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Financial Markets Updates

Monday, August 14th 2017 

Stock markets around the world declined last week on escalating tensions between the U.S.A. and North Korea. Small capitalization stocks and sectors which respond well to economic growth here at home were particularly hard hit with the S&P mid-capitalization index losing 2.44% for the week. The Dow gave back 1.1%, the S&P 500 lost 1.4% and the Nasdaq declined 1.5%. As noted in the chart below, the S&P 500 entered a key support zone on Thursday lying between 2425 and 2450. A violation of the lower end of that zone will likely result in further correction towards 2350 in the benchmark index. However, if we can hold at the support line and the evolving crisis with North Korea is somehow resolved and averted, I believe the trend in equities can grind higher with a potential synchronized worldwide global economic expansion. Of course, the jury or should I say “Congress” is still out on whether anything constructive can be passed in Washington which will hold the key to how stocks finish out  2017.

European stocks also fell last week and the pan-European benchmark Stoxx 600 logged three consecutive days of losses, ending the week nearly 3% lower and one of the worst weekly losses this year. The FTSE 100 (London Stock Exchange Index) hit a three-month-low on Friday, and on Thursday Germany’s DAX 30 briefly traded below the 12,000 level for the first time since April 2017. Japanese stocks declined with the widely watched Nikkei 225 Stock Average losing 1.1%. For the year to date, the Nikkei is up only 3.2%, the broad-based TOPIX Index is up 6.5%, and the TOPIX Small Index has advanced about 13.3% this year. The yen strengthened versus the greenback for a fifth consecutive week, and closed near ¥109/dollar, which is about 6.8% stronger than ¥117 per dollar at the end of 2016. The Yen tends to rally on geopolitical uncertainty.

The prospect of a military conflict with North Korea unnerved investors worldwide who had enjoyed a relatively benign investing environment so far this year. The CBOE (Chicago Board Options Exchange) Volatility Index (VIX or fear gauge), which had been trading near historical lows, spiked 55% last week to close near its highest level since the November 2016 elections. The North Korean episode is the latest in an almost regular series of events that have shaken worldwide markets over the past several years. For example, the Brexit vote in 2016,the Greek bailout negotiations in 2015, the Russia-Ukraine conflict, oil market selloff in 2014, the “Taper Tantrum” in 2013, the European debt crises and “fiscal cliff” showdown in 2012. However, even with all these negative events, the major equity indexes have more than doubled over this five and a half year period. Wise investors have grown a thick skin and realize that these episodes often have limited economic impact for individual companies and industries. In addition, these flare-ups can create opportunities for long-term investors to selectively acquire stocks that others may have discarded in a move to avoid risk.

"If North Korea gained and used a nuclear weapon, we would quickly and overwhelmingly retaliate. It would mean the end of their country as they know it.” Those words did not come from President Trump, but from President Clinton some 24 years ago. However, North Korea now has nuclear weapons and the unstable leader of North Korea possesses the means to deliver them to foreign shores which carries significant risks to financial assets at this stage of the market cycle with many areas and many stocks trading at dubious risk/reward ratios as valuations are elevated relative to history. In addition, I think it is difficult to see the blue economic skies ahead that many are proposing.

Inimical demographic trends, disruptions in various industries (such as retail by Amazon), changes in the spending habits of the millennial generation, low velocity of money, cautiousness among financial institutions, uncertainties in Washington are just a few of the features that may install a lid on anything other than tepid economic growth. Also, according to Shiller and many other great market mavens, stocks’ valuation ratios do not leave much room for investor enthusiasm to elevate prices beyond the organic growth that companies are able to generate. As noted earlier, stocks can grind higher on the hopes of a synchronized worldwide global economic expansion with the hope that politicians around the globe act responsible and enact policies to reduce global debt.

Accordingly, I believe a more “tactical” approach to investing employing hedges at times makes sense to protect money and investments from a long overdue normal correction or “black swan event” with respect to a potential nuclear conflict with North Korea. I do not by any means want to alarm anyone, however we are dealing with a lunatic leading North Korea and a regime change seems to be wishful thinking at this points. The North Korea news is causing a flight to safety leading to a higher yen, higher U.S. Treasury Security prices and higher gold prices with the exchange traded gold fund, symbol GLD, trading up 2.62% last week. Gold caught a geopolitical fear bid as the ghouls in the media sensationally covered the rising tensions between the U.S. and North Korea. Gold’s rise last week was a bullish development for the near-term technical outlook, but until gold breaks through $1300 a troy ounce, many investors are still remaining neutral on the yellow precious metal. In commodities, oil prices declined 1.6% last week even though OPEC boosted estimates of demand for crude over the next two years, while lowering their forecast for non-OPEC supply.

Politics have largely overshadowed the second quarter earnings season, but results have been impressive. Over 90% of companies in the S&P 500 Index have reported earnings and ,of these, 70% have met or exceeded analysts’ sales estimates and 82% have met or exceeded analysts’ earnings per share estimates. Sales for the quarter are now expected to rise 5.2%, while earnings are expected to rise 10.2%. These results, which are significantly above initial expectations, reaffirm a positive outlook for corporate profits. Department store retailers Nordstrom and Macy’s were in focus last week and both companies pointed to a strong start to the popular back-to-school shopping period. However, weak overall traffic patterns and concerns over online competition persist with the stocks down 4% and 11%. Walt Disney traded down after reporting weak second-quarter results that included declines in the number of its cable network subscribers (primarily from ESPN) and decreasing advertising revenue. Other companies perceived to be “Amazon proof,” such as Home Depot, have outperformed thus far this year. 

This week, specialty retailers, including Home Depot, TJX Companies (owner of T.J. Maxx and Marshalls), and L Brands (owner of Victoria’s Secret and Bath & Body Works) will report earnings. The updated results and management commentaries will provide important insights into the state of retail with regard to the rapidly evolving nature of their businesses, particularly as it relates to online competition, as well as broader consumer sentiment. Stay tuned. . . . .

"One world is enough for all of us." Sting. In a week of minimal economic data releases, global news captured the headlines. As noted earlier, tensions between the United States and North Korea heightened last week, causing investors to react and move dollars into the less-risky Bond markets. Stock markets plunged as a result. Meanwhile, inflationary pressures here at home were anything but tense. Wholesale inflation in July was tame. The Producer Price Index (PPI) and Core PPI, which excludes volatile food and energy, both were -0.1 percent in July versus the 0.2 percent expected. Year over year, PPI was 1.9 percent and Core PPI was 1.8 percent. Likewise on the consumer side, the Consumer Price Index (CPI) and Core CPI, which also excludes food and energy, both rose 0.1 percent in July and 1.7 percent for the 12 months ending in July. The more closely watched Core CPI has been declining since early in 2017 and is below the Fed's target range of 2 percent. Inflation reduces the value of Mortgage Backed Securities and other Bonds. When Bond prices worsen, home loan rates can too. The reverse is also true, meaning low inflation typically benefits Bonds and home loan rates.

Weak economic news normally causes money to flow out of Stocks and into Bonds, helping Bonds and home loan rates improve. In contrast, strong economic news normally has the opposite result. The chart below shows Mortgage Backed Securities (MBS), which are the type of Bond on which home loan rates are based. When you see these Bond prices moving higher, it means home loan rates are improving. When Bond prices are moving lower, home loan rates are getting worse. To go one step further, a red "candle" means that MBS worsened during the day while a green "candle" means MBS improved during the day. As you can see in the chart below, Mortgage Bond prices improved recently keeping home loan rates near historic lows.

Chart: Fannie Mae 3.5% Mortgage Bond Friday, Aug 11th

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