May 3, 2014 Blame It On The Rain

Risk/Reward Vol. 219
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"And you feel like such a fool
Gotta blame it on something
Blame it on the rain."---lyrics from "Blame It On the Rain" lip-sync'd by Milli Vanilli

"So look at me now/I'm just makin' my play
Cause I'm back/Yes I'm back
Well, I'm back in black."---lyrics from "Back in Black" sung by AC/DC

"We just want to dance here/Someone stole the stage
They call us irresponsible/Write us off the page
We built this city/We built this city on rock and roll."---lyrics from "Built This City" sung by Starship

On Wednesday, the Commerce Department released a report on first quarter (Q1) 2014 gross domestic product (GDP), the broadest measure of how the US economy has performed. For the first three months of 2014, GDP grew at a woeful 0.1% annualized rate, far short of the 2.6% annualized rate reported for Q4 2013 and well below 1.1%, the consensus estimate from economists before the report's issuance. The GDP report preceded a press release of the Federal Reserve which also was issued on Wednesday. In that press release, the Fed referenced the sharply lower Q1GDP number but attributed it to weather and cited its expectation of much better numbers in Q2 as a justification for further tapering its asset purchase program (QE3). Really? Really? Instead of owning up to the fact that its accommodative monetary policies have failed to jump start the Main Street economy (see last week's edition Riskrewardblog ), the Fed "like a fool" "Blames it on the Rain". Well, I guess Ms. Yellen and her cohorts have to "blame it (no growth) on something", and the weather is as good as any other fall guy. But if you believe that weather was the cause of our economy's pitiful performance, then you believe that the dog ate the homework---and that Milli Vanilli actually could carry a tune.

So if the GDP report was a disappointment, why did the Dow Jones Industrial Average (DJIA) record a new high on Wednesday--- and drop after Fridays' seemingly positive jobs report? (Note: the DJIA dropped before any details came from Ukraine, news which admittedly contributed to Friday's negative close.) Here is my take. The employment report is a mixed bag. The headline gain in jobs (288,000) and drop in the unemployment rate (6.3%) is encouraging, but a deeper dive into the report reveals that the labor force (job participation rate) is shrinking. Only 62.8% of working age persons are employed or unemployed and looking for a job. This is the lowest labor participation rate in 35 years---a time when women did not participate in the work force in the numbers that they do now. As discussed last week, an aging and shrinking labor force (800,000 people dropped out of the pool in April alone!) carries long term and lasting negative implications for economic growth. Fewer workers means less demand, and less demand means less growth. Moreover, minimal wage gains were reported which signals that the new jobs that were added are lower paying ones. I submit that any positive movement in the market this week had less to do with lower unemployment OR the expectation of future growth and more to do with another statement in the Fed's press release; to wit, that the Fed will keep the Fed Funds rate low as long as inflation remains below its 2% target. This could be a very long time since 1) inflation is currently below 1%, and 2) the greatest driver of inflation, wages, remains stagnant. The bond market obviously agreed as the yield on the 10Year US Treasury Bond did not rise above 2.68% during the entire week and fell to 2.59%% at Friday's close. So what does this have to do with stock prices? Low interest rates make borrowing inexpensive for credit worthy companies such as those comprising the DJIA. This cheap and plentiful credit promotes mergers, acquisitons and stock buy backs. Thus, it is not surprising that currently Pfizer is in the hunt for AstraZeneca , AT&T is pursuing DirecTV and Exelon is buying Pepco, all at huge premiums to their market price. In addition, Apple sold $12billion in bonds this week and intends to use the proceeds to fund in part its announced $90billion share buy back program. The entire purpose of buybacks is to keep stock prices elevated. Like AC/DC, "look at Apple now/Just makin' its play" It's "buyin' stock back/ Yes, it's buyin' stock back/Well it's buyin' stock back/Puttin' its shareholders more into the black." Accordingly, in my humble opinion, it was the prospect of more mergers, acquisitions and buybacks fueled by continued cheap credit that drove the stock market higher for the week.

Last summer's spike in the 10Year Treasury rate, a concomitant drop in the price of all securities that trade in relation thereto and the ripple effect of Detroit's bankruptcy made 2013 a terrible year for municipal bonds. Many investors wrote this sector completely "off the page." But the prospect that Detroit, the "irresponsible" "city built on rock and roll (and automobiles)" may actually forge a workable solution to its problems, combined with improved tax receipts in cities nationwide, investor desire for tax advantaged investments and most importantly low and stable interest rates has made muni's a big winner so far this year. Having "stolen the stage", they are beginning to be spotlighted. I own some muni bonds outright but prefer the returns available through leveraged closed end muni bond funds. I own EIM, MNP, MQT, MUS, MVF, MYD, OIA, PMO and VGM.

I know that I sound like a broken AC/DC record, but "Hells Bell" if you remember nothing else from these epistles, remember that the most accurate stock market barometer is the interest rate on the10Year Treasury Bond. The 10Year drives the credit markets, reflects market sentiment and is the closest instrument we have to the hypothetical risk free security against which all risk adjusted returns are measured. Those that thought that the stock market would explode like "TNT' in the wake of Friday's jobs headlines simply failed to appreciate this fact. Those that watched what happened to the 10Year were not fooled. Markets can move on the "Flick of a Switch", but miscalculating which signals to follow is the surest path to the "Highway to Hell." Contrary to what Michael Lewis asserts, I believe we CAN make money in the stock market without resorting to "Dirty Deeds Done Dirt Cheap" But we must keep studying, observing, recording and learning. "It's A Long Way to the Top (If You Wanna Rock and Roll).