In general, though I’m glad that optimism has replaced fear, I see little reason to be giddy. I still believe that we are headed into another recession sooner rather than later. A couple of November 2 Barrons articles highlight the sad truth behind recent economic statistics. Alan Abelson passes on an observation that the recent quarter’s spike up in economic activity was fueled by an unusual depletion of savings, rather than income. “In the past quarter century, there have been only four other instances when savings have fallen so much in a single quarter….Put another way, all of the quarterly gain in GDP ‘was funded by a rundown in the savings rate that occurs less than 5% of the time’.”
Abelson also passes on an observation by John Williams, proprietor of Shadow Government Statistics, that “every recession in the last four decades has had at least one positive quarter-to-quarter GDP reading, only to be followed by a renewed downturn… (Williams thinks that) it’s a fair bet that historic pattern will be repeated in the current quarter.”
Then, in the Market Watch segment of the same paper, Stephanie Pomboy’s Oct. 29th newsletter is excerpted wherein she notes that inventory liquidation was the second strongest on record, which added a full 1% to GDP. The cash-for-clunkers and home-buyer-tax-credit added another 1.5%, which leaves only 1% of sustainable underlying growth. Furthermore, she notes, “not only did companies NOT rebuild inventories, but capital expenditures logged its fifth straight quarterly contraction. Clearly, current inventory levels are low – which is a good thing. But it’s hard to see an economic rebound resulting from current business activity. It could be much worse, but neither is it likely to be strong enough to offset the hemorrhaging of consumer spending that drives the bulk of economic activity.
Earnings for companies in the S&P 500 Index have rebounded to approximately $60 from nearly $100 at the peak. While Wall Street analysts are projecting an earnings recovery back nearly to prior peak levels, the difficulties facing this economy and the pressures on profits, in particular, leave me wondering whether we won’t be lucky if profits don’t flatline soon around the $60 level.
In spite of my concerns, the market has rallied more – and this rally has lasted longer – than any of the rallies that markets enjoyed during the 1929 through 1932 period. Either the markets are trying to signal a recovery ahead of the statistics, which we hope is the case, or the Fed is holding savings rates so low that money can’t help but flow back into the stock and bond markets, which is inflating values.
There is an old saying on Wall Street, “Don’t fight the Fed.” A closely related and slightly altered axiom is that the Federal Reserve can spend your tax dollars irrationally longer than you can remain in a high tax bracket, even in spite of a higher and higher tax burden falling on increasingly less wealthy taxpayers.
The Fed is pumping billions of dollars into the system. Unfortunately, more of it is getting to the market than is getting into the economy. Banking system excess reserves (dollars that the banks hold “in reserve” instead of putting it out into the economy) just recently passed the trillion dollar mark. Whether the banks want to be lending or not isn’t clear. What is clear is that the real economy is not yet enjoying an “easy money” environment.
No longer bankable are used modular homes, loans where the appraisal is too low, or even too high. Jumbo loans are just beginning to become thinkable. Spec homes are non-starters with your local banker (which is probably a good thing) but credit card rates are soaring, pushing consumer default levels ever higher. Normally, low rates signal a monetary easing. This time around, low rates signal a defacto tax on savers in order to prevent the FDIC from having to make good on its unfunded promises to the American people. Profits in the financial services sector are rebounding, but the sad truth is that there are more foreclosures and defaults just around the corner, so 2009 earnings have all the credibility of the not very credible 2007 reports.
As negative as this rant sounds, I do believe that we have turned the corner and avoided financial catastrophe. Whether or not that is enough to make the stock market a great buy and hold investment, however, is another thing. Economic stability, and in the long-run eventually a recovery, is great news. For company profits and stock investors, however, I believe that the recovery will not be as robust as Wall Street analysts have forecast.
I still maintain that liquidity in the financial system is sufficient to fund the Treasury’s current trillion dollar deficits. I even think that there is enough money on the sidelines to absorb the upcoming onslaught of foreclosed real estate as property as it shifts from “renters” (dwellers who should never have been given a “no money down” mortgage upon which they have defaulted) to real investors.
However, with the government sector, the real estate sector, and the stock market all clamoring for liquidity, something has to give. The problem with deficits is that they don’t flex. Debt is forever. Similarly, disposal of the excess real estate inventory is going to happen. It may not be a fun time, but at some price properties are going to shift from the banks into the hands of private investors. The question is, with all this forced borrowing and liquidation occurring, will there also be enough money in the system to support stock valuations at 17X or 18X earnings.
Personally, I have my doubts.
So how do you invest in this environment? Be creative, for one thing. Atypical investments in client portfolios currently include an inverse bond fund, inflation plays, a bit of cash, and junk bond funds instead of consumer stocks. Remember, sometimes it’s what you don’t own that is most important!
Second, stay on top of current trends. For most of the year, energy investments have been a suitable substitute for gold. During the past few weeks, however, that has begun to change. We recently sold or trimmed our natural gas investments and added gold back into the portfolio.
We often say that our job is to stay in the way of where the market is working, and get out of the way of where it’s not working. Gold is a good example. We’ve owned it some, this year, but in August (we regret) sold out. Since then, it has attracted an even larger following, including the central banks of China and India. Could gold keep going up to $2,000 per ounce? You bet. It’s possible given the currency uncertainties out there. If it does, clients would have expected us to be taking advantage of that move. For us to not own gold, given that economic fundamentals and current market activity both suggest it can keep going higher, would leave clients wondering if we do what we say we do. We swapped out of gas into gold when gas stopped working as an effective hedge against future inflation.
Lastly, we are trying to keep our exposure to traditional U.S. stocks in areas where valuations are reasonable, even given the current economic environment. Industries which have stable fundamentals in spite of the recession are favored over more cyclical companies. Property casualty companies went down significantly alongside the implosion in the banking sector, yet pricing trends in the insurance industry are fairly stable and the insurance company executives have generally done a much better job of managing their huge asset base.
Pharmaceutical companies, also recently added, seem to have negotiated a deal with Congress that leaves them with the ability to continue their current business model and perhaps even sell more drugs to more patients in the new healthcare regime. Given that the valuations on these companies appear to be extremely attractive, it made sense to add these companies back into the portfolio once the market stopped punishing them for being part of the highly politicized healthcare delivery system.
The $64,000 question, of course, is when will the dour economic realities drive the market back down? That’s where a crystal ball would be helpful. Lacking that, we keep in mind the fact that we began talking about the “upcoming” real estate recession in October 2006, yet the market didn’t peak until a year later, and commodity oriented investments kept working even into early 2008. Reality bites. And sometimes it’s late.
Make hay when the sun shines and keep an eye on the exits. By all means, keep up your guard. That is our current strategy, and maybe it’s a good description of our overall investment mission.
I’ll try to post more often, about fewer topics (per post), in the future. Have a great Thanksgiving celebration.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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