a conventional ballistic missile strike on Israel. Although the US will certainly be informed of any strike, may be complicit in providing resources and is winding down the second of its two recent adventures in the region, Iran will not want to take on the US directly in its retaliation.

The market reaction? A short sharp price spike in Oil, Precious Metals and “safe” assets like US Treasuries is the most likely. Building a small exposure to these assets (particularly the first two) is a sensible precaution. If nothing happens, an economic recovery and the risk of US inflation would probably benefit energy and precious metal asset classes anyway.

Inflationary Spike in the US

The consensus for a long slow recover in the US is another “baked in” conclusion in the market. However, taking the recent past and projecting it in a straight line into the future is a risky bet. An inflationary spike (a temporary move to double digit inflation, for example) could arise if banks were to start lending out the high powered money created by the Federal Reserve in response to the Global Financial Crisis.

Could it happen? Already, we are seeing signs that the most bombed out property market, Las Vegas, is starting to see some clearance in January. Prices don’t have to move up for the banks to start to see the light at the end of the tunnel and restart their mortgage lending machines.

For an incumbent president running for reelection, a reigniting of “animal spirits” amongst loan officers at the banks is not a fire that the deflation-phobic Bernanke FED is going to rush to fight. With a commitment to keeping rates low through 2014, the FED can allow banks to rebuild their balance sheets while dominating the secondary market in Treasuries to keep interest rates on US debt low.
Whether the FED is able to stuff the inflation genie back into its bottle once released is another matter.

Traditionally, hard assets like commodities would be a desirable hedge against this type of inflation. However, with global demand likely to remain subdued in the short term (on the back of a European recession), hard assets in the US (like real estate), may be the better choice for the first move. If the inflation stokes demand that spills over into export orders for China, then industrial commodity plays would be an excellent way to catch the second wave.

Waiting on QE3

“When the only tool you have is a hammer, every problem begins to resemble a nail.”
- Maslow’s Maxim

The market is gearing up for the announcement of another round of Quantitative Easing to be dubbed QE3, although one could argue that QE3 has already started with the opening of practically unlimited swap lines between the US and European Central Banks.

The signs that the Risk Markets need a kick to keep the party rolling are popping up around the globe:

US

GDP was a bit soggy in 4Q. There are plenty of reasons for disappointment:

  1. a bit too much inventory build,
  2. a worrying drop in the savings rate,
  3. lower 4Q earnings surprises and growth than 3Q numbers, and
  4. 1.5 – 2% GDP growth rate which means that US voters will go to the polls in November with around 8.5% unemployment.

To confirm the slow growth trend, the FED has made the unprecedented announcement that it will keep rates at current near-zero levels for the next three years. Team Obama may hope that the Republicans tear themselves apart in the primary season but that is no reason not to try a few more Keynesian and Monetarist kicks to the system to spruce up the economic backdrop for the autumn.

China/Asia

Asia typically greets the first day of trading after Chinese New Year with a rally, especially for a “Dragon Year”. However this year, only Taiwan managed to pull out a positive day on delayed reaction to strong Apple numbers. Hong Kong and Chinese investors parsed poor real estate sales results over the Chinese New Year Holiday and took the Hang Seng Index down towards the so recently breached 20k mark.

Europe

And not to be left out, Europe is preparing for another cycle of summits to solve the “Euro Crisis”.
Whatever solution bubbles up from the cauldron this time, it seems to be too late to save Greece from exiting the Eurozone. The real question now is whether the Eurozone can draw a line at Spain and Italy (Portugal appears to be the other acceptable casualty of the Euro Crisis). No matter what the politicians decide, recession (and worse) will haunt the Eurozone for most of 2012.

What is the System Saying?

The system can be described as somewhat lukewarm about risk assets with a definite preference for US listed equities. Top ratings for funds and ETFs are in the teens and for S&P 500, there are a few rating in the 30s and 40s. Given the extremely high likelihood of another round of government stimulus and Central Bank pump priming, one should wait for the next burst of bullish enthusiasm before taking profits.

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