Weekend Strategy Review November 24, 2013

Posted by OMS  at November 24th, 2013

During the week, I received an email from Charles noting my comments on the Fed and how their hawkish view might send gold lower. Charles wondered if this might also effect dividend stocks negatively?

When I receiver the email, I put it aside, partly because I wasn’t sure what Charles meant by dividend stocks, but mostly because I wasn’t sure how to answer his question.  Was he talking about Utilities?  REITs?  To tell the truth, I’m not sure what a “Dividend Stock’ is anymore.  It used to be easy to put stocks into categories like “Dividend Stocks’ when dividends were over 4 percent.  But today, with interest rates so low, even stocks that pay 1 –1.5 percent might fit into that category.

So while I was thinking about how to answer the question Charles posed, I happened to look at a chart of Bonds.  That’s because Bonds prices reflect what will happens to interest rates, which of course effects the cost to borrow money.  As I have mentioned before, utilities like Con ED, are extremely interest rate sensitive.  Utilities tend to borrow a lot of money which makes their share prices rise and fall along with interest rates.  But high dividend payers like the REITs are more sensitive to the underlying economics of their sector.  For example, a REIT that owns a lot of shopping malls is very sensitive to consumer spending.  If consumers stop visiting the malls, it doesn’t matter what interest rates do, the share prices of these REITs will come under pressure.   On the other hand, a REIT that focuses on residential apartments might do better than one that invests in commercial office spaces.  If apartments are expensive and hard to get, like they are in New York City, it probably doesn’t matter what interest rates will do.  In this case, occupancy rates will be the more important factor in pricing the REIT.  Same for a stock like Cedar Fair, FUN.  The company operates amusement parks, and pays a high dividend (5.2 percent yield),  The  company is much more sensitive to the economy than it is to interest rates.

So the best answer I can give Charles is that it depends.

In general terms, under normal circumstances, a stock’s price does depend to a large degree on interest rates.  This is because money tends to flows into the highest level of risk-adjusted return.  When interest rates are low, money will flow out of bonds and into stocks.  This is what we’re seeing now.  Bond prices are falling and stock prices are rising.   Investors feel that they are not being compensated for the inflation adjusted risk in bonds, so they sell bonds and pour money into equities.  Conventional wisdom also says that IF interest rates start to rise, some of the money currently going into equities will likely move back into bonds.  This is the way it usually works.  But in the current environment, the issue is a bit more complicated.

Recall that several months ago, when I last talked about bonds, I said the long bond would fall from the 147 level to 126-127 before RISING.  Rising???? Has the Professor gone mad? How could bond prices rise with all the talk and concern about the Fed’s tapering policy?  If the Fed tapers, wouldn’t bond prices FALL causing interest rates to rise?  Wouldn’t this cause equity prices to fall?  Isn’t the fear of higher interest rates the reason why gold prices are falling?  Hmmm? After all, this is what is being reported.

The long bond is currently trading near 130, so it likely has a few more points to fall.  But once the current decline completes, my chart shows a pattern with a good possibility that bond prices will rise to the 160 level or higher.  This would mean significantly LOWER interest rates.  How can this be?  Especially when Wall Street is so concerned that the end of the Fed’s easy money policies would be the end of the world.  They’re worried that IF the Fed starts to taper, interest rates will rise causing equity prices to fall.

For sure, this is the prevailing wisdom that is being reported on the major networks. But there is another side to the story.  Something that goes against the conventional wisdom.  It has to do with the Professor’s bond chart that says bond prices could be going through the roof.  On the surface, the conventional wisdom would think that even if what The Professor says comes true, interest rates would remain low and stock prices should continue to rise.  Isn’t this what should happen?

Yes, ordinarily this is what should happen. But as I told Charles, it’s complicated.  That’s because there could be something else on the horizon that could destroy Wall Street’s current thinking, causing equity prices to fall, even though interest rates would fall like a stone. It’s called depression.  If the county goes into depression next year, it won’t matter what the Fed does.  They can keep interest rates low, or even reduce them to zero.  If our country enters a depression, whatever the Fed does will become irrelevant.  In a depression, equity prices will fall dramatically, and the money will flow into bonds causing their prices to skyrocket. Like in the Professor’s bond chart.

This is why I spend so much time talking about the job market.  It is also why I got very concerned last week when I saw the BLS report that over 700,000 people left the jobs market last month. That’s the equivalent of a city the size of Jacksonville, FL, stop looking for work because there were no jobs.  And when people don’t have jobs, they spend less.  Less for Christmas to be sure, but they also stop buying things like houses, refrigerators and furniture.  And when consumers stop spending, companies, like Target, Gamestop, and Sears start to see their revenues decrease.  Last week we saw all three companies report decreases in revenues.  Each week, we’re seeing more and more companies report decreasing sales and revenues.  The other thing that happens in this environment is that the banks stop lending.  All banks do when things start to slow down is park money at the Fed.  Again, this is what we’re seeing now.  This is NOT a recipe for a robust economy.  It’s what happens at the start of a depression.

Think it can’t happen?  Then think about this.  In 1990, interest rates in Japan were at 8 percent with the Nikkei trading above 39,000. By 2001, interest rates in Japan had fallen to less than 1 percent, yet the Nikkei declined to under 13,000.  A decline of 26,000 points during a period of falling interest rates.  Land values and home prices were cut in half!  CNBC doesn’t talk about this.  All they talk about is how Janet Yellen, the next Fed Chair, will be a dove and keep printing.  They want you to believe that as long as the Fed keeps printing money, interest rates will remain low, the stock market will keep going up, and everything will be just fine.  They talk about Facebook, Twitter, and new Sony PlayStations.  They hype all the latest crazes.

So as you watch the markets push to new highs, I want you to think about what I said above and use it to develop your own strategy going forward.  This is why I always like to take a few minutes during the weekend to review where we are in the current market, and develop a few possible alternate scenarios.  Scenarios that are not based on hype.  Scenarios that are based on chart patterns, Lists and indicators.  Scenarios that talk about defense and the need for caution and protecting yourself, especially when the markets are trading at record highs.

For now, all of my Lists and indicators are positive, so I remain positive.  However IF they start to turn negative, I’m out.  We could be approaching an important top.

On Friday, the S&P closed at 1804.  My target for this leg up is the 1810 level, so we’re getting close.   The days ahead of the Thanksgiving Holiday are usually very positive for the markets, so it should be interesting to see how the market reacts as it approaches my target.  Equity prices should also benefit form end of month portfolio re-balancing.  However once we get into December, things could start to change as December has not been an especially good time to be in equities for the past two years.

One other thing.  Starting Tuesday, Marcia and I will be taking a much needed vacation.  This year we will be going on a 12 night Southern Caribbean cruise to celebrate our 15th anniversary.  The cruise will also give me an opportunity to relax, recuperate and do some serious strategic thinking.  I have made arrangements to obtain limited international internet capability during the period.  However, because the internet is extremely slow aboard ship, it precludes taking a download, so my Lists will only be updated when I’m in port   As for my Daily Comments, because the cruise is supposed to be a vacation, I’m probably going to limit them to 3 times a week.  But you know me.  If I see something happening, I’ll post my thoughts to keep you updated.

Have a great weekend.

That’s what I’m doing,

h

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