Tapers, Capers & Papers

One can hardly look at the Papers these days without being bombarded with the activities of two seemingly unrelated entities.  The NFL and the Federal Reserve would, on the surface, appear to have little in common.  After all the FED is staffed by straight laced bankers and PH.D. types and the NFL….well you get the picture.  However, at the moment the two institutions have a number of interesting commonalities: both organizations are getting a bit of unwanted publicity, each represents a vital part of the American Free Enterprise System, and at the moment the credibility of said institutions could certainly use some “brushing up”.

Roger Goodell, commissioner of the NFL, has been described as “the most powerful man in sports”, and while he has championed the safety of players in the NFL, an action which one can hardly take issue with, while at the same time overseeing the continued rise of the NFL as the preeminent sporting franchise in the United States, he has a significant credibility problem.  His teams, at least in the minds of some, are rapidly degenerating into a menagerie of hoodlums, crooks, or perhaps just simple barbarians.  Not to worry we hear you say, the Patriots were “duped” and Aaron Hernandez was a loose cannon after all. Football remains the most popular professional sport in America as well as the most profitable, and as we all know, the game must go on!

So too we might say, Ben Bernanke, once hailed as Time’s person of the year and arguably the most powerful man on the planet has also been suffering lately.  The FED Chairman’s handling of the 2008 Great Recession earned him his title, but continued utilization of unconventional monetary policy including successive rounds of Quantitative Easing have caused many to doubt the “PH.D. Standard” of monetary policy as Jim Grant of Grant’s Interest Rate Observer terms it.  Our redoubtable chairman has championed “transparency” as the highest of all virtues and once again few can take issue with such a laudable objective, but alas the word “Taper” had hardly escaped the lips before it was taken up in full hue and cry by both markets and FED watcher’s alike.  Gentle Ben can hardly be blamed; after all as we all know a “Taper” can hardly be called a screeching halt!  If one considers it, in the broadest literary sense of the word, one might consider a candle.  Candles have been around quite a while.  In case you have failed to see one recently they ofter flicker and dim, but they can continue to burn for an awfully long time.  So too, we suspect the FED’s “Taper” as they hastened to assure us was in no way likely to be a fast burning fuse, but rather a slow and steady dissolution of the QE candle.  We might remind our readers that the market seems to have failed to notice that the candle has yet to be lit, and the FED has left itself with considerable flexibility regarding the kindling of its taper.  In the meantime, until the light of monetary easing begins to fade, the market is likely to continue its ascent.

For our part, we believe the FED has no real interest in moving particularly quickly and in fact may delay said taper until the very end of 2013 or perhaps not initiate their removal of QE until early 2014.  Regardless, the response of the market to even a hint of monetary tightening was negative.  Bond prices dropped significantly during the month, and outflows from bond mutual funds hit a new record in the final week of June.  According to ICI and Reuters, over 28 billion dollars flowed out of bond funds in the week ending July 3rd, and the yield on the ten year treasury rose 81 basis points between early May and late June.  While a late month rally helped equity indexes, there was no place to hide and virtually every asset class lost ground during the month. The decline, while not precipitous, did cause some consternation among investorsand volatility increased during the period.  U.S. Macroeconomic data strengthened as did the Dollar and international markets were hampered by dollar strength and poor economic results.  Japan, in particular, has seen significant negative volatility return to its market in the last few weeks following a significant rally brought about by the easy money policy of Shinzo Abe.

The most recent quarter caps a strong first half of 2013. As we reflect on the first half of the year, a few key elements may be isolated from the noise.  Entering 2013 equities were widely perceived as undervalued.  While no longer a significant arguement in favor of immediate equity price appreciation, current valuations remain quite reasonable, and barring a sudden and unexpected drop in earnings they should support continued positive equity returns. Secondly, the U.S. Macro backdrop continues to provide a neutral playing field for U.S. equities.  However, relative to most developed economies the U.S. environment remains quite favorable, and fund flows from overseas should help support U.S. equity prices. China’s slowdown is becoming more pronounced and is negatively affecting the commodity driven economies of Australia and Canada.  In fact, the drop off in emerging markets is not limited to China but extends widely across the BRIC countries (Brazil, Russia, India, China).  Weakness, volatility, and currency issues all serve as a prop to support continued U.S. stock price improvement.  Finally, with the FED remaining on hold and the monetary spigot wide open in the U.S. and, to some extent, throughout the World the outlook for equity securities remains favorable.

As we enter the third quarter, concerns surrounding the Syrian conflict and the ouster of Egypt’s Mohamed Morsi have dominated geopolitical news, but markets have shrugged off such concerns preferring to focus on the FED, earnings, and macroeconomic variables.  In our view, markets are likely to remain somewhat volatile throughout the remainder of the summer as these issues remain in flux and volume remains light.  Concerns about elections in the Eurozone , poor earnings, the “debt ceiling” debate, and continued jawboning on the part of the FED may lead to modest correction during the third quarter, but we expect that any pull back will likely be short term in nature given the underlying strength of equity fundamentals. Further, when the third quarter of 2013 concludes, five year rolling equity returns will improve significantly on both an absolute and relative basis.  We expect continued fund flows from bonds and cash as well as from overseas investor to support equity pricing in the short-term and provide a reasonable boost to returns over the next couple of years.

Bryan Taylor, CFA

Cornerstone Management Inc.

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