Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Goldilocks to Meet the Bear Shortly
11/13/2013 11:00 am EST
Investors have not had to worry about economies being too cold, or government tapering pressure being too hot, but MoneyShow's Jim Jubak, also of Jubak's Picks, fears the temperature might be about to change.
The US stock market ended last week in a very familiar Goldilocks mood.
Yes, the surprisingly strong 2.8% Gross Domestic Product (GDP) growth for the third quarter, reported on last Wednesday, raised fears that the economy was so strong that the Federal Reserve would begin to taper off its $85 billion in monthly mortgages and bond purchases sooner rather than later.
But then Thursday, a stronger-than-expected, but still tepid, report on October jobs—204,000 added in the month—renewed hopes that the Goldilocks economy that has powered this year's 26.3% rally in the Standard & Poor's 500 (SPX) would continue.
Just enough growth to keep earnings climbing, but not so much to bring an end to the Fed's cheap money stimulus.
Looking out at 2014, I have to wonder if—to mix my fairy tale metaphors—the clock is ticking on poor Goldie and we're getting close to the moment when she has to flee the party as her carriage turns back into a pumpkin.
My worry for 2014 is that the US and global economies will be too cold rather than just right, and that the political pressure on central banks—including the Federal Reserve—will be too hot.
And that would mean bye, bye Goldilocks.
Global economic cooling
Let's start with the argument that the world's economies will be too cold in 2014.
As pleasant a growth surprise as the third-quarter GDP numbers were last week, the 2.8% growth rate for the quarter doesn't look sustainable. The main reason for the step up in growth from the second quarter was an increase in inventories that added about 0.4 percentage points to the growth rate in the quarter. Inventories have now climbed for three consecutive quarters.
Weak consumer spending—and consumer spending grew by just 1.5% in the quarter, down from a 1.8% pace in the second quarter—argues that companies will have to let inventories run down in the fourth quarter and into 2014.
Such a rundown would mean that fourth-quarter GDP will have to give back some of the inventory-based gains in GDP growth recorded in the third quarter. Final sales, a growth measure that doesn't include changes in inventories, was up just 2% in the quarter. That's down from a 2.1% increase in the second quarter and is the slowest growth since the 1.5% rate in the second quarter of 2011.
One big negative for the US economy is the automatic budget cuts set to go into effect in 2014, pending budget talks between Democrats and Republicans in Congress. The agreement that ended the government shutdown in October kept sequester cuts at fiscal 2013 levels. But if budget talks fail—which is likely—the cuts for the fiscal 2014 year that ends in October 2014, will be more painful to the economy than the 2013 cuts. The new spending reductions will come on top of the cuts already made in government budgets, and they'll come after a year when many agencies used up all of their rainy day money. For example, the Pentagon used $4 billion in prior-year funding in fiscal 2013 to pay for Navy and Air Force procurement. That money won't be available for fiscal 2014, and the Pentagon would have to delay the delivery of an aircraft carrier and a nuclear submarine.
Even if you think cutting government spending is a good idea, or think that some of the cuts in the sequester are so worthwhile that they make the pain of the other cuts worthwhile, the math still says that, in the short-run, less government spending will produce slower US economic growth in 2014.
Companies running out of steam, too
Next year looks like it could also be the year when many companies will find it impossible to compensate for a lack of top-line growth.
This quarter, big economic bellwether stocks such as IBM (IBM) and Kellogg (K) have shown signs that the days of being able to use stock buybacks and cost cutting to generate growth in earnings per share, even when revenue isn't growing, may be numbered. Or, at least, that the market's enthusiasm might be waning.
(Is there a connection between this faltering earnings growth story and the outperformance of stocks such as Amazon.com (AMZN) that don't show any earnings growth at all, and where all that counts is revenue?)
For example, after reporting a sixth straight quarter with a drop in sales, on October 29, IBM's board announced that the company would add $15 billion to its buyback plan. That put the total buyback plan for the next 12 months at $20.6 billion. The stock moved up slightly on the news, from $177.35 on October 28 to $189.15 on October 29. But by November 8, shares were back down to $179.99.
Or take Kellogg's November 4 earnings report on guidance. The company announced that it would cut 7% of its work force to generate annual savings of $425 million to $475 million. Those savings would be poured back into expanding Kellogg's presence in developing economies and on product development.
But note that this plan, called Project K, would take four years to fully kick in.
That's not a time schedule that suggests Kellogg is optimistic about the near future.
And of course, the US economy isn't the only one to worry about in 2014.|pagebreak|
The European Commission recently cut its growth projections for the eurozone, and last week a surprise interest rate cut from the European Central Bank demonstrated that the bank took that slow-growth scenario seriously.
It's hard to see the global economy growing very strongly in 2014 if the US and eurozone economies are simply stumbling along. Especially if recent projections of lower-than-recent-trend growth in developing economies, such as China and Brazil are reasonably accurate.
Too fired up for the Fed?
In a Goldilocks market, a modest slowdown in economic growth is supposed to be balanced by more stimulus from the world's big central banks.
But here, too, I think the clock is counting down an end to the fairy tale magic in 2014.
Yes, the Federal Reserve might see the US economy as weak enough, and unemployment to be high enough, to hold off on reducing its asset purchases until March—instead of beginning in December or January—but no one is contemplating an increase in monetary stimulus from the Fed in 2014. I think we've seen the end of quantitative easing, unless the economy gets markedly worse. (And that would mean the end of Goldilocks from that direction.)
The European Central Bank just cut its benchmark interest rate to 0.25% from 0.50%. Theoretically, that leaves the bank room for another 0.25 basis point cut before it has to follow the Federal Reserve into the uncertain territory of quantitative easing.
That's in theory.
In reality, the bank's 0.25 percentage point cut of last week set off a major revolt among the bank's governing council, with two German members on the 23-strong group leading six members to vote against bank governor Mario Draghi on the rate cut. (Joining the two German members were the heads of the Austrian and Dutch central banks.) I'd doubt that the bank is going to do much more to stimulate European economies, in the first half of 2014, at least. (And absent a rate cut, we're likely to see a stronger euro in 2014, which would hurt growth in Europe's export-oriented economies.)
Part of the problem for the world's central banks is of Goldilocks' own making. Since global economic growth is okay, central banks don't have reason to be really aggressive on stimulating growth. So the Banco Central do Brasil has spent 2013 focused on inflation at the cost of growth. The People's Bank of China is devoting a considerable percentage of its policy-making to fighting asset bubbles and bad debt. The Bank of Japan is facing internal and external pushback on a massive asset-buying program that makes it, at least, questionable whether or not the bank can offset the impact of the sales tax increase scheduled for 2014.
Frankly, Goldilocks looks tired for 2014.
Goldilocks and your portfolio
What does that suggest for a strategy for approaching the end of 2013 and 2014?
First, an extension of the end-of-the-year market-melt-up strategy I've suggested a couple of times lately. I think there's a good chance that we'll see a rally into December; Goldilocks is likely to have enough energy left to get us to that point. And I think the risk/reward ratio right now suggests that it is worth playing for that possibility.
Second, as I've also suggested, take a good look around in mid-December, as we await the Federal Reserve's December 18 meeting, to see what the odds of a tapering off of the Fed's asset buying program in December or January might be. If the market is starting to bet on a January taper, that would definitely change the risk/reward ratio significantly. It would be time to re-evaluate your cash position and possibly take some profits.
Then, as we move into 2014, take a read on the health of Goldilocks. To keep this fairy tale market alive, we'll need more economic and earnings growth to make up for the increasing likelihood of a reduction in stimulus from the Federal Reserve.
If Goldilocks looks exhausted, I'd consider raising cash for the day when the Federal Reserve does finally decide to taper its asset purchases. On past reaction, the market isn't likely to be very happy, and if that unhappiness is sufficiently extreme, I'd look for bargains in stocks paying 4% to 5% dividend yields with good prospects for future dividend growth. I'd look for bargains in the shares of companies with strategies that aren't heavily dependent on the growth of the overall economy. Some names here would be Cheniere Energy (LNG), Middleby (MIDD), and Cummins (CMI).
I'm not looking for a huge sell-off in 2014, but this rally has gone a long time without a 10% correction. A rethinking of our faith in Goldilocks would certainly be enough to produce that kind of move.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund's portfolio here.
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