The January Effect

"As goes January, so goes the year." - Stock market saying

When trading stocks there are a few signals that cannot be explained by efficient market hypotheses.  One of these signals is the January Effect.  This so called "effect" is an unusual indicator given by the returns of the small cap market in the month of January each year.  If one believes in the Random Walk Theory popularized by Burton Malkiel, that is that stocks do not follow patterns but act more like a person walking in random directions, then January should not be an important month.  However studies have shown that from 1904 to 1974 that the average January return for these stocks was roughly 3.5% whereas the average monthly return for each month outside of January was only 0.5%. 

This can be taken one step further as the saying in the quote above so taking this quote literally I went back to look at the last twenty years of data for both the Russell 2000 Index (small cap stocks) and the S&P 500 (large cap stocks). 

For the Russell there were six years when the market was down in January.  Of these six years only three or 50% resulted in a down year and the rest produced some significant returns (see data below). 

2002   Jan (1.82%)   Year (20.56%)

2003   Jan (4.17%)   Year 42.50%

2008   Jan (9.88%)   Year (39.60%)

2009   Jan (2.77%)   Year 35.83%

2010   Jan (4.92%)   Year 24.81%

2011   Jan (1.88%)   Year (6.97%)

Looking at the S&P 500 produced similar results with six negative returns in January but only two corresponding down years.  So the S&P 500 was only down 33% of the time following a down January (see data below).

2002   Jan (1.42%)   Year (22.60%)

2003   Jan (3.50%)   Year 23.60%

2005   Jan (3.20%)   Year 3.56%

2008   Jan (8.10%)   Year (40.99%)

2009   Jan (2.92%)   Year 29.29%

2010   Jan (4.59%)   Year 11.90%

Looking at the magnitude of the downward movements in January does not show much other than when the move was significant or more than 5%, it set the stage for a very poor year.  Outside of that it appears to be a coin toss as to how the rest of the year will progress however, the data did show that over the last 20 years, there has not been a 20% plus down year without a negative January.  It also pointed to a very directional year in that the magnitude of the moves following a down January were all double digit returns (either positive or negative) barring one year for the S&P 500.  Furthermore each massive downward swing came on the back of significant run ups in the previous five years (anybody remember 2002 and 2008?) and all of these meltdowns began with a poor January.

So while this poor January may not be a harbinger of a poor year ahead especially since the market is down less than 5% for the month (at the time of this writing), it is certainly an indicator that you should keep in the back of your mind as all poor years begin with a poor January and expect a rollercoaster ride for the remainder of 2014.

Looking Outside The Box

"If you think you can, you can.  And if you think you can't you're right." - Mary Kay Ash

"The key to success is to risk thinking unconventional thoughts.  Convention is the enemy of progress.  If you go down just one corridor of thought you never get to see what is in the rooms that lead off it." - Trevor Baylis 

We all have heard the saying "think outside the box" so it was interesting to me when writing this blog to find out that the saying originated in 1914 with the standard nine-dot puzzle.  For those who have not done this puzzle put nine dots in a square on a piece of paper and see how few lines it takes to join the dots.  The solution is that you have to let the lines extend past the edges of the imaginary box but for some reason when we are first presented with the problem our brains automatically visualize a box and assume that we need to remain inside that imaginary square.  Thinking outside of this imaginary box provides the solution.

When it comes to investments I have repeatedly expounded on the need to think outside of the "normal" box of stocks and bonds as not doing so will create a significant issue for your retirement plans.  As a survey I looked at the wealthiest people that I know to see what they are doing differently from the rest of us and in almost all cases it is a clear case of outside the box thinking and investing.  Dissecting this group the majority own their own businesses; of the remainder some are paid very highly for what they do (think investment banking) but there is a group that have not earned much but have still managed to achieve a very high level of investment success and it is this investment success that has carried them to a wonderful retirement.

This last group is the one that interests me the most for a number of reasons; first they are normal 9 to fivers so we can all relate to them and second they have not had a lucky break like winning the lottery or being awarded a ton of stock options at the right time.  These are what I call regular people much like the majority of the country.  So when I read that the average retirement savings of the baby boomer in the United States is a mere $120,000 it is time to sit back and see how we as readers of this blog, can do things differently and become part of the group of "normal" people with large retirement accounts. 

A normal retirement plan suggests that you withdraw 4% of your net worth each year.  This amount supplements the income that will be generated from your pension from your job (if you have one which most of us do not) or the government payments from social security.  In the example above 4% of $120,000 is a mere $4,800 a year or $400 a month!  Add to that social security of say $1,500 a month and you will be retiring on less than $2,000 a month and this is before inflation takes a bite from this meager amount.  I don't know about you but there is no way I could retire on that amount as to me retirement would be some kind of a prison sentence rather than the fun thrill seeking adventures that I have envisioned and which are strengthened with advertisements on television.

So when I dissect the average person's investment portfolio I pretty much always find some mutual funds, a bit of cash and possibly a house.  Boiled down this equates to stocks, cash and property.  Well looking at the property first, most of the time it is not paid off so the value is often times minimal.  One quick solution here is a reverse mortgage which is why so many people are signing up for these but the reality is that this will often only provide you free accommodation (still a major win)but not a significant level of cash (unless you have a lot of equity built up).  Looking at the mutual funds they will be scattered around in various funds that are typically not producing much in the way of return or they will be bunched into one sector of the market.  The reason for this is that people do not pay attention to these investments and expect that they will take care of themselves and, as you can see, the majority of the population retires on nothing.

Looking at the group that can afford to retire and travel, they took control of their investments early.  They studied the markets and investment opportunities and looked outside of the box at alternatives in real estate (outside of their homes), private equity, hedge funds, commodities and other alternatives.  Their array of investments allowed them to participate in major upswings and limit the damage to the downside.  They rebalanced their portfolio during the good times to take advantage of deals when they presented themselves.  In short they worked their retirement money rather than turning a blind eye to it and their efforts were rewarded.  Make sure that you do the same as there is no safety net in retirement but the alternative investment may provide you with one.

Against the Grain

"Going against the grain may result in a few splinters, and it may rub a few people the wrong way, but going with it is like forcing your true self to walk the plank!" - David Roppo

I just love this quote as I have always forged a path that is anything but conventional and certainly a lot of money is made by catching a market top or timing the turn at the bottom.  This is not for the faint of heart though as many an investor has ruined themselves by betting against the freight train that is a run away market.  The reason people continue to try is that the rewards are so appetizing and the ego that comes with it is enormous.

On the ego side I am sure you have been to the party where one person has a crowd around them and is expounding how they timed the market to perfection, caught the swing and made a fortune.  That is ego talking as we all know that the only way to catch these events is through sheer luck.  But that said there are a number of indicators that people use to try to gauge whether we are getting close to a top or at least whether the market is running out of control and these are called contra indicators.

One theory goes that any market that runs a long way either up or down is prone to correct itself back to its long run trend line.  When the market hurtles above the trend line during an extended bull market the theory expostulates that it is akin to an elastic band being stretched away from the line and that eventually it will snap back.  However it often does not snap back exactly to the line but bypasses it falling further than it probably should until it turns and rockets back.  So looking at how far the market is from this trend line is one indicator that the market is ripe for a correction.

Another indicator that can show overheating is the IPO market.  Last year was a record for Initial Public Offerings (IPOs) of companies that had no earnings.  An IPO is the procedure used to become listed on the stock exchange.  A company essentially broadcasts that they are going to go public and tries to entice investors to buy their shares.  The company and often times the management team pockets this money and the investor hopes that the price paid for the stock appreciates.  In normal times companies will only attract investor interest if they are solid companies with stellar earnings prospects.  During heady times investors pile into companies that have no earnings on the hope that earnings will magically appear out of thin air because the company now has billions of dollars.  This shows a very frothy market and can be used to show that a market is near a top.

Another indicator used is the level of investors that are bullish versus bearish.  When investor sentiment reaches a climax of around 85% all agreeing to the direction of the market it should be time for you to think the other way.  A healthy market has a balance (not necessarily 50:50) of bulls and bears.  In this environment good companies are rewarded and poor ones are punished.  When sentiment gets skewed even the poor companies see their stock prices rise and good companies see their stock price sent into orbit.  This results in the pass the hot coal syndrome where each investor buys on the hope that there is another one ready to purchase that same position from them at a higher price.  There is no fundamental value placed on the investment just blind belief in the continued momentum.  Once the momentum breaks everyone heads for the exits and carnage ensues.

Now these are just three but there are plenty more that I could expound on but the point to the blog is that while no single indicator will show you a top as more and more of these contra indicators pop up the odds of a continued rally or a continued correction start to shift to a change in direction.  The issue is when does the direction change and there is no magic bullet to answer that question but one thing that you can be assured of that when things turn they normally turn quickly and with a vengeance and this is why you can make so much money catching the turn.  That said though with all the Federal Reserve money being pumped into the system and with interest rates low there is no saying how far this market could go so betting on a change in direction could cost you a pretty price and most of us do not have the deep pockets to fight the tape.

One thing that you may have gathered from this blog is that there were plenty of times where the word HOPE was used.  In investing HOPE is the worst four letter word in the dictionary and so if your investments are based on the HOPE that things will continue this might be the best contra indicator of all that you should review your strategy and save face while you still have time.

The Unemployment Puzzle

"What this country needs is more unemployed politicians." - Angela Davis

"Why are peopled unemployed? Because there is no work.  Why is there no work? Because people are not buying goods and services.  Why are people not buying goods and services? Because they have no money.  Why do people have no money?  Because they are unemployed." - Craig Bruce

Today the December unemployment numbers came out and they were terrible.  Actual payrolls increased by only 74,000 jobs in December which was the lowest monthly gain since January 2011 and fell far short of the 197,000 jobs expected by the consensus poll.  Despite this the unemployment rate fell sharply to 6.7% from 7.0% in November.  This is the lowest unemployment rate reported since October 2008.  So how is this possible?  Poor job growth but a falling unemployment rate does not seem to make sense.

Well looking a little deeper the reason the unemployment rate fell so sharply is due to the fact that more and more people are losing their emergency unemployment benefits.  Once a person falls off the benefits roster they are no longer counted as unemployed even though they more than likely have not found a job.  In fact as time progresses it becomes increasingly more difficult to find a job so the likelihood that any of these people who lost their unemployment benefits found work is slim.  Now with the sequester of the emergency unemployment benefits it appears that the unemployment rate (at least the one reported by the Bureau of Labor Statistics) will fall to 6.5% next month!

This has some significant implications for the Federal Reserve as they have said that they will maintain their easy money policy until the unemployment rate falls to 6.5% or lower.  Now they have also said that they will continue with the current easy money policy until inflation starts to gain traction but on the surface the first hurdle will have been cleared.  Now as you can clearly see this hurdle has not been cleared at all.  In fact they have not even walked around the side of the hurdle; as it turns out there was no hurdle at all only an illusion.

Looking at the chart below which is the Labor Force Participation Rate it is clear that the trend has not changed.  People are still not able to find a job.  All that has happened is that they have now lost their benefits.  As stated in the quote above this will have a large impact on consumer spending and is not the rosy picture that the numbers imply.  In fact you have to go back to 1977 to get to a lower labor participation rate - 1977!  That means that economic growth will be sluggish for the simple reason that more than 70% of consumptions comes from the consumer and the consumer does not have a job.

Until this trend can be reversed any thought of an economic recovery can be put on ice.  The problem is that if inflation now rears its head, the Federal Reserve may choose to tighten based on the numbers coming from the Bureau of Labor Statistics and while printing more money is a recipe for disaster, tightening before this graph can turn the corner will pull the economy into a recession.  So as I have mentioned before the Federal Reserve has painted themselves into a corner with no exit and Janet Yellen does not have the ability to get them out.

Negative Interest Rates

Secular Stagnation is a slump that is not a product of the business cycle but more-or-less a permanent condition. - Bloomberg Businessweek

As I have mentioned in previous blog posts banks are awash with reserve cash and are using that cash to make themselves enormous profits by receiving money in the form of interest from the Reserve Bank and by placing bets in the massive derivatives markets.  In order to stimulate an economy using an easy monetary policy it is imperative that the money that is "printed" makes its way into the hands of the entrepreneurs that are the backbone of the economy.  This is not happening for the simple reason that the money being "printed" is being given straight back to the Reserve Bank.  This may be resulting in Secular Stagnation which is an economy that is stuck in a long term state of stagnation for the simple reason that the money being used to stimulate is not reaching the economic drivers of small business and the consumer.

A simple solution to this problem would be to charge banks interest on these reserves.  This would result in a negative rate of interest and would instantly reduce the massive reserves that are held at the Reserve Bank to a minimum.  Now to understand negative rates you need to understand the theory.  Banks require a rate of return that is not only higher than their borrowing costs but also takes into account the erosion of their capital base through inflation.  While the spread they receive may be low, leverage provides the profit however this leverage is being provided by the derivatives market rather than by lending to businesses and households (for a more full description of this see my previous blog).  Charging them interest on their reserves would immediately reduce reserves to a minimum and result in massive amounts of investment capital coming onto the market.

In the past banks were not paid interest on their reserves and therefore it was enough to lower interest rates to close to zero to stimulate bank lending.  Also in the past inflation hovered around 2.5% so lowering interest rates to zero resulted in an implied negative rate of interest.  The problem is that today, with inflation running at a rate around 1% or possibly lower, lowering the interest rate to 25 basis points really does not do the job.  Taking Japan as an example it can be clearly seen that while they have printed inordinate amounts of money and have held interest rates at zero for decades, deflation eroded any stimulus and has not provided the economy the boost required.  Using this example you can clearly see that no amount of money thrown at an economy can solve this dilemma until rates are negative.

The United States can achieve a negative rate simply by charging banks interest on their reserves but the issue now is that with more than $2 trillion piled up in reserves the results are hard to quantify for the simple reason that there is no control of where that money would end up.  Had it dribbled into the economy in a controlled way that would be one thing but flicking the switch over to charging them interest would result in an avalanche of money flooding the system and it is anyone's guess as to the outcome.  Furthermore banks would fight this policy change for the simple reason that they are now making more money than ever and what banker would want to end the gravy train?  This is another reason why I firmly believe that interest rates will remain subdued and that real growth rates in the United States will remain anemic for the coming year which is why it is imperative that you find yield in places outside of the norm.

A Look Back to Look Forward

"You can't help but with 20/20 hindsight go back and say, 'Look had we done something different, we probably wouldn't be facing what we are facing today." - Norman Schwarzkopf

In hindsight it may even seem inevitable that a socialist society will starve when it runs out of capitalists." - Larry Niven

The problem with looking back is that your mind is warped with a different sense of what happened at the time.  While historians can try to relive famous battles or dissect military maneuvers pointing out the flaws and speculating at the revised outcome, they are not dealing with the stress and the inputs of the situation as it happened so it is impossible to say that the choice made would have been different.  Furthermore speculating at the changed outcome is also rather pointless as changing history results in a completely different world from that which we live in today.  For every action there is a reaction and speculating at what that reaction would be to something that did not happen is relatively pointless.  With that said it is always good to look back on the year to try to relive some of the decision points in an effort to learn from them in an effort to limit the errors going forward.

The stock market had a banner year and will end up around 30%.  While I did not participate in this rally I feel comfortable with my results for the simple reason that pretty much everything that I worked on is panning out as expected.  What I did not expect was a massive rally on the back of weak economic fundamentals but in hindsight the Federal Reserve's easy money policy set the stage for the rally.  Based on this it certainly looks like more to come in 2014.  Janet Yellen, the incoming Federal Chair, will continue to print money and the market should continue to fly however once again I do not intend to participate for the simple reason that the market is running too far too fast and without the support of economic fundamentals the result is going to be as disastrous or maybe worse than 2000 and 2007.  Now whether this crash happens in 2014 is any one's guess but I would not be surprised to see the market continue to rally at least through the first half of the year.

One potential problem for the market is the yield on the 10 year note.  This is a barometer for interest rates in the United States and with the yield approaching 3% this could start to have a negative impact on growth.  Already the housing market is feeling the pain of higher rates and if rates creep much higher money is going to start to return to bonds at the expense of the stock market.  Just looking at large company retirement funding obligations, once the rate reaches around 3.5% a lot of corporate treasurers will be plowing billions into the bond market, locking in the yields and protecting their companies from another round of underfunding.  There will be other buyers along with the Federal Reserve but this is a number worth following closely.

Housing had another excellent year but as hard as it is to believe with rates as low as 4% on a mortgage it appears that the easy money has been made in this market and that without a healthy uptick in the employment numbers this market will probably not see much in the way of return in 2014.  Obviously there will always be pockets of the country that will produce a good rate of return but as rates tick higher the impact on this market will be large.  This will affect unemployment as a weak housing market will place more people back on the unemployment line once again.

On the unemployment front 2013 was a struggle.  Sure the unemployment number did fall but the results of the continued stimulus were not at all successful.  Unemployment has remained stubbornly above 7% and it looks like it will take a herculean effort to get it below 6.5% which is the Federal Reserve's target.  Until we get to that number the Federal Reserve expects to keep stimulating but the problem is once again the interest rate increases.  If these start to spiral higher at some point they will have to turn their attention to driving the yield down as otherwise all their efforts to stimulate will be for nothing.  For these reasons I do not see unemployment falling below 6.5% in 2014.

Precious metals were the worst performer of 2013.  Those of us that invested into gold and other precious metals we felt the pain of another bear market.  Stock prices fell around 40% and the commodity price fell over 20%.  It was carnage in this market which makes it even more interesting given that the fundamental reason for holding gold is firmly in place.  So you had a year where stocks rocketed on weak fundamentals while gold was decimated on strong fundamentals.  Furthermore you had more a market that brought more money losing companies to market than in any year barring 2000 and you can see why I am still not interested in participating in the stock market in 2014 other than a small trade here and there.

Not that I am not participating at all as the majority of my assets are tied up in privately held businesses that are starting to perform admirably.  It is clear to me having been involved in numerous start up companies over the past few years that the playing field has been tilted firmly in the direction of large business.  Small businesses continue to struggle and until this playing field is leveled the outlook for economic growth and lower unemployment in the United States is bleak.  The problem is that it took over 50 years for congress to get us to this point and there are no laws on the horizon to change this.  In fact things are getting even more arduous with the Health Care Reform and higher tax rates destroying the middle class and forcing many small businesses to shut down.  Without this engine of growth the United States will continue to see slow or negative growth for the foreseeable future.

I wish all of you  a wonderful holiday season and all the very best for 2014.  I look forward to an excellent year and I hope that you all manage to listen to my radio show on ESPN 1700AM radio or download the podcasts at www.theportfoliodoctors.com.

Tally Ho!

Lieutenant George: "Tally ho, pip pip and Bernard's your uncle."
Captain Blackadder: "In English we say good morning." 

General Melchett: "Ah, tally-ho, yippety-dip and zing zang spillip.  Looking forward to bullying off for the final chucka?"
Captain Blackadder: "Answer the General, Baldrick!"
Private Baldrick (whispering): "I can't answer him sir, I don't know what he is talking about."

Scenes from the wonderful English comedy Blackadder

The stock market rocketed forward once more this week on the back of the Federal Reserve decision to put tapering off for the foreseeable future.  Yes they did say that they would cut back on the purchase of mortgages and treasuries by $5B a month each but this is ultimately a drop in the bucket when you consider that they will still continue to purchase these at a rate of $75B a month and that their balance sheet has already ballooned to over $3 Trillion in the past few years.  Cutting the continued buying by $10B is really just a rounding error and nothing significant at all.

To make sure that this was not perceived as "bad" news Bernanke said that the Federal Reserve would continue to hold the federal funds rate at the historic lows for a significant period of time, beyond even the initial target of a United States unemployment rate of 6.5%.  Considering that the unemployment rate is currently 7.0% (according to the Fed) and it has taken them from October 2009 to get there from 10.0%, it can be seen that to reach the initial target of 6.5% is going to take most if not all of 2014.  Once that target is reached (assuming it ever is) if the inflation rate is still below 2.0% they will hold these rates down ad infinitum.

No wonder the market rallied.  The fuel that has been pumped continually onto the fire in a massive spigot will remain open for at least the next 12 months and more than likely well beyond that.  Furthermore Bernanke affirmed that the new Fed chair would continue to keep these policies in place after his tenure expires.  So as expected Janet Yellen will keep dumping money into the hands of the banks thinking that this is creating jobs.  As we all know, giving free money to banks who then turn around and give it straight back and earn a return does not produce jobs. 

Another weapon that the Federal reserve has is to reduce the Federal Funds rate to zero.  Doing this would eject more than $2 Trillion out of bank reserves into the loan market.  While this would certainly help jettison spending (think back to 2006) the problem is that sub prime lending would jump straight back into the fray as in all reality those that should qualify for a loan can and have; adding more debt onto a consumer that is not adequately equipped to assume it would result in a situation that would be worse than 2006 for the simple reason that the numbers are far larger this time around.  Last time the Federal Reserve was in for a few hundred billion and this time around it is 100 times larger.

Another problem that the Federal Reserve has with this weapon is that a lot of the bank reserves are being left at the Fed not only to earn interest but to form a type of margin account for the massive risks that they are taking in the derivative markets.  As I mentioned a few blogs ago this market has burgeoned to more than a quadrillion dollars (better become familiar with this number as I am sure at this speed that trillions will be child's play in a few years) and so a few trillion is little more than a deposit on this potentially explosive problem.  Should this market ever implode there is no central bank in the world that could shoulder this level of debt and this would truly be the end, but the game is being played with a small nominal value of a few trillion deposited with the Federal Reserve.  So it is interesting to think that if this margin balance is ever needed (to pay losses in the derivative market) rather than investing the money in places that would actually help the economy grow (as the Fed believes it is) it would just go to pay off gambling debts!

So it is no wonder that the market rallied as the juice to fuel the massively dangerous derivative and equity markets is being left in place and the game can continue.  The problem is that when this bubble finally bursts the only remaining solution will be to let everything find a proper base and that my friends is a long way down.