Some indicators are still strengthening – namely in the energy drilling and semiconductor billing activities. Other indicators have been strengthening, but caveats apply. For instance, retail sales have been climbing, but the Christmas season came in only 4.7% ahead of a disastrous 2008 season. Similarly, capital utilization rates have been climbing, but remain well below non-Recession levels. In the manufacturing sector, new order rates are rising, but inventory levels are starting to climb as well, indicating that orders may be ahead of sales.
Profits are climbing as fewer banks reported huge “one-time” losses as they did in 2008. On the other hand, banks do not seem to be raising provisions for bad loans, in spite of the fact that loans are still going bad and reserve levels are nowhere near normal levels.
A couple key indicators look to have “rolled over,” and are indicating that recent economic activity is unsustainable. The National Federation of Independent Businesses Outlook survey shows that small business optimism has faded. This indicates that job creation will continue to be sluggish, and the unemployment rate isn’t going to show any real improvement in the near term.
Growth in the M2 money supply, which was one of the few indicators in late 2008 that indicated that the economy could still rebound, has flattened out. Money growth is still positive, but just barely. For those of us who believe that money really matters, this signal is a big red flag to the optimistic expectations being broadcast from Wall Street and many of the big investment firms. Happy talk doesn’t matter. The money supply, however, matters a lot.
Finally, if you look at the root cause of many of today’s problems – a banking system more concerned with propping itself up than in making loans to cash-starved businesses and credit-worthy consumers – the problem just keeps getting worse. Commercial and Industrial loan portfolios are shrinking. A year ago, C&I Loans were increasing as banks stepped in to roll over debt borrowed in the so-called “shadow banking” system, which disappeared when Shearson and AIG went belly-up and the banking system imploded. Now, even this increase in market share can’t disguise the fact that lenders continue to tighten standards, sapping the economy of what little liquidity is left in the system.
As a result of these conditions, the May-Investments Leading Economic Indicator has turned down. It is now nearing the monthly low that it set in April of 2009.
Portfolios are now sitting on roughly 20% in cash (money market funds) and have another position in an inverse U.S. Treasury fund. These funds could be used to reinvest in stocks, at lower levels, if the stock market continues to decline from what we believe is the high end of a trading range.
Another 20% of the portfolio remains invested in high yield (“junk”) bonds. These funds were not immune from the market sell-off of 2008, and they provided tremendous profits during 2009. We consider them to be high yielding stock-equivalents, able to do better than traditional stocks in a muddle-through but profit-depressed economic environment that we expect.
About 20% of the portfolio remains invested to benefit from inflationary pressures which we anticipate in the precious metals and energy sectors. To be frank, however, these investments have not been working as well as we’d expected. The concern we have is that faltering commodity prices are not signaling a lack of concern about inflation, so much, as an economy that is rolling over as economic activity weakens. Updating the Leading Economic Indicator index, unfortunately, reinforces these concerns.
Finally, we have invested about 30% of the portfolio in traditional stocks, emphasizing companies in the insurance, software, and pharmaceutical sectors. These areas remain relatively strong and have reasonably healthy industry fundamentals in their favor.
As I’ve said before, we don’t raise red flags because we enjoy being a naysayer. I am anxiously awaiting a market where valuations are cheap and the economy is poised for growth. However, wishing it to be so won’t make it happen any sooner. I will continue to position the portfolio for the world as I see it. If, in fact, this economy rolls over and the market follows it down, we want to have money on the sidelines in order to profit, once again, from the ability to add money to stocks when prices are low.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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