Financial Engineering — October 2014

October 23, 2014

Dow Jones Average: 16,461
S&P 500 Index: 1,927


Financial Engineering


The stock market in the U.S. has performed better than any of the major indices in the
world since the crash of 2008-2009. The first part of the rally was driven by stabilization
of the banking system. The Federal Reserve’s unprecedented monetary policies, modest
economic growth, and financial engineering by many corporations have propelled later
stages of the market advance. Stock gains that result from financial engineering are often
seen as suspect, while those based on profits from new products and new customers are
considered to be more sustainable. The enormous influence of Fed policy and corporate,
financial engineering on the markets during the past five years have raised doubts about the
quality and durability of the stock gains.
There are many ways for corporations to manufacture or engineer earnings even
when the underlying business is faltering. In a super low interest rate environment, simply
refinancing corporate debt can produce higher earnings. Buying back shares, laying off
workers, freezing compensation, shedding less profitable divisions, and situating operations
in lower tax jurisdictions are some other ways that companies can report improving earnings
in the face of stagnant or declining revenues. While some of these strategies can hurt a
company’s long-term prospects, they usually result in better short-term earnings, and at least
a temporary boost to the stock price.
In recent months investors have started to divide companies into several categories.
Companies that have been dependent on financial engineering for results have fallen out of
favor. Investors have become wise to corporate strategies designed to obscure poor revenue
trends. Commodity related companies have also taken a beating, as sluggish worldwide
growth has undermined commodity prices. The favored categories in the stock market are
companies reporting real revenue and earnings growth in a challenging economic climate,
and those companies with large, well supported dividends.
It is likely that the stock market will become more reliant on real revenue and earnings
growth spread among more companies over the next few years. The era of gains driven by
cost cutting, debt refinancing, share repurchases, and other financial strategies appears to
be drawing to a close. Artificially supported prices, whether it is support from extreme Fed
policy or financial engineering, eventually give way.
Current Strategy
While the markets have been resilient over the past few years, in the face of many potentially
destabilizing events, the tone changed in early October. Some major indices, such as the
Russell 2000, fell into correction territory (down 10 percent) on the year, while the S&P 500
Index dropped to break even for the year. That level can represent a psychological tipping
point, as pressure on money managers to be in or out of stocks becomes evenly balanced.
The twin fears of missing the upside or being too committed during a downdraft can
accentuate market direction. In a market decline selling begets more selling as cash starts
to look attractive when compared to eroding stock prices. On the way up, rising stock prices
force more buying as cash sitting in money market funds cannot compete with rising stock
prices. It is somewhat surprising that the recent selling wave, which quickly erased trillions
in global stock market value, seems to have reversed already. The yield on the ten-year U.S.
Treasury note dropped below 2 percent as stocks fell. That was apparently enough to remind
investors that there is no reasonable yield alternative to stocks, and buyers resurfaced.

We made very few, if any, changes in our clients’ holdings during the October market
decline. The majority of our widely held stock positions are companies with stable to growing
businesses, decent dividends, and large cash reserves on their balance sheets. We intend
to hold most current positions regardless of near-term market direction. The current mix of
equity holdings includes a number of large dividend payers, some small to mid-size growth
companies, and a few industrial companies that are geared to potentially stronger economic
conditions. We think that it is a good blend for this market environment. If prices remain
volatile we may have an opportunity to add a few new holdings to the portfolios.

The fixed income markets moved away from a buy zone once again. At the first sign
of stock market turmoil interest rates fell by almost a full percentage point to below 2 percent
on ten-year paper. If the markets settle down and the economy continues to improve, rates
could move quickly back up to the 3 percent level. We would be inclined to buy more bonds,
treasuries or municipals, at that level. In the meantime, stocks that pay dividends will have
to carry the income load for clients.

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