New Normal

Bill Gross, the world’s most rich and famous bond guru, helped coin a new phrase when he began describing the post-Lehman bankruptcy world as a “new normal” era in finance. But what does that mean?

Does it mean de-leveraging (borrowing less), de-globalization (protectionism), and re-regulation (bigger government), all of which disrupt the normal functioning of business and delay the potential for economic recovery? Does it mean that the dollar loses its cache as the reserve currency, resulting in rapid inflation and the ascent of gold? Will the new normal be characterized by millions of unemployed workers promoting redistributionist political policies? Will this lead to civil unrest and a declining standard of living, as many believe?

Or will it just be…different?

Economic activity appears to be on the mend. Yet it is nowhere near 2007 peak levels. Some industries are reaching new levels of profitability, while others are nowhere even close to restoring the false sense of profitability that was being reported in 2006 and 2007. Money is flowing back into the financial markets, driven back into more risky asset classes by Certificate of Deposits priced at 200-times earnings.

However, both the small business lending market and structured securities markets remained closed. Capital starved small businesses are struggling to remain open. On the other hand, the demise of the Wall Street derivatives casino is probably a healthy outcome. Is the new normal better than the old normal?

Or is it just…different?

No doubt, we have to contend with high worker unemployment, essentially zero return to savers, and cash starved businesses. However, we also have more affordable housing, improved capital allocations, and greater labor force productivity than we had before. Financial industry speculators and materialistic consumers are clearly worse off. But what about the guy who wants to borrow money to buy a big home? What about the conservative car company CEO that didn’t need a government bailout to fix his union problems? What about the Arkansas-based industrial motor company that consolidated plants and reduced its debt burden and is now prepared to manufacture new high efficiency motors more profitably than before?

Are things really that much worse, or just different?

A lot depends on which industry you’re in. The technology industry experienced a deep recession when the technology bubble burst, but only a mild recession in 2009 and earnings this year will likely be well above 2008 prior peak earnings. The tech sector’s corporate customer base is cash rich. BCA Research points out that new orders for technology goods are soaring relative to inventories, tech industrial production is growing faster than capacity, inventories are still under control, and therefore hardware companies are able to raise prices even in the “new normal” environment.

The Baseline chart, below, shows that industry earnings were more than halved from their tech bubble peak. Stock prices fell even more. From the 2002 bottom, however, stock prices have about doubled, while earnings power in the sector is up five hundred percent!

In the healthcare industry, stock prices have truly experienced a “lost decade,” having gone nowhere since 1998. Companies in the sector, however, have not been standing still. In fact, corporate earnings for the companies in this sector have roughly tripled since then.

We know that the concerns about Obamacare have pressured stocks lower across the healthcare industry. BCA Research notes that the sector is trading close to one standard deviation below its long-term trend. After a period of weakness, medical equipment orders have revived. Drug companies have pushed through price increases in anticipation of the new law.

Biotech companies may actually have been one of the biggest winners by retaining a 12-year window of “data exclusivity” for branded biologics. Kevin Cook from the Options News Network explains that generic competitors will not be able to threaten the patent moats of proprietary formulations with “biosimilars” for 12 years.

No doubt, taxpayers have taken on trillions of dollars of liability with the new legislation. Now that the government is more involved than ever in healthcare, in time this country’s status as the place where new drugs and treatments are discovered may be in jeopardy. But are the companies in this “new normal” environment a bad place to invest, given their healthy profits and low valuations?

The May-Investments discipline does not depend on macroeconomic forecasts. Sometimes our view of the big picture causes us to “tweak” the model. At the worst of the sell-off, we actually had to set the model aside for a few months. But the discipline could be maintained with no input as to the macro environment at all.

Particularly now, with the “new normal” giving so many mixed signals, it is actually reassuring to have a model that doesn’t require a thorough understanding of exactly what’s going on from a top down perspective.

We have a “flexible Beta” approach that tends to take on more risk when markets are doing well, and reduces exposure to market fluctuations when the market is soft. However, this is not a “top down” decision that we make to move the beta above or below that of the S&P 500. The flexible beta characteristic is a bottom up result of following our discipline.

We have often said that our strategy tries to get in the way of what’s working, and get out of the way of what isn’t. We combine fundamental research with relative strength to allocate capital to healthy industries with broad investor support. There are some healthy industries, and some of those are attracting investor interest. We want to be invested in those areas.

There are some industries, particularly in the financial services sector and in industries that sell directly to the consumer, that are still doing much worse than they performed in 2007, and seem likely to continue to do so. We don’t want to invest in those areas. Regardless of what the “big picture” looks like for stocks; regardless of whether “the market” can rally much from current levels, at the end of the day we want to invest in healthy industries with companies whose stock prices are low enough to attract the interest of other investors.

For that reason, we’re continuing to search for attractive investments, regardless of what “big picture” concerns we might have. Having a discipline helps us to move forward, even in times of uncertainty.

It appears that in this “new normal,” just like the old normal that came before, uncertainty remains a constant and investors must have a strategy for operating in the face of it.

That’s not new at all. That’s…normal.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

Go to Investments main page.

Exports Stabilize Economy

The May-Investments Index of Leading Economic Indicators set a new 12-month high in March. While economic indicators remain severely depressed compared to previous year levels, most of the indicators are improving, particularly as compared to when the economy stood at a standstill in April of 2009. While slow growth in the money supply is holding back economic activity, a recovery in export markets and a receding bank crisis helped nudge the indicators higher.

Slower growth of the M2 money supply remains worrisome. A year ago, M2 was growing at a double-digit pace which indicated an upturn in economic activity in the coming months. Unfortunately, today the money supply is growing at only about 2 percent, which is usually associated with less activity ahead, and is even more of a concern given that today’s low interest rates suggest that the Federal Reserve has the spigot wide open, but only a drizzle of economic activity is coming out of the hose.  Money is practically being given away for free, yet the demand for it (by the economy) is almost nonexistent.

Export activity is getting stronger. Higher freight rates are a result of improving global export activity, so the global economy is still moving forward and our manufacturing sector is benefitting from that.  To the degree that economic activity continues to get stronger, the cash rich industrial sector seems to be a primary beneficiary.  We recently added to our investments in this area to take advantage of this activity.

Bank lending is still on the decline, but not at the same pace as a year ago. A year ago, companies were scrambling to find cash, just to survive. Today, though the banks are still hoarding cash, which doesn’t help, but at least the banks are not calling in as many loans as they were a year ago, which has made this recession worse than it needed to be. 

Bank regulators continue to force banks to call in loans on real estate, not understanding that forcing banks to cough up these assets only further bloats the number of distress sales, depresses prices, leads to below-replacement-cost appraisals, and generally cause things to get worse.  For loans already in the system, the bankers should be working with the borrowers, not forcing them to join the ranks of the unemployed.

Raise lending standards on new loans.  Yeah - I get that.  Janitors in California that earn $1,000 per month really shouldn't qualify for a $600,000 mortgage.  But when inexperienced out-of-town appraisers refuse to approve of real arms-length sale/purchase agreements, because the computer models can't find any recent transactions to use for comparisons, that's a Catch-22 that might just drive Milo Minderbinder nuts.  In order for a comparable sale to hit the record books, the lender has to approve a loan.  But the lender won't approve the loan - because there aren't any recent transactions, except for the one that the seller and the buyer would like the lender to approve, so the appraiser can't come up with a value unless it's well below previous sales, and the current proposed sale, and probably below cost as well. 

And for this, the bankers want to borrow money at 0.25%, the ability to sell their toxic assets to the government at 100 cents on the dollar, and to be out from under TARP so they can pay themselves million-dollar bonuses.  Don't you just know that Milo Minderbinder is running a bank somewhere on the left coast and studying up on how to package and sell Cap & Trade credits to the pension fund of someone you love?

The May-Investments indicator shows an economy which is operating at a much lower level of activity than at the prior peak, whereas the widely watched Conference Board Leading Economic Indicator index shows economic activity to be reaching new highs. The Conference Board indicators err by giving today's low interest rates too much credit.  Despite low rates, money is still tight.  As a result, the traditional LEI indicator is indicating that the economy is marching full steam ahead.  It is not.

We’ve stablilized with high unemployment and a lot of excess capacity.  But at least we’re moving up.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

Go to Investments main page.

Valuations Matter

The market is +78% from the 2009 depths. We’ve long maintained that stock prices are a function of both earnings and valuations. I believe it is valuations, more than economic fundamentals, that recovered in the past year.

Earnings have recovered some, which isn’t surprising given the unprecedented 90% plunge in earnings as 2008 drew to a close. But earnings are still down significantly from the 2007 peak. Strategists who expect a “V-shaped” rapid recovery to prior peak levels are betting on a normal recovery, in the face of economic pressures from tight money and continued de-leveraging.

Last week’s stronger than expected job growth was more a function of fewer layoffs than more hiring, and few commentators mentioned that it was accompanied by a swelling number of people looking for jobs, so the unemployment rate was little changed.

The fundamentals still seem to be following my “stabilization amidst recession” playbook, but you’d never know it from media reports and market action.

It wouldn’t be the first time that the media misinterpreted market strength to mean that the fundamentals were improving, yet their analysis missed by a mile. In September 2007, as the subprime debacle began to unfold, the Federal Reserve started cutting rates while CEO’s lied about their exposure to the growing menace of defaults and mark-to-market pricing. A knee-jerk rally to new stock market highs, in October of 2007, didn’t change the fact that a financial crisis lay just around the corner.

Today’s efforts to climb back above 11,000 on the Dow are no more reassuring. Though we continue to position the portfolio for strength (don’t fight the tape), we have not lost our skepticism about the durability of this recovery. If the market keeps climbing the proverbial “wall of worry,” we don’t want to get left behind. But we are increasingly focused on trying to find contra-cyclical investment alternatives that could zig if markets flag and screens turn red once more.

However, we think that the stock market recovery reflects only a dramatic recovery in the corporate bond market – not in the economy overall, nor that prospects for investors are significantly better than they were nine months ago. Rock bottom interest rates have propped up valuations (boosted Price/Earnings ratios). End of story. Don’t draw too many conclusions from 2010’s market enthusiasm.

The rally has been led by low quality companies and sectors leveraged to the backs-against-the-wall consumer. In many cases, the sectors that have done best (banks, consumer cyclicals) are sectors with the worst economic fundamentals. We’ve seen the mother of all dead-cat bounces, but I’m still hoping to see some sign that the renewed “animal spirits” investors have shown will jump-start the economic engine.

All we know for certain is that prices are much less attractive than they were a year ago.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

Go to Investments main page.