The Sky Is Not Falling

All too often in recent years most investors have allowed themselves to be frightened into selling the shares of well-positioned companies in the wake of some exogenous event whose significance is often magnified by overreaction on the part of the financial news media.  These media outlets cater almost entirely to short term traders, typically those using online brokers, whose objectives are to take a position, make a couple of quick points and then sell.  Ergo, the networks’ entire frame of reference and message is invariably at odds with successful long term investing.  The facts the television networks disseminate are often useful, but the opinions of their pundits are anything but.

Natural disasters come and go.  They cause interruptions in economic activity, as did the earthquake and tsunami in Japan last year, the floods in Thailand, Australia and Latin America, but rarely are the effects more than transitory.  Within a reasonable period of time the impact on corporate revenues and profits is usually reversed and often made up.  Likewise, the ineptitude of governments, here and abroad, has rarely, if ever, prevented well-managed corporations from serving their stakeholders, including, of course, their shareholders.  The fiscal problems in peripheral Europe, which seem to defy resolution, are merely one recent example.  There are numerous others, including of course, the ongoing gridlock in Washington, which is preventing resolution of our major long-term fiscal issues.  And one must not forget the all too numerous instances of overreaching reform legislation in the wake of some event like a credit bust or a fraud.

Two fundamental premises, underly all equity investment in today’s globalized world economy.  These are: (1) the desire of virtually everyone on the planet to achieve a better standard of living and (2) the recognition by most that free market capitalism remains the best path to greater prosperity for all.  Accordingly, the management teams of well-run corporations spend considerable energy and effort planning for unforeseeable and unknowable contingencies which might interrupt demand for their products or the production and distribution thereof.  In the last analysis, therefore, prudent long term equity investing is a wager on the ability of each management team to execute successfully a strategy designed to achieve a meaningful market share of a growing addressable market and to do so in a consistently profitable manner.  When a financial crisis or a natural disaster, or even acts of war, interrupt the execution of an otherwise successful strategy, strong management teams tend to adapt in fairly short order.  There have been more than a few examples of this during the past decade or so, but rarely does the vast majority of investors have sufficient conviction to take advantage of attractive stock prices in the wake of a sell off.  Indeed, the majority of investors shorten their horizons and rush to become defensive, doing the very opposite of what they should in order to achieve optimal long term returns.

Admittedly, the upward progression of profit growth is often interrupted by these events, and as a result the present value of the affected equities is temporarily reduced.  But barring an Armageddon scenario, such set backs are invariably temporary, and most of the time they present an opportunity for serious long-term investors to initiate or add to their equity holdings.  In recent years, the extra volatility of stock prices caused by the deregulation of financial markets, together with computer driven algorithmic trading amplifies the fear factor when markets react to a temporary exogenous event, but the effect here is merely to enhance even more the future returns for those with the conviction to take advantage of bargain basement prices.

Conviction is a state of mind that is hard to attain and easily lost, particularly in recent years, which have witnessed numerous investment frauds, a host of disruptive macro events around the globe, seemingly beyond our control, and a twenty-four hour news cycle in which bad news seems to outweigh good news and which features more than a few bearish pundits who get to center stage by predicting frightening outcomes.  In short, it takes a complete change in mindset for investors to see every significant decline in stock prices as a short lived opportunity rather than a catalyst for greater fear.

In the management of funds for wealthy individuals, whose fortunes have typically been made through enterprises other than the equity markets, the fear factor is often magnified.  High net worth clients who claim to be long term investors often shorten their horizons when macro concerns roil the markets.  They fear that lost capital can never be recovered and their instinctive response is to get liquid as quickly as possible.  What else can explain the willingness of so many to accept negative real returns from U.S. Treasuries, insured bank deposits or money market funds, and all this before paying taxes on the meager income.  When this occurs, their investment managers also tend to overreact by becoming defensive, or even outright bearish, at just the point when they should be urging clients to step up to take advantage of opportunities.  Fear of losing a client often trumps sound investment judgment.

Ever since the fiscal crisis in Europe emerged, sparking fears of another global financial meltdown, the valuation of equities has been under pressure.  Last year the S&P 500 Index was absolutely flat (except for reinvested dividends) even though corporate profits rose nearly 20%.  The P/E ratio ended the year at about 13 times trailing earnings and about 12 times forward estimates.  Relative to historical valuations and current interest rates, which are unlikely to rise much this year, a more normal valuation at year end 2012 should be 15-16 times the $100 plus consensus estimate.  At this writing the S&P 500 is already up 7% or so for the year to date.  If fears of the macro environment were to dissipate, or be overcome by investors, a year end valuation approaching 1600 would seem possible, representing a gain of 15% from today’s 1355 level.

 

Despite the Headwinds

After screeching to a halt in July and early August, as the debt ceiling debacle was unfolding, the US economy has been gaining traction on many fronts despite a number of persistent headwinds, none of which are likely to abate any time soon.  The fears and uncertainty caused by these factors, together with the volatility created by high frequency, computer-driven trading, are keeping a lid on the valuation of equities despite very low interest rates, solid gains in corporate earnings and good prospects for 2012.  In the absence of these forces the S&P 500 Stock Index might well have ended the year with a multiple of 15x-16x 2011 earnings instead of the roughly 12x at the close of trading in a year when the Index was flat.

Despite a litany of uncertainties, cost burdens and sometimes irrational regulatory impediments, US corporations are continuing to achieve revenue, profit margin and earnings growth at rates of progress that range from worthwhile to outstanding.  There is no question that continuing caution and deleveraging by American households and a negative wealth effect, coupled with slower growth in the major emerging economies, as well as the recession now underway in Europe and continued stagnation in Japan are having an adverse impact on American multinationals.  In addition, a dysfunctional Federal government, including both the Administration and the Congress, have hindered corporate investment and job creation.  The gridlock in Washington will not be alleviated during this election year.  Other macro uncertainties such as the volatile situation in the Middle East, fiscal drag at both the Federal and state levels and fears of a financial crisis triggered by European banks also weigh on economic activity, as well as on the valuation of equities.

Even with these headwinds, the inherent resilience of American corporations continues to enable them to grind out increased profits.  Also, there have been signs in recent months that job creation has begun a meaningful improvement.  If this trend is sustained, a rise in consumer purchasing power, together with even modestly relaxed bank lending standards, should enable some of the pent up demand for automobiles and housing to begin to impact the economy in a meaningful way.  It probably will take a change in the Administration to remove the handcuffs from the energy industries, which have the potential to create large numbers of well-paying jobs.  Likewise a solution to the vast and complicated home mortgage problem has so far eluded implementation, but significant improvement here would have a huge ripple effect throughout the economy.

Thus, we believe the year 2012 will see modest 2%-3% real GDP growth, provided none of these impediments becomes more acute and assuming no “Black Swan” events, nor a financial meltdown stemming from a European sovereign debt and banking crisis.  In this environment corporate profits (excluding those of large financial companies, which remain a wild card), should improve at a near double digit pace for the year as a whole.  It is unlikely that there will be any expansion of equity valuations as long as this litany of overhanging uncertainties and burdens remains in force.  Furthermore, the volatility of the marketplace is unlikely to be mitigated as long as short term traders react disproportionately to macro events.  Therefore, while 2012 should produce moderate appreciation in the S&P 500 by year end, progress will by no means be linear.

As the year progresses we will do our best to use periods of stock market weakness to add well-positioned companies to our portfolios, particularly industry leaders with solid balance sheets, strong market shares and histories of good execution, including regular increases in cash dividends.

 

The Revulsion Phase

Last December, at a small pre-Christmas luncheon, I was asked by the host to look ahead to 2011 and offer a few thoughts regarding the economy and the financial markets.  To summarize briefly, I opined that the US economy was gradually recovering from the “great recession,” that major corporations, having cut costs sharply, were benefitting greatly from an improvement at home and particularly from rising demand out of the emerging economies, and that corporate profit growth this year would greatly outpace GDP growth.  On that basis, US equities, which were then selling at about 13x projected 2011 profits were quite attractive, particularly since most fixed income alternatives offered only meager yields, which seemed poised to rise as the economy recovered.  Moreover, there was a “mountain” of sideline cash, and if only a small portion moved into equities that could support a strong rally.

With regard to the US I got most of it right, but it was all the macro issues I missed that have prevented any rally in stock prices this year and put what could be a long term lid on equity valuations, i.e. P/E multiples.  The earthquake and tsunami in Japan, which disrupted the global supply chain, the sharper than expected cutbacks in state and local spending, the severe winter weather including floods, were minor impediments as it turned out relative to three other factors that I missed.

First, I failed to recognize the overwhelmingly anti-business attitude and policy making of the Obama Administration and a multitude of Federal agencies.  I failed to see just how great would be the uncertainty and fear resulting from a wave of anti-business regulation and legislation, including both Dodd-Frank and Obamacare, all of which have caused banks to curtail lending, businesses to hold back on both hiring and capital expenditures and to maintain tight control over inventories.  The hiring freeze, in turn, has greatly impacted consumer confidence, income growth and spending (the current Christmas surge notwithstanding).  This has kept a ceiling on economic growth and is sustaining a high rate of unemployment.

Second, the ugly and unproductive partisan dispute over raising the Federal debt ceiling shocked both household and business confidence in the third quarter, and the fall out has only begun to subside in the last couple of months.  Gridlock was once viewed positively as a means of controlling overspending and overregulation, but with both parties in the grip of their extreme wings there is no hope of any compromises to deal with the nation’s major problems.  Contrary to conventional wisdom, I do not believe this gridlock will end after next year’s elections since twenty plus years of gerrymandering has created “safe seats” only for the extreme members of each political party.

But the most critical oversight on my part was my failure to gauge the utter incompetence of Europe’s politicians and bureaucrats, as they continually fall behind the curve in dealing with their sovereign debt, and the now widespread banking crisis that has thrown Europe into a recession and is causing a global slowdown that threatens the US economy and those of the major emerging countries, particularly China, India and Brazil.  These Socialist politicians are simply ignorant of the power of market forces.  The whole 20^th century economic history of Europe has been one of protectionism, but in a globalized world with freedom of capital movement there is no hiding from financial market forces.  The obstinance of the politicians has caused the markets to revolt, and the crisis will only get worse next year as Governments and banks must raise huge sums of new financing.  Not only will a European recession impact the global economy, but if a few major banks there go bust, there would be great risk to our banking system from the opaque derivatives commitments.  Frankly, I never imagined that our market would be held hostage to the daily news flow out of Europe, and so far at least, I see no solution to their problems.

Against this litany of macro issues which I failed to foresee has been the ever increasing impact of a few computer driven, high frequency traders, whose activities coupled with the lack of an uptick rule have created an intraday volatility that dwarfs anything in the history of the US equity market and goes virtually unrecognized by the regulatory authorities in Washington.  A handful of traders are raking in billions at the expense of ordinary investors.  The resulting intraday volatility has caused many investors to abandon equities altogether.

Both institutional and household investors have walked away from the equity market, in many cases never to return.  As a result, the valuation of equities continues to be mired far below the average level of the last hundred years.  I believe the US will avoid a recession next year, even as the European crisis drags down the entire “old world.”  A global monetary easing cycle is underway which will support many economies and financial markets.  The Fed will engage in QE3 if needed.  Corporate profits will be retarded somewhat since Europe accounts for 20% of our exports, plus local production by US multinationals, and it will take some time for the emerging economies to reaccelerate.  But the valuation of US equities is likely to continue to suffer from all these macro issues for some time to come.  A modest gain in stock prices is good bet for 2012, but the full potential appreciation of equity values is some time off.  Accordingly, going forward, our equity portfolios will emphasize, much more than we have in the past, the shares of companies with long records of annual dividend increases.  Many of these outperformed in 2011 but still remain reasonably valued based on visible prospects for the years ahead.  If, and when, the European crisis abates and global growth accelerates, we will move back toward economy sensitive issues.

 

The Month of November

During November, hopes for a resolution of the European debt crisis faded as sovereign bond yields reached record highs and wholesale funding sources for Euro area banks continued to dry up, crimping lending in both Europe and the emerging nations.  Amidst disagreements between countries and conflicting statements by politicians and bureaucrats, these events trumped continuing improvement in the US economy.  (The recent downward revision in third quarter GDP was due entirely to a runoff of inventories, which sets the table for a strong fourth quarter.  Final demand grew a solid 3%.)  The Standard & Poors 500 Stock Index declined 0.5% for the month from its 1253 close in October to 1247 at month end.  At one point, however, the Index was down 7% in the month.  At its month end level the Index was valuing the current run rate of earnings at 12.5x, which is roughly 20% below a more normal valuation of 15-16x that would typically prevail at this time of year, particularly since the consensus of analysts expects at least a modest increase in 2012 profits.  Unfortunately, stocks are now in between quarterly reporting periods, and although the data so far suggest a strong fourth quarter earnings season, those results will not be available until mid-January.  In the meantime, equity valuations continue to be held hostage by global macro events, particularly the crisis in Europe, but also by the gridlock in Washington and the slowdown in growth in the major emerging economies, part of which reflects conditions in Europe.

In the United States, the Super-Committee failed to agree on deficit reduction measures, which will lead to a $1.2 trillion sequestration over 10 years, but, of course, this doesn’t start until 2013.  So on the surface there will be no fiscal drag next year except for the fact that the payroll tax holiday, the bonus depreciation and the extended unemployment benefits that formed part of last year’s bargain, all expire at year end.  Failure to renew these and a few minor others would cut about 1.5% off the economy’s growth rate for next year, and if there is another ugly fight over their extensions, with the Republicans demanding a spending reduction to offset the loss of revenue, investors will likely abandon equities once again, fearing a double dip recession.

A second major depressant on values is the ongoing crisis in Europe.  It seems almost pointless to discuss in this memo the current status of the various plans that are being floated to impose fiscal discipline on overspending countries, recapitalize bank balance sheets and promote a tighter fiscal union, because the state of play changes almost daily. The only thing one can say for sure is that the political leaders in Europe are very far behind the curve, and the deterioration in the markets for sovereign debt, bank funding and bank lending is so far advanced that at this point the prospect of a breakup of this monetary union can no longer be dismissed.  The odds may not yet be high, but they are rising daily.  So far, European political leaders cling to the mistaken notion that insolvency can be cured by injections of liquidity.  At the very least Europe is in recession, which will have some negative impact on US corporate profits next year.  This may be offset in large part, however, if the emerging economies of Asia and Latin America begin to restimulate their economies, which is highly likely since the rate of inflation is coming down all over the world and the fear in China, as well as in other emerging economies, is that a European recession is now a much more serious threat than domestic inflation.  What the markets fear most, however, is a Lehman-type financial meltdown that causes a global recession or worse.  No one knows for sure the extent of the derivatives exposure among the major banks, here and abroad.  Thus, the fear of a cascade of defaults is palpable.

As a result, there have already been thirty-five examples of Central Bank monetary easing around the world with a high probability of more to come.  The ECB has cut its rate once, and more reductions are likely, but until the bank stops sterilizing its bond purchases, money supply growth in Europe will remain sluggish at best, and the drying up of badly needed wholesale funding will crimp lending not only within Euroland but also to many emerging economies.  Here at home, despite irrational cries from the political right, the Federal Reserve is edging ever closer to a third round of quantitative easing.

Throughout all of this, as we have noted repeatedly, American corporations are coping exceedingly well with the incompetence of political leaders around the world, but fears of a possible global financial crisis and a recession continue to trump their successes.  As a result, we expect continuation of a volatile, range bound equity market until the politicians on both sides of the Atlantic wake up to the realities facing both Europe and the US.  We continue to have high conviction in our portfolio companies, not only in their strong finances and leading industry positions but also in the execution of their profit growth strategies.  Virtually all of these companies are significantly undervalued, and for investors willing to ignore the daily headlines, patience and conviction will be rewarded in the not too distant future.

 

The Month of October

After a five month decline which saw the Standard & Poors 500 Stock Index fall more than 21% from peak to trough, several events in the month of October contributed to an improvement in investor psychology and enabled a significant gain in equity prices.  The S&P 500 rose 10.8% to close October at 1253, for one of its best monthly performances on record.

First, recent economic data in the United States has been decidedly upbeat relative to previous widespread fears that the economy was falling into a recession (or, as some perma-bear pundits were saying, already had).  Indeed, the first (of three) estimates of third quarter GDP showed a quarter-to-quarter increase of 2.5% annualized, with Real Final Sales to Domestic Purchasers rising at a 3.6% annual rate.  Also, by month end, 60% of the S&P 500 companies had reported third quarter earnings gains averaging 19% on a year-on-year basis, with 74% achieving positive surprises relative to expectations.  On the revenue side 58% of those firms that had reported showed positive surprises on revenues, with gains of nearly 12% over last year.

Next, on the macro front, the bankruptcy of Dexia galvanized the political leaders of Europe to develop a plan which will involve a 50% haircut for holders of Greek debt, a vow to increase the capital of all European banks to 9% of assets by mid-2012, and a reported $1.4 trillion backup fund to protect Europe’s banks.  The latter might receive some assistance from the IMF as well as from some emerging countries, (e.g. China, Brazil and Russia) which have very substantial forex reserves, sizeable trade relationships, and needless to say, a keen interest in gaining influence in the Eurozone.  While news of this plan sparked a dramatic rally in global share prices last week, the myriad details of implementation have yet to be fully resolved, and the Greeks are already trying to weasel out of the deal, while the major Eurozone banks are working on ways to avoid raising new capital by changing asset risk profiles and selling loans.  Most disturbing at this point is the fiscal situation in Italy, which is clearly too big to save, and which could cause this entire ambitious scheme to unravel.  At this writing, all maturities of Italy’s sovereign debt are commanding record high yields.  While we believe that the Europeans finally “get it” and will eventually implement effective policies, their problems will take years to resolve, and any backsliding will provoke renewed fears of a global financial crisis among investors and traders.  The time is rapidly approaching when the US will begin to turn its attention away from this “Disneyland for Adults” and focus on our real future, which lies in Asia.

Moreover, since the third quarter earnings reporting season is essentially over, market psychology will be governed for the next few months principally by macro developments here and abroad.  Front and center among domestic issues will be the results of the so-called “Super Committee” of Republicans and Democrats, charged with developing a plan to reduce our fiscal deficit by $1.5 trillion over a decade.  Their report is due on November 23^rd, the day before Thanksgiving, and we believe that due to the preponderance of hardline idealogues on both sides of the political spectrum, the efforts of this committee will fail.  Another downgrade of US debt could result and provoke more alarm in the financial markets.  Aside from the need to reform entitlements, the most pressing problems in the US continue to be the interrelated issues of unemployment and housing (prices, mortgages, foreclosures).  While the roots of these problems are many and complex, the solutions are essentially political in nature.  During an election cycle it is unlikely that any progress will be made toward resolution of either the short or longer term issues.

China’s economy continues to slow as the authorities there are still concerned about consumer inflation and the risks of a property bubble.  Chinese Government spokesmen have indicated that they are in no rush to restimulate growth, even though near recession conditions in Europe and sluggish growth in the US are also acting to reduce Chinese economic activity, which in turn affects US multinationals.  Finally, the month ended with the bankruptcy filing of an overleveraged broker/dealer, MF Global, whose bad bets on European debt have left it with large losses that have wiped out its capital base.  At this point no one can be sure of the knock-on effects on its counterparties and creditors, but the sums involved do not seem to pose a systemic risk.

Notwithstanding the above, we remain positive toward the extended term outlook for US equities.  A global financial crisis seems off the table for now, as does a US recession.  The emerging economies continue to achieve rapid growth in which US multinational companies are playing a major role.  US corporations are doing well, stocks are greatly undervalued, bonds are unattractive, and there is a mountain of uninvested cash.  We expect overall S&P 500 earnings to run between $95-$100 this year and expect a modest further increase in 2012.  At this writing the Index is selling at about 13x forward earnings, offering a 7.7% earnings yield, which compares quite favorably with about 5.0% on BBB bonds.  We are mindful, however, that profit margins for many companies declined in the third quarter, suggesting that cost pressures and reduced opportunities for productivity gains are beginning to impact results.  Until there is a change in the direction of Washington policymakers, it is unlikely that the economy will begin to create new jobs and higher wages at a pace sufficient to stimulate faster growth, but corporate profits are running far ahead of GDP.  Accordingly, it is our best judgment that the broad market will remain range bound for the next few months, and daily volatility will remain high as traders react to every news development, both economic and political.  We continue to maintain broadly diversified portfolios of well-positioned, well-managed, well-capitalized, attractively valued industry leaders.  For the year as a whole we care a lot more about absolute, rather than relative, performance.

 

Big Bang Bankruptcies

Over the course of the last half century or so, except for the credit collapse of 2008, virtually every recession in the US economy came about as the result of a tight monetary policy engineered by the Federal Reserve in an effort to slow economic activity and bring inflation down to a more acceptable level.  Higher interest rates and a reduction in credit availability, together with the slowdown in economic activity, have often caused some major firms to fail.  Each time there was a major bankruptcy, e.g. the Penn Central Railroad, Lockheed, Continental Illinois Bank, Penn Square Bank, etc., etc., the Fed came to realize that it had pushed its tight policy as far as the economy could withstand without much more serious consequences, and in each case almost immediately it began a process of easing policy.  

At the same time deep pessimism among investors, businessmen, and consumers was palpable.  More than a few commentators opined about “end of the world as we know it” scenarios.  Typically, Wall Street pundits were universally bearish and, in the wake of margin calls, individuals and hedge funds capitulated, creating the market bottom at just about the same time the big bankruptcy occurred.  The stock market, which already had dropped significantly into bear market territory began to recover, however, as investors quickly perceived the favorable implications of a change in policy.

Currently, there is an analogous situation in Europe.  For the past year and a half, European politicians, finance ministers and central bankers have been grappling with the insolvency of the so-called PIIGS, of which Greece is by far in the worst condition.  Ignoring the fact that these countries have unsustainably high fiscal deficits and debt-to-GDP ratios, the Europeans have tried to cure the insolvency of the PIIGS with short term incrementalist policies that have relied on periodic injections of liquidity coupled with draconian fiscal austerity measures, which are causing major social unrest.  The thought that a heavily indebted, non-competitive country can shrink its way out of debt is absurd, to say the least, but to think it could rely on increased borrowings, coupled with austerity measures, to remedy its insolvency simply defies all human logic.  Bond holders have certainly not been fooled, as the 10-Year 6.25% Greek benchmark bond now sells for 40 cents on the Dollar.  The European banks, particularly the French banks, who own much of this toxic paper, have not marked down these bonds to market values because to do so would force them to write down their equity capital.  But there is an additional problem, to wit: These European banks rely far too heavily on purchased funds in the money market to support their loan books, rather than core deposits.  Just as the bond holders have marked down the value of these sovereign bonds, those firms (such as US money market funds) providing short term loans to the banks have pulled their credit lines, and accordingly, the European Central Bank (ECB) is being forced to print money in order to keep the Eurozone’s banking system afloat.

Inevitably, however, the weakest link in the chain has finally snapped.  Dexia, a fourth rate institution, cobbled together a decade or so ago in Belgium, has gone bust.  This has caused the leaders of France and Germany, if not the rest of the Eurozone, to recognize that all their banks, particularly their largest banks, are exceedingly vulnerable.  Accordingly, if the most recent news reports can be believed, these leaders have finally decided it is far more important to protect and recapitalize their banks than to worry about a sovereign debt default by Greece, whose total economy is a rounding error in the Eurozone as a whole.  As usual, the weekend communiqué from Merkel and Sarkozy talks about having a bank recapitalization plan in place by the G-20 meeting on November 3-4, but so far there are no specific details.  The policy differences between them are not insignificant and, regrettably, the urge to kick the can down the road is still alive and well.  The sums involved are in the trillions of Euros, and France’s AAA credit rating is in jeopardy.  But the risks of inaction are even greater, and this time our bet is that the end game is fast approaching.  To save their skins, the politicians must first save their banks.

If our hunch is correct, the fear of a banking system meltdown, such as occurred after the Lehman bankruptcy of 2008, will be averted.  Europe may even avoid slipping into a recession, although that hardly matters, since it never grows very rapidly anyway.  So, if fears of a financial meltdown are averted, the grossly undervalued equity markets of the world will rally substantially.  The recent data strongly suggest, and we strongly believe there will be no recession in the US, only painfully slow growth as long as the current misguided economic policies remain in place, but corporate profits, particularly those of our multinationals, will greatly outpace GDP and support a substantially higher level of equity valuations.

 

Three Little Words

Stock markets around the world have been tumbling for the past four months.  The decline so far in August has been the most volatile and violent.  There is no doubt in our mind that the problems facing the developed economies of Europe, North America and Japan have been caused by the malfeasance of their governments, who naively and stubbornly are too much in denial and too ideologically opposed to develop fair and effective solutions to the problems of overpromising to their citizens and over borrowing to fulfill those promises.  In the US there is an unwillingness on the part of the current Administration to recognize that both traditional fiscal and monetary policies are impotent in the current environment and that new tools must be employed sooner rather than later in order to stimulate a moribund economy.

Even if the Obama Administration and its Democratic allies in the Congress were to propose effective remedies, the likelihood is that the Republicans would do everything possible to thwart their efforts in the belief that a recessionary, or stall speed, economy with high unemployment and slow income growth in 2012 will guaranty them the White House in the November elections.  Though the stock market is deeply oversold, and at about 1100 on the Standard & Poors 500 Stock Index is discounting a steep 30% recession in corporate profits, little more than occasional relief rallies can be expected until the leadership of both parties fulfill their obligations to the nation as a whole, not just their own political self interest.

There are three crucial elements to any plan to move the economy forward: (1) political compromise, (2) implementation of incentives for corporations to hire and invest, and (3) removal of restrictive regulations, the disincentives that are barriers to progress, as they create too uncertain and costly an environment for creating income and wealth.

The most critical role of government beyond (a) security of the homeland, (b) development of necessary infrastructure and (c) a social safety net, is to create an environment in which private capital can succeed in earning sufficient returns to enable the financing of the functions of government while at the same time enabling the living standards of all its citizens to rise without resorting to excessive government borrowing.  The current environment is the antithesis of what is required.

Because the current malaise has been caused by a credit collapse, households and corporations have been racing to deleverage, to pay down their borrowings and to begin to live within their means.  Corporations, particularly those involved in serving the rapidly growing emerging economies, have been extremely successful.  Their balance sheets are in great shape, and they are earning record profits.  But for households, suffering from rising unemployment and slow wage growth due to foreign competition, as well as sharply declining household wealth, the task has been much more difficult and painful.

Lowering interest rates and increasing bank reserves in an effort to get frightened households to borrow and spend more money is an exercise in futility.  Chairman Bernanke will speak at Jackson Hole on Friday, and he will most likely outline various additional monetary policy instruments by which he could continue to pump low cost liquidity into the financial system if a recession began.  Some will scream that his is an inflationary policy, even “treasonous” according to one crackpot.  They are too young to remember the “Liquidity Trap” of the 1930s.  Despite the swelling of the Fed’s balance sheet the money supply is growing only modestly because there is very little borrowing going on.  There is absolutely no risk of a generalized price inflation (except for commodities) as long as households and corporations are not borrowing aggressively.  Likewise, except for stimulating the financial markets to a modest degree, the impact of further monetary stimulus on the real economy will be de minimus.  As far as fiscal policy goes, there is room for tax reform and tax credits for hiring and funding certain types of infrastructure investments, but a generalized package of Keynesian spending was a waste of money in 2009 - 2010 and will be again, if tried again.

If the US wishes to avoid a lost decade, or longer, than it must vote out of office all the hardliners on the left and right extremes of both political parties in favor of those willing to take a pledge to compromise for the good of the entire nation, not merely for their own narrow personal or regional self interest.  Without compromise no effective incentives to business to hire and invest can be implemented and disincentives removed.  Corporations will continue to grow their profits by keeping lean workforces in America and expanding their employment and capital bases in the emerging economies of Asia, Latin America and other politically stable areas, but the domestic economy will continue to stagnate.

In addition to creating incentives, a vast number of onerous restrictions and regulations, some of which have yet to be written, must be swept away.  For the current Administration to try to implement a broad agenda of social reform in the interests of class warfare at a time of great economic stress can only be described politely as terribly shortsighted.  Our own feelings are somewhat stronger.  Not only do these regulations overtly discourage businesses from expanding, but enormous uncertainty has been created in those cases where regulations have not been written or where tax rates are slated to rise.  In cases where bureaucratic sclerosis is holding up worthwhile projects and trade deals, both major parties share equal blame for the paralysis as well as for the fear among businesses and households that resulted from such fiascos as the recent debt ceiling negotiations.  These caused the US economy to stop in its tracks during the months of July and August, and now to get the motor started again, positive action will be needed, but not traditional fiscal nor monetary stimulus.  Only then will it be possible to create the economic strength in which entitlement reform can be successfully implemented.

If Obama’s September speech on job creation does not recognize the need to remove onerous impediments and to create incentives and a degree of long term clarity for American business by jump starting many projects and ideas that could have a major positive impact on hiring and domestic investment, the price of gold will tell him how wrong he is.  If the Republicans block well conceived efforts, they will hand him a second term.

 

Reflections on the Current Turmoil

In some ways this short memo builds on our longer piece, THE GREAT DIVIDE, which we sent to you last week. The S&P 500 peaked at 1370 on May 2nd and reached 1119 yesterday for a decline of 18.3%, pretty close to an outright bear market. Indeed, given the destructive changes made to the structure of trading by the SEC over the years, the pace of the decline has felt much worse. In fact, for the types of stocks most investors normally own, the price erosion has been greater than for the Index as a whole.

We believe that the US economy will avoid a recession, perhaps with some assistance from the Federal Reserve Board. If, however, we do enter a new recession and S&P earnings drop from the current run rate of nearly $100 to, let’s say, $70, then at today’s 1135 the S&P would be valued at 16.2 times depressed earnings and yielding 2.3%, which seems to us to be a pretty reasonable valuation of likely trough earnings. Of course, if psychology deteriorates further in the near term, there is always the risk of an overshoot in this phase, but we almost have the courage (not quite) to declare that yesterday’s low of 1119 was the “benchmark low,” to be followed by a relief rally and then a retest.

Whether that proves to be the case or not, markets in decline move fairly quickly to a conclusion, and we expect the “benchmark low” to be reached fairly quickly, certainly in a matter of weeks, at most. The relief rally that follows (perhaps triggered by FRB action) will inevitably peter out, and there will need to be a low volume retest of the “benchmark low” to establish a “confirmation low,” from which a sustainable advance can then begin.

Senators and Congressmen, home on vacation this month, must be getting an earful from their constituents, but we don’t know if that will galvanize any constructive action given the ideological divide. The White House is showing no political courage whatsoever, and nobody wants to compromise. Indeed, every time Obama speaks the market sells off. A poll this weekend shows that 82% of Americans disapprove of Congress. Admittedly, these are not confidence building statistics, but remember that corporate profits long ago disconnected from GDP. For example, when GDP rose by 1.3% in the second quarter of this year, sales growth for the 421 companies that have so far reported rose more than 13% year-over-year and, earnings per share rose by more than 17.5%, as 76% of companies posted upside surprises.

A word on Europe. The ECB is effectively embarking on a quantitative easing program as it buys Italian and Spanish bonds. They have no choice if they want to preserve the Euro. Germany has been dragged kicking and screaming into this, and we notice that German bond CDS spreads are rising due to fears that this is the only country that can carry the load. At the end of the day, Europe will have to print money, which is one of the reasons that gold is $1740 an ounce. The European problems will be with us formany years to come, but growth in the emerging economies will soon resume, as inflation there tapers off and allows their monetary authorities to begin to stimulate again. Europe does take one-third of our exports, but over time this percentage will inevitably decline.

One final note – there was clear evidence, to us at least, of a flurry of margin calls yesterday as volume soared, which always tells us we are much nearer the bottom than most pundits dare believe. Indeed, one reliable source confirms there were substantial margin calls on hedge funds yesterday, always a reliable sign of capitulation.

Most important of all, your portfolios are well diversified among a group of strong, well managed companies which continue to produce consistent growth of revenues and earnings in an admittedly difficult environment. At yesterday’s closing prices, these companies were valued at ridiculous low levels given their globally strong industrial positions and near term earnings prospects.

The Great Divide

Not since the Civil War has the Government of the United States been as ideologically divided as it is today, at just the time when our economic and political standing in the world and our security are all under attack from various quarters.  The intransigence of the extreme wings of both major political parties must be held accountable for this divide and any adverse consequences.  If the currently vulnerable US economy, which is now operating at stall speed, drops into a recession, it will be the first since 1937, which was caused by flawed policy decisions.  All of the wrangling in Washington over the debt ceiling and long term deficit reduction and the dire predictions made by politicians and bureaucrats and aired daily by the news media, have prompted great fear and uncertainty among investors, consumers and businessmen, caused the economy to grind to a halt and the stock market to plunge in recent days.  The worst of the fear mongering was caused by the toothless threat of a credit downgrade.  It is our belief that loss of our AAA credit rating would cause little, if any, harm to anybody.  The Dollar will be the world’s reserve currency for a long time to come, and Dollar bonds will be the safest haven for cash.

The tragedy of all of this “in-your-face” debate in Washington is that in the end nothing was accomplished.  The debt ceiling has been raised by enough to get through next year’s elections, while the amount of spending reductions, which begin next year amount to little more than 0.1% of 2012 GDP.  Another blue ribbon commission will be formed and, heavily influenced by an army of lobbyists, will make more recommendations for spending cuts that will be promptly ignored.  It’s the same old story: Politicians get reelected by dishing out largesse to their constituents.  They are too afraid to do anything else and will defer any substantive reform for another day, when there is a real crisis, not a manufactured one.

We rely on market-based indicators for our strategic investment moves, not the pronouncements of politicians or pundits.  A 2.51% yield on the 10-Year Treasury Note, and a 0.28% yield on the 2-Year are not reflective merely of a flight to safety, but rather of an impending recession, or the fear thereof.  The declines in oil and other commodities, coupled with the sharp rise in the price of gold, the Swiss Franc and the Australian Dollar are all forecasting recession, or the fear thereof.  Muted forward guidance, if not outright warnings, from corporate managements, as they report second quarter profits, have only served to reinforce the concern of equity investors, who tend to fear the worst possible outcome in times of stress.

This Administration came into office during an extremely serious recession based on a credit collapse.  It has spent virtually all its energy during its first term focused on the blame game, waging class warfare, sponsoring left wing legislation to punish the banks and others it deemed the perpetrators of the credit collapse.  It seems not to remember that a liberal Congress, which wanted nearly universal home ownership, and various agencies, such as the SEC and the Fed, who slept through the storm, share equally in the blame.  At this point an aggressively accommodative monetary policy can do no good, since most businesses and consumers are trying to pay off their debts and certainly don’t want to borrow any more.  Those who do can’t get financing because bank lending standards are too tight, since bankers don’t trust the collateral and don’t yet know the rules they will have to operate under.  A $787 billion fiscal stimulus program, focused on consumption, was equally impotent, and it has run out.  Consumers, who must compete with foreign labor, are receiving little in the way of wage gains, barely enough to stay even with inflation, so household spending is in line with or below incomes.  Indeed, the personal savings rate has risen from essentially zero to more than 5% of disposable income.  With a quarter of all homes under water and 401k plans depleted there is little optimism among households.  Seeing no domestic increase in demand and fearing the high costs of healthcare and various new regulations, businesses are reluctant to invest in new capacity or to hire additional workers.  When a leading pharmaceutical manufacturer talks about laying off 10,000 workers in the US and replacing them with an equal or larger number in emerging economies the problem becomes all too clear.

Every time the President makes a speech about how important it is to create jobs the stock market declines, because it knows this is just talk.  Just ask 74,000 FAA workers and contractors who are living off their credit cards because Congress has gone on vacation while letting petty squabbles cut off funding for their jobs.  The only ways by which government can play a role in stimulating job growth and faster economic growth is to begin to address by administrative decrees or Congressional votes a long list of impediments, including ratifying the free trade agreements with Korea, Panama and Colombia; increasing oil drilling permits in the Gulf of Mexico; supporting full exploitation of shale oil and gas; clarifying the CO2 sequestration program at coal fired generating plants; moving ahead with nuclear power plant construction loan guarantees; granting subsidies to convert truck fleets from diesel to natural gas; extending unemployment benefits and the payroll tax holiday; completing the 4,200 pending regulations required by the Dodd-Frank bill and various other agencies; removing some of the hindrances created by Obamacare; enacting true tort reform; dropping the NLRB suit against Boeing; setting up an infrastructure bank, to be privately financed, but with some government seed capital; eliminating interest payments on bank reserves; and solving the mortgage foreclosure problem once and for all.  And finally, the most important change of all: reforming the tax code to broaden the tax base, close loopholes, cap preferences, eliminate unnecessary subsidies, lower all individual and business tax rates and create incentives for domestic investment and new hiring.

These are only a few ideas, which ought to be bipartisan, but may well not be.  We aren’t wise or knowledgeable enough to know all the possible actions that good government could take to shore up confidence, but we do know that any serious moves along these lines would have a swift and significantly favorable impact on confidence and economic growth.  Stocks are exceedingly cheap by all conventional measures.  The market values of well positioned, well run multinational corporations will soar at the first sign that the politicians are finally doing no harm.

 

The Multi-Factor Market

While I have no conviction on the timing, I am absolutely sure of one thing, to wit: Whenever the litany of worries hanging over the equity market begins to dissipate, there will be an explosive rally which will take the S&P 500 to a new high for this year, surpassing the 1370 level, which was reached on May 2^nd.  Of the many overhanging negatives, including: (1) the European sovereign debt crisis, (2) the uncertainty regarding the amount of fiscal drag that will result from the conclusion of debt ceiling negotiations, (3) the extent of the impact on global growth of the slowdown in China and other emerging markets that are fighting inflation with tighter monetary policies, (4) the degree to which factors other than $4.00 gasoline and the Japanese earthquake have contributed to the economic slowdown in the U.S., the majority of these issues are likely to be resolved favorably.  Fears of a double dip recession will quickly dissipate, and since equities are being valued at the cheapest level in more than twenty-five years, investors will once again be willing to pay higher, if not yet historically normal, valuations for projected earnings.

Readers of these memos know that we place far more weight on market-based indicators than on the proclamations of Wall Street pundits.  The latter are nearly always divided about equally between bulls and bears, so somebody gets it right each time, but not every time.

Since its peak nearly two months ago, the S&P 500 Index has retreated about 7.5%, but lately it has been tracking just above a rising 200-Day Moving Average line in the face of all these concerns.  Numerous individual stocks we follow also have technical patterns that suggest their corrections are at or near an end.  The market, in the aggregate, always knows more than the pundits.  In addition, Doctor Copper is still trading above $4.00 per pound,  the CRB Index of raw industrial commodity prices has been no worse than flat for the last couple of months, albeit a few percent below its April peak, and the South Korea Stock Index (KOSPI) is also tracking just above a rising 200-Day Moving Average line.  The Australian Dollar continues in a bull trend, reflecting the continuing strength of the Asian economies.  Despite the mess in Europe, the Euro at $1.43 continues in an uptrend, although signs of abating inflation may cause the ECB to modify its hawkish rhetoric, which would weaken the currency.  Admittedly, in the face of an imminent end to QE2, the 2-Year U.S. Treasury Note yields less than 0.40% and the 10-Year less than 3.0%, both reflecting two months’ worth of disappointing U.S. macroeconomic data.  However, if the yields on these two instruments begin to move up, it will be a signal that the economic recovery is regaining some momentum.

Indeed, there are faint signs, both anecdotal and statistical, that suggest the third quarter will see the beginning of an economic reacceleration.  These include a cresting of Initial Unemployment Claims, strength in May in the manufacturing segment of the FRB Index of Industrial Production, a modest firming of housing permits and starts in May, the strong gain in the May Index of Leading Indicators, previously announced sharp increases in third quarter automobile production, and as of the moment, a steep drop in the WTI crude price to $93 per barrel, which will soon be reflected at the gas pump.  Business borrowing, while far from robust, has been moving up over the past few months, and surveys of capital spending plans are also rising.  All these data come with a lag, and hopefully releases over the next month or two will reinforce these straws in the wind.

In the meantime, there have been very few pre-announcements of disappointing second quarter revenue and profit results from important, bell weather companies, and there have been a few notable reaffirmations of second quarter, and sometimes full year, results.  At today’s 1280± on the S&P 500, a 14.5 forward price earnings multiple would imply full year results of only $88, which is exactly equivalent to the trailing 12-months results.  Clearly, it would take some sort of global recession to cause flat profit results or worse for the balance of this year.  Corporate BBB bonds currently yield about 5.75%, implying a fair value P/E ratio for the S&P of 17.4.  If our conservative estimate of $92 of S&P operating earnings for this year were to be valued at that level, it would imply an S&P of 1600, up 25% from today’s 1280.  We don’t offer that as a forecast, but only as an indication that there is significant upside potential for equities if the litany of overhanging worries begins to dissipate.