Monday, February 24, 2014 - Wine and Neurosis

Wine and Neurosis

by Sinclair Noe

DOW + 103 = 16,207
SPX + 11 = 1847
NAS + 29 = 4292
10 YR YLD + .01 = 2.75%
OIL + .64 = 102.84
GOLD + 10.50 = 1337.60
SILV + .11 = 22.07

The S&P 500 hit a new high today; topping out at 1858; surpassing the intraday high of 1850 set back January 15^th, and finishing at 1847.61, just below the record high close of 1848.38, again from January 15. So, we couldn’t hold on to a record close, but it was tempting. The S&P was banging up against resistance, briefly floating above the ceiling and into new, rarified air. And we would all love to be on that rocket, if it really is going to soar. Patience, patience.

Now, we know that fundamentals, the news of the day, only offers justification for movement, and we know that the fundamentals can also prove to be contrary indicators. Still, the best explanation I’ve heard today for the enthusiasm is the recent M&A activity has created something of a halo effect. There has been quite a bit of merger action. Consider: RF Micro Devices will merge with Triquint Semiconductor in an all stock deal announced this morning, last week was news of Men’s Warehouse upping its offer for Joseph A. Bank conditioned on Bank dropping its bid for Eddie Bauer, Actavis is buying Forest Laboratories, Comcast buying Time Warner Cable in a deal to create the world’s biggest consumer complaint, and Facebook buying WhatsApp.

And suddenly everybody wants to catch the M&A fever. Maybe that explains new market highs, maybe not. What we haven’t seen is an improvement in the economy; blame it on the weather if you wish, but it’s hard to find demand. Households, businesses, governments are all holding onto their money; meaning supply outweighs demand. Another way to look at this is when demand increases, buyers bid prices higher, or you have too much money chasing too few goods, and the result is inflation, and this is usually a sign of an expanding economy. But prices are not inflating.  We saw the CPI and PPI reports last week and what we have is disinflation or perhaps just stagnation; and the economy is just muddling along.

Of course, there are multiple causes of inflation; you might see supply decrease and cost of production increase, and that could push prices higher; this is known as cost-push inflation; you might see demand increase while supply remains constant or drops, and that pulls prices higher; this is known as demand-pull inflation. The Fed has hoped that by throwing money into the banking system, they could increase demand. That hasn’t happened, and so the Fed is backing away from their monetary stimulus scheme and they are cutting back QE.

Last Friday we saw the transcripts of the Fed’s deliberations from 2008, and it revealed policymakers were largely in the dark about the impending meltdown; they were in the dark about how the markets would respond to stimulus; they were in the dark about where and why and to whom they should apply stimulus – they really missed the mark on that count; they were in the dark about how economic models could miss changes in conditions; they were in the dark about the consequences of a meltdown; they are still in the dark to this very day.

So, we’re back to the basics of supply and demand. Throwing money at Wall Street does not increase demand; it does increase mergers and acquisitions and stock buybacks and executive bonuses. And that creates a feverish frenzy among Wall Street traders looking for the next big buyout. Anyway, we hit a high but we couldn’t hold onto it. You can celebrate that record with wine and neurosis.

If you are trying to trade these markets, don’t get caught up in the M&A fever. Follow the trend, not the fad. This means that you will not hit the tops and bottoms in the market. In other words, you will not be exactly right on any given trade; you will be a little late on any given entry and exit, but you will let the technical data, the price action tell you when to buy or sell. You won’t predict where the market is going but rather follow the market. If it sounds a bit stressful, it is. But you have to ask yourself if you want to be right or if you want to be profitable. Or maybe that’s not the question at all. Maybe you should be questioning why you are in the market at all.

If you can make it through a weekend without checking the stock quotes, you might consider not checking the quotes for a week. So says Warren Buffet.

Mere mortals should not try to outsmart the stock market. That’s what Warren Buffet is saying, or writing in his upcoming annual letter to investors. Buffet writes:  "The goal of the nonprofessional should not be to pick winners -- neither he nor his 'helpers' can do that -- but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."

Buffett thinks the best course of action is to take almost no action. Stick to what you know, which is probably nothing. Buy a basket of 500 stocks, a smattering of bonds, and forget about it for the next 100 years or so. Treat investing this way and you'll actually beat the experts in the long run.

Buffett takes a few shots at the hedge fund managers and the newsletter writers and the talking heads on CNBC and similar outlets. Buffett writes: “Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits -- and, worse yet, important to consider acting upon their comments," Buffett writes, adding: "In the 54 years [partner Charlie Munger and I] have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people."

So sayeth the Oracle of Omaha, and he’s right, of course; unless you didn’t get out at the top and prices are collapsing and you’re wondering whether to eat your losses or buy more, and remembering that you don’t have quite the balance sheet of Warren Buffett.

Meanwhile, Defense Secretary Chuck Hagel today outlined a modest proposal to deal with spending caps ahead of the formal budget presentation next week. Hagel has laid out how he will cut spending. The Department of Defense plans to reduce the size of the Army to between 440,000 and 450,000 soldiers, he said. The Army is currently about 520,000 soldiers and had been planning to draw down to about 490,000 in the coming year.

A reduction to 450,000 would be the Army's smallest size since 1940 - before the United States entered World War Two - when it had a troop strength of 267,767, according to Army figures. The Army's previous post-World War Two low was 479,426 in 1999.

The Defense Department is in the process of reducing projected spending by nearly a trillion dollars over a 10-year period. A two-year budget deal in Congress in December gave the Pentagon some relief from the budget cuts, but still forced it to reduce spending in the 2014 fiscal year by $30 billion. The Pentagon's budget for the 2015 fiscal year is $496 billion, roughly the same as in 2014 but still lower than had been projected last year. There would also be cuts to some spending on equipment, but Hagel argues the cuts would be more draconian and less strategic if executed under sequestration.

Hagel also announced a series of steps to try to reduce the Defense Department's military and civilian personnel costs, which now make up about half of its spending. While Congress voted to undo cuts to military retiree benefits on February 12, some cuts will still be made to compensation, however the new recommendations do not cut pay. Hagel said the department would slow the growth of tax-free housing allowances, reduce the annual subsidy for military commissaries and reform the TRICARE health insurance program for military family members and retirees.

Hagel cautioned that reducing Army troop levels would increase the risk involved in protracted or simultaneous ground operations, as the US saw during the wars in Iraq and Afghanistan. Hagel said: “As a consequence of large budget cuts, our future force will assume additional risks in certain areas.”

Hagel also raised the specter of disaster if Congress does not reverse sequestration cuts to the military that would set in at deeper levels two years from now.

“Sequestration requires cuts so deep, so abrupt, so quickly, that we cannot shrink the size of our military fast enough. In the short-term, the only way to implement sequestration is to sharply reduce spending on readiness and modernization, which would almost certainly result in a hollow force - one that isn’t ready or capable of fulfilling assigned missions.”

“In the longer term,” Hagel went on, “after trimming the military enough to restore readiness and modernization, the resulting force would be too small to fully execute the president’s defense strategy.”

This is a major change in defense spending and a bit of a gamble in a midterm election year. Defense advocates in both parties will debate the merits of closing bases and idling factories and what benefits must be honored for the troops and their families. And there will be people arguing for cutting the deficit yet arguing for more defense spending.

This is not going to be easy, but to maintain a little perspective, in 2013 the US spent about $680 billion on our military, which works out to 4.4% of GDP. We spend more than any other country. We have about 5% of the world population but we account for 39% of the world military spending. The cutbacks would still leave us spending more than any other country by a long shot. The plan calls for downsizing so we can fight one land war, not two, at the same time. Maybe we could avoid war for a while and really save some money.