The Month That Was - July 2013

Sydney M. Williams

August 5, 2013
                                                             The Month That Was
                                                                      July, 2013

                                       “Republicans believe every day is the Fourth of July,
                                            but Democrats believe every day is April 15.”
Ronald Reagan

This begins what I hope to be a continuing concept – looking back at the previous month to remind ourselves of critical issues and attempting to determine those whose impact may be more than ephemeral. While the idea was suggested by a friend, any errors, or prognostications that prove erroneous, are mine alone.

The above quote by President Reagan may sound unnecessarily partisanly, and I am sure his eyes were twinkling when he said it. But it is a quote I have always liked and has some basis of truth; so, if you find offense, please pardon its inclusion.

Perhaps the most important message about July is what did not happen, or what happened that was in contradiction to what we might have expected, and that was the heady performance of stocks. There was continued turmoil in bond and oil markets; the U.S. Dollar declined 2%; Egypt underwent a revolution, and a hedge fund was hit with criminal charges. Despite all that, stocks rose 4.9% and volatility declined. The VIX, a measure of option pricing, declined 20.2% and the number of days during which the DJIA moved up or down more than 1.5% was exactly none. In terms of the latter, volatility is at the lowest level since the first six months of 2007.

Oil, during the month, was up 8.9%. Between June 21st and July 19th, the price of crude rose 15%. Following suit, gasoline prices rose 3.9%, from $3.49 to $3.63. Gold rose 7.2% for the month, and the U.S. Dollar Index declined from 83.14 to 81.45.

The acquittal of George Zimmerman was a “dog-bites-man” story, garnering headlines because of race, an element that even the prosecutor said had no relevance in the trial. Mr. Obama’s trip to Africa may have a lasting impact, but there has been virtually no follow-up. The Snowden case simply suggests that the wrong re-set button may have been pushed four years ago, and makes the U.S. appear a “paper tiger.” All three stories served as diversions to the simmering scandals that threaten the Administration – Benghazi, the IRS and the alleged intimidation of the Associated Press and Fox News Washington correspondent, James Rosen. The situation in Syria worsened and Iraq had a prison break from Abu Ghraib prison and the greatest spate of violent deaths in years, further proof that al Qaeda has not only not been vanquished, but is gaining strength. The Weiner-Spitzer candidacies, besides providing fodder for the front-page headline writers at the New York Post, showed that unethical behavior remains rampant in the political world – not exactly an eye-opening revelation. The fatal landing of Asiana Flight 214 was a tragedy for those killed and injured and their families. It showed that experience is still important when landing a passenger jet, no matter how sophisticated its computer equipment.

The weather was oppressively hot for a week in mid month, but that made up for what seemed like a cool spring. Changing weather is nothing new (despite observations from those whose fortunes are tied to climate change.) This is especially so for one who grew up in New England, where an old saying goes: if you don’t like the weather, wait five minutes.

The military overthrow of Mohamed Morsi on July 3rd may have severe, destabilizing ramifications for the Middle East. During the last week in July, 80 Morsi supporters were killed, some shot in the back of the head execution style. What is worse for the United States: A country run by members of the anti-American Muslim Brotherhood, or a military dictatorship?

The announcement by the Federal Reserve on June 19th that they would begin walking back from their $85 billion per month purchases of Treasuries and mortgages caused a 60 basis-point back-up in the yield on the Ten-year, over the subsequent two weeks. Since the beginning of May, the yield on the Ten-year has risen 59% to a still historically low 2.59%. It is the trend, however, that is critical. Mr. Bernanke seemed surprised by the reaction and quickly soft-pedaled his announcement. The question becoming: Does this mark a sea change? For the month of July, the yield rose 11 basis points. The delay in the implementation of the Affordable Care Act can only be explained by a government not ready with insurance exchanges, and a growing sense that Obamacare is not the panacea that had been promised. The indictment of SAC should send a shiver up the spines of successful entrepreneurs – that a government, which is unable to find charges to file against management, can still indict a firm. The last time this happened, in 2001, 28,000 employees of Arthur Anderson lost their jobs. The Supreme Court later overturned Mary Jo White’s case – too late to save the firm and its jobs, yet providing enough publicity to give Ms. White the Chairmanship of the S.E.C. this past January.

In the summer issue of “City Journal,” a publication of the Manhattan Institute (and published this past July,) Steve Malanga wrote an article entitled, “The Indebted States of America.” In that essay he suggests that the debt for states and local government is likely far higher than what has been publically expressed. Forensic accounting studies have been initiated by taxpayer groups, elected officials and other researchers over the past couple of years. According to the States Project, a joint undertaking by Harvard and the University of Pennsylvania, instead of total debt being approximately $2.5 trillion, which is the value of the municipal bond and other public debt markets, it appears it could be over $7 trillion. We are a highly indebted nation, a fact about which there seems to be too much complacency. Federal debt equals about $16.4 trillion. Unfunded liabilities for Medicare, Medicaid and Social Security add another $30 to $35 trillion; so that total federal debt is somewhere between $45 and $50 trillion. U.S. mortgages approximate $13 trillion. Student loan, credit card and other miscellaneous debt add another $2 to $3 trillion. There are about 118 million households in the U.S., indicating an average indebtedness of about $570,000. Average household income is less than 10% of that number. The numbers are sobering. Extraordinary low interest rates have obliterated the enormity of that debt.

It is, I contend, impossible to look into the future, but one cannot help wondering if July marked the beginning of an exit off a saucer-based bottom for interest rates – a bottom that has lasted for two years. If that proves correct, in my opinion it will be July’s most important lesson. The decline in rates began over thirty years ago. History provides no reason for stock investors to be fearful of rising interest rates, at least in the first stages. The last major bear market in bonds occurred in the thirty-five years following World War II. In 1945, interest rates on long Treasuries were around 2%. By the end of 1968 they were over 5%. As interest rates were rising (and bond prices falling), the DJIA rose, compounding annually at 8.6% before dividends. It is true, of course, that during that last ten years of the bear market in bonds, when the yield on Ten-year Treasuries went from 6% to 18%, stocks suffered a decade-long decline.

Given the amount of debt washing around the system, it is unsurprising that the thirty-year bull market in bonds may be coming to an end. The most basic lesson in economics is that when a commodity is in surplus, its price goes down. Debt is in surplus. Bond prices have remained high (and rates low) because the Federal Reserve, concerned about jobs and housing, has artificially influenced their direction, preventing, thereby, the market from self-adjusting. It suggests that the Fed’s real concern is what untethered markets might do. How long can this charade go on? Is it coming to an end? No one knows, but markets tend to anticipate rather than reflect events; so, my lesson from July, is that the bond market bears watching, as we enter August and the rest of the year.