Shifting Sentiment?

Richard Croft
September 17, 2012
9 minutes read

Sentiment is fickle. It can change with the wind and it can dramatically impact financial markets in the short term. It can cause panic selling or panic buying. Often with information that taken in context would have very little long-term impact.

It is the time of season for sentiment shifts. Aside from the volatility that typically accompanies trading in September and October we will bear witness to the mudslinging that is the US Presidential election. Even more so this time as the chasm between Democratic and Republican platforms has never been greater.

President Obama wants to rebuild the US economy from the middle class out. The idea being that a strong middle class with job security powers consumption that benefits big business. In short the Democrats want to move the country further away from the conservative top down approach fostered by Republicans, on the belief that the old ways exacerbated the financial crisis.

Empowering the middle class is a tall order that begins with job security and ends with tax certainty. To that end both parties agree that the US needs to fix the tax system. The Democrats would make the rich pay a “little” more by closing “loopholes.” Namely increasing the tax one pays on dividend income and capital gains.

The Republicans would rather broaden the tax base by removing deductions and lowering rates which, in an ideal world, would put more disposable income in the pockets of the consumer.

Neither is an easy fix. Especially considering that a straightforward tax system requires US politicians to take away some very popular deductions. Note mortgage interest deductibility. Aside from its popularity, any change to that policy would have a marked negative affect on housing.

Over the next six weeks, the outlook for earnings, dividends and the general long-term trend of the economy won’t matter. Instead we will be swept by a tsunami of polls dissecting the nuances of the economy from every conceivable angle. Pollsters will spin the results based on their political allegiance. And despite the irrelevance of the data financial markets will oscillate to the winds of shifting sentiment.

Sentiment will also shift on the back of central bank intervention. Recent stock market performance supports that thesis as we have been rallying on the back of ECB and FED action.

The ECB will provide unlimited funding to buy short term bonds of the weaker member States who ask for assistance. Read that to mean Greece, Portugal, Ireland, Spain and possibly Italy.

Whether the ECB actually buys the bonds is secondary. That they are willing and able to do it was enough to calm markets and lower the cost of borrowing. Note that Spanish and Italian debt is changing hands at a 3% rate rather than the 6% cost of borrowing before ECB intervention. It was also enough to drive markets higher on the back of improving investor sentiment.

When Fed Chief Bernanke pulled the trigger on QE 3 last week, stock markets surged again. That the rally fizzled on Friday points directly to a shift in sentiment as investors begin to evaluate the longer term impact of central bank intervention.

We know, for example, that the ECB is walking a fine line. Action to answer distress calls from member States is within the ECB mandate. Direct ECB intervention without a call for assistance is beyond the mandate of the ECB.

In my mind the Eurozone is in a catch-22. Any request for intervention implies that the State making the call is in such bad shape it cannot extract itself without assistance. For large predatory hedge funds that’s low hanging fruit. They will circle the prey like great white sharks around a wounded seal.

That the ECB is willing to walk this tightrope implies that the Eurozone is likely in worse shape than we have been lead to believe. That German politicians and its judicial branch are supporting ECB action only compounds the fear. Yet markets rally on sentiment.

Look for more of the same in the coming weeks with risk to the downside increasing on the back of every short term sentiment driven rally! If that were not enough, October which is typically one of the worst months for investors, is just around the corner.

If there is a take away from all of this it is the fact that longer term performance will be determined by the outlook for the broader economy and ultimately the earnings power of global companies. Political leanings aside, business can survive and prosper in any environment. The key is removing uncertainty and providing a level playing field.

In the interim, political rhetoric and ECB policy will provide short-term support for the Eurozone which theoretically, will allow time for weaker States to get their act together. The litmus test will be whether the support will be enough to influence political change so that respective economies have an opportunity to grow. We’ll see!

The US Fed on the other hand, has already shot most of its arrows at the economy. QE 3 has more to do with spin than any real economic benefit. We already have ultra low interest rates. A quarter point reduction at the long end of the yield curve will have little impact on consumption.

The problem is that American consumers are not spending. They are doing what governments should be doing; getting their balance sheet in order! The US savings rate has climbed to 4%. Prior to the sub-prime crisis it was 0%!

And don’t look for housing to pull the US out of a recession. Recent home ownership surveys suggest that while 64% of Americans want to own their own home, that’s down from 69% prior to the sub-prime crisis. A 5% change may not seem like much, but it translates into more than four million homes.

Fed action is unlikely to help the jobs picture either. Going back to 1973-74 the time it takes for employment to normalize has been getting longer with each successive recession (see chart). The tepid US jobs recovery may simply be a sign of the times!

I am not sure anything that politicians or central banks do will stimulate economic growth over the short term. The problem is that we are living through a recession that in terms of magnitude resembles the Great Depression. It will simply take time for global economies to heal.

If there is a bright light it comes from the knowledge that 1) longer term, sentiment takes a back seat to fundamentals like earnings and dividends and 2) central bank intervention will act as a short-term put on the market effectively buttressing any sell-off.

Long-term investors might want to focus attention on cash flow which I believe will take on a more important role. Dividend paying stocks, REITs, real return bonds, preferred shares and covered call writing strategies should be a major component of ones long term investment strategy.

It won’t be exciting but with the central bank put option it should dampen your exposure to shifting sentiment.

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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