No Shutdown, No Problem

The good news from Congress this week is that it looks like the U.S. government isn’t going to have to shut down again due to partisan political bickering.  Last week, literally at the last minute, on the day that current funding provisions would have expired, the U.S. House of Representatives created a new government funding bill that will keep the lights on until September of 2015.  The narrow 219-206 vote also gave the Senate a grace period until Monday to approve the legislation dubbed “CRomnibus” before everybody goes home for the holidays.  The Senate followed suit and sent the bill to the President for signature on Monday.

In all, the spending legislation comes to 1,603 pages, and both Democrats and Republicans seem to be unhappy about it—for, of course, very different reasons.  But when you get past the immigration and health care reform debate on the right, and the rollback of Dodd-Frank provisions that would have barred Wall Street firms from using taxpayer-backed funds to engage in risky derivative trading that angered politicians on the left, the bill really doesn’t have much of an effect on most of us.  It keeps domestic spending essentially flat at $1.013 trillion, while providing additional funds to fight Islamic state militants in the Middle East and the Ebola outbreak in West Africa.  There are no new taxes, and enforcement of the current taxes is likely to be less stringent after the Internal Revenue Service’s budget was cut by $345.6 million—roughly what it costs to hire 5,000 auditors.  Also defunded: the Environmental Protection Agency, whose budget has been rolled back to 1989 levels.  And a specific provision will prevent the Fish and Wildlife Service from adding a Western bird called the sage grouse to the protected species list.

Perhaps the most interesting provision in the House-passed bill, which is not mentioned in the press anywhere, can be found in Section 979, where our lawmakers set salaries and expenses of the House of Representatives at a highly budget-conscious $1.18 billion, with a “b”.

Now the House and Senate will spend a few days debating whether to pass extensions of 55 different tax credits, including tax deductions for research and development expenses by U.S. corporations, tax credits for renewable energy production plants, and a provision that would exempt forgiven mortgage debt from taxable income.

Cheap Oil Gets Cheaper

The economic news that everybody is talking about lately is the sudden unexpected drop in oil prices.  One type of oil, West Texas Intermediate crude, has fallen from over $140 a barrel in the Summer of 2008, and $115 a barrel as recently as June, down to $91, and there is no sign that the decline will stop there. 

The price drop seems to be the result of a perfect storm of factors, both on the supply and demand side.  On the supply side, U.S. production has risen to the point where only Saudi Arabia extracts more oil from its soil.  In the recent past, America’s additional production was offset by sharp declines in production caused by the civil war in Libya, plus production declines in Iraq, Nigeria and the Sudan.  Those countries are now back in business, adding the production equivalent of 3 million barrels a day, a significant fraction of the 75 million barrels a day of global production.

On the demand side, meanwhile, China’s growth has fallen by half, European economies are weakening, and people everywhere are driving more fuel-efficient cars and living in more energy-efficient homes. 

As always, a major shift in global economics is producing some winners and losers.  American consumers are among the most prominent winners, since they consume more oil and gas per capita than the citizens of any other country.  The stiff drop in oil prices this year has resulted in U.S. gasoline prices falling 26¢ to an average of $2.88 per gallon, down from $3.14 a month ago. That’s equivalent to a $40-billion tax cut that will benefit various the transportation sector, energy-dependent manufacturers and, of course, the handful of Americans who drive automobiles.

Lower energy prices are also a boon for countries that import a significant amount of crude, including India, which brings in roughly 85% of its oil, and Japan, which is importing oil again now that its nuclear reactor industry is on hiatus. 

Losers?  You can expect the major oil companies to report lower profits in the months ahead, and the Russian economy which is heavily dependent on energy exports and already feeling the impact of an impending recession, is being crushed.  Surprisingly, some believe the biggest loser is Iran, whose social program spending and high costs of extraction imply a break-even well above today’s prices, estimated as high as $130 a barrel.

As mentioned earlier, oil prices could—and probably will—drop further.  But don’t believe the predictions that have popped up in the newspapers and on the financial TV stations of a new era of oil abundance.  Oil prices almost certainly won’t fall to pre-2007 prices, which can be seen on the accompanying chart.  Why?  According to the International Energy Agency, the capital cost of producing a unit of energy—that is, the cost of finding oil and gas, drilling for it (and hiring the people who will do these things, who are some of the best-paid workers in the world), moving it from the well to the refinery and refining it have doubled since 2000, and the rise in these costs increases yearly.  If oil prices drop much further, shale oil producers in North Dakota and Texas will find it unprofitable to keep drilling.

Another floor under prices is the OPEC cartel, which together supplies about 40 percent of the world’s oil.  A Bloomberg report noted that OPEC nations—particularly Saudi Arabia—have been surprisingly relaxed about the supply/demand shifts.  The cartel nations pumped 30.97 million barrels a day in October, exceeding their collective output target of 30 million barrels for a fifth straight month.  However, if oil prices were to dip closer to $80 a barrel, the cartel could well turn down the spigot and change the equation back in favor of higher prices.

What should you do about all this?  Enjoy!  When was the last time you saw prices fall dramatically on an item that you use every day, that you could hardly function without?  Chances are, you’ve been whacked by higher gas prices a few times in your life; this is your chance to enjoy a different dynamic—while it lasts.

Oh…  And don’t spend a lot of time worrying about the big oil companies.  Somehow they’ll manage to muddle through and stay profitable long enough to reap big gains the next time prices jump in the opposite direction.

The 2014 Midterm Election is over, get fully invested and fasten your seat belts!

Now that the midterm elections are safely behind us, a lot of people are wondering how politics will impact their investment returns.  The conventional wisdom is that divided government--where one party holds the White House while the other controls the House, the Senate or both--is good for the markets.  But is that true?

The truth is, there is no magic formula.  The specific circumstances of each era, and the actions taken by each President and Congress, are much too individual and different for us to generalize.  But the statistics are interesting nonetheless.  Perhaps most interesting of all, the markets seem to like midterm elections regardless of who wins.  The S&P 500 has gained in every six-month period following the last 16 midterm elections, with a remarkable average return of 16%.  Going back a little further, from 1922 to 2006, the Dow Jones Industrial Average has jumped 8.5% in the 90 trading days following the midterms, versus just 3.6% in non-midterm-election years.

If you look at divided government vs. times when one party controlled both the White House and Congress, the results are a bit harder to interpret.  The average annual total return for the S&P 500 when Washington is a one-party town has been 9.4%, compared with 10.6% when the parties were checking and balancing each other.  However, another study going back to 1900 found that during times of total unity (67 of the 111 years analyzed), the Dow gained 7.6% a year.  When Washington is locked in partial gridlock, in other words, where one party controlled Congress and the other the White House, (32 years in all), the index gained 6.8%.  And during the 12 years of a gridlocked Congress, the S&P gained just 2% per year.

Since 1945, the pattern holds. Under total unity, stocks climbed at a 10.7% annual pace. Under partial gridlock, they gained 7.6% per year. And under total gridlock, which accounts for eight of the 65 years, they gained just 3.5% per year.

This gloomy news might be offset by another trend, however.  Since 1900, the third year of a US presidency has been easily the best year for markets, with investors enjoying median annual gains of 16.5%.

There’s one other statistic to note, which might trump them all.  It appears that the Standard & Poor's 500 Index performs two or three times better when Congress is out of session than when at least one of the two chambers is at work.  A famous quote from an 1866 New York court decision, that “No one’s life, liberty or property are safe while the legislature is in session,” would seem to have some truth for the equity markets.

September Sinks Third Quarter

You could say that the markets took a breather in the third quarter of 2014, but you would come to that conclusion only if you looked at the overall returns and ignored the drama of the past 30 days.  The markets experienced a difficult month of September, giving up some of the gains from the prior eight months and causing investors to worry that we’re about to experience more of the same.  The end of the month was especially difficult, with a general market slide starting September 22, and some indices dropping more than 1% on the final day. 

 

The Wilshire 5000--the broadest measure of U.S. stocks and bonds--rose a meagre 0.37% for the third quarter even as it lost 1.71% in September.  But the index is hanging on to a 7.26% gain for the year.  The comparable Russell 3000 index was essentially flat in the third quarter, which means it is still holding onto a 6.95% year-to-date gain with three months to go in 2014.

Large cap stocks were the market leaders over the past three months, but the gains were modest.  The Wilshire U.S. Large Cap index gained 1.13% in the second quarter, and is now up 8.38% so far this year.  The Russell 1000 large-cap index eked out a positive 0.70% return for the quarter, but is still provides 7.97% gains so far the year.  The widely-quoted S&P 500 index of large company stocks posted an even smaller gain of 0.60% for the quarter. The index is up 6.7% since January 1, but it has fallen back from its record highs on September 18.

The news was less happy for smaller stocks.  The Wilshire U.S. Mid-Cap index lost 3.54% in the third three months of the year, and is clinging to a 4.99% gain so far into 2014.  The Russell Midcap Index fell 1.55% for the quarter (posting a 3.34% loss in the month of September), but still stands at a 6.87% gain overall since the first of the year.

Small company stocks, as measured by the Wilshire U.S. Small-Cap, fell 4.98% in the third quarter (4.38% in September alone), but the index is hanging onto a positive 0.44% return heading into the year’s home stretch.  The comparable Russell 2000 Small-Cap Index fell 7.60% in the third quarter, representing its worst quarter in three years--and is now down 4.40% so far this year.  Meanwhile, the technology-heavy Nasdaq Composite Index managed to gain 2.45% for the quarter, and is up 7.88% for its investors so far this year.

The rest of the world put a drag on diversified investment portfolios.  The broad-based EAFE index of companies in developed economies fell 6.39% in dollar terms during the third quarter of the year, and is now down 3.63% so far in 2014.  The stocks across the Eurozone economies contributed to the foreign stock slide, dropping 7.37% for the quarter, but the red ink spilled over to most of the foreign indices in Asia as well.  Ironically, the emerging markets stocks of less developed countries, as represented by the EAFE EM index, represented a bright spot, losing “only” 4.33% over the last three months, and is still up 0.26% so far this year.

Looking over the other investment categories, real estate investments, as measured by the Wilshire REIT index, fell 2.54% for the quarter, but the index is standing at a robust 15.08% gain for the first three quarters of the year.  Commodities, as measured by the S&P GSCI index, fell 12.46% this past quarter, and now sit at a loss of 7.46% for the year.

The expected rise in bond rates never materialized, confounding the experts yet again.  The Bloomberg U.S. Corporate Bond Index now has an effective yield of 3.07%, while Treasury rates held steady.  30-year Treasuries are yielding 3.20%, and 10-year Treasuries currently yield 2.50%.  At the low end, 3-month T-bills are still yielding a miniscule 0.02%; 6-month bills are only slightly more generous, at 0.04%.

Nobody seems to have a convincing explanation for the recent stock market slump.  The economy still seems to be pushing along in a long slow, steady growth process, and corporate earnings are well-above historical averages.  Oil prices are at their lowest level since November 2012, consumer spending has rebounded, and although the Fed will cease its bond purchases this month, there is no indication that it is going to sell its inventory back on the market, and its policymakers are projecting low interest rates well into 2015.  Corporate cash at larger corporations is near an all-time high. 

But pullbacks don’t always reflect reality.  They are also affected by the sentiment of investors--in other words, human emotions and a crowd (or herd) mentality.  Investors seem to be worried that stocks are overdue for a correction, and if these things operated on a schedule, they would be right.  We are in the fourth-longest bull market since 1928, without having experienced even a small 10% correction since 2011.  The Conference Board reported that U.S. Consumer Confidence slipped dramatically, and unexpectedly, in September, lending some credibility to the surmise that the investing herd has been startled--and their expectations appear to be creating market reality.

The best (although imperfect) way to chart investor sentiment is via the VIX Index, which measures the volatility of the market by tracking the behavior of S&P 500 index options.  When the VIX spikes, it means that investors are excited or scared--as they seem to be now.

The interesting thing about the long-term VIX chart--shown here starting in the third quarter of 2007, is the heartbeat-like rhythm of the spikes and drops, as if people get nervous in a kind of pattern.  The 2008-2009 market meltdown shows up in the enormous spike toward the left, but if you let your eyes move to the right, you can see that volatility has been pretty moderate since the end of 2012.  Maybe it’s just time for the “heart” that represents how investors feel about the markets to give another tick.

Does that mean we should take action?  Unfortunately, nobody knows whether the markets are poised to act on the good economic news and move up, or are ready for another fearful selloff that would finally deliver that long-delayed correction.  History tells us that it’s a fool’s game to try to anticipate market corrections, and that investors usually get rewarded for sailing through choppy waters, rather than jumping off the ship when the waves get higher.

You can’t know in which direction the markets will experience their next 10%, 20% or 30% move.  But unless you believe the world is about to end, you do know, with some degree of certainty, in which direction it will make its next 100% move.  That’s the best prediction of the markets you’re likely to get, even if it doesn’t come with a timetable.