I’m glad I ignored Jim Cramer five years ago

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Published October 08, 2013

| Covestor

jim cramer

Stock markets worldwide enjoyed a strong rally in the quarter ending September 30, 2013. The S&P 500 Index (SPX) generated returns of 5.2% for the quarter, while the Russell 2000 Index (RUT) of small companies and the MSCI EAFE International Index both produced returns exceeding 10%.

Stocks benefited from continued growth in the U.S. economy, improving economic conditions in Europe and China, and reduced political tensions related to Syria and Iran. The S&P 500 Index finished the quarter with year to-date returns of almost 20%.

The beginning of the current 5-year run of stock gains coincides with the global financial meltdown in the fall of 2008. In fact, it was on October 6, 2008, when Jim Cramer, the renowned market pundit, cautioned the Today Show audience by saying, “Whatever money you need for the next five years, please take it out of the stock market.”

Well, here we are five years later, and the stock market has generated 10% annualized returns since his prediction of doom. An investor who ignored his advice and held when Cramer said to sell would be up over 75%, using the S&P 500 as a proxy for performance. (In fairness to Cramer, he was referring to funds one needed to spend over the past five years – not long-term holds.)

While the recent strong market performance is a welcomed reward for long-term investors who stayed the course over the past five years, it also raises some concern that investors are becoming overly exuberant.

Stock prices have risen much faster than company earnings over the past year, making valuations relatively less attractive. Although the economy is still expanding, it still requires a significant amount of support from the Federal Reserve in the form of the current quantitative easing (bond buying) program.

Stocks rallied in September when the Federal Reserve announced that it would not begin to taper its $85 billion per month quantitative easing program. This came as a surprise, since the Fed had hinted in May that it would slow its purchases of bonds in the near future.

The Fed’s bond buying program is intended to keep interest rates low in order to stimulate the economy. Lower interest rates make it easier and cheaper for businesses and consumers to borrow and then to use the money to buy goods and services.

The Fed buys bonds in the marketplace, rather than directly from the Treasury. By competing with other market participants and adding to the demand for government bonds, the interest rate that the Treasury has to pay investors is very low.

At the end of September, the interest rate on the 10-year Treasury bond was just 2.62%. The 85-year average interest rate for 10-year Treasury bonds is 5.1%, or about 2.0% higher than the average inflation rate of 3.1%. Investors who might normally invest in Treasuries have turned to riskier assets, such as corporate bonds and stocks, to get a higher return.

So by purchasing government bonds, the Federal Reserve not only encourages borrowing and consumption by keeping interest rates low, it supports higher asset prices by creating demand for riskier assets. It almost sounds too good to be true. (It begs the question: Is this creating an asset bubble?)

Since its first quantitative easing program began about five years ago, the Fed’s balance sheet has expanded from less the $1 trillion in assets to over $3.7 trillion, and it is growing at roughly $85 billion each month. While the Fed’s assets include both Treasury securities and mortgage backed securities, the holdings are significant when considering that the national debt is $17 trillion.

Eventually the Fed will buy less bonds (taper), then it will stop buying bonds, and at some point it will need to sell bonds or at the very least allow them to mature. So far, the program has worked well, but there is significant risk in unwinding it. Fed Chairman Ben Bernanke has taken the spaceship to Mars; now his successor will have to get it back safely. It will be no easy task.

The Fed intends to continue to stimulate the economy until unemployment falls to 6.5%. The unemployment rate currently stands at 7.3%. Real GDP (the measure of all goods and services adjusted for inflation) is now 4.3% higher than its pre-recession peak in the second quarter of 2007.

However, during that same time frame the total number of people employed fell by 1.2% from 137.7 million workers to 136.1 million. As a nation, we are now producing more stuff with less workers – greater automation and working harder has made the U.S. more productive.

So there is some possibility that as we continue to increase productivity it will be increasingly harder to lower the unemployment rate. Ultimately, employment can increase if the economy grows more quickly or if the total hours worked is spread over a larger number of people. However, that assumes that those currently unemployed have adequate abilities to do the work as more knowledge-based skills are required by employers.

Bond markets recovered somewhat in the third quarter, helped by the Federal Reserve’s decision to maintain its bond buying program. The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, generated returns of 0.6% for the second quarter. However, this index has posted a loss of 1.9% for the year-to-date period as interest rates have risen significantly since the beginning of the year.

The yield on the 10-year Treasury bond ended the quarter at 2.62%, up sharply from 1.76% at the beginning of the year. Longer-term fixed income investments still appear to be unattractive, considering that interest rates will likely increase, especially as the Fed unwinds its quantitative easing program.

With the stock market near record levels and signs of market speculation increasing, I believe a degree of caution is warranted. While companies are performing well in the current environment, so much of future performance is dependent on the successful actions of government leaders, policy makers, and bureaucrats.

In addition to being dependent on Federal Reserve policy, markets will also be impacted by the outcome of the current budget stalemate and debt ceiling negotiations. Looking ahead, stocks are likely to outperform other asset classes as the economy continues to improve. However, considering the uncertainties, investors could experience greater volatility and more moderate returns in the near term.

Photo Credit: Tulane Public Relations

Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.

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