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A Change In Visibility

Richard Croft
July 3, 2013
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6 minutes read
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So much for last weeks’ commentary. Global financial markets did what they have for most of the year… exactly the opposite of consensus. Instead of following through on the sell-off that occurred two weeks ago, last week saw an about face. Pattern recognition is quickly becoming a lost art.

The spotlight shifted away from the act of tapering and onto the rationale behind tapering, with emphasis on Mr. Bernanke’s comments that the US economy is doing better than most believed. Add to that playbook last weeks’ steady parade of Fed governors, jawboning markets with supportive statements about the US economy.

So how did the outlook for the economy change so quickly? The answer lies not in the numbers, but in the statistical interpretation. Rather than focusing on historical metrics ,which painted US economic growth at 1.5% to 2%, as a glass half full, the Fed seems willing to accept these numbers as a new norm. To buy into the glass half full thesis, the Fed had to weigh the positives of Fed stimulus against the negative implications of reduced visibility.

Think about this in terms of the employment statistics. I cite this because of the Fed’s earlier comments that linked the timeline for quantitative easing (i.e. QE) to a 6.5% unemployment rate. At that point there was consensus among Fed governors that US employment was well below historical norms for this stage of a recovery. The Fed interpreted that to mean that management had insufficient visibility to make major changes in their staffing levels, which required stimulation and hence QE III.

The impact from this enhanced liquidity was positive for the stock market but did little to encourage management to expand their labor force. Under the new norm thesis, quantitative easing was doing more harm than good. It clouded visibility around growth because corporate executives had to weigh just how much of the current growth trajectory was the result of liquidity infusions, and how much was driven by the real economy. Good corporate governance is not so much about how quickly the economy grows, but how predictable that growth is.

The thinking is that companies can now set reasonable goals within a new norm environment (i.e. long term growth in the 1.5% to 2% range). Within that framework, management can evaluate current productivity (i.e. often referred to as capacity utilization) which, depending on the industry you look at, is between 75% and 80% of capacity. Management must then assess how much additional capacity can be squeezed from those already employed.

As productivity inches towards 90% capacity, management is in a position to embark on major hiring programs. Using those metrics, and assuming that the growth expectations are reasonable, we should see employment begin to tick up sometime in 2014. Since equity markets tend to value companies on where they are likely to be six to nine months from now, last weeks’ rally seems appropriate.

Longer term, the question is whether stocks are priced correctly given these expectations. Certainly there are few alternatives to stocks as fixed income assets were hardest hit by the tapering statement. Undoubtedly, the mass exodus out of fixed income assets was supportive to equities.

The unfortunate implication is that equity markets are still being maneuvered by sentiment, and traders are clearly fickle. Should it become apparent that valuations are stretched because the growth trajectory is inflated, markets could quickly revert back to weighing anemic growth as a glass half empty.

To properly weigh the pros and cons requires additional data, which will come in the form of second quarter earnings and guidance. That begins in earnest during July and into August. The key will be whether companies beat on top line estimates – i.e. sales numbers – rather than on bottom line earnings, which are more susceptible to manipulation.

At this stage you need to focus on the things that are clearly visible, namely increased volatility and higher option premiums. The goal is to write put options on high dividend paying mature companies that you would like to own, and sell calls on stocks you already own. Whether you get assigned on the short positions is not as important as the enhanced cash that these options will generate, holding to the belief that enhanced cash flow will provide stability regardless of the economic climate.

To that point, you might want to focus on the banking sector. Assuming the new norm thesis remains intact, then banks will benefit, especially as interest rates rise and net interest margins expand.

In a real economic recovery, banks typically lead, and because of their inherent leverage, earnings can expand in an exponential fashion.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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