Investment Insights Podcast – August 13, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded August 11, 2014):

What we like: Fair amount of correction in the equity markets around the world; small correction also in U.S.

What we don’t like: U.S. stock market will likely correct closer to their 10% before the Fed finishes bond-buying program in October

What we’re doing about it: Hedging more during seasonally-weak time period; mindful of midterm elections

Click the play icon below to launch the audio recording or click here.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Monthly Market and Economic Outlook: August 2014

Amy MagnottaAmy Magnotta, CFASenior Investment Manager, Brinker Capital

After pushing higher for most of July, the U.S. equity markets fell -2% on the last day to end the month in the red. Continued geopolitical concerns, a debt default in Argentina and a higher than expected reading on the Employment Cost Index could have provided a catalyst for the sell-off. Investor sentiment levels were elevated in July, so it is not surprising to have any bad news lead to a short-term pull-back in the equity markets. However, we believe equity markets are biased upward over the next six to twelve months and further weakness could be a buying opportunity.

U.S. small cap stocks have significantly lagged large caps so far this year. In July the small cap Russell 2000 Index declined -6.1%. The Russell 2000 is down -3.1% for the year-to-date period, compared to the +5.5% gain for the Russell 1000 Index. From a style perspective, value lagged growth in July but remains solidly ahead for the year-to-date period.

Developed Europe significantly lagged the U.S. equity markets in July, but Japan was able to deliver a positive return. Emerging markets continued their rally in July, gaining +2.0% for the month. Emerging markets have gained +8.5% through the first seven months of the year, well ahead of developed markets. Countries that struggled in 2013 due to the Fed’s taper talk, like India and Indonesia, have been very strong performers, while negative performance in Russia has weighed on the complex. The U.S. dollar has shown recent strength versus both developed and emerging market currencies.

New York Stock ExchangeU.S. Treasury yields edged slightly higher in July. The 10-year yield has fallen 56 basis points from where it began the year (as of 8/7/14), while the 2-year part of the yield curve has moved up eight basis points. As a result, the yield curve has flattened between the 10-year and 2-year tenors; however, it remains steep relative to history. While sluggish economic growth and geopolitical risks could be keeping a ceiling on U.S. rates, relative value could also be a factor. A 2.4% yield on a 10-year U.S. Treasury looks attractive relative to a 0.5% yield on 10-year Japanese government bonds, a 1.1% yield on 10-year German bonds, and a 2.6% yield on Spanish 10-year sovereign debt.

All taxable fixed income sectors were flat to slightly negative on the month. High yield fared the worst, declining -1.3% as spreads widened 50 basis points. Municipal bonds were slightly positive for the month and continue to benefit from a positive technical backdrop with strong demand for tax-free income being met with a lack of new issuance.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, with a number of factors supporting the economy and markets over the intermediate term.

  • Global monetary policy remains accommodative: Even with quantitative easing slated to end in the fall, U.S. short-term interest rates should remain near-zero until 2015 if inflation remains contained. The ECB and the Bank of Japan are continuing their monetary easing programs.
  • Global growth stable: U.S. growth rebounded in the second quarter. Outside of the U.S., growth has not been very robust, but it is still positive.
  • Labor market progress: The recovery in the labor market has been slow but steady. The unemployment rate has fallen to 6.2% and jobless claims have fallen to new lows.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Corporate profits remain at high levels and margins have been resilient.
  • Less drag from Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth in 2014, and the budget deficit has also declined significantly.

Risks facing the economy and markets remain, including:

  • Fed Tapering/Tightening: If the Fed continues at the current pace, quantitative easing will end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual and the economy appears to be on more solid footing this time. Should inflation pick up, market participants will shift quickly to concern over the timing of the Fed’s first interest rate hike. Despite the recent uptick in the CPI, the core Personal Consumption Expenditure Price (PCE) Index, the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months.
  • Election Year/Seasonality: While we noted there has been some progress in Washington, we could see market volatility pick up later this year in response to the mid-term elections. In addition, August and September tend to be weaker months for the equity markets.
  • Geopolitical Risks: The events in the Middle East and Russia could have a transitory impact on markets.

Risk assets should continue to perform over the intermediate term as we expect continued economic growth; however, we could see increased volatility and a shallow correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could lead the Fed to tighten monetary policy earlier than expected. Equity market valuations look elevated, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. Investor sentiment, while down from excessive optimism territory, is still elevated, but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.

Asset Class Outlook

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Source: Brinker Capital

Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index

An End to Complacency

Joe PreisserJoe Preisser, Portfolio Specialist, Brinker Capital

Volatility abruptly made an entrance onto the global stage, shoving aside the complacency that has reigned over the world’s equity markets this year as they have marched steadily from record high to record high. Asset prices were driven sharply lower last week, as gathering concerns that the Federal Reserve Bank of the United States may be closer than anticipated to raising interest rates, combined with increasing worries about the possibility of deflation in the Eurozone, and a default by the nation of Argentina, to weigh heavily on investor sentiment. The selling seen across equity markets last Thursday was particularly emphatic, with declining stocks listed on the NYSE outpacing those advancing by a ratio of 10:1, and the Chicago Board Options Exchange Volatility Index (VIX), which measures expected market volatility, climbing 25% to its highest point in four months, all combining to erase the entirety of the gains in the Dow Jones Industrial Average for the year.

Preisser_Complacency_8.4.14The looming specter of the termination of the Federal Reserve’s bond-buying program, which is scheduled for October, is beginning to cast its shadow over the marketplace as this impending reality, coupled with fears that the Central Bank will be forced to raise interest rates earlier than expected, has served to raise concerns. Evidence of this could be found last Wednesday, where, on a day that saw a report of Gross Domestic Product in the United States that far exceeded expectations, growing last quarter at an annualized pace of 4%, vs. the 2.1% contraction seen during the first three months of the year, and a policy statement from the Federal Reserve which relayed that, “short-term rates will stay low for a considerable time after the asset purchase program ends” (Wall Street Journal) equity markets could only muster a tepid response. It was the dissenting voice of Philadelphia Fed President, Charles Plosser who opined that, “the guidance on interest rates wasn’t appropriate given the considerable economic progress officials had already witnessed” (Wall Street Journal), which seemed to resonate the loudest among investors, giving them pause that this may be a signal of deeper differences beginning to emerge within the Federal Open Market Committee. Concern was further heightened on Thursday morning of last week, when a report of the Employment Cost Index revealed an unexpected increase to 0.7% for the second quarter vs. a 0.3% rise for the first quarter (New York Times), which stoked nascent fears of inflation, bolstering the case for the possibility of a more rapid increase in rates.

Negative sentiment weighed heavily on equity markets outside of the U.S. as well last week, as the possibility of deflationary pressures taking hold across the nations of Europe’s Monetary Union, combined with ongoing concerns over the situation in Ukraine and the second default in thirteen years by Argentina on its debt to unsettle market participants. According to the Wall Street Journal, “Euro-zone inflation increased at an annual rate of just 0.4% in July, having risen by 0.5% the month before. In July 2013 the rate was 1.6%” While a fall in prices certainly can be beneficial to consumers, it is when a negative spiral occurs, as a result of a steep decline, to the point where consumption is constrained, that it becomes problematic. Once these forces begin to take hold, it can be quite difficult to reverse them, which explains the concern it is currently generating among investors. The continued uncertainty around the fallout from the latest round of sanctions imposed on Russia, as a result of the ongoing conflict in Ukraine, further undermined confidence in stocks listed across the Continent and contributed to the selling pressure.

ArgentinaInto this myriad of challenges facing the global marketplace came news of a default by Argentina, after the country missed a $539 interest payment, marking the second time in thirteen years they have failed to honor portions of their sovereign debt obligations. The head of research at Banctrust & Co. was quoted by Bloomberg News, “the full consequences of default are not predictable, but they certainly are not positive. The economy, already headed for its first annual contraction since 2002 with inflation estimated at 40 percent, will suffer in a default scenario as Argentines scrambling for dollars cause the peso to weaken and activity to slump.”

With all of the uncertainty currently swirling in these, “dog days of summer,” it is possible that the declines we have seen of late may be emblematic of an increase in volatility in the weeks to come as we move ever closer to the fall, and the terminus of the Fed’s asset purchases.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – July 25, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded July 23, 2014), we alter the format to provide commentary on a recent publication from the Ned Davis Research Group.

The article references an old adage that when the public gets in the stock market, it’s too late. While that’s a bit cynical, the public is not always wrong. Recently, the bond market seems to show that over the past five years, the public is pretty smart. Here are some additional takeaways:

  • The allocation to stocks is on the high side, but not excessive
  • Cash allocation seems low
  • Flows into equities and bonds have been good

This, and other measures, lends itself to believe that the public is in (the market), but not excessively in. However, are they in because they want to be in or because the have to be in? The Fed’s zero interest rate policy seems to drive behavior of investors towards stocks–creating a feeling that the public is not in.

The takeaway is that we have to be mindful if the allocations get too big. A defense for that is diversification across different asset classes.

Click the play icon below to launch the audio recording or click here.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – May 13, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded May 12, 2014):

What we like: Bob Doll’s comments on favoring the economy more than the stock market; positive economic data post-winter

What we don’t like: Stock market no longer a bargain, now more fully valued

What we are doing about it: Focus more on larger themes and individual active managers; looking out for potential rise in interest rates during summer

Click the play icon below to launch the audio recording or click here.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – April 17, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded April 16, 2014):

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What we like: Strong stock market last year with $5.6 trillion added to shareholder wealth

4.17.14_chart

What we don’t like: Blowout tax-collection season as a result of this wealth creation; tax burden reaching into the middle class demographic

4.17.14_chart_3

What we are doing about it: Expect more demand for municipals

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Source: Strategas Research Partners, Policy Outlook, April 16, 2014

The views expressed are those of Brinker Capital and are not inteded as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – April 9, 2014

Bill MillerBill Miller, Chief Investment Officer

On this week’s podcast (recorded April 8, 2014):

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  • What we like: When companies buy shares, decreasing supply of stock in the market; Underlying fundamentals in economy are strong

Pages from JDT_APR2014-4

  • What we don’t like: When companies do too many initial public offerings, the supply in the marketplace dilutes the buying power of demand in the short-term setting the stage for a correction; IPO calendar is heavy

Pages from JDT_APR2014-3

  • What we are doing about it: Watching the IPO calendar carefully; intersection of the seasonal factors–slower summer months; Looking for a strong third and fourth quarter market

Pages from JDT_APR2014-2

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Charts Source: Strategas Research Partners, Investment Strategy Outlook, April 2014

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

2013 Review and Outlook

Amy MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

2013 was a stellar year for U.S. equities, the best since 1997. Despite major concerns relating to the Federal Reserve (tapering of asset purchases, new Chairperson) and Washington (sequestration, government shutdown, debt ceiling), as well as issues like Cyprus and Syria, the U.S. equity markets steadily rallied throughout the year, failing to experience a pullback of more than 6%.

Source: Strategas Research Partners, LLC

In the U.S. markets, strong gains were experienced across all market capitalizations and styles, with each gaining at least 32% for the year. Small caps outperformed large caps and growth led value. Yield-oriented equities, like telecoms and utilities, generally lagged as they were impacted by the taper trade. The strongest performing sectors—consumer discretionary, healthcare and industrials—all gained more than 40%. Correlations across stocks continued to decline, which is a positive development for active managers.

YenDeveloped international markets produced solid gains for the year, but lagged the U.S. markets. Japan was the top performing country, gaining 52% in local terms; however, the gains translated to 27% in U.S. dollar terms due to a weaker yen. Performance in European markets was generally strong, led by Ireland, Germany and Spain.  Australia and Canada meaningfully lagged, delivering only mid-single-digit gains.

Concerns over the impact of Fed tapering and slowing economic growth weighed on emerging economies in 2013, and their equity markets significantly lagged that of developed economies. The group’s loss of -2.2% was exacerbated due to weaker currencies, especially in Brazil, Indonesia, Turkey and India. Emerging market small cap companies were able to eke out a gain of just over 1%, while less efficient frontier markets gained 4.5%.

Fixed income posted its first loss since 1999, with the Barclays Aggregate Index experiencing a decline of -2%. The yield on the 10-year U.S. Treasury began rising in May, and moved significantly higher after then Federal Reserve Chairman Bernanke signaled in his testimony to Congress that tapering of asset purchases could happen sooner than anticipated. The 10-year yield hit 3% but then declined again after the Fed decided not to begin tapering in September. It climbed steadily higher in November and December, ending the year at 3.04%—126 basis points above where it began the year.

TIPS were the worst performing fixed income sector for the year, declining more than -8%, as inflation remained low and TIPS have a longer-than-average duration. On the other hand, high-yield credit had a solid year, gaining more than 7%. Across the credit spectrum, lower quality outperformed.

Magnotta_Client_Newsletter_1.7.13_5We believe that the bias is for interest rates to move higher, but it will likely come in fits and starts. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. Despite rising rates, fixed income still plays a role in portfolios, as a hedge to equity-oriented assets if we see weaker economic growth or major macro risks. Our fixed income positioning in portfolios, which includes an emphasis on yield advantaged, shorter duration and low volatility absolute return strategies, is designed to successfully navigate a rising interest rate environment.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we begin 2014, with a number of factors supporting the economy and markets.

  • Monetary policy remains accommodative: Even with tapering beginning in January, short-term interest rates should remain near zero until 2015. In addition, the European Central Bank stands ready to provide support, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Global growth strengthening: U.S. economic growth has been slow and steady, but momentum has picked up (+4.1% annualized growth in 3Q). The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S., growth has not been very robust but is still positive.
  • Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged more than 200,000 and the unemployment rate has fallen to 7%.
  • Inflation tame: With the CPI increasing only +1.2% over the last 12 months, inflation in the U.S. is running below the Fed’s target.
  • Increase in household net worth: Household net worth rose to a new high in the third quarter, helped by both financial and real estate assets. Rising net worth is a positive for consumer confidence and future consumption.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested, returned to shareholders, or used for acquisitions. Corporate profits remain at high levels and margins have been resilient.
  • Equity fund flows turn positive: Equity mutual funds have experienced inflows over the last three months while fixed income funds have experienced significant outflows, a reversal of the pattern of the last five years. Continued inflows would provide further support to the equity markets.
  • Some movement on fiscal policy: After serving as a major uncertainty over the last few years, there seems to be some movement in Washington. Fiscal drag will not have a major impact on growth next year. All parties in Washington were able to agree on a two year budget agreement, averting another government shutdown in January. However, the debt ceiling still needs to be addressed.

However, risks facing the economy and markets remain including:

  • Fed Tapering: The Fed will begin reducing the amount of their asset purchases in January, and if they taper an additional $10 billion at each meeting, QE should end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, the economy appears to be on more solid footing.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.
  • Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal. The market has not experienced a correction in some time.

Risk assets should continue to perform if real growth continues to recover, even in a higher interest rate environment; however, we could see volatility as markets digest the slow withdrawal of stimulus by the Federal Reserve. Valuations have certainly moved higher, but are not overly rich relative to history. Markets rarely stop when they reach fair value. There are even pockets of attractive valuations, such as emerging markets. Momentum remains strong; the S&P 500 Index spent all of 2013 above its 200-day moving average. However, investor sentiment is elevated, which could provide ammunition for a short-term pull-back. A pull-back could be short-lived should demand for equities remain robust.

Asset Class Outlook

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class ReturnsAsset Class Returns

Sentiment

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

In February 1637, tulip bulbs sold in Holland for as much as 4,000 guilders each, over 10x the amount a skilled craftsman would earn in a year.  Months later, many tulip traders found themselves holding bulbs worth just a fraction of what they had paid for.

As crazy as prices got, tulip mania actually started with good fundamentals. Tulips were a relatively new introduction to Europe, and the flower’s intense color made it a heavily-desired feature of upper-class gardens. Most desirable were the exotic-looking, multi-colored tulips, which was caused by a mosaic virus not identified until the 1970s and now called the “tulip-breaking virus.” At best, tulip bulbs weren’t easy to produce and those with the virus suffered even lower reproduction rates. In the beginning, what occurred in the tulip market was classic supply and demand—a highly sought-after item with limited supply increasing in price. In 1634, that started to change as 11.1.13_Raupp_Sentimentspeculators were attracted to the rising prices, and in late 1636 prices started to accelerate rapidly, to where even single-color tulips were attracting prices of over 100 guilders apiece. The Dutch created a futures market for tulips that enabled traders to purchase and trade contracts to buy bulbs at the end of the season. At the peak, tulips could be traded several times a day without any physical tulips actually being exchanged or either party ever having any intention of planting the bulbs.

Then in February 1637, buyers vanished. Some suspect an outbreak of the bubonic plague as the cause, some a change in demand caused by war in Europe. Any way you look at it, the sentiment for the future price of tulip bulbs took a big U-turn, leaving many investors ruined.[1]

11.1.13_Raupp_Sentiment_1History is full of similar episodes, where investor sentiment got to extreme levels and prices diverged meaningfully from the underlying fundamental value of something, be it stocks, real estate, currency, or even tulip bulbs. Most recently the dot-com bubble in the early 2000s and the housing bubble in 2008 proved that speculation is alive and well.

While periods of extreme sentiment are easy to identify in retrospect, they’re anything but obvious while you’re in them. And while extreme levels of sentiment usually result in big price reversals, more modest levels can mark periods when the market is overbought or oversold, often followed by a market pull-back or rally. Recently, Robert Shiller of Yale University won the Nobel Prize in Economics for his work on irrational markets.

11.1.13_Raupp_Sentiment_2So how can you gauge sentiment? Some of the more popular ones are the Consumer Confidence Index and the Michigan Consumer Sentiment Index, which both try to gauge consumer’s attitudes on a variety of things, including future spending, the business climate, and their level of optimism or pessimism. More direct, and generally more volatile, are the AAII Investor Sentiment Survey and the Wells Fargo/Gallup Investor and Retirement Optimism Index, which ask investors directly about their thoughts on investments. It doesn’t end there. Investors watch Closed-End Fund discounts, Put/Call ratios, even tracking the occurrence of certain words or phrases in the media. In addition, many firms create their own blend of surveys and indexes to best gauge the overall sentiment level.

Sentiment certainly isn’t the be-all, end-all for trading your portfolio. There’s a saying that is attributed to John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.” When sentiment starts moving in one direction, it’s hard to say when the reversal will occur and what will cause it. But knowing where sentiment levels are at any given time can help you get a better understanding of what markets have been doing and what to expect going forward.


[1] Mackay, Charles (1841), Extraordinary Popular Delusions and the Madness of Crowds, London: Richard Bentley, archived from the original on March 31, 2008.

Morning Comment from Tower Bridge Advisors

pic-meyerJames M. Meyer, CFA, Principal and CIO, Tower Bridge Advisors

Stocks finished mixed in a relatively quiet session the day after the Fed decided not to begin reducing its bond buying program.

If you never put a lid on the cookie jar, eventually your kids, and probably your dog, will get fat and sick. If your doctor prescribes an antibiotic every time you have chills or a fever, half the time there will be no benefit and eventually your body will develop a resistance to the antibiotics. If the Fed keeps dropping $85 billion every month out of helicopters, stock and bond prices will go up in the short run but eventually we will all have to face a set of unintended consequences.

9.20.13_TowerBridge_ComentaryWith that said, I don’t want to overstate any reaction to the Fed’s decision to keep its full bond buying program in place. Another couple of months of buying $85 billion per month instead of $70-75 billion won’t make a big difference. Stocks and bonds reacted Wednesday afternoon and that’s about it for the reaction. However, buying $85 billion of bonds every month is rather similar to persistently giving a strong antibiotic, whether it is needed or not. There may not be immediate harm but there will almost certainly be unintended consequences the longer the process persists. How long is too long? No one knows yet. But with the Fed’s balance sheet closing in on $4 trillion and the fact that soon it will own 40% of all government debt maturing five years out or longer, the problems in the future unwinding what it has created are only going to get more difficult if the Fed doesn’t stop adding to its balance sheet soon.

I understand that the government could shut down in October for a few weeks and that Republican conservatives might create a similar debt ceiling crisis to the one it created two years ago. But the Fed isn’t going to solve that problem with an extra $10 billion in bond purchases. In fact, the Fed isn’t going to solve those problems at all. I get the possibility that the Fed was concerned that real interest rates were getting too high and wanted to scare the bond vigilantes with a surprise. It get the possibility of delaying the start of tapering until the Fed knows who the next Chairman might be to make sure he or she is on board with the game plan. So I am willing to give the Fed a couple of months grace period. But with that said, QE is a much more effective crisis policy than a policy designed to maintain economic growth. Flooding the economy with money doesn’t create demand. Certainly, recipients will gladly take the money but the choice of spending it or investing it depends on market conditions. Given the very slow velocity of money both before and during QE, the market has said rather loudly that it would rather invest than spend. That means investors benefit with much stimulation of economic growth or job creation. Here once again is an example of misguided policy whose unintended consequence is to widen the gap between the wealthy and middle classes.

9.20.13_TowerBridge_Comentary_1We are almost certainly not going to see economic data over the next 1-3 months that is going to move the needle enough by itself to change forward outlooks. Indeed, our economy has been adding about 180,000 jobs per month for almost four years and the pace has remained remarkably consistent if you look at a three or six month moving average. Jobless claims are back to pre-recession levels. Existing home sales, which are about 15x new home sales, are booming. So are car sales. Ladies and gentlemen, we are not in a sick economy and everyone who voted to maintain the status quo yesterday should know that. And those who were unsure yesterday are likely to still be unsure next month or next quarter. Economics is never an exact science and there isn’t a formula that will determine tomorrow’s rate of growth. Federal Reserve forecasts of future growth have been persistently too high since the recovery began. Every subsequent forecast adjustment has been downward, including the adjustment announced on Wednesday. Yet forecasts of job creation and unemployment rates have been pretty accurate. The missing ingredient has been weaker than expected productivity, a function of weaker than expected investment. Tax policy, regulatory policy, fiscal policy and uncertainty created by a dysfunctional government all contribute to lack of investment spending.

With that all said, the Fed didn’t move and that leaves us with the question, “What now?” First of all, there is no need to change any economic or earnings projections. There is no need to change outlooks for Europe or China. Interest costs might be marginally less but the economic impact will be negligible. Obviously, throwing more money at financial assets raises asset prices. The impact of Wednesday’s surprise was felt Wednesday afternoon. There isn’t likely to be much follow through. Again, does anyone really believe that a change of $10 billion in Fed bond purchases would move any needle by a whole lot? I certainly don’t. Just as so many government programs in recent years (e.g. first time home buyer credits or cash for clunkers) pulled benefits forward without creating long term value, Wednesday’s decision created a pop in asset prices that probably simply borrow from future gains. No more or no less.

The true facts are that this economy is what it is, an economy growing about 2% per year, despite significant headwinds created by fiscal policy and Congressional gridlock. The headwinds may be a bit less next year as we anniversary the payroll tax increase but housing growth rates will decline next year and one can’t count on the trickle down impact of a 15-25% growth in stock prices to continue indefinitely. As noted, the Fed has persistently forecasted future growth that was too high. As Fed Chairman Bernanke noted yesterday, the fly in the ointment has been weak gains in productivity. With capacity utilization below 80% and incentives to invest virtually non-existent, one shouldn’t expect productivity to improve until investment spending accelerates. Certainly the uncertainty the Fed created this week surrounding monetary policy won’t help in that regard.

The bottom line is that my near term economic and stock market outlook don’t change. By near term, I mean through 2014. I don’t even see a storm that is likely to hit in 2015 at this time, but no crystal ball is that clear looking two years out. Eventually, and that means within five years, as the Fed does exit and interest rates return to normal levels, there will be problems. Big ones. Government debt service costs are going to skyrocket. That will not only cause further cuts in government spending and entitlements.

9.20.13_TowerBridge_Comentary_2Let me make one point very clear. Nothing has been done about entitlements to date because Congress wasn’t forced to act. When debt service costs rise by $200-400 billion per year, it will be forced to act. Market forces can overwhelm politics. Just look back to 2008. When Congress is forced to act, it will raise the starting age and/or means test Social Security more than it does today and it will cost shift Medicare so that recipients must pay some of the costs. Congress won’t do this because it is the right thing to do or because it is good politically. It will do this because it will be left with no other option. Again, it will happen this decade and the timing will be directly tied to the sharp increase in costs to service our Federal debt. Parenthetically, every developed nation plus China will face the same dilemma; how do you offset rising debt service costs. The responses may differ but the problem is widespread.

That storm is at least 2-3 years away. It may be 4-5 years away. But it isn’t 10 years out. Problems ultimately get solved when markets force them to be solved. Look at the health of U.S. banks today. Markets forced that. Markets made railroads efficient after the Penn Central bankruptcy. Mini-mills saved the steel industry. Japan and German car makers forced the U.S. Big Three to enter the 21st century. The good news is that crisis not only forces change, it forces change for the good because that is the only path to survival. Politicians almost always lack the courage to make changes ahead of crisis. That point transcends both borders and political parties. It takes crisis to force change.

Futures point to a flat opening.

The views expressed above are those of Jim Meyer and Tower Bridge Advisors and are not intended as investment advice.

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