Investment letter – January 11, 2011
THE RUNNING OF THE BULLS
As we begin 2011, there is a newfound optimism. The stock market finished 2010 strong and economists have been raising their estimates for GDP growth in 2011 to 3.0% and higher. Although the extension of all the Bush tax cuts was a small psychological positive, since it didn’t increase disposable income, the 2% cut in payroll taxes was a pleasant surprise. With more disposable income to spend, the average worker earning $50,000 will have an extra $20 per week to spend. Despite the anticipated improvement in economic growth in the first half of 2011, the Federal Reserve is maintaining its commitment to QE2 and will purchase $600 billion of Treasury bonds. The cover story of the December 20, 2010 issue of Barron’s revealed 9 of the 10 strategists from the largest investment firms on Wall Street were bullish, expecting an average gain of 10% for the S&P in 2011. The lone non-bull thinks the market will be flat. In other words, no one was bearish. The consensus is that a self sustaining recovery will take hold in 2011, as rising confidence spurs businesses to increase hiring and invest more and consumers returning to the shopping malls. A survey of 302 global money managers in mid-December found that those expecting stronger global growth surged to 44% from just 15% in October, and the percent forecasting better profits soared from a mere 11% in October to 51%. Nothing like a rising stock market to convince investment managers of all the reasons they should be bullish!
As we have discussed on a number of occasions, the stock market is not a discounting mechanism, which anticipates economic events, i.e. recoveries and recessions. The majority of strategists and advisors who truly believe this axiom can be compared to car drivers who navigate their way by looking in the rear view mirror. If the markets are consistent in at least once facet, it is that markets always take a long and winding road. When a majority of drivers peer into their rearview mirror and reflect on how lovely the drive has been, they won’t notice their car has left the road until it is airborne and in free fall. Of course, the opposite occurs at market bottoms. All the drivers see are potholes and ditches in the rearview mirror and feel as if they’ve been driving in Death Valley without air conditioning for like forever! At every market top and bottom, the market is wrong. At the top in October 2007, the market was not ‘telling’ us that the credit crisis would be contained and there would be no recession, as most strategists and advisors believed. And at the lows in March 2009, the market was wrong in suggesting the sky was indeed falling, and not surprisingly most strategists and advisors were negative.
This is pertinent because various measures of investor sentiment reflect an excessive level of bullishness. The American Association of Individual Investors has reported an average of 30% more bulls than bears on a four week average for the last two weeks. The weekly Investors Intelligence Survey has recorded 35% more bulls than bears, for eight consecutive weeks. Sentiment hasn’t been this bullish since October 2007. For most stock market technicians this level of bullishness is clearly a sign of a top, and cause for a market decline. However, it isn’t so cut and dried in the real world.
Although we believe the current level of excessive bullishness is clearly a warning sign, it doesn’t automatically mean the stock market will suffer a meaningful decline right away. The reality is that most institutional investors don’t pay much attention to sentiment surveys. Instead, they are focused on how individual companies are performing in the space they cover, whether that is small cap, mid cap, or large cap stocks. They are far more concerned about the management quality of the stocks they own, and whether their profit estimates will be achieved. What they are not going to do is come into their office on a Monday morning and sell the stocks of companies they like and believe in, just because a sentiment survey or two is reflecting too much bullishness. If anything, a rising tide of positive sentiment makes them feel more comfortable. Most institutional money managers view cash as a negative, since it can lead to underperformance if the market and the stocks they own continue to rise. For most, it is a risk they do not want to take, which explains why most mutual funds rarely hold much more than 3% of their assets under management in cash. Currently, their expectation is that the economy will continue to improve and so will corporate profits. Until their outlook is seriously challenged, they won’t sell.
The lack of selling pressure has been a primary support for the market during November and December, and it has continued into early January. It doesn’t take much buying to push the market higher, whether the buying is coming from new bulls or short covering from trampled bears. We expected that the market would exceed the November 5 high at 1227, and likely grind higher into year end. This has occurred, but now the S&P 500 is approaching an important price level. A quick analysis of the pattern of the rally from the July 1 low will help explain this risk. From the S&P low on July 1, 2010, at 1011, the first short term high was reached on August 9 at 1129, a gain of 118 S&P points. This represents Wave 1, which was followed by a decline into August 27 (Wave 2). A strong rally into a high on November 5 at 1227 followed for Wave 3. Wave 4 ended on November 16, when the S&P bottomed on November 16 at 1173. The current rally is Wave 5, and would be equal to Wave 1 (118 points) at 1291.
A review of the NYSE chart on page 2 will show why the completion of 5 waves is often significant, especially when it is accompanied by an extreme in market sentiment. In February 2009, we thought the market was near a low because the market was completing 5 waves down from the October 2007 high and sentiment was overwhelmingly bearish. In April 2010, sentiment was fairly bullish and 5 waves up from the March 2009 low were completing. In the April 20 letter, we advised becoming more defensive in anticipation of a correction. Between late April and July 1, the NYSE fell 16.7% and the S&P 500 lost 17.2%. With the market now completing 5 waves up from the July 1 low, and sentiment overly bullish, the market is now vulnerable to a correction. Will it be a garden variety dip of 4%-7%, or something worse?
A deeper correction will only develop if, after the market begins to decline, institutional money managers’ view of the economic outlook is so challenged, they decide to do some selling. So, what problems could derail the anticipated coming of a self sustaining recovery?
THE USUAL SUSPECTS
In order for the U.S. to embark on a self sustaining economic expansion, job growth and income growth must improve measurably. In 2010, 1.3 million jobs were created according to the Labor Department, which doesn’t sound too bad. However, the economy needs to create 110,000 jobs per month just to absorb new entrants into the labor market. This means the economy needs to create 1.3 million jobs each year just to tread water. As we’ve noted often, job growth does not begin at 0, but at 110,000. The rebound in job growth during this recovery has been extraordinarily weak, if one reviews every other post World War II recovery. In nine of the eleven recessions since World War II, all the jobs lost during the recession had been recouped at this point in the recovery. The two exceptions were in 1991 and 2001, which were referred to as the jobless recoveries. Compared to this recovery, 1991 and 2001 look like boom times! At this point in the 1991 and 2001 recoveries, less than 1% of the labor force remained unemployed. In the current ‘recovery’ more than 5% of the labor force remains out of work. Temporary employment has increased in 14 of the past 15 months, and has accounted for 26% of 1.1 million jobs created in this recovery. This compares with 7% of the jobs after the 2001 recession, and 11% after the 1991 recession. Not only is job growth pathetically weak, but the quality of the jobs in this recovery are lower paying than in the jobless recoveries following the 1991 and 2001 recessions.
Of the 14.5 million workers out of work, more than 6 million workers, or 44%, have been unemployed for more than six months. The unemployment rate has held above for 20 straight months, longer than at any other time since the Depression. The longer a person is out of work the more difficult it becomes to get a job, as job skills erode over time. And once a new job is found, compensation is often less, which has been especially true in this recovery. According to the Labor Department, 54.9% workers who had held a job for more than three years prior to losing it during the recession have found a new job that pays less than their old job, with 35.8% of them taking a pay cut greater than 20%. If this pattern persists, most of the 14.5 million workers who do eventually find a job will be making less money.
The employment-to-population ratio, which measures the number of people who are employed and older than16, are not in the armed forces, jail, or nursing homes, has plunged to 58.3% from 62.7% in 2007. That’s the lowest participation rate since the early 1980’s, when fewer women were in the work force, and the overall population was 226 million versus 308 million as of the 2010 census. In addition, average hourly earnings were up a paltry .1% in December and ahead by only 1.8% over the past year. The workweek held at 34.3 hours for the third month in a row.
We expect job growth to improve modestly in 2011, but not enough to launch a self sustaining recovery. If that proves accurate, those expecting a solid recovery are going to be disappointed. Earnings growth will also come up short, which will make it tough for the stock market to make much headway.
Housing starts have plummeted to less than 400,000, since their peak near 1.4 million in 2006. The good news is that housing represents a far smaller slice of GDP, after shrinking 70%, so further declines will not subtract much from GDP. But the 30% decline in median home prices since mid 2006 as measured by the Case-Shiller Index is larger than the home price decline during the Depression. Unfortunately, home prices are likely to decline further. According to research by economists Robert Shiller, Karl Case, and Allan Weiss, home prices averaged an average annual increase of 3.35% between 1900 and 2000. In order for home prices to return to their 100 year long term average appreciation line, home process would have to fall another 20%. We are not that bearish, but do believe an additional decline of 5% to 10% is highly likely, since supply and demand will remain out of balance for at least two more years.
According to Core Logic, 11 million homeowners, or 23%, owe more on their mortgage than their home is worth. Another 2.5 million have just 5% equity. The majority of these homeowners are effectively removed from the housing demand equation, since they can’t afford to sell and buy another home without absorbing a significant loss of equity. As prices fall further, more homeowners will be basically trapped in their current home. Another factor reducing future demand is the increase in lending standards, which will never get as lax as they were from 2001 through 2007. Lenders are limiting mortgage payments to roughly one-third of a buyer’s income and verifying income. Imagine that! Even homeowners who are current on their mortgage and have a decent job are unlikely to want to trade up to a larger home, as long as home prices are flat or declining. The Federal Reserve estimates that homeowners extracted $1.1 trillion of home equity in 2006 and 2007, and there is a good chance most of that money has already been spent.
The 9.5 months supply of homes for sale is almost double the average that existed between 2001 and 2006, and the supply of homes for sale is likely to remain bloated. This figure does not include the shadow supply represented by homeowners who would put their home up for sale, if they believed they could get their desired asking price. More importantly, more than 2 million homes remain in the foreclosure pipeline, and home prices are likely to sag as these forced sales hit the market. Almost 35% of foreclosed homes are vacant, which means they have not been maintained properly.
Another source of homes for sale will come from Baby Boomers as they look to downsize and fund a portion of their retirement by selling their home. The 79 million baby boomers represent 26% of this country’s population. According to the Pew Research Center, about 10,000 boomers a day will turn 65 for the next 19 years. According to a recent study by MainStay Investments, 47% of those surveyed said they would downsize their home in order to fund a better retirement standard of living. Just 38% said they could retire anytime, with the balance planning on working longer to fund a better retirement (40%) or to cover the basic expenses (22%). In 1980, 39% of private sector workers had a pension that guaranteed a steady retirement income. Now, just 15% of private sector employees are covered by a pension. As a result, a record 42% of private sector workers have 401(k)s. But the past decade in the stock market has not been very kind to them, which means they will have to work longer and save more. Not quite the golden years many Baby Boomers imagined.
State spending represents 12% of GDP and is second only to consumer spending (70%) as a contributor to GDP. Unfortunately, the fiscal condition of most states is going to go from bad to worse. The National Conference of State Legislatures estimates that states are projecting another $136.4 billion in budget deficits through June 2012. One-third of states don’t expect their revenues to match 2008 levels until 2013. In 2010, state and local governments cut 256,000 positions. With aid from the Federal government diminishing, most states will be forced to cut more services and workers, and raise taxes and fees. Weak employment growth will keep state income tax growth muted, and property tax revenue will fall, for local governments as homeowners apply for revised assessments. This will cause local governments to raise real estate tax rates, rather than lay off more teachers, firefighters and police officers. These state tax increases will offset much of the 2% cut in payroll taxes. Increasingly, states are lowering their spending by sending less money to local governments. With the Federal government giving less money to states, and states giving less to local governments, a new form of trickle-down economics has emerged. According to the American Society of Civil Engineers, the collective tab to fix and upgrade infrastructure in the U.S. over the next five years is $2.1 trillion. Since the fiscal year begins on July 1, the battle over tax increases and cuts in services will be a major story in June, if not sooner in California and Illinois. It won’t be pretty, and the net affect will be a drag on GDP in the second half of 2011.
On January 5, the cost of insuring the sovereign debt of 15 western European countries was $203,000, while the cost of insuring the debt of 15 emerging market sovereigns was $199,000. Optimists would conclude that emerging market debt is looking better, and they would be right. Most emerging economies are growing faster than European countries, their budgets are either balanced or in good shape, their banks are healthy, and their governments are not on the hook for huge social programs. Pessimists would conclude that the European Union is a slow motion train wreck, and they would be right. The stresses within the European Union are going to intensify. The austerity program Greece was forced to adopt is causing its economy to continue to shrink, and is down 7.2% from its 2007 high. Ireland is going to struggle maintaining and paying for the ECB enforced austerity program. Ireland’s GDP is 12.8% lower than at the end of 2007 and has yet to reverse higher. Greece and Ireland required a bailout orchestrated by the ECB, when the cost to issue new debt reached unsustainable levels. Portugal is now facing a similar fate, as its cost to issue new debt rises to levels that precipitated Greece and Ireland’s bailout. Spanish banks must still absorb more real estate losses, while dealing with an unemployment rate of 20%. Spain’s GDP is still 4.5% below its peak, but has stabilized.
Unless the ECB is willing to take bold action, the credit crisis in Europe will spread to Portugal and Spain, and possibly Italy. The stress test on European banks allowed for a high degree of flexibility in how the banks valued various assets. The markets weren’t fooled, which is why the cost to insure the sovereign debt of these countries continues to march higher. If the ECB wants to stem the tide, it will have to initiate a realistic plan to recapitalize the European banks, and establish lending facilities to convince market participants the ECB will not allow them to play dominoes with EU members.
As these economies continue to struggle with their debt, weak economic growth, and high unemployment, those bearing the brunt of the economic burden will question whether maintaining their country’s membership in the E.U. is really worth it. Demonstrations and protests will become more frequent, and global investors will question whether the E.U. will hold together. If it comes to this, the markets will not like it. Ironically, disenchantment with the European Union is also rising in Germany, even though Germany’s GDP is just .8% below its 2007 high, and growth is good. A recent poll revealed that almost 50% of Germans questioned staying in the E.U., up from 33% a year ago.
As we have discussed over the past six months, there is a large disparity between the monetary policies of developed countries and emerging developed countries. The central banks of the U.S., E.U., Japan and Britain are maintaining extreme accommodation to minimize the risk of deflation and the coming drag from fiscal frugality. Despite massive fiscal and monetary stimulus, a self sustaining recovery remains elusive, which is why the Federal Reserve initiated QE2 and the ECB reversed course and bailed out Greece and Ireland. In contrast, the fiscal and monetary stimulus enacted in the emerging developed countries resulted in a sharp rebound in growth and demand for raw materials. A combination of crop shortages and bad weather has also led to a large increase in the price of corn, wheat, soybeans, onions, and cooking oil. The United Nations Food and Agriculture Organizations monthly food price index rose to a record high in December, after climbing for six consecutive months. For many emerging countries this is serious business since food comprises a large portion of the average worker’s income. While food makes up 10% of the average American’s income, it consumes 30% to 50% of the average workers income in many of these countries.
Inflation is rising in China, India, Indonesia, Australia, South Korea, and every other part of the world where economic growth is strong. The figures in the adjoining table are a month old, and inflation has increased since this was published. Inflation is now up to 5.1% in China. As a result, monetary policy has been tightened in many of these countries to slow growth and lower inflationary pressures. Brazil is also dealing with higher inflation, which is now approaching 6%. During 2010, Brazil’s central bank increased interest rates three times. The People’s Bank of China has increased its reserve-requirement ratio six times since early 2010, from 15.5% to 18.5%.
At the end of December, China’s Ministry of Finance announced it would increase the tax on cars with engines of 1.6 liters or less to 10%, from 7.5%. Just as the U.S.’s Cash for Clunkers pulled car sales demand forward, the increase in China’s car tax was widely expected and caused a surge in demand before the tax would be implemented. The net result is that car sales growth will likely slow from 30% in 2010 to 10% in 2011. In the city of Beijing, authorities issued new rules in late December in an effort to reduce the amount of traffic. The municipal government said it would only issue 240,000 license plates in 2011, down from 750,000 in 2010. The net result is that a slowdown in Chinese manufacturing, as measured by the HSBC China Manufacturing Purchasing Managers Index was already evident in late 2010. This slow down will likely pick up speed as these measures take hold. Throughout 2010, the Peoples Bank of China took a number of steps to curb real estate speculation. Their efforts are starting to show results, as the sales volume of real estate transactions has dropped from a growth rate of almost 80% in late 2009 to less than 20% at the end of 2010.
One of the keys to 2011 is that the central banks that have already raised rates will be forced to increase rates more, or take other tightening steps to address inflation in their countries. At some point, it is going to dawn on folks that growth in the second half of 2011 will be negatively impacted in these countries that have been leading the growth parade. Slower growth will also mean less demand for raw materials, and that should lead to a shakeout in copper, oil, silver, gold, and everything else that has been swept up in the global growth story.
The run up in food prices poses a political problem for many of these countries, since food costs represents as much as 30% to 50% of the average workers income. The central banks can raise rates and tighten monetary policy to slow economic growth and temper inflation, but that won’t bring the cost of food down, especially if additional shortages develop. We expect a number of these countries to increase subsidies and introduce price controls on some commodities, just to keep protests and violence in check.
The consensus expects economic growth in the U.S. to accelerate and establish a self sustaining recovery. We think tepid job and income growth, lower housing prices, and cutbacks in spending at the federal and state level along with tax increases will slow growth after the first quarter. In addition, another credit crisis could flare up in Europe at any time, which will prove unsettling to credit and equity markets. And the tightening of monetary policy in most of the countries that have been growing the fastest will raise doubts about second half growth and cause a sharp shakeout in commodities.
As noted in the December 19, 2010 Special Update, “Investors’ confidence in the recovery has improved with the passage of the tax package. Bullish sentiment has become more entrenched, which is an intermediate negative. But in the short run, bullish sentiment and the calendar could help the market. Since capital gains taxes aren’t going up next year, there is no obvious tax reason for individual investors to sell before December 31, 2010. Institutional money managers who have been fully invested also have no reason to raise cash. However, institutional money managers who are lagging behind their various benchmarks have a reason to commit cash before year end. With so little selling pressure, a little buying pressure can continue to move the market higher in the very short term.” As expected, the market did grind higher into year end. As discussed, the S&P could reach the 1291 area, which isn’t much higher than current levels. At a minimum, we think the market is due for a correction of 4% to 7% from current levels. Bulls will be happy to buy the first dip, and the market’s internal strength is OK, so a period of choppy trading may precede the onset of the correction. A deeper correction is possible if the European credit problems worsen in coming weeks. At some point in 2011, we think the S&P could trade as low as 1,050, if the problems we’ve discussed develop.
We thought the 10-year Treasury yield would hold between 2.5% and 3.2%, which is where the 10-year yield bottomed in the last half of 2009. That resistance didn’t hold as faith in the recovery increased after the payroll tax cut was enacted, and some reallocation out of bonds into stocks occurred before year end. Based on the weekly chart, the yield could approach 3.85%. If it gets above 3.7%, we would recommend buying, since the economy will slow in the second half of 2011. And if Europe does experience more credit problems as we expect, there will be another flight to quality that will lift bond prices and bring yields down. Another confirmation of trouble in Europe and the growth story will be signaled if the yield drops below 3.2%.
As long as gold holds above $1310, the major trend is still up. However, for the first time since the lows last summer, upside momentum is waning, even as bullish sentiment remains high. The correction since the November and December highs looks corrective, which suggests there is one more rally left. We would advise selling into that rally.
Since late November the dollar has been holding in a trading range. A close above 82.00 on the March futures contract would target a rally to 84.50-85.00. We still believe the dollar has the potential to reach 88.00 to 92.00. That forecast depends on renewed problems in Europe, and a weakening in the U.S. economy in the second half of 2011. A close below 78.50 would be negative.