Fear, Greed and Need

Investing is a human endeavor that is subject to human emotions. When markets are up and doing well, confidence runs strong and investors take on more risk. When markets are doing poorly, conviction is lost and safety is sought. This dynamic is captured in the old Wall Street adage that financial markets are moved by fear and greed, a concept rephrased by Warren Buffet, “Be fearful when others are greedy and greedy when others are fearful.” Of course, investors devote vast amounts of time and effort to understand economic fundamentals and conventional financial theories such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These rational financial theories do a reasonable job of predicting and explaining most of the action and events of the market, but certainly not all. In fact, these and other modern financial principles assume that people, for the most part, behave rationally and predictably. However, human behavior, the ultimate source of investment decision making, is anything but rational or predictable. Indeed, fear and greed are human behaviors born of raw emotion.

 

Traditionally, we have associated over-bought markets as being driven by greed and over-sold markets as being driven by fear. The equity markets have more than tripled since March of 2009 and the market has now gone 43 months without a 10% correction. So, it’s hardly a stretch to consider the current equity market over-bought. However, we suggest that the current over-bought market is being driven not by greed, but by fear, or more precisely, a derivative of fear, need. Seven years of zero bound interest rates have left institutional and individual investors falling woefully short of returns required to satisfy their short and long term financial needs. Accordingly, investors in need of higher returns to achieve their goals and objectives have been forced to take equity-market risk with funds that would otherwise be allocated to lower risk bonds. While the Federal Open Market Committee is likely to raise rates sometime soon, the Fed has been very clear that the progression of rate increases will be very slow. As such, investors will continue to have a “need” to take more risk in order to meet their goals.

 

So, does this dynamic mean that the equity markets will continue to move up until interest rates normalize? We think not. The economic recovery from the Great Recession is historically long in the tooth, and recent economic data has not confirmed sustainable economic growth. To the extent the economy falters and equity markets begin to retreat, we believe that investor “need” may revert to investor fear, and equity markets may correct as they have historically in the wake of such emotion. Accordingly, our message today is that the markets’ continued move up, especially in the absence of sustainable economic improvement, is being driven by emotion rather than sound fundamentals. While our portfolios are diversified for long term exposure to various asset classes, it is incumbent upon us to raise awareness of the current circumstances surrounding the equity markets in order to better manage expectations.

 

David E. Post

Chief Investment Officer

May 20, 2015

 

PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. This market commentary is a matter of opinion and is for informational purposes only. It is not intended as investment advice and does not address or account for individual investor circumstances.  Investment decisions should always be made based on the client’s specific financial needs, goals and objectives, time horizon and risk tolerance.  The statements contained herein are based solely upon the opinions of Telemus Capital, LLC.   All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third party sources, which we believe to be reliable, but not guaranteed.

To Raise or not to Raise?

According to the minutes of the FOMC meeting released today, Federal Reserve officials who met in late April doubted that they would be ready to raise short-term interest rates by midyear. They are trying to make sense of a first-quarter economic slowdown, and although many officials believe temporary factors were to blame for the weak data, they want to be confident that growth is on track, unemployment will continue falling, and inflation will rise toward their 2% goal.1 Second-quarter economic data should provide us with more clarity as to whether the slowdown was indeed transitory in nature. Stay tuned.

 

1 http://www.wsj.com/articles/fed-minutes-june-rate-hike-doubtful-1432144801

Three Cheers for Earnings??

According to FactSet Earnings Insight, over 90% of the S&P 500 companies have reported Q1 2015 earnings. A welcomed surprise was the fact that earnings have come in much better than analysts’ expectations at the end of Q1. The good news is that blended earnings growth will be positive, albeit just barely at +0.1%. Indeed, certainly better than the expected -4.5%. However, if we cheer for these results it appears that we will be cheering for financial engineering or something similar. While earnings are of course important, a lot can happen between the top and bottom lines, some of it having nothing to do with the health of the business or the economy.

On the other hand, top line revenue can’t be hidden and is directly related to the health of the business or the economy. According to FactSet it now appears that top line revenue growth will be down 2.8% year-over-year in the first quarter, which is actually a pretty rare occurrence. With the price of oil down and the strong US dollar impacting foreign sales, many may be inclined to suggest the dip in revenue as transient. However, consensus expectations are now calling for a 4.8% drop in Q2 revenue, which, when combined with the Q1 decline, may threaten a revenue drop in the full year 2015. If so, 2015 would be only the second time in 15 years with negative revenue growth. The other occurrence was in 2009 during the worst economic downturn since the Great Depression. In order for earnings to continue to support current market valuations without revenue increases, profit margins would have to expand beyond their current all time highs. This may be just too much to ask.

Economic Growth and the American Dream

There has been much talk about the increasing disparity of wealth in our country and there are few facts that explain this dynamic better than a comparison of wage growth and the growth of financial market value. As we know, wage growth is particularly germane to the vast majority of the population and there are a number of metrics that demonstrate a lack of real growth in wages. According to FRED (Federal Reserve Economic Data) the inflation adjusted real median household income in the US in 1981 was $46,205. According to Sentier Research (FRED only has numbers through 2013) the 2015 real median household income was $54,203. This amounts to less than 0.5% of annual wage growth over the past 35 years! In contrast, financial assets, which are more germane to a small fraction of the population, have grown 15 times since 1981. According to the Fed’s flow-of-funds calculations the sum of credit market debt outstanding plus the market value of equities has increased from $7.2 trillion (2015 constant dollars) in 1981 to $95 trillion in 2015, about 7.7% annual growth. Left to market forces this circumstance would have corrected itself long ago. However, Fed policy, particularly in the past 30 years, and more particularly in the past 10 years, has created “asset inflation” that has accrued to the benefit of asset owners, while wage earners have been left behind. This dynamic must change for the American dream to stay alive.

Labor Statistics: For Support, Not Illumination

A look beyond the headline jobs numbers reported by the Labor Department last Friday tells a much different story than that taken away by investors who pushed the Dow up 267 points upon hearing the news. Here are a few takeaways from the “below headline” numbers: 1) the weekly earnings of production workers rose 67 cents (0.1%). This number is not some anomaly, short or medium term. Rather it has been going on for that last 30 years and it relates not to part-time after-school workers or those working a second job. This constant dollar flat wage growth of which I speak is for all full-time workers. 2) Last Friday’s jobs report tells us that only 46% of prime work age (16-54 years old) have any kind of job at all, a percentage that is 10% below where it was in 2000. And, 3) it is important to understand that 95% of the jobs “created” last month is an estimate of the jobs created by an estimate of newly formed companies. To repeat, 213,000 of the 223,000 jobs created in April were an estimated number of an estimated number. This is why the Bureau of Labor Statistics states that the nonfarm payrolls number has a 90% chance that the actual number of jobs created is within 105,000 jobs of the estimate, in either direction. In the current day of “data dependency” we are cautioned to remember two things: 1) Statistics are used much like a drunk uses a lamppost: for support, not illumination, and 2) Statistics are no substitute for judgment.

The Goldilocks Report

Last Friday the Labor Department reported that 223,000 new jobs were created in April. It was widely reported that Wall Street referred to the news as a “Goldilocks” report, not too hot and not too cold. Investors took that as a positive pushing the equity markets up across the board with most indices closing the week at or near all-time highs. However, the problem with “headline” numbers, in this case, 223,000, is that they don’t tell the whole story. Even if you just look at the headline numbers for more than one month you get a slightly different story. Namely, the March increase in jobs was revised down to 85,000, so the two-month average of jobs created was 154,000, well below the Q1 average of 184,000 jobs created, and even further below the 2014 average of 260,000. These headline numbers show a downward trend that seems undeserving of the investor elation shown last Friday.

Lord Almighty, I Feel My Bund Yields Rising

A worldwide sell-off in government bonds deepened today, buoyed by rising German Bund yields that recently hit record highs and narrowed their gap with U.S. Treasuries. Benchmark 10-year Bunds now trade at 0.53%, having hit a record low of 0.05% last month when many expected them to turn negative. The brutal meltdown in the bond market is also raising pressing questions for investors – is this a correction or merely a trend change?1 Keep an eye out over the next several months as the release of economic data will help answer that question.

 

1 http://seekingalpha.com/news/2491466-the-bond-rout-continues?ifp=0

Organizational Leadership

A worldwide sell-off in government bonds deepened today, buoyed by rising German Bund yields that recently hit record highs and narrowed their gap with U.S. Treasuries. Benchmark 10-year Bunds now trade at 0.53%, having hit a record low of 0.05% last month when many expected them to turn negative. The brutal meltdown in the bond market is also raising pressing questions for investors – is this a correction or merely a trend change?1 Keep an eye out over the next several months as the release of economic data will help answer that question.

1 http://seekingalpha.com/news/2491466-the-bond-rout-continues?ifp=0