Macro Strategy Report for September 2014

September 13th, 2014
in contributors

by Jim Welsh with David Martin and Jim O'Donnell, Forward Markets

U.S. Economy

In its second estimate of second quarter gross domestic product (GDP), the U.S. Department of Commerce calculated the U.S. economy expanded at a 4.2% annual rate. Large swings in the level of inventories during the last two quarters have contributed to volatility in reported GDP. In the first quarter, inventories were slashed by 1.2%, which lowered GDP from -0.9% to -2.1%. Companies rebuilt inventories in the second quarter, lifting GDP by 1.4%—which represents a significant portion of the estimated 4.2% increase. In order to increase their inventory levels in the second quarter, companies increased production. While this was clearly a plus in the second quarter, should sales fail to meet expectations in the third quarter, it may presage a softening of production in the fourth quarter.

Follow up:

Since consumer spending represents nearly 70% of GDP, a better sense of the economy’s health can be discerned from the real personal consumption expenditures report (PCE), which is a component of the GDP report. In the second quarter, PCE grew 2.5%, up from an increase of 1.2% in the first quarter. Clearly, the economy is not as weak as the first quarter decline of -2.1% in GDP suggested and probably not as strong as the 4.2% estimated growth in second quarter GDP implies. The PCE provides a valuable measure of activity not provided by reported GDP and is not nearly as volatile.

The 4.2% GDP estimate for the second quarter has only reinforced the consensus view that GDP growth in the second half of 2014 will remain close to 3.5%. Optimists point to better job growth, an expectation that housing will improve and forecasts that corporations will finally increase business investment. Our view has not changed. The contraction in the first quarter was the result of extraordinarily bad weather and a reduction in inventories, which we expected since inventory levels were excessively high at the end of 2013. The second quarter rebound was aided by sales that did not occur in the first quarter and inventory growth. Importantly, it did not include a pickup in wage growth. This suggests that economic growth is likely to slow gradually in the second half of this year rather than being maintained at the elevated second quarter pace.

In July, 209,000 jobs were created, marking the first time since 1997 that more than 200,000 jobs were added in six consecutive months. Monthly job growth has averaged 230,000 through July versus a monthly average of 185,000 in 2013. While the sustained increase in job growth is certainly welcome, the overall labor market can hardly be described as strong. For the fifth month in a row, the average work week has been stuck at 34.5 hours. Although the participation rate ticked up to 62.9% in July from 62.8% in June, it is still down from 63.4% in June 2013. Average hourly wages are up just 2.0% from July 2013, continuing the pattern of subpar growth that has been in place since 2010. With inflation running at 2%, most workers are not getting ahead and many have been falling behind for years. With wage gains stagnant, no growth in the average work week and a historically low labor participation rate, the Federal Reserve (Fed) is probably correct in its current assessment of labor market slack. The Fed’s bias to rely less on the unemployment rate for guidance will continue until wages begin to grow faster and labor market slack show signs of diminishing. The Fed has said it is data dependent, so the Federal Open Market Committee (FOMC) does not know the timing for the first increase in interest rates. That reality, though, won’t stop the talking heads from turning the debate into a circus in coming months.

According to Sentier Research and data produced in the U.S. Census Bureau’s Current Population Survey, real median annual household income has fallen 3.1% since the economic recovery began in June 2009. Since January 2000, real median annual household income has fallen by 5.9% and is about the same level as in 1995. The stock market may be hitting new all-time highs, but many hardworking Americans have not experienced a real recovery in their personal finances. This extended period of challenging times is affecting people’s perspective of the future. A recent poll taken by NBC News and the Wall Street Journal between July 26 and August 3 found that despite the better news on job creation in recent months, 76% of adults said they lacked confidence that their children’s generation will have a better life than they do and 60% believe the U.S. is in a state of decline. Nearly 70% blamed the current economic malaise more on Washington leaders than on deeper economic trends. As Robin Williams’s characters in Man of the Yearquoted, “Politicians are a lot like diapers. They should be changed frequently, and for the same reason.

As discussed in the July 2014 Macro Strategy Review (MSR), the long-term patterns in small business optimism and consumer confidence bear watching since both have risen to important levels. A look at the National Federation of Independent Business’s (NFIB) Optimism Index during the last 30 years shows it has recovered to a level that has previously separated periods of growth from the onset of recessions. Readings of 97.0 and higher have been coincident with sustained economic expansions while readings below 97.0 have been indicative of recessions. It is remarkable that more than five years after the recession ended in June 2009, the index is just now nearing 97.0. Since reaching 96.6 in May, the NFIB’s Optimism Index dipped to 95.0 in June before rising to 95.7 in July. If the index can rise above—and stay above—97.0 in coming months, it would increase the probability that growth will be better than we expect in the second half of this year. The Thomson Reuters/University of Michigan Index of Consumer Sentiment measures consumers’ assessment of current conditions and their expectations for the next six to 12 months. Historically, the range of 80 to 82 on the index has been the demarcation between recovery and recession. Since reaching 81.9 in May, the index dipped to 81.2 in June before bouncing back to 81.8 in July. The Index of Consumer Sentiment for August jumped to 82.5, the highest since July 2007. If the index can stay above 82 and continue to improve, it would bolster the chances of 3% growth being maintained in the second half of 2014. It’s already August and the index is just barely above 82.0, which is another reason we remain skeptical of a .strong second half.

Another measure of the economy is the capacity utilization rate, which has been grinding higher over the last three years and reached 79.2% in July. As the rate edges closer to 80.0%, companies may begin to invest in new equipment and plants so they can meet future demand. Business investment spending represents about 14% of GDP, so a pickup in spending would give the economy a lift. As we noted in the May MSR, we think there is a good chance that business investment will modestly improve before the end of the year. In the second quarter, business investment was up 6.4% from a year ago, the strongest increase since the second quarter of 2012. As discussed in detail last month, we do not believe the supply and demand dynamics underpinning the housing market are supportive of any meaningful pickup in housing over the next year.

One of the bright spots in the Commerce Department’s estimate of second quarter GDP was a 10.1% increase in real exports of goods and services. Unfortunately, exports are going to be encountering a headwind since the dollar has been strengthening since May. A large part of the dollar’s rally since May has been the result of the decline in the euro, which represents 57% of the dollar index. As discussed in the April MSR, we expected the euro to fall in coming months by 7.5% to 9.2%, which would add 4.3% to 5.3% to the dollar index. As of August 24, the euro has declined by 5.3% since the May 8 high and the dollar index has gained 4.1%, as other currencies have also weakened against the dollar. Although the euro may experience a bounce from our initial target of 131.00–132.00, we expect the euro to decline further in coming months. As the dollar rises in value, our exports become more expensive. That appreciation could progressively weigh on export growth in coming quarters and not add to GDP to the extent it appears to have in the second quarter.


Our expectation has been that GDP growth in 2014 would not exceed 1% by much, which may prove too optimistic. Since the second quarter of 2013, eurozone GDP is up 0.7%, but only grew at an annualized rate of 0.2% in the second quarter. While the second quarter growth rate was disappointing, the details were even uglier. Germany’s GDP actually contracted -0.6%, which is worrisome since it is considered the juggernaut of growth in Europe. GDP also fell in France (-0.1%) and Italy (-0.8%), which are the second and third largest European economies. Combined, France and Italy are 132% the size of Germany’s economy, so their performance matters. After his “whatever it takes” comment in July 2012, European Central Bank (ECB) president Mario Draghi created a window of opportunity for individual countries in the eurozone to address their internal issues. France and Italy have structural problems that are beyond the reach of monetary policy and neither took advantage of that opportunity.

After its GDP fell -0.1% in the second quarter, France avoided fulfilling the classic definition of recession (two consecutive quarters of negative GDP) only because GDP was unchanged in the first quarter. The unemployment rate rose to an all-time high of 10.2% in July, and, absent labor market reforms, it is unlikely to improve much in coming quarters. France holds the dubious distinction of having twice as many companies with exactly 49 employees as companies with 50 or more employees. You probably won’t be surprised to learn that the less-than-invisible hand of government regulation is responsible. When a company takes on a 50th employee, it becomes subject to almost three dozen labor laws prescribed by France’s 3,200 page labor code. A 2012 study by the London School of Economics and Political Science showed that the cost of additional rules for companies with 50-plus employees in France added 5% to 10% to labor costs. The study concluded, “There is a strong disincentive to grow.”1

One of the rules requires employers with 50 or more employees to enact stringent and costly job protections, including a works council with labor union delegates, a health and safety committee and annual collective bargaining. Proponents say the 50th worker threshold is meant to protect employees and give them some say in managing the company. This “protection” has come with a high cost to France’s economy, which is only 1.39% larger than it was at the end of 2007. It has contributed to slower growth and has created a significant distortion within France’s labor market as evidenced by the number of firms with exactly 49 employees. France’s unemployment rate is at an all-time high, but all those firms with exactly 49 employees have a good reason not to hire and won’t.

Italy’s GDP fell in the first quarter and the second quarter (by -0.8%), so it is in a recession for the third time in five years. Italy’s debt-to-GDP ratio reached 135.2% in the first quarter and will continue to rise unless GDP growth returns. Like France, Italy has labor market rules that have protected one group of workers over another. In Italy’s case older workers are protected at the expense of younger workers. In an attempt to help young people get jobs in the 1980s and 1990s, Italy encouraged short-term labor contracts, which made it easier for companies to hire and fire employees. In 1998, 20% of workers younger than 25 were temporary workers, compared to more than 50% now, according to Eurostat. A 2013 Bank of Italy study found that entry level wages for young workers under temporary contracts fell almost 30% between 1990 and 2010. This created a large income gap between older workers, whose jobs and incomes are protected by labor laws, and young workers. The temporary contracts allowed young workers to be let go when the financial crisis struck, so young workers were disproportionately affected. According to Eurostat, since 2007 the employment rate for those under 40 has fallen 9%, while it rose 9% for workers between 55 and 64 years old. In June, the unemployment rate for workers under 25 rose to a record of 43.7%. Unless Italy changes its labor laws, a whole generation of young workers will clearly have a lower standard of living than their parents.

The political challenge for France and Italy is that necessary labor market reforms will likely result in an increase in the unemployment rate in the short run as reforms are implemented, which won’t be popular in the political arena. Any changes will likely adversely affect older workers, who have more political leverage than younger workers. This is a big reason why labor reform hasn’t taken place and is unlikely to occur anytime soon in either country. The conundrum facing Mario Draghi and the ECB is that proactive monetary policy can alleviate some of the pressure on countries like France and Italy to make the structural changes needed to improve economic growth over the long term. In the short term, weak economic growth and low inflation will win out over doing nothing, which is why the ECB is likely to implement quantitative easing (QE) before year-end.

In August, inflation in the eurozone fell to 0.3%, the lowest since 2009 and well below the ECB’s 2.0% target. With anemic economic growth and inflation trending lower, the pressure is rising on the ECB to launch QE and further lower the value of the euro. As we noted in the February MSR, a lower euro would improve the export competitiveness of every eurozone member and especially for those countries whose productivity has lagged Germany’s over the last decade. Although the euro has declined 5.3% since the May 8 high, it will need to fall much more in coming months so export growth can lift Europe’s moribund economy. However, a weaker euro could cause international investors to sell European sovereign bonds since depreciation in the value of the euro could easily offset the skimpy yields from holding European sovereign bonds. By launching a QE program that would purchase European sovereign bonds, the ECB could mitigate any potential rise in sovereign yields, even as it pursues policies to cheapen the euro.

The ECB will announce the results of its asset quality review (AQR) on October 17. While most of the 128 banks reviewed are likely to be deemed healthy, there are also likely to be a group of banks that will need to strengthen their balance sheets. The Texas ratio compares a bank’s nonperforming loans to its equity and cash set aside for bad loans. When the Texas ratio is above 100%, it suggests a bank is close to failing and will need to raise new equity capital to stay afloat. According to analysis by international investment bank Nomura, 11 of the 128 banks in the AQR have a Texas ratio above 100%. There are also a number of banks whose ratio is between 70% and 100%. By comparison, the average U.S. bank has a Texas ratio of 16%, which illustrates how much healthier the U.S. banking system is compared to European banks on average. The release of the AQR results has the potential of unsettling financial markets, which is one reason why the ECB may wait until after the results have been released to launch their quantitative easing program. If the ECB does initiate a QE program, global equity markets will be pleased.


We have expected the euro to decline to 131.00–132.00, and as of August 25, the euro has dropped below 132.00. Although it is oversold and a bounce is overdue, any rally is unlikely to reach 136.00. Longer term, a further decline to 128.25–128.75 seems likely, especially if the ECB launches a QE program as we expect.


In recent months Chinese policymakers have initiated selective stimulus measures to support economic growth as they attempt to unwind the credit and asset property bubbles that have formed in the wake of China’s huge post-financial crisis stimulus plan. No central bank has ever been successful in unwinding a credit bubble or deflating an asset bubble without significant collateral damage to their economy. We don’t think the People’s Bank of China will be the first central bank to succeed, but they may be more successful than other central banks in preventing a full-scale financial crisis. This does not change our view that China is heading toward a liquidity event, as we discussed in detail in the May MSR. In 1966, Robert F. Kennedy spoke of a traditional Chinese curse that purportedly says, “May you live in interesting times.” This expression may ring true in 2015 if property values fall and more credit problems materialize, as we expect will happen.

In our January 29 quarterly MSR webcast, we thought a trading low would be established if the Shanghai Stock Exchange (SSE) Composite Index traded under 2,000. This view was based on the technical pattern in the SSE Composite and not the fundamentals of the Chinese economy. In early March, the composite did trade under 2,000 and has since rallied. In our May MSR we thought that a rally to 2,240 was likely if the SSE Composite could trade above 2,140. The composite has reached the 2,240 objective and a level that is likely to provide some resistance. Trading is also likely to become choppy as economic data in coming months is likely to remain uneven, with some good news and disappointing reports mixed in.

The correlation between copper and the SSE Composite has been fairly high in recent years. When copper topped out in early 2011 it was coincident with the SSE Composite peaking above 3,000. The decline in copper from over $4.50 a pound to under $3.00 matches the percent decline in the SSE Composite as it fell from over 3,000 to under 2,000. Between June 2013 and the first quarter of 2014, copper traded in a very tight range, as did the SSE Composite. Copper has been lagging noticeably behind the composite during the recent six-week rally, suggesting a pullback in the SSE Composite toward 2,140–2,160 is possible. We think policymakers will continue to provide additional stimulus measures that could lift the SSE Composite toward 2,450 before year-end. The odds of the composite climbing above 2,270 and making a run to 2,450 would be increased if copper can close above $3.50. If we’re correct about a coming liquidity event, the SSE Composite is unlikely to get above 2,500. The SSE Composite could provide valuable clues as to if and when the expected liquidity event is beginning to develop, since it would probably top out before it really gets going.

Human Nature and the Fine Line Between Helping and Dependency

This discussion is not intended to diminish the spirit or intention behind the creation of the Emergency Unemployment Compensation (EUC) program, the Supplemental Nutrition Assistance Program (SNAP) formerly known as food stamps or Medicare. The purpose is to focus on the unintended consequences of government programs that are almost never discussed, let alone addressed. It is valuable for a society to help those in need. The assistance, however, isn’t free and often results in less productivity and efficiency in the overall economy and an unintended long-term increase in dependency of some recipients on the programs that were designed to only provide temporary help.

On December 28, 2013, EUC benefits for 1.3 million workers ended. In the first six months of 2014, an additional 1.9 million recipients received their last EUC check. The EUC program was expanded in 2008 to provide income to the long-term unemployed who had exhausted their 26 weeks of state benefits. Under the EUC, unemployment benefits could be received for up to 99 weeks. If just 10% of the 3.2 million people who could no longer count on their EUC checks were more motivated to find a job, an additional 320,000 formerly unemployed people would have landed a job in 2014. Spread over the first seven months of 2014, the 320,000 new jobs would add roughly 46,000 jobs to the monthly average. The increase in the monthly average of job creation from 185,000 in 2013 to 230,000 in 2014 could easily be attributed to the end of the EUC program.

No doubt the EUC program helped millions of hardworking decent people who truly needed the lift the program provided until they were able to find a new job well before the 99 weeks of support ended. For the vast majority, the EUC program accomplished what it was intended to do. However, no program can help everyone all the time, and usually there is a separate group of individuals who easily rationalize to themselves taking advantage of an opportunity to enjoy a free lunch on the government. Since they aren’t hurting anyone specifically (i.e., stealing someone else’s lunch), they feel it’s all right. After all, the government is offering money for nothing, so it would be stupid not to take it.

While this may sound a bit cynical, it is intended to raise an interesting point that is often overlooked by policymakers and compassionate fellow citizens who want to help those who are less fortunate or going through a temporary tough time. The EUC program was intended to help those who could not find a job within the 26-week window of benefits provided by states. However, the EUC program also created a disincentive for some people to really look for a job, since they would be able to collect benefits even if they didn’t aggressively seek a new job. For example, take some 20- to 24-year-olds with either a high school or college degree who have been working while living with their parents and then lost their jobs. They are faced with an economic choice: they can find a job, pay taxes and incur commuting costs, or not work and receive a check from the EUC program. Even though they may be able to make $2.00 an hour more by working, the allure of having total free time plus some income may be tough to turn down. Those faced with this choice are really only making an economic evaluation and decision based on the value of their time and society’s willingness to pay them for doing nothing.

From their first jobs, most young adults learn basic skills that literally last a lifetime: being on time for work, understanding instructions, performing tasks thoroughly, working with coworkers and accepting criticism from a boss are experiences most 20- to 24-year-olds need to acquire if they are to have a successful career. Taking a year or more off because the government is willing to pay someone for doing nothing is not good for the individual or society. The cost to society extends well beyond the money paid out in unemployment benefits since there is the additional cost of missed production from those capable of work but choosing instead to accept the government’s incentive not to work. According to the U.S. Department of Labor, the unemployment rate in July for those with a bachelor’s degree or higher was 3.1%, half of the 6.2% rate for all workers. For those with some college it was 5.3% and for those with a high school diploma, 6.1%. The unemployment rate for 20- to 24-year-olds was 11.3%—almost double the national average. In the first half of 2007, the unemployment rate for 20- to 24-yearoldswas 7.8% before soaring to over 16% in 2010. There are likely numerous reasons why the unemployment rate for this group hasbeen slow in coming down. We suspect one of the reasons is the EUC program.

Between 2001 and 2007, the number of Americans receiving foodstamps increased 50%, rising from 17 million to 26 million. The cost of the food stamp program during this period rose from $15 billionto $30 billion. What makes these increases noteworthy is that theyoccurred during a period of economic growth. Although the overallunemployment rate rose from 4.2% in January 2001 to 6.3% in June2003, it subsequently fell below 5% in August 2004 and remainedunder 5% until January 2008. In other words, the 50% increase infood stamp recipients took place while the overall economy wasperforming reasonably well prior to the financial crisis. In the wakeof the financial crisis, the number of Americans receiving foodstamps (now known as SNAP) soared from 26 million in 2007 to 40million by the end of 2010. The cost of the program rose from $30 billion in 2007 to $64 billion in 2010.

The recovery that began in June 2009 just celebrated its fifthanniversary, but the number of Americans receiving benefitsfrom SNAP has continued to swell. At the end of 2013, 47.6 millionAmericans were receiving aid at a cost of $76 billion. The currentrecovery is by far the most tepid of the 11 recoveries since WorldWar II when measured by job and income growth. Most of thegrowth in SNAP participants is likely due to the economy, but not all of it. Surely, there are a good number of recipients that could nowget by without the aid, but the temptation of a free lunch is hardto give up voluntarily. This could explain a large part of the nonstopincrease in the number of food stamp recipients since 2001.

The government has significantly increased tobacco taxes toencourage smokers to quit, believing the disincentive of expensivecigarettes would discourage the bad behavior of smoking.According to Gallup’s annual Consumption Habits poll takenin July 2012, the number of adults who smoke in the U.S. hasdropped from 43% in 1973 to just 20%, with the largest declinesince 2005 among the 18- to 29-year-olds (from 34% to 25%). Thisshouldn’t be a surprise because people respond to disincentivesand incentives and will change their behavior accordingly. This iswhere the challenge lies for government programs that are bornout of compassion. There is a fine line between helping and theunintended consequence of encouraging dependency. When wehelp unemployed workers or low-income people there is a real riskit will lead to more low-income people as some recipients respondto government incentives not to work or to work less. For all thetrillions spent on fighting poverty, it is no lower now than 50 yearsago. If money was the solution, the poverty rate would be far lower.Maybe it’s time to consider whether government programs haveprovided too much help and have instead increased dependencyamong those receiving assistance.


An August 16 New York Times article entitled “Pervasive MedicareFraud Proves Hard to Stop” describes the federal government’sefforts to address Medicare fraud. Systemic overcharging andfraud are estimated at $60 billion a year, or 10% of Medicare’s$600 billion annual cost. The Centers for Medicare and MedicaidServices is responsible for the government’s antifraud effort. Ofthe 1.2 billion claims it receives annually, it reviews just 3 millionclaims manually (can you imagine the calluses on those workers’fingers?) Last year the center’s efforts only recovered $4.3 billion,or about 7% of the estimated $60 billion lost to fraud. In an April 9,2014, article, the New York Times reviewed how two Florida doctorshad billed Medicare a total $39 million in 2012. Of that total, oneophthalmologist received $21 million in Medicare reimbursementsfor a drug to treat macular degeneration made by a company thatpays doctors a generous rebate—a true double dipper! The seconddoctor is an interventional cardiologist who was reimbursed $18million, the most for any cardiologist in the country and four timesthe $4.5 million the second place cardiologist received. Both doctorsare still certified to receive Medicare payments despite ongoinginvestigations by the FBI.

The Affordable Care Act

Considering the impact of French labor laws on its labor market,one wonders if the Affordable Care Act (ACA) could createdistortions in the U.S labor market. After all, the ACA requires thatall businesses with over 50 full-time equivalent (FTE) employeesprovide health insurance for their full-time employees, or pay amonthly Employer Shared Responsibility Payment on their federaltax return totaling $2,000 a year. This employer mandate wasdelayed until 2015 for companies with more than 100 employeesand until 2016 for employers with 50 to 99 employees. A full-timeemployee works more than 30 hours per week, so there is an incentive for employers to reduce hours for those employees whonormally work a little over 30 hours a week. A worker who has theirhours reduced from 33 hours to 29 hours experiences a 10% declinein their income.

Three Federal Reserve Bank employer surveys suggest theAffordable Care Act is affecting hiring decisions by companies in theUnited States. The Philadelphia Fed found that 3% of the surveyedfirms said they were increasing employment due to the ACA, butabout 18% said they were cutting back and another 18% said theyhad increased their number of part-time workers. About half of 8 Macro Strategy Review www.forwardinvesting.comthose employers surveyed had modified their health plans, and ofthose who did, over 88% increased employee contributions to offsethigher insurance costs—effectively lowering their employees’ takehome pay. The New York Fed found that 21% of manufacturers andalmost 17% of service firms said they were reducing the number ofworkers in response to the ACA. The Atlanta Fed found that 34% ofbusinesses planned to hire more part-time workers than in the past. Since the employer mandate kicks in during 2015 and 2016, thefull impact won’t be realized until mid-2016. The Fed surveys implythat once the employer mandate is fully implemented more firmsare likely to hire less, increase the number of part-time workers andpass along cost increases in healthcare insurance to employees. Iftrue, it doesn’t sound like the ACA will provide a boost to medianincome growth.


If one looks at valuation metrics beyond the standard priceearnings(P/E) ratio, the stock market is at the third or fourthmost expensive level in the last 120 years. There is a high level ofbullishness, so sentiment is another caution sign. However, thestock market doesn’t decline just because it’s expensive or thereare too many bulls. Unless a reason to sell materializes, the marketcan get more expensive and sentiment even more bullish. Althoughwe think expectations for growth in the second half are not likelyto reach the consensus of 3.5%, growth of 2.8% is hardly a reason toturn bearish. The prospect that the ECB will launch its version of QEis also supportive until it happens, or, less likely, it doesn’t.

The S&P 500 Index continues to move higher, making higherhighs and higher lows, so the trend is positive. When discussingmomentum we often use this analogy: when a ball is thrown intothe air, it starts rising at 60 mph and then gradually deceleratesuntil it stops rising. Even though it may be gaining altitude, therate of ascent slows to 30 mph, then 20 mph, and so on until itreaches 0 mph. Although the market’s momentum is still decent, itis showing signs of slowing. The number of stocks making new 52-week highs has been contracting since early July, even as the S&P500 makes new highs. The NYSE advance/decline line has made anew high, but the rate of ascent has slowed. Finally, the pattern inthe S&P 500 appears to be completing a five-wave rally from theearly February low. This pattern suggests that an interim peak ispossible relatively soon. On August 25, the S&P 500 cleared 2,000for the first time. The pattern would look complete if the S&P 500tops between 2,020 and 2,040. If the S&P 500 reverses and declinesbelow 1,975, a further decline to 1,905 or 1,915 is likely. Should itclose below 1,890, it would suggest that a more important top hadbeen reached. Since valuations are stretched, any break of a priorlow should be heeded.

Treasury Bonds

tapering would result in lower bond prices and higher yields. Basedon technical analysis, we thought the yield on the 10-year U.S.Treasury bond was more likely to fall to 2.5% before any meaningfulincrease was likely. We think the Treasury bond market is at aninteresting junction now from a fundamental and technicalperspective. It was totally logical to expect yields to rise as theFed proceeded with its tapering of Treasury bonds and mortgagebackedsecurities. After being blindsided by the rally in Treasurybonds and decline in yields, fundamental investors are far moreaccepting that bond yields may stay down for a long time. From apsychological point of view, this suggests that the Treasury bondmarket is more vulnerable now for an increase in bond yields than itwas at the end of 2013 since so few are expecting a rise. Technically,the pattern in the 10-year Treasury now suggests that a rise in theyield is more likely.

This paragraph is for aficionados of technical analysis. BetweenDecember 31, 2013, and February 3, 2014, the yield on the 10-yearTreasury declined 45.7 basis points (bps) from 3.036% to 2.579%.Over the next two months, the yield worked its way higher until itreached 2.808% on April 2. The increase was 22.9 bps—an almostperfect 50% retracement of the 45.7 bps decline. An equal 45.7 bpsdecline from there would be 2.351%, and from the high onApril 2 the yield fell 40.6 bps to 2.402% on May 29 before jumping to 2.692%. An equal decline from that provides a target of 2.286%,and on August 15 the yield fell to 2.305%, which is in the middle ofthe two yield targets (2.351% and 2.286%). This suggests the yieldon the 10-year Treasury may have reached a low, or will if there isone more small decline below the August 15 low. As of August 24,we think an increase to 2.65% is likely, while a close above 2.66%would open the door for a test of the April 2 high at 2.808%.

Definition of Terms

10-year Treasury is a debt obligation issued by the U.S. Treasury that has aterm of more than one year, but not more than 10 years.

Basis point (bps) is a unit of measure that is equal to 1/100th of 1% andused to denote a change in the value or rate of a financial instrument.

Capacity utilization rate measures the rate at which potential output levelsare being met.

Debt-to-GDP ratio is a measure of a country’s federal debt in relation to itsgross domestic product (GDP). By comparing what a country owes to whatit produces, the debt-to-GDP ratio indicates the country’s ability to pay backits debt.

Federal Open Market Committee (FOMC) is a branch of the Federal ReserveBoard that determines the direction of monetary policy.

Gross domestic product (GDP) is the total market value of all final goodsand services produced in a country in a given year, equal to total consumer,investment and government spending, plus the value of exports, minus thevalue of imports. The GDP of a country is one of the ways of measuring thesize of its economy.

Mortgage-backed security (MBS) is an asset-backed security whosecash flows are backed by the principal and interest payments of a set ofmortgage loans.

Quantitative easing refers to a form of monetary policy used to stimulatean economy where interest rates are either at, or close to, zero.

Personal Consumption Expenditures (PCE) is a measure of price changes inconsumer goods and services.Price-earnings (P/E) ratio of a stock is a measure of the price paid for a sharerelative to the annual income or profit earned by the firm per share.A higher P/E ratio means that investors are paying more for each unitof income.

S&P 500 Index is an unmanaged index of 500 common stocks chosen toreflect the industries in the U.S. economy.

Shanghai Stock Exchange (SSE) Composite Index is a market compositeof all A and B shares traded on the Shanghai Stock Exchange and providesa broad overview of the performance of companies listed on the Shanghaiexchange.

Texas ratio is a measure of a bank’s credit troubles and is used to identifypotential problems.

Thomson Reuters/University of Michigan Consumer Sentiment Index is aconsumer confidence index published monthly and based on answers from500 telephone interviews of persons living in the continental United States.

Valuation is the process of determining the value of an asset or companybased on earnings and the market value of assets.

Volatility is a statistical measure of the dispersion of returns for a givensecurity or market index.

One cannot invest directly in an index.


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