Saturday, November 1, 2014

November 1, 2014 Like A Heat Wave

Risk/Reward Vol. 240

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“You’re a heartbreaker, dream maker, love taker
Don’t you mess around with me.”---lyrics from “Heartbreaker” sung by Pat Benatar

“Got people here/Down on their knees prayin’
Hawks and doves are circlin’ in the rain.”---lyrics from “Hawks and Doves” sung by Neil Young

“Nowhere to run baby
Nowhere to hide.”---lyrics from”Nowhere to Run” sung by Martha and the Vandellas

Like most market watchers, I began my Wednesday morning tuned into “Squawk Box” believing that the most impactful news of the day would come in the press release following that day’s meeting of the Federal Reserve’s Open Market Committee (FOMC). But I nearly fell off my elliptical when word came across the wires that American Realty Capital Properties (ARCP), one of my favorite triple net lease real estate investment trusts, had discovered accounting irregularities and would be restating its results for the first and second quarters of 2014. Accounting irregularities, especially for a high yielding stock like ARCP, can be a death knell, and it certainly looked that way when the markets opened. From the start, my substantial holdings were down over 30% recovering somewhat by day’s end. My “dream maker” had become a “love taker, a heartbreaker.” Mr. Market was saying loud and clear “Don’t mess around with ARCP”. Down that far that fast, I decided to hold, having learned from past mistakes not to sell into a panic. Moreover, I received some solace from an early press release which indicated that ARCP’s handsome $1/share annual dividend would not be affected. Later that day I listened to a replay of the investor call-in hosted by ARCP’s CEO--- who was not implicated in any wrongdoing. Therein, he detailed the steps taken by ARCP’s audit committee and the professionals that that committee had hired to investigate and rectify the errors. Having represented both management teams and audit committees in similar situations and understanding the dictates of the Sarbanes-Oxley Act, I was impressed by the audit committee’s work as explained. I decided to hold my ground unless or until other unfavorable news emerges. Indeed, if none does emerge, I may add to my position if the price stays depressed.

It was not until Thursday that I focused on what the FOMC had done on Wednesday. Predictably, it announced the end of QE3. In addition, it stated that the foci of its dual mandate; to wit, employment and inflation (price stability) had both improved. This statement was interpreted by many in the equity markets as “hawkish” (meaning more likely that the Fed would raise interest rates sooner); at least by those that had been “down on their knees prayin’” for more “dovish” remarks. The bond market interpreted the statement differently as the yield on the benchmark 10Year US Treasury continued to hover around 2.3%. Bond (or fixed income) traders found solace in the FOMC’s pledge to “maintain the 0 to ¼% fed funds rate for a considerable time…especially if projected inflation continues to run below the Committees’s 2% longer run goal.” On Thursday, better than expected Q3 gross domestic product numbers caused the major stock indices to move upward. On Friday these indices skyrocketed to record highs on 1) news that Japan was expanding its quantitative easing program thus assuring investors that the world’s cheap money punch bowl would be replenished and 2) release of US personal consumption expenditure index numbers (PCE) (those relied upon most heavily by the FOMC) showing that inflation was running at 1.4% annually far below the 2% goal mentioned by the FOMC on Wednesday. In other words, any interest rate increase appears to be far away. This is good news for interest rate sensitive investors such as yours truly.

With interest rates at historic lows and growth prospects in Europe and China worsening, there is simply “Nowhere else to run, baby/Nowhere else to hide.” Whether you seek growth or you seek income, U.S securities are the only game in town. The following quote from Friday’s Wall Street Journal captures our situation: “…economic growth looks underwhelming compared to other post war cycles for the U.S. but it may prove to be the envy of other advanced economies.” And it is for this reason more than any other that the Dow Jones Industrial Average and the S&P 500 rose this week. Frankly, neither U.S. corporate profits nor U.S. corporate dividends warrant the prices that U.S. stocks garner at present, but there is no alternative unless you want to hold cash. That stated, cash is not a bad choice so long as inflation does not spike. I am 50% in cash at present and am more cautious than enthusiastic when it comes to securities of any kind---despite this week’s spike in stock prices

And so, what CNBC has termed “ the most hated stock rally in history” continues. We hit new records yet I don’t see anyone ”Dancing in the streets/ In Chicago/Down in New Orleans or even/Up in New York City.” That is because central banks now hold more sway than any other market input. And, at first glance, their concerns are counterintuitive. Instead of rejoicing that their traditional bête noire, inflation, is muted, central banks now adopt policies aimed at promoting it. On Friday, Japan, the most energy starved country in the world, actually cited lower imported oil prices as a DRAG on its economic goals! Huh? Talk about good news being bad news! Like Martha and the Vandellas “ Sometimes I stare into space/Tears all over my face/Don’t understand it/I ain’t never felt this way before” Does any of this make sense? Actually it does. But only after you realize that the greatest threat to the central bank of a debtor nation is deflation. Deflation means that such a nation will have to repay its mountain of debt with expensive currency; currency not debased by inflation. Unfortunately, deflation is the new normal in the aging societies of the developed world. Aging societies mean fewer children; fewer children means less demand; and less demand means deflation. Look at Japan (which is tantamount to crystal balling our own future) where more adult than children’s diapers are sold, and watch their central bankers sweat. “It’s like a heat wave”.

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