Poignancy will not be lost in
this edition of the strategist. I write to you this week from Bretton
Woods in
New Hampshire as I prepare to embark on a 200-mile relay race with 12
friends from all over the country. We will begin at Mount Washington,
and
we will finish on the coast. For 30 hours or so we will all be locked
in vans, cheering on our teammates, reminiscing and debating the
pressing
issues of the day. Inevitably the conversation will turn to the topic
du jour, politics. The tempers around the political issues of the
day will manifest and ultimately lead to concession or divided
silence. Sound familiar? I am devoting this week’s email to address
a dangerous investment trend brewing: The emotional degree of today’s
political debate undermining the rational investment
decision-making process. Many who feel under-represented or
un-represented by the ruling administration of the day have used their
portfolios to
express votes of "no confidence." Selling stocks, buying bonds and
raising cash most often represent the "no confidence" ballot, and yet,
as I
will argue, this strategy actually expresses the utmost confidence in
today’s political characters. While the financial panic of last
year led to a series of emotional responses, I am finding the political
panic of this year contains even more hyperbole. I will do my best to
examine the root causes of this hysteria, peer forward to prognosticate
most likely outcomes, and detail how we will position our portfolios
accordingly.
Twitter Me This
In graduate school, one of my
finance professors gave me a "C" on a research report I had written on
a
telecommunications company. My spreadsheets were flawless, my
investment thesis was sound and my target price for the security ended
up being
right on the money. The flaw? My headline was boring. She told me
that ultimately my reports would compete against an infinite number of
Wall Street research reports and that the differentiator would not be
the quality of my analysis but the seductivity of my title. How
prescient. Today’s technological prom queen, Twitter, requires users
to limit entries to headlines only (140 characters max). With
newspapers terminal, content has become so passé. Journalism has
become editorialism and incendiary emails spread like
viruses. (I recognize that by default my observations and opinions
populate your inbox weekly, making me party to the mania, but my
highest
objective would be to be your chosen filter).
Want to be recognized? Say
the most combustible thing you can think of. How much type became
devoted
to the MTV Video Awards spat between Kanye West and Taylor Swift this
past week? Enough so that the President of the United States tied off
the
event by labeling Kanye West a "jackass" (full accord with the Pres on
that call). What bothers me most is that I know about this tiff, the
President knows about this tiff, and it’s because technology attacks us
through various channels, piercing our intelligence, violating our
intellectual domains and injecting us with toxins. Technology has
become obnoxious. The stimulative properties of today’s
technology mixed with the limited time in our schedules for further
inquiry leave us more susceptible to emotional baiting than ever
before. So
at a point in time when the nation has chosen to debate and re-evaluate
major social institutions, ubiquitous technology and editorialists have
sensationalized even the most benign variables. Investors must protect
themselves from the resultant emotional acceleration. Decisions
made at the height of emotional energy are seldom the correct ones. So
we must recognize that political anxiety transitions poorly into
investment strategy. However, policy decisions do influence investment
returns. The key is to sift through the rhetoric and identify the
macro-policies within. Once these macro-policies have been distilled,
the strategies become clear. In many cases I may not personally like
what the government is doing, but I know precisely how to make money on
it.
The Government Playbook
Grow the Economy – In the 1930’s the monetary and
fiscal stimulus measures deployed by the US government amounted to
8.3% of GDP. To combat the most recent recession, the government has
allocated nearly 30% of GDP. Recovery has begun and corporate
earnings growth will follow. This is a certainty.
Swap Private Debts for Public Debts – To mitigate
the trauma of a marketplace resolution to the unsustainable debt levels
in
the private sector, the government has chosen to simply absorb the
excess debt levels on to its balance sheet. Debt levels have not been
reduced
by these actions; they have merely been shifted from individual
institutions to the collective taxpayer. This has bloated the deficit
to a
projected $9 trillion over the next decade.
Entitlement Reform - Over the
next 10 years the government projects spending of $43 trillion. Of
this
amount, social security, defense and net interest payments account for
48% of the outlays. Non-defense discretionary spending accounts for
15%,
and 13% of remainder spending services diminishing programs like TARP.
Medicare and Medicaid not only make up the largest component (24%) but
also the fastest growing at 7% annually. Clearly the most meaningful
reductions in government spending come through health care reform,
hence
the current debate. Whether appeasing all of the constituents
necessary to acquire the votes for passage leads to cost savings is
another
matter. The truth remains, either systematic cost has to be reduced,
or benefits must be reduced.
Restructure GDP - The US and
China have engaged in a codependent economic relationship for years.
By
pegging the Chinese yuan to the US dollar at a low level, China boosted
its manufacturing and export sector while the US boosted its consumer
sector. The excess cash China accumulated simply became re-invested in
US debt, keeping interest rates low. The combination of low
interest rates and cheap imports…you know the rest. The new reality is
that the US needs to reduce the consumption portion of GDP while
China increases the consumption portion of their GDP. The US needs to
increase its manufacturing and export components while China reduces
their
reliance on manufacturing and exporting. The easiest way to look more
like China is to act more like China. If the undervalued yuan
stimulated exports and manufacturing while suppressing consumer
spending, why wouldn’t an undervalued US dollar do the same? A weak
dollar is the economic agent to restructure our economy. Furthermore,
the only way to get China to appreciate the yuan is to force inflation
upon them. By pegging to our currency, they adopt our loose monetary
policy, which simply adds accelerant to an already speedy economy.
Social Re-organization - Points
1-4 translate directly into portfolio strategy, as I will exhibit in
the next
section. Debates around the restructuring of the healthcare, financial
services and energy industries are nothing more than that at the
moment. Furthermore, any re-organization of these enormous sectors of
our economy will take years
to accomplish. And, as
Americans, if we are not happy with our chosen path, we simply vote in
new pathfinders. To me, these incendiary topics have "potential"
labels
on them while 1-4 have "essential" labels on them. The investment
implications of these re-organizations shift hourly as the debates
migrate. Trying to align your portfolio with the legislative process
is like sailing a rudderless boat. Who knows where you will end up,
and you will likely get seasick.
W&A’s Playbook
Capture Market Upside - The
amount of fiscal and monetary stimulus administered globally ensures
economic
recovery. Our outlook for stocks and corporate bonds has been and
remains positive. Furthermore, as risk appetites improve, riskier
market
segments tend to outperform. Our exposure to small cap stocks and
emerging markets demonstrates this thesis.
Avoid Government Debt - To
finance the government’s strategy of absorbing private sector debt
balances,
the Treasury must issue substantial quantities of bonds. While the
global appetite for US debt remains robust, a successful restructuring
of the
global economy will potentially diminish demand. Greater supply and
lower demand leads to lower prices and higher yields for government
paper. Municipal paper adds significant tax advantages to Treasuries
but yields tend to correlate. Any municipal or federal paper should
be held in short maturity. The government has four methods to reduce
debt balances over time. First, they can increase taxes.
Second, they can reduce expenditures. Third, they can rely on robust
economic growth to increase tax receipts. Fourth, they can simply
inflate the obligations away. Obviously, inflating away our debt would
irritate our creditors and would be the worst singular solution.
However, blaming inflation on "necessary" stimulus measures might offer
some political cover, and the threat of inflation needs to be accounted
for in
portfolios. Inflation is cancerous to bond portfolios and therefore
necessitates cautious construction of any fixed income allocation.
Managing bonds during rising rate regimes requires vigilance.
Align Portfolios with Global Restructuring - Although
the US represents 20% of global GDP, it will account for
only 5% of its growth rate in 2010. Brazil, Russia, India and China
will account for 70% of global growth. The development and strength of
these economies will dictate industry growth patterns. For example,
the highly successful Chinese stimulus package led to sizable commodity
purchases, increasing values across fuels and metals, benefiting US
materials and energy names and jumpstarting the US stock market. Our
portfolio benefited from having direct exposure to the buyers and to
the sellers. Moving forward, the increase in emerging market
consumption
could be substantial, by some estimates perhaps even greater than US
consumption by 2011. This means terrific opportunities for US
exporters and
emerging market retailers and financial services firms. The weaker US
dollar will also contribute to these developments, and provide greater
dollar adjusted returns for our international holdings!
Respect the US - While we have
steadily been reducing our exposure to the US over the last year, the
flexibility
of the US should not be underestimated. If the government’s
initiatives on entitlement reform reduced our long-term obligations,
the US
dollar would soar; further attracting global investors (see
1995-2000). While the US may produce relative underperformance in
global
advances, it produces relative out-performance in global retractions.
Remember that in 2008, the US dollar advanced, and the stock markets
held
up much better than those of our more fleet-footed friends. US policy
debate may be heated, but that process defines democracy, the most
proven
economic governance system ever. While W&A’s long-term investment
strategy revolves around the developing world, so do the strategies of
many US CEOs. Recall that through the first eight months of 2009,
General Motors has increased car sales in China by 50% over last year.
US headquartered corporations will provide their investors with global
earnings power, and our portfolios will benefit.
Back to the Poignancy
As I stated, the race from
Bretton Woods that will be underway as you read this proves poetic. In
1944,
representatives from 44 allied nations gathered at the Mount Washington
Hotel in Bretton Woods to establish the US dollar as the world’s
reserve currency. Now, 65 years later, in the aftermath of 2008’s
financial crisis, confidence in US fiscal sovereignty has eroded
significantly. With the dollar’s relative valuation extending its
declines to ever lower levels, it may seem that the world is running
away from Bretton Woods. Add to this ego blow the cacophony of
political discourse and the inflammation of today’s invasive
technologies,
and this can be a very unsettling time for Americans. It seems as
though our governing principles, values and institutions are all being
interrogated at the same time.
Many I talk to simply cannot
bear the confusion and have chosen to increase levels of cash and
bonds.
Ironically, if the US truly is in a state of decline, the worst place
to hide is in cash and bonds, which will suffer significantly with a
weakened
currency and higher inflation. If you find yourself troubled by the
path being drawn by the leaders of the US, consider the path being
drawn by
the leaders of the planet. At no other point in history have so many
global inhabitants been exposed to the benefits of democracy and
capitalism. Truth be told, "Americanism" is not in decline, it’s
spreading like wildfire. Our share of the global economic pie may
shrink, but the overall growth of the pie benefits us much more than a
larger chunk of a smaller pie. The S&P 500 hasn’t climbed back
above 1050 because US policies have ignited growth, but through the
collaborative policy efforts of our global partners. While this shift
in
leadership may feel awkward to us, distributed responsibility makes for
a more balanced and resilient global economic regime.
As I leave Bretton Woods, I
can’t help but admire the remarkable work that was done here to
construct a
post WWII global economic order and the position of US economic
strength at its center. Alas, 65 years have passed and the economic
prosperity
of the globe has improved immensely, poverty has declined and peaceful
interrelationships abound. Mission accomplished! It is also not
lost on me that finishing the 200 mile race we are embarking on
requires the effort of twelve of us and could not be accomplished by
any one of us
alone. The current G20 will meet next week in Pittsburgh to discuss
various measures, but it is clear that ex-US contributions and global
coordination continue to increase. While many may claim that these are
the worst of times, I assure you they are not. Do not confuse the
sensationalized relative decline of America with the very real global
rise of Americanism. We have not ended an age of prosperity, we have
simply entered a new one…and there is money to be made in this age too!
Remember: Performance is not an outcome, it's a discipline.
Please let us know if you have any questions or comments.
* Equity model & bond model composite information and disclaimers are available upon request.
**This blog represents the opinion of W&A and is for
informational purposes only. It is not intended to be construed as tax
or legal advice by
the recipient. Past returns of investment are no guarantee of future
results.
***Any data reported in this blog has been compiled from the Wall
Street Journal, Morningstar, Investors Business Daily, or various other
informational internet sites.
As if simply following the
media script, markets finally pulled back again this week after
relentless gains.
Measuring the severity of the fall, last Friday we closed at 1,020 on
the S&P, today we will wrap up near 1,010, marking a 1% reversal.
Yikes! For the
sake of metaphor, the stock market acts like a bobber on a rising tide
of cash; each time bearish traders bite, the bobber descends. However,
given
the bears’ limited ability to set the hook, the bobber ascends to its
natural location on the undulating cash. The point is, the news flow
continues to keep the bears’ bite far too weak to pull this market
down. The index has essentially flat-lined for the last month, making
it
susceptible to declines. Yet whenever these declines manifest they have
been met with waves of cash and bullish news flow. This makes a
difficult
environment for short sellers (those who wager on declines). Pauses and
pullbacks are merely pit-stops in the race toward higher levels and we
welcome
them. What’s perhaps most notable about this month-long period of
digestion is how uncooperative stocks have been with the "pullback"
paparazzi. Alas, the most interesting action this week came not from
the stock market but from the metals markets as gold kissed $1,000 an
ounce. This
move created media excitement and journalists seem to get the most
creative when it comes to reporting the mysterious drivers of gold
prices. I will
devote some attention to this topic as well as inventorying the week’s
economic data, and then let you out of school early to enjoy your long
weekend.
Economic Roll Call
The first week of a new month
gives us the most useful economic data. This week the totality of the
indicators
show us that recovery continues. The Institute for Supply Management
releases well regarded indicators on both manufacturing and service
activities,
and both releases this week surprised to the upside. Manufacturing
activity in the US actually grew in August (first time in 19 months)
while activity
on the service sector shrank slightly (highest level in 11 months).
Both of these reports indicate positive trends and significant
improvements from
trough levels reached in the 4th quarter of 2008. Housing statistics continue their improvement as pending home sales advanced for the
6th
straight month and mortgage rates dropped, further encouraging buyer
and re-finance behavior. Furthermore, housing prices increased in
the second quarter compared with the first quarter, adding support to
the notion that the market has stabilized if not turned. With corporate
earnings
rebounding, recoveries afoot in service and manufacturing industries
and a rebound in the housing market, why isn’t employment rising?
Because
it lags! Today the unemployment rate in the US inched up to 9.7%, while
employers shed 216,000 jobs last month. This continuous payroll
elimination
suppresses consumer activity, reflected in the anemic retail sales data
we received this week. Jobs and consumer spending activity re-enforce
each
other and will join this party belatedly. Every economist and most
professional traders know this, which is why the markets advanced today
in the face
of grim headlines. Rest easy when you read your Wall Street
Journal tomorrow; the US economy will be adding jobs six months from
now.
Choose Your Gold wisely
Unprecedented monetary and
fiscal stimuli have stoked economies around the world. If too much
money chasing too
few goods defines inflation, then look out ahead. Legislators spending
like drunken sailors and the decline of US fiscal credibility worldwide
endanger the reserve status of the dollar. Our policies will surely
frighten off the large buyers for US Treasuries, weakening the currency
and
inciting inflation. China will wage economic war on the US, stage a US
debt buyer’s strike and watch the Greenback burn. These are the
financial tabloid headlines of our day. Typically they accompany emails
(that get forwarded to me) with links at the bottom to a gold broker.
Gold
climbed back toward $1,000 this week, so be prepared for gold bug
emails. While we do favor the notion that the dollar will depreciate,
there are
several strategies to profit from that event, so let’s consider the
relative merits of each. (All returns are YTD through 9/3/09.)
The Anarchy Trade:
Gold has no practical
application other than adornment. Gold devotees primarily seek the
metal out as a virtual
bunker to protect capital from politics and central banking. The
easiest way to get to gold directly is through the Gold ETF (GLD). Year
to date
returns? 11.18%.
The Mining Trade:
Gold miners derive their
profits from a combination of fluctuations in gold prices and
management acumen. Many
miners hedge gold, which can be good or bad. The primary input cost for
minors is oil, which can be good or bad. When management, input costs
and gold
prices all move favorably, mining stocks can add exponential movement
to the underlying commodity. Clients of W&A have exposure to this
trade through
our holdings in the Nuveen Tradewinds Global Opportunities fund (up 35%
year to date) and through Royce Value Services (up 30% year to date).
The
easiest way to own the gold miners is through the Gold Miners ETF
(GDX). Year to date returns? 32%
The Priced-in-Dollars Trade:
Most natural resources clear
the marketplace priced in dollars. These non-gold natural resources
benefit from
having practical application. Consider oil. A weaker dollar will drive
oil prices higher, as will increasing oil demand. Therefore, a
strengthening
global recovery coupled with a weaker dollar adds significant
propellant to oil prices – up 52% year to date. Broader energy baskets
offer
greater diversification while still representing the weak dollar,
strong economy themes. The easiest way to own broad energy is through
the
Powershares DB Energy ETF (DBE). Year to date returns? 16%.
The Hard Currency Trade:
For the dollar to weaken,
something has to strengthen. It’s a rule. Perhaps my favorite way to
position for
a weakening dollar is to locate countries whose currencies stand to
benefit and identify attractive investment options there. Consider
Brazil. Brazil
has ample natural resources (see the Priced-in-Dollars Trade, above),
improving management and input costs (see the Mining Trade, above) and
has an
improving sovereign fiscal position. Trifecta! Countries with similar
fundamentals are known to have "hard currencies" that tend to trade
inversely
with the dollar. Here are some year to date currency movements for
these nations versus the dollar: Brazilian Real +20%, Australian Dollar
+15%, New
Zealand Dollar + 13%, Norway Krone +13%, and the South African Rand +
19%. Why buy Exxon in the US (-13.5% this year) when you can buy
Petroleo
Brasileiro in Brazil (+66% this year). Clients of W&A have a good
deal of exposure to this trade but most notably through our position in
Janus
Overseas (up 57% year to date). Other than constructing your own
currency basket, the closest way to gain hard asset exposure is through
the Van Eck
Global Hard Assets fund (GHAAX). Year to date returns? 32%.
My point? Gold gets the
headlines but there are smarter ways to play the theme. Right now
elements of "The Mining
Trade" and "The Hard Currency Trade" populate our portfolios; we also
have a "Priced in Dollars" trade on deck if oil prices dip. "The
Anarchy Trade"
requires far too much mayhem for our tastes.
Enjoy your rest on Labor Day.
Remember: Performance is not an outcome, it's a discipline.
Please let us know if you have any questions or comments.
* Equity model & bond model composite information and disclaimers are available upon request.
**This blog represents the opinion of W&A and is for
informational purposes only. It is not intended to be construed as tax
or legal advice by
the recipient. Past returns of investment are no guarantee of future
results.
***Any data reported in this blog has been compiled from the Wall
Street Journal, Morningstar, Investors Business Daily, or various other
informational internet sites.
In the Fed’s FOMC release on
Wednesday, Bernanke and Co. asserted that from their vantage point, the
economy is "leveling off". This shift in language from "stabilizing" is
both subtle and profound. Essentially the Fed has communicated to the
markets
that we have bottomed, but that they will continue to provide stimulus
until more significant signs of recovery appear (i.e., job gains).
Economic
data released last week was mixed. Retail sales volume came in light,
but homebuilder announcements showed promise. Weekly job data
disappointed,
while productivity numbers surged. Our trade deficit widened, but both
imports and exports logged marginal gains.
This mixed bag simply
represents the realities of "leveling off." Economic recoveries never
simply progress
straight from negative releases to positive releases. As we shift
gears, the economic transmission system will have negative resistance
and positive
force confronting one another. We have shifted out of reverse and into
neutral; we have yet to slide into drive. Signs of leveling off in the
markets
surround us. Looking at our leader, China, the Chinese stock market hit
its highest point on August 4th
and has retreated nearly 10% since
then (it’s still up 73% this year). Oil prices peaked in early June at
$74, trading today at $68 (still up 55% this year). So, those markets
to
reach euphoria first should also be first to test that euphoria, which
is exactly what is occurring. We have moved into the pause that
refreshes
phase.
Remember a few emails back
when I stated that the current market cycle will likely be a stair step
pattern marked
by anticipation, trepidation and confirmation phases? The earnings and
economic news over the last month and a half confirmed the move from
the March
lows to 950 on the S&P 500. The move above that has been gratifying
but probably a touch ahead of schedule. Now the trepidation has begun
and will
likely continue until the next anticipation round occurs in late
October. Remember that market pullbacks are healthy and not in
themselves reasons to
trade (although we would take advantage of temporary mispricings in
energy and/or emerging markets). Pullbacks will likely be seen as
purchase
opportunities for those who have yet to re-commit. For evidence of
this, simply pull a Yahoo chart on the S&P 500 and look at the
intra-day activity.
The S&P has not closed the day at its lowest point since June 22nd.
Peak Seeking
A great deal of typeset has
been devoted to defining the lower bounds on the current market. We sit
today on the
S&P 500 at 1,000, and we bottomed at 666; if we retrace, how low do
we go? Although I have an answer on this (nowhere near 666), let’s
explore
the opposite question. How high could we go? To answer this question,
we need to look at previous earnings cycles and see if we can find
wisdom in the
data. Given the severity of the earnings decline since their peak in
2007, let’s look at previous periods of extreme weakness and see where
we
went from there.
PeriodEarnings
DeclineNext PeakAdvance
June 2007 – March
2009
-92% ???
???
December 1916 – December 1921
-81% Dec 1929
455%
December 1929 – January
1933
-75% Sept 1937
198%
September 2000 – December 2001
-54% June 2006 244%
January 1937 – January
1938
-49% Sept 1941
92%
June 1989 – January
1992
-36% Sept 1997
153%
So based upon this extreme
data (compiled by Robert Shiller), after a trough in S&P 500
earnings, they have
historically advanced between 100-500%. That’s interesting, but it
might be more insightful to see how much higher new earnings peaks have
climbed over old earnings peaks.
Peak
DatesPeak
EarningsIncrease over Previous Peak
June
2007
$84.92
58%
September 2000
$53.70
32%
September 1997
$40.64
61%
June
1989
$25.22
52%
You get the idea. I ran this
analysis all the way back to 1906 and the average advance for a new
peak in earnings
from an old peak in earnings is around 40%. Assuming history rhymes, if
not repeats itself, that would put the next eventual earnings peak at
$119
(40% above the $84.92 from June 2007). Applying a historically
appropriate multiple of 15 times earnings, that would project an
S&P 500 target of 1800
for the next bull run. 1800 may seem like quite a distance from the
1000 where we are today, but I will remind you that the index stood
over 1500 in
the year 2000. What’s my point? While everyone is trying to guess how
deep the next pullback will be, let’s look further forward and try
to determine how high the next advance could be. If history lends any
credibility to this forecasting effort, the end of the next bull market
might
occur around S&P 2000. Make mine a double!
Seasoning
August and September have
historically been the weakest months in the S&P 500, logging
returns of .1% and -.5%
respectively since 1950. With the crosscurrents created by the great
"leveling off," and the historical weakness of this period, this makes
a terrific
time to ladder money into the markets. Late October, November,
December, and January represent the months of greatest historical
returns. Consider
using this pause in the data and various markets to get positioned
prior to the 4th quarter. For those fully invested, keep your focus
further down the line and avoid pullback anxiety.
Remember: Performance is not an outcome, it’s a discipline!
Please let us know if you have any questions or comments.
* Equity model composite information and disclaimers are available upon request.
**This blog represents the opinion of W&A and is for
informational purposes only. It is not intended to be construed as tax
or legal advice by
the recipient. Past returns of investment are no guarantee of future
results.
***Any data reported in this blog has been compiled from the Wall
Street Journal, Morningstar, Investors Business Daily, or various other
informational internet sites.
Students of the Stock Traders Almanac will tell
you that market returns over the best six month period of the year (November 1st thru April 30th) tend to trump those of the
historically worst 6 month period of the year (May 1st thru October 30th.) On average for the DJIA, the November though April
periods since 1950 returned more than 7% while the May through October periods remained flat.Hence the saying “sell in May
and go away!”Just for fun, let’s look back at the six-month periods surrounding this
crisis.
Best
6: Nov 1,
2006- Apr 30, 2007: 8.1%
Worst
6: May 1, 2007 - Oct 30,
2007: 6.6%
Best
6: Nov
1, 2007 - Apr 30, 2008: -8.0%
Worst
6: May 1, 2008 - Oct 31,
2008: -27.3%
Best
6: Nov 1,
2008 - Apr 30, 2009: -12.4%
Start of
Worst 6: May 1, 2009 - May 29, 2009:
4.1%
So the pattern held until November of
2008…so far.With May completed, we have now booked 1/6th of the worst six-month period this year and have
amassed a 4% gain.While seasonality historically plays a role, I believe reversion to the mean tendencies trump
seasonality.Let’s look at the time periods of six-month losses in succession (since 1950) and the returns over the
subsequent six-month periods:
Successive
Six-Month
Next
BeginningLoss PeriodsSix Months
Nov 1,
1959 216.9%
Nov 1,
1961 221.7%
Nov 1,
1965 211.1%
Nov 1,
1968 32.7%
Nov 1,
1973 2 23.4%
May 1,
1976 32.3%
May 1,
1981 2 16.9%
May 1, 1983 23.1%
Nov 1,
2000 29.6%
So on average, over the last 60 years the first
positive six-month period after a succession of negative six-month periods averages almost 12%.Furthermore, there has not been a
fourth consecutive negative six-month period to date.So while the seasonality doctrine may suggest selling in May, the reversion
to the mean doctrine tells you to buy.This is not high finance by any means, but it makes me feel
better.
The Other Markets
We
spend a disproportionate amount of time in
these weekly emails discussing the stock market. Now that corporate
earnings season is behind us and the conviction around economic
recovery has
firmed, the stock market needs to look for inspiration elsewhere.Moves in the stock market as of late have been reactionary to
moves in the bond, currency and commodity markets, so for this week let’s turn our attention to these markets.
Bonds
Last year the only bonds worth owning
were US Treasury bonds.This year they have become toxic within portfolios.The 10-year Treasury bond yield
has risen rapidly from 2.25% at year end to 3.55% today.Remember that prices fall when yields rise, so that amounts to large
losses for Treasury bond holders.Inversely, corporates and municipals have rallied strongly.10-year
municipal
yields that were 4.46% are 3.45% now, while high yield corporate bonds
were 19.5% at year-end and 14% now, serving up ample returns for
holders.(As an example, the high yield allocation in our bond model has appreciated 21% year-to-date).This
recovery in the risky sectors of the bond market reconciles with growing conviction in economic recovery.However, the increase in
the Treasury bond yield has raised eyebrows.The speed and trajectory of the advance has stock market watchers concerned that key
economic rates like mortgages will soon follow, choking off some of the oxygen to the economy.The
Fed has committed to purchasing
Treasuries with $300 billion of their capital to suppress rising
yields, but with Treasury issuance in the trillions, the $300 billion
is nothing more
than a gesture.The most critical element of current market anxiety centers here.Look for the 10-year yields to
stabilize a bit, calming market fears.The next 10-year Treasury auction occurs next week.Light participation
would validate concerns that foreigners are hesitant to hold longer-dated US debt.This could have negative implications for the
stock markets as worries persist about US solvency.Heavy participation would pull this concern from the headlines and bolster
stocks.Either way, the US is funding all of its bailout initiatives with very cheap money historically.I
don’t believe the US will be a banana republic, but this is the wall of worry stocks must climb to move higher.
Currencies
The action in the US dollar has drawn vast
attention.Remember that currency prices are relative.While the global economy is $48 trillion, the sum of all
the financial assets equals $167 trillion.This total moves with mouse clicks and can cross borders on command.With all of this global money sloshing around, any shift in currents can have a huge impact on currencies.Consistent
with
the move in Treasuries, when the global investor panicked in 2008, the
dollar increased dramatically as Americans repatriated their foreign
holdings
and foreigners sought the safety of the dollar.Between July 15th, 2008 and March 9th, 2009, the dollar
rallied 23%.Since March 9th the currency has fallen 11%.This slide contains elements of offshore
risk-seeking activity, foreign repatriation and growing concern over the sanctity of US Treasuries.As with the change in
Treasuries, a measured move meets with expectations, while an exaggerated move raises concerns.A decrease in confidence in the
dollar will lead to foreign and domestic selling, seeking the relative safety of stronger currencies or commodities.In
my view, a
dollar slowly drifting lower meets multiple agendas; a dollar falling
precipitously would require intervention (either foreign or
domestic).As demonstrated, governments are no longer passive players.
Commodities
If you have real concerns about the quality of
US debt or the soundness of the US dollar, buy oil!Oil prices have rallied from below $40 a barrel in February to $67 today, a
70+% move.Add to the concern the economic optimism trade, and you have powerful propulsion.
Since gold does not benefit from economic expansion per se, but
more from heightened anxiety and dollar concerns, the move in gold
offers more
insight into US solvency fears.Gold has vaulted in the last six weeks from $870 to $978, or 12%.These
speculators have only one wish, the demise of the US dollar.While that may not be patriotic, we do have bets alongside
them.Broader measures of US commodities such as the Dow Jones and Reuters commodity indices have advanced 5-8% year to
date.Commodities offer the double benefit of being offensive in an economic recovery and defensive in light of dollar
declines.We have been progressively moving more money here.
So there you have it.At the
risk of being redundant, the economic recovery trade is on, and the US insolvency trade has now begun.The staggering advance off
of the March 9th low indicates that the stock market believes in earnings recovery.Now the debate rages in the bond,
currency and commodity markets over whether the US government can afford the clean-up bill.The insolvency trade is short
government bonds, short the US dollar and long commodities.We currently have negligible Treasury bond exposure; we are
overweight commodities and have more than 30% overseas.Our most recent conversations have explored expanding our exposure to
foreign and commodity-based holdings.The issue is not whether this is prudent; the issue is how much exposure becomes imprudent.
* Equity model composite information and disclaimers are available upon
request.
**This blog
represents the opinion of W&A and is for informational purposes
only. It is not intended to be construed as tax or legal advice by the
recipient. Past returns of investment are no guarantee of future
results.
***Any
data
reported in this blog has been compiled from the Wall Street Journal,
Morningstar, Investors Business Daily, or various other informational
internet
sites.
Earlier this week, Stacie and I had a terrific opportunity to travel to Washington for a comprehensive debriefing.Through my membership in the Society of International Business Fellows (sibf.org), we gained access to outstanding individuals who offered us insights and perspectives on the most pressing issues of the day.As the government extends its reach into the private sector, reformatting policies and regulations, politics becomes an active variable that requires more weight in today’s macro-analysis.The first challenge for us as investors is to decode the messages coming out of Washington; the second is to determine the investment risks and opportunities associated with these messages.Not an easy task.While shifts in policy and governance paradigms can affect investment returns at the margin, larger geo-political events can lead to dramatic gains or losses.Therefore, we must be sensitive to the marginal items (i.e. tax policy changes) and also to the major items (record fiscal deficits), and have investment playbooks for each.After a short overview of this week’s market events, I will offer perspectives on our Washington briefing in today’s edition.I hope my perspectives are enlightening at some level, recognizing that my biases will color the message.I try to stay a-political.I am a member of the investor party first and foremost.At a minimum, my report to you will save you the cost of a plane ticket, Washington hotel rates, and hours of sifting through Washington-speak.
Just another 5% week
Markets converted more non-believers this week as economic data globally met with positive spin.As expected, the bank Stress Tests were nothing to stress over.Just to validate, the KBW Bank Index rallied 29% this week.Simply put, none of the 19 banks scrutinized are going to fail, the additional capital necessary to meet the government’s “stress” scenario appears modest and the capital can likely be raised without further government control or shareholder dilution.Additionally, the TARP fund looks adequate and may even be replenished with paybacks from some of the healthier institutions.Good news… this may be one of the final acts in the 2007-2009 credit crunch drama!Assuming the banks can raise the capital required (highly likely), they will have met the solvency criteria of the Treasury, FDIC and investment community.Barring a new collapse in housing, or something of equal magnitude, the banking system has officially recovered going concern status.To confirm this hypothesis, LIBOR spreads (the interest rate banks charge each other over and above Treasury or swap rates) have narrowed to levels not seen since last August.The LIBOR-OIS spread peaked at 3.64% in October of 2008, and stands today at .73%. If the stock markets joined these credit markets in returning to pre-crisis levels, the Dow would rise above 10,000 and the S&P 500 above 1,100.That level discounted recession and earnings headwinds.The decline between S&P 1,100 and 666 discounted the end of the banking sector and capitalism.With capitalism and financial services now preserved, the waterline may naturally rise toward that range.I can make a case for it and judging by the ticker tape, others are making the case as well.
In Washington We Trust
To apply some structure to these comments I will highlight the topic and speaker, and then offer my impressions and strategic implications for investors.
America on the Brink of Financial Crisis: David Walker
As the previous Comptroller General of the United States and the head of the Government Accountability Office, David Walker has the most sobering and accurate view of the US financial condition.In his opinion, we will survive the first sub-prime crisis in housing, but we may not survive the second sub-prime crisis in government.The growth in deficits and national debt are well documented; what remains undocumented is the plan to reduce them.David hopes that a committee will be appointed to draft and deliver a fiscal responsibility plan sometime this summer.The debt course that we are currently on is unsustainable, period.Unless we reform our entitlement spending and restrict our discretionary spending habits, we jeopardize our credit rating.Any tick lower in the US AAA rating would initiate a series of consequences that in cumulative could lead to the undoing of our supremacy, ala Britain in the early 1900’s.Walker was optimistic, however, that the political process could meet this challenge and therefore preserve our status.I agree in theory, but the investment strategy, given the concern surrounding the issue, must be to have geographic and currency diversity in our portfolios.
The Obama Agenda – The Media View: The First Hundred Days
Candy Crowley of CNN fame probably headlined this panel, but John Mecurio of The Hotline and Anne Kornblut from the Washington Post offered insights as well.Truly the takeaway here is that the media have been bewitched by the Obama administration and though they retain mild skepticisms for the appearance of impartiality, they will not be an impediment to the administration on policy initiatives.In the political process, the absence of protest outweighs the presence of support.With large agenda items, this protest-free distribution network provides the White House with a considerable advantage.The implication for investment strategy is that the media support only increases the likelihood of Obama’s ideas becoming America’s policies.
A View From Abroad
Sir Nigel Sheinwald, the British Ambassador to the US, began his discussion with traditional dry English wit.His discussion concluded with the cautions of protectionism.The reversal of free and open trade initiatives would handicap economic growth prospects worldwide.Concern seems to be brewing that the United States may lead the world with a separatist agenda.Coincidentally, as he urged us not to reverse the gains of globalization, the White House issued its plans for taxing US corporate profits earned abroad, claiming that the existing tax system encourages US corporations to ship jobs overseas.Without getting into the particular merits of this argument, this cannot be seen as an olive branch extended to our trading partners.From an investor standpoint, a reduction in trade activity leads to a reduction in overall economic activity, making the hunt for relative growth more meaningful.Emerging economies maturing their consumer base, with low leverage ratios and without large fiscal debt burdens, may sustain above average growth rates.Furthermore, corporate expatriates bring new skills and capabilities to host countries.
Views from Within – White House Briefing
By far, I found this session the most enlightening.Valerie Jarrett, one of Obama’s most trusted advisors, was scheduled to host us.She cancelled at the last minute and arranged to have her chief of staff host us.He also cancelled at the last minute.Oh well, we still had a strong line-up of three staffers.Almost.One had just joined the Commerce Department last week, and another had responsibility for our Russia policy, which clearly hasn’t been edified yet.The most compelling staffer was Bob Kocher, MD, one of the chief architects of the Obama healthcare plan.His knowledge and experience gathered confidence among the group until he revealed how limited his role will truly be, since it is up to Congress to draft the plan.The White House simply drew a broad outline and looks forward to the strategy and plan Congress will construct.Dr. Kocher expressed very little confidence that Congress would return a plan that met his criteria.“So goes the political process”, he said.
This meeting concluded with remarks from Elizabeth Vale, who acts as the White House’s business liaison.She has a terrific business background, and her responsibility is to construct demonstrations of policy.For instance, to elucidate for the press the $8,000 first time homebuyer credit, the liaison might have the President walk a first time homebuyer through the process before the cameras.Noble enough, except that she kept referring to the participants as “real people”, which is what the White House considers those outside. I asked the person sitting next to me if he felt, given the tax revenue represented in the room, that we had been snubbed by the White House.His response was that while we might represent a good deal of tax revenue, we have very few votes.Point well taken.
My takeaway from this session was that the White House knows exactly where they are going and will happily report on their progress, but they will not be asking for directions.The investment implication?Coupling the tenacity of the White House with an accommodating media, change is not only coming, it’s certain.The costs and benefits of these changes remain to be seen, but status quo has few allies in DC.Our portfolio allocation to healthcare stocks is currently half that of the S&P 500.
Opposing Views
Representing the left was Howard Dean, former Vermont Governor and Democratic Committee Chairman.Representing the right was Ed Gillespie, former Chairman of the Republican National Committee.This session was terrific.Both of these individuals were outstanding and found plenty of things to disagree about, as you might expect.The one thing they could both agree on is that the Republican Party has been evicted from Washington.Essentially, the pendulum will not swing right unless the Democrats make a highly visible mistake.The Republicans cannot pick up the ball until the Democrats drop it.I did ask them what they thought the strategic implications were of having a majority of Americans not paying income taxes.Dean responded that this was not an issue, since these individuals will be paying payroll taxes, property taxes, etc.In his words, “we’ll get them one way or another.”Gillespie responded that it was a huge issue, but he didn’t seem to have a strategy to reverse it, or monetize it for voter gain.The investment implication?Presently, there is no credible counter agenda to the Democratic agenda.Resisting government initiatives at the moment is a money loser.Getting in front of government initiatives is a moneymaker.
A Challenged World – The Center for Strategic and International Studies View
This panel couldn’t have been more enlightening.Anthony Cordesman described the Middle East as a tinderbox where the front has expanded from Iraq to Afghanistan, Pakistan, and Iran as well.Of the 30 countries in the Middle East, seven pose strategic threats to us at the moment.Even if we rooted out Al-Qaeda and the Taliban, the region would remain hostile toward us.Andy Kutchins described Russia as a nation confused (as always).Their confidence and capabilities rise and fall with the price of oil, making them perpetually unstable.Charles Freeman spoke about China, which has navigated the crisis well, although regrets being pushed to the forefront as a burgeoning superpower, preferring to keep its powers obscured.My sense is that the US lacks a defined China policy, which breeds caution and mistrust between us.Ultimately, we are business partners and should treat each other as co-dependents.Investment takeaway?The Middle East is a mess.Russia is a trade but not an investment.The economic future of the planet is the US-China relationship.We should have a policy for it.
In Conclusion
I returned from this trip with deep respect for what the Democratic Party has accomplished.The Republicans dropped the ball, and the Democrats were quick to pick it up, and they are running with it without much opposition.Whether you agree with their ideology or not, they have put the machine in place quickly, and it is operating.
The best of the status quo revisions would be entitlement reforms.David Walker thinks this may be possible with this administration.This would be structural reform, making us more economically viable, and preserving our AAA rating.The worst of the status quo revisions would be an over-reaching government without fiscal sensibilities that crowds out private industry viewed as insensitive to the American “middle” class.This magnified class warfare would weaken us and confuse our country’s founding virtues. The polls demonstrate that American’s have gone to their ideological corners.
Nonetheless, the Obama administration has achieved a 60% approval rating, won over the media, built a filibuster-proof Congress, and you can keep track of it all on Twitter.With an unobstructed pathway to reform, look for the pace of legislation to be relentless until the 2010 elections.America will then have the chance to re-assess.
* Equity model composite information and disclaimers are available upon request.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.
To view the 2009 State of the Union videos on Youtube click here.
From Housing…
We concluded last week’s edition of the Strategic
Insight with the following:“We will need other areas of the market/economy to join the party to build on this
momentum.Our most important invite outstanding is to the housing industry, and they appear to be considering
it.”
The housing data released this week proved
inconclusive.On Thursday, the National Association of Realtors released data on existing home sales.Those
sales declined by 3% from February to March, while the median selling price of existing homes fell 12% from a year earlier.February existing home sale figures were also adjusted downward.In addition, half of the March home sales were byproducts
of foreclosure.
Today, the Commerce Department revealed that sales
of new homes declined by a mere 0.6% during March.That downturn was much milder than economists’
expectations, and February new home sales data was adjusted upward.
First-time homebuyers are moving into the
market.In fact, those first timers represented half of the existing home sales in March.President
Obama’s
tax credit appears to be gaining traction with the intended target, and
we have personally encountered people in the Memphis area who
are making their first purchase with the tax credit in mind.
We have also had questions posed to us regarding
the mechanics of the tax credit.Here is a snapshot, but please consult with your personal tax professional to see if you might be
eligible.Married filing jointly taxpayers are eligible for a tax credit if they make a first-time home purchase between
1/1/09 and 11/30/09.The tax credit is equal to the lesser of 10% of the purchase price or $8,000.For
those
married taxpayers, the credit begins phasing out for modified adjusted
gross incomes over $150,000 and is completely reduced once the income
reaches
$170,000.As a general rule, you are a first-time homebuyer as long as neither you nor your spouse owned a principal residence in
the 3 year period preceding the date of your current purchase.If you maintain the home as your principal residence for 3 years
going forward, you never need to pay back the tax credit.
…To
Banks…
Oh, to be a fly on the wall in major bank offices
today!Federal regulators are meeting privately with the bank brass to give them the results of the infamous stress
tests.The Fed recently applied those tests to the nation’s 19 largest banks.One test applied current
economic conditions to the bank balance sheets, while another test factors in a much bleaker economic picture.The
goal is to
separate those banks that might need continued capital infusions from
Washington from those that are able to stand under their own power.The Fed will publicly release parts of the stress test results on May 4.Until then, expect leaked information to have a
large impact on financial stock performance.
…To Revenue
It
surprises no one that business conditions for the
first quarter were dreadful. Tepid credit markets, fearful consumers
and defensive corporations simply remove revenue potential from the
economy. This revenue evaporation has been non-discriminatory. In
fact, revenues have fallen 11% on average across the first 30% of
the S&P 500 companies that have already reported. Earnings have
fared worse, falling 18% below this time last year. Yet, to date,
these
reports have added credibility to this most recent market rally. Why?
Because analysts expected earnings to be 20% worse. Corporate
America has adapted their operations quickly to the revenue shortage.
While unemployment and delays in investment spending please no one upon
announcement, they do indicate that corporations are “right-sizing”
quickly to the operating environment. If corporations
can scale to the new revenue environment, earnings can stabilize. It’s
the delay between shrinking revenues and shrinking expenses that
harms earnings most. Earnings will trough once companies can align
expenses with revenues. Based upon the cautious guidance that
corporations are issuing, and the continued displacement of workers, we
are not there yet. But we are moving rapidly closer. What will
truly astound investors will be the earnings momentum that will return
with even modest upticks in revenue. Current forecasts for 4th
quarter 2010 earnings, if realized, would provide earnings growth of
70% from today’s levels. While that may sound optimistic, that
absolute level only takes us back to the earnings environment in the
first quarter of 2006. The market P/E that quarter was 16.35. Doing
the math, that amounts to 1,359 for the S&P or roughly 63% higher
from here. The bottom line is that companies have shed capacity and
continue
to shed capacity to adapt to the revenue environment.Any up-tick in revenue will lead to significant earnings growth and market
returns.
The market has shown tremendous resiliency
lately.Ford released encouraging numbers today.Those
figures, combined with the better than expected new home
sales data referenced earlier, have allowed the S&P 500 to scratch
and claw today towards a seventh straight week of gains (closing just
0.4%
short), even after Monday’s 4% decline.
Please let us know if you have any questions or comments.
* Equity model composite information and disclaimers are available upon
request.
**This blog
represents the opinion of W&A and is for informational purposes
only. It is not intended to be construed as tax or legal advice by the
recipient. Past
returns of investment are no guarantee of future results.
***Any
data
reported in this blog has been compiled from the Wall Street Journal,
Morningstar, Investors Business Daily, or various other informational
internet
sites.
The family trip to Disney World has done wonders
for Disney shares.Our adventure last week drove them up 8%.Orlando appears to be recession resistant since the
Magic Kingdom shut the entrance twice while we were there due to overcrowding.As an analyst, trying to define the capacity of the
park multiplied by the ticket price plus accoutrements, I was overwhelmed.Let’s do some math.The
attendance figures in 2007 across all four parks in Orlando equaled nearly 47 million visitors.I don’t know what the
average ticket price is, but multiply anything by 47 million and it’s a big number.This
excludes accommodations, meals,
balloons, light sabers, princess dolls and the obligatory pictures at
each ride of your contorted faces as the coasters go into free fall.It swept through my bank account like a bush fire.Here is the takeaway: consumerism may be under duress in America at the
moment, but I am hesitant to support forecasts of a new, responsible American consumer.For Disney to be completely sold out with
the jobless rate at a 30 year high speaks to the voraciousness of consumers.Furthermore, with the social safety net spreading
wider and wider for “average” Americans, why not spend a little green as the consequences diminish?And yes, beyond
all of the economic musings, we did ride the rides and took about a thousand pictures.
Did I Miss It?
The markets have continued to climb higher.Before I address whether it is justified, I’ll offer perspective.The S&P 500 peaked on October 11th, 2007
at 1,576.A year later on October 10th 2008, in the midst of the financial roller derby, the S&P hit 840, amounting to a
decline of 47%.In my opinion, October 10th, 2008 marked the true market low as most of the world markets began trending
up from there.For the US, the ultimate low wasn’t reached until March 6th, 2009 at 666.Today, the index trades at 867.Here are some potential ways to view this:
“The market has run too
far.”The market today stands 30% above its March low, making it a little pricey to buy at this point.Sell High!
“The market is the deal of the
century.”The market today stands 45% below its 2007 zenith.Buy Low!
“The market has
stabilized.”The market today stands 3% above its October 10th, 2008 low.The buying decision
today is mathematically equivalent to the buying decision on October 10th.Doing nothing seems just
fine.
Which perspective appeals to you?Numbers are just numbers; meaning comes from your interpretation.Allow me to widen the lens a bit.
Between 2004 and 2008, the S&P 500 fell -2.2%
annually.Since 1927, negative 5 year runs have occurred 8 times (prior to this most recent period).Here is a
table showing the returns of the next five years, following each of these periods.
Time
PeriodReturn
(Annualized)Next 5 years (Annualized)
1927-31-5.1%22.5%
1928-32-12.5%14.3%
1929-33-11.2%10.7%
1930-34-9.9%10.9%
1937-41-7.5%17.9%
1970-74-2.4%14.8%
1973-77-0.2%14.1%
1998-02-0.6%12.8%
So on average, coming out of a negative five year
period, markets climbed 14.8% per year, ranging from 10.7% at the worst to 22.5% at the best.So, what do you think the next five
years are going to look like?If you extend your measuring stick out to five years, the range for the S&P 500 falls between 1,500
and 2,500, representing absolute gains of 73-187% from where we are at the moment.Interested?
You have not missed it.Although
W&A’s equity model is now positive for the year*, the S&P is still negative.If you still have a cash balance,
it’s time for your re-entry plan.Cash needs to be folded in.Whether the market moves higher or lower
over the next 6 months is only relevant emotionally.The value of the market 3, 5, 10, 20 years from now is what’s truly
relevant.‘Sell low, buy high’ decision making dominates the retail investor mindset.Do not
allow these tendencies to direct you.It is not too late.
Mixed Signals
Debate has returned to Wall Street!The earnings, economic and technical indicators have now become mixed.A month back, the debate was moot, the picture was
bleak and there was no denying it.Now we have the grist for a bull-bear debate.I cannot overstate the
importance of this shift.Dialogue has now moved from the Great Depression to the slope of recovery.While I
expected this to occur, I did not expect it so soon.1st quarter bank earnings reports have stepped well over the low
bar that had been set for them.Make no mistake; the banks are what this rally has been all about.The 19 that
have been subjected to the stress test have rallied an average of 103% in the last month.Reality has now confirmed rising
expectations.We will need other areas of the market/economy to join the party to build on this momentum.Our most important invite outstanding is to the housing industry, and they appear to be considering it. We will keep you
posted.
Please let me know if you have any questions or comments.
* Equity model composite information and disclaimers are available upon
request.
**This blogl
represents the opinion of W&A and is for informational purposes
only. It is not intended to be construed as tax or legal advice by the
recipient. Past
returns of investment are no guarantee of future results.
***Any
data
reported in this blogl has been compiled from the Wall Street Journal,
Morningstar, Investors Business Daily, or various other informational
internet
sites.
I remember having breakfast with one of our treasured clients on Thursday, September 18th.He asked me if I felt that the markets could repair themselves.I responded emphatically, "No."The degradation of the financial system coupled with the collateral damage in the real economy would cause economic activity to halt.The only force powerful enough to kick-start a stalled economy would be the government, and we fully expected a governmental response of considerable magnitude would be announced within days.Friday morning, Treasury Secretary Paulson laid out the case and parameters for the TARP package that would provide $700 billion in rescue funds to be used as the Treasury saw fit.The S&P 500 rallied 11% from the low on the 18th to the close on the 19th.After a week of discussion and negotiations, with the market treading water, the House voted no on September 29th (a moment still unrivaled in its idiocy).The market fell nearly 10% on the next trading day and almost 30% over the next 10 trading days.The investment community went into that legislative discussion full of hope only to be aghast at the process that followed.Bad Surprise!
Now the situation may be reversed.Two enormous packages will reveal themselves this week as the fiscal stimulus package moves toward a vote and the new Treasury Secretary Tim Geithner unveils TARP II.The once bitten investment community has deeply discounted the potential effectiveness of these programs, driving stock prices down to the bottom end of the current trading range in anticipation.The risk from this position is not that the programs are flawed, that is what’s expected; the risk is that the programs might be effective. Good Surprise!It is to this end that the markets have been rallying into the weekend as traders recognize that if the legislation proves rational, logical and even mildly promising, they might once again be caught on the wrong side of the trade.Better to close out the short positions and see what unfolds.That is why the market completely blew off the announcement Friday morning that another 600,000 jobs were shed in January and that the unemployment rate has lurched from the cycle low of 4.4% to 7.6%.
In other words, we know things are bad, we have reflected that in asset prices.The market expects little from the Keystone Cops in Washington.With expectations low, any eclipsing reality will move markets.The risk is now to the upside. Tune in this week! It’s Showtime.
What in the World
Now that we have 10% of 2009 behind us let’s take a look at the planet and see where the money is flowing (priced in US dollars):
2009 YTD ReturnsTrailing Year Returns
Chile:+14%-50%
Brazil:+11%-50%
Norway: +3%-56%
While 2008 was certainly shocking and painful, the liquidation trades worldwide over-rode any fundamental differentiators, so let’s concentrate on the more rational 2009 results.
These top three markets have some common elements.Chile has a budget surplus, a strong banking sector, and an economy driven by commodity exports.Brazil has a slight budget deficit, has an ever improving credit rating, and has the most advanced balance between trade and domestic GDP generation in Latin America.Norway runs a large budget surplus and a large trade surplus. Their economy revolves around oil production, but they used the run-up in oil to hoard capital, effectively creating a self-insurance policy.An honorable mention must be made for Saudi Arabia, which is slightly negative this year, but also has a nice budget, a trade surplus and obvious natural resources.The bottom line is that although earnings and demand are falling worldwide, the countries that have stronger financial disciplines in place to weather the downturn, and an abundance of natural resources to participate in the upturn, seem to be attracting capital.To test a theory, one must consider the negative articulation as well.Here are the bottom performers:
2009 YTD ReturnsTrailing Year Returns
Romania:-50%-78%
Poland:-32%-65%
Nigeria:-32%-73%
Romania’s economic condition includes twin deficits, both budget and trade.Natural resources are pretty limited, so they rely on industrial output and a domestic consumer.Poland also suffers from twin deficits and few natural resources.Nigeria, rich in both natural resources and corruption, also suffers from budget deficits and an overall lack of credibility.So the inverse proves the rule.Global capital currently favors countries with deep pockets and natural resource reserves.This seems like a prudent litmus test at the moment and has led us to some portfolio manager discussions, as we consider our international exposure for the remaining 90% of 2009 and beyond.
Survey Says
The economic data released so far profiling January have actually surprised to the upside, if you can believe it.The ISM manufacturing index expressed that we are in a deep contraction, but registered a more moderate reading than expected.The same can be said of the services reading.Both ticked incrementally higher than December readings. Employment came in weaker, bad for consumers, but productivity came in higher, good for companies.Those who remain on the job actually saw incremental wage gains in January while the hours worked held steady.The economic weakness most clearly centers on the household indicators, such as employment, consumer borrowing, and household spending activity, which are all weak.Households tend to carry more votes than corporations, so the weight of the stimulus activity will naturally fall there.Corporate earnings for the 4th quarter have been ugly.273 companies of the S&P 500 have reported earnings, with total net income figures 40% below year ago levels. Even ex-financial earnings have fallen 22%.2009 earnings estimates continue to fall with an 8% net income decline expected for the year compared to a decline of 13% for 2008.Halfway through earnings season, even positive earnings surprises outnumber negative surprises by below average margins. So survey says: economic data weak but stabilizing, employment weakening at a consistently rapid pace, and earnings deteriorating, albeit at a less dramatic rate of change.
Remember this: Investment Returns = Reality - Expectations, and even in the face of grim political and economic realities, if the expectations fall even lower, it’s a recipe for gains.While that may seem twisted to some, it was beautiful to watch last week!
Enjoy!
David S. Waddell
Senior Investment Strategist
Media Mentions:
David S. Waddell commentary, Washington Post, Tuesday, February 3, 2009.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.
If you haven’t picked up a copy of Thursday’s Wall Street Journal, please do. It reads like Hemingway. I laughed, I cried, I liked it better than "Cats." The world suffers no shortage of drama at the moment. Our new Treasury Secretary has initiated a dangerous economic tiff with the Chinese. First, he accused them of manipulating their currency, and then they accused us of ruining the world economy; both of which are true. Nonetheless, given the fact that we need to sell $2 trillion in Treasury bonds to finance our “porkulous” package and they just happen to have $2 trillion in cash, perhaps we should wait until we cash the check to pick the fight.
Also adding dramatic flair was Russian Prime Minster Vladimir Putin’s declaration that the US dollar makes an irresponsible global currency, which might draw attention to the fact that his own currency has collapsed. Furthermore, when Dell CEO Michael Dell asked him how his company might help them develop Russia’s IT infrastructure, he responded, “We don’t need your help.”
Also last week, after two days of meetings, the Fed issued a prepared statement that read like an Escher drawing, seeing as it has cut interest rates to zero already and has previously committed to reflating the economy by any means necessary. As a poker player, the Fed is more or less all in, and has “called” the economy. In a sign of bi-partisanship, the Obama camp held a cocktail party to woo support for the stimulus bill from Republicans, who demonstrated their gratitude by unanimously voting against it. Eleven of his Democratic allies defected as well, likely bitter that their pork never hit the grill.
Wall Street resumed its animal spirits by rallying for 4 straight days, led by the financial sector, which may soon have the opportunity to swap their $2 trillion of toxic assets for taxpayer funds or freshly minted dollars. With the market economy spending all day watching C-Span 2 and trying to trade off each political suggestion, these times make for high drama. Thursday’s sell-off stems from memories of the TARP debate, which precipitated a 30% decline in the major indices. A repeat of this tomfoolery seems unlikely, but not guaranteed.
4th Quarter More Like an8th
GDP reports Friday told everyone what they already knew. The economy shrank significantly in the 4th quarter at the hands of timid consumers, although less than the 5.5% Wall Street expected. GDP shrank by 3.8%, the most since 1982. Consumer spending fell 3.5% after falling 3.8% in the 3rd quarter. For the year, the US economy expanded a mere 1.3%, down from 2% in 2007. Looking into 2009, the high inventory levels will likely steal from GDP in the 1st quarter. Here is the bottom line: the US economy has been far too dependent on debt-fueled consumption and must restructure. Consumer spending dominates our economy and with unemployment rising and confidence falling, it cannot be relied upon to lead us out. Household saving rates have risen from near 0% to 2.9% as frugality reigns. With the consumer hibernating, investment activity gasping for credit and export markets suffering their own declines, the burden of economic advancement falls on the government. Government spending increased 5.8% in the 4th quarter, while consumption fell 3.5%, investment declined 19.1%, and exports decreased 19.7%. This is why the debate over the stimulus package is not “if” we need stimulus, but “how much” we need. Furthermore, what percentage should be tax breaks vs. spending and transfer payments? Tax breaks hit the economy faster (see last year’s GDP), while spending programs require bureaucracy for implementation, also known as economic leakage. If a bill gets passed mid-month, and includes fast acting tax relief, we should look back on the Q1 2009 GDP print as the cycle low. Hang in there.
The Price is Right-er
Housing sales increased 6.5% in the month of December, which is good news, as average home prices fell 18.2%, also good news. While prices falling at an accelerating pace may not seem cause for celebration, the markets may be zeroing in on realistic clearing prices. Bottom searching in housing requires the following: 1) the cessation of new building (we have plenty of national inventory) 2) rising foreclosure sales to drive prices to clearing levels and 3) frozen buyers re-engaging, drawn by low interest rates and low prices. Housing affordability has increased to near pre-bubble levels, yet price-to-rent ratios signal further declines. Prices have fallen 25% since August of 2006, and they likely have another 10% to go. A buyer’s credit from the federal government would amount essentially to a mail-in rebate for homebuyers, which may artificially elevate the price equilibrium point in question. But as one who favors removing a band-aid quickly, the sudden drop in prices would hurt but would also allow us to heal more quickly.
Animal Spirits
What makes economies thrive is a well-rewarded sequence of risk-taking. The opposite of risk-taking is hoarding. While hoarding has been rewarded to this point by loss avoidance, two forces are now purposely diminishing the attractiveness of hoarding. First, low interest rates make idle capital expensive. Many firms are now discontinuing their Treasury-backed money market funds due to the fact that they do not yield enough to accommodate a fee, which forces capital to pursue more risk. Additionally, with the money supply expanding rapidly, the trillion dollar stimulus package in play, and the discussions around the creation of a $2 trillion toxic asset purchase program, inflation expectations have returned. Nothing eats at low yielding cash quite so voraciously as inflation. With stocks squarely in a trading range and government bonds showing losses year to date, some signs of profit pursuit are beginning to emerge. Equity mutual fund flows have been positive each week this year. New issuance in the high yield bond marketplace has returned with a vengeance and while buyers are still requiring lofty interest payments, these have fallen in 2009. And in an even more encouraging development, IPOs (initial public offerings) have begun populating the calendar after being almost completely absent last year. Given the flurry of seemingly relentless government activity, nothing would support the markets more than growing sentiment that the riskier assets might be US bonds and US dollars. Corporations may not have the ability to manufacture currency to make interest payments, but they certainly have cleaner books than the US government.
Super Bowl Sunday offers the opportunity to give meaning to another meaningless indicator, the “Super Bowl indicator.” Historically, an NFC victory equates to higher market returns than an AFC victory. That would favor the Cardinals over the Steelers. This is no time to abandon superstition. I will be decked out in Cardinal gear, and likely waving a large foam finger that reads, “Go market!” I may even paint my face.
Patience is the investment strategy of the day. We are simply range bound, waiting for a very pregnant Capitol Hill to reveal its progeny.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.
Anxieties around the banking sector have once again paralyzed the markets. With Citigroup and Bank of America trading like lottery tickets and negative surprises emanating from State Street and others, we seem to be right back into the fall of 2008. The governmental solution at the time was the TARP plan, which morphed from a toxic asset purchase plan into a capital injection plan and now may be morphing back into a toxic asset purchase plan. Truth is, the conversation must be an “and” conversation and not an “or” conversation at this point. The size of the government intervention likely needs to grow as well from the $700 billion to a number far greater.
At one point the off balance sheet soup of credit derivatives equaled $2.2 trillion (so says Treasury Secretary to be Timothy Geithner); if we mark these assets down to .50 cents on the dollar we systematically need to write off $1.1 trillion, a bit more than $700 billion. If the government decides to purchase these assets, it needs to arrive at a price. A price too low would cause system-wide markdowns, which could threaten the solvency of even more banks; a number too high will enrich the banks at the further burden of the US taxpayer... Catch 22. While I believe that a purchase arrangement should and will likely occur, the pricing decisions will determine both the outcome and unintended consequences of the facility. Uncertainty surrounding this issue translates into lower equity prices. Just how far have the banks fallen? In 2007 the KBW Banking index, made up of 24 of our nation’s largest banks, fell by 22%; it fell 47% in 2008, and has fallen 38% so far year to date. The combined market values for Citigroup and Bank of America equal $46 billion. This amounts to half of what they have received in emergency funding from the government to date. Until we can inoculate the banks, any steps forward in the market or the economy will be questionable.
Looking past the banks
While the investing environment year to date may resemble that of last fall, there are some notable differences. First, we haven’t seen the late day selling climaxes that we experienced then. In fact, none of the days so far in 2009 have closed at the lowest point in the range. Of the 7 negative trading days so far this year, stocks on average have rallied .72% off the daily lows. Furthermore, daily average volume has fallen over 20% since October. This demonstrates that the blunt selling we experienced in the fall has become more selective. For example, technology names have held up well year to date, which is a theme we access through our position in the Calamos Growth Fund. While still lower on the year, this tech heavy allocation has outperformed the S&P 500 by nearly 4 percentage points. Relative strength in technology may signal the potential for new market leadership. Even with low debt ratios and global revenue diversification, many technology names are trading at valuation levels they have never seen before. It is far too early to anoint technology as the groundhog, but the consideration and debate is in itself a positive sign. In fact, using Morningstar’s classifications, the stock types that have performed the best so far in 2009 are those classified as “speculative growth.” Welcome back speculators.
Hold the line
I recently tripped over an interesting piece from Ned Davis Research that looked at the patterns of waterfall declines in the stock market. There have been 10 quick, high volume declines of more than 20% since 1929. Following the nadir, in this case November 20th, markets tend to enter a range-bound basing period for about three months where the lows may be retested (where we are right now). From that phase, markets tend to advance into the end of the recession, plateau into the date of lowest earnings and move higher from there. This process historically takes about a year. Using it as our map, our basing phase should continue into March. The sign of health during this period is therefore not a sustained advance but a successful re-testing of the lows. For those playing at home, the low point on the Dow was 7400. We breached 8000 last week four different times, attracting buyers each time, a healthy sign. So in light of an abysmal week of financial earnings, we escaped without breaking lower. Industrial and energy earnings will be up for scrutiny this week and will provide insight into the condition of the real economy outside of financials. The big news comes Friday with the advanced 4th Quarter GDP release. The market expects the economy to have contracted by more than 5% in the 4th quarter providing plenty for investors to digest.
What we are talking about
With all of the liquidity being pumped into the system, any increase in velocity will likely stoke inflation. In an inflationary environment, materials, commodities and gold tend to perform well. We have exposure to these themes in our portfolio but have options at the ready to expand that exposure, if deflationary fears shift to inflationary fears. For example, among our largest underlying stock holdings are Newmont Mining, Anglogold, and Barrick Gold. Another theme we have been researching revolves around the expected infrastructure-spending spree. Worldwide government spending makes a case for global construction and engineering names, but caution is warranted. These stocks have advanced considerably off the November lows and may need to retreat a bit for us to be more interested. Another conversation involves Asia, which may be in the best position to weather this global downturn, as they have built up huge savings surpluses. This enables both the Asian governments and consumers to spend in an economically stimulative fashion without borrowing. We have identified opportunities to re-enter Asia after leaving in Q1 2008 and will be watching consumer trends closely to see if Asia can stimulate domestic demand to offset export demand. So far this is inconclusive, but we’re monitoring it closely. Our conversations evolve daily but these are the themes receiving the most current attention.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.
