1. finance
2. investing
3. stocks

October 8, 2014
Highlights:
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We anticipate a strong year-end for equities when the focus shifts to corporate earnings.
The increase in risk aversion in the 3rd quarter led to a rough performance for the broad
market and client equity holdings while bond portfolios were about unchanged.
Why long-term interest rates may not increase when the Federal Reserve raises the shortterm interest rates.
How to plan your finances to age 110.
After a Very Strong First Half of 2014, 3rd Quarter was disappointing
Fear was the underlying theme of the 3rd quarter, as investors seemed to be expecting an early Halloween.
Stocks, bonds and commodities were all impacted. The greater the potential for risk, the more fear and
poor performance. High yield bonds were the worst performing bond sector, while small cap stocks
were at bottom of the equity market performance matrix. In addition, there was concern over potential
changes in the Federal Reserve policy, the healthcare concerns related to the Ebola virus, renewed threats
of terrorism and the weakening European economy due to conflicts with Russia. While the situation in
Russia does have material economic impact, the other concerns are mainly psychological and hopefully
will be resolved soon. Let’s hope that soon investors will start to shift their focus back to the growth of
the domestic economy which is broadening its base.
While the SP500 rose less than 1%, most stocks declined. Large cap growth stocks, such as Apple and
Gilead Sciences held their own in most client accounts, and even resulted in gains after positive
developments. The large cap growth sector produced the best gains slightly higher than 1%, while midcaps lost about 3%. The worst performing equity sector was small caps which lost about 7%. Given the
positive outlook for the economy, the weak performance can be attributed to various fear factors rather
than fundamental problems.
Most of our client’s accounts underperformed the SP500, therefore, returning much of the
outperformance which occurred during the first 6 months of the year. Bond portfolios, on the other hand,
were for the most part, unchanged. This was largely due to a growth bias in the portfolio which was not
in line with the equity market which experienced a risk adverse trend during the third quarter. Now that
we have September (which is historically, a weak month for the markets) behind us, in the next few
weeks, we can look forward to strong corporate earnings to hopefully change the market trend.
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Economic Outlook—A Path to Sustainable Growth
The economy is broadening its base of growth. During the second quarter, Gross Domestic Product
(GDP) rose by 4.6% and is projected to rise by 3% or better in the third quarter. The September
employment report was strong with 248,000 new jobs created, including 81,000 in the professional
category. Employment has grown 1.6% over the past year, most of which have come from the private
sector and is on pace to be the strongest increase in employment in years.
The areas of the economy that are showing momentum include technology, non-residential construction,
and healthcare. Businesses are beginning to invest in capital equity, such as replacing outdated computers
with new equipment in order to keep up with innovation led by mobile applications. Further, the iPhone
6 may have a minor, yet positive macro-economic impact on the economy in the 4thQuarter.
Areas of concern stem from exposure to Europe with Russia’s political bad behavior. When temperatures
begin to decline and energy needs rise, Russia’s actions will gain a greater focus. The weak economy in
Europe has the potential to negatively impact the US growth in those industries that rely upon exports and
energy-related companies that will be harmed by falling oil prices. The Ebola situation may possibly
negatively impact the travel industry; however, similar healthcare scares in the past have tended to result
in minimal long-term impact. Domestically, the trend of residential real estate is in question, as the rate
of housing starts has slowed. Investors are debating if this is due to a lack of demand or a lack of
inventory as builders are hesitant to build on speculation.
Key Economic Indicators
(Year over Year Increases/Decreases)
Personal Income
+4.7% - good
Consumer spending
+3.9% - not bad
Employed Persons
+1.67% - ok
Unemployed Persons
-17% - good
Residential Construction
3.3% - lackluster
Non-residential Construction 9.2% - excellent
Industrial Production
4.6% - good
Consumer Price Index
1.7% - excellent
The very moderate rate of inflation is a positive attribute of the economy. At less than 2.0% annual
growth, inflation will help consumer spending and keep the Federal Reserve from raising interest rates
sooner than otherwise expected.
Preparing for a Neutral Federal Reserve Policy
As the economy has largely recovered to the point where the Federal Reserve can ease off the gas pedal,
Federal Reserve Chair Dr. Janet Yellen has articulated the potential process to exit the Quantitative
Easing (Q.E.) program of purchasing Treasury bonds with the strategy of lowering bond yields to
stimulate borrowing. The next tool that the Federal Reserve may alter is the “zero” interest rate policy.
Since the financial crisis, short-term interest rates are targeting Federal funds at 0% to 0.25%. Decision
Economics, Inc. expects Federal funds to be raised to 1.25% to 1.50% by mid-2015, and near 3.0% by
year-end 2016.
Decision Economics’ expectations are largely the consensus among its leading
economists.
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Looking forward, there is a good case that rate increases will be less than expected. With the economy
barely back to a 3.0% run rate, excessive growth is not a problem. Similarly, inflation is contained and
trending under 2.0%. Since the risk of a weakening economy is much greater than rising inflation, the
Federal Reserve may be slower to increase the short-term interest rates than we expected. Furthermore,
from a political view, the voting members of the 2015 Federal Reserve Open Market Committee are
believed to favor growth versus controlling inflation.
Portfolio Strategy for the 4th Quarter
For most of our clients, the long-term portfolio strategy is to allocate the funds that they will need over
the next five years to fixed income, while funds that are dedicated for their long-term needs are best to be
invested for growth, which is usually the equity market. This guideline is based on the analysis that the
most severe bear market cycles do not last more than five years. This was the case in 2013 when the
SP500 exceeded the all-time highs from July 2007- yes, about five years later. Therefore, to restate our
strategy, if a client needs funds over a five year period, we buy boring, low-yield bonds that have a
predictably maturity. This is the key to managing risk.
Our strategy for asset allocation has not materially changed since the 3 rd quarter. Generally, we are
over-weighted in stocks, while under-weighted in bonds as we continue to anticipate higher yields. Our
commodity exposure remains nominal. However, with the sharp selloff in commodities, we are
considering increasing the exposure as a “contrarian opportunity”.
Fixed Income—Boring, but a predictable Return
The bond market has performed surprisingly well this year as the benchmark the 10 Year Treasury Bond
yield has recently fallen from 3.0% to 2.4%. Despite the anticipated end of the Federal Reserve’s bond
buying program, investors continue to invest in US Treasuries as they have higher yields than most other
developed nations, and offer security for nervous investors.
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10 Year Treasury Bond yields still below attractive range
Looking forward, many investors anticipate long-term bond yields to increase, however; this assent may
be more gradual than expected. First, any increase in the Federal funds that is orchestrated by the Federal
Reserve may actually dampen growth, and subsequently, longer term bond yields. Further, inflation,
a/k/a “the devil” to bond investors, remains well contained. While the growth in the United States is
broadening, the renewed weakness in Europe will cause the rise in long-term yields to be more gradual
than many investors are anticipating.
For our clients in the fixed income sector, our general strategy focuses on medium to high grade laddered
bonds (corporate or municipals) coupled with short-term and floating rate bond funds, as a temporary
measure until rates become more attractive. In addition, closed-end taxable and tax-exempt bond funds
are held in some portfolios for clients who seek higher yields and tolerate a tad of volatility.
Equities—Expecting Strong Finish When the World Calms Down
Stocks are beginning the 4th Quarter recovering from some injuries that were experienced during the
rough 3rd Quarter. After a strong first-half of 2014, the 3rd Quarter was a “down” for most stocks.
Although the SP500 showed a small gain, most stocks declined, as evidenced by the 7% in the Russell
2000 small cap index. We are sticking with our outlook for gains of 10% to 12% of stocks for the year.
Looking ahead, and as we happily say goodbye to September, historically the weakest month of the year,
stocks are well positioned for a decent end to 2014. While the current wave of risk aversion is spooking
some investors, the economic growth leads to earnings growth, which hopefully will translate to higher
stock prices. Likewise, after mid-term elections, the equity market historically has performed well.
The recent spell of risk aversion is rooted among a number of political issues, including the riots in Hong
Kong, the conflict in Ukraine and the upcoming U.S. elections. The concerns over the Ebola virus have
added another element of panic and worry. This level of fear can be measured by the put-call ratio (a
measure of the number of put options being purchased relative to call options), which is a reliable
contrarian indicator that has moved into the “buy” zone. Below are several indicators of investor
sentiment that we monitor. While the indicators do not serve as a “timing” model, they do provide
investors with a broad perspective of the current market sentiment.
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Stocks are attempting to stabilize after sell offs in July and September
Sentiment Indicators Flashing “Danger” which are often used as contrarian indicators:
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Put/Call Ratio: High and rising
Volatility: Highest Level this year
Insider buying: ratio improving
High Yield Bond Performance: weak
Closed End Fund Discount to Asset Value: increasing
Our general strategy for equities is to moderately overweight relative to a client’s overall portfolio. Stocks
offer returns in line with historical averages of about 11% per year. However, given the emotional
rollercoaster ride that stocks usually take, we generally recommend that stocks are best to fund long-term
cash needs of five years or longer.
We favor industries which have historically done well in the middle of the economic cycle. These sectors
include technology, energy, and materials. The focus on technology is weighted largely on established
businesses that are trading at reasonable valuations. For example, Apple is the largest holding motivated
by the new iPhone 6 line up with new growth potential in the iWatch. Additionally, Apple has possibly
created a new advancement with iPay in addressing the secure payment technology. Two interesting
technology holdings include Synaptics and Trimble Navigation. Synaptics provides “touch” technology
to smart phone and computer manufacturers. Their new biometric security products are particularly
noteworthy. Trimble’s business has been focused in the construction and agriculture markets but the
potential for a drone product would be a nice fit for farm, pipeline, and border security.
The big question under consideration is the strategy for the energy and commodity related holdings. The
rising U.S. Dollar has historically been negatively correlated to the price of oil and other commodities.
With the US Dollar spiking higher, the following holdings are under performing: Helmerich & Payne,
EOG Resources, Trimble Navigation, Deere, and to a lessor extend, NextEra Energy and General
Electric. Investors are focused on the drop in oil prices from about $105 in July to $89 per barrel
recently. While the drop is significant, the primary concern is over the potential drop to $75 per barrel or
lower, which would make drilling unprofitable. Further, the financial media is discussing if this is the
end of our domestic energy revolution. Looking forward, the key issues impacting oil prices and most
likely, energy stocks include:
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Weather
Russian supply of Natural Gas & Oil to Europe
European economy
US Government energy policy potential changes
With the energy sector losing 9% in the 3rd quarter and the sell-off of holdings in this sector, any positive
development may have a significant rise in the prices of the energy stocks.
In the healthcare industry, we remain focused on Gilead Sciences. Gilead has risen by over 60% in the
past six months. Further gains are warranted with the success of Gilead’s new drug, Solvaldi. Within
the first six months on the market, Solvaldi cured 9,000 patients of Hepatitis-C! Our other core
healthcare holdings include Johnson and Johnson and Merck, both stable companies with attractive
dividend yields of about 3.0%.
Across other sectors, we hold stocks with attractive dividend yields, including Verizon and NextEra
Energy. During the rough month of September, these stocks tend to perform better than the overall
market during downturns. Conversely, some of the growth stocks held in client accounts include Hexcel,
a manufacturer of carbon fiber products for aviation and Trek bikes; and Under Armour, the athletic
clothing manufacturer that is benefiting from expanding its product lines in the casual apparel market.
Index funds (ETF’s)Pose New Challenges to Investors
Over the past decade, investors have taken to index investing via ETF’s (Exchange Traded Funds).
Unlike traditional mutual funds that allow trading at the end of the day, ETF’s allow investors to buy or
sell throughout the trading day just like any normal stock. With the capabilities of computer technology,
investors can purchase their favorite index such as the SP500 via an ETF. The challenge for the financial
markets is when ETF investors all try to sell at the same time, which is usually associated with a market
event. With one trade, investors can sell all their exposure to an index. This situation creates two
problems: 1. For investors, research has shown that they tend to sell on bad news when prices are low,
thus materially underperforming the index that they wished to replicate the performance. 2. For financial
markets, with so many investment dollars concentrated in ETF index funds, when investors panic and sell
at the same time, it pushes down prices more than circumstances warrant. The opportunity is that when
the selling is over, there can be bargains amongst the quality companies that have been caught up in the
selling pressure.
What the Rising U.S. Dollar Means
Currencies are not the most exciting topic at a cocktail party. However, the trend of the rising U.S. Dollar
relative to foreign trading partners has significant consequences to the financial markets and helps to
counter comments that the United States is in financial decline.
There are three key factors that account for the strong U.S. Dollar. First and most significant is that U.S.
Treasury yields are higher than other developed nations. For example, Germany’s 10 year Treasury bond
yields 0.9%, while the U.S. Treasury yields 2.44%. Second, the domestic economy is stronger than most
developed nations with growth of 4.6% Gross Domestic Product (GDP) in the second quarter 2014.
Third, the improved economy and stable government expenditures have improved the deficit, thus
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lessening the supply of treasury bonds being issued to fund the deficit. For the first 11 months of fiscal
year 2014, the Federal deficit has declined by 21%, on 1% growth in spending and an 8% increase in
revenues.
The theory behind potential movements in the financial markets is based on inter-market analysis, an area
of study developed by legendary Technical Analyst, John Murphy. Generally, a rising dollar leads to
lower commodity prices, higher bond prices (lower yields), and mixed stock prices. As the dollar rises,
exports become more expensive reducing foreign demand and limited inflation pressures. Lower inflation
is good news for bond holders, but bad news for stock investors as lower demand can lead to slower
corporate earnings. However, foreigners who wish to profit from the rising dollar may purchase U.S.
equities.
US Dollar rising, a sign that foreigners like our economy.
Potential Impact of a Higher U.S. Dollar
- Lower commodity prices
- Higher bond prices (lower yields)
- Lower multi-national stocks
- Higher domestic stocks
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Planning Your Finances to Age 110
Yes, to age 110.
Former emergency room doctor, now converted financial planner, Dr. Carolyn
McClanahan, spoke recently at the Fidelity Conference of Investment Advisors, and she recommends that
advisors project their clients’ lives to age 110. Dr. McClanahan’s comments were focused on combining
healthcare and financial planning. Since approximately 60% of our clients are females, who have higher
lifespans than males, we find this issue of particular interest. For those with good health, living to age
110 may become common. However, living a triple-digit lifespan will pose another challenge for one’s
finances. Dr. McClanahan commented that the rise in healthcare costs may be moderate but individuals
will become financially responsible for a greater portion of their healthcare.
Financial Plans To Age 110:
1. Part-time employment past normal retirement
2. Extended commencement of Social Security benefits to age 70 (or as long as possible)
3. Keep portfolio withdrawals to no more than 5%.
4. Consider Long Term Care insurance or hybrid life insurance with Long Term Care riders
Our firm assists clients by preparing long-term projections of their portfolio values and projected
expenses. These valuable projections provide our clients with an insight into the viability of their
portfolio supporting the needs for the long term.
Our Mission Statement:
“To act in the best interest of our clients, and
provide customized investment management and
personalized financial concierge services at a very
competitive fee, while offering a high level of service to
all clients, regardless of the size of the portfolio.”
Disclosures
Information sources used to prepare this report include Argus Research, Value Line Investment
Survey, Zacks, Barron’s, Kiplinger’s, Fidelity, and Decision Economics. Founded in 2010,
Andrew Hill Investment Advisors, Inc. is registered as an investment advisor with the state of
Florida and only transacts business in states where it is properly registered, or is excluded or
exempted from registration requirements. Andrew Hill and clients of AHIA hold positions in the
investments mentioned in this report. Please contact Andrew Hill Investment Advisors, Inc. if
there are any changes in your financial situation or investment objectives, or if you wish to
impose, add or modify any reasonable restrictions to the management of your account. Our
current disclosure statement is set forth in Part II of Form ADV and is available for your review
upon request. Tax and estate planning advice is general in nature and the firm is not engaged in
the practice of law.
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