Markets vs Economy: Dangerous Memes vs Realities
We want to focus on the state of the markets, their outlooks and the relationship to the state of the economy. And then say a little about positioning. But let's start with a re-look at the "controversy" swirling in the blogosphere, the MSM and the commentariat about GDP having been grossly over-estimated because inflation was badly under-estimated. This is something we've already beaten to death we thought, but nobody's either giving in or actually trying to dig thru the data to see what reality is. The heart of the matter is the the estimate of inflation was around 1.5% while the CPI was around 3.5% so obviously when you adjust for inflation GDP growth was over-estimated. First off we reply that one should look at YoY changes instead of QtQ and then a great deal of clarity ensues. Done that way real GDP growth was 2.5% Q1 and 2.2% Q2 - the economy is indeed slowing but not in a recession. The heart of the heart goes to accounting for trade-related inflation, that is are we importing inflation. You see GDP measures only what's made domestically,not a great surprise since that's its' name ! But forturnately the BEA has anticipated us and publishes Gross Domestic Purchases which adds back in the effects of trade. When you take a look at that, which we did and posted (Conspiracy Theory vs Real Data: Another Sidetrip to Realities), you get very different results, with GDPurchase growing 1.1% and 0.4%; much more importantly it began diverging from GDP late in '07. Strangely enough just about the time that oil prices shot the moon and oil imports got to be so painful; and also strangely enough just about when the domestic economy started depending on exports for growth as we've previously dissected in component-level detail. (GDP, Jobless Claims, Markets, Oh My: Still Tipping Over !)
This may all seem arcane and a bunch of wonks amusing themselves but it's important because lots of folks will be making their evaluations and decisions on the conspiracy/malfeasance memes instead of on the facts as they are. And that will influence businesses, the markets, your job and the rest of everything else. In yet another attempt to put things to bed, or at least provide you with a clearer understanding, we attempt to sidestep the whole issue with a primitive, bruteforce algebra fix by simply netting out the trade (imports, exports) from the basic GDP numbers. The results are at first startling and then a V8 moment - you know, head slip and "oh, of course". Guess what GDPxTrade grew 1.1% in Q1 and 0.5% in Q2 - so close to the official GDPurchase data as to make us think in divine control or that the BEA actually knows what it's doing. More importantly is the divergence issue which you can see clearly - the domestic economy is clearly headed into the tank. In fact given our views on the outlook for consumer spending the tipping point has clearly been crossed (discussed in the Conspiracy Theory post). Now that's what you should be paying attention to.
Market Outlook
As are many of the commentators in the readings excerpts after the break, including 3.5 of the four horsemen of the market apocalypse (Grantham, Rodriquez,Hussman and Leuthold). Only Luethold, the 1/2, sees any basis for market optimism and he sees it on the basis that we're in a recession with recovery beginning nine months out and the markets bottoming soon. We think, and just finished documenting to a fair-thee-well, why that's an overly optimistic view. In fact we think the two central facts you should be looking at are this: 1) the real economy is tipping over into a more severe downturn than so far experienced and 2) none of the valuations, PEs, or earnings estimates under-pinning current market levels have factored that in. As the other three horsemen all argue, each for different reasons. It's nice to share a perspective with guys with such track records and respect. Also in the readings is a very good, thoughtful and in-depth article from Dave Merkel providing the most detailed diagnostic for judging a bottom we've ever seen. And his conclusions are in line with ours and the Horsemen's. When you take a careful look at the market chart for the SPX and NDX, notice that each chart puts the other index in the background, you'll find the points we've been making, here and in early postings (especially on the Tech outlook) reinforced. Tech didn't follow the mainstream down but it's beginning to; AND it was down recently more than the mainstream - indicating a major....major shift in perspectives on the Tech outlook to which you ought to pay serious attention.
Dollar and Oil
Central to all this sturm und drang are what's going to happen to the dollar and to oil. Right now there's another huge meme driving a lot of the common thinking which can best be put as follows: the world's not de-coupled at all, the developed countries are headed for recession much faster than anyone anticipated but the US is going to escape lightly. And the developing world is also slowing. As a result of this the downward pressures on the dollar suddenly abated and world demand for oil and commodities all dropped significantly. All of that is true. HOWEVER....while the dollar has suddenly leaped for either no apparant reasons discernible in the data or charts but likely to represent this startling shift in mental outlook it's not likely to keep shooting up. As you can see in the chart. While it probably won't re-start its' precipitous fall again either we wouldn't count on a future export demand boosts or currency conversion boosts to foreign earnings like we've seen. HINT: back to tech earnings !
Similarly the developing Asian countries are de-emphasizing the anti-inflation fight, which is much more serious for them on two fronts. First off, inflation is higher and they have a much more serious problem calling for tighter central bank controls. Second off - they face much more serious domestic stability problems if growth falls to far. As a result they're shifting back to allowing growth and not fighting inflation as hard. The net result of that will be continued inflation, renewed demand for oil and commodities emerging later this year and the likelihood that we've seen what we've seen in oil price drops and in dollar increases. (Hurtin Worldwide:Outlook, Countries, Commodities & Geo-politics). It's rather enormously amusing as the drop in oil prices appears to flatten out that it's doing so well above where this surge started. And, if you back at the cited post, the price boundaries we guestimated are turning to be all too accurate
The final section of the readings has a couple of articles on positioning. One pointing to the Kresge Foundation that illustrates a theme we've been striking for a long...long time (This One's for Jay: Investing Strategies for a Dicey Market)- this not a buy-n-hold market and will never be again for a long time if ever. And you need to follow more complex strategy or find someone to do it for you. And another great Jubak column on using Buffet-like business principles to pick long-term winners which gets to the heart of our argument that ultimately one should focus on well-run businesses with major competitive advantages. (Masterclass: Buffett on Investing and Business Analysis)
Market Apocalypse
The Four Horsemen of the Market and why you should heed them Jeremy Grantham, Bob Rodriguez, John Hussman and Steve Leuthold are contrarian-minded investors and opinionated commentators who share one thing in common: Those who buy into their funds never know exactly where their money will be parked. It could be emerging markets or alternative energy, high-yield debt or Treasurys. And if these risk-conscious money managers don't see compelling values, they might hedge their portfolios against unruly markets or even stash a good chunk of shareholders' assets in cash until better bargains appear. Jeremy Grantham is not given to false alarms. But nowadays, his digging for attractively valued stocks is mostly hitting rocks, and that has Grantham deeply concerned."The fundamentals have turned out to be worse than I had thought," Grantham said. "My advice would be, don't take any risk." What he means is that in this market, don't be a hero; live to fight another day. Here's why: Global economic growth is slowing under the weight of increasingly illiquid credit markets and inflationary pressures. Weaker growth slashes corporate earnings, and since stock prices are tied to earnings, the outlook for equities worldwide, as Grantham sees it, is poor to middling. Hussman said he's looking for another shoe to drop once investors recognize that the U.S. has not avoided recession. "The stock, bond and foreign-exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession," Hussman wrote in his weekly market commentary in late August. Investors' consensus is mistaken, Hussman contends. He said the U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit. "The potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact," Hussman wrote. Like Hussman, Leuthold is convinced that the U.S. economy is in recession. But he points out that the stock market typically bottoms around the midpoint of the downturn. By his reckoning, the economy entered recession toward the end of 2007, and the extensive valuation criteria he uses tell him there's now light at the end of the tunnel. "The bottom has been made," Leuthold said. "The economy is going to start showing some positive signs sometime in the first half of 2009." So he's getting in early, loading up on shares of biotechnology and alternative-energy companies in particular, and keeping a modest amount in oil drillers and natural gas producers.
Warning: Worldwide wipeout ahead Yet if you take a moment to look around the world, you may be surprised to learn that U.S. stocks are the picture of health compared with their counterparts worldwide. And measured against the gloom in bonds, U.S. stocks are like a sunny day in spring. Time to gloat? Not on your life. For if there's one thing we know about global markets these days, it's that they seldom diverge for long. So while it might be tempting to look with pity at investors across the seas and in other asset classes, it's more likely that U.S. equities will plunge than that foreign equities will float higher toward our perch. Most of the European and Asian countries' biggest companies are banks that have suffered the same fate as U.S. financial institutions. Gullible and desperate for income at a time of record-low yields in the mid-2000s, they were suckered by Wall Street investment banks into borrowing to the hilt to buy high-yielding mortgage-backed securities that were mislabeled as high-quality, low-risk investments. It takes only a 4% loss to wipe out your capital when you're at leverage levels of 30-to-1 -- a measure of how much capital you have at risk compared with how much capital you have before borrowing -- as many banks around the world were. And add to that a crash in metal and energy prices in the past two months, plus a slowdown in industrial growth, and you have a conflagration of capital that knows no borders. In many places, a perfect wave of growth has reversed into a brutal riptide. Indian information-technology companies such as Cognizant Technology Solutions and Wipro swelled in importance by helping U.S. companies fix the "millennium bug" in the late 1990s and then went on to grow at 40%-plus rates as the tech outsourcing fad exploded. Now, The Wall Street Journal reported this week, the Western credit crunch and capital expenditure slowdown have sapped sales, and the cheaper dollar has shrunk Indian tech company profits. At the same time, rising labor costs have permitted competition to emerge in lower-cost countries in Eastern Europe and the Philippines. The big Indian tech companies' shares are down 30% in the past 10 months versus a negative 18% for U.S. techs. Meanwhile, fear has gripped corporate bond investors by the throat in ways that make stocks' problems look tame. Surely you remember bonds, those widows-and-orphans instruments that were once considered the market's equivalent of a boring IOU, paying a percentage point or two above U.S. Treasurys? Well, now many are trading like penny stocks. You can call your broker to buy debt by the mortgage unit of blue-chip GMAC Financing at crash-landing prices that would give you a 50% annualized rate of return over the next three months when they mature in November. The Merrill Lynch Corporate Master Index, which tracks the performance of investment-grade-rated corporate bonds, shows 72 of them trading in "distressed" condition, or more than 10 percentage points over Treasurys -- 28 of them issued by banks such as regional giants National City and Washington Mutual. That means corporate bankruptcies are virtually inevitable over the next 18 months.
Diagnostics
The Fundamentals of Market Bottoms, Bubbles pop when cash flow is insufficient to finance them. But what of market bottoms? What is financing like at market bottoms? There are some reasons for optimism in the present environment. Shorts are feared. Value investors are seeing more and more ideas that are intriguing. Credit-sensitive names have been hurt. The yield curve has a positive slope. Short interest is pretty high. But a bottom is not with us yet, for the following reasons: Implied volatility is low, Corporate defaults are not at crisis levels yet, Housing prices still have further to fall, Bear markets have duration, and this one has been pretty short so far, Leverage hasn’t decreased much. In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books, The Fed is not adding liquidity to the system. I don’t sense true panic among investors yet. Not enough neophytes have left the game. Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now. Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom. For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough. Exacerbating that will be all of the neophyte shorts that have piled on in this bear market. This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more). There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals. In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm. As for asset allocators, time to begin edging back into equities, but I would still be below target weight. The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present. That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question. Long only investors must play defense here, and there will be a reward when the bottom comes.
Fundamentals of Residential Real Estate Market Bottoms My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline. Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now. Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I — and you — can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks.
Heads Out of the Sand, Homeowners!
The key to our wild market: Asia At the core of the current wave of volatility are investor worries that growth is slowing in the Asian economies, which have been driving the global economy forward since the U.S. economy dropped into low gear in the fourth quarter of 2007.Investors have been expecting that Asia's export-driven economies would follow suit. Lower growth in importing economies must lead to a slowdown in exports from Asia, right? Recent figures suggest the slowdown has finally arrived. Growth in China slowed to an annual rate of 10.1% in the second quarter of 2008 from 11.9% in 2007. The pattern is similar in other Asian economies, big and small. India, where gross domestic product grew 9.1% in the fiscal year that ended in March, will see growth of 7.1% this fiscal year, according to Morgan Stanley. All the economies of the developed world, including the United States, would kill for growth rates like those, but it's not the absolute level that matters. A drop from a 9.1% growth rate to a still high 7.1% is enough at the margin to cut demand for the commodities that fuel these economies. And that explains the price drop in commodities from oil to fertilizer to copper. But while the slowdown in growth in Asia is pretty much what Wall Street has been expecting ever since the U.S. economy started to slump, the slowdown doesn't seem to be happening because growth in the U.S. economy has slumped. Instead, soaring inflation in Asia seems to be at the root of the slowdown, and the damage to Asia's economies is largely self-inflicted. We're seeing the beginning of a shift away from the fight against inflation that has contributed to a slowdown in economic growth in Asia back toward more growth-at-any-cost policies in the region. In the short run, that will act to stabilize prices for most commodities near current levels. And even after recent 20% drops, those levels are well above the prices that Wall Street analysts are projecting for 2008 and 2009. That means, in my opinion, that on the fundamentals we've seen most of the decline in the prices of commodities. In the long run, the shift away from fighting inflation and toward growth at any cost is going to accelerate global inflation. Note that the battle against inflation in an economy such as China's has hardly been won. Inflation dropped to 6.3% in July at the consumer level but is running at 10% or better at what's called the factory gate in China (roughly equivalent to producer prices in the United States). That means the next wave of inflation will begin from a higher base rate. A move back toward growth in Asia at this time almost guarantees that global inflation will accelerate to dangerous levels in the next few years. In that environment, you want to own commodity stocks and other inflation hedges.
Tactics and Strategies
Small Kresge Foundation Teaches Big Lessons in Investment Strategy Every year, investors turn to Harvard and Yale in hopes of discovering how these revered endowment funds beat the market. During the credit crunch, they might have been better served studying the lesser-known Kresge Foundation. The $3.8 billion Troy, Mich., foundation returned 9.3% for the 12-month period ended in June. That compares with a median return of negative 4.7% for foundations and endowments with $1 billion or more in assets, according to the Wilshire Trust Universe Comparison Service. Kresge's returns were aided by energy holdings and hedge-fund performance. The foundation also bought credit-default swaps on corporate bonds, a type of derivative that protected the portfolio from selloffs in the debt market. This year, the fund has been buying credit-default swaps on European banks and investing in distressed residential-mortgage funds. With a target return of 5% annually, after adjusting for inflation, Mr. Hunia has de-emphasized fixed income, which he thinks doesn't do enough to meet that return goal. He also has looked to alternative assets with low correlations to the stock market. That meant investing in a variety of hedge funds, except those with the strategy of going long or short the equity market. In recent years, Kresge also has eschewed consultants. Beating the market, Mr. Hunia believes, requires finding little-known niche investments that have been widely overlooked. "Because consultants mass-produce," he says, "they can't do that for you." Even though Mr. Hunia sold all his credit-default swaps on corporate bonds, that doesn't mean he thinks the credit crisis is over. Kresge recently purchased credit-default swaps on European banks because, he says, they are just as beleaguered as U.S. banks, "but the price of the swap is cheaper." Fearing that stocks will continue to tumble, he also has bought put options to cover all his equity holdings. He is avoiding all financial stocks. "The time to buy corporate distressed debt is a year away," he adds. Still, he believes residential mortgages look attractive at current prices, and has been investing in distressed mortgage-debt funds. Mr. Hunia thinks his position in distressed debt could grow to as much as 15% of his total fund assets, up from 4% now.
5 bargain stocks and 4 duds With the coming anniversary of my 50 Best portfolio, let's preview some choice stocks and a few I'm likely to drop. Hint: Some major oil, banking and aircraft companies aren't doing so hot. The goal, as I put it then, was to compile a list of stocks that truly deserved the often too easily bestowed moniker of blue chip. To make the list, a stock had to have:
- Truly outstanding opportunities for global growth over the next five or 10 years.
- A competitive edge that would allow the company to seize the lion's share of that global opportunity.