Economic Update 9-15-2014

• Aside from the FOMC meeting—where language was scrutinized but little actually changed—the economic week was mixed. Several regional economic indexes came in with positive results, inflation was virtually unchanged and housing results were a bit disappointing relative to expectations.
• Equity markets were higher in the U.S. with a lack of hawkish surprise from the Fed and a few other geopolitical risks (notably Scotland) easing, and outperformed foreign markets. Bonds were slightly higher on rates that initially rose and then retreated.

U.S. stocks gained over a percent on the week, led by early speculation (later validated) that the Fed would keep an accommodative tone in their post-meeting statement.  In news abroad, sentiment was perhaps validated by the People’s Bank of China lending a significant amount ($81 billion) to the five largest banks to ease the slowdown, although that may have helped U.S. sentiment more than it did foreign.  From a sector standpoint, health care and materials gained over a percent, while consumer discretionary and energy barely gained on the week.

The US dollar gained again on Wednesday following the Fed meeting, on the order of almost a percent.  As we discussed last week, currency values can generally fluctuate for a number of reasons—in this case, a planned end of QE as well as higher interest rate projections for coming years, which remove some inflation risk.

Foreign markets were a mixed bag last week, with developed markets generally flat and emerging market names weaker.  The U.K, was one of the better-performing larger nations, naturally due to the defeat of the Scottish independence referendum.  Russian stocks were the worst performing, not due to the Ukraine, but by internal money laundering probe at a major firm.

In U.S. fixed income, after initially higher yields during the week due to increased Fed projections for rates in coming, these came back to earth resulting in a decent week for bond prices.  Long treasuries led, followed by high yield debt as liquidity and supply/demand dynamics improved in that market (the new issue calendar has tended to pick up after summer).  Despite strength in the dollar across the board, foreign bonds were mixed, with the European periphery stronger and emerging markets weaker due to ratings deterioration in Latin America.

U.S. retail REITs led, with a half-percent gain, while most other domestic categories as well as Asia/Europe fell back.

Commodities experienced another poor week on average, in no doubt harmed by a stronger U.S. dollar, on pace to their worst quarter in two years.  Cocoa prices shot up +5% on fears surrounding harvest areas in West Africa affected by Ebola, while natural gas prices rose on cooler weather (as usual).  Crude oil prices weakened again, dropping down towards $91, a key technical support point of the last two years.  Sugar and cotton were the worst performers on the week, dropping along the lines of -5%.

Should I buy into the hype of IPO stocks like Alibaba?  How can I put the risks of an IPO into context for clients?

There was a good deal of hype around Alibaba, the 2^nd largest IPO in history, raising nearly $22 billion, which pegged the total value of the company at $168 billion.  The gain of over +30% in its first trading day may say something about the company’s fundamental prospects, a mispricing of the offering itself or the underlying levels of investor excitement—only time will tell which.

As with any security, the question of whether to invest or not doesn’t consist of one absolute answer, but a relative one.  It might be first helpful to go back into the function of capital markets to lay out some perspective about why a company might want to go public in the first place, then evaluate the situation from there.  (Hint:  they’re not doing it for your benefit or enjoyment.)

Capital markets, in this sense referred to as ‘primary markets,’ are, at their core, places for business owners to take their ownership stakes and monetize them—essentially, allowing a single, illiquid stake or group of stakes to be expanded into a broader, liquid and diverse set of stakes.  This has been done for any variety of reasons:  to raise capital for expansion (at perhaps a cheaper rate than through private financing), change a balance sheet’s structure or improve its future flexibility, begin a succession plan for a company founder, enlarge the scope of a firm’s public image (especially in the modern era), and/or create liquidity (such as when venture/private equity investors are looking to sell their early interests and move on, or to allow more attractive management incentives going forward, like stock option programs).

Skipping several important, time-consuming and expensive legal/regulatory/operational steps, the initial IPO price is generally set based on a variety of factors and is part art (investor sentiment and interest) and part science (valuation metrics), as pricing too low would bring in less capital than one otherwise could; pricing too high could result in low buyer interest and inability to fulfil the offering.  The primary objective is to get as much of an issue sold as possible, so the IPO price is the mechanism for doing that.

Then the issue begins trading on the ‘secondary market’ (the major world stock markets we deal with) and proceed to trade by the fraction of a second indefinitely…at least in theory.  If the early investors are fortunate enough, the price goes up (often dramatically on the first day, if a high-profile and popular offering); but often, it doesn’t.  It’s a bet, either way.  We only hear about the headline-worthy offerings, but many new issues don’t live up to the hype and offer quite disappointing initial year returns and many institutional portfolio managers avoid IPO’s for this reason.  But, pleasing investors really isn’t the point of the IPO process—the purpose is raising capital for a company.  It’s easy to forget this in the frenetic trading of today’s stock markets, but once the initial offering of shares is completed, the company doesn’t directly benefit from the stock’s market price after the money is raised (other than executive stock-option arrangements, intangible prestige from a stock’s popularity, etc.)  Making a profit by a rising share price is only a nice byproduct of investing in equities, to compensate for the equally-viable risk of loss (the forgotten reality is that a price falling to zero, resulting in a total loss, is the ultimate risk of any single equity, if conditions got bad enough).

Investing in an IPO requires some homework as it does with any already-traded stock.  Unfortunately, a limited history doesn’t offer clients a lot to go on, and these tend to be in ‘new era’ industries, so much of the implied value stems from potential for the concept to sustain itself and result in future growth in earnings, which is required to sustain the stock price.  With financial modeling, especially in the future, small changes in inputs can result in largely variable outputs, so it’s important to use care when reviewing any forward-looking data, particularly for new industries.  Especially in new emerging industries and markets, as in the case of Alibaba, where underlying information about consumer markets is not always easy to come by.  We get reminders of this every few decades or so, whether it be the auto industry of the 1920’s or internet bubble of the 90’s, where Main Street exuberance can compete with and sometimes overwhelm well-thought-out financial decisions.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                 

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.  FocusPoint Solutions, Inc. is a registered investment advisor.