The Potential Consequences of Quantitative Easing And A Weaker U.S. Dollar

As the Federal Reserve continues to push quantitative easing and a resultant weakening of the U.S. Dollar, following is what John Maynard Keynes had to say about this in his writing, The Economic Consequences of the Peace.

"Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become "profiteers," who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

As the below chart shows, the U.S. government is doing a pretty good job of debauching the U.S. Dollar.

From The Blog of HORAN Capital Advisors

As noted in a post I wrote in mid 2009, there can be short term positive implications for multinational U.S. companies as a result of a weaker U.S. Dollar. The problem is if many other countries are trying to force their currencies lower as well, it becomes a race to the bottom.

h/t: Ned Davis Research

Analysts Lower Earnings Expectations For S&P 500 Index In Q3

The earnings season for the third quarter is now underway and it seems analysts have lowered their expectations for earnings. Although expectations have been lowered, earnings are still estimated to increase by 24% compared to Q3 2009. Three of the S&P 500 sector earnings were revised higher, i.e., industrials, technology and consumer discretionary.

From The Blog of HORAN Capital Advisors

• Quarter to date 30 companies have reported earnings with 80% exceeding expectations and 7% meeting expectations. 13% of the companies earnings reports were below analyst expectations.

• The ratio of negative-to-positive pre-announcements for the S&P 500 for Q3 2010 is 2.0. This ratio is slightly below the long-term average of 2.1.

• The forward four-quarter (Q410 – Q311) P/E ratio for the S&P 500 is 12.7, below the average forward four-quarter P/E ratio of the previous 52 weeks (13.7).

From The Blog of HORAN Capital Advisors

As the quarter unfolds, company comments regarding their future outlook is one piece of news we will be evaluating in determining the sustainability of this market advance.

The Stock Market Might Be Anticipating An Improvement In Consumer Confidence

The market's strong advance in the third quarter of this year, up over 11%, may be occurring in anticipation of improved consumer confidence later this year and into 2011. The improvement in confidence may be tied to the results of the mid term elections in November.

The importance that is placed on consumer confidence is valid from the standpoint that consumer confidence tends to lead the direction of the stock market. Consumer confidence does have a direct impact on consumer spending. And with consumer spending accounting for over 70% of GDP, improved consumer confidence and a concurrent improvement in consumer spending, an improvement in economic activity likely follows.

From The Blog of HORAN Capital Advisors

In recent discussions with business owners, accountants and attorneys, one theme that is repeated frequently, is the fact businesses are not making hiring or expansions plans due to the uncertainty surrounding future costs related to taxes and health care regulation. If a change in control of Congress provides more clarity on the regulatory environment, this could positively impact business expansion and hiring plans.

From The Blog of HORAN Capital Advisors

Source: Gallop

As I noted in a post about a month ago, a change in control with Congress can have a positive impact on the economy and the stock market. The below chart shows the current market advance relative to the market returns achieved after the midterm elections in 1994, when a democratic congress switched to a republican majority.

From The Blog of HORAN Capital Advisors

Given recent polling data, it seems probable that we will see a change in control of congress in the mid term election this year as well. After the 1994 midterm, the market advanced over 34% in 1995. For investors, an important question is how much of the market's recent advance is pricing in this potential election outcome. Further, if a change in Congress is not realized it is likely the market will not react favorably.

All Eyes On The Friday Employment Report

One primary reason cited for a choppy start to this week's market is the anticipation surrounding Friday's employment report. If the report is anything like recent mixed economic reports, it will not provide clarity on the economy's future direction. The job environment is one reason for the tepid economic recovery. As the below chart shows, consumption accounts for over 70% of GDP. If consumers are unemployed and/or spending more frugally, GDP or economic growth will be constrained.

From The Blog of HORAN Capital Advisors

In spite of this mixed economic environment, the market's advance in the third quarter can be characterized as one in which it climbed a wall of worry; however it wasn't a steady climb higher.

From The Blog of HORAN Capital Advisors

From a pure technical standpoint, the market's recent action seems to show it is attempting to form a base near the 1,118 level on the S&P 500 Index. Of some concern is several of the technical indicators are rolling over, i.e., stochastic oscillator and the MACD. The On Balance Volume (OBV) indicator has been in a longer term downtrend since early May as well. The numerical value of the OBV is not important, but rather the direction of the line. Investors should focus on the OBV trend and its relationship with a security's price. In short, one should expect the market to digest gains achieved in the third quarter. Support can be found at the 200-day moving average on the S&P 500 Index around 1,118.

At HORAN Capital Advisors, we remain cautiously optimistic about the market. An anticipated near term pullback will likely give investors an opportunity to work some cash into equities before the November elections in the U.S.

Dividend Payers Had Respectable Showing In September

In a strong market like that experienced in the month of September, the dividend payers in the S&P 500 had a respectable showing versus the non-payers. The average return for the payers was 6.77% versus 7.51% for the non-payers. Year to date though, the dividend payers continue to outperform the non-payers and the broader S&P 500 Index as detailed in the table below.

From The Blog of HORAN Capital Advisors

Source: Standard & Poor's

During the month S&P reports,

• 483 of the stocks in the index generated a positive return.
• 237, or 47%, of the index stocks had a return that was greater than 10%.
• September's price return of return of 8.76% was the best since the index returned 16.46% in September 1939.
• the best performing sectors achieving double digit returns were technology (+12.11%), Industrials (+11.20%) and Consumer Discretionary (+11.00%.)

The first trading day in October (Friday) saw the market move higher by .44%. This coming week will see many investors focused on Friday's non-farm payroll report. A strong recovery would see payrolls increases around 250,000. The economy is far from this figure at the moment.

Will Dividend Increases Follow An Increase In Stock Buybacks?

As I noted in an earlier post, recently released data by Standard & Poor's shows companies have increased their stock buyback activity in the 2nd quarter of 2010. S&P reported a YOY 220% increase in Q2 2010 buybacks. During this same time period, dividend increases have equaled 5.9%. Given this improved buyback activity at HORAN Capital Advisors, we believe companies that exhibit stong cash flow will also begin rewarding their shareholders with increased dividend payments as the economy gains a firmer footing.

From The Blog of HORAN Capital Advisors

Tough Environment For Consumers

Following is an excerpt by Bill Simon, Wal-Mart Stores' (WMT) President, CEO of Wal-Mart US. This was delivered at Goldman Sachs (GS) Retail Conference:

"Our customers are focused on their savings, and they need us now more than they ever have. Unemployment, we all know, remains mid-9s and doesn't appear to be going anywhere quickly. Gas prices are high. They don't appear to be going anywhere. We need to figure out how to operate in this environment.

The paycheck cycle we've talked about before remains extreme. It is our responsibility to figure out how to sell in that environment, adjusting pack sizes, large pack at sizes the beginning of the month, small pack sizes at the end of the month. And to figure out how to deal with what is an ever-increasing amount of transactions being paid for with government assistance.

And you need not go further than one of our stores on midnight at the end of the month. And it's real interesting to watch,about 11 p.m., customers start to come in and shop, fill their grocery basket with basic items, baby formula, milk, bread, eggs, and continue to shop and mill about the store until midnight, when electronic -- government electronic benefits cards get activated and then the checkout starts and occurs. And our sales for those first few hours on the first of the month are substantially and significantly higher.

And if you really think about it, the only reason somebody gets out in the middle of the night and buys baby formula is that they need it, and they've been waiting for it. Otherwise, we are open 24 hours -- come at 5 a.m., come at 7 a.m., come at 10 a.m. But if you are there at midnight, you are there for a reason. And we have to look at that and we have to watch that and we have a commitment to serve those customers who need that. And we are very, very focused on that."

Standard & Poor's Reports Jump In Stock Buybacks

Today S&P reports that stock buybacks in Q2 2010 jumped 220.9% versus the record low reached in the second quarter of 2009. On a sequential basis buybacks were up 40.5% to $77.64 billion in the second quarter of this year. Factoring in dividends, the buyback + dividend yield is 4.43% at the end of Q2 and this compares to 3.38% in Q1.

More Confirmation Investors Increasing Bond Allocation

Below is a chart from the American Association of Individual Investors that summarizes investors current asset allocation. The data included in the chart is updated at the end of each month by AAII. As the chart shows an investors bond allocation at 21% is above the longer term average of 15%. Additionally, the equity allocation is down to 55% or 5% below the 60% longer term average.

From The Blog of HORAN Capital Advisors

Source: American Association of Individual Investors

The AAII data supports the mutual fund flow data we have outlined in prior posts. Below is a chart that shows the flow of funds into bond mutual funds and out of equity funds. This is the opposite of what occurred at the top of the market in 2000.

From The Blog of HORAN Capital Advisors

As the below chart of the iShares Barclays 20+ year Treasury ETF (TLT) shows, the price has broken support.

From The Blog of HORAN Capital Advisors

A declining price means higher interest rates. If rates would continue to move higher, bond prices would adjust lower. With inflation working its way into the pipeline, and who knows what happens in November (could be bullish for stocks and bearish for bonds), inflation seems a greater threat than deflation.

Bullish Investor Sentiment Continues To Move Higher

In today's sentiment survey released by the American Association of Individual Investors, the weekly individual investor bullish sentiment increased seven percentage points to 50.89%. This bullish sentiment level compares to the yearly low of 20.74% that was reported in the last week of August. The bull/bear spread widened to 26.6%. In spite of the increase in bullish sentiment, the 8-period moving average remains in the mid thirty percent range, i.e., 36%. The 8-period moving average has been as high as the upper 50% to lower 60% range at prior market tops.

From The Blog of HORAN Capital Advisors

Source: American Association of Individual Investors

The Dividend Paying Stocks In The S&P 500 Index

In a recent Bloomberg article, Phillip Cruz provides a list of the dividend yield stocks in the S&P 500 Index. The notes the list is arranged as follows:

The yield is calculated by taking the latest declared dividend, annualized and divided by the stock price. Payout ratios are calculated based on latest quarterly dividend paid divided by earnings. The data is first sorted by the industry name alphabetically and then by the yield in descending order. Dividends are paid on a quarterly basis unless noted.

Full View

Market Continues To Trade In A Range

For the last 3-4 months, the S&P 500 Index seems stuck in a trading range. Additionally, the trading volume during this time period continues to trend lower. Now that summer is officially over and and next week offers the first full week of trading since Labor Day in the U.S., more clarity may be forthcoming in the market's future direction. If the S&P can break through resistance at the 1,130 level a more sustainable rally might be at hand. The coming week may be more volatile due to Friday's quadruple option expiration day.

From The Blog of HORAN Capital Advisors

The percentage of stocks trading above their 50 day average stands at 72% which is off the summer lows around 5%. Still, this percentage remains below those achieved at prior market highs when this percentage was over 90%. A lower percentage of stocks are trading above their 150 day moving average, 52%.

From The Blog of HORAN Capital Advisors

For investors looking at broader market movements, watching the stochastics indicator in the first chart is a technical indicator that can provide some insight into the market's potential future direction. This indicator is best used to determine overbought/oversold levels. No one indicator provides a certain answer, but it is one indicator that investors might use in this trading range market.

U.S. Budget Deficit or Surplus

At some point in the not too distant future, the U.S. budget deficit needs to be brought under control. Stronger economic growth is a key to this gap being closed.

From The Blog of HORAN Capital Advisors

Inflation and Equity Valuations

Of some concern at this point in time is what will be the future rate of inflation. The concern with inflation is its impact on the expected returns for stocks and bonds. For stocks, higher levels of inflation will reduce the value of future earnings since those future earnings will be worth less in present value dollar terms. Because of this lower value of earnings, one can expect the price to earnings ratio (or P/E) to contract. From an investment perspective this is will be a headwind for stock prices as PE multiples will tend to contract.

At HORAN Capital Advisors, we do believe inflation will be a factor investors will need to contend with in the not to distant future. This being the case, what impact might this have on stock returns and valuations going forward? As I have noted in prior posts, specifically, Inflation in the Pipeline and Relating Company Fundamentals To The Dividend Discount Model, inflation does have an impact on stock valuations. An important question then becomes what level of inflation can an investor expect and what will be the impact on stock valuations. At HORAN we do believe inflation will be an issue in the future that investors need to factor into their expected stock returns. We do not believe we will see an environment where we get hyper inflation though.

At today's valuations and moderate expected levels of inflation, stock valuations do seem to be trading at valuations levels below historical averages. Fidelity recently published a research article noting where stocks might trade at various levels of inflation.

From The Blog of HORAN Capital Advisors

Source: Stock Valuations Influenced by Inflation

We would agree with Fidelity's assessment of the current valuation environment:

As of July 2010, year-over-year inflation stood at 1.3%, while the S&P 500’s P/E ratio (using trailing 12-month earnings) was 15.6 as of August 2010—somewhat below the index’s historical average (17.7).

Using earnings forecasted over the next 12 months (to August 2011) the market’s P/E ratio was 14.1 as of the end of August—also below the index’s long-term average. Thus, given the low current level of inflation and both trailing and forward-looking measures of earnings, the stock market’s current valuation is somewhat below historical norms.

Inflation becomes a more serious problem for investors if/when the economy begins to show better growth. Not that politics drives the economy; however, the policies coming out of Washington over the last two years have not been pro-growth. With a likely change in the control of Congress in November, sentiment and gridlock might be a positive attribute for higher stock prices and a stronger economy. Consumer and investor sentiment historically have had a strong influence on the economy and the market.

More Stimulus and More Debt

Today President Obama announced a $50 billion infrastructure stimulus plan that he hopes will create new jobs during this slow economic recovery. He also proposed creating an "infrastructure bank" where the government would decide which projects are worthy of federal funding. Having the federal government take over more control of a segment of the private sector is concerning. The infrastructure bank will be on top of the federal government's additional control over health care and the automobile industry. Historically, projects/expenses that are controlled by the government sector have been done in a less efficient manner than the private sector.

As the below chart details, the amount of total treasury debt, nearing $14 trillion, now surpasses the size of the U.S economy as measured by GDP. This trend in the debt is unsustainable and should be addressed sooner versus later.

From The Blog of HORAN Capital Advisors

Emerging Markets Representing Larger Percentage of World GDP

The GDP of emerging markets continues to garner a increasing larger percentage of world GDP. In 1987 China was not one of the top ten countries by GDP weight; however, by the end of 2008 China accounted for 6.3% of world GDP. By 2030 it is projected that the BRIC countries will account for nearly 25% of world GDP.

From The Blog of HORAN Capital Advisors

Source: MSCI

At the end of 2009, the US accounted for 41.9% of the weighting the MSCI All Country World Index. This is down from 52.5% at the end of 2003.

From The Blog of HORAN Capital Advisors

Data Source: City of London Investment Group PLC

For investors, allocating some investment assets toward the emerging markets will likely enhance ones returns; however, emerging market returns do tend to exhibit higher volatility. Additionally, the quality of economic and financial data from emerging countries tends to be less robust than that of the developed markets. One avenue investors can pursue to gain emerging market exposure is via multinational companies that are doing business in these countries. Many of the multinational firms have a stated goal of expanding their business activities in these higher growth countries.

Dividend Payers Versus Non Payers Performance in August

Although the month of August saw the average return for the dividend payers in the S&P 500 Index trail the non-payers and the S&P 500 Index as a whole, on a YTD and 12-month basis, the payers continue to outperform. On a year to date basis, the average return of the payers equals -.62% versus -3.41% for the non payers. On an average return basis, the payers and non payers are outperforming the market cap weighted S&P 500 Index. The fact that the equal weighted returns are outperforming the market cap weighted returns continues to support the findings in the July 2010 report issued by Standard and Poor's.

From The Blog of HORAN Capital Advisors

Source: Standard & Poor's

Alternative Investments: Navigating Volatile Markets

The world has changed. Market volatility is here to stay and increased correlations are making investors less reliant on modern portfolio theory. These higher correlations are likely the result of the globalization of trade, the introduction and adoption of new investment vehicles, and quantitative trading programs. The lack of diversifying properties within asset classes, particularly equity, has caused serious reservations among investors about future prospects. A recent Barron’s article commented that mutual fund flows from January 2008 to June 2010 has nearly $600 billion dollars moving into bond mutual funds while nearly $250 billion has exited equity funds (chart below).

From Horan Capital Advisors Blog

Ramblings about bubbles forming in the bond market may have investors spooked but data would not suggest any near term outflows. Investors have opted for fixed income securities as more and more people become frustrated and disenchanted with equity returns. However, those same investors are starved for yield and now frequently reach to uncharted territory to satisfy income needs. Is lower quality or longer duration better? Which camp are we in, deflation or inflation? Is the double dip going to become a reality or is extended slow growth the next step? The common investor asks every day, “Where should I direct my investments?” Maybe he or she should be asking, “How do I invest to reduce overall market risks?”

Investors need strategy specific solutions which can provide consistent returns and hedge systemic risk. The environment for the past decade calls for such. The investment management community has heard those cries and responded quickly by providing alternatives in various wrappers: ETFs, ETNs, alternative mutual funds, structured products, and hedge funds. Clearly the adoption of these various vehicles has added to market variability but nevertheless, their intent is often times to provide hedged market returns within specific or multiple asset classes. These vehicles attempt to set predetermined return expectations. Some managers focus on absolute returns while others position for hedged but directionally long exposures. Regardless of which strategy, both intend to provide consistent and more predictable return streams.

Alternative investments, in their truest form, are unencumbered from trading constraints and provide intellectual freedom far beyond traditional money manager constraints. Example strategies: capital structure arbitrage, special situation events, long/short exposure, discretionary and systemic market trading. The global opportunity set truly becomes utilized as alternative investment managers act to expose market dislocations without traditional market boundaries. Alternatives are simply an expansion of an existing asset class or an investment intermediary between traditional asset classes to help facilitate acceptable balances between risk and return. Investors move between equity and fixed in a blurred or complimentary fashion via alternative investments. Managers must evaluate the means in which they assess market volatility relative to the fees they pay for risk-adjusted returns. For example, hedged equity has mostly long equity properties and should perform like long equity over a full market cycle but with significantly less market variability. Fixed income arbitrage and equity market neutral strategies should exhibit standard deviations equivalent to conservative fixed income securities as they hedge most market risk in an effort to achieve absolute returns conservatively higher than the risk free rate. A liquid alternative with compelling numbers in this category is the TFS Market Neutral Fund (TFSMX).

From Horan Capital Advisors Blog

In this type of economic environment, investors should be setting allocations to investment vehicles that answer the questions regarding how they will generate better risk-adjusted returns rather than where they will necessarily find them.

The Real Facts About The Recent Hindenburg Omen Trigger

One technical data point that has received quite a bit of press recently is the triggering of the criteria that make up the "Hindenburg Omen" indicator. On the surface, it would seem the data provides support for the underlying factors that comprise this indicator. However, as Bespoke Investment Group and Liz Ann Sounders of Charles Schwab note, the facts are not as they appear.

As Bespoke notes, the five criteria that need to be met are as follows:

1. The daily number of New York Stock Exchange new 52-week highs and daily number of new 52-week lows must both be greater than 2.2% of total NYSE issues traded that day.
2. The smaller of these numbers is greater than or equal to 69 (2.2% of 3126 NYSE issues). This is not a rule, but more like a check.
3. The NYSE 10-week moving average must be rising.
4. The McClellan Oscillator must be negative on the same day.
5. New 52-week highs can't be more than twice new 52-week lows (however, it's fine for lows to be more than double highs).

As Schwab outlines in a recent research article the most important factor is the first one noted above. Following are the real facts behind the supposed trigger of this variable:

"Looking at the list of news highs and lows from Thursday, August 12 (the first Hindenburg Omen trigger day), there were 92 stocks (2.9% of NYSE) that hit new highs and 82 (2.5%) that hit new lows.

However, a closer look at the list of new highs shows that most of the "stocks" hitting new highs were hardly stocks at all. Practically all were closed-end fixed income securities, preferred stocks or some other form of fixed income product masquerading as stocks. In fact, of the 92 issues that hit new highs, only seven were common stocks!

Given that there are so many fixed income products that now trade on the NYSE, and with demand for them so high, perhaps a better way to measure new highs (or lows) is by filtering out all the quasi-stocks. B.I.G. did this by looking only at stocks in the S&P 500® index and applying the same Hindenburg Omen parameters.

On the initial trigger day, only 0.2% of S&P 500 stocks hit new highs while 5.6% hit new lows. Of course, a day with 5.6% new lows doesn't highlight a healthy market, but it may not reflect the confusion that the Hindenburg Omen supposedly conveys. As B.I.G. noted, 'Call us crazy, but an indicator that measures the internals of the equity market should probably avoid using fixed income securities in its analysis.'"

Appropriately, as one factors out the non-equity variables, only seven of the new highs were stocks! And, as the noted above, only .2% of the stocks hit new highs on the 12th of August.

For investors then, as uncertainty about the future direction of the market abounds, be sure not to take the bearish or bullish market signals at face value. This is not the same market your parents or grandparents invested in historically.

Source:

Land of Confusion … Bubbles and Omens Dissected
Charles Schwab & Co.
By: Liz Ann Sounders
August 30, 2010
http://www.advisorperspectives.com/commentaries/schwab_090110.php

Know Your Indicators: Hindenburg Omen
Bespoke Investment Group
August 18, 2010
http://www.bespokeinvest.com/thinkbig/2010/8/18/know-your-indicators-hindenburg-omen.html

Change In Control Of Congress And The Market

Many eclectic technical market indicators have surfaced recently given the uncertain direction of the economy and the stock market. We have the Hindenburg Omen, the Kindleberger Cycle just to name a few. I sometimes wonder if these indicators bubble to the surface or gain popularity because fundamental indicators do not support a bear market case.

In any event, one other technical indicator that may come to pass is the potential change in the party that controls Congress. The last time the Democrats held control of both houses of Congress and the White House was during the first two years of President Bill Clinton's first term in office in 1993 and 1994. During the mid-term elections in 1994, the Democrats lost control of both houses of Congress. Prior to the election, the Democrats held 57 senate seats and 258 house seats. Today the Democrats hold 55 senate seats and 256 house seats. So how might the stock market react if one or both houses of Congress change hands over to the Republicans?

Subsequent to the 1994 mid term elections and during the second half of Bill Clinton's presidential term, the stock market advanced over 34% in 1995.

From The Blog of HORAN Capital Advisors

If one believes in cycles and playing in favor of the market now is the fact the third year of a president's term tends to be the best performing one.

From The Blog of HORAN Capital Advisors

More detail can be found in an earlier post I wrote on this topic titled, Presidential Election Cycle Nearing Its Best Quarters. The above table comes from a Standard & Poor's research piece written by Sam Stovall and titled, Whistling a New Tune in June?

One can track the prediction market for these potential outcomes on Intrade. The likelihood that the House of Representatives changes over to Republican control has increased to 77% from below 30% at the beginning of 2009.

The reported economic data is certainly not suggesting strong growth. Slow growth is a potential outcome, but sentiment could change as the end of the year approaches. (This week will see some important economic reports with initial claims for unemployment reported on Thursday and non-farm payrolls reported on Friday.)