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Tuesday, July 22, 2014

A Striking New Divergence between Large & Small Cap Stocks

By Louis Navellier

The financial markets were hit Thursday by the tragic Malaysian Airline crash over Eastern Ukraine, but the S&P 500 rallied on Friday, rising over 1% to close the week up 0.54%. The airliner was possibly shot down by accident by unidentified Russian-backed insurgents, who also shot down a large Ukrainian army transport plane on June 14 and initially bragged about shooting down another Ukrainian army plane.

Due to rising global tensions, a significant market trend has slipped under the radar: The Russell 2000 small-cap stocks are suddenly diverging from the larger-capitalization stocks in the S&P 500. This is an encore performance. A similar divergence happened between February 26, 2014 and May 8, 2014 when the Russell 2000 fell 7.13% and the S&P 500 rose 1.65%. Through Friday, the S&P 500 is now up 7.03% YTD vs. a 1.03% decline in the Russell 2000. Clearly, this 8.06% divergence is unsettling to many investors.

In the first half of the year we have seen a trend emerging where large-cap stocks are moving overseas to reduce their tax liability. The U.S. has the highest corporate tax rate in the world, so some big U.S. companies are motivated to buy a foreign company and assume its foreign charter to lower its tax liability. These foreign mergers (or “inversions”) are popular because capital always migrates to wherever it is most welcome, and public companies have an obligation to their shareholders to reduce their overall tax liability and boost their underlying earnings.

Treasury Secretary Jacob Lew sent a letter to leaders of congressional tax-writing committees charging them to “enact legislation immediately … to shut down this abuse of our tax system.” Lew is essentially asking the impossible. If anything, his aggressive position could encourage more foreign merger activity. A far more practical request would be to ask Congress to lower America’s super-high corporate tax rates.

In this week’s Income Mail, Ivan Martchev will examine the investment implications of the new tensions in Ukraine. In Growth Mail, Gary Alexander will review some recent (and ancient) books on the “coming crash.” Then I will examine last week’s economic statistics and Janet Yellen’s latest stock market advice.

In This Issue

Income Mail:

The First Casualty of War

by Ivan Martchev

Russian Dividends in Serious Danger

The Euro May Be Getting Ready to Dive

Growth Mail:

The Sky is Falling, Once Again

by Gary Alexander

More New Books by the Legion of Doom

When Will the Next Crash Come?

Stat of the Week:

The Leading Economic Indicators Have Risen for Five Straight Months

by Louis Navellier

Janet Yellen’s Latest Market Sector Timing Advice

Income Mail:

The First Casualty of War

By Ivan Martchev

Some Income Mail readers may wonder where the “income” angle is in this Ukrainian conflict, whose developments often find their way into this column. Income Mail is about macro-economics and interest rate trends that greatly affect all investments. In this case we have a major geopolitical crisis that does the same. The Ukrainian crisis moves the price of oil, which is the most important commodity traded on world markets, whose price spikes have been known to cause recessions and create or wipe out fortunes.

The Ukrainian situation also affects emerging market bonds, particularly those of Ukraine and Russia. It also affects the trade picture in Europe. With Russia having the EU as its largest trading partner, it is no wonder that the Europeans are reluctant to impose strict sanctions as they would be shooting themselves in the foot at a time when the European economy is weak.

I never bought the theatrical withdrawal of Russian troops from the Ukrainian border. I am of the opinion that the Russians feel their national interests were attacked by the substantive foreign interference in the toppling of Ukraine's former President. Ukraine represents the ultimate Gazprom* choke-hold as it controls the pipelines that transport 55% of Gazprom's European natural gas exports.

There is also the unhappy Russian minority in Eastern Ukraine and the easternmost part of Moldova who had felt repressed for many years and would like nothing more than to join the Russian Federation. The Russian government knows this and is using the present situation to further its multiple political goals.

Ukraine Credit Default Swaps Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I don't follow this crisis to identify who is right and wrong, but I am interested in how it affects financial markets. My reading of the situation has been that the conflict was intensifying all along as the casualty numbers started to accelerate and the number of downed aircraft began to notably increase. The Ukrainian bond market, and the Russian financial markets for that matter, took the withdrawal of Russian troops from the Ukrainian border as if Russia had decided to let it go, and it was only a matter of time before the Ukrainian army was going to wipe the rebels out.

This is evident from the action of Ukrainian credit default swaps which had been suffering a massive inversion in April and May, when the one-year CDS contract was trading at about double the price of the 5-year CDS contract—in normal times it is usually the opposite, as the chances of default normally should be higher over a much longer period of time. Under this CDS inversion, investors felt that over one year, Ukraine had a higher chance of default than over five years.

In June, the CDS inversion began to close, and this week we have one- and five-year Ukrainian CDS almost at parity. I think this is absurd. I think the markets misread the withdrawal of Russian forces as a sign that the worst was over. One reason the Russians withdrew, in my opinion, was to bait the Ukrainian military into attacking the rebels so the situation on the ground would become so hopeless that they could show the world they had no choice but to intervene. We are close to such a point.

All three sides to this conflict—the Ukrainian military, the rebels, and their Russian backers—say it was not them who shot down the civilian plane. There are tapes of conversations with traffic controllers in Kiev that have been seized by security services that should shed some light on why this plane was flying at 33,000 feet when air space up to 32,000 feet was restricted by the Ukrainian aviation authority. Then there are the missing black boxes and several conflicting reports as to whether they have been found.

I do not believe the spin that comes from all sides as the first casualty of war has historically always been the truth. The YouTube “smoking gun” of rebels talking about the downed plane intercepted by Ukrainian security services is impossible to authenticate as those are just two voices speaking with native Russian accents. A large part of Ukraine doesn't even speak Ukrainian, and Russian speakers are plentiful on the Ukrainian government side. This latest “smoking gun” does not size up well with authenticated YouTube leaks of a call between EU foreign affairs chief Catherine Ashton and Estonian foreign minister Urmas Paet, or that of Turkish PM Erdogan talking about finding pretexts to invade Syria. Those are real leaks.

It looks to me like this conflict is about to escalate and that the false hope exhibited by Ukrainian CDS prices and, until recently, Russian stocks, is about to get priced out of those markets.

Russian Dividends in Serious Danger

It is quite rare for a benchmark index to yield 4.25%. Years ago, the S&P 500 dividend yield got as high as 6%, but that was at a time of high interest rates and high rates of inflation. Today, the Russian market is the perfect example of a value trap with its juicy dividends and its depressed book values.

Not only does the MSCI Russia index yield 4.25%, but it sports an index average forward P/E of 3.89 and a price to book of 0.71. There is only one other time when I have seen this same index have a P/E in single-digit territory below its dividend yield and that was in November 2008. Then, the S&P 500 touched 741 while now it is close to 2000. This time, the geopolitical situation is clearly adding to that index compression. Curiously, before the Malaysian airliner incident, the Russian stock market had made a fresh post-Crimean high and risen to a level higher than where it was before the Crimean situation broke out. I think this was the stock market misreading the Ukrainian situation as improving.

How low can the Russian index P/E go, and is a 4.25% yield worth chasing here?

In my view, the simple answers are (1) “nobody knows” and (2) “no.” It is impossible to pick an index level where the selling will stop. If Russian troops get involved in a major way in Eastern Ukraine, I think the Crimean low will be breached. The situation of generous dividends in Russian stocks becomes one where Russia will actually face more sanctions and bigger trade disruption. Ultimately those generous dividends will likely get cut, as they did in 2008 and 2009.

There are numerous ways to express the view of where the Russian stock market is going, but the major two are the Market Vectors Russia ETF (RSX) and the iShares MSCI Russia Capped Index (ERUS). There are also the leveraged ETFs which make for good short-term trading vehicles—read days, not weeks—which most buy-and-hold investors should stay away from.

Market Vectors Russia ETF and iShares MSCI Russia Capped Index Chart

Source: Yahoo Finance. Graphs are for illustrative and discussion purposes only. Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. Performance results presented herein do not necessarily indicate future performance. Please read important disclosures at the end of this commentary.

The daily 3X compounding works miracles if the market moves in your favor and results in horror stories if the market moves against you. The worst example is the Direxion Russia Bull 3X Shares (RUSL), which after a sharp sell-off in the summer of 2011 related to the euro-zone crisis has never managed to come back and is increasingly diverging from an unleveraged Russian ETF like the RSX.

The Euro May Be Getting Ready to Dive

In the midst of this geopolitical mess, the euro is likely poised for a serious decline. Not only does Europe suffer significantly from Russian sanctions, but the ECB has gone out of its way to weaken the continent’s common currency with negative deposit rates. It is another perfect storm for the euro.

Euro FX - Monthly Nearest OHCL Chart

Source: Barchart.com. Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Over its short history, the euro has been as low as 83 cents to the dollar and as high as $1.60 in 2008. On a purchasing power parity basis (PPP)—roughly, what one can buy with the same amount of money in the U.S. and the euro-zone—the exchange rate should be close to $1.15 vs. the present $1.33, so there is room for a serious decline. The theory was that in the midst of the euro-zone mess, the euro did not decline as the rather large euro-zone financial system was deleveraging and European banks were selling foreign assets and buying euros to shrink their balance sheets at home.

I have never bought the idea that the euro-zone is fixed. It clearly stabilized after the issues in 2011, and if it were not for present trade frictions with Russia, it could have stabilized more. But it is one thing to “fix” Europe and another to apply a rather large ECB band aid to stabilize it. This is because the euro-zone has one central bank but a dozen and a half different finance ministers with different budgets and deficits, all running their own fiscal policies. That makes it impossible for fiscal policy to sync with monetary policy.

The euro-zone almost broke apart in 2011, and it is still in danger of doing so if fiscal policies are not integrated. Since the bigger costs of this are likely to be borne by Germany, it is impossible to sell the idea to the Germans and many euro-zone members. The Europeans want a united Union, but only to a degree. This is beginning to resemble an open marriage, and I am not aware of a great many of those that have worked out. I think the euro-zone is still in danger of a nasty divorce more than a happy marriage.

Growth Mail:

The Sky is Falling, Once Again

By Gary Alexander

“When your lucky star is on the rise, you turn your back and close your eyes.
When things are looking up, you’re looking down.”

—From “You’d Rather Have the Blues,” a song by Dave Frishberg

After attending the Freedom Fest in Las Vegas (July 9-12) and hearing dozens of speakers talk about the end of the world as we know it, I retreated to my bucolic little island in the Pacific Northwest for a little peace and quiet. The next morning, I strolled into our library, migrating as I usually do to the rack of “new and recommended” hardback books. What should greet me in the center of the new title rack but The Crash of 2016: The Plot to Destroy America, by Thom Hartmann. Yikes! I can’t escape.

As I perused the opening chapters of this latest jeremiad, I noticed Hartmann is predicting a deeper (than 2008) crash, which has been delayed by the Fed’s latest rounds of quantitative easing. But now that QE is almost tapered out, he believes there is nothing to prevent the financial destruction of America from happening soon.

Hartmann comes to the Doomsday cult from the left side of the political spectrum. In Las Vegas, I heard the same story from those associated with the right wing. One speaker’s book had previously set a date for the next big market crash. In 2011, Peter Ferrera wrote Obama and the Crash of 2013. That crash didn’t happen. In fact, 2013 turned out to be the best stock market year since 1997. Ferrera’s book was published on November 15, 2011. Since that date, the S&P 500 has risen by over 50%. Some crash!

These two titles demonstrate one of the key tenets of doomsday writing: Try to put the day of reckoning far enough in the future (say, 2-3 years) so that it gives people time to plan for it – yet near enough to sound scary…and also far enough in the future that people will forget about your book when the date arrives.

Previous examples include Dr. Ravi Batra’s best-selling The Great Depression of 1990 (published in 1987) and his follow-up Surviving the Great Depression of 1990 (1988). You don’t want to get caught proclaiming a serious crash (say to Dow 6,000) too soon (in 2014), like Harry Dent did in late 2013.

More New Books by the Legion of Doom

One of the hot new books released at Freedom Fest was The Murder of the Middle Class by Wayne Allyn Root, an energetic “capitalist evangelist.” Root was taped on a live edition of Fox’s “Stossel Show” during Freedom Fest. Among other statements, Root claimed that “there are no more middle-class lifestyles in America.” Stossel pushed back: “That’s garbage.” Stossel cited the fact that inflation-adjusted income has risen in all income categories since 1979. Although the top 1% is getting richer faster (+201%) than the bottom 20% (+49%) or the middle class (+40%), every income sector is now better off.

We also heard from the ubiquitous Peter Schiff, whose new book The Real Crash: America’s Coming Bankruptcy (released April 8, 2014) was the focus of his several appearances in Las Vegas, including an encore airing last weekend on Book-TV. Schiff basically says the U.S. dollar is doomed to fall 50% to 70%, but I’d ask: Compared to what? To the euro? Ivan Martchev lays out the case above for the euro to decline in terms of the dollar. Schiff also says there is virtually no growth, but we’ll see about that when the second-quarter GDP numbers come out in about 10 days. In truth, these are old worries that the Doomsday press has been telling us about for well over 50 years. I know, because I once believed them.

In my talks about our seeming addiction to apocalyptic books, I often hold up a series of dust covers from books I read (and mostly believed) from the 1970s. The best-selling book in 1970 described a religious apocalypse, The Late Great Planet Earth by Hal Lindsey, while the best-selling book at the end of the decade profiled a secular collapse, Crisis Investing (1979) by Doug Casey. One common denominator among many of the 1970s doomsday books was the tantalizing word, “Coming….” Some examples:

The Coming Dollar Devaluation (1970) by Harry Browne
The Coming Dark Age (1971) by Roberto Vacca
The Coming Credit Collapse (1974), by Alexander Paris
The Coming Bad Years (1978), by Howard Ruff
The Coming Real Estate Crash (1979) by John English and Gray Cardiff

As a financial journalist, I read these books, did some follow-up research, and then regurgitated some of these same fears in my own writing. In the mid-1970s, as I was writing doomsday prose, my wife was working at the Los Angeles Arboretum in Arcadia, next to the Santa Anita Racetrack, where employees were subjected to a class in “The Environmental Crisis.” Her 30-book reading list (which I still have) was dismal fare – from Rachel Carson’s Silent Spring to The Club of Rome’s The Limits to Growth to Paul Ehrlich’s Population Bomb. The bulk of these books pictured a macabre future of starvation, disease, and depleted resources, and they were wildly wrong in their projections of future crises.

Instead of global starvation, here’s a look at what actually happened to the world’s poor since 1970:

Poverty Rates for the World and East Asia Chart

Source: www.aei-ideaa.org/channel/carpe-diem/ Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Why are doomsday books so popular? Matt Ridley, author of The Rational Optimist, says it seems wiser to talk about what might go wrong. If you talk about what might go right, you sound shallow, flippant, or unrealistic. You are often labeled a Pollyanna, or an ostrich burying his head in the sand.

Despite all the crises of the last century, most investors kept making money in the stock market:

The Dow’s Growth in the Last 25, 50, 75, and 100 Years
Data source: Measuringworth.com. Calculations based on Dow 17,100 as of July 18, 2014
July 22 Dow Jones Gain Since Then
1914 59.21 +28,780%
1939 147.65 +11,481%
1964 847.65 +1,917%
1989 2607.36 +556%

There are many other books you can consult for a more positive worldview, such as Smaller Faster Lighter Denser Cheaper: How Innovation Keeps Proving the Catastrophists Wrong, by Robert Bryce (released last May 13, 2014). He tells the story of how the quiet innovators slowly and gradually deliver the solutions that the more histrionic doomsday prophets and headline writers find so easy to ignore.

When Will the Next Crash Come?

A week ago, on July 12-13, Mark Hulbert headlined his weekend Wall Street Journal column as: “How Overvalued Markets Translate into Lower Returns.” He began his column by saying “U.S. stocks are overvalued and have been for months. That is what six well-known measures of valuation show.” The problem is, he admits, “the bull market has continued higher even though the measures have told much the same story for some time.” In fact, Hulbert wrote a similar column for MarketWatch six months ago.

Stock markets can keep rising long after they seem to be “too high.” I distinctly remember the chaos of July 23, 1996 when Elaine Garzarelli issued her famous sell signal, based on a downturn in her 14 market and economic indicators. The market had been rising for over five years without interruption, like now. In the fall of 1996, Yale economist and Nobel Laureate Robert Shiller introduced the phrase “irrational exuberance” at a meeting with the Federal Reserve. In early December 1996, Fed chairman Alan Greenspan borrowed Shiller’s phrase, spooking the market. Then what happened? The S&P 500 gained over 30% in 1997 and the bull market still had plenty of fuel to run out the rest of the decade – 1990 to 2000.

Will we have another stock market crash? Yes! That’s almost inevitable. Will it happen soon? I believe that’s not likely. The stock market typically follows corporate earnings and the outlook for domestic and global economic growth. Look at the overview of the last few years: The unemployment rate has fallen from over 10% to 6.1%. Annualized new vehicle sales hit 16.8 million in May, the best month since July 2006. In fact, new vehicle sales have been averaging over 16 million in each month of 2014, a streak not seen since 2007. As a result, second-quarter GDP growth may astound skeptics. In housing, CoreLogic says that 95 of the 100 largest metropolitan markets now enjoy higher average housing prices than a year ago.

Bad news will still dominate the press each day because, like Dave Frishberg says, too many of us would “rather have the blues.” At Freedom Fest, science writer David Brin said many wonderful things, including “In the short-term, the grouches seem to be right, but in the long-term the optimists are right.” He asked: “Can you name a single month in the last 25 years when they weren’t trying to scare you?”

It should be an easy case to prove that life is getting better – life-expectancy is longer, technology gives us more choices and labor-saving devices; the world enjoys significantly higher incomes, with rapidly growing wealth in long-suffering nations like China. But I suppose it’s much more tempting to look at what might go wrong. Peace and prosperity can be boring. War and calamity fuel an adrenaline rush.

Stat of the Week:

The Leading Economic Indicators Have Risen for Five Straight Months

By Louis Navellier

The economic news last week was mixed, but the most comprehensive single economic indicator was positive: On Friday, the Conference Board reported that its index of Leading Economic Indicators (LEI) rose 0.3% in June after May’s LEI was revised up to +0.7% (from 0.5%). Six of the 10 LEI components increased in June. This was the fifth straight monthly gain for the LEI, which bodes well for GDP growth.

The other indicators were net positive, but somewhat anemic. On Tuesday, the Commerce Department announced that June’s retail sales rose 0.2%, well below economists’ consensus estimate of a 0.6% rise. Vehicle sales fell 0.3% in June after a strong May, but excluding auto sales, retail sales rose by a healthy 0.4%. The other good news was that May’s retail sales were revised up to 0.5%, from 0.3% previously reported. In the past 12 months, retail sales have risen 4.3%, so consumer spending is steadily rising.

On Wednesday, the Fed reported that industrial production rose 0.2% in June and was growing at an annual rate of 5.5% in the second quarter. Utility output declined 0.3% in June, and this week’s cold front that hit much of the Midwest will likely lower July’s utility output. Since the weather can significantly impact industrial production, I do not think we should worry too much about these month-to-month swings. Overall, industrial production has risen in four of the last five months and is steadily improving.

Also on Wednesday, the Labor Department announced that the Producer Price Index (PPI) rose 0.4%, a notch above economists’ consensus estimate of 0.3%. The culprit was energy costs, which rose 2.1%, and wholesale drug prices, which rose 1.4%. The good news was that wholesale food prices fell 0.2% in June due to lower grain and cheese prices. Excluding food and energy, the core PPI rose 0.2% in June. In the past 12 months, the PPI has risen 1.9%, dangerously close to the Fed’s 2% inflation target rate.

On Friday, the University of Michigan/Reuters reported that its preliminary estimate for consumer sentiment slipped to 81.3 in July, down from a final reading of 82.5 in June. This was a big surprise, since economists were expecting consumer sentiment to rise to 83. Although consumers’ view of their current conditions rose to 97.1 in July, up from 96.6 in June, consumer expectations declined to 71.1 in July, down from 73.5 in June. Unfortunately, slow wage growth may be depressing consumer sentiment.

In the euro-zone, industrial production fell 1.1% in May, so economic growth may be stalling in Europe. However, industrial production is still on the rise in China, which is a good sign that worldwide demand remains strong. On Wednesday, China’s Nation Bureau of Statistics announced that its GDP grew at a 7.5% pace in the second quarter, up slightly from a 7.4% annual pace in the first quarter. Overall, China’s exports and imports will likely continue to be closely monitored as a leading indicator for global growth.

Janet Yellen’s Latest Market Sector Timing Advice

Speaking before the Senate Banking Committee last Tuesday, Federal Reserve Chairperson Janet Yellen said that “considerable uncertainty” surrounds the economic outlook. She added that the Fed’s decisions about interest rates will depend on the economic data. Yellen explained: “If the labor market continues to improve more quickly than anticipated…then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.” On the other hand, “If economic performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated.” Yellen admitted that inflation has migrated higher in recent months, but she added that most Fed officials expect it to stay below 2%. That means the Fed has no intentions of raising key rates soon.

Then, Ms. Yellen wandered away from her area of expertise a bit and began to talk about asset bubbles. In her prepared testimony, she said, “While prices of real estate, equities and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms.”

Her prepared testimony also said that “valuation metrics in some sectors do appear substantially stretched … particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year” (emphasis added). Yikes! I have never before seen the Fed’s official prepared testimony attack selected sectors in the stock market like this. Naturally, the stock market’s reaction to her shocking comments about social media and biotechnology stock valuations was not well received, especially after many of these stocks had already corrected earlier this year.

I hope this is not the beginning of a trend by the Federal Reserve to offer stock market sector analysis.



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