"Kee" Points with Jim Kee, Ph.D.

Well, I imagine that few would have believed just a few weeks ago amidst the broad stock market sell-off, that the S&P 500 would end October trading at a fresh all-time high. But, it did. The market is up just over 9% year-to-date, with the Energy sector being the only sector (out of 10) in negative territory (-1.3%) for the year. There is a good lesson here for controlling sector exposure, or not having too much invested in any one sector. Proprietary research conducted at our firm and authored by Jeanie Wyatt and myself in the Journal of Asset Management shows that, over a 20-year period, restricting or capping your exposure to any single sector produces higher risk-adjusted returns, and that’s what you should always be striving for.

 

Oil prices have come down significantly in the latter half of this year, and that is consistent with the outlook held by most of the speakers at our annual energy symposium last May. On the demand side, just about all of the growth in global energy demand over the past several years has come from emerging economies, and almost none from the developed world. And on the supply side, US oil output as it stands today is higher than any point since 1986. OPEC oil production has increased this year as Saudi Arabia and Libya production increases have offset declines in Iran, Iraq, and Nigeria. And as for non-OPEC production, declines in Russia, Brazil, and Mexico have been more than offset by increases in the US, which has become a stabilizing factor. So I would say that oil prices are broadly reflecting the underlying economics of the energy market.

 

Looking globally, another driver of strong equity market performance was the announcement from Japan that the central bank there will be boosting asset purchases, including stocks (not new for Japan) to the tune of about $713 billion a year. Other positive news was the third quarter US GDP growth number, which came in at an annual pace of 3.5%. On a year-over-year basis that puts US real (inflation adjusted) GDP growth at a “remarkably consistent” (WSJ) 2.3%. Not great, but certainly the best of the developed world. Consumer confidence in the US also came in at a recovery high. Confidence has been low by historical standards during this expansion and is just now moving up into more normal territory. Also in the US, the Federal Reserve ended its “tapering” program by completing its last $15 billion in monthly asset purchases. That too signals confidence in the on-going expansion by the US Central Bank. As I’ve mentioned in prior Kee Points, monetary policy is the easy part of the policy equations; it is the fiscal side (tax, regulatory, and spending reform) that is difficult to implement politically. And it is fiscal reform that the developed and developing world is struggling with.

 

Also of importance in the US are this Tuesday’s midterm elections in which Republicans are widely expected to gain control of Congress. One unambiguous winner of that outcome (based upon most of the Wall Street research that crosses my desk) would be medical device manufacturers. That is because Republicans are expected to repeal the excise (per unit) tax that was imposed on the industry to help pay for the Affordable Care Act. The medical device group (e.g. the i-shares US Medical Devices ETF ) has moved upward dramatically over the past few months, which is a pretty good indication of the market’s bet on the election outcomes. I would also expect that group to be one of the largest decliners should an alternate election outcome ensue. Another big event this week in the US will be Friday’s jobs report for October, and current expectations are for continuing job creation along the lines of the 225,000 jobs per month that the economy has averaged this year (for example, Bloomberg’s consensus estimates are for 234,000).

 

Finally, the Japanese yen’s plunge to a seven-year low against the dollar has fueled a lot of headlines regarding the impact of low currency valuations on export-led growth. But most of the peer-reviewed research that I have seen has consistently shown that increases in economic growth following large currency depreciations are transient, lasting perhaps a few quarters. You don’t see sustainable booms caused by currency depreciations or devaluations; just the opposite. It is usually when currency credibility is established (such as when Hong Kong, then China, and prior to that Argentina fixed their currency to the US dollar) that economies start to prosper. And it is when currency credibility gets called into question that economies start to implode. That’s also why many stock analysts view such currency plays as “trades” rather than as more enduring investment themes. It is why analysts are skeptical when companies blame currency movements for poor operating performance beyond a quarter or two. The dollar has touched below $1.25 per euro, an important price to watch, and I would see further strengthening visa-vis the euro as a drag to US GDP growth.