November 21, 2014

November 21, 2014

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Executive Summary

1.  Our favorite markets.  We continue to be longer-term U.S. bulls, and would buy every dip.  Lower oil prices, rising consumer confidence, falling unemployment, low inflation, healthy GDP and corporate profit growth, and inflows of foreign cash into U.S. stocks are just some of the reasons for our bullishness on the U.S.  We view India as an attractive long-term bet, given Prime Minister Modi’s progress on various reform fronts.  The Japanese Yen should continue to fall, since their upcoming sales tax increase has been delayed until 2017, and the Bank of Japan has aggressively ratcheted up its QE program.  Chinese stocks will sometimes be attractive as a trade between tightening phases.  The Euro remains a good short sale as Europe is edging closer to more robust QE, including, potentially, the purchase of sovereign bonds by the European Central Bank.  One risk we see on the global stage is instability from Vladimir Putin’s aggression against Russia’s neighbors — we will watch this situation closely.

2.  “Net neutrality” is more heat than light — forget the rhetoric and pick the winners.  The debate over “net neutrality” is heating up again, with President Obama weighing in on much tighter regulations for internet service providers (ISPs), and ISPs and related companies making impassioned pleas for property rights and free markets.  Underneath the rhetoric, we just see competing groups angling to get a regulatory regime that favors their interests — and puts more of the burden for internet infrastructure build-out on someone else.  The outcome has much more to do with network wrangling far upstream from the pipes that bring the internet into your home.  We recommend that investors look past emotional arguments, realize that the landscape will likely not be shifting dramatically, and assess winners and losers from different outcomes.

3.  Good omens for U.S. workers and consumers.  We point out a few of the trends that show the U.S. worker and consumer getting stronger.  Credit card default rates are still declining, and suggest that we have not yet moved into a later phase of the economic cycle.  Wages are improving, with October’s year-on-year growth rate for average weekly earnings at its highest level since January, 2012.  And gasoline prices are near a four-year low, giving consumers a bonus as we head into the holiday retail season.

4.  The market loves midterm elections.  Since 1950, the S&P 500 has risen an average of 16 percent in the six months following midterm elections, and has never been in the red for that six-month period.  An analysis of declines and rallies during the present bull market suggests that it may have quite a bit further to run.

5.  Market summary.  We continue to be bulls on the U.S. and India.  Within the U.S., we believe investors should focus on biotech, hospitals, HMOs, internet tech, cloud-based tech, cybersecurity, quality retailers, airlines, drug stores, and home improvement.  Quality larger-cap companies will attract more foreign capital inflows than small-cap stocks.  We remain bearish on the Yen and the Euro and believe they will continue to fall against the U.S. Dollar.  Gold may be completing a bottom; the upcoming Swiss referendum on the gold holdings of their central bank could increase demand for gold substantially, although current polling suggests it will not pass.  OPEC will meet soon, and will likely cut production, but we suspect that OPEC members will not comply with their quotas and will continue to overproduce.  We anticipate that Brent crude oil will stay in the $75-per-barrel area for a few weeks more.

Our Favorite Market Is the U.S. — We Also Have Some Other Favorites

We continue to be longer-term U.S. bulls, and would buy every dip.  The only potential market-correcting factor currently visible is the crisis in Ukraine.  Continued Russian aggression and intransigence could cause a temporary market setback in the U.S.

The U.S. is doing great.  Lower oil prices are acting like a tax cut, and are boosting consumer spending.  The stock market continues to rise slowly.  The University of Michigan Consumer Sentiment Index is at 89.4 in the preliminary November print.  It was 86.9 in October; the current preliminary reading is the highest since July 2007.  Unemployment has continued to fall, and has reached a new six-year low of 5.8 percent.  Job openings are at decade highs; the help wanted index of unfilled jobs is at a multi-year high.  Inflation is under control, and U.S. GDP and U.S. corporate profits are rising — GDP at 3.5 percent and corporate profits at 7 percent.

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Net foreign purchases of U.S. stocks are turning higher, and new money is flowing into mutual funds, stocks, and ETFs.  Among U.S. stock market groups, we favor biotechnology and medical-related, technology, transportation, and high-quality service providers.  Two formerly uninspiring groups are on our radar: retail is becoming attractive, and manufacturing may eventually become attractive as manufacturers are benefitted by lower oil prices.

Many other groups of stocks are benefitted by lower oil prices as well, and we notice that a large number of take-overs and buybacks are acting to support the market.  Gold, after several years of decline, is beginning to rally, and we believe that this rally may continue and carry gold higher for a few weeks as short sellers abandon their positions, and central bank buyers including Russia and possibly Switzerland, add to demand.  Stay tuned — we will report progress.

          Our Other Favorites

India: Attractive for Long-term Investment

Prime Minister Modi has been in office for several months and is making rapid progress on multiple fronts.  Inflation is moderating, interest rates are starting to fall, business confidence is way up.  Industrial production is rising nicely as businesses gain confidence that the new government can make lasting change away from corrupt government-mandated growth, and towards private enterprise and freedom of opportunity.  The market is not cheap, so we suggest buying on a market correction.

Foreign direct investment is being courted, and to do that, the oppressive bureaucracy is gradually being tamed and changed.  Permits to do business are no longer held up for months while a bribe is solicited.  Government ministers are not allowed private meetings with business executives to avoid hints of corruption and favoritism.  Japan, the U.S., and Europe are all going to be big investors in the new India.

Japan: The Japanese Yen Continues To Be an Attractive Short

The Japanese Yen has fallen substantially, making Japanese stocks and Japanese exports much less expensive.  We expect this trend to continue for at least another year, and possible longer.

The new consumption tax is being delayed by at least 18 months from October, 2015 to about April, 2017.  A huge new program of QE has begun, with the Japanese central bank making a very large commitment to buy Japanese and foreign stocks and shares.  The central bank will sell some bonds to do this, and the Japanese Treasury will buy them.

Although the Japanese economy has shrunk for the last two quarters, the delay of further tax increases will cause it to revive and move ahead.  We continue to believe that the Japanese Yen is an attractive short sale.

China: Attractive on a Dip for Trading

China has had a move up, and we would not enter until the market corrects, but on a correction, China could be attractive.

Shanghai stocks began to trade in Hong Kong starting this week, and have run up in expectation of this opening to the wider world.  Formerly, Shanghai stocks have been difficult for most foreign investors to buy — only a privileged few have had the right to buy Shanghai stocks in China, and even they were restricted in the amount they could buy.

Now Chinese stocks will be much more available.  We would not be surprised to see a market setback as the Hong Kong/Shanghai connection comes online and the speculators who bought in advance take profits.  We will wait to enter China, yet we must remember that China will periodically want to slow down their shadow banking system.  When they do, the Chinese stock market can take a nasty fall for a few months then rebound. When the market falls, we will recommend buying stocks.

Europe:  QE Is In Place and May Expand — The Euro Remains a Good Short

European Central Bank (ECB) chief Mario Draghi recently said at the European Parliament that “the governing council is unanimous in its commitment to unconventional measures, which could include changes to the size and composition of the Euro-system balance sheet, if warranted, to achieve price stability over the medium term.”  Market participants have interpreted this to mean that the ECB would buy sovereign bonds of European nations in order to engage in an even more aggressive type of QE than has already occurred.  None of this will cause the Euro to rally; we continue to think it has farther to fall against the U.S. Dollar.

This news sent European markets moving higher, in spite of Vladimir Putin’s continued aggressive and disruptive moves.  Putin announced the implementation of flights by Russian aircraft over the Caribbean, and recently he had part of the Russian navy accompany him when he went to Australia for a meeting of G-20 leaders.

“Net Neutrality” For Investors:  How to See Through the Smoke and Mirrors

Consumers love data, particularly in the form of movies.  Netflix (NASDAQ: NFLX) streaming video data account for about a third of peak internet traffic in the U.S.  Traffic has to flow along a road, and roads need to be built for that traffic to flow.  Both consumers and producers have a strong interest in a good road system — since without it, they couldn’t buy or sell any goods.

The question is: who will pay for the roads that make commerce possible?  In the case of the interstate highway system — one of the foundations of post-WW2 U.S. prosperity — the answer is simple.  They’re public, since it would make no sense to have competing privately-run interstate highway networks.  So we have funded them through taxes.

This same question — who will pay for the infrastructure? — is the driving force behind the “net neutrality” debate.  As internet-delivered applications get more data intensive, and as consumer demand for them grows, settling that question becomes more contentious.  There are many parties involved — digital content providers, regional and national internet service providers, companies that manage the internet’s backbone, and content delivery networks that help move internet traffic to its destination.  All of these parties see the regulatory environment as something that can help them or hurt them — and all of them are struggling to shape that regulatory environment in a way that protects and promotes their interests.

The net neutrality debate is generating more heat than light.  The appeals made by all sides are emotional and are intended to provoke a response, rather than inspire careful thought.  The very term “net neutrality” itself is not neutral, but is intended to shape the thought of the public in a particular way.  

          What Do They Mean By “Net Neutrality”?

To understand what “net neutrality” means, you need a broad picture of the internet’s structure.

Consumers think of the internet mostly in terms of their own “last mile” provider.  If the internet is a highway system, the last mile provider is the road that goes from the off-ramp to your driveway.  This provider is your internet service provider (ISP) — either a big national company like Sprint or AT&T (NYSE: T), or a regional company like Cox, Frontier (NASDAQ: FTR), or EarthLink (NASDAQ: ELNK).

However, the trip that data takes from a “content provider” like Netflix to your last mile provider can be complex.  If your ISP is a big national company, it might carry the data all the way to you from its point of origin.  These companies provide last mile service as well as operating national networks.  Alternately, the data may pass through a “backbone” company, a national network which doesn’t provide last mile service to any customers.  Some big content providers are building connections directly to local ISPs.  And in between, there may also be “content distribution networks” (CDNs) — companies who buy servers and position them strategically to carry clients’ data to its destination more efficiently.
How That Movie Makes It To Your Screen
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Source:  Guild Investment Management, Inc.


In its original meaning, net neutrality referred to “last mile” provision.  In short, when it comes to that final stretch from the internet’s highway into your home, your provider should treat all the data equally and not give preference to data originating from a content provider with whom they have a special relationship (financial or otherwise).


          Muddying the Waters


Those on both sides of the “net neutrality” debate are guilty of muddying the waters.  The issue of the “last mile” service provider is only part of the story — and there is broad agreement that in that restricted “last mile” sense, net neutrality should prevail.


The other part of the story is the deals that happen and the conflicts that arise as players further upstream negotiate with one another, jockey for position, and try to get someone else to build the infrastructure to deliver the ever-growing torrent of data that consumers want and producers want to sell to them.


This area, where backbone providers, content delivery networks (CDNs), and national ISPs interact, is called “peering.”  In the past, big networks have agreed to carry each others’ traffic reciprocally without payment, since such an arrangement eased the transit of traffic to consumers, made consumers want to buy more, and made money for everyone involved.  That worked as long as the amount of data carried into and out of each network was comparable.


Now data streams have gotten bigger and more asymmetrical, and big network peers are sparring over who should pay to build the pipes.


          Jockeying For Position


The argument goes something like this.  Content producers, like Netflix, talk to the national ISPs and CDNs and say, “Retail customers are demanding our content.  When they signed up with you, you promised to deliver all the content available on the web — so you should pay to build the pipes and deliver it to them.”


In response, the people who build and run the internet’s backbone turn the demand around, and say to the content providers:  “Retail customers are demanding your content.  Your content has gotten much more data intensive, so clearly you should pay to build the pipes that take it to them.”


You could look at either argument and think, “That’s a reasonable position.”


          It’s a Tussle, Not a Debate About Principles


An old German saying says, “When there’s fire in the heart, there’s smoke in the head.”  The two sides arguing here are trying to encourage an emotional response in their audience — and that makes it harder for people to think clearly.


Our job as investors is to think clearly.


If content providers like Netflix are prohibited from paying the various data transit companies, then the burden of building out infrastructure capable of handling ever-increasing data streams will fall on those transit companies themselves, if they want to keep the customers who demand the data.  So of course, content providers have a motive to convince the public that something nefarious would be going on if they had to contribute more directly to the infrastructure that makes it possible for their products to reach consumers.


Likewise, the transit companies like AT&T or Sprint make a similar pitch to the public and to legislators — but theirs is about property rights.  They want convince the public that something nefarious would be going on if they were the ones who had to pay the price for infrastructure expansion.  “Net neutrality,” to them, means that they can’t accept payment from content providers to help them build out the infrastructure.  So they say, “It’s our system — we can make whatever arrangements with content providers we want to.  That’s our right as property owners!”


All we’re witnessing is a tussle between the two sides — and we’re watching as they make emotional appeals to the public and to lawmakers to try to get a regulatory regime that’s more economically friendly to them.


So as an investor, put it to bed.  Realize that in this particular debate, there are no great matters of principle being determined.  Look at what the various outcomes may be, and who might benefit from them.


          Likely Outcomes and Beneficiaries


Which outcome would be best for consumers — a win for “net neutrality” or a defeat?  We’re not sure; we suspect that innovation in this space will continue, and will continue to provide unexpected twists, no matter what happens.


With the President weighing in behind net neutrality, there’s a headwind for the transit companies.  The prospect that they may be placed under Title II of the 1934 Communications Act will worry investors, since it entails the prospect of closer regulation, as well as government control of rates — although Mr Obama and other “net neutrality” advocates say they don’t want to do that.


However, we note that during the last “net neutrality” scare in 2010, the correction in transit companies’ stocks was transient, and followed by a strong rally.  We believe there may be a similar over-reaction now — with the markets getting anxious and then calming down as they determine that any changes won’t be earth-shattering.


Likewise, the prospect of “net neutrality” regulation is a tailwind for content providers (such as Netflix, Google [NASDAQ: GOOG], or Apple [NASDAQ: AAPL]). (GIM owns AAPL and GOOG for some clients.) They won’t have to compete with one another to pay transit companies to take their data to customers… and those customers’ demand will make sure the transit companies get the job done themselves, lest they lose out to competitors.


Investment implications:  Keep an eye on the “net neutrality” debate as it heats up.  Pay no attention to the emotional appeals made to matters of principle.  Realize that the outcome is probably not going to represent a truly substantive shift in the landscape — so watch for groups getting punished by negative market sentiment as possible buying opportunities.  If and when the dust settles, look at the shape of legislation to see which groups may incrementally benefit.


Bullish Signs For the American Worker and Consumer

As we noted in our first section, we see several pieces of incremental data suggesting the improving health of the U.S. consumer.  This is one more item supporting our bullish view of the U.S. economy and the U.S. stock market; it also suggests that moving towards the holiday season, retail stocks may leave the doldrums and begin to be more attractive.

Consumer Discretionary Stocks Have Lagged the S&P 500 in 2014

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Delinquency Rates Heading Towards a Cycle Low?

Consumer delinquency rates continue to fall.  An upturn (as in 1995 and 2006) would suggest we’ve entered a later phase of the economic cycle; but this hasn’t happened yet.

Not Yet At a Bottom

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Improving Wages

We also noted some good news in the last payroll report.  As we said above, unemployment has continued its steady decline.  However, Janet Yellen and other Fed officials have long pointed out signs of weakness in employment — especially in the rate of underemployment (workers who can only find part-time positions when they’d rather work full-time).
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Data Source:  Energy Information Administration

All in all, these are positive data points for the U.S. consumer.  

Investment implications:  Data points continue to suggest that the U.S. consumer’s economic health is improving, in spite of the Fed’s cautious monitoring of the fine points of the employment picture.  Improving consumer debt delinquency rates, rising disposable income, and sharply falling fuel prices are working together to give U.S. workers and consumers a happier holiday season than they’ve had for years.  Retail and other consumer discretionary stocks may benefit.

The Markets Love A Midterm Election

As October’s correction unfolded, we saw the potential for macroeconomic factors and seasonal forces to align and propel the subsequent rally.  In this, we weren’t disappointed.  The recently past midterm elections have the potential to add to this momentum.  

John Hook (, whose quantitative historical research is invaluable, recently drew together several points about how the market reacts to midterm elections:

•        Since 1950, the S&P 500 has risen an average of 16 percent in the six months following midterm elections.  In no case did the index fall during that period.

•        Since 1928, stocks have risen an average of 7 percent in the three months following midterm elections, and the move was positive 86 percent of the time.

•        Since 1950, stocks have gone up an average of 18 percent during the third year of a President’s term (that’s 2015 for Mr Obama).

          Corrections During the Current Bull Market

On a related note, we examined corrections of greater than 5 percent in the S&P 500 since 2009 (excluding October’s correction, since we don’t yet know what the final peak of the rebound will be).
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In 13 declines and subsequent rallies, the median decline lasted 18 days (October’s correction was 20 days); the median depth of the decline was 6.40 percent (October’s was 7.41 percent, using the S&P close); and the median subsequent rally was 15.14 percent over a 71-day period.  If the current rally followed the pattern of previous corrections in the present bull market, it would continue for the next several months, and reach a peak 15 to 20 percent above its low during the correction.

Investment implications:  Historical data on midterms and recent corrections show that the odds favor a continuing bull market in the U.S.

Market Summary

Stock Markets

We continue to be bulls on the U.S. and India.

We believe that within the U.S., investors should focus on biotech, hospitals, HMOs, internet tech, cloud-based tech, data security companies, quality retailers, airlines, drug stores, and home improvement.  Own quality companies, not small-capitalization stocks.  Foreigners buying U.S. stocks will buy the types of stocks we own for clients.  A few of the stocks we own for clients include Google (NADAQ: GOOG), Alibaba (NYSE: BABA), Home Depot (NYSE: HD), Walgreens (NYSE: WAG), and Delta Airlines (NYSE: DAL), to name a few.


We continue to be bears on the Yen and the Euro, and think they will fall more versus the U.S. Dollar.


Gold may be completing a bottom; much depends upon the Swiss referendum which would mandate that the Swiss National Bank hold 20 percent of its assets in gold.  Their current gold holdings would have to more than triple, and this would increase demand for gold substantially.  The polls indicate the referendum is not going to pass, but we’ll see what happens on November 30.


We believe that the price of grains will rise modestly because demand for U.S. soybeans is strong from abroad.


OPEC meets soon, and although they will vote to cut production, the OPEC members will cheat on their quotas and production will remain high until members are convinced that it is important not to cheat and overproduce.  We anticipate that oil prices may stay in the $75-per-barrel area for a few weeks more.

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