TPWC Market & Economic Update

By Jeff McClure

February 10, 2012

Administrative Items

The always efficient and dedicated TPWC staff has asked me to provide you with a few items of information they believe may be helpful… So here they are:

ROTH and traditional IRA contributions for 2011 have a deadline deposit date of April 17 this year. Please do not wait until            the last minute to contribute, as your contribution has to be at the custodian by the deadline, not just handed to us.

The modified adjusted gross income (“MAGI”) limit reported on your tax return if you want to make a contribution to a full tax-deductible IRA and you have an employer retirement plan for persons married, filing jointly, is $90,000. The deductible amount phases out between that number and $110,000.

For single filers, the deductible IRA MAGI limit is $56,000 to $66,000.

The MAGI limit for ROTH IRA contributions is $169,000 phasing out to $179,000 for joint filers. For singles the limit is $107,000 to $122,000.

The contribution limits for both the ROTH and the traditional IRA are $5,000 for those under age 50 and $6,000 for those older. The contribution cannot be more than the taxable earned income you received in the tax year.

Pershing has received an extension to report on IRS form 1099 until February 15, so do not be alarmed if you have not received your 1099 already.

Fund Changes

I just finished many hours of work researching mutual funds. While I typically look at the funds at least once per quarter, I try to dig extra deep in January. As a result, you may see, or have already seen some changes in your investment line up. Among other changes, we are going to be able to use “institutional” class shares in several funds where we previously were restricted to classes that are more expensive. Pershing has recently negotiated the lower expense ratios and we are planning to take advantage of the cost reduction wherever possible. There is normally no taxable event and usually no transaction fee when we change share class to the lower-cost institutional shares.

In other cases, you may see a move from a one fund to another where we have concluded that the new fund is simply likely to do better over the long term than the old one. In some cases we will be moving into what we believe are better funds that were previously closed to new investors but have recently reopened. In other cases, there have been management changes at the old fund and we have seen the performance become less than exceptional.

WRL

For those with Western Reserve variable products, the funds available there continue to be less diverse and some are closing to any new investment. That effectively means that for accounts where automatic rebalancing was occurring, you may receive a letter advising you that it has been “turned off” if you have a fund or funds that are no longer accepting money. We are continuing to monitor this, but if you do receive a notice from WRL, please let us know, as they do not provide copies to us.

The Markets

The S&P 500 Stock Index (“S&P 500”) hit a low for this cycle back on March 9, 2009 as it closed at 676. As I write this, today the S&P 500 stands at about 1,340. That is not quite a doubling of value, but is close enough that I think it is safe to simply state that the value of the stock market has doubled, or increased by about 100% over the past three years. Meanwhile, according to Morningstar, the average intermediate term bond portfolio has gained about 32% over the same period.

As the chart below shows, the S&P 500 has had some bumps along the way. In2010 and again in 2011, it dropped around 20% but then went on to recover. Those short term declines, normally generated by some element of fear are widely known as “corrections.” That is normal market behavior when it rises this fast. It is important to recognize that the faster the market appreciates, the greater the fear that will normally accompany that rise. As Jake often quotes from Sir John Templeton, “A bull market climbs a wall of worry.” It is when there is no fear and people say, “This could go on forever.” that we need to be cautious.

Of course, your portfolio is not the same as the S&P 500 stock index. Generally, our allocations right now include Mid-Cap Value domestic stock funds, Real Estate stock funds, Diversified Emerging Market funds, and GNMA or general Bond funds as well as some cash positions in regular brokerage accounts. Here are the returns for those asset classes. The 3-year number is the average annual rate of return. The asset classes used here are from Morningstar Categories or funds.

The reason for including this table here is to demonstrate the need for diversification into different asset classes over time. For example, over longer periods the Diversified Emerging Markets asset class has produced the highest return. Even in this relatively short-term sampling, it has well outperformed the S&P 500, but over the last year has done very poorly. The reality of this picture is that either by reallocating more money to that asset class by rebalancing or by simply staying put in an asset class that has recently underperformed its historic norms, an investor has a much higher potential return than in the recently better performing classes.

As an example of why we use asset allocation, if an investor had an allocation of 33% Mid-Cap Value, 7% Real Estate Stock, 24% Diversified Emerging Markets, 33% Intermediate Term Bond, and 3% in cash, over the last three years that allocation results in an average annual return of about 20% per year. For one year, the return was 1.71%, and for the last three months it was about 5%. Those results compare very favorably with the S&P 500 but the portfolio was only 64% invested in stocks. As a result, the ride was smoother with the downturns taking a far smaller bite out of the portfolio than they did out of the S&P 500 Index.

Another aspect of the numbers listed above is the fact that Real Estate Stock funds did better than any other asset class. That was certainly counter-intuitive. Three years ago, the consensus was that real estate as an investment was a horrible idea. Looking back from today, we can see that having a bit of that “horrible” asset was an excellent move.

The future is always uncertain so the best we can do is noting that over the long-term asset classes have had some consistent behaviors. Of all the methods to predict where one should have money invested, to date, asset class history is the one that has worked the best. If I had made the asset allocation choices three years ago based on my “gut-reaction” I can assure you I would not have chosen this particular allocation. The discipline of following the science of Portfolio Theory, once again seems to be working.

The Economy

GDP and Employment

The Commerce Department reported the U.S. Gross Domestic Product (“GDP”) to have risen to an annualized rate of 2.8% in the fourth quarter of 2011. In January, the official unemployment rate dropped to 8.3%. The official number of new jobs expanded by 243,000 in January as well. Quite significantly, in the Household Survey the Labor Department reported an estimated 491,000-job growth.

The difference is not insignificant, and is consistent with the reduction in unemployment. The official number, known as the “Establishment Survey” asks state employment agencies and major corporations how many jobs they saw created. The Household survey involves calling residences and asking questions about how many people have jobs of those in the household who want to work. Historically, when the economy starts to seriously grow, self-employment and hiring by small start-up companies leads the way. Those new jobs do not show up in the Establishment Survey. Over time, those jobs show up in the data, but it takes a while.

Another good indicator is present in the revisions. The Labor Department revised the job number up about 211,000 for the last two months of 2011. Upward revisions tend to mean that smaller businesses are hiring more people. Generally, there visions to the employment numbers go in the direction employment is likely to go in the future; upward revisions indicate future job growth while downward revisions indicate future job shrinkage.

Manufacturing numbers are up, as are the number of hours worked. The entire employment picture is very consistent with a steady growth in productive employment. There are negatives though. The two areas where the most jobs are being lost is in finance and government. At all levels, governments are reducing employment. Given the mandated federal government funding cuts scheduled to hit at the beginning of next year we could see the overall employment picture slip into reverse. That will not necessarily be a bad thing, but it will increase spending for unemployment and sound ominous when it happens.

Meanwhile the private sector is adding jobs. In that area, the business and the jobs are growing in consumer durable goods and other necessities. People are replacing their larger appliances and their worn out cars. What they are not yet doing is buying a lot of clothes and non-necessities.

Debt

From the numbers I see, it appears that the reason the consumers are not driving this recovery is quite simple. They are still paying down outstanding debt, and many are trying to sell a house somewhere. In order to find work, more than a few people had to relocate. The house where they lived before is in many cases empty and for sale. That is both a potential time-bomb and a sign of responsibility. At some point those absentee home owners may just give up and stop pouring money down that particular black hole. If they do, a new but manageable financial crisis will be upon us. As the economy recovers, at some point in the next few years, it may be possible to sell those houses. However, I suspect that the price they may bring may be still below the mortgage owed in many cases.

In some ways, this situation is like the European debt crisis. The lenders, assisted by the government, can agree to take a partial loss on the debt, or they can get little or nothing from their loan. Since there is much discussion on this subject right now. An announcement came out this morning that the state attorneys general and the major banks reached a $26 billion settlement that may assist at least some of those homeowners to reduce their mortgages. We will have to see the details before determining whether or not this is likely to help. One of the problems with forgiven debt, like those mortgages, is that it creates "phantom income" for tax purposes. If a bank knocks $100,000 off of a mortgage, it may be that the out-of-work homeowner will owe income taxes on that $100,000. Far from being a solution, that might make a bad problem far worse.

The government debt is still growing. In mid-December, the Republican controlled House of Representative passed an “Omnibus Spending Bill” that was quickly approved by the Senate and signed by the President. Federal spending was thereby set for 2012 at a bit over $3.2 trillion. The House Ways and Means Committee estimated that total federal revenues would be about $2.5 trillion. Given that the federal government is already running over budget for this year, we are likely to see a trillion dollar or so deficit. That is the bad news. The good news is that a one trillion dollar deficit is a lot less than the ones we had the past two years!

The better news is that beginning next year, the “sequestration” law that Congress passed last summer goes into effect. The spending cuts required by that law are “draconian” and include a very substantial reduction in defense funding. That is about the time that the economy should be kicking into a serious, sustained growth mode. The combination of the two, unless of course Congress or some outside event derails them, will very likely set us on the course to federal fiscal responsibility. The Congressional Budget Office (“CBO”) also estimates that, if no exceptions are passed by Congress, tax revenues will rise quickly, not only because of a reversion to the “pre-Bush” tax levels, but because an improving economy will push many people into higher tax brackets. Very critically, the CBO also noted that the Alternative Minimum Tax, unless it is repealed, will start producing a great deal of revenue and be critical in paying down our federal debt.

I actually do not think anyone seriously considered that law when it was crafted to be likely to take effect, but today it looks more and more like there will be no compromise. We will get our budget cut, but we probably will not like it.

There is an area we are watching that is worth being concerned about. The ten-year Treasury note continues to trade at an annual interest rate of around 2%. Effectively, regular Treasury securities out to about ten years are trading at a real yield to maturity that is below zero. Insurance companies, banks, and individual investors have poured quite literally trillions of dollars into those debt instruments. At some point as our economy gets into a more rapid expansion, the broad interest rate environment will rise. When that happens, the market value of those Treasury bills, notes, and bonds will fall accordingly. That could easily result in a new set of problems. Again, the Federal Reserve and a lot of people are aware and concerned about this. The most critical effect may be on insurance companies. Many of the major life insurance/annuity companies appear to still be on shaky ground. Following the crisis in 2009 they stocked up on Treasury securities as they traded in their mortgage bonds to the Federal Reserve. That was a life saver then but may have some potential for difficulty going forward.

You may remember that back in the early 1990s, banks and savings and loan institutions that were in the worst shape offered unreasonably high rates on their CDs in order to get more money to stay afloat a little longer. Today, insurance companies are offering high commissions and interest rate guarantees that do not appear to be possible to sustain. It could be they have some magical set of securities to back those rate guarantees, but it appears more likely to me that they are scrambling to get investors' money transferred to their books to stave off possible default. Financial companies tend to do that in hope that things will get better if they can just hang on a little longer. Only time will tell. Remember that any interest rate offered that is higher than an FDIC insured bank CD or a U.S. Government backed debt instrument carries a distinct risk. The higher the rate supposedly "guaranteed" the higher the risk of default. Any organization issuing a rate guarantee of 4% or higher in this environment is at a heightened risk of failure.

One of the difficulties with non-variable products issued by insurance companies is that the underlying portfolio backing the interest rate and principal guarantees is not available for public review. Recently MF Global declared bankruptcy only about a week after being audited by at least one ratings agency. The Congressional testimony in the hearings related to that collapse and the disappearance of about $1.2 billion of supposedly secure customer money revealed that MF Global did a masterful job of hiding their "off balance sheet" risks in Greek and other distressed Eurozone bonds. Insurance company internal portfolios are commonly far less open to scrutiny than was MF Global's portfolio. One of the reasons MF Global got so big so fast was that it was offering higher than standard market interest rates. That is a story that has been repeated as long as there have been markets.

Taxes

This Congress and to a lesser degree, the last one, seemed to be enamored with passing bills that they were confident would not actually go into effect. As one of the last acts of the last Congress, it passed a bill extending the “Bush tax cuts” until the end of 2012, but which raised taxes dramatically on January 1, 2013. Unless this Congress can agree on a compromise, in my opinion a rather unlikely event, next January the tax code will substantially revert to what we had in 2000.

That means taxes will go up, and do so significantly in 2013. When we add the tax increase to the mandated “sequestering” in last year’s budget bill, it means we will be getting out of debt. The difficulty is that we all may suffer some withdrawal pains. Then, in 2014 the Medicare portion of the payroll tax applies to “investment income” for those making over $250,000 per year. The net result is that we need to be aware that taxes are going to be higher in the future. That, in turn, means that we will need in some cases to adjust your portfolio expected rate of return to accommodate the reality of that situation.

As the Congressional Budget Office ("CBO") noted in its 2012 budget analysis, a key element in whether we move toward a long-term reduction in federal debt as a percentage of GDP or tip over into a rapidly increasing debt load is the Alternative Minimum Tax ("AMT"). For many years, Congress has deferred the imposition of that tax, even though it passed at the urging of Ronald Reagan in the 1980s! It is extremely unpopular among wealthy Congressional donors in both parties, but Congress has not repealed it because it is critical to keep it on the books else the CBO will announce that the federal debt will spiral out of control. In short, according to the CBO, the Congress will either allow a big tax on higher income Americans (which is already on the books) to take effect or face a near certain Greek-like debt crisis in the future. Between the AMT, the extension of the Medicare tax to investment income over $250,000, and the increase in regular tax rates, the "millionaire tax" is a moot point. Higher income recipients will pay a much higher portion of their income to the IRS (unless of course Congress passes a tax cut aimed solely at upper income filers).

Note that the CBO has also assumed that the “draconian” spending cuts passed into law last summer that were to take effect unless the “super committee” came up with an acceptable solution in 2011 will go into effect. The result of what appears to be a series of laws passed that were proclaimed publically to be very unlikely to actually take effect is that we actually do have a route out of the debt trap. The question is whether Congress and the President will blink. If they hold to this course, we will suffer some collective pain, but be headed in the right direction. If they relent we can look forward to a much bigger problem in a few years.

We will be watching this carefully, but in the meantime, it is probably a good idea for you to consider that taxes on investment income this year will almost certainly be less expensive than income deferred until next year. The really good news about higher taxes and reduced government spending, as painful as that will be in the short term, is that it will put us on the path to a better economic situation several years from now.

Europe

The European debt crisis sometimes seems like a never-ending story. Greece teeters in and out of a total collapse, but at least in my opinion, it is mainly for dramatic effect. The Greeks have managed to get their creditors to agree to about a 70% reduction in Greek government debt. Admittedly, the Greeks will have to cut their collective life style for a bit, but I would be quite surprised if they did not cheat on the rules as soon as everyone looks the other way. In reality, it is very questionable that the Greeks can even pay back the 30% of the debt remaining. The key is to make it all appear to be “voluntary” to not trigger the credit default swaps held by banks all over Europe. The Portuguese have already used the Greek crisis to their advantage by getting their creditors to agree to a debt reduction before their situation becomes another Greek crisis.

Following a last minute resolution of the Greek debt crisis, watch for the other countries with overwhelming debt to follow suit. One thing that appears clear to me is that each of the involved nations has already anticipated the moves. Each nation is maneuvering to get the maximum advantage either in debt reduction or in legally mandated control over the rest of the Euro-zone. There is still not any resolution as to where all the money will come from to reduce the debt load of the Eurozone countries that are in trouble. The final solution is still an unknown, but at least they are talking about it very seriously.

The risk factor is parallel to the one generated by our Congress. By continuing to hold out the threat of default until the last possible minute in order to terrorize those in power, a slight miscalculation could push things over the edge. I frankly do not like this kind of brinkmanship, but I do believe that the participating parties are not likely to intentionally “blow-up” the situation. I also see evidence that the banks and the Federal Reserve here in the United States have made contingency plans for the collapse of the Euro. The British have also reportedly drawn up plans for that event. It may yet happen.

It is critical to understand that any crisis we see coming for months or years is very unlikely to do much damage. Lehman Brothers’ collapse was unexpected, and the world economic and financial systems were unprepared. In this case many and possibly most players think that a collapse of the Euro system is quite possible. As a result the fire-walls are in place and the fire extinguishers have been passed out. Meanwhile, the rest of the world looks to the dollar and the American system as the most secure in the world. Never lose sight of the fact that as dysfunctional as we may seem to us, we are far, far ahead of and better than anywhere else!

The Future

I continue to believe that the rolling crisis scenarios will fizzle out in 2012 and we will begin to see a perceivable return to a more normal economy. In 2013, I expect to see the economy and the equity markets move very positively. Whomever we elect President will get the credit for a delightful growth surge in the market and the economy. I believe that by the time this decade ends we will see a significant reduction in the portion of our GDP represented by government debt, a stock market far higher than any of us can imagine today, and an economy in great shape and moving forward.

Meanwhile, all the evidence in the short term points to a steady improvement with little or no inflation. Many things could go wrong, but so many people are aware and worried about them that the corrective plans are already on the books. That means that even if something happens, it will not be devastating. The bottom line is that I believe we will look back in a few years and wonder why we were so worried.

As always, your comments, questions, and suggestions are welcome.

Sincerely yours,

Jeff McClure

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 December 8, 2011

The Drama Continues

 A Pair of Shakespearian Dramas

Over the last couple of years there have been two major productions underway, one as a traveling dramatic presentation appearing at various capitals in the Eurozone and the other in that greatest of theaters, the American capital. The European version is playing out as a tragedy while the American theatrical production appears to be a comedy.  Perhaps some form of reality TV show would be even a better analogy. The initial episodes were not too exciting but beginning in early August of this year the stakes were raised and the media hype jumped accordingly.

The European Tragedy

The Eurozone is in a mess. I have written this before, but there is no record in history of a common currency surviving if there is no strong central government to control that currency. Here in the United States we had a currency debacle not too unlike the one going on in Europe. Before that we had the infamous Continental Dollar. Back in the now ancient 1950s and ‘60s it was not uncommon to hear one of my elders refer to some worthless thing as, “not worth a Continental.” We Americans initially addressed the problem by creating a Constitution but did not really resolve the issue until the Civil War. It took us nearly 100 years to conclude that a strong federal government was needed and that only that federal government should issue and control money.

Too Many Languages, Too Much Democracy

In Europe the governmental evolution is much like America before the Constitution. In fact, things are even less organized there than they were here. That is not too surprising when one considers that there are about twenty official languages used in the European Union (EU). Even the smaller European Monetary Union (EMU) has around 15 languages.

The Europeans did have a constitution drawn up last year and it was rejected. The problem was too much democracy.

Our Constitution was drawn up in the Philadelphia Convention from March to December of 1787. It was not ratified by the states until 1791, four years later. Two imperatives drove us to “Form a more perfect Union.” First, Great Britain was threatening to invade and reclaim her 13 rebellious colonies.  Second, the collapse of the common currency (the Continental) had plunged the new United States into a depression from which it was having a very difficult time emerging.

Today, Europe is not directly threatened with invasion from without, although anyone with an eye for history can see that Russia is a potential threat. It is however facing the demise of its common currency and quite possibly a depression.

So, why did the European Constitution fail? To put it quite simply, when the various United States ratified our Constitution (including the Bill of Rights) in 1791, we had already suffered a collapse of our currency, and the threat of invasion was a “clear and present danger.” Importantly, we did not put it to a common vote. In each state the final decision was made by a simple majority of its legislature, not by a popular vote of its citizens. Notably, in several states, including New York, the ratification was accomplished by a margin of only one or two votes!

The delegates from the EU nations took several years to craft a constitution they could all accept, but rather than take it to their parliaments, several nations decided to hold a public referendum on the new treaty/constitution. The popular vote went against the new Union first in Ireland. There is little doubt that the Irish would love to rescind that decision today so as to have the rest of the EU assume their debt.

The Likely Outcome in Europe

It appears to me that things will have to get a whole lot worse in Europe before they can get better.  There are only a few European states that are willing to give up much in the way of sovereignty (states’ rights) in return for a “more perfect Union.” A collapse of the Euro, accompanied by a continent-wide economic contraction will probably have to become a reality before the ancient European nations will be willing to surrender some of their national pride and sovereignty.

While I hate to even contemplate such a thing, it may well take a major war to finally unite Europe. Sadly, even then, the solution may come too late. The Europeans are confronted with a demographic dilemma. They are not having enough children. As a result the population is aging quickly. The strikes that have worsened the situation there are largely about governments attempting to increase the retirement age for government pensions.

There are several major trends underway on the Continent, some or all of which may mark the early stages in what is to come.

• Russia is rearming. Vladimir Putin is about to return to the Presidency and he has already pushed a bill through the Duma dramatically expanding the military budget. Since the rest of Europe is busily cutting military readiness, Russia’s rearming move reminds me of Germany’s similar move in the 1930s.
• Poland, Sweden, Germany, and France are discussing a political and economic union. This could be the beginning of a new Eurozone, but with the political authority to make it work. It could be the core of a United States of Europe.
•  Europe has held together and avoided a major war for a generation because the United States has kept troops stationed there. Budget and political pressures may cause the United States to pull out. If so, then history suggests the nations of Europe will soon be rearming and preparing for war.

In the Short Term

In the shorter term, the Euro, at least as we know it today, is on life support. I would give it a less than 20% probability of survival. Presuming that it fails, there will likely be a short term panic in the markets.

Unlike the unexpected failure of Lehman Brothers, which could have resulted in a total worldwide financial meltdown, the failure of the Euro is widely anticipated in the financial community. The surprise would be if it didn’t fail.

Banks and other financial institutions have been and are running scenarios and drills for just that event. Here in the United States, the impact would be minimal and short. The Federal Reserve has made contingency plans and set up the channels by which it would supply dollars for use by European companies that owed money to American companies.

The upshot of this is that there is a very real possibility that the dollar could effectively replace the Euro as the European common currency, at least for the short term. European companies and nations are purchasing dollars at a record rate. A potential freeze-up in the European banking system was averted last week with the announcement that there would be a coordinated effort by all the major banks in the world to supply European banks with U.S. dollars in order to facilitate the orderly continuation of commerce. That was a major step and amounted to an acknowledgement of the American Dollar as the European backup reserve currency. At the same time it provided a means to get the surplus dollars being held in China, India, and other major exporters into Europe where they are needed.

That, in turn, allows those same dollars to be used to purchase oil, food imports, and equipment needed to keep Europe running. As you may guess, the suppliers of those things whether they happen to be in Africa, Asia, or America, insist on being paid in dollars.

There is a certain irony in all of this considering that Russia, China, Iran, and several other countries were calling for the Euro to replace the dollar as the standard currency for oil purchase a few years ago.

This week the heads of state of EU will meet. If they do not come up with a definitive resolution to the problems they are facing, then it may all be downhill from there.

The Bottom Line

The odds are very high that the Euro will collapse, and even if the system is somehow patched together, Europe will have a very long-term and severe recession. Unless the Eurozone breaks up, the debt load of the insolvent countries will drag down the rest of the continent for years to come.

If the Eurozone comes unraveled, expect a short term market panic, very likely followed by a relatively quick “relief recovery” here in the United States. Every economic indicator here (except for housing) is pointing upward. The reverse is true in Europe and even in China.

Our major trading partners are in North America with our secondary market along the Pacific rim and India. We can not only survive without Europe, we very probably will prosper if the Euro fails. Meanwhile give thanks you are in America rather than Europe. $$.

 The Markets

From Recovery to Expansion

November was a microcosm of what we have seen both over the last decade and even over the last year. If we look at the pure numbers for the month, the S&P 500 Stock Index (S&P 500) was very slightly down. At mid-month it was down more than 5%, but recovered with a 7% jump in the last week of the month.

I have been asked why we do not attempt to get out of the market when we think it is likely to decline and then jump back in before it rises. Last week provided a good example of why.

It was pretty clear that the Euro was in deep trouble for the past several years, and more particularly since the second quarter of 2009. It doesn’t take a great deal of imagination to see that when the Euro finally fails the markets are likely to react negatively. Had we jumped out of the market in March of 2009 awaiting the failure of the Euro before reentering, we would have missed the S&P 500 rising about 80%. Had we jumped out when the Italian bond market indicated that the demise of the European currency was imminent, we would have missed that 7% rise in value we saw last week.

The Economy and the Markets

Growth in real gross domestic product here in the United States is ratcheting up to the 2.5% to 3.0% annualized rate based on November data. Unemployment dropped from 9.1% to 8.6%. I know that many commentators have attributed that to people giving up on attempting to find jobs, but the underlying details of the Labor Department report do not support that.

The Wall Street Journal reported that U.S. auto sales in November were at a 13.6 million annual pace. That is the highest rate since the recession hit in 2008 and up 13.9% from a year ago. During the third quarter of 2011, consumers increased their “durable goods” purchases at an annual rate of 5.5%.

Perhaps the most important number for those with domestic stock investment portfolios is the degree of corporate profitability. According to Mark Zandi, the chief economist at Moody’s Analytics, who has been uncannily accurate in his assessments over the past several years, publically traded corporations are averaging a 15% profit margin today. That is the highest level since 1969.

If the economy is growing at a meager 2.5% rate, how are corporate profits the highest they have been in over 40 years? Like most other things, there are several factors at work here. First, corporate productivity has risen dramatically.  More specifically, here in the United States our manufacturing productivity has been rising at an annual rate of about 5%. At the same time, expenses per employee in the U.S. work force have been declining at a 2.5% rate.

That is both good news and bad news, depending on whether you are a wage earner or an investor. It also explains why our GDP is now officially higher than it has ever been, but we still have 8.6% unemployment.

Businesses are still purchasing new equipment for the long term. That includes computers and machinery that increase their productivity. The net result is that even in this environment in which prices on manufactured goods are actually falling, corporations are able to make things for less and thereby able to maintain their profits.

Our biggest driver in the economy today is a surprise for most people who hear of it. It is exports. Quietly in the background of all the noise and excitement our exports have been rising and our imports have been falling. Each quarter the Commerce Department reports that we are getting closer to being a net exporter of goods and services.

One milestone that was either hit or to which we are very close is the energy trade. We are now exporting about the same dollar value of petroleum products as we are importing. Our imports are primarily in the form of raw crude oil but we are exporting large quantities of gasoline and other end user products.

A Normal Recovery & Expansion

There are business-cycle recessions and there are financial-recessions. The recession we officially emerged from in 2009 was a financial recession. The recovery and expansion following a financial recession is different from that of a business cycle recession.

Business cycle recessions are generated by an excess accumulation of inventory by businesses. They end when the businesses unload their inventory and people resume buying new “stuff.” Financial recessions are very different. First they can easily become depressions. In this case the Federal Reserve and Treasury executed a school-book rescue to halt the banking melt-down that sometimes results from such events.

The Cause and Effect

Financial recessions result from an excessive accumulation of debt, mainly at the corporate and individual level. A key component in that debt before a financial recession is that much of it will be used to speculate. A study released by the Bureau of Economic Analysis last month indicated that the largest single contributor to the housing mortgage crisis was not poor people buying too much house, but speculation by otherwise well-off people.

That speculation was enabled by mortgage companies and banks willing to loan money to people with good credit ratings so that they could buy houses with little or nothing down. In many cases the borrowers stated that they intended to move into and occupy the house, at which point they would sell their previous home and apply the sale price to the new mortgage.

In fact a significant number of those borrowers had no intention of living in the house they were having built or buying. They intended to “flip” the house to someone else at a profit.

The result was that home prices rose across the board, including for those who were legitimately buying or building homes in which they were going to live. The same thing was going on in Ireland, Spain, and other countries. Now we are facing the results.

With the rise in real estate values, taxes collected by local governments rose and those same governments increased staffing and borrowing. The mortgage bonds which resulted from those speculative purchases were assumed to be for primary residences, and as such were considered to be a “safe” investment for banks, insurance companies, pension funds, and everyone else.

With the realization that far too many people and institutions were “gaming the system” in a speculative frenzy, the house of cards came down. Now we have a lot of debt on the books of a lot of institutions, people, and governments.

Recovery and the Benefit

We are now well into the real recovery from that debacle. A financial panic and recession can be a good thing; that is, if the companies in the economy use it to “tool-up” and get better technology to become more competitive. That idea is the subject of the classic book, Creative Destruction. Here in the United States we have done a very reasonable job of recognizing our errors and are well on the way to correcting them.

Corporate debt is at historic lows. Personal debt is coming down fast. While it may be hard to accept, even our national debt is at a not-unhealthy level. Yes, we do need to figure out how to deal with the projected expenses of our entitlement programs for the elderly, but that had little or nothing to do with the current crisis. The key is that the crisis is causing us to debate the issue.

The Congressional Budget Office has noted that if we do nothing and allow the Bush tax cuts to expire at the end of 2012 we should be well on the road to paying down the national debt a decade later. Only time will tell.

The Market

Meanwhile the S&P 500 is low. Historically, the average forward price to earnings (P/E) ratio of that Index has been about 17. Today it is about 10. That means that when we finally get the Congressional reality show and the European tragedy behind us, even if corporate earnings were to remain flat, we would likely see a rise in market values of about 70%. That equates to a Dow of about 20,000. I know that sounds absurd, but if anyone (other than me) had told you in 2009 that we would see a double in market value three years hence, you would have thought that was crazy too.

In 1982, the last time the P/E ratio was this low, the Dow was at 1,000. $$

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The Dow Jones Industrial Average (The Dow) ended September and the third quarter of 2011 at 10,913, about where it was back in 1998. Despite its drop at the end of the month, it ended October at 11,955. That 1,042-point increase equates to a 9.55% gain in the Index. As I write this on the third day of November, the Dow has risen above the magical 12,000 mark and ended the day up 208 points at 12,044.47.  That puts it up about 10.4% in just over a month.

Note that what has changed since the end of September is that the probability of Greece defaulting on its sovereign debt in the near future has actually risen, but the value of the Dow is up over 10%. So what happened?

In the last week or so, the Commerce Department announced that the Gross Domestic Product (GDP) of the United States rose 2.5% in the third quarter, even as the stock market reflected values that seemed to signal a return to recession. We now know that automobile sales rose 7.5% in October. Sales at Chrysler rose 27%. Toyota, Honda, and Nissan all reported that the reason they did not hit high sales levels was that they had a shortage of cars! You may recall that about a year ago, I wrote that based on a J.D. Powers survey, Americans were likely to be in the position of wanting to purchase more cars than we had the capability of producing sometime within the next few years.

In the GDP report, the Commerce Department noted that consumer spending rose 2.4% in the third quarter, even as the consumer confidence polls reported that those same people stated they were not increasing spending. A closer look at the rise in consumer income and spending reveals the reality. In both August and September, American saved or paid down debt to the tune of just under half a trillion dollars per month ($479 billion in August and $417 billion in September). Americans increased their purchases primarily in the area of “durable goods” at a rate of 4.1%. We effectively did not spend more on buying prepared food at restaurants and decreased our spending on clothing and footwear. The biggest increase in dollars was on “Furnishings and durable household equipment.” Apparently, those surveyed people who were so gloomy considered buying washing machines and cars as something other than spending money! The same appears to apply to at least some credit card purchases.

Yesterday, the MasterCard Corporation reported its profits rose 28% in the third quarter. MasterCard and Visa derive the lion’s share of their income from transaction fees on credit card purchases. Given that the card companies have very real dollar data to report and the Commerce Department makes estimates, my guess is that the economic activity of the American consumer is rising a lot faster than the government recognizes.

It’s the Debt Service…

So what does all of that mean? As I wrote last year, we have been paying down our debt. Most of that half trillion dollars per month we have been “saving” has really been going toward reducing debt. The latest month for which the Federal Reserve has released data on consumer debt is August. In August, consumers were reducing their total debt load by 4.6% per year. Since late 2007, consumers have reduced the debt load they are carrying by about 18%.

The amount of debt we are carrying on our credit cards, mortgages, car loans, and everything else is not as important as the percent of household income that is going to service that debt. The graph below reveals where we were as of the end of the second quarter of this year (June). As of the end of June, consumers had reduced their collective monthly debt service from 14% of income to around 11%. All the evidence suggests that the decline continued through the third quarter and into October.

There is a very important message in the graph. The last time we had a recession and unemployment like the one we see now was in the 1980-1982 period (resulting in the election of Ronald Reagan). We had another economic rough patch around 1992-1994 (resulting in the election of Bill Clinton). Our debt load is very nearly down to where it was at the bottom of each of those recessions. It also means that our next President will likely be a Republican. We typically over spend and create too much debt under on President, and then pull back and have a “debt-hangover” under the next one and, of course, blame him.

If history is any guide, then we are now about where we “bottom out” in our debt reduction binges. In other words, the carrying cost of household debt rises and falls with our perception of how well we think things are going to be in the future. When we are pessimistic, we like to get our debt load below 11% of income. When we are euphoric, we can push it up as high as 14%. When we redirect our income to reducing that debt load, we dramatically reduce the things we are buying in the economy and we have a recession.

Another clear message that the graph above reveals is that the greater and more steep the decline in household debt, the more severe the economic decline appears to be. Note that I wrote, “appears.” As of last month, the GDP of the United States was back to the same level it was at its peak in 2007. That officially signals that we are no longer in “recovery,” but now have moved into “expansion” in the total economy. With over 9% official unemployment and probably around one in five persons who want to work either unemployed or “under-employed,” the consumer side of the economy (where we live and experience) does not feel “recovered.”

Consumer Debt is the Key

While the total percentage of our incomes that go to pay on our mortgages has fallen a bit, the big decrease has been in “Consumer” debt, which includes car payments, credit card payments, and the like. Once again, note that the data here only goes through the end of June. At that point we were at the consumer debt level of the early 1980s and were working our way down to where we were in the early 90s. If the trend continued, and all the evidence I can find suggests it did, then we should now be about at the point where we will start buying again. Sure enough, in the last part of the third quarter we started buying cars and other “capital” items and the credit card companies reported significantly increased activity.

Perhaps the most important thing to take from this chart is the trend line. At the current rate of debt pay-down, we will hit the 4.5% level by the end of next year. That is the point where we opened our pocket-books and started spending in 1994, triggering one of the greatest economic booms in our history. Because of the nature of the way things change, we should actually see a leveling off starting this year, accompanied by an increase in consumer spending.  In fact, we may have just seen the beginning of that reversal with MasterCard and Visa reporting record earnings. Based on the debt service load data, I would not be surprised to see the bottom in the housing market occur in 2012. When houses begin again to appreciate is another story, and a very difficult thing to predict.

Federal Debt Service

There is a lot of light and noise about the federal debt. From what I have seen it is the most popular ring in the political circus right now. Factually, it is not at all what it is made up to be. Just as with consumer debt, the quantity of dollars is not the important number to watch, rather it is the cost of that debt as a percentage of income. The most common way that a country’s “sovereign debt” is measured is by the relationship of the total governmental debt as a percentage of the total output of the nation (GDP).

The reality is that the debt-to-GDP relationship, within limits, is irrelevant. Using numbers we can get our minds around, let’s discuss a debt in the thousands instead of trillions. If a family has a net, take-home income of $80,000, but has a total debt (including home mortgage, car loans, credit card balances, and perhaps student loans) of $100,000, your first impression might be that they are in deep trouble. In fact, presuming they are a relatively young family with children, a house, and all the things that go with that, they may be in great shape. The key to determining whether they are in danger or quite well off is to know the interest rate on that debt and the number of years they have to pay it off.

If the debt they are carrying has an effective interest rate of about 3.75% (gross interest minus the tax deductions), and an average debt maturity (payoff) of 12 years, then they are actually carrying an annual debt service load of just over 13%. That, by the way, is the historical norm, and really quite healthy.

Now let’s switch perspectives and think of the federal government as if it were our hypothetical family. In terms of billions of dollars, our government takes in about $2,250 per year ($2,250 billion). The crucial number is the debt cost to the government on debt held by someone other than another government agency, or as it is officially called “debt held by the public.” The interest rate on that debt averages 2.886% per year. The public debt stood at $1,256 billion as of the end of October. That means that the interest the U.S. Government is obligated to pay is just under $300 billion per year, or about 13% of its revenues. Yes, that is only the interest on the debt, and eventually we will need to pay down some (but not all) of the principal.

One more detail and I will move on. Government revenues are down, way down. When tax rates were a bit higher and the economy was humming along in full expansion mode in the 1990s, the federal government took in about 20% of the total GDP. Currently, federal revenues are down to about 15.5%. Part of that is the income tax reductions that were passed and signed into law during the last decade and part is the fact that it is the taxable part of the economy that is still at below normal growth. In very real terms, the government took a pay cut of about 1/3 at the same time it needed to increase spending to support some of its children (citizens) who lost their jobs. It is also facing a growing cost to take care of its ailing parents (senior citizens). Since our government has a truly outstanding credit report, it can borrow money at less than 3% per year, so that is where it turned to get the difference. Its condition is not a heck of a lot different than many American families.

In short, the federal public debt could get out of hand if we do not address it, but it is currently not a serious problem. It is a popular issue to worry about though. There are actually quite a few ways to get it under control. Unfortunately, they all equate to a combination of cutting entitlements, mainly to older people (which the Democrats will not allow) and increasing taxes (which the Republicans will not allow), so we are stuck until we conclude that both are necessary. Just as in our hypothetical family, there may be a need to reduce spending and if that is combined with a change in employment somewhere in the family, leading to higher income, then things will probably turn out well.

As much as I hate paying taxes, and I write checks to the IRS each year that make me shudder, the fact is that we tend to do best as an economy at about the 18% (of GDP) federal tax level. A 3% increase in revenues combined with the economic recovery that is likely to be about to take place will go a long way toward getting us out of the woods. We also need to deal with the issue of health care for terminally ill patients. At present the largest single expenditure of our spending on health care is done in the last two years of a person’s life. There is no evidence that the people on whom that money is being spent are benefiting from it, but we can say for sure that the rest of us are likely to suffer from the expenditures. We have a system that cannot refuse a next-of-kin’s demand to spend an effectively unlimited amount of money on a very elderly dying person. I don’t know how we can fix that, but we must.

The Stock Market

As I write this, the Standard & Poor’s 500 Index stands at about 1,261. So far this quarter with 327 of the 500 companies on the record for the third quarter, 218 had better than expected earnings, 72 were below expectations and 37 hit the estimate. That puts 67% of the reporting companies with earnings higher than expected. More, the reporting so far indicates that both operating and “as reported” earnings are going to break all previous records. In short, corporate earnings are at an absolute record high. Meanwhile, the Index itself is about 20% below where it was in 2007 despite the fact that reported earnings are 20% higher than they were in 2007!

In rough terms, that means that the stock market value is effectively 40% below where it was in 2007. Here’s the most fascinating thing, at least to me, about that set of numbers. The stock market was not overvalued in 2007. If the market was at the same, quite reasonable, price to earnings (P/E) ratio it was in early 2007, the Dow Jones Industrial Average would be at nearly 17,000 and the S&P 500 would be at about 1,700. Just for the record, the price to earnings ratio back in 2007 was 17. In 2001 it was at 45! The historical normal level is between 17 and 20. The current P/E ratio is around 10.

Translated into percentage yield, the Standard & Poor’s is currently yielding a whopping 8.26% per year in the form of corporate profits (earnings). The vast majority of that yield is being reinvested back into the companies, as it well should be, but still that is a heck of a high yield. In fact it is the highest it has been since 1982. By any definition, the stock market is the cheapest (most undervalued) it has been in thirty years. Oddly, because of the amazing increases in annual profits, the stock market in the United States is actually lower in terms of absolute value than it was in March 2009!

That value imbalance is present not only here in American, but is even more pronounced in the the emerging market countries. Emerging market funds fell further than the major U.S. Indexes in the third quarter, and as they tend to do, appear to be coming back faster. The Vanguard Emerging Markets Stock Index is up about 14% in just over a month.

One last piece of good news regarding the market, although perhaps not too good if you are out of work: Companies in the United States reportedly increased their productivity by 3.1% last quarter. That fits quite well with the news that companies have continued to purchase capital goods; things like computers, machine tools, and the like. It means we are capable of making more goods and providing more services for less expense, which increases the profits of publicly traded corporations, but means they can make more with fewer workers. In effect, it means that the stock market will probably do much better than the job market in the near future.

Greece and the Eurozone

So, what does that have to do with Greece and the Eurozone? As I have written before, Greece is going to default on its debt. The agreement that was reached last week among the member nations of the European Union was that each nation would supply a Euro guarantee amount to a fund that would back-stop the bonds of the other troubled nations, Italy, Spain, Portugal, Ireland, and Belgium. Second, the agreement was that each nation would put the pressure on local banks to take around a 50% “haircut” on the value of Greek sovereign debt. That meant that the various nations would step in and shore up the banks’ reserves to compensate for the losses they would book from the debt write-down. Because the write-off of half of the Greek national debt was to be “voluntary” there would be no triggering of the credit default swaps (CDS), which are, in effect, insurance policies against the failure to pay in full by the Greek government.

Another thing that initially sounded quite good was the agreement by the EU countries to “guarantee” a fund that was intended to attract outside investors to boost the value of the internal fund. In essence, the European financial stability fund would borrow money by issuing bonds to backstop the bad debt of the southern tier of Eurozone countries. Unfortunately, the European Union only reached an agreement to “guarantee” those new bonds at 25% of their face value. Frankly, I don’t think they are going to get a lot of takers.

It is those CDS obligations that have markets running scared. It is good to remember that it was the CDS obligations issued by AIG (a life insurance and annuity company) that nearly took the whole system down in 2009. AIG had assumed that Lehman Brothers would make good on their obligations or that the Federal Government in some form or fashion would “bail them out.” When the decision was made by the Bush administration to let Lehman Brothers go down, it caught quite literally everyone by surprise and the ripple effect nearly took the entire world financial system down too. Note here that it was not the failure of Lehman Brothers that nearly brought the house down, but the potential for failure by a United States life insurance company that was making a fortune selling annuities to risk averse investors.

The concern is that either one of the Eurozone countries or now perhaps Greece itself will pull out of the deal and in doing so effectively render the Greek sovereign bonds worthless. That very fear was the deciding factor in the failure of MF Global Investors, LLC this week. There will be repercussions from that failure as well, but note that in the ensuing days, the Dow has risen about 5%. MF Global, as it turns out, took a big position not in Greek debt, but in Italian and Spanish bonds. Worse, the attempted sale of MF Global fell through at the last minute because of “discrepancies” found in MF Global’s books. Those discrepancies now have been admitted to as illegal use of client funds by the firm.

There are two very large lessons here.

First, the decision by the Greek government to hold a referendum on whether or not to accept the terms of the Euro bailout (which has now been rescinded) meant that Greece would probably default in a very uncontrolled manner and is pretty much a worst-case scenario. On that news, the Dow dropped 5% over two days before starting to rise again. The lesson from that event is that the traders on Wall Street have finally figured out that just about everyone concerned has made provisions for the Greeks to default. When it happens it will not be a Lehman Brothers. It also shows that The folks on Wall Street have concluded that the Germans and the other Eurozone nations with a few Euros to spare will not allow the Greek failure to spread to Italy, Spain, and so on.

In short, the first lesson that we can learn here is that the movers and shakers in the stock markets of the United States have concluded that a rolling series of defaults across Europe will not mark the end of the world. Sure, we do some business with Europe, but not a heck of a lot. Our main trading partners are here in the Western Hemisphere and across the Pacific, not the Atlantic.

The second lesson is far closer to home, and extremely critical to understand. MF Global had attracted a lot of investor money because they offered a promise of much higher interest rates than were available elsewhere. They were proud of their “managed futures” program, which offered the lure of a mystical ability to make money in falling markets.   Those “high net worth” investors who took the bait are now listed as “unsecured creditors.” Sadly, some of the investors will probably turn out to be anything but “high net worth.” because MF Global also was heavily marketed as a source of “privately managed accounts.” They often marketed their programs to “reduce portfolio volatility” through other firms and individual “advisors.”

The Greek tragedy and MF Global’s collapse are two faces of the same coin. There are no secret ways to get a high return while eliminating market risk. There are just ways to raise your risk of total loss as an alternative to seeing the volatility, or variance that is part of the price we must pay to potentially have a higher return in the long run.

The Germans, among others, allowed Greece into the Eurozone because they concluded they could very profitably sell what was made in Germany to the Greeks, along with the Irish, Portuguese, and others. They also concluded that German banks could loan money to the Greeks to buy those expensive German goods and would earn above normal returns because the Greeks would be so thrilled to be allowed to borrow and buy that they would pay the high rates. If that sounds familiar, all you need to do is substitute one of the now failed Wall Street firms names in place of “Germans” and substitute “Americans who couldn’t afford them” for the Greeks. Here we sold houses. They did that in Europe too, but they also sold a lot of anything made in Germany on one of the other “rich” countries.

The money to do all of this came from investors who wanted a high return without risk. The idea was that by buying Greek sovereign bonds they were able to get a much higher return, but that Germany would ultimately back the Greek government if anything went wrong. The search for high returns without market risk that is probably the single most deadly investment error that anyone can make.

Here in the good old United States of America, the marketing blitz is on to get people who have had a dismal return in the market for a decade to turn their money over to privately managed accounts so that genius managers using secret formulas can work their wonders. Bernie Madoff certainly did a magnificent job of that. The other siren song is coming from the insurance companies that are promising a completely secure, steady return via the plethora of “guaranteed” annuities they are offering. The problem is that if the insurance company goes under, who will replace your money? In most cases, the answer is “no one.”

Again, the rescue of AIG by the Treasury is what stopped the collapse. What the news media did not well publicized is that many of the major annuity-issuing life insurance companies also required a rescue by the Treasury or the Federal Reserve in the weeks that followed.  Since then, the Congress has effectively blocked the Treasury from doing that again. I strongly suspect that the next time a major insurance holding company is on the verge of failure, the government will not step in and rescue it. There will be a lot of pain associated with that inaction. My recommendation is that you avoid that trap.

If you are afraid of market variance and want security, go to the bank and buy a certificate of deposit. Yes, you will get at most about 1.6% per year, and that only on “jumbo” CD offerings for five years. If you are willing to put up with market variance to have the opportunity to get that higher rate of return, then stick to mutual funds. Yes, the market may move around, both up and down, a lot, but if your money is in mutual funds, you have the protection of the Investment Company Act of 1940 against having the creditors of some management company getting first shot at your money. More, make sure if you use a brokerage account to hold the funds that the account is fully insured by someone other than the company running the account.

These are basic issues, but it is now, just as things seem darkest, when through greed, fear, or both, charlatans will be more than happy to take your money and promise you the world. Beware, because they are out there. The stock market is cheap and (in my opinion) due for a rather significant increase in value in the not too distant future.

Until next time, take care. Enjoy life. Give thanks for all our blessings.

As always, feel free to write or call with your comments or questions.

Jeff McClure

The Force of Fear

The stock market decline in the third quarter of this year (July-September), are a proof of the force of fear. Even as corporations report increased earnings and the GDP is revised upward, the market has continued to act as if the end of the world was at hand. The Dow Jones Industrial Average fell about 12% for the three months. The S&P 500 Stock Index fell about 14% for the same period.

Last week, the stock market seesawed up and down as much as four or five percent per day. The Reuters News Service headlines at the end of each market day were quite revealing as to why. Two of those headlines (the bolding is mine):

• Stocks Drop, led by Commodities on Economic Fear
• Stocks rally on Europe Debt Optimism

Traders are vacillating between Fear and Optimism. I want you to consider that neither of those is real. They are feelings. In the end, the values of things we own do not depend on our emotions, but on the hard-nosed reality of economic principles.

Even the fear itself is not at all well defined. The number one “wicked” something that people seem to fear is the default of Greece. I have written this before and I will probably get to write it again. Greece is going to default. The numbers are very clear. Greece absolutely cannot afford to pay its debts.

The fear appears to be that if (when) Greece defaults, European banks and nations will become insolvent because they have large holdings of Greek bonds. Investors seem to fear that the chain of defaults that follows will be more severe than that following the Lehman Brothers default back in 2008-2009. Greece is not Lehman Brothers. With Lehman, there was a massive worldwide unpreparedness. There is ample evidence that preparations are being made in every institution and nation across Europe and the United States.

The second “wicked” thing we seem to fear is that something terrible is about to happen here in the United States. Among those who express that fear, the consensus seems to be that it will come because of the nefarious activities of the President. Beyond that, I have been unable to nail down any specific terrible event that they fear.

When John Kennedy was President, I listened as conservatives insisted that the Pope would set himself up as the ruler of America (Kennedy was our first Roman Catholic President). I again listened as very intense, left-leaning college students insisted that Richard Nixon was going to stage a coup and become dictator. While Jimmy Carter was President, conservative friends of mine insisted that the Trilateral Commission was a front for the “one world government” that would take over and enslave us all. During George W. Bush’s presidency, the conspiracy theory (from the left) was that Halliburton was secretly running the government and the wars in Iraq and Afghanistan were solely for Halliburton’s profit.

In this age of 24 hour news channels, cell-phones, and mass email forwarding, conspiracy theories and urban myths can easily “go viral” and be widely believed. That does not make them more real or less damaging.

The Wicked “Something”

I have taken the title of this letter not from its origin in Shakespeare’s Macbeth, but from Ray Bradbury’s novel by that name. In Bradbury’s novel, fear gradually settles over a small town as a carnival arrives late in the year. It opens with a lightning-rod salesman warning that, “A storm is coming.” The scene is set quite literally in the “fall” of the year. The carnival is indeed an evil mechanism that exists to imprison the carefree souls of young boys. Very critically, fear is the only weapon Mr. Dark, the master of the carnival, has at his disposal. Laughter, dancing, and singing free the children’s souls and the loving embrace of a father destroys the power of the carnival master.

The “something wicked” that comes in the novel is fear. Securities markets tend to be moved in the short-term by the twin emotions of fear and greed. The highest levels of volatility in the market come near the top and the bottom of market cycles as the adherents of those two emotions battle it out. If in the relatively recent past the optimists have been the dominant force, then market values are likely to reverse course and decline substantially. If in the past couple of years there has been a great deal of pessimism and fear, then it will not be long before the market starts back up. These reversals can take months, and sometimes many months, but the end of the high fluctuations is almost always a mark of the reversal of sentiment.

Right now, it is clear that as a whole, those corporations listed on the exchanges are doing quite well. That is where we invest. We do not invest in the unemployment rate or the GDP. Those are indicators, and they are important indicators, but even in times when unemployment is high and the GDP is in bad shape, there will be companies that are turning a nice profit. As an example, the employment reports consistently reveal that companies are hiring and the government is laying-off workers. The net result is high unemployment, but it is mostly in local and state governments where that is occurring. Fortunately, our investments are not in governments!

The Thing That is Really Coming

At some point, the greed factor will overcome the fear factor in the markets. If history is any guide, that will happen sometime between now and the end of this year. I only say that because it is such a consistent pattern in history. If we analyze the data again at the end of the year we may find that nothing has actually changed. What will likely make the market indices rise is simply a reversal of sentiment.

When there is a legitimate reason for concern evident in the underlying economy, the pattern we commonly see is gains in the summer followed by a decline beginning in October. When the underlying economic reality is solidly profitable, but baseless emotion forces the market values down, then we typically see losses in the summer and a reversal to the upside in late October. The stock market peaked in October, of 2000 and again in 2007. In retrospect, during the summers we now can see as the ends of the bull markets, values rose in spite of bad economic data. During the summers at the end of bear markets, market values tended to fall despite improving economic data. “It’s Déjà vu all over again.” *

My reading is that the car and truck count on I-35 is growing. The parking lots at the outlet malls are full. Here in Salado, we just had what appears to be a record-shopping weekend. If that pattern holds, then things are getting better and the stock market will respond. It is not so much a matter of “if” as “when.”

As always, if you have any questions or comments we are available.

Sincerely yours,

Jeffrey W. McClure, CFP®

*Quote from that wise sage of New York, Yogi Berra.

A Bumpy Road

Last week the Dow Jones Industrial Average (the Dow) dropped 6.4%. So far this week it is up over 5%. It is basically where it was back at the end of 2010. The purported reason for the decline last week was the same non-news about the potential default of Greece. I call it “non-news” because there is no alternative to a default by Greece on its sovereign debt, at least there is none that I have seen.

In reality there is another element here even as there was at the end of July and into early August. Congress failed to pass a bill funding the government beyond the end of September. A stop-gap measure was passed by the Senate which looked like it would be acceptable to the House Republicans and the stock market immediately rallied over 5%. Today, the news is that the House will hold a “pro-forma” voice vote tomorrow (Thursday) to extend current funding for four days. If even one Congressman objects then the bill dies. The reason is that Congress is formally not here, but on a short vacation to celebrate Rosh Hashanah. Congress is scheduled to be back at work on Tuesday when they will vote on whether or not to keep the government doors open. Each of these votes is coming at the last possible moment. If either of them fail to pass, as did the bill last week, then the federal government stops paying its workers and stops paying its bills.

If this sounds familiar, it is because it is. In this case the battle is over whether to provide sufficient funds to allow FEMA to fund disaster relief in the Northeast following the hurricane damage there. No matter that the grand compromise that was passed on August 2 actually allows for exactly that funding, the House conservatives insisted that defunding of a relatively small federal research grant for automobile fuel efficiency research and development be eliminated or they would not agree to fund FEMA. Whether or not you agree with the demand, the fact is that when funding bills finally pass, just before a scheduled vacation by Congress, the market rises. When funding bills fail at or near a deadline, the markets fall.

The Greek default drama makes for some good background to all of this melodrama in Congress, but at least in the short term, when the biggest customer of publicly traded companies in the world threatens to not pay its bills, it does have an effect on the prices of the stocks of those companies.

The Real World

Last week as the market fell, news reports I read claimed that part of the fall was because of disappointment with FEDEX. I found that at least as amusing as the Greek story. FEDEX did report its earnings last week. They were up 22% when compared with this time last year. Going forward, the CEO warned that earnings for the next four quarters would probably not grow as fast as some were expecting. His explanation was that with the threat of the federal government default hanging over their heads, businesses and consumers were holding off on purchasing electronic components and products.
FEDEX is one of the best barometers of what is happening in the economy, both domestically and world-wide. So, I took a look at the consensus of earnings estimates for the next year. FEDEX is expected to have about a 33% increase in earnings between now and one year from now. That was disappointing? That estimate is right in the middle of the CEO’s estimate as well. The story at UPS is the same, great growth in the last twelve months and even better growth ahead. Of course in both cases the stocks have fallen.

The FEDEX CEO warned that while he expected good growth in the domestic market, a slowing in China was hindering their total financial growth. That sounds pretty bad so I turned to the East Asia area to examine what was happening. Mainline China considers any information about GDP growth to be highly sensitive data and puts people in prison for talking about it, so there is not a lot to learn in that area. Taiwan, on the other hand, is pretty open on the subject. It appears that a sort of slowdown in growth is indeed forecast there. The Taiwanese economy is widely forecast to only grow about 5% over the next year and exports to the US are only forecast to be up by about 7%, based on manufacturing orders they have already received.

The FEDEX CEO was asked in his earnings call if he expected a recession to occur in the near future. His answer was a simple, “No.” The earlier answer from UPS was the same. Back when the Dow Jones Transportation Index was really just transportation companies (railroads) it was an excellent forecaster for the Industrials. The logic went that if companies were going to have earnings they would need to sell and ship things, and that would reveal what was really happening. UPS earnings are currently forecast to rise only about 26% in the next twelve months. That too was apparently disappointing.

The Economy

Greece is teetering on the edge of default. Their parliament is scheduled to vote this week on a major property tax increase. If it does not pass, then theoretically the rescue money will not go to Greece and they will finally default on their government bonds. Even if it does (and I think it will) the bill calls for the tax to be collected through electric bills. The electric workers union has stated firmly they will not allow it to be collected.
In some form and in the not-too-distant future, Greece will default on its debt. The Germans could stave off the date for a while by loaning more money, but the reality is that the Greeks will need a cratering experience to realize that this all is for real. The public response to the recognition that great sacrifice must be made else they will default was and is to go on strike. It is not too different from our Congress which at each crisis climax votes to allow all the borrowing and spending needed and then takes some time off. We can afford to do that because we have the wherewithal to pay the bills, albeit with borrowed money. The Greeks don’t have that luxury.
When Greece finally does default the markets will probably act as though the end of the world has finally arrived. Then, someone will look east and see the sun rising and exclaim, “Wow, the earth is still turning!” at which point people will rush back into the market to purchase stocks. Unfortunately as the people who need to notice the sun rising live in New York City where they can’t actually see the eastern horizon, it may take them a while to realize that the world has not ended after all. They may notice that the European Central Bank (ECB) has been flooding the banks around Europe with cash (mainly dollars) to ensure that they can weather the storm. The ECB has also served notice that it will buy as many Italian and Spanish bonds as are needed to stave off the short sellers who will attack those markets.
In short, Greece will probably default. The markets will panic. Then, after a bit of soul searching and hand wringing, business will head back toward normal. Meanwhile American and many foreign companies will continue to have record earnings, high earnings growth, and immense quantities of cash on hand.
That will only leave three problems to solve.

1. We will still have a few million more houses than we have households to live in them.
2. We will still have more personal debt on the books than we are comfortable with… and
3. We will still have a faction (or two) in Congress that will keep threatening to blow everything up if they don’t get their way.

Numbers one and two will solve themselves over time.

Sales of existing homes were up 18% in August over last year. Given a couple of years and the phenomenally low mortgage rates being engineered by the Federal Reserve, the housing overhang will be getting close to gone.

We will see a slow growth economy and high unemployment probably through next year as we Americans buy down our debt. At that point, probably in early 2013, the economy will surprise all the pundits as it kicks into overdrive.

Forecasting the American electorate’s behavior is a loser’s game, but let us all pray that we can come to our collective senses and get some folks into the halls of Congress who can work together. More, let’s pray for a President, of whatever persuasion, who can inspire and lead us.

Europe is going to be in a shambles for a while. This is an amazing opportunity for the United States to cement itself as the sole economic super-power in the world. We the people will make that decision next year in November. I have faith in us that we will make some good decisions. No matter what, we will be on top of the world. Our system has its warts and pimples, but it is so much better than anything else on the planet that there is no real comparison. We Americans are at our best when we are faced with a challenge. Good times are hard on us. We have a challenge, –actually more than one. I firmly believe we will triumph over those challenges and emerge as a guiding light to the world. That is what we have done over and over. We are still who we are.

Forecasts

I am going to make some forecasts here that frankly scare the bejibbers out of me. I don’t like making forecasts but right now that is what I believe we all need.

1. Greece WILL default. Germany will ride to the rescue but in return demand that the Euro-zone countries turn over a lot of what they currently believe is their sovereign right to spend other people’s money to the European Central Bank, which will be placed under the control of some hard-nosed Germans. If the other countries don’t go along, the Eurozone will shrink to include only those who will. Greece will be kicked out and will suffer horribly. This will not be a pretty picture, but will be necessary.
2. Russia will elect Vladimir Putin as its President. He will then begin to rebuild the military strength of Russia with an eye on reestablishing the old Soviet empire. We will have the option of facing him down or things will be very interesting in a few years.
3. Congress will not wreck the Republic. Yes, they will continue to posture, but following the elections in 2012 people will be completely tired of such foolishness and Congress will get the message.
4. We will pay down our personal debt and suddenly start to spend like mad. That process is already started and will accelerate though 2013 at least.
5. The Dow Jones Industrial average will reach 20,000 in the next five years (or sooner).
6. The world will not end anytime soon.

Meanwhile those who keep invested and/or invest in the shares of well run companies here and around the world will see that appreciation they have been waiting on for so long.

Your thoughts and comments are always welcome.

TPWC-10-29-2011 002 Second hour of October 29th’s program

TPWC-10-22-2011 Replay from 10-15-2011 program

TPWC-10-15-2011 001 First hour of October 15th’s program

TPWC-10-15-2011 002 Second hour of October 15th’s program

TPWC-10-08-2011 001 First hour of October 8th’s program

TPWC-10-08-2011 002 Second hour of October 8th’s program

TPWC-10-01-2011 001 First hour of October 1st’s program

TPWC-10-01-2011 002  Second hour of October 1st’s program