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Macro Strategy Review April 2013 Unlocked (1)

Macro Strategy Review April 2013 Unlocked (1)

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April 2013
Forward Markets: Macro Strategy Review
Macro Factors and Their Impact on Monetary Policy,The Economy and Financial Markets
U.S. Economy
Sooner or later most car drivers have this experience. You’re drivingon the freeway, listening to some good music, the sun is shining,and you decide to switch lanes. You check the rear view mirror,note everything looks clear, turn on your right blinker, and beginto ease into the lane on your right. Suddenly this smooth processis interrupted by the sound of someone laying on their horn. Youcheck the rear view mirror, see the car you’re about to collidewith, wonder where it came from, and promptly move back into your original lane. If you’re lucky, you’ll also see the other drivergesture their appreciation of your driving skills. After regaining yourcomposure after the close call, you realize the car you didn’t seemust have been in your blind spot.At important tops and bottoms in the stock market, manyinvestors are impacted by their blind spot and it often costs themdearly. By their nature, markets are forward looking and discountthe future, and if one listens closely, the message of the marketcan be discerned. As such, markets anticipate changes in theeconomy, whether it is the changing level of interest rates, stockprices, home values, gold, oil, copper, or any asset whose price isdetermined by supply and demand. The opinion that the marketsare a discounting mechanism is expressed almost daily on CNBCor Bloomberg and in financial publications. For the most part, thedirection of any market is aligned with the views of participants.If the ‘news’ is negative, most investors will be inclined to selland the market will be in a declining phase. When investors arepositive and supported by good ‘news’, there will be more buyersthan sellers and the market will be in an uptrend. This process mayseem elementary and obvious and it is. The process that createsthe blind spot is reinforced by three factors – fundamentals, time,and human nature.At the beginning of a new trend there will be some fundamentalbasis that justifies the reason to become positive or negative. Overtime, more market participants will agree with the fundamentalreasons supporting the trend, and will take the appropriateaction – buying if the fundamental reason is positive or selling if the fundamentals are poor. The market responds to the increaseof buying or selling, forcing more investors to take action, whichfurther reinforces the trend. Humans project the recent past intothe future, which means investors have a tendency to invest lookingthrough the rear view mirror. If the stock market has been trendinghigher for an extended period, investors know most of the reasonswhy the market has been going up and expect the trend will remaintheir friend. Investors are repeatedly advised by the financial pressand advisors that it is a mistake to sell, so they resist the urge tosell even as the stock market is falling. When the pain from a steepdecline becomes too great and they simply can’t take it anymore,they frequently throw the in towel not far from a bottom. Investingthrough the rear view mirror is why so many investors buy near amarket high, and sell at market lows.The notion that the stock market is a discounting mechanism thatanticipates changes in the economy is part of Wall Street folkloreand is widely accepted. It is logical, easy to understand and worksmost of the time, which creates the blind spot. But here’s the rub.At every major top and bottom in the stock market, the marketis wrong. We appreciate that this view borders on heresy, but aquick review of history should prove the point. The advent of theinternet in the early 1990’s brought about a technological boomthat boosted productivity. After almost a decade of gains, the ‘NewParadigm’ resulted in extraordinary valuations, but that didn’tinhibit investors from flooding technology mutual funds with
 
Macro Strategy Review www.forwardinvesting.com
2
money. In March 2000 when the Nasdaq Composite was above5,000, what was the market discounting and ‘telling’ technologyinvestors? Don’t worry, be happy, tech stocks are still going higher!The bull market that began in March 2003 was more than four years old when the first rumblings of the credit crisis appearedin August 2007. After the Federal Reserve cut the federal fundsrate several times, and Fed Chairman, Ben Bernanke, said housingwould stabilize by the end of 2007, the stock market rallied to a newall-time high in October 2007. Clearly, the stock market was tellinginvestors that a potential credit crisis was a non-event. Wrong. ByDecember 2008, the Federal Reserve had slashed the Federal fundsrate to .25%, but the economy and stock market remained in freefall in early 2009. Certainly, the stock market was confirming thatthe sky was indeed falling.What is amazing is that investment professionals are just as likelyto develop a blind spot as the retail investor who follows marketmovements only part time. It’s possible that professionals are morelikely to believe that markets truly are a discounting mechanismsince they know all the reasons why the current trend is happening.For instance, it is the responsibility of the rating agencies to rateand measure the amount of risk in the securities related to housing.Moodys, Standard & Poors, and Fitch Ratings all used sophisticatedmethodologies to evaluate mortgages, mortgage back securities,and all the derivatives they routinely rate AAA. Amazingly, theanalytics used by the rating agencies presumed home prices wouldnot decline, since they had not fallen since the 1930’s. Between1965 and 2000, the ratio of home prices to median incomeremained remarkably stable, fluctuating near 3.3 to 1. This was theresult of mortgage lenders not allowing the monthly mortgagepayment of a home buyer to exceed 33% of income. As shown inthe Radio of Median Home Price to Median Household Incomechart above, by 2006, the ratio of home prices to median incomehad risen from 3.3 to 1, to 4.7 to 1. And yet, the rating agenciesbelieved the risk of a decline in home prices was still 0%.In our opinion, the stock market and markets in general arealmost always wrong at every major top or bottom. Despite thehistory and facts, the belief that the stock market is a discountingmechanism continues. In recent weeks the common theme onCNBC, Bloomberg and in the financial press is the recent strengthin stock market is telling us the U.S. economy is in good shape. Theexpected pick up in GDP and earnings in the second half is whyinvestors should buy if the market dips. As we noted last month,there are a number of reasons why a second half improvementis unlikely. Investors’ faith that the market is a discountingmechanism may be creating another blind spot if the economyfails to accelerate as forecast.Last year Gross Domestic Products (GDP) grew 1.7%, and that waswith an improving housing market and increase in auto sales. Evenif they continue to improve, the incremental addition to GDP will besmall, and not likely to offset the impact of the tax increases andsequester. The Congressional Budget Office has estimated that thecombined drag from the tax increases and sequester will amount to1.75% of GDP. Our view has been that the impact from the increasesin taxes and sequester was likely to be cumulative. The 2% socialsecurity payroll tax is about $20 a week for a worker with medianincome of $50,000. We doubted most consumers would respondwith spending reductions after they received their first paycheckin January. Instead, many consumers would maintain their lifestyle for a period by charging a bit more and dipping into savings.The cuts implemented by sequester are likely to take some timeas they ripple through the economy, as down steam suppliers areincreasingly affected. This suggests the drag from the tax increasesand sequester are likely to intensify in the second half of this year.Consumer spending represents 70% of GDP and the overallfinancial health of many consumers has gradually deterioratedduring the last two years. Wages grew just 2% on average in 2011and 2012, less than the increase in the cost of living. Real per capitadisposable income has shrunk by 0.4% at an annualized rate overthe past five years. That is the worst reading since this data seriesbegan in 1964, according to the Bureau of Economic Analysis. Since2002 median income has declined 9.1%, falling from $56,438 to$51,320 in March 2013. According to Sentier Research, since therecovery began in June 2009, disposable income has fallen from$54,275 to $51,320, a drop of 5.4%, which only reinforces how sub-par this recovery has been.Only 88,000 jobs were created in March, which was far belowthe gain of 268,000 in February. We suspect the March reportoverstated the degree of weakness, which implies a better numberis likely when the figures for April are reported in early May. Thatsaid there was not much to like in the March report. Nearly 500,000
200%250%300%350%400%450%500%
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Source:U.S.
Census
Bureau,
Sentier
Research,
National
Association
of 
Realtors,
period
ending
03/31/13
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Macro Strategy Review www.forwardinvesting.com
3
Americans dropped out of the labor force, the biggest one-monthdecline since December 2009. The participation rate measures thenumber of people who are working or looking for work. In Marchthe participation rate fell to 63.3%, the lowest since 1979. There isno question that demographics are playing a role as out-of-workbaby boomers choose to retire. However, this only explains about60% of the decline in the participation rate. The participation ratefor workers 25-54, considered prime-age-workers, was 81.3% inMarch, the lowest since 1984. When the recession began in January2008, the participation rate for those under 25 was 60%, but wasdown to 55% in March. There are a lot of college graduates whohave a diploma, an average of $25,000 in student loans, and areworking at Starbucks. According to MFR, Inc., the unemploymentrate would be over 11%, if the participation rate was at its 2007level of 66%. There are 7.6 million workers who are working parttime, but want a full-time job. The U-6 rate was 13.8% in March,which includes those seeking a full time job and those whohave given up looking. The labor market continues to grow at arate that is not likely to boost wage growth or bring the level of underemployment and unemployment down in a meaningful wayin coming months. This suggests the odds do not favor a significantimprovement in consumer spending before year end.The American consumer has often been considered a spendthrift,but that has not always been the case. Between 1958 and 1988,the average savings rate was over 8%. Despite the roaring bullmarket of the 1990’s and the housing boom until 2007, theaverage savings rate declined until it was below 2.0% in 2006. Inthe first quarter of 2011, the savings rate had improved to 5.4%.In another reflection of weak income and job growth over the lasttwo years, the savings rate fell to 2.6% in February. Consumershave been dipping into their savings since early 2011, which couldmake it difficult for savings to support an increase in spending inthe second half of 2013.
Message to U.S Economy: Don’t Fight the Fed!
The Federal Reserve (Fed) has held the Federal funds rate just above 0% since late 2008, and initiated three rounds of Quantitative Easing (QE) over the last 5 years in an attempt toignite a self sustaining recovery. Despite unprecedented monetaryaccommodation this recovery has been far weaker than the averageof the 10 post World War II recoveries. Clearly the economy isfighting the Fed. The lack of a stronger economic response to theFed’s efforts introduces an interesting topic for debate.As far as Wall Street folklore goes, ‘Don’t fight the Fed’ may be themost accepted piece of Wall Street wisdom, popularized by MartyZweig in his 1986 book “Winning on Wall Street”. Historically, thereis no question that monetary policy has had a significant effecton the stock market over the last 60 years. The stock market hasusually begun a new bull market after the Fed lowered rates, oftengaining 30% to 50% in the first year. More importantly, monetarypolicy has been the most effective policy tool in managing theeconomy. In times of strong growth and rising inflation, the Fedhas raised rates to slow the economy and bring inflation down.To lift the economy out of recession and spur growth, the Fed haslowered rates. For most of the past 60 years, the economy hasresponded within 6 months or so whenever the Fed has eithereased or tightened policy.The legitimacy of ‘Don’t fight the Fed’ has been a strong reboundin the economy which validated the run up in stock values. We areconcerned that investors are too focused on the positive impact of QE3 on stock prices and are overlooking how important it is thatequity valuations be validated by the economy. A quick review of how effective monetary policy has been in managing the economysince 1954 will reveal that monetary policy has indeed lost some of its economic Mojo.
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й
DĂƌĐŚhŶĞŵƉůŽLJŵĞŶƚZĂƚĞϳ͘ϲйDĂƌĐŚhͲϲZĂƚĞϭϯ͘ϴй
12%14%
WĞƌƐŽŶĂů^ĂǀŝŶŐƐZĂƚĞ
Source: Bureau
of 
Economic
Analysis,
period
ending
02/01/13
 
4%6%8%10%12%
 
0%2%4%
Ͳ
3%
Ͳ
1%1%3%5%7%9%0%2%4%6%8%10%12%14%16%18%20%
       &     Ğ       Ě       &     Ƶ     Ŷ       Ě     Ɛ       Z     Ă      ƚ     Ğ
Fed
Funds
Rate GDP
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Source:Bureau
of 
Economic
Analysis
and
Federal
Reserve
Bank
of 
St.
Louis,
01/01/54
Ͳ
12/31/86

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