Is There a Psychiatrist in the House?

It is a source of considerable annoyance (and sometimes amusement) to all serious investors that two years after the flight of many household and institutional investors the much reduced daily trading volume is dominated by hedge funds and “prop trading” desks, manned by relatively young and often rather inexperienced momentum traders.  Having no real knowledge of either the intricacies of macroeconomic data nor the inner workings of corporations, their ultra short­term focus merely reacts to the daily news flow and, often in their quest to scalp a few pennies, they make the wrong move.  Decimalization and the removal of the uptick rule have combined with electronic trading to create volatility all out of proportion to the significance of the daily data releases, most of which are merely “noise.”  Sometimes these trends can last a few days, long enough for a new investor consensus to develop, only to reverse suddenly and cause stocks to change direction.  The huge growth of industry-specific ETFs also magnifies these volatile but trendless short term movements.

In recent weeks the price of crude oil has risen by about 50% for both Brent and WTI.  Many are quick to place the blame at the feet of the Federal Reserve Board, arguing that QE2 has weakened the Dollar and caused a flight to hard assets.  While there may be some validity to that claim, other more important factors are also at work, including surging demand from the emerging economies, curtailed supplies from the Middle East as well as the Gulf of Mexico, and the magnification of these trends by speculators.  The evidence of the large open interests on the commodity exchanges proves that speculative activity is playing a major part in both the frequency and the amplitude of price moves among these commodities, which in turn is reflected in the price volatility of the underlying equities.  But surging oil prices, along with agricultural commodities, give rise to inflationary fears, which then cause interest rates to move up, thereby negatively impacting the present value of equities.  Also, of course, as the primary Government bond dealers prepare their books for large offerings of Treasury Notes and Bonds, yields inevitably rise, only to fall back again once the auctions are completed. 

The bears also raise the argument that nobody will be around to buy new issues of Treasury securities once QE2 ends in late June.  We simply discount that notion.  However, the very public dissension among members of the FOMC regarding QE2 certainly heightens investor concerns, as does the comedy of errors playing out in Washington in the battles over the fiscal deficit, the nation’s debt to GDP ratio and the need to raise the debt ceiling.  If there is a modest uptick in inflation, with no follow through in terms of much higher private sector borrowing or wage growth, then the recent inflation hysteria will prove to have been excessive.  While all of these inflation fears were playing out in early April, the stock market held its ground quite well, and even at this writing is down less than 1% for the month and is still up nicely for the year-to-date.

However, the next iteration in this schizophrenic drama has concluded that higher oil and other commodity prices are a tax on the global economy that will inevitably slow global growth.  When the IMF, not well known for the accuracy of its forecasts, downgraded global prospects for 2011 by a modest amount, prices of all commodities tumbled, and this led to a rout in commodity related equities over the past few days.  These had been among the leading performers for a long time.  Investors and traders had large unrealized profits in these groups, and the stocks being quite liquid were relatively easy to sell by those who suddenly feared slow growth rather than inflation.

Next week investors will get back to reality.  The earnings reporting season will be in full swing, and the focus will shift away from all this background noise to the real fundamentals.  Since there have been few significant preannouncements (typically disappointments), we expect another strong quarter to be reported for corporate revenues, margins and earnings.  Even with all the issues that affected GDP, including the tragedy in Japan, the turmoil in North Africa and the Middle East, higher energy costs, the harsh winter weather, the late Easter this year, etc., the numbers are likely to exceed consensus expectations in a majority of Q1:11 earnings reports.  Given all the background noise, however, managements are likely to be conservative in their forward guidance for the balance of this year.

Nonetheless, the Standard & Poors 500 appears to be on track to produce profits of about $95 per share this year, give or take a small amount.  If the Fed terminates its extraordinary stimulus in June, as appears likely, it will be a sign that the economic expansion has become self sustaining.  Interest rates will likely move up somewhat in the absence of purchases and ultimately some asset sales by the Fed, but they would have to move much higher than current levels to impede the economic expansion.  Indeed, some argue that higher interest rates will stimulate both borrowers and lenders to increase private sector credit.  Savers will also benefit from higher yields.  It is a political imperative for both the developed economies and the emerging economies to keep the global economy on an expansion path.  The riots in the Southern European countries and the turmoil in North Africa and the Middle East are clear signs to the politicians that permitting another global recession is simply not an option.  Even if corporate BBB bond yields move from about 6% currently to 7% on average, equities with nearly an 8% forward earnings yield, and with upside over time, are still by far the better bet.  And even if nominal GDP growth begins to exceed M2 growth in this country, there is still a mountain of sideline cash that needs to participate in equities.  Last year the average hedge fund with a 2%-20% fee structure barely returned double digits from all that useless short term trading.  Pretty soon, serious investors will begin to look through the nonsense of this activity and realize that this global expansion and bull market in equities still has a long way to run.

 

Swan Lake Redux

If Marius Petipa, the choreographer, and Pyotr Tchaikovsky, the composer, were creating this ballet in today’s globalized world, they would most likely dress the corps de ballet in black and put Odile, the evil seductress, in white.  Over the past couple of years the number of Black Swan events that have interrupted an otherwise soundly based upswing in equity market values is unprecedented, at least in my recollection.  There is little doubt that the U.S. economy is improving, at a modest but accelerating pace, and corporate profits continue to outpace domestic growth because of the large and growing exposure of many corporations to the emerging economies of Asia and Latin America in particular.  Moreover, high and rising incremental margins in a broad sampling of corporate income statements suggests that there is still significant profit margin leverage as revenues continue to improve.  Equity valuations remain quite reasonable relative to bond yields, and there remain massive amounts of uninvested cash, both here and abroad.

At the same time, the appetite for equity risk has been tested by a series of geo-political crises which have inhibited investor participation and what should be a gradual increase in valuations.  The volatility of the equity market has kept many investors, both individual and institutional, on the sidelines.  Each time a new crisis arises the stock market overreacts and overdiscounts the probable economic impact while the crisis is still unfolding.  The market immediately and inevitably assumes a worst case outcome, which rarely comes to pass.  Indeed, once the crisis stabilizes there is always a process of repair as corrective measure are undertaken, but only a small minority of investors brave the instant consensus to take advantage of the drop in prices.

However, investors are becoming aware of the distinction between a new, heretofore unimagined crisis and a mere replay of an old problem.  Hence, there is a big difference in today’s investor reactions to the sovereign debt crisis in Europe as it spreads from Greece to Ireland and now to Portugal, compared with a bolt out of the blue, such as the Japanese earthquake or the uprisings in North Africa and the Middle East.  As these latter events come under control, however, the assessment changes from fears of a serious market headwind to mere “bricks” in a traditional wall of worry.  Once all the experts have opined on the significance of the latest crisis, investors come to realize the market will have already discounted the most probable outcome, and they can ignore them unless, of course, a major new dimension surfaces.

Ergo, at this juncture it is far more important to look ahead to examine a few possible surprises that might occur over the next few months even if some of these are not major issues. 

The first quarter is ending in a few days, and in about three weeks the earnings season will be in full swing.  Our guess is that some companies will miss the numbers because of supply chain disruptions and/or lost sales due mainly to the Japanese earthquake, but also to the loss of some export business in places like Egypt.  In addition, of course, there will be higher input costs (oil, metals and agricultural products) not all of which can be offset by price increases or productivity gains.  Nevertheless, for the most part first quarter profits are likely to compare quite favorably with year ago numbers, but given the geo-political backdrop, managements’ forward guidance is likely to be somewhat muted.  In the very short run this may upset some traders, who will have bid up prices in advance of the quarter’s earning reports.  But it is nothing more than noise and should be ignored by serious investors.

With regard to all commodity prices, including energy, there are some who believe prices are being inflated due to an excessively loose monetary policy in the U.S. driving a flight to hard assets.  That argument has some validity, but far more important is rapidly growing emerging market demand that is clearly outpacing supply, which in many instances has suffered from decades of underinvestment.  Also, in agriculture recent widespread droughts and floods have curbed supply.  We believe demand for most commodities will continue to match or exceed supply for some years to come.  Prices will remain firm to higher, and producers and their equipment suppliers will continue to be attractive investments.  Higher commodity prices are a more serious problem for the emerging economies than in the U.S.  To the extent that food and fuel prices remain elevated in these countries the potential for social unrest remains high.  If the riots in other Middle East countries spread to a major oil exporter, it will be an intolerable game changer.

Looking further beyond, the U.S. economy will need to contend with somewhat increased fiscal drag, partly the result of the deficit battle in Washington, more likely because of the austerity imposed on state and local budgets.  The robust manufacturing sector, leading the way in private sector job creation, should offset much of this, however.  But by the end of June the Fed’s QE2 program will come to and end, and this trader dominated market is likely to have at least a brief “panic attack” over this.  Our view is that the winding down of QE2 will have only a marginal impact on interest rates or systemwide financial liquidity, and any significant market weakness leading up to the end of June or immediately thereafter, will create an opportunity for investors.

There are, however, signs of both rising inflationary pressures and rising inflationary expectations, some of which may be masked by the heavy weighting of housing related items in the Consumer Price Index.  As employment grows, housing activity is likely to improve and should lead to higher prices.  While this would be a major net positive, it will expose inflationary pressures that are building in the system.  Depending on how this plays out, it could cause the Fed to change monetary policy, at least at the margin, sooner than most market participants are expecting.  While the Fed’s initial steps will be modest, one can be sure that the stock market will overreact to this development as well.  Nonetheless, a modest change in monetary policy will by no means signal the end of the economic expansion.  Indeed, until there is a sharp and sustained increase in consumer borrowing we would not be concerned about inflation.  Given all the factors involved in consumer demographics, household balance sheets, and modest wage gains this is not a significant near term risk in our view.

 

Recent Stock Market Turbulence

Sent to our clients on March 16th, 2011

At the moment the crises in Japan, North Africa and the Middle East are still very much in flux, so it would be premature and unwise to draw any firm investment implications at this time.  The most pressing situation is the tragedy in Japan, and the ebb and flow of news regarding the six nuclear power plants is trumping otherwise very encouraging economic and corporate news in this country.  Until the authorities onsite are able to control, one way or another, the radiation threat from these power plants, the airwaves will be filled with self-styled experts only too eager to pose in front of a camera and espouse their own, often conflicting, views.  Earlier today an EU energy chief characterized the situation in Japan as “out of control and heading towards catastrophe.”  He later qualified his remarks and said that his comment was “not based on any specific, privileged information.”

I cannot count the number of dramatic crises and wars that have occurred during my investment career, but I do recall that no matter what the event, the stock market  has always overreacted and overdiscounted the ultimate economic impact while the crisis itself was still unfolding.  It happens every time.  The stock market immediately assumes a worst case outcome, which rarely comes to pass.  Secondly, in the wake of every crisis there is always a process of repair, during which those in charge, having brought the situation under control, now move to forward to correct the damage.  In the case of Japan, there is no doubt that while there will be an immediate negative economic impact, it will be followed by a major infrastructure rebuilding program, which will provide an economic stimulus to the Japanese economy and probably to some U.S. manufacturers. 

Thirdly, those U.S. companies which are being directly impacted by interruptions to their supply chain or their Japanese customer base, as is the case with IBM and Qualcomm, for example, will take whatever steps possible to protect their interests.  Their earning power may be interrupted or reduced in the short run, but, ultimately, it will be restored and the value of their shares will reflect the recovery.

 In summary, not only do we not have all the answers, but we are not yet sure of all the proper questions.  I can assure each of you that we are constantly and carefully monitoring this situation, along with all the other geopolitical issues (oil, etc.) and will take whatever steps are necessary to protect your interests.  In the meantime, please do not hesitate to call with any comments or questions you may have.  Once again, all of us at Bryden-Abrams thank you for your confidence and trust.

 

Headwinds--Or Only a Wall of Worry?

Written December 29, 2010

At the end of 2008 investor sentiment was as depressed as I have ever witnessed.  Again, at the end of 2009, despite a strong rally from early March through year-end, investors were still fearful, and most were on the sidelines or, at best, significantly underweight U.S. equities.  Now, at year-end 2010, investor sentiment has brightened significantly in the wake of considerable data showing that the economic recovery in the U.S. is gaining momentum, and most recently reflecting the tax compromise just enacted.  I am a strong believer that the U.S. recovery is sustainable and that not only are corporate profits still in a solid uptrend, but equities are still cheap relative to corporate bonds, and there is a vast amount of underinvested cash on the sidelines.  Equity mutual funds are just beginning to see inflows, while bond funds are now experiencing redemptions.  Furthermore, the outlook for Europe and Japan is lackluster at best, and many of the emerging economies are, or soon will be, tightening monetary policy to moderate growth and keep a lid on inflation.  A moderately paced, non-inflationary expansion would be the best possible environment for U.S. equities.  By all indications, these should be among the best performing asset classes next year.

 

However, given the broadly based consensus that 2011 is going to be a good year for equities, which is leading stocks to close this year at their best levels, I am, nevertheless, a bit concerned, because the markets always seem to outfox the consensus.  Maybe a dose of caution is appropriate, or at least an awareness of what could derail, even temporarily, the current bull market.  On the one hand there are a list of possible negative developments, which I enumerate below, but the mere fact that these are well known and widely discussed by market pundits suggests that their potential impact may already be largely reflected in stock prices.  Let’s face it, the most damaging developments are those that come as a complete surprise to the investor consensus and cause an immediate surge in fear.  We can’t predict these.  We can only hope to recognize them early enough to take steps to preserve our capital.  Few among us did a good job of recognizing the “canaries in the coal mine” in 2007 and 2008.  Let’s hope we do a better job of recognizing and responding going forward.

 

Apart from the unexpected, the following are some issues which appear to be dismissed by investors at the moment, even though they are being discussed daily in the media.  As one peruses the list, it will quickly become clear that some of them are mutually exclusive of others.  Moreover, some, if they occur at all, will develop only gradually, perhaps imperceptibly, until they reach a tipping point.  Others could come about with shocking speed, and finally, I admit that the ones I fear the most are those that I am not astute enough to have listed.

 

• BORROWING FROM Q1:11 – As the stock market finishes the year at its highs, it is reflecting, among other factors, what is likely to be a very strong fourth quarter for the economy and for corporate profits. Christmas sales appear to be running more than 5% ahead of last year, the best annual gain since 2003.  Clearly, consumers have felt confident enough to open their wallets, but when the credit card bills arrive in January, there may be some rude awakenings, so if in fact, a strong fourth quarter borrows from the first quarter of next year, as many households replenish their savings, the softening will start to show up in the data by late January and early February.  The stock market may interpret this to be a sign that the economy is heading for another “soft patch” or even a “double dip” and react accordingly by selling off.  At this point my response would be not to get faked out, but in fact to buy the dip, after letting it run its course for a few weeks.
• THE HOUSING PROBLEM – Everyone is aware that foreclosures continue to rise; there is a large inventory (plus a shadow inventory) of unsold homes; and house prices continue to drift lower.  Were it not for “doubling up,” reduced immigration and the increasing proportion of baby boomers, this overhang would be absorbed much more quickly than is probable.  If for any reason there were to be another 10% drop in residential home values, a very significant percentage of homeowners would find themselves underwater.  The effect on consumer psychology and spending could be quite significant.  Even though this condition would likely sneak up over a period of many months, the stock market would react more quickly.  In this case it might be best to hold on to some cash.
• SLUGGISH JOB GROWTH – Although private sector employment has begun to recover in recent months, new jobs are still not increasing fast enough to bring down the headline unemployment rate (currently 9.8%) or the more comprehensive U-6 measurement (currently 17%).  State and local governments continue to cut back on employment.  There is no growth in construction and real-estate related employment which, it must be remembered, accounted for 40% of total job growth between 2003 and 2008.  Moreover, many corporate announcements of new hirings reflect jobs added overseas, where markets are growing rapidly and labor costs are still well below those in the U.S.  Equity investors are acutely aware that private sector job creation is the key to a more vigorous and sustainable economic expansion.  If significant improvement is not forthcoming over the months ahead, stock prices could well reflect this.  Treasuries would likely rally and signal that a more defensive posture would be called for.
• DON’T FIGHT THE FED – Despite its commitment to the current round of monetary stimulus (QE2), if the economy does begin to grow fast enough to start narrowing the output gap, not only will the current $600 billion program end around mid-year, but the Fed will, most likely, begin to normalize monetary policy.  Indeed, if bank lending picks up, the Fed will be compelled to act.  The addition of two hawks to the FOMC, as well as political pressures from the new Congress could also play a role as well.  Even though the initial policy change will be a long way short of an actual tightening, the impact on stock prices is likely to be sharp and swift, particularly if it is accompanied by even a modest inflation scare.  Buy the dip, but only after a month or two of price declines.
• THE EMERGING ECONOMIES FIGHT INFLATION – Led by the BRICs, especially China, the emerging economies now account for about 35% of global GDP and a much higher percentage of global growth.  Many of these countries are now experiencing inflationary pressures, to which they are responding by tightening monetary policy, albeit gradually, and allowing their currencies to appreciate against the Dollar and the Euro.  A bursting of the real estate bubble and an ensuing hard landing in China would have serious consequences for the entire global economy.  To the extent that growth in the EMs slows there is likely to be some easing of demand pressures for energy and other industrial commodities, which have been market leaders for several years.  In addition, our exports of high tech and other industrial machinery and equipment would be susceptible to some slowdown.  If the market leaders in these industries come under pressure, the entire market will suffer some adjustment.  You can’t hide in the likes of Johnson & Johnson and AT&T.  Defensive issues may go down less, but they will go down!
• PROFIT MARGINS – In the final analysis, the “Mother’s Milk” of a bull market is widespread expansion of corporate profit margins.  Throughout the recession profit margins were remarkably well-sustained because of the sharp cutbacks in labor and other controllable expenses.  As revenues began to move higher, the leverage on incremental sales produced sharp increases in corporate profits in 2009 and again this year.  For 2011 most pundits expect more of the same, although perhaps at a somewhat slower pace.  However, there are already the earliest faint signs that productivity gains will be harder to come by over the next year or two.  Higher labor costs (wages and health care costs among them) will be in effect.  Overtime hours have been stretched about as far as possible; new hires will reduce productivity gains.  In addition, various commodity costs and other inputs will put pressure on margins in a still intensely competitive environment where pricing power is often hard to come by.  Once a company’s margin expansion is over its stock becomes a market performer at best.  One must watch carefully the trend of each company’s incremental margins for early warning signs.
• OIL PRICES – Notwithstanding the foregoing, one must note that regular grade gasoline now costs more than $3.00 per gallon at the pump.  One industry expert believes that $5.00 gasoline is likely in 2011.  Needless to say, every one dollar increase at the pump has a significant impact on discretionary spending by consumers, who purchase an average of 1,000 gallons per year.  (Another source of a consumer price inflation squeeze is the Chinese currency.  As the Yuan appreciates, prices at Wal-Mart will inevitably rise.)  Needless to say, anything that hurts discretionary spending is a negative for stocks.
• THE EUROPEAN SOVEREIGN DEBT CRISIS – I tend to be fairly relaxed about this one, at least for 2011, because the ECB is gradually buying up the sovereign debt of the PIGS and taking it off the books of the French and German banks.  At some point, not next year, there will inevitably be a debt restructuring, which by then will already have been reflected in market prices for this paper.  Some American banks have exposure here, but relative to their mortgage problems the total isn’t enough to worry about.  Paradoxically, the weak Euro has greatly improved the export competitive position ofGermany and France, who are growing quite nicely, and conversely, still remain good markets for our exporters.  This is another area where I would buy any dip caused by Europe’s problems.
• MUNICIPAL BONDS – Recent estimates suggest that states and municipalities are facing a $140 billion budget shortfall for 2011.  By law this must be closed.  States are suffering from a shrinkage of income taxes, property taxes and sales taxes.  They are raising tax rates and fees, cutting employment and other services and playing games with their already drastically underfunded pensions.  None of this is lost on the municipal bond market, where spreads have widened significantly in recent months.  Most observers point to a long history of municipal finance with only a very few defaults.  Under the current circumstances, that form of analysis may not hold up.  We have already seen one state capital (Harrisburg, PA) in deep trouble.  A rash of these would be unsettling, to say the very least.
• GRIDLOCK IS NOT GOOD – For many years the conventional wisdom on Wall Street has been that gridlock in Washington was good because it restrained excessive government spending and prevented the promulgation of onerous new regulations whose impact would be negative for business in general.  At this point, however, it is clear that we are approaching a tipping point in our national finances, and accordingly, the Federal deficit needs to be brought under control.  Clearly, the combination of higher taxes and reduced government spending, both of which are necessary to make any headway, will require bipartisan support, which I believe would be welcomed by investors, who are well aware of the negative long term implications of doing nothing.  If the new Congress descends into partisan gridlock, investor confidence will certainly not be enhanced and could well suffer.  One clue will come in the first quarter, when the debate over raising the Federal debt ceiling begins.  In addition, if the flood of new regulations, including Fin-Reg and the healthcare initiative, all of which came on the heels of the financial crisis and recession, are not dealt with in a more even-handed manner, corporations will suffer and stock prices will reflect it.  The great irony is that much of the Dodd-Frank bill is unnecessary because the discipline of the free market will prevent those excesses from occurring again.  In short, if there is no constructive leadership out of Washington over the near year or two on the difficult issues, it will be a negative for equities and bonds.  The bond market will tell the tale.  Watch the yield on the 10-Year Treasury Note.

In short, I have no illusions that these musings will solve the problem of risk control in 2011.  Hopefully, they will sensitize the reader to be alert to any developments that have the potential to interrupt what should be a lengthy economic expansion and bull market in equities.

 

All Forecasts Are Subject

The only function of economic forecasting is to make astrology look respectable.

- John Kenneth Galbraith

It is wise to remember that end-of-the-year forecasts and predictions for the following year made by Wall Street pundits often turn out to be wrong, because surprise developments inevitably occur which were not part of anyone’s calculations in December.  Bearing that warning in mind, I nevertheless believe that 2011 will prove to be a rewarding year for stock market investors and a frustrating one, at best, for holders of sovereign and corporate debt.  The rise in the yield on the 10-Year Note from a low of 2.33% in October to 3.50% at this writing, in the face of aggressive monetary easing by the Fed and a strong dollar, is ample evidence for me that the rate of improvement in the U.S. economy is picking up somewhat and is likely to accelerate further as we go through next year.  The 2-Year Note hit a low of 0.33% in early November and is now at 0.64%, even as the Fed anchors the Fed Funds rate at between 0 and 25 basis points, clearly another sign of improving growth.  Bank credit and commercial paper extensions have yet to pick up, but that is likely to occur next year as well.  Many economists have raised their GDP forecasts to call for more than 3% growth next year.  Some are even predicting a 4% rate of gain.  The key determinant will be private sector job growth.

After a spring and early summer “soft patch” the economy has been gaining momentum on the jobs front, as well as consumer confidence, wage and salary increases, consumer debt reduction, automobile purchases, manufacturing and exports.  Indeed, the Christmas season appears quite robust and might even be borrowing some from the first quarter of next year.  Of course, various headwinds remain, most notably house prices, and a continuing high level of foreclosures, the squeeze on state and local budgets, which keeps their spending down and layoffs elevated, the severely underfunded status of public pension funds and the winddown of the $787 billion fiscal stimulus bill.  The latter, however, will be significantly offset by the tax compromise currently pending.

When GDP forecasts for next year were in the 2% range, we anticipated that the Standard & Poors 500’s operating earnings would gain at least 10%, paced by strong foreign business, an improving U.S. economy, continuing good productivity gains and some pricing power.  For now we will stick with that forecast, which implies about $92 of S&P 500 earnings next year, but the upside risk to this forecast is not trivial.  We forecast a range for the S&P 500 Index of between 1335 and 1475, compared with today’s level of 1241.  The low end assumes a P/E of 14.5 and an earnings yield of 6.9%, which compares with 6.1% currently for BBB bonds.  The high end forecast assumes a P/E ratio of 16, or conversely, an earnings yield of 6.3%.  The two critical moving parts are, of course, the level of earnings and the level of bond yields.  More significant P/E expansion is out of the question in our judgment, given the high probability of rising interest rates and the continuing low level of confidence and high level of risk aversion among most long term investors.

Up until the past couple of weeks the stock market, which is still dominated by short term traders, was not discounting beyond this year’s results.  In the wake of the still pending compromise over taxes, equities have now begun to look at 2011 earnings.  Nevertheless, the rising tide effect is over.  Investment outperformance will require portfolios to be heavily weighted toward companies with 2011 earnings growth rates well above whatever the S&P 500 achieves.  It will be less important whether these companies are large or small, value or growth, or any other label.  At our firm we look for companies that can achieve at least 20% earnings growth next year, and we watch carefully the trend of incremental profit margins to gauge the degree of leverage inherent in each company’s operations.

There is no shortage of risks to which investors must remain alert.  The Federal Reserve Board is more likely than not to begin to normalize monetary policy sometime in 2011.  This will cause a few months “panic attack” in the equity market.  Watch bank and C/P borrowing and the yields on the 2-Year Note (0.64% currently) and the 10-Year Note (3.50% currently) for signs of further economic improvement and inflation expectations.  Also watch the 10-Year TIPS spread, currently 2.37%.

In addition, further monetary policy tightening in China is likely, which will have an impact on commodity prices and earnings expectations in this country, since China has clearly become the primary driver of global growth.  Conversely, European debt, deficit, deflation and growth problems are likely to persist and even worsen for years to come.  A  nation cannot dig itself out of debt via an austerity fiscal budget.  Sovereign debt restructuring in Europe is inevitable.  It is only a question of when.

The U.S. deficit problem will come into sharper focus next year.  There could well be a crisis in the Spring, when the Federal debt ceiling comes up for an increase.  Inevitably, the U.S. must rein in government spending and probably raise taxes as well, but little is likely to be accomplished by the deeply divided Congress until a crisis hits home.

Simply put, the outlook for 2011 appears quite favorable, as corporate profits are making good headway, equity values are still quite reasonable, bonds are likely to be under increasing pressure as growth accelerates, and there is a mountain of sideline cash that could fuel equity values once confidence in a sustainable expansion becomes more widespread.  In the meantime, wealthy individuals and large retirement plans all of whom were badly burned in 2007 and 2008 will be slow to return to equities.  The stock market will remain dominated by short term trading strategies on the part of hedge funds and proprietary trading desks.  As a result, volatility will remain elevated, particularly intraday volatility, as these traders react to news developments, both domestic and foreign, economic and political, as well as market technicals.  Serious investors with portfolio holdings in which they have high conviction will have to fasten their seatbelts many times during the year ahead, but a year from now they will have reaped significant rewards.

 

 

Outlook For 2011

• The stock market’s recovery from the financial crisis and recession is essentially over. The market is up 80% from its March 2009 low, earnings have recovered (in some cases have reached new highs), and the P/E on current earnings is a reasonable 14.5. For all intents and purposes, the market has paid for this year’s profits.

• Next year the overall investment climate will remain conducive to capital appreciation, but for above average performance one must be in the right stocks. The tide that has lifted all boats since early 2009 is not likely to be as supportive for companies that don’t have special attraction. Of all the companies listed on U.S. exchanges only a couple of hundred, or so, are of significant investment interest at any point in time.

• Even if the domestic savings rate stabilizes at around 6%, this will not generate an appetite for increased borrowing/lending by households or banks. Household debt is still too high relative to the slowly growing incomes of an aging population. Moreover, cash out refis will not resume because so much residential real estate is under water. Real estate values will take years to recover, and the combination of foreign competition and high unemployment will hold down wage growth for all but the most talented. As a result GDP will continue to grind higher at about a 2%+ pace.

• However, next year’s operating earnings for the S&P 500 should rise at least 10% to $92 even in a 2% GDP growth environment. Profits will be driven significantly by exports and foreign domiciled sales, which favor our large multinational companies, virtually all of which are well capitalized, highly efficient, global market leaders.

• Stock market gains should, at a minimum, parallel earnings growth. A return to higher valuations will depend largely on political progress as it improves longer term prospects for the economy and the same time boosts investor confidence. Unfortunately, political gridlock is the most probable outcome until a crisis forces the politicians to reach a sensible compromise regarding the nation’s fiscal problems. The principal (but not high) risk to equities in 2011 would be a rise in inflation or inflationary expectations. One must watch bank lending for an early warning signal, but that is more likely after 2011.

• Successful investing outperformance next year will depend much more on bottom up analysis that concentrates on those companies with profit growth well above that of the Index. The opportunities here remain good because the current trader dominated market is not discounting very far into the future, which suggests that companies with well above average earnings growth next year will achieve at least parallel market appreciation. One clue to finding companies with vigorous growth prospects for 2011 is the trend of incremental profit margins relative to overall company margins.

• Emerging markets equities and companies developing “new, new things” will be of great interest as well. For a combination of income and growth there are several well managed convertible bond funds. Avoid all government debt.

End of the Week Reflections

•The U.S. economy is growing, albeit very slowly, close to stall speed. Unless there is a shock, the risk of a double dip remains low, however, because there is definitely forward momentum to consumption, exports, capex, and Federal spending. A cheaper dollar is a big plus as long as other countries do not retaliate.

•Consumers (70% of GDP) continue to deleverage, i.e. pay down mortgages, credit cards, auto loans and other indebtedness, which keeps spending in line with or less than personal income growth of little more than 2% per annum. The wealth effect is working against consumption also, because of the decline in house values. Low interest rates are also hurting savers and retirees, which also curbs consumption. If the savings rate levels off, spending would pick up.

•Small and medium size businesses are not hiring for multiple reasons: sluggish demand, uncertainty regarding taxes, healthcare costs and various onerous regulations, as well as still tight credit standards at the banks. Big multinationals are still shedding jobs in the U.S. while hiring abroad. There is still much debate over how much unemployment is cyclical and how much is structural.

•State and local governments are still in the early stages of belt tightening. More layoffs, higher taxes and pension modifications will be forthcoming, particularly if Republicans gain control of more state houses next month.

•Residential and non-residential construction will continue to be drags on GDP growth. Until foreclosures peak and the inventory (and shadow inventory) of existing homes begins to decline, house prices will remain under pressure and labor mobility will be restricted. This process could take years to work through even though demographics suggest a demand for more than 1.25 million new units per year. Caterpillar Tractor forecasts an increase in new home construction to 800,000 starts in 2011. Let’s hope.

•The Federal Government will also be a source of fiscal drag, as the stimulus program winds down, and at least some taxes go up.

•The ECB is more interested in removing monetary stimulus than expanding it. Fiscal drag plus aging populations are curbing growth in Europe and Japan. Once the emergency credit facilities expire, a debt restructuring in Greece and other peripherals will be inevitable. The European banks will have sold enough sovereign debt to weather the haircuts.

•The emerging economies are the principal drivers of global economic growth. This benefits large multinational corporations but not most small domestically oriented businesses. As they develop domestic demand, U.S. exporters will benefit even more than currently.

•Corporations continue to improve productivity despite sluggish revenue growth. Tech oriented capital spending is recovering. Incremental profit margins are still rising, suggesting that earnings will continue to outpace revenue growth.

•Monetary policy is the only remaining tool to stimulate growth, but another round of quantitative easing in the U.S. has already been largely priced into the equity and fixed income markets, aswell as the energy, commodity and currency markets. For QE2 to be successful in the face of the structural headwinds that are holding back consumers and businesses it will have to remain in effect for quite a while until confidence recovers somewhat and growth begins to pick up. The first QE2 announcement will likely not be the last.

•Despite a surge in bank reserves on deposit at the Fed, which will be greatly augmented under QE2, there is negligible risk of inflation until households and businesses begin to borrow again. Interest rates will remain extremely low until private sector credit demands pick up and force the Fed to modify its policies.

•As of November 3rd, three principal stock market drivers will have moved from hope to reality: (a) QE2, (b) Q3:10 earnings and forward guidance, and (c) a new political line up in Washington and in the state houses. Hope is always worth more than reality, and a short term stock market consolidation is likely to ensue. This is by no means the end of the bull market.

•The events of the past two years have destroyed investor confidence to a degree never seen in our lifetimes. Long term investors have abandoned equities while pursuing safety in the form of negative after tax real returns from short term money market instruments and the illusory safety of bond funds. Equities have reached the revulsion stage in the minds of investors. There is no more forced liquidation, only a trickle of capitulation, as equity mutual funds are still in redemption mode. Sideline cash, here and abroad, exceeds the $12 trillion value of U.S. equities. The market has been abandoned to short term computer driven trading based on the daily flow of news items, much of which is simply “noise.” Following a deflationary bust, it simply takes time to repair the damage and get the economy back toward trend growth. All of this tells me that this is the best entry point for long term investors in a great many years.

•Operating earnings in 2011 for the S&P 500 should be up at least 10%. At a minimum the S&P 500 should track that gain, which implies a level of 1300 by this time next year, which is about 14 x projected 2011 operating earnings of $92. Any improvement beyond that will depend on estimates of higher earnings or a major recovery in investor confidence, which would boost P/E ratios. Much will depend on whether or not Obama demonstrates a true move toward the political center.

•In any event, multinational companies providing energy, materials, industrial and infrastructure machinery and equipment will remain market leaders, along with transportation companies and selected tech issues as well as those companies on the cutting edge of “New, New Things.”

Issues On My Mind

There is little risk of a double dip recession. Paced by strong growth from the emerging economies GDP will continue to grow, albeit at only a 1.5%-2.0% pace. Corporate profits will far outpace GDP because of large and growing foreign exposure and strong productivity gains. The bottom line is that assuming that the S&P 500 can achieve operating earnings of $90 or more in 2011, the forward P/E of the Index is still less than 13x, which produces an earnings yield of 7.7%. This compares favorably with yields of about 5.5% on BBB bonds. Despite this, investor sentiment is about as bad as it gets, and global sideline cash exceeds the total value of U.S. equities. This bull market is far from over, but some of the near term positive dynamics have been largely priced in, and there are continuing threats from the Obama Administration’s anti-growth stance on corporate and individual tax rates, together with a worldwide drift toward protectionism. These threats cannot be ignored.

The equity market continues to be dominated by short term traders reacting (not anticipating) to both positive and negative news announcements, both macro and company specific. Long term investors are absent. Equity mutual funds have been in net redemption for nearly two years. The September jobs report continued to reinforce the notion that the economy is growing very slowly, certainly not fast enough to absorb the unemployed, which has ominous implications for public policy going forward. Somewhere between 125,000 and 150,000 sectors jobs need to be created each month merely to keep the unemployment rate flat. Moreover, a growth rate of 1.5%-2.0%, coupled with an inflation rate of about 1% or less, leaves the economy vulnerable to a shock that could produce outright deflation and/or another recession. This causes us to fear the response of the Administration and Congress, who are likely to continue the failed policies of high taxes, deficit spending and creeping protectionism.

All of this has given rise to the notion of another round of monetary stimulus in the form of quantitative easing (QE2) by the Fed as the best way to accelerate job growth and, in the Fed’s own words, to bring the inflation rate up to an acceptable level. If successful, QE2 would drive equities higher, mortgage rates lower, the dollar lower, and could force banks to become more active lenders. Business and consumer confidence might be raised, notwithstanding the Administration’s anti-business posture. However, whether this effort will be successful or not is the subject of daily debate among the various experts. Clearly, there is division among the members of the FOMC, with some of the so-called “hawks” making frequent speeches against the idea. The November 2nd-3rd FOMC meeting may not even launch this policy. I am dubious that QE2 will produce the desired stimulus to growth, since the headwinds of consumer deleveraging, declining home prices, and the anti-growth legislation recently enacted, together with the threat of higher taxes will collectively restrain growth.

Nevertheless, both the bond and the stock markets are already in the process of discounting this undertaking, even as the St. Louis Fed President suggested last week that by the time of the November meeting such a move may not yet be called for by the latest data. At this writing the 2-Year Note yields a record low of 0.34% and the 10-Year is at 2.33%. Ever since late August when the topic was first discussed by Chairman Bernanke, the Dollar index has dropped by nearly 10%, clearly reflecting expectations that the Fed will flood the financial system with moreliquidity. Likewise, the Standard & Poors 500 Stock Index has gained more than 10% over this period, Gold is at a record high, and virtually all commodity prices are substantially higher. In my judgment, stocks will undergo a bout of profit taking as soon as QE2 is announced. If there is no announcement at the November 2-3 FOMC meeting, or if the measures announced are deemed to be too modest, stocks could sell off more sharply.

Also, two other dynamics are at play at the moment. The first, and always the most important, are corporate earnings. The next three to four weeks will witness reporting of third quarter results together with managements’ accompanying statements regarding the outlook and future profit guidance. Our expectation is for another strong quarter, despite the translation effect of a weaker Euro than a year ago. There have been very few negative significant pre-announcements, and the anecdotal evidence has been positive. Given the enormous uncertainty regarding taxes and the onerous healthcare and FINREG legislation, many of whose enabling regulations have yet to be written, it would not be surprising to see corporate guidance tempered, but make no mistake the economy is still moving forward, productivity is still high, the foreign component of major company earnings is large and growing rapidly, and there is even some pricing power. However, one must recognize that unlike the May-June sell-off, stocks have already been rallying into Q3 earnings. A period of consolidation should not come as a surprise.

The final elements in this calculus are the midterm elections. The old saw that political gridlock is good for the economy and the stock market may not hold. If the Administration loses its majority in either or both Houses of Congress, the real question will be whether Obama will move to the political and economic center to begin to compromise in a way that will accelerate the economic recovery and continue to support financial asset prices. If the tax and redistribution policies continue, if the Bush tax cuts expire, if modifications to Obamacare and FINREG are not enacted, if trade barriers are erected, stocks will be negatively impacted. Finally, the report of the deficit commission is due in December. If no reasonable deficit reduction plan is put forward, stocks will also be vulnerable.

Musings On a Hot Summer Day

For more than a month we have expected that second quarter corporate profits would be surprisingly strong and would trigger a recovery in stock prices following the 16.5% decline from mid-April through the end of June.  Our fear was that once the thrust of from these strong second quarter reports was over, the continuing stream of lackluster macroeconomic data releases would trigger another stock market setback, perhaps not all the way to the June lows, but at a minimum, a frustrating sideways move until late September, at the earliest.  Seasonal factors also argue for such a pattern.  We are about halfway through the earnings season.  In another two weeks most all of the major bellwether corporations will have reported, and the rally will run out of fuel.  The problem is that the consensus of investment opinions has now moved to agree with this view.  That makes us uncomfortable, but it does not change our strategy.  We are gradual sellers into the current rally.

 

As of these last few days of July, the Standard & Poors 500 Stock Index has risen about 7.7% for the month to date, sharply reversing the steep sell-off from the mid-April peak.  Fears that the European sovereign debt crisis would adversely impact the U.S. recovery, and perhaps even our banking system, have faded away as the EU, the IMF and the ECB have taken aggressive steps to shore up the banking system of the Eurozone, and the recently completed stress tests of 91 of Europe’s largest banks, however imperfect, have allayed fears of contagion.  More important, a sharp decline in the Euro is stimulating the export sectors of Europe, and the major economies are now growing quite nicely.  All of this can be summarized by looking at the Euro itself, which has risen from $1.18 at the beginning of June to roughly $1.30 at present.

 

The spring sell-off in the U.S. set the stage for a strong rally, as second quarter earnings are coming in better than expected,  not only on the bottom line, but in many cases on the top line as well, and most important, management’s guidance has been surprisingly robust for a large number of bellwether companies.  Nearly half of the S&P companies have reported, and 80% of those have had positive earnings surprises, well above recent trends.  Incremental profit margins, a metric we use to gauge the amount of remaining operating leverage, have been generally very strong.  The S&P 500 at 1110 today is selling at 13.5 x our minimum estimate of $82 for this year, providing a 7.5% earnings yield.  It is capitalizing potential 2011 earnings of $90 at only 12.3 x, producing an earnings yield of 8.1%.  These figures are cheap historically and cheap relative to investment grade corporate bonds, whose yields are about 6.0% currently.

 

The twin problems facing the market, impeding a return to more normal valuations, are a combination of fear and uncertainty.  There is fear that without more robust private sector job growth, and with continued deleveraging by consumers, the current sluggish expansion could peter out, sending the economy into a renewed recession, or a so-called double dip.  Europe’s sovereign debt crisis has reminded the markets and the politicians that unbridled fiscal stimulus is no longer feasible, yet there is fear that the expiration of the Bush tax cuts at year end will hit the economy hard enough to produce a new downturn.  In total dollars the wealthiest Americans have been hit the hardest over the past couple of years and have clearly trimmed their borrowing and consumption.  Note that the 5% highest earning Americans account for one-third of household consumption.

 

In addition to fear there is uncertainty brought about by the blitzkrieg of recent unfriendly regulations and legislation, particularly those of healthcare and FINREG.  Small businesses, which account for two-thirds of all job growth over time, are fearful of higher taxes, are still having difficulty borrowing from banks, fear the unknown cost of the new healthcare program and see only sluggish demand growth, limiting  their need to add staff.  Along with large corporations they are using more temporary help and more overtime hours rather than taking on the added costs of hiring additional permanent employees.  In addition, harsh as the analysis may seem, there is little doubt that extending unemployment benefits for up to 95 weeks is also impeding job growth, and there are surveys which suggest that many positions are going unfilled for lack of skilled workers.  Finally, many companies which are hiring are doing so in foreign markets, where labor costs are less and customer demand is growing rapidly.

 

There is the perception, which in this case is reality, that the Obama Administration is anti-business.  At best, members of the President’s inner circle have no business experience.  The first two years of this Administration have been spent punishing those perceived to be responsible for the financial crisis and borrowing to give handouts to the neediest.  There has been absolutely no creative effort to incentivize businesses to hire and invest.  The $787 billion stimulus program was poorly crafted and produced no lasting effects.  The balance sheets of publicly-traded non-financial corporations in America have over $1.8 trillion of surplus cash, which they are reluctant to spend for fear of another downturn or another banking crisis which could shut off their access to financing.

 

Perhaps it would be an overstatement to suggest we are on the verge of a deflationary spiral, but clearly there is the risk that economic growth could fall below stall speed.  Real final domestic demand is growing at less than a 2% annual rate.  This is well below the pace required to reemploy those out of work and those who are working part time.  Demographic and scrappage factors suggest that automobile sales should be running at a 16 million SAAR rate, 60% above the current level.  Demographic factors suggest that new home construction should be running at about 1.25 million units per year rather than a rate of 300,000 plus.  In order to move toward these targets, private sector employment and wages must grow, and both consumers and banks must be willing to borrow and lend.  Because we are locked in this non-virtuous circle, it is hard to project a near term increase in aggregate demand.  There are many policies which the Government could implement to stimulate the economy, but none are even under consideration.  With the August recess looming, followed by campaigning for the November congressional elections, not much is likely to get done in the near term.  Stocks are locked in a trading range at best, and we think it will prove wise to carry extra cash for the next few months.

You Can Feed a Man a Fish or...

In recent weeks several highly respected economists have offered suggestions for accelerating the pace of economic recovery, focusing in particular on the all- important problems of unemployment and job creation. Their suggestions have a common theme insofar as they all rely on expanded government initiatives. The fallacy of this approach is that Government can tax and redistribute incomes, or borrow and distribute funds, to help sustain the current level of economic activity, but by itself Government cannot increase either incomes or capital investment, both prerequisites for sustained employment and wage growth. The proposed government based solutions fail to recognize the critical importance of private sector initiatives, as well as the inherent efficiency of the private sector, versus the inefficiency inherent in government bureaucracy.

Instead of extending or expanding unemployment transfer payments across-the-board, the Government should incentivize all private U.S. corporations to hire and train any employable high school graduate out of work for six months or more, who applies for work, by giving each company a 100% tax credit for all the out-of-pocket costs of their employment, including wages, payroll taxes and healthcare insurance, for a 5-year on-the-job training program. There would be no financial risk to the participating companies, who would end up over time with a younger, more capable workforce. Conceivably, this subsidy could be phased out gradually over the 5-year term.

If one million workers could be employed under this program, at a most conservatively estimated per annum all-in cost of $50,000 each, the annual revenue loss to the Treasury would be $50 billion, a proverbial drop in the bucket relative to the cost of today’s failing stimulus programs. Moreover, unemployment benefits, which average $21,000 per person per year, would be eliminated for this group, and there would be a small recovery as these workers contributed payroll taxes and paid some income taxes. Importantly, the high propensity to consume of these newly employed workers would augment aggregate demand and likely would stimulate additional hiring by the private sector.

The current education system in America simply does not address the problem of preparing young people for the jobs that are available in today’s information-based economy. Indeed, recent evidence suggests that many open positions are going unfilled because the applicants lack the necessary skills. Even if it were possible to dramatically revamp the curriculum of the public education system, it would take more than a generation to do so, if for no other reason than today’s teachers themselves lack the necessary training. It would be far more efficient to incentivize the private sector by having Government pay for what would be essentially apprenticeships for on-the-job training. Corporate America knows what skills are required.

Many older workers, who have retired or are nearing retirement, could stay on or return to their former employers to act as teachers and mentors to younger workers, who would benefit accordingly from their experience and job skills. Those older workers would also continue to contribute to Social Security and Medicare, in-house retirement plans and corporate health insurance plans, as long as they remain as instructors. The Government should subsidize all these costs as well. Relative to the proposals currently being floated, the dollars involved would be trivial.

The largest, most diversified, and most geographically dispersed corporations would be in the best position to implement such a program. They could take on apprentices in each of their locations and functional areas and depending on their evaluation of each person’s capabilities, training could be either broadly based or focused on specific roles within each company. Over time, as companies gain experience with this program they could expand the number of apprentices and create a leveraged impact on both their own efficiency and the growth of the economy itself. The newly employed would quickly gain newfound motivation to improve their lot in life.

There is one major risk, however, which could nullify the benefits of such a program, to wit: if the Government were to constrict it with a myriad of regulations and requirements that would prevent corporations from doing what they do best.

Or you can teach a man to fish…