With The First Half In The Books Investors Need To Strap In Cause the 2nd Half's Offering Volatility And Yet Higher Returns

Ritchie Valens implored me to “C’mon and go and do it again and again and again”. I got that tune stuck in my head for the last few months after the constant parade of Federal Reserve Governors stepped one after another to the podium in an effort to clarify our Fed Chairman Bernanke’s commentary surrounding the timing of the impending QE Tapering! The soothing Fed Governor commentary helped us recoup most of the 5% swoon and tamp down the fear factor and market volatility as we closed out the first quarter and headed into this just closed out first week of the second half. We closed out the first half of 2013 with solid returns but shaken confidence. The nervous Nellie’s and perma-bears went into hyper sale mode after the mere mention the Federal Reserve may lighten up on the size of their monthly $85 billion in asset purchases ONE DAY. US Treasury 10 year bond yields rocketed higher from 1.67% up to 2.64%. On a percentage basis that is a huge move magnified by the fact it took place in the scope of less than 2 months. This does present issues for re-hedging a trading position, for closed end bond funds that borrow short and buy long duration assets, funds of all kinds that must raise cash for investor redemptions and firms of all kinds that require a line of credit in general. The bigger worry was/is the spike in rates would dampen enthusiasm for home and automobile buyers. But let’s take a moment and think bigger picture. The rates on 15 year and 30 year mortgages stands currently at 3 3/8% and 4 ¼% respectively. I’m quite sure we all can still remember waaay back when the opportunity to lock in a mortgage at 7% was reason enough to pop the champagne corks. Which gets us to the real point, it’s not the rates themselves we’ve reached, it’s the time frame at which we achieved them. The huge move in rates saw institutional investors selling aggressively in anything bond fund/leverage related. Investors pulled out $60 billion from bond funds in June alone. One need only look at the road kill left of the large and “safe” mortgage REIT Annaly Capital Management-NLY. This mortgage REIT had/has a very attractive yield of 13% currently. But, when considering total return just take a look at the price range over the last year. The fund traded at a high of $17.75 and currently changes hands at $11.50. With rates expected to march higher from here (albeit not as aggressively as we’ve just experienced), we should see similar total rates of return for years to come along with the added bonus of dividend payout cuts. This is why we at GSA prefer individual bonds and investments. We may also experience some of the price volatility, but we have the option of holding our bonds to maturity and receiving our principal back. Bond funds have no maturity so this option of principal recapture is not available. Now, first we saw institutional investors rush for the exit signs, once individuals begin receiving their monthly statements and continue to see the losses piling up the pace of sales will pick up steam again. This shift out of bonds and into alternatives should lead to continued elevated market volatility short term. Longer term we should be able to withstand the selling as the real story is quite positive. When we actually see the trees for the forest, the Federal Reserve providing less stimuli would be in response to stronger economic growth and an economy able to stand on its own. Where we are: Leading economic Indicators (LEI). LEI rose at a modest .1% in May after April’s .8% pop. So, smoothing out the month to month volatility and looking at the three month average +.2% and +.22 for the six month average which would suggest steady if unspectacular growth going forward. The 3month results were impacted by the .3% decline which may be attributed to the as yet unknown effects, both actual and psychological of the sequester. We would expect a pick up in activity as we get deeper into the second half of 2013. Housing. Housing starts in May hit an annualized run rate of 914,000. Permits however cooled some declining 3.4% to an annualized run rate of 974,000. Still, these are the highest twelve month averages for both since 2008. Clearly the recovery is in full speed. We anticipate further progress in both permitting and new and existing home sales as fence sitters fear missing the boat on the current generational lows in mortgage rates. Nothing like higher rates to spur the buyers. Institute of Supply Management Manufacturing Index (ISM). The June ISM rebounded back to expansion mode with a 50.9 reading (anything above 50 suggests growth) up 1.9% from May’s 49 reading. Generally respondents state conditions remain good to improving. They also point to sales strength in electrical and appliances which would be supported by the strong housing numbers. Among areas of strength were the New Orders component +3.1% and exports +3.5%. There was some concern about the weakness in the employment index -1.4% and order backlog being -1.5%. So, in all better but needs monitoring. Institute of Supply Management Non-Manufacturing Index (Services). The June ISM Services index dipped to 52.2% softening some from the prior months 53.7% but still in expansion mode. Respondents reported continued growth in sales, they interestingly noted lower revenue figures due to elevated healthcare costs and the need to monitor or reduce head count (Obamacare). They also note business is profitable but mainly due to cost cutting and streamlining so the ability to pass along higher costs to consumers is somewhat restrained. We saw expansionary levels across the board, ex-new export orders. This is not entirely unexpected as China’s economy is working through a slow patch and the EU zone appears to finally be forming a bottoming pattern. Industrial Production (IP). IP turned in an unimpressive 0% growth rate for May. Year over year IP inched forward 1.6% largely in line with past expansions. Capacity Utilization ticked down to 77.6 from 77.7. The slack in Cap U acts as a sponge in absorbing inflationary pressures should they materialize. For now, not a problem. JOBS! Yes we weren’t going to skip over this one. June’s Non-Farm payroll figure clocked in at a surprising +195,000 where most Wall Street economists had modeled a 145,000 or worse figure. The six month average for this important monthly figure is right on top of 200,000. As important, average hourly earnings increased $.10 or 2.2% over last year. So, aside from the continued yet grinding higher progress in new entrants into the labor force, they are commanding higher wages as well. This translates very positively to more consumers with increasing levels of disposable income. Even the most pessimistic/skeptical investor must concede the progress made and the positive implications. Outside the Lines. Globally. This has been our Achilles heel and is still causing the US economy to limp some. China is I believe attempting to be proactive in piercing its own asset bubble in real estate (something Chairman Greenspan identified here in the US but did nothing about). This is causing a drag on economic expansion as they attempt to simultaneously switch solely from an export driven economy to one more balanced between exports and domestic consumption. No easy task and the difficulty evidenced by the drop from 10%+ economic expansion to the current rate of 7 ½%. India, another 1 billion+ populace nation whose economy remains constrained by the shackles of cronyism, corruption and the disgusting and tolerated abuse of women, may expand at a sub-optimal 5.5% well below potential and the heyday rates of expansion of 8%+. On the up and coming the Euro-zone and United Kingdom appear to be bottoming. Spain’s unemployment rate, while still painfully high fell 2.6% recently. Also, the UK PMI Services sector index soared to 56.9 the highest level in two and a half years. On the whole the Euro-zone PMI for June jumped to 48.9 still in contraction mode but up nicely from May’s 47.7 reading. The Euro-zone and UK economy have both benefitted from the proactive steps taken by new ECB Chairman Draghi whose policy moves have depressed sovereign borrowing costs and kept bond vigilantes at bay. Going Forward: The US economy and job creation continue expanding at suboptimal paces, but both with brighter days ahead. Despite the incompetence in DC the resilience of the US worker and markets are being proven daily. They both simply need clarity surrounding taxation and policy in order to make investments and daily spending decisions. In other words we need Washington and our career politicians to get out of the way. Consumer confidence is solid. When consumers feel secure in the jobs and prospects (evidenced in the JOLTS figures and Consumer Confidence) they feel and act more confident in making big ticket purchases such as homes and automobiles which are at multi-year highs. During the depths of the financial crisis and near financial collapse the US focused on growing our export economy as domestic consumption collapsed and fear raged. That time has passed and the global economic players are now looking to Old Reliable the US consumer to do the heavy lifting again. This time it’s a bit different. One potential game changer is the US energy production boom. The US is poised to become the driving force of new energy production techniques, pricing, exporting and jobs creator, in spite of DC. Inexpensive natural gas along with a retooled auto industry and weaker dollar should help power specialty chemicals producers, global auto sales, aerospace industrials along with lessening our dependence on foreign oil. The continued boom in US exports and benefits of cheaper more reliable sources of energy should secure our position back to where we should always be, the leading economic and entrepreneurial global powerhouse. For now we maintain our aggressive posture to the market and our 2013 year end S&P 500 target remains 1704. We are reworking our S&P 500 2014 target but are not yet prepared to release them as the increased volatility in the credit markets and borrowing costs in general may impact our estimates should rates spike violently higher. Thank you again for your continued confidence in this very challenging investment environment. Yours in pursuit of the KWAN!