3 Biggest Risks for the Market! – Alpha Select Update

Climbing_the_Wall_of_Worry_-_Google_SearchBy David Nelson, CFA

Alpha Select – August 2014 Update

*Alpha Select – August +5.2%  YTD +12.36%
**S&P 500 – August +3.8% YTD +9.58%
* Net of Fees
** Includes Dividends

August erased all of June’s losses pushing markets into record high territory boosting the S&P through another millennium. It feels good, looks good and probably is good so how come we all have a bout of vertigo?

In the last month nothing seemed to hold us back. Alpha Select was able to wipe out July’s poor showing gaining 5.2% and is now up over 12% YTD.

While markets have largely shrugged off rising geopolitical concerns, it would be a mistake to believe we are immune from threats overseas.

3 Biggest Risks

  1. The Ukraine is number 1 with a bullet. Not only is this a military conflict and spreading, we’re in the early stages of a trade war.
  2. The Middle East is spiraling out of control seized by a terrorist group that has the motive, capability and desire to bring this fight to our shores.
  3. There is a growing wave of protectionism sweeping the world. China is right out in front blocking US technology companies. They are determined to blunt U.S. access to potentially the largest market in the world.

The question remains. Why aren’t markets responding to these escalating threats? The answer may be simpler than you think. They haven’t hit the bottom line….. yet.

ukraine_crisis_-_Google_SearchEurope on the Brink

While the U.S. and our European Allies are in a tit for tat sanction war with Russia, we’re still early in the process. President Putin is determined to bring back Russia to its former glory. His popularity is incredibly high and I’ve said in the past on air that Russia has a long history of defying logic. Each side has launched a series of economic sanctions. Even though Russia has the most to lose, Europe is on the brink of a triple dip recession and can ill afford a continued trade war.

Former Treasury Secretary Lawrence Summers recently said, “Europe is at risk of secular stagnation.” With an unemployment rate hovering just below 12% five years after the financial crisis, that seems like a fair assessment.

According to the Congressional Research Service, the United States and the European Union economic relationship is the largest in the world. As a key bilateral trade partner they take about $265 Billion of our exports each year. Total U.S. Trade turnover is over $649 Billion. A full blown European Recession has to have bottom line implications for a host of industries and companies on both sides of the Atlantic.

Senator Robert Menendez (D), Chairman of the Foreign Relations Committee said on CNN Sunday; “This is a direct invasion by Russia and we must recognize it as that.” He went on to say headlines are wrong when they refer to advancing troops as rebels. “It’s not rebels, It’s Russian Soldiers.” The ongoing crisis looks to get worse before it gets better.

isis_threat_to_us_-_Google_SearchMiddle East Meltdown

The human tragedy unfolding in the Middle East has shocked the civilized world as ISIL has grown into the most powerful terrorist threat we face today. I’m not going to go into what I believe are political failures in this forum, so for the moment let’s talk about the economic risks.

I was wrong earlier this year when I expressed my concern about a potential energy spike on the heels of turmoil in the region. The supply disruption never materialized and at least as of late ISIL has not made its way into southern Iraq gaining access to the bulk of their production. For now the amazing strides in U.S. production have rendered the current unrest as harmless. However, if and when that comes, my error may only be in timing having made the call far too early.

The 2nd and perhaps larger risk is a potential attack on our shores. We’ve learned in recent weeks that jihadists from all over the world, many with European and US passports have found their way into the fight. While every effort is being made to keep these lunatics from our shores, logic suggests some will get through.

microsoft_china_windows_-_Google_SearchProtectionism

Finally, the growing wave of protectionism I mentioned above is a long term threat that could place a drag on global growth. Former Federal Reserve Chairman Greenspan may have said it best when he criticized protectionist proposals as leading “to an atrophy of our competitive ability.” While I have often come out on the other side of any Greenspan debate, here I take his side. Protectionist policies are popular with voters and therefore politicians believing it is panacea. However, any short term benefits are more than offset by the long term stagnation created.

China seems to be front and center launching a series of protectionist policies designed to help stimulate its tech industry which sits well behind the U.S. Earlier this year they banned Microsoft’s Windows 8 operating system to give time to their own efforts which up until now have been an abysmal failure. Many U.S. tech companies have chosen to partner with Chinese counterparts to blunt Chinese efforts limiting their access. IBM recently announced a partnership with China’s Inspur hoping to regain access to the Middleware market.

Companies that choose this route risk a one way flow of intellectual property that could prove problematic if and when the partnership ends. Also to be considered, just how far will China go with regards to plagiarism and the theft of intellectual property to develop their homegrown products? If China continues on this path, calls here will likely be retaliatory demanding a response launching protectionist policies of our own.

The time table on all of the above is difficult to measure nor are they inevitable. How we confront these challenges will at the very least be a contributing factor in equity prices. The seasonal tailwinds are strong and probably enough to carry us through till the end of the year but with each passing day geopolitical threats take a toll.

August in the Rear View – The New Millenium

I first wrote “The Road to 1500” back in January of 2011. We went through that sign post and never looked back.

SPX_Aug_31_2014

Sector Performance

Sector_August_2014

All sectors posted descent returns for August however Energy was a noticeable laggard. For the moment strong U.S. production seems to be blunting the heightened tensions in the Middle East putting downward pressure on oil prices.

Sector_Jan_-_Aug_2014

Again even here all sectors are in the green with Healthcare, Tech and Utilities leading the way. Bringing up the rear are Consumer Staples, Industrials and Consumer Cyclicals.

Interest Rates

Chart__US10YT_RRConventional wisdom coming into the start of 2014 was for Benchmark yields here in the U.S to continue a trend higher started last year when the Fed first talked about exiting quantitative easing. Many including yours truly we’re looking for rates to remain over 3%. With the 10 year sitting more than 65 basis points below where they started the year that theory hasn’t exactly panned out. Despite a Fed that’s setting the stage for its first hike in years, yields have pushed lower. This helps explain the recent strength in Utilities which are something of a bond proxy.

The knee jerk reaction that bonds are predicting an economic downturn here in the U.S. hasn’t held water. Economic data in the last month seems to confirm that Q1 was an anomaly and continued strength in U.S. corporate profits seems to confirm.

German_10_Year_BenchmarkAs I said earlier, Europe is close to falling into recession so it’s understandable why German 10 year yields have fallen below 1. The yield spread today sits close to 147 basis points approaching the upper end of its range and acts as an anchor dragging down U.S. Benchmark Yields. Sellers don’t have to mark down prices when there are few high quality alternatives.

The Good the Bad and the Ugly

Realized Returns

Discover Financial (DFS) took the honors locking in a +44% gain after our sale earlier this month. Our full sale of Dow Chemical (DOW) and partial sale of Disney (DIS) realized +10.4% and +15.8% respectively rounding out the top 3.

The three largest realized losses for the month were Helmerich & Payne (HP), IBM (IBM) and United Healthcare (UNH) coming in at (-6.96%), (-2.25%) and (-2.23%) respectively.

Click Here for full Year of Closed Transactions

Unrealized Returns

All but two stocks currently in the Alpha Select Portfolios were up on the month. The hands down winner in August was Gilead (GILD) up 17.6% this month and is up more than 55% since its purchase in April.  This is our second dance with GILD having locked in an over 27% return early this year.

Also posting excellent returns were Southwest Air (LUV) +12.6% and Celgene (CELG) +8.9%.

The two losing positions still on the books are Halliburton (HAL) and Thermo Fisher (TMO) down (-6.8%) and (-3.35%) respectively.

Climbing the Wall of Worry

As we push deep into the third quarter we seem to be faced with a formidable Wall of Worry. Here at home the economic and corporate data supports continued market gains. Rising threats overseas on a series of fronts look to challenge that view.