From Healthcare to Hoops

by Jason Norris, CFA Executive Vice President of Research

I Want a New Drug

We have seen a major resurgence in the healthcare space with regard to R&D and stock performance. In 2013, with the broad market up over 30 percent, the healthcare sector returned close to 45 percent and was the second best-performing sector. This year, in a flat, sideways-trending market, healthcare has been the best performing sector. We believe the sector gives investors a great mix of growth as well as stability and income. The worst of the drug patent cliff and generic substitution is behind us. We saw this transition peak in 2011 and 2012 with the likes of Lipitor, Plavix, Viagra and Singular coming “off patent.” This total was roughly $90 billion of revenue for big pharma companies. With this event sunseting, big pharma has cut costs, spun off divisions and made acquisitions to “right size” their lines of business. We anticipate the emerging pipelines from big pharma to more-than-offset the loss of revenue that will occur in 2016 and 2017. This reemergence is driven by diabetes, oncology and anti-clotting drugs.

Another space displaying strong R&D performance is biotech. In 2013, Biogen Idec launched its revolutionary multiple sclerosis drug and this year we have seen Gilead’s hepatitis C treatment (Sovaldi) come to market. The growth opportunities for this type of drug are great. For example, six months ago, Gilead was estimated to sale $2 billion of Sovaldi in 2014. Now expectations have risen around $7 to $10 billion. The R&D efforts in drug development around the world continue to break new ground.

Cover Me

The end of March will mark the conclusion of the first open-enrollment season of the Affordable Care Act (ACA). While the rollout was far from perfect, there is still quite a bit of uncertainty of its effects on the healthcare sector. We believe, relative to investing, most of the uncertainty has been diminished. The taxes that were implemented on the drug makers and medical device manufacturers have already taken effect. It is anticipated that the remaining uncertainties will affect hospital and insurance markets. As we have seen some adverse selection in the enrollment, the overall costs to the plans may see steep increases. While there is a clause in the ACA to reimburse insurance providers for their losses, we have heard “rumblings” from Congress to repeal this provision. While that is highly unlikely, it still creates uncertainty.

Finish What You Started

On Wednesday, the Federal Reserve continued to reduce their monthly bond purchases and gave all indications that they want this program to wrap up by year end. The Fed did state, however, that they will continue to remain “accommodative” while the economy muddles along. The major change was the removal to the 6.5 percent unemployment-rate threshold. We anticipated this because of the issues around labor participation can distort the rate. We do believe that the Fed funds rate will be anchored at 0.25 percent well into 2015.

Come Monday

On Monday, April 7, the NCAA will crown a men’s college basketball champion. For those lucky enough to still have a viable bracket, you are moving closer to winning $1 billion from Warren Buffet, providing you continue to have the perfect picks. The odds of this are 1-in-9 quintillion (yes that’s 19 zeros).  Let’s hope that in the last couple days, worker productivity did not fall too much as fans tried to follow all the games.

Our Takeaways for the Week

• We remain bullish on the healthcare sector and believe it will outperform the broad market
• Even though interest rates have fallen year-to-date, as the Fed unwinds its bond buyer and the economy picks up, the 10-year Treasury will end the year above 3 percent

 Disclosures

Underneath it All

by Ralph Cole, CFA Executive Vice President of Research

Workin’ for a Livin’

The U.S. jobs report has become the most watched economic indicator in the world. The jobs report comes out on the first Friday of the month and includes the unemployment rate and number of new jobs created the prior month. Both January and February reports were underwhelming due to weather, but we think employment will strengthen more than people think in the coming months.

Dan Clifton of Strategas alerted us this week to some underlying trends that will be playing out in the labor market in the coming months. Extended unemployment ran out at the end of December. The Senate voted this week to retroactively extend those benefits through May of this year, which may or may not become law. The fact is that long-term unemployment benefits ran out for a significant number of people in December. History tells us that many of these folks will go out and find jobs, bringing down the unemployment rate faster than people expect.

We have a real-life example in North Carolina. North Carolina’s emergency benefits ran out six months ago. Since that time, the state’s unemployment rate dropped 2 percent!  During that same time period, employment in North Carolina increased 1.3 percent versus the national average of just .5 percent.

The Gambler

Vladimir Putin continues his quest to win over Crimea. He has been admonished by every major country in the world, but will not give in until after Crimea’s secession referendum on Sunday. The U.S. and other major powers have stated that this is an illegal vote that is contrary to the Ukrainian constitution. How this plays out in the near term is important, but the more interesting part of the story is the long-term implications of Russia’s aggression.

We’ve written at great length about the energy revolution here in the U.S. and the benefits that will accrue over time because of it. Much of Europe’s natural gas comes from Russia, with more pipelines in the works. This partnership is being questioned in light of Russia’s latest activities, resulting in our European allies turning their attention to “the Saudi Arabia of natural gas” (i.e., the United States). While the U.S. won’t be able to assist in the near term, we think recent tensions will cause additional pipelines and liquid natural gas terminals to be approved in the coming months.

Our Takeaways from the Week

• The labor market is stronger than people believe and will lead to rising interest rates in the coming months
• Vladimir Putin has overplayed his hand. While he may win the Crimea vote on Sunday, he just offended his country’s largest customer
• Uncertainty in China and Russia led to a sell-off in the S&P 500 of 1.7 percent for the week

  Disclosures

"Putin" Russia Behind Us

by Shawn Narancich, CFA Executive Vice President of Research

Good Friday, Great Week

Shaking off another bout of Russian adventurism in the former Soviet Union, stocks moved further into record territory this week on the heels of a better than expected jobs report domestically and encouraging manufacturing reports both here and abroad. Investors have witnessed a slow but steady reversal of the early 2014 risk-off trade, with benchmark U.S. Treasuries retracing approximately half of their earlier year gains and the S&P 500 now up 7 percent from its early February lows. Despite cold and snowy weather that has put a damper on retail sales this winter, we continue to foresee a stronger U.S. economy this year, supported by a rejuvenated energy sector that is in turn producing a renaissance in U.S. manufacturing.

Decoupling

A monthly jobs report signaling net non-farm payroll gains of 175,000 is not ordinarily a reason to celebrate, but viewed against the cold and snowy weather of one of the nation’s worst ever winters, the fact that February employment gains approached the average levels achieved last year is notable. We are encouraged to observe that local and state employment, after being such a material drag for so long, posted gains during the month, but even more important is the continued employment gains reported in construction and manufacturing. Dovetailing with the detail of today’s jobs number was the purchasing managers report for February out earlier this week, which showed manufacturing expanding at a faster pace domestically. Given the encouraging economic data, we foresee the Federal Reserve continuing to pare its purchase of Treasuries and mortgage backed securities, as likely to be detailed at its next FOMC meeting March 19^th.

This week, investors witnessed Russia’s ruble tumble in response to the country’s Crimea incursion, forcing the central bank to boost short-term interest rates in support of the currency, but also adding to the risk that Russia falls into recession.  With emerging market currencies under pressure and in turn creating inflationary problems beyond US and European shores, we see developed economies that have increasingly decoupled from their emerging market counterparts. Supporting our outlook for the world’s developed economies to outperform in 2014, Europe reported its best retail sales numbers in thirteen years and coupled that with surprisingly strong manufacturing growth.

Tales of the Cash Register

Over the past couple weeks, U.S. retailers book-ended a fourth quarter earnings season that once again produced a clear plurality of better than expected results. For the retailers, hits and misses were as numerous as in any quarter we can recall. On the plus side of the ledger, investors were pleasantly surprised by strong sales at department store operator Macy’s and by the home improvement retailers Lowe’s and Home Depot, which both reported strong finishes to fiscal years advantaged by the rebound in housing. Meanwhile, investors in Radio Shack and Staples were left to lick their wounds, as both these companies continue to suffer from sales lost to the digital economy in general and Amazon.com in particular. Both undershot investor expectations and are in the process of closing hundreds of stores to right-size their disadvantaged business models.

Our Takeaways from the Week

• Stocks forged new highs despite geopolitical tensions in Eastern Europe

• Despite bad weather, the U.S. economy continues to make encouraging progress

Disclosures

Puerto Rico Debt Crisis

by Brad Houle, CFA Executive Vice President

As of late, Puerto Rico has been in the news due to financial problems that stem from too much debt, a shrinking population and weak economic growth. Consequently, Puerto Rico's debt has now been downgraded to below investment-grade status. Puerto Rico is a territory of the United States and as a result is able to issue municipal debt that is federal and state tax-free to investors in every state. Puerto Rico has roughly $70 billion in outstanding debt that is widely owned by municipal bond investors in high-tax states with limited municipal bond supply due to Puerto Rico’s favorable tax treatment and ample supply.

The government of Puerto Rico has been taking steps to stabilize their economy. Governor Alejandro Garcia Padilla has enacted drastic pension reform and economic growth has improved recently. However, Puerto Rico needs to access the bond market next month with a planned $3 billion dollar bond sale. In order to attract investors, Puerto Rico will have to pay a high single-digit rate of interest in order to compensate investors for the default risk. We believe that Puerto Rico will be able to successfully issue this debt which should shore up the finances as well as lessen the news flow. Additional liquidity coupled with less financial media attention should allow for a rebound in the prices of the debt.

While the situation in Puerto Rico appears to have stabilized, the territory is not yet out of the woods. There are still high levels of unemployment and violent crime and a business climate that is considered to be unfriendly. If the financial situation gets worse, there is some question whether the U.S. Government would step in to provide assistance. This is a complicated situation in that Puerto Rico is a territory and not a state. Detroit was allowed to go bankrupt and received no state or Federal assistance. In addition, there is not a clear mechanism for an orderly bankruptcy due to the territory status.

If the situation in Puerto Rico becomes more serious, some are concerned that it would become a systemic crisis across the municipal bond market. In past municipal bond market corrections, we have used the dislocation to buy bonds at attractive valuations for our clients. Overall, municipal bonds have been a very safe investment, specifically according to Moody's for the last 40+ years, only .012 percent of municipal bonds have defaulted. Said differently, Strategas Research has calculated that of the greater than 1 million municipal bond issues outstanding only 71 have defaulted between the years of 1970 and 2011.

Our takeaways for the week:

• We have not actively purchased Puerto Rico debt for our clients in the past and are not buyers at this time. We view Puerto Rico debt as a “hold” for investors that do own the debt. Presently, the situation is characterized by more smoke than fire. Following a successful bond offering and as news flow abates, there will probably better opportunities to exit positions in Puerto Rico debt if individual risk preferences warrant doing so.
• This week we saw the S&P 500 hit new all-time highs.

Disclosures

Money Talks

by Jason Norris, CFA Executive Vice President of Research

Money Talks

Earlier this week, Facebook anted up close to $20 billion (with a capital B) to purchase WhatsApp, a mobile texting company. The company is estimated to gross $300 million in revenues this year and $500 million in 2015 by charging $0.99 per year to allow users to by-pass texting fees from their wireless provider. One can argue if the price will be “worth it” for Facebook, but we do know that WhatsApp’s 50 employees are pleased.

This deal is just one of the several major merger and acquisition (M&A) deals we have seen this year. On top of the Facebook deal, over the last week we saw a major take-out for Forest Labs, talk of Safeway going private, and Comcast bidding for Time Warner Cable. Corporate America is flush with cash and, as we forecasted, is putting it to work. Industry analysts have yet to declare that we are off to the races for M&A, but confidence is improving.

Modern Day Cowboy

Move over Henry Ford, here comes Elon Musk, the CEO and Chief Product Architect for Tesla Motors. The high-end electric car maker continues to push the limits on manufacturing and innovation.  While global demand is picking up and Tesla has been ramping up production to meet these needs, profitability and valuation are key determinants of a good stock, on top of a good company. One can get caught up in the hype of the revolutionary envelope Tesla pushes on a manufacturing basis (check out this video for a demonstration). Is a good company necessarily a good stock?  When you look at the value investors are giving Tesla, it is $817k per vehicle sold. The auto average is $13k. One could argue that Tesla should command a premium, but the current premium may be a little too rich for our taste.

Baby, It’s Cold Outside

The recent polar vortex that has affected most of the U.S. the last few weeks has impacted several economic indicators (as highlighted last week by Ralph Cole) as well as commodity prices, specifically natural gas. Natural gas prices in mid-January hovered around $4.00/btu. Since then, gas has spiked to over $6.00/btu. While this may have a short-term impact on the cost of energy, we do not foresee much more upside pressure to gas prices. At these levels, we are likely to see some shift in exploration and production from oil to gas since the cash flows at these prices can be very attractive. Therefore, as demand slows with warmer weather and more supply comes online, we would expect gas prices to trend lower.

This phenomenon in the U.S. has led to an energy/manufacturing renaissance. Low energy prices have allowed manufacturers to “on shore” their production because the costs have become more attractive. Especially those industries where natural gas is a major feedstock:  chemicals, fertilizer, etc. There are plans for 10 new ethane facilities (or crackers) in the U.S. due to the increased supply of energy and natural gas. This will result in a major increase in polyethylene supply, which is a major input for plastic, thus, lowering the cost for thousands of consumer and commercial products, while increasing jobs in the U.S.

Takeaways for the Week

• M&A deals are starting to pick up and companies are paying premiums for growth
• Low commodity prices and technological innovation is a boom for the U.S. economy, thus benefitting the U.S. consumer

 Disclosures

Sympathy for the Weatherman

by Ralph Cole, CFA Executive Vice President of Research

Sweater Weather

As economic and market forecasters, we have a great deal in common with meteorologists. We know forecasting daily moves in the stock market is a fools game, but that over longer  time horizons, our forecasting accuracy improves greatly. Weathermen face the difficult task during snow storms of forecasting snowfalls and temperatures minute-to-minute, and hour-to-hour – to which we say... “No thanks!”

The East Coast has been battered by several snow storms over the past month, and this has had a negative impact on high frequency economic data. The reason that this has such a large effect on government data is because the Northeast megalopolis that spans from Washington D.C. to Boston is responsible for 20 percent of the nation's GDP. Largely due to poor weather conditions, retail sales in the month of January were down .4 percent. Similarly, industrial production also came in weak for the month of January, down 1.4 percent.

We believe the current slight weakness in economic data is a blip on the Doppler radar, and economic growth should accelerate as, literally, the snow thaws.

Welcome to the Jungle

One of Janet Yellen’s first duties as Federal Reserve Chairwoman was the semi-annual report to Congress. Timing of the report was helpful to both Congress and the markets because both senate and house leaders are trying to determine and understand the likely pace of tapering to expect in 2014. More specifically, what indicators will the Fed be relying upon, and are there any hard and fast rules governing the pace of tapering? As any good Fed Chairwoman would do, Janet left answers to all of those questions up in the air. Yes, she would like to continue tapering at this pace, but she is not tied to a $10 billion monthly reduction. Yes the Fed will be monitoring the unemployment rate, but it is not the only indicator they will be considering.

Despite the lack of specifics in her answers, the Fed Chairwoman’s performance was received very positively by the markets and as of this posting the S&P 500 was up 2.4 percent for the week.

Takeaways for the Week

• Despite several weak near-term economic statistics, the economy continues to expand at a reasonable pace
• The new Fed Chairwoman assured Congress and the markets that she will be a steady hand at the helm of the Fed

Disclosures

Synchronized Global Expansion?... Far From It

by Shawn Narancich, CFA Executive Vice President of Research

Dawn of a New Era

Amid heightened turbulence in the global economy and capital markets, Janet Yellen was sworn into service as the Federal Reserve’s first chairwoman this week. Although she has a dovish reputation as an economist focused on the labor market implications of monetary policy, she ascends to a position requiring the optimization of full employment and low inflation. In this spirit, and acknowledging the faster pace of U.S. economic expansion at present, we do not expect this morning’s surprisingly weak payroll report to throw the Yellen Fed off its course of continuing to taper QE3. The headline number of 113,000 net new jobs created in January is anemic but, like December’s similarly weak number, unusually severe winter weather could be at play. More importantly, the underlying detail is encouraging – more private sector hiring and less competition from the government, which continues to shed jobs. After retreating nearly 6 percent year to date, blue chip U.S. equities shook off the weak payroll headlines and rallied back into positive territory for the week.

Decoupling

While retailers cut back following a choppy Christmas selling season, construction and factory jobs surged in January, providing more anecdotal evidence of a renaissance in U.S. manufacturing. Combine that with the surge in U.S. energy production and low inflation, and what we see is a relatively healthy domestic economy that appears able to withstand an increasingly uneven outlook internationally. The global purchasing manager surveys out this week demonstrate that economic activity globally is far from the synchronized global expansion that some would claim. Consider China, where the manufacturing sector is teetering on the edge of contraction, and contrast it with Europe, where despite 12 percent unemployment, factory output is growing at a faster clip. While China is still growing, its rate of expansion has slowed, taking the punch out of commodity prices and serving to help developed nations worldwide, whose lower bills for gasoline and agricultural commodities are helping boost consumers’ disposable personal income.

Emerging Market Contagion?

With the sun beginning to set on another reasonably constructive earnings season, we observe corporate earnings for the fourth quarter of 2013 that in the aggregate appear to have risen by about 8 percent. But with emerging equities already down as much as 11 percent year to date, investors are concerned that the relatively modest pullback U.S. stocks have already experienced could turn into something more sinister. So far, the interest rate hikes in nations like India, South Africa, and Turkey that are being used to help stem currency weakness and capital outflows appear localized to such economies disadvantaged by current account deficits that are driving up inflation. In contrast to the late 1990’s when currency devaluations in countries like Thailand were exacerbated by foreign currency debt obligations (making those obligations more expensive to repay), emerging market challenges today center around the more common but less pernicious problem of stagflation, a combination of slowing economic growth and rising inflation. As emerging market countries adjust to higher interest rates, we expect their growth to slow and in turn, dampen the level of global economic growth. But just as it did against a strong domestic backdrop amid the Asian Financial Crisis, we expect the U.S. economy and capital markets will weather the storm. Acknowledging the near-term challenges presented by emerging markets, we recently reduced our allocation to this equity style.

Our Takeaways from the Week

• Janet Yellen became the Fed’s first Chairwoman, amid an increasingly turbulent global economy
• Stocks bounced back, defying disappointing headlines on the jobs front and mixed manufacturing data

Disclosures

Are You Ready For Some Football?

by Jason Norris, CFA Executive Vice President of Research

Super Bowl Shuffle

With Super Bowl XLVIII due to kick off this Sunday, the results have historically had an impact on investors’ portfolio for that calendar year. This match up, for me, is a classic. Growing up in Boise, Idaho, most likely you were either a Seahawks fan or a Denver Broncos fan. From the late 1970s through the 1990s, both teams played in the AFC West and were archrivals. My allegiance always went to the Seahawks with great players like Steve Largent, Kurt Warner, Dave Krieg and David Hughes. And with Super Bowl XLVIII, my allegiance has not altered, and this would be beneficial for equity markets. Even though correlation does not lead to causation, historically, if a team from the NFC wins the big game, the S&P 500 is positive 80 percent of the time. Now that the Seahawks have made the move to the NFC, a win “may” portend a positive gain for equities.

While we are not big fans of seasonal and/or cyclical indicators, we do pay attention to them. With the S&P 500 down more than 3 percent for the month of January, history does not look good for the remainder of 2014. The returns in January usually predict what the returns will be for the entire year. Since 1950, this “January Barometer” has a completion percentage of 80 percent. While not perfect, it is an interesting factoid. Therefore, we should be cheering for the Seahawks to offset this calendar trend…

One final note on the subject: the Seattle Seahawks have been a great investment for owner and former Microsoft co-founder, Paul Allen. He bought the team in 1997 out of “civic duty,” and since then it has increased in value six-fold, while his Microsoft stake has merely doubled.

Down in a Hole

Global markets continue to be disheartened with events in emerging markets. Currency devaluations and higher interest rates are resulting in a “risk-off” trade for global investors. This sell-off has not been limited to just emerging markets. As we have seen here in the U.S., global developed markets felt the effects as well. The global markets (as measured by the MSCI All-World Index) are down five percent for the month of January. These risk-off trades have resulted in developed market interest rates declining meaningfully. The 10-year U.S. Treasury yield started 2014 at 3.00 percent; it is now trading at 2.65 percent. Yields in Germany and the UK have dropped by similar levels.

Due to this uncertainty, we are looking to reduce our emerging market exposure and allocate those funds into the UK, focusing on the consumer.

It’s Alright

While the January sell off is disappointing, we are still constructive on equities, especially developed market equities. This week we saw strong economic data in the U.S. regarding GDP and consumer spending even though consumer sentiment continues languish. Earnings for U.S. companies have been relatively healthy with 72 percent of companies having reported beating expectations. While we have seen some uncertainty in some parts of the earnings reports, specifically enterprise technology, we are still like the overall market. Specifically we increased our exposure to U.S. healthcare this week as we see the sector as offering great defensive/growth opportunities.

Takeaways for the Week

• Even though we believe interest rates are going to trend higher, holding bonds in portfolio is still warranted
• Developed market economies continue to improve, and while we are experiencing some volatility, we are still positive on U.S. equities

 Disclosures

Why the Price of Tea in China Matters

by Brad Houle, CFA Executive Vice President

One of the risk factors we highlight in our 2014 Capital Market Outlook is China's growth, which is slowing more than expected.  This week China's Purchasing Managers Index (PMI) was released.  A Purchasing Managers Index is an indicator of economic health.  PMI data is collected from various industries all over the world. PMI data is collected by analyzing five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.¹ The point of PMI is to indicate if an economy is accelerating or decelerating.  A number above 50 suggests improvement and a number below 50 suggests deceleration.  The latest PMI for China was 49.6 down .9 from the three month average of 50.3.  This is the fourth month in a row the Chinese PMI has declined.

Even with a decelerating economy China is expected to have Gross Domestic Product (GDP) growth between 6-7 percent.  China has been able to engineer a soft landing, managing GDP growth from 11 percent to the 6-7 percent level.  A soft landing is an expression for a decelerating economy that slows down without going into recession.  However, Chinese economic data is looked upon with some skepticism by market participants. Chinese GDP is reported in a way that is not consistent with how GDP data is reported in all the world's developed economies.  There is very little transparency in the numbers not to mention an unusual stability that might suggest certain components of the data are not completely factual.  In China there is a large underground cash economy that would be difficult to measure.

The China PMI news put a downdraft in the U.S. markets and caused some minor selling in other developed markets.  Other emerging markets also had a difficult week.  Argentina's peso declined the most in 12 years due to the cumulative effect of years of the Kirchner government’s economic mismanagement. Argentina has been challenged with uncontrolled inflation and a currency black market that has undermined the government’s efforts to regulate capital flows.  In addition, Turkey has been struggling with a political crisis that has undermined confidence and led to a large drop in the Turkish lira.

Earnings season is underway and according to FactSet Research, of the 53 companies of the S&P 500 that have reported fourth quarter 2013 earnings, 57 percent have reported earnings above the mean estimate.  The blended growth rate has been 5.9 percent with financials having the best growth rate and the energy sector having the lowest growth rate.

Our Takeaways for the Week:

• The strength of the Chinese economy is top of mind for investors and will continue to be impactful to developed and emerging markets

¹Source: Investopedia

Disclosures

Off to the Races

by Shawn Narancich, CFA
Executive Vice President of Research

 Ohhh, the Weather Outside Is Frightful

Rubber hit the road this week for investors as traders and money managers returned to work after what for many turned out to be a nice two week break. Stocks appear to be consolidating gains realized over Christmas and New Year’s, with a plurality of economic data pointing to faster U.S. growth in 2014. A fly in the ointment was this morning’s December employment report which showed the economy producing just 74,000 jobs - albeit in a month where bad weather seems to have had a disproportionately negative impact on the headline number. Nevertheless, if one excludes construction job losses and cases where people were counted as unemployed because they couldn’t get to work, the job numbers still fell short of estimates. And while the unemployment rate dropped to 6.7 percent, it fell primarily because more of the jobless gave up hunting for work. Indeed, as we look back to year-end, the labor force participation rate has fallen to a new cyclical low of 62.8 percent - that is the percentage of “employable” people either with a job or looking for work.

Gaining Momentum

Will one month of relatively poor employment data dissuade the Fed from its planned tapering of QE? We doubt it. Q4 retail sales picked up, the renaissance of U.S. manufacturing and energy is going full steam ahead, and capital spending by companies flush with cash appears on the verge of inflecting upward. In related fashion, this week’s monthly trade data was bullish. The November report showed U.S. imports exceeding exports by a four-year low of $34 billion. Increasingly positive trade flows are being driven by two key trends: rapidly falling oil imports resulting from new domestic production and surging exports of gasoline and diesel being refined from the crude. As a result of these encouraging trends, GDP growth estimates for the fourth quarter are being revised upward, and for the first time in recent memory, the U.S. economy may have grown in excess of 3 percent for two consecutive quarters. With fiscal headwinds waning, 2014 is shaping up to be a year of faster economic growth domestically.

The Dawn of Another Earnings Season

Alcoa unofficially kicked off the fourth quarter reporting season by reporting weaker than expected profits that left investors disappointed and shareholders with lighter pockets. Other early reports from seed and herbicide producer Monsanto, US beverage producer Constellation Brands and chipmaker Micron were more encouraging, and each of these cases resulted in nice stock price gains afterward. Overall, investors are expecting blue chip earnings growth of 6 percent for Q4, on flat revenues. These estimates could prove conservative if fourth quarter GDP growth was as strong as the 3 percent rate we expect. Next week, several big banks including JP Morgan and Citigroup will come to the earnings confessional, as well as industrial conglomerate General Electric. Let the fun begin!

Our Takeaways from the Week

• Stocks are taking a breather, consolidating some of their heady 2013 gains
• Despite a hiccup in the monthly employment report, the U.S. economy appears to be gaining steam

Disclosures

Reeling in the New Year

by Jason Norris, CFA Senior Vice President of Research

With 2013 coming to a close, one of the most frequent questions we have received is, “What’s the encore?”  The S&P 500 rose over 32 percent, the best return since 1997. Will 2014 result in profit taking or will there be continued follow through as investors deploy their cash?

A year ago, investors were looking at a lot of uncertainty with the pending government sequestration, increasing taxes (as you recall, the payroll tax was increased to 6.2 percent), as well as international questions with Europe and a possible slowdown in China. Those fears, at least by market perception, were put to bed as the Federal Reserve continued to hold interest rates down with their bond buying program. As the U.S. economy showed steady gains and the Fed signaled the end to quantitative easing, investors chased stocks higher and exited bond positions. In the last six months of 2013, over $175 billion left bond mutual funds but only $75 billion found its way into equity funds. We believe there is still a lot of cash to be deployed in 2014.

Against the Wind

2014 will be the advent of the Janet Yellen tenure at the Fed, a mid-term election, as well as the conclusion of QE3. We continue see slow improvement in economic data for the U.S. economy. Unemployment claims are trending lower (after a volatile month due to the holidays). Manufacturing data remains healthy, as reflected by this week’s PMI reading of 57 (a score of 50 or above signals strength). The U.S. consumer remained engaged into the end of the year as retail sales rose over four percent (primarily driven by double digit on line sales growth). Finally, the housing market is improving with prices rising and inventories falling.

What could derail the expansion? Rising rates. As the Fed unwinds its bond buying, we believe rates will continue to trend higher. Will these higher rates be a meaningful headwind to growth and equity returns? We don’t believe so. However, we will be monitoring closely.

Back for More

This brings us back to the first question: what does 2014 have in store after such a strong 2013? Looking at historic returns, equities revert to their averages. Since 1928, there have been 17 periods when stocks returned over 30 percent. The following year, equities averaged an 11 percent return and were positive two-thirds of the time (in line with historic annual returns). Therefore, this year, equity returns are going to be contingent on corporate profit growth and market valuation, which we believe are both constructive.

We hope you all have a healthy and prosperous 2014 and we look forward to seeing our clients and friends at one of our many Investment Outlook presentations over the next six weeks.

Our Takeaways for the Week:

• The retail investor remains skeptical of equities
• The U.S. economy continues to show steady improvement

 Disclosures

Christmas Comes Early … and Late

by Ralph Cole, CFA Executive Vice President of Research

Melt with You

It feels like the market is melting up these days as stocks continued their year-long rise during the shortened holiday week. Investors continue to be heartened by positive economic data signaling stronger growth as we enter 2014. Durable goods orders were up 3.5 percent in November with automobiles, airplanes and refrigerators helping drive end demand. Also, new home sales remain robust with record-setting sale prices. Both of these data points hit on some important topics for our 2014 Investment Outlook.  Specifically, we think demand for capital equipment will finally accelerate in 2014 due to underinvestment and substantial cash balances on corporate and consumer balance sheets. Furthermore, consumers are increasing their spending as a result of the “wealth effect” that has been fueled by increased home and stock prices.

Crosstown Traffic

Our investment team has been writing for some time about the shift to online shopping and this trend came to a head this week for Amazon and UPS.  For those of us who like to start shopping closer to Christmas, Amazon Prime^© seems like the perfect solution.  For an annual fee of $79.00, Amazon provides two-day free shipping on most merchandise. We don’t think anyone is surprised to learn that we live in an era of procrastinating techno-geeks who wait until the last minute to ship gifts. This time, the sheer volume of orders overwhelmed both Amazon and UPS. Though UPS has not stated how many packages were affected, the number seems to be in the hundreds of thousands. While both Amazon and UPS are doing what they can to satisfy customers, the real story is the volume shift to cyberspace. Amazon signed up over 1 million additional Prime^© customers in the third week of Christmas alone. This is a nice development for Amazon because these shoppers tend to spend twice as much in a given year as those who don’t have Amazon Prime^©.

Our Takeaways for the Week

• Christmas week was just another reason for investors to keep bidding up stock prices
• Interest rates continue to move slowly higher on Fed taper talk

Disclosures

Early Christmas Gifts

by Shawn Narancich, CFA Executive Vice President of Research

Early Christmas Gifts

In what turned out to be a surprisingly action-packed week before Christmas, the markets finally shook off the shackles of worry concerning what would happen when the Fed began tapering its program of quantitative easing (QE). Bernanke proved that he’s no lame duck chairman and investors learned that stocks can still go up despite a slightly less accommodative Fed. In reducing monthly purchases of Treasury and mortgage-backed bonds by $10 billion per month, our central bank is acknowledging a slowly improving labor market and an expanding economy that is being boosted by several key drivers: a renaissance in U.S. energy production and manufacturing and, increasingly, the wealth effect of rising house and stock prices that is giving a nice lift to consumer spending. Looking ahead, we expect incoming Fed Chair Janet Yellen to continue what Bernanke started. Our view is that further reductions to QE will be commensurate with continued improvement in labor markets, subject as always to the Fed’s other key mandate—keeping inflation low.

Always a Bear Market Somewhere

In stark contrast to stock prices that are once again setting new highs, gold prices have fallen substantially. After attracting increasing amounts of attention as a hedge against monetary dislocation and unchecked growth in the money supply, gold is increasingly being abandoned by investors now more attracted to robust stock market returns and, for those with a lower risk tolerance, bonds that are now offering real rates of return. From its high in August 2011, gold is now down 36 percent. It may be pretty to look at, but with the Fed now in the early stages of unwinding QE, it has lost its shine.

Blue Burner

Sticking to the commodity theme, one key source of energy whose price is going the opposite direction is natural gas. Much maligned by investors because of its seeming ubiquity, the front-month contract is up 31 percent since August. Cold weather has boosted the demand for natural gas, one of the nation’s most common sources of home heating. Weather vicissitudes aside, we like the longer-term demand case for the cleaner burning fuel to take market share of electricity generation from its dirtier cousin coal. Will gas currently priced for $4.40 per-million-BTUs go to $5.50? In the short-term, probably not, because the prolific shale fields in Pennsylvania, Wyoming and Texas will induce considerably more production if prices continue to rise.

Nevertheless, key suppliers can make a lot of money with natural gas prices in the $4.00 to $5.00 range. More importantly, our economy should increasingly benefit from using low cost natural gas and natural gas liquids to generate cheaper power and manufacture plastics. In the latter case, low cost ethane, propane and butane feedstocks are displacing oil-based naptha, incenting major chemical companies like Dow and the petrochemical arm of Shell to locate plastic manufacturing facilities stateside. The beneficial result for America is new jobs, additional exports, and healthier levels of GDP growth.

In this festive season, we wish all our friends and clients a Merry Christmas and a very happy and healthy new year.

Our Takeaways from the Week

• Investors took the start of Fed tapering in stride, as stocks rallied to new highs

• A continued flow of encouraging economic data points to faster GDP growth in 2014

Disclosures

Black Friday Magic

by Jason Norris, CFA Senior Vice President of Research

Good Mourning Black Friday, Welcome Cyber Monday

Black Friday shopping numbers were not much to write home about, but it is uncertain if it is the state of the consumer or the “expansion” of Thanksgiving weekend specials to the day of turkey day or even before. Thirty-three percent of “Black Friday” shopping occurred on Thursday, up from 13 percent in 2011. Over the entire weekend, traffic remained healthy; however, sales were a bit below expectations (up 2.3 percent) and would have been negative if not for 15 percent growth in online sales over the weekend. The weakness was most notable in the Northeast.

The other phenomenon is the growth of Cyber Monday. Online sales that day (the Monday following Thanksgiving weekend) were up over 19 percent and are projected to be up 15 percent this holiday season. Online sales will account for 14 percent of the $600 billion expected to be spent this season. While Amazon.com continues to be the main beneficiary of this trend, valuation metrics can’t get us excited about the stock, but as consumers we continue to benefit.

Learning to Fly

Speaking of Amazon, its CEO Jeff Bezos was interviewed on 60 Minutes and pulled off a great publicity stunt to keep the e-commerce retailer in the news all week. If you haven’t already heard, Mr. Bezos announced that Amazon was looking at using unmanned drones to deliver packages. While Amazon has a reputation of being a visionary and willing to invest in growth, the near-term applications of this announcement seem more or less PR rather than delivery. We just hope it doesn’t get to the point where our kids can’t enjoy the snow during the holidays because they will have to be avoiding all the Amazon package deliveries from the sky.

Detroit Rock City

Looks like we are witnessing a slow motion car accident with the approval of a federal bankruptcy filing by the city of Detroit. Deidra Krys-Rusoff, Ferguson Wellman’s municipal bond analyst and portfolio manager, believes that with U.S. Bankruptcy Judge Steven Rhodes ruling that Detroit is eligible to file for bankruptcy protection it may permit them to emerge from $18 billion of debt. This ruling grants the city the power to establish a financial plan which will allow the city to provide public services while meeting adjusted debt obligations. Judge Rhodes also ruled that pensions may be adjusted under federal bankruptcy, despite the fact that Michigan’s constitution does not allow for cuts to established pension obligations. This ruling may permit the trimming of pensions and retirement benefits, taking away the “protected” status usually afforded to the plans and placing them on an equal platform to other creditors (such as bondholders).  We expect unions to fully challenge this decision, and the local union has already filed an appeal.

We believe that this event is isolated and should not have an overarching effect on the muni market. Any way you look at it though, this may end the same way as the 1976 classic song at some parties.

Stagefright

This week was the 17^th anniversary of FED Chairman Greenspan’s “irrational exuberance” speech, and investors are anxious for what to expect in 2014 after a 25 percent+ move in equities this year. While this week we have seen some weakness in stocks as rates have risen, we still don’t foresee a major sell off. Putting history in context, in the bull market run from 1990 through 1996, equities DID NOT have a 10 percent correction, and we didn’t peak until March 2000. We are not saying that history will repeat itself, but with the U.S. economy improving and inflation remaining tepid, we would be buyers of equities on any major pullback.

Our Takeaways for the Week:

• Even though stocks have run, we are still constructive on equities
• Any weakness in the municipal bond market should be seen as a buying opportunity for quality muni bonds.

 Disclosures

Giving Thanks

by Shawn Narancich, CFA Senior Vice President of Research

Early Christmas Gifts

Another week, another record close. With both the S&P 500 Index and Dow Industrials breaking into new record territory, equity investors have much to be thankful for as they celebrated the Thanksgiving holiday and began to ponder full year returns that are shaping up to be the best in fifteen years. Trading volumes slowed to a crawl in typical holiday week fashion, with fewer investors around to digest a relatively light slate of news flow.

A Quiet Time

Those manning their desks were left to digest new housing data that showed a drop-off in October pending home sales juxtaposed against another strong Case-Schiller report, which showed house prices nationally up over 13 percent in September. For us, the tie-breaker was new residential housing permits for October, which rose 6.6 percent sequentially, to annualized levels exceeding one million units. While new apartment complexes drove the gains, permitting for single-family homes also rose, an encouraging development given the political upheaval that occurred last month. Housing has been a key driver of the U.S. expansion to date, and remains vital to our expectations for economic growth next year. In turn, interest rates on the 10-year Treasury are a key input to setting mortgage rates. As such, the Fed is paying close attention to them as it considers its next move. Tapering QE too soon or too quickly could spook bond investors, causing prices to fall and mortgage rates to rise. With housing data more mixed recently, this is the type of outcome the Fed is attempting to avoid, and a key reason why we think policy makers will err on the dovish side.

Black Friday (Thursday?)

Whether Santa Claus will deliver a Christmas bounty or a lump of coal to retailers is yet to be seen, but judging by the overflowing crowds seen at key shopping venues like Wal-Mart and Best Buy, shoppers’ enthusiasm for a deal is as strong as ever, incenting some to venture out as early as Thanksgiving Day. Estimates for holiday sales growth seem to be settling out around the 3-4 percent level, but the question as always for retailing investors is the price at which those sales transact. In addition to the level of sales growth, investors will attempt to discern the profitability of those sales, and the underlying gross margin data does not typically arrive until retailers report their financial results in late February. As indicated in last week’s web log, we believe the best success will be had by those focused on either the high-end or low-end, with general merchandisers like Kohl’s and Target caught betwixt and between.

That said, we bid our readers happy shopping on this Black Friday, so named for the day’s typically heavy selling pace that can swing retailers from losses to profits for the year. Moreover, we wish our clients and friends a peaceful and most enjoyable holiday season!

Our Takeaways from the Week

• Amid low trading volumes, stocks scaled new heights in a holiday shortened week

• Retailers are in the spotlight as the Christmas selling season begins

Disclosures

Gaining Elevation

by Shawn Narancich, CFA Senior Vice President of Research

Dow 16,000

A slow growth, low inflation environment that continues to enable highly accommodative monetary policy remains a recipe for stock market success. With year-to-date gains now topping 25 percent on the S&P 500, the venerable Dow surpassed another 1,000 point threshold as key equity benchmarks forge further into record territory. With retailers book-ending third quarter earnings season this week, investor attention is being redirected back to the global economy, where key U.S. reports continue to indicate the possibility but not likely the probability that the Fed will begin tapering its program of quantitative easing before year-end. Domestic inflation decelerated for the third consecutive month in October, to an annual rate of 1.0 percent not seen since deflation beset the economy in 2009. With next to no wage pressure and a domestic energy boom keeping natural gas and oil prices well contained, incoming Fed Chair Janet Yellen can afford to be patient. Will Ben Bernanke presiding over his next-to-last FOMC meeting next month steal her thunder? Barring a surprisingly strong November jobs report, probably not. Those betting on an early taper would point to last month’s better than expected payroll gains and this week’s surprisingly strong retail sales report, in which strong auto sales, restaurant spending, and furniture sales drove better-than-expected 3.9 percent growth.

Crystal Clear

While retail sales were surprisingly robust in an October disadvantaged by the partial government shutdown, investors are clearly witnessing a case in which a rising tide is not lifting all boats. In the plus column is Home Depot, which posted U.S. same-store sales exceeding 8 percent for its fiscal third quarter. For a retailer with $80 billion of yearly sales, such growth is impressive and speaks to where consumers are spending – on durable goods like washing machines and new carpet for a typical house that now has home equity. Where consumers are not spending as much is in categories like apparel and center aisle grocery, negatively impacting the likes of Target and packaged food companies Campbell Soup and JM Smucker. In contrast to another beat-and-raise quarter from Depot, each of the aforementioned fell short of investor expectations, with the stocks being summarily punished.

Winners and Losers

In an environment of muted wage gains and still elevated unemployment, consumers are increasingly price sensitive, but in contrast to past economic cycles, technology has enabled them to be smarter shoppers. Armed with smart phones able to compare prices across retailers and internet sites at the touch of an app, bricks-and-mortar retailers like Best Buy are having to offer price matching (think deals on Amazon) to keep up with online competitors. While Best Buy’s stock has performed spectacularly this year (up 231 percent year to date), it suffered a setback earlier this week because same-store sales missed expectations and the company warned of a heavily promotional holiday season.

Our final observation from the land of retail would be the high-end, low-end dichotomy. We expect the Nordstroms and Louis Vuittons of the world to post much healthier Christmas sales than general merchandisers like Wal-Mart, Target, and Kohl’s, reflecting lower rates of unemployment for college educated, upper income shoppers and record stock prices that are having a beneficial impact on higher-end spending.

Our Takeaways from the Week

• Stocks are setting new highs amid a benign economic backdrop
• Retailers concluded the third quarter earnings season, reporting mixed results

Disclosures

Ch-ch-ch-ch-changes

by Ralph Cole, CFA Senior Vice President of Research

If the hearings yesterday on Capitol Hill are any indication, Janet Yellen should have smooth sailing to her confirmation as our next Federal Reserve Chairman. She was clear and concise in her answers, and conveyed a clear understanding of the job at hand. She gave the capital markets confidence that there would be no unsettling changes to current policy, while comforting legislators' concerns by stating the Federal Reserve’s oversight of banks would become a higher priority during her tenure. After reading her testimony, we believe that further improvement in employment will lead to tapering sometime in the first quarter of next year.

Not So Fast My Friend

A contrite President Obama stood in front of reporters yesterday and admitted that the administration had fumbled the roll out of “Obamacare” (the Affordable Care Act). Because of ongoing website problems individuals have found it nearly impossible to sign up for coverage online. In response, the administration has relaxed some deadlines, which will simply delay the implementation of the Affordable Care Act. As such, we are maintaining our current strategy for the healthcare sector, which focuses on companies that benefit from an increased volume in healthcare services, because with more people covered by insurance, more services will be used.

Tiny Bubbles?

As of this writing, the S&P 500 index and S&P earnings stand at all-time highs. When Janet Yellen was asked during her testimony about bubbles in the stock market, she asserted that on most valuation metrics, the stock market is far from bubble territory. That said, the zero interest rate policy that the Fed is currently maintaining may ultimately cause a bubble. The last two recessions were caused by the dot-com bubble and the real estate bubble. As investors, it is important that we keep a vigilant watch for the next potential bubble… At this point we don’t see one on the horizon.

Takeaways for the week

• Janet Yellen will almost certainly be confirmed as the first female Federal Reserve Chair
• While stocks continue to set new highs, valuations remain reasonable

Disclosures

Shifting the Gears of Focus

by Shawn Narancich, CFA Senior Vice President of Research

Super Mario?

 As the sun begins to set on third quarter earnings season, investors are increasingly turning their attention back to the broader economy. With regard to key data, this week provided plenty to ponder. Mario Draghi’s surprising decision to cut short-term rates in Europe speaks to the European Central Bank’s concern about last week’s surprisingly low inflation reading, which has spawned talk about potential deflation on the Continent. And while the U.S. administration may not like the fact that Germany generates half its GDP from exports, the likes of BMW and Siemens must have been raising a toast to the resulting drop in the euro, which promises to make German exports that much more competitive. Only time will tell if more aggressive actions might be necessary in Europe, but from a monetary policy standpoint, the ECB retains more dry powder (reducing the rate that the central bank pays on excess bank reserves, quantitative easing, etc) than its U.S. counterpart, which has already spared no dollar in an attempt to stimulate the economy.

Less than Meets the Eye

As the Fed ponders its next move, investors got their first dose of the third quarter GDP data, which showed that the U.S. economy grew at a surprisingly robust 2.8 percent rate. Peeling back the onion, the underlying detail paints a less rosy picture—consumption spending up a lackluster 1.5 percent and reduced levels of capital spending more indicative of an economy growing at a slower pace. After subtracting a build-up of business inventories, real final sales rose by that not-so-magical number of 2 percent that investors have grown increasingly accustomed to seeing from the U.S. economy.

Taper Talk

Juxtaposed against the uninspiring GDP data was Friday’s payroll report which was surprisingly robust. Despite the early October government shutdown, the economy added a net 204,000 jobs to nonfarm payrolls during the month, boosted by hiring in the manufacturing sector and better hiring trends in retail, leisure and hospitality. The response from financial markets was mostly predictable, as bonds fell, gold declined and the dollar strengthened—all in anticipation of the Fed tapering its program of quantitative easing sooner than otherwise expected. What is encouraging to us was the reaction by equity investors, who bid stocks higher to close the week. As we have indicated in past commentary, when the Fed does begin to taper, it will be for the right reasons.

Our Takeaways from the Week

• With nearly 90 percent of large U.S. companies having reported, an acceptable third quarter earnings season is drawing to a close
•  Despite added volatility, stocks remain well bid in a rising interest rate environment

Disclosures

What to Expect When You Are Expecting a New Fed Chair

by Brad Houle, CFA Senior Vice President

Ben Bernanke’s tenure as Fed Chairman is coming to an end this year. He became Fed Chairman in 2006 and led the organization through the financial crisis. Prior to his tenure as Fed Chairman, he was an economics professor at Princeton University. One of his primary areas of interest was the Great Depression and that perspective shaped the Federal Reserve’s response to the crisis.

Janet Yellen has been nominated as the next chair of the Federal Reserve Open Market Committee. She is expected to be confirmed and would start to serve her term in early 2014. The financial markets are in favor of a Yellen Fed in that her viewpoint is thought to be similar to the outgoing Ben Bernanke. She is characterized as being “dovish” which means that she is in favor continuing zero interest rate policy and quantitative easing for an extended period of time until unemployment is reduced to a more acceptable level. Financial markets crave as much certainty and continuity as possible and the Yellen Fed fits the bill. She was tasked by the outgoing Chair Bernanke to facilitate a more open and transparent Fed. It is expected that Yellen will use this platform to steer expectations of market participants.

Countless articles and endless analysis of the Yellen Federal Reserve in the financial press have debated the minutia and theorized what a Yellen Fed will be like. At Ferguson Wellman, we have a unique perspective on the Yellen Federal Reserve. Jim Rudd, CEO of Ferguson Wellman, had the opportunity to serve as the Chair of the Portland Fed for several years under Janet Yellen who was then President of the 12^th District of the Federal Reserve of San Francisco. Having witnessed her management skill first hand, Jim commented that she embraces the culture of the Fed and has the ability to manage the process of setting monetary policy. He also indicated she was on the front line of the real estate crisis in the Fed 12^th district during the Great Recession and that had a lasting impact on her and how she views the fragility of the recovery.

Takeaway This Week

• There were not a lot of surprises from the Fed minutes released on Wednesday. The only material change was language surrounding an acknowledgement of a slowing in the housing recovery

Disclosures

Technically Speaking

by Timothy D. Carkin, CAIA, CMTSenior Equity Trader 

With the partial shutdown of the government behind us, the equity markets have been on a near constant rise seemingly setting new highs daily. “Kicking the can down the road” gave investors the excuse to jump back into the markets as evidenced by the S&P 500’s 100-point gain since October 9. As the market ran up, Chicago Board Operative Exchange Volatility Index (VIX) was dropping. This is positive – it signals investors’ acceptance of the continued market highs. Looking further into the equity markets we see confirmation of the rally with industrial, healthcare, and consumer discretionary sectors setting new highs. Not surprisingly, almost 70 percent of the Dow Transportation Index are within 3 percent of their 52-week high. Strength in these sectors, coupled with an increase in volume, and a reduction in volatility is a recipe for a continuation of the bull market.

The market’s reaction to Microsoft’s earnings this morning, opening up more than 6 percent, was supportive of a bullish rally. In a typical market rally, quality stocks lead the market up. As the proverbial rising tide lifts all boats, the lower quality stocks rally as well. As the market exhausts, investors seek out newer opportunities and start to buy up those riskier, lower quality stocks, eventually driving valuations to excess leading the market to correct. Continued leadership of other bellwethers like Boeing, Verizon, Nike and American Express is a good sign of the health of this rally.

With all that said, one simple truth is that the market does not go straight up. Most equity markets can handle a loss of a few percent without losing their bullish momentum. As you can see in the chart below, we are at the upper bounds of the market channel. Trading down to the trendline would be perfectly normal and still maintain the trend. However, if that pullback is preceded by higher volatility or rallying lower quality stocks, this might indicate a more significant pullback.

Our Takeaways from the Week

• Market momentum is strong, even at market highs
• As the rally continues, watch for signs of stress

Disclosures