Welsh Investment letter – September 2009



Growing up in Chicago, I looked forward to every baseball season, and I cheered for both the White Sox and Cubs, since neither team won that much. I never saw the point in being choosey. The GO-Go White Sox went to the World Series in 1959, before winning it 46 years later in 2005, and 88 years after winning in 1917. The Cubs haven’t won a World Series since 1908, and that 100 year streak appears safe in 2009. Anyone following the San Diego Padres knows the season was effectively over by early June. But, what so often happened in Chicago as I was growing up, the home team has started playing much better near the end of the season, with a bunch of no-name young guys. For any diehard baseball fan that means there’s hope for next year! In fact, over the last 50 games the Padres have been playing .600 ball, so next year they could win 96 games and go to the play offs!! Thinking about next year is just the medicine needed to overlook the current reality. The Padres are still 15 games below .500, and 22 games out of first place.

The psychology of the diehard sports fan is very similar to the psychology that drives most institutional money managers, in relation to the economy and stock market. As the economic data points have gone from dreadful to lousy since March, institutional money managers have been looking forward to next season (the second half of 2009). As I have forecast since March, GDP was likely to be positive in the fourth quarter, and possibly in the third quarter. In the July letter, I explained why the recession probably ended in July. This week Federal Reserve Chairman Bernanke confirmed what should have already been obvious to most economists, when he said that “From a technical perspective the recession is very likely over at this point.” As noted in July, the end of the recession only marks the trough in economic activity, and tells us nothing about the strength and durability of the subsequent recovery.

The stock market bottomed in March, and it would appear the economy bottomed in July. The sequence of the stock market bottoming before the economy will perpetuate one of the great falsehoods on Wall Street, which says the stock market anticipates and discounts the future. In this case, the sages state that the rally off the March low is discounting the coming earnings rebound. Myths are maintained because there is just enough truth to convince the unsuspecting. The irony in this case is the unsuspecting are the same people spewing this nonsense. What the Wall Street sages will fail to mention is that the rallies off the lows of March 2008, July 2008, October 2008 and November 2008 were all heralded as signs the economy was about to turn for the better. They also won’t explain what wonders the NASDAQ was discounting when it traded above 5,000 in April of 2000, or when the DJIA reached 14,200 in October 2007.

As detailed each month since March, economic data were expected to support the V-shaped recovery consensus. Institutional money managers have a built in bias against holding cash. And with the improving economic statistics confirming the expectation of a V-shaped recovery, institutions would have no reason to sell. This is why the stock market has been able to rally since March, even though total volume has contracted from 1.8 billion shares a day to les than 1.3 billion shares since mid July. With selling pressure virtually non-existent, it doesn’t take much buying to push the market higher. Short covering has also certainly played a strong supporting role. The market has enjoyed the largest rally since 1938, so to say the market has come along way is an understatement. But now that Fed Chairman Bernanke has made the recession’s end official, it’s time for caution. I believe there is a gap between stock prices and economic reality. In July, investors could overlook the 17% decline in revenue from June 2008 experienced by the companies in the S&P 500, as earnings weren’t as bad as companies had guided investor expectations. The bar is higher now and companies are going to have to show respectable increases in revenue to justify current stock prices. Oracle’s shortfall could be a sign of things to come in October and November.

The most important point is not that GDP will turn positive, as inventories are rebuilt and more of the government stimulus is spent. The key question is whether demand increases incrementally, after inventories are restocked and fiscal stimulus is expended, so that production levels are increased. This leads to an increase in hours worked and job growth, which provides the additional income consumers need to increase their spending. A higher level of demand causes production levels to be raised even more. This is how a self sustaining recovery develops. However, numerous secular and cyclical headwinds will cause the economy to falter after positive GDP growth in the third, fourth, and possibly first quarter in 2010. I have no idea if the ensuing dip will qualify as a “double dip” recession. But the dip is likely to spark enough fear of a double dip, to cause the stock market to fall 10% to 15%, possibly more. If this scenario is to play out, technical analysis should provide a warning before stocks decline.

The problem for most investors is that we won’t know whether or not a self sustaining recovery is taking hold for at least several months. As discussed in the August letter, technical analysis could be especially helpful in coming months. As long as market breadth remains strong and selling pressure minimal, the probabilities favor higher stock prices. In recent weeks, the number of stocks making new highs has exceeded 300, while new lows have been negligible. This is another indication that the market’s internal strength remains healthy. If top line growth proves disappointing as companies report third quarter earnings, the coming correction could be sharp and the deepest since the March low. However, technical analysis suggests that after this correction, another rally to higher highs is likely.


There are numerous secular headwinds that will impede the development of a strong sustainable recovery in coming years. Since 1982, the total debt to GDP ratio has risen from $1.65 for each $1.00 of GDP to more than $3.50 in 2008. Although consumers cut back on their debt in the second quarter, the growth in government spending increased total debt by 4%. The increase in the debt to GDP ratio during the last 25 years is simply unsustainable. The interest expense burden it places on the cash flow of consumers, corporations, and government is significant, and interest rates are at multi-generational lows. According to baseline estimates by the Congressional Budget Office, the total net federal interest bill for the 2010-2014 period is $1.5 trillion. Imagine the drag on the economy if rates climb in coming years. Not a pleasant thought.
More frightening is the fact that each dollar of debt is generating less GDP growth. In 1966, $1.00 of debt boosted GDP by $.93. In 2007, $1.00 of debt only added about $.20 to GDP growth. As the mountain of debt was accumulating between 1982 and 2007, demand for goods and services was goosed, which lifted average annual GDP growth. Between 1982 and 2007, GDP was only negative for 8 months in 1991 and 8 months in 2001. Going forward, debt induced GDP growth will be less than in the previous 25 years.

According to BCA Research, bank lending has grown from 30% of GDP in 1980 to more than 50% in 2008, as the top half of the graph below shows. The bottom portion illustrates how much bank lending as a percent of GDP has climbed above and below a growth trend of 2% since 1970. Between 1970 and 2005, bank lending had never strayed more than 10% above or below the growth trend. In 2008, bank lending rose to almost 30% above trend. Over time, bank lending will slow as lending regresses to the mean of the past 40 years. This suggests credit availability will remain constrained for an extended period. In July, bank lending declined a record $64 billion. Over the last 3 months it has fallen at a 12% annual rate, which has never happened before. In the last 15 years, banks have made a concerted effort to move loans off their balance sheets, either through securitization or the formation of Structured Investment Vehicles (SIV’s). Thirty years ago, banks provided nearly 75% of the credit to the economy. That percentage has diminished to near 35%, as the securitization markets grew to provide roughly 40% of credit. The Fed is achieving some success in reviving the

securitization markets, but the volume of securitized lending is down 70% from 2007 levels. A
self sustaining recovery is dependent on the availability of credit. The contraction in bank lending and only partial recovery in the securitization markets will mute the rebound.

The National Bureau of Economic Research determined that the last recession ended in November 2001. However, state tax collections and employment didn’t pick up until the summer of 2003, just after the tax cut of 2003 took effect. As I noted back then, most of the post World War II recoveries were sparked by lower interest rates and pent up demand for cars and homes. In 2003, there was no pent up demand for cars, since the automakers had been offering 0% car loans in the wake of 9/11, and the Fed had lowered the Federal funds rate to 1.25% before the end of 2002, without much effect. The tax cut provided the spark that lifted the economy on self sustaining trajectory. In the current cycle, rather than a tax cut taking hold 18 months after the recession ends, there will be a substantial federal tax increase on January 1, 2011.

The 1982 tax cuts and the trend toward less regulation that picked up speed in the 1980’s, certainly played a role in launching the subsequent economic boom that carried at least into 2001. Not only are taxes going up in 2011, and probably in subsequent years to pay for the sizeable increase in government spending that seems likely, but the pendulum has clearly swung toward more regulation and higher operating costs. Higher taxes and more regulation will not boost economic growth, no matter what the perceived social benefits may be.

Consumer spending represents 70% of GDP, but according to economists Dean Maki and Michael Palumbo, half of U.S. consumer spending comes from the top 25% of wage earners. More than 60% of total Federal income taxes paid in 2008 were paid by the top 5% of earners. The combination of higher taxes on those with the most discretionary income, and a need to save more, particularly by baby boomers, will crimp consumer spending. According to a recent survey by Bloomberg, only 8% of consumers planned in the next 6 months to increase spending, while 33% planned on cutting back. A study by research firm Alix Partners, suggests Americans will spend at about 86% of their pre-downturn level. That seems a bit draconian to me, but the savings rate is likely to reach 8%-9% in coming years, as I suggested it would in April 2008.

In January, I wrote that for most people on this planet, and especially in our country, more is more. The logic of more as being better is easy for our ego to understand. I suggested that this

was likely to change, and that more people would come to accept that less is more. In June, consumers cut back their credit by $21.6 billion, the most on record dating back to 1943. The unprecedented decline in consumer credit is certainly a reflection of a change in attitude. No doubt some of the drop in consumer credit is being driven by banks being stingy with credit. Over the last year, consumer credit has contracted by -4.4%. In the 2001 recession, consumer credit actually grew, which underscores my point about the lack of pent up demand coming out
of the 2001 recession. In the 13 months between May 1991 and June 1992, credit dropped -1.3%. In the deep 1974 recession, credit fell -1.79%, between September 1974 and June 1975. These comparisons suggest that a secular seismic shift in consumer spending is underway. Although consumer credit will begin to grow at some point, it is unlikely to accelerate to the ‘norm’ of the past 25 years. Annual GDP will be weaker, as consumers save a bit more and borrow a little less.

Spending by states represents 12% of GDP, and has averaged an annual growth rate of 6% over the last 30 years. Higher state spending was financed by higher sales tax revenues, as consumer spending rose from 64% of GDP to 71%, and more real estate tax revenue as property assessment values soared. States also raised income taxes, sales taxes, and initiated a myriad of new taxes and fees. However, in fiscal 2009 state tax collections fell 3.8%, while spending grew, creating a collective $143 billion deficit. States closed the budget gap with funds received as part of the Federal stimulus plan, rainy-day funds, spending cuts, tax increases, and one time accounting maneuvers. At least 33 states already project deficits looming to the tune of $160 – $180 billion in their 2010 budgets, as tax revenues from all sources fall, and demand for state aid rises. The Federal government is expected to provide another $40 billion, which will help, but rainy-day funds have been spent, and conceivably, there is a limit to accounting gimmicks, even for state politicians. That means more spending cuts and tax increases.

The pain on the state level is trickling down to the city level as state aid is cut. According to the National League of Cities, revenues declined by .4% in 2009, even as expenses rose 2.5%. They also expect tax revenue to decline for two more years, as property tax collections fall until 2013. In 2009, property tax collections rose just 1.7%, down from an increase of 6.9% in 2008, even though 25% of the 379 cities surveyed raised property taxes. Another 45% of cities reported they had raised fess on just about anything they could, from garbage collection to over due library books. As I have said before, by the time this is over, there will be marches on state capitols, even as cities become more tolerant of homeless camps.

Consumer spending and borrowing has undergone a sea change, and home values, after falling further, are likely to rise only modestly after the bottom is reached. This means the rising tide of sales and real estate taxes that lifted state spending at an annual average of 6% for 30 years are a memory. The new reality is an increase in spending at half that rate.

There are a number of cyclical headwinds that will make the transition to a sustainable recovery, at best, a bumpy ride. There are two methods used to determine ambient temperature. Water freezes at 0 degrees, if Celsius is used, and 32 degrees with Fahrenheit. When it comes to job growth, investors need to differentiate the level of job growth that actually reduces the ranks of the unemployed. In August, 216,000 jobs were lost, less than the 276,000 lost in July. Obviously, -216,000 is closer to zero than -276,000, but that’s the wrong yardstick. The correct yardstick is not zero jobs lost, but a gain of +125,000, since the economy needs to create 125,000 new jobs just to absorb new job entrants to the labor market. The August job figure is actually -341,000 below what is needed before a single unemployed person is rehired. And the Labor Department’s birth/death model added 118,000 jobs supposedly created by small business. If these phantom jobs are excluded, the August tally came up short by -459,000 jobs.

Since the recession began in December 2007, a total of 6.9 million jobs have disappeared. If, by some miracle, 325,000 new jobs were created this month, it would still take 3 years before the 6.9 million people out of work found a job. Manpower’s quarterly survey of 28,000 firms found firms are planning to hire fewer workers in the fourth quarter than in the third quarter. Unfortunately, job losses are not the whole story. Hours worked per week have been slashed to 33.1 hours, which is the equivalent of another 3 million jobs. In August, the average workweek was unchanged, and 7,000 temporary workers were let go. These are the two most sensitive thermometers of when the labor market is warming up, and in August both are still below zero.

Although the 9.7% unemployment rate is closing in on 10%, that means 90% are still working, but income growth is stagnating. In July, personal income fell -2.4%, the seventh straight monthly annual decline. But the decline in income could have been far worse. Since 1959, according to the Bureau of Economic Analysis, government income transfers have risen from 6% of total personal income, to 17.3% in June, and up from 14% since the recession began. (In 1959, did anyone forecast that government income transfers would almost triple in 50 years?) Without the support of unemployment benefits and the one-time $250 distribution to social security recipients, incomes would have fallen by more than 5%. By year end, almost 1.4 million of unemployed workers will have exhausted their benefits. Incomes are going to remain under pressure in coming months, due to weak wage and job growth.

A few months ago, I suggested that the low end of the housing market was likely nearing a bottom, since prices had fallen by more than 40%, and the $8,000 tax credit would boost demand. According to the National Association of Realtors, sales of homes priced under $100,000 are up 38.8% from last year, and homes priced under $250,000 are up 8.7%. But homes priced above $250,000, $500,000, and $750,000 are down -6.2%, -8.9%, and -10.6%, respectively. Although the low end of the housing market has  firmed and median home prices have risen for two months, home prices have not bottomed. The low end of the housing market fell first, primarily due to lax lending standards. The high volume of low end foreclosure transactions pulled the median home price down disproportionately. The second phase of foreclosure activity is being driven by job losses, which has impacted the mid and upper end of home prices. Although foreclosure sales have dipped from 45% of transactions to 35%, this good news is misleading, since it is due to state and bank moratoriums. According to RealtyTrac, 70% of 750,000 bank-owned properties aren’t even listed as available for sale or auction. There are also another 1.1 million homes in the foreclosure process, which means owners are behind on their payments, and at risk of losing their home to their bank. RealtyTrac believes the third wave of foreclosures from adjustable-rate mortgages will hit over the next 18 months, and “will make the sub-prime meltdown look like a walk in the park.” This suggests that mid and upper end home prices are going to decline through 2010. Prime mortgage borrowers now account for more than half of the mortgages that are more than 90 days past due, versus 35% for sub prime mortgages. Prime loans account for 80% of U.S. bank exposure to mortgages and credit cards, which means losses from prime borrowers could exceed losses from sub prime borrowers.

Commercial real estate prices have plunged almost 40%, which is going to present a challenge on about $1 trillion in loans coming due by the end of 2010, and $40 billion annually for the next decade, according to Cushman & Wakefield, the nation’s largest real estate services firm. According to the Federal Reserve, delinquency rates on commercial loans have more than doubled to 7%, as corporate downsizing lowers office occupancy rates, retailers close, and apartment vacancies climb. The Fed is reviewing 800 regional and community banks, but will not make the results of these stress tests public. Hmmm …

As commercial real estate owners are unable to refinance loans, the loans are taken over by special servicers, whose task is to salvage as much as possible for the investors who bought sliced and diced packages of Commercial Mortgage Backed Securities. Fitch Ratings estimates that $50 billion of CMBS were being handled by special servicers at the end of June. Fitch Ratings expects the total to climb to $100 billion by year end, which would represent 12% of CMBS loans outstanding. Since many of these loans are worth more than the underlying property, the stage is set for drama, and more bank losses.

The list of secular headwinds could have easily included Medicare, Social Security, and potentially universal health care and cap and trade. There has never been a government program that didn’t cost more than the initial projection. If the government has any hope in making good on all its guarantees and promises, tax rates are going higher, even for the middle class. The list of cyclical headwinds could have included the FDIC and FHA, which are both going to need Federal money, as home prices sink further and more banks fail. And, if the global economy falters in 2010 or 2011, the current modest rumblings of protectionism could build into something that inhibits trade. We are going to get a V-shaped recovery, but it will struggle against mighty secular and cyclical headwinds that will prevent a self sustaining recovery from taking hold. 7

Last month’s advice was to buy the September dollar futures and ETF UUP, using a stop of 77.60, which was triggered on September 7, for a small loss. Between the first week of March and first week of June, the dollar index fell from 89.50 to 78.50. Since early June, negative sentiment has risen to the point that Larry Kudlow has started to refer to the dollar as the dollar peso. It is worth noting that since early June, as the negative volume has ratcheted up, the dollar has fallen just 2 points. In recent weeks, the percent of dollar bulls has shrunk to the lowest level since the dollar bottomed in March 2008, when the dollar index was just above 70.00. Although the dollar is below the June low, momentum indicators are less oversold, which is a technical positive. The bottom line is that the dollar is groping for an intermediate trading low. At a minimum, a rally to 81.00 is likely. However, there is risk down to 74.50. The stock market will likely hold up going into the end of the quarter, which could put downward pressure on the dollar. Buy the dollar December futures below 76.40 and UUP, using 74.50 as a stop.

The long position in TLT just missed the sell level at $97.80 when it traded up to $97.66 on September 2. The long position from $91.00 was stopped on September 8 at $93.81. The 20 year Treasury short ETF is TBT. Buy TBT below $43.35, using $42.70 as a stop.

The dollar did not rally as I expected, and gold broke out of a triangle chart pattern the day after the ISM moved above 50.00. This reinforced the V-shape bottom story, with the attendant perceived inflation risk. The average short price of gold on August 27 was $947.45 and long price of DZZ was $20.56. The $963.00 stop was triggered on September 2, with DZZ at $19.89. Sentiment is very optimistic toward gold, with the percent of bulls exceeding 85% to 90% for weeks. Seasonality is favorable, so gold is likely to push higher going into early October. Short December gold at $1,038.00, using $1,054.50 as a stop. Buy DZZ at $17.00, with a $16.45 stop.

Last month I expected the S&P to pull back to 980-1,000, before rallying to 1044. The S&P dipped to 992 on September 2, and then rallied to 1,047 on September 11. It is noteworthy that the S&P pushed above 1,044, after Bernanke’s comment that the recession was likely over on September 15. Institutional money managers do not like holding cash, even during large declines. With the quarter’s end just days away, most institutions will not want to increase cash holdings. This suggests the market will likely hold up until September 30. As noted earlier, the market’s internals have been healthy, which is another short term plus. However, the market has come a long way, and investors are going to be a bit more demanding than they were in July. Oracle’s revenue shortfall and subsequent sell off may be a hint of things to come. The S&P could push up to 1,095 going into early October. If revenue shortfalls prove disappointing, the S&P could drop to 990-1,015 by the end of October, or early November. Selling a little over the next two weeks is a good idea. The market is likely to make higher highs after this correction.

E. James Welsh

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