July 2013 Portfolio Summary

As the summer rolls on and the market continues up, the May-Investments portfolios sit pretty fully invested and well positioned, we believe, for the current market environment.

Generally speaking, the mutual fund portfolio has nine fully invested positions and a tenth position in gold, which is only a partial position but the remaining cash in the portfolio is tentatively scheduled to increase our investment in the precious metals asset class.  We’re just waiting for it to stop falling before we double up.  It has been a long wait.

Eight out of ten positions are in U.S. stocks.  The U.S. market is much stronger than most international markets and alternative investments, so we are less diversified than we would be were that not the case.  We are over-weighted in financials (banks and brokerages), healthcare (biotech as well as a more broadly diversified fund), and consumer cyclicals (automotive and a more diversified consumer discretionary fund).  We are under-weight technology (but do have a position in software).  Our position in Japan is back up to a full weighting.

In the Custom Wealth Management portfolios, the core equity portfolio is fully invested again after a management buyout at Zhongpin, a Chinese pork producer, forced the sale of one stock and opened up room for a couple new positions.  The “flexible middle” part of the portfolio is fully invested, home to exchange traded funds in the financials, healthcare, and consumer cyclicals sectors, as well as an automotive industry sector mutual fund.  In the diversification part of the portfolio, we have Japan and a partial position in gold.  We also own the S&P MidCap 400 Value Index position, which isn’t much of a diversifier, but reflects the fact that few markets are keeping up with the U.S. market.  Why diversify when the best performing market seems to be our own?  Generally speaking, the remaining cash is set aside for us to allocate back into precious metals at some point in the future.

It looks like the economy may continue with its slow growth on into the latter part of 2013.  For the past three months, the May-Investments Leading Economic Indicators have posted modest increases, reversing a three-month decline during the first quarter of the year.  The fear of sequestration during the first quarter turned out to be worse than the reality of sequestration thereafter.

There is modest strength in retail sales, global shipping, corporate profits and manufacturing new orders.  Weakness is apparent in the outlook by small business owners, drilling activity, and capacity utilization, and the rate of growth in commercial & industrial loans and the money supply (M2) is declining. 

Overall, the LEI isn’t projecting robust growth, but at least there is a slight upward trend. The indicators are supposed to help us look forward about six months, so hopefully our January forecast for continued economic growth throughout the year will remain on target through the rest of 2013.

If so, I would expect markets to cooperate as well.  As money begins to dribble in off of the sidelines, valuations (Price/Earnings ratios) are adjusting up.  Corporate profits have increased slightly, but as P/E ratios increase the value of stocks goes higher and the strong performance of stocks is attracting the attention of investors who are getting paid almost zero, nada, zilch to have their life savings invested in banks.  Today’s low interest rates continue to enable huge deficits by the government at the expense of consumer spending, particularly by seniors.  It probably isn’t a good thing that “savings” are being moved into “investment” accounts, but it’s happening every day and it’s one reason why the market keeps rising even as the pace of economic growth simmers down.

The biggest market risk remains…the political mess in Washington D.C.  While we got past the debt cliff and have even moved past the onset of sequestration with minimal fanfare, the budget wars are far from over and it’s never too late for the folks in Washington to step in and make matters worse.  It seems to be what they do best. 

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

Economic Indicators Up For Second Month In A Row

The economy has been sending mixed signals for most of 2013. May-Investments developed its own Leading Economic Indicator to help our firm understand the current economic environment. Today’s LEI readings are again forecasting continued economic growth during the months ahead. After weakening earlier in the year, the month of May proved to be the second straight up month.

May-Investments developed its in-house indicator rather than rely on the Conference Board’s traditional LEI. With the Federal Reserve adopting Enron-style off balance sheet financing vehicles in order to move the government’s new bond issuance out the doors into buyers’ hands, the old economic indicators became obsolete and the Conference Board’s new indicator is untested. In the meantime, investors are having difficulty understanding whether today’s economic growth is a mirage, an encouragement, or a house of cards about ready to fall and take investors down with it.

Our economic indicator peaked a year ago when activity in the drilling patch declined, small business owners retrenched, and purchasing manager new orders dropped off. Whereas eight of ten component indicators were rising in March of 2012, by the end of May only half of the indicators were on the rise. In October, 2012, only three were moving higher. As 2013 began, in spite of our positive economic forecast for the year, the May-Investments Leading Economic Indicator began trending down again.

In April, however, small business optimism improved slightly and the decline in drilling activity was less significant than it had been a few months back. Overall, the upturn represents less of an “improvement” than it does a less forceful downtrend than at the beginning of the year.

Retail sales are still an area of strength, but they are not as strong as they were a year ago, or in January, and are what we are watching mostly closely for signs that the recovery will continue. Global shipping rates remain weak and bank lending is not growing as fast as it did in 2012. A slowdown in the growth rate of the money supply is also surprising, and worrisome, given the moves that the Federal Reserve continues to make to try to flood the economy with money. We are thrilled that the LEI moved up, but it is too early to conclude that there is much strength there.

As things are now, we stand by our forecast for continued economic growth during 2013. We had projected Gross Domestic Product (GDP) growth of +2.5% this year. We projected an economy that would be making progress in its move back toward normal. As of the most recent GDP report at the end of May, the U.S. economy is growing at a +2.4% rate, pretty much as we expected. Hopefully this recent upturn in our Leading Economic Indicator suggests that slow steady growth rate can continue throughout the rest of this year.

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

Market Uptrend Under Pressure

Today the Investors Business Daily changed its market scorecard to “uptrend under pressure.”  IBD has been whipsawed as many times as we have, in recent years, but it still makes sense to pay attention to what the overall market is doing.  Stocks and commodities “go up like an escalator and down like an elevator.”  Trying to avoid a big drop doesn’t make sense, and then doesn’t make sense again, and then doesn’t make sense, until suddenly it’s the only thing that does make sense.  Trying to reduce risk in highly risky markets is at the core of our “Flexible Beta” strategy, so we haven’t stopped paying attention when the markets raise warning flags.

IBD’s scorecard isn’t the only thing that makes us worry about whether 2013 will be as good of a year as we’d been expecting.  A quick study of which asset classes and sectors are doing well, and the most recent update of our May-Investments Leading Economic Indicator, also gives us pause for thought.

Bonds and defensive stocks, especially utilities, often do best during tough times.  Bonds recently took a breather from selling off and yesterday the moving average convergence-divergence (MACD) signal just turned positive.  That’s a concern because bonds are not cheap.  The primary reason for them to do well is if the economy is heading for a downturn.  Ditto for utility stocks.

International stocks also seem to be moving from strength to weakness.  Unemployment in the Eurozone hit a record 12 percent in February.  While rates in Greece and Spain are above 26 percent, the recession is evidenced throughout the continent.  In Greece and Spain, half of the young adults under the age of 25 are unemployed.

Commodity stocks have been hit hard, too.  Gold stocks are selling at prices equivalent to where they sold at the height of the financial panic in the Spring of 2009.  Flows out of gold bullion exchange traded funds are down 20 percent in recent months.  Investor sentiment is extremely negative.  While normally this is a contrarian sell signal, it hasn’t signaled a turnaround thus far.  We don’t think that people have to get excited about gold stocks for them to do much better.  We just need to see an end to the “dumping” of shares.  After all, the last time that gold shares sold at current levels, in 2009, the price of gold was about $900, well below today’s price of $1,550.

At the beginning of each month, we update our Leading Economic Indicator inputs.  Of the ten variables that make up our LEI, about half are updated at the beginning of each month.  When we input the most recent data, it appears that our LEI chart is turning down again.  The pattern looks very similar to 2007-8.  (Note, however, that the market conditions are quite different than in 2007, so my overall level of concern is not the same.) 

Our technology sector indicator, as well as the Institute for Supply Management (ISM) “New Orders” index, both turned negative for the first time in several months.  We’ve been thinking that 2013 would be a year of modest continued growth, but the factors that often point to which direction the economy is headed are beginning to tell a different story.  Unfortunately, the story being told is consistent with weakness that is beginning to develop in the stock market.

May-Investments response to increased risk is to reduce our holdings of stocks owned in exchange traded funds to quickly and cost effectively reduce overall stock exposure.  Because the U.S. market retains its “most favored” status among global investors, most U.S. sector ETFs have yet to hit what we consider to be “sell” signals.  This is a good thing, partly because we are still in sectors that enjoy relatively better performance than the rest.  Our positions in financials, healthcare, and consumer cyclicals are still doing better than average.  If this market trend turns down, however, we don’t expect them to somehow avoid the trend.

Most portfolios still have about 10 percent invested in cash equivalents.  We have said before that we’re not sure if that 10 percent represents our last investment “in” to the market as it recovers, or the first 10 percent to come “out” of the market in the next downturn.  After spending the first quarter of 2013 looking for what to buy with that money, this past week we’ve been forced to turn our attention to the fact that maybe we ought to be looking at what we next need to sell, instead.

We’ve been on an escalator for four years now.  The current bull market is already longer-than-average, if not “long in the tooth.”  Investors need to remember that sometimes markets feel more like an elevator (down) than an escalator (up).  We certainly haven’t forgotten.

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

Housing Moves Past 2008 Financial Crisis

Amidst the doom and gloom “sequestration” headlines has been good news about the U.S. housing sector.  Homebuilding seems to have moved beyond the crisis that began almost 10 years ago with easy money, government policies designed to put people into homes regardless of their ability to pay, and a financial sector more than willing to package toxic sub-prime debt and sell it to overpaid investment managers who weren’t paying attention to the enormous housing bubble that these policies created.

As with the technology bubble before it, severe pain accompanied the bursting of the bubble, and it took nearly a decade for the industry to recover some sense of normalcy.  (Hint: bond investors and taxpayers, beware.)

The good news is that the housing industry is finally well on its way to getting back on its feet again.

Although very few experts will date the recovery the same way that I do, it’s fairly obvious that the real estate market bottomed exactly one year ago today, on February 28, 2012.  That is the day that I closed on the sale of our old house on Catalina Court.  That date represents the absolute nadir of home values in Mesa County, and most likely the rest of the country.  I don’t want to overstate the importance of personal, anecdotal evidence.  It is quite probable that Europe and Asia will be on a different timetable.  For most of North America, however, I think it’s safe to say that 2/28/2012 was the bottom.

Prices have been going up and prices should continue to rise, at least until they’ve reached an equilibrium with replacement costs.

And I would like to take this opportunity to personally apologize to all of my old Paradise Hills neighbors for the horrible comparable sale that will haunt real estate appraisals in that neighborhood for the next few years.  On the upside, we found fantastic buyers who, word has it, are a real asset to the cul-de-sac.

This week’s Case-Shiller home price index confirms that home prices are on the rise, and also the time frame of February 2012 as marking the bottom.

The main reason that prices are starting to move up is that the swollen “shadow” inventory of existing homes, and especially foreclosed and “distressed” homes, has declined significantly in the past year.  The National Association of Realtors inventory statistics reported this week that total inventories, reported in months’ supply, are at a record low.  At the onset of the Great Recession of 2008, the industry professionals were quick to cut prices and unload inventory while existing homeowners were reluctant to recognize how quickly values were falling.  New home inventories plunged, almost as fast as sales.  Having cut new home inventories at the outset, the industry kept them low for most of the past four years.  However, during 2009 – 2011, existing home inventories ballooned and for most of the past four years the gap between low “new” and high “existing” home inventories grew.  This inventory of existing homes for sale, and additional foreclosed real estate inventory on the books of banks (the so-called “shadow inventory”), weighed heavily on real estate values.

Home prices fell furthest when distressed sellers had to unload existing homes “at any price.”  Given the dramatic oversupply of existing home inventory, buyers were able to purchase homes at prices well below replacement cost.  This isn’t news to anyone reading this blog, of course.

What is new is that this month’s statistics indicate that the excess inventory has been worked off.  The fact that “total (home) inventory” is at a record low confirms this.  This should dramatically reduce or eliminate the number of distress sales.  Supply and demand are no longer so out of balance that buyers can drastically under-bid sellers, and be successful.  As a result of both government policies and the horrific unemployment numbers, we started with too many "renters" who were given mortgages without equity and eventually these renter-owners needed to be replaced, in many instances, by landlord-owners.  This transition was painful and costly.  But with these pricing pressures relieved, home prices finally bottomed and should now rise to where home prices are roughly equal to replacement cost.

Now we are seeing experienced home builders, in Mesa County and other markets, go back into the homebuilding business.  The only way they can do this is if they are able to sell product above cost.  Therefore, prices generally should rise at least to the point where houses are selling above replacement cost, which wasn’t true at the bottom, a year ago.  There's no way that you could rebuild my old house, and acquire a lot, and put in landscaping, for our selling price - even after factoring in about 13 years of deferred maintenance because I'm not too handy of a guy.

The dwindling supply of existing homes means that more demand will be met through new home construction.  During the bubble years, new home sales peaked at around 1.3 million homes per year.  Recently, we have been selling nearly 425,000 annually, up significantly from 2009/2010 levels.  With the excess existing home inventory worked down, new home sales will likely continue to improve to something in the range of 600 thousand to 1 million, annually.

There will be some “wealth effect” as homeowners “write up” the value of their homes, but I wouldn’t expect this to be significant.

What will likely be significant is that the shift from people buying existing inventory to new homes will reduce unemployment, some, and begin to put upward pricing pressure on copper, lumber, and building materials prices.  After all, one reason that we haven’t experienced inflation in recent years is that there has been virtually no demand in the U.S. for new construction.  Looking out into 2013 and 2014, this should change.

It will also be interesting to see if construction methods change as well.  Necessity is the mother of invention.  During the good times, buyers weren’t cost sensitive and builders were happy making money the old fashioned way.  With new Computer-Aided Design technologies and pre-fab building techniques, it will be interesting to see if new companies and processes emerge as this new cycle progresses.  If you know of any such stories, please give me a call.  Talking with a skilled professional in the plumbing trades, which is an industry which is increasingly moving toward pre-fabricating systems that are quickly assembled on-site, it’s not an easy transition to make.

It is good news, however, that we are making headway working through the real estate bubble.  I still don’t expect the construction industry to lead the U.S. out of its current economic doldrums, which is traditionally how the economy does get out of a recession.  But maybe, if the recession lasts long enough, and the building industry continues to improve, it will have a greater impact than I expect.

Homebuilding stocks, which are very cyclical, historically trade in a wide range around a Price/Earnings ratio of roughly 11.5-times earnings.  Based on current earnings, the stocks trade at a multiple of about 28X.  Even based on projected 2014 earnings, the stocks are expensive at 16.2X forecasted earnings.  This is clearly an instance where the stocks rebounded in anticipation of the industry fundamentals.  Still, industry earnings in 2014 are only expected to recover to about 20 percent of 2006 earnings levels, and the stocks themselves remain at only 50 percent of their previous highs.  There could be more upside, but current valuations make it hard for me to get too excited about investing in those companies.

Whether the stocks are ahead of themselves, that’s the question.  Whether the future of the homebuilding industry looks better than the recent past – well, that looks like a much better bet and this week’s industry statistics help explain why.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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2013 Outlook: New Normal not too bad

The May-Investments economic forecast for the year ahead is based on a continuation of the 2012 trend toward “normalcy.”  That we’re living in a “new normal” only means that the future will look a bit different than the past, but that’s not “new” and it isn’t necessarily anything about which we should worry.  As market volatility, valuations, and investment spending return to more normal levels, the outcome for stock investors could be quite satisfactory.

The lone “red flag” that is on the horizon is the May-Investments Leading Economic Indicator, which weakened in the fall, and dipped again right at year-end, perhaps in conjunction with the fears surrounding the “fiscal cliff.”  The tax increases, in and of themselves, are not as worrisome as the fears that surrounded the debate.  Investors feared a 40 percent tax on dividends, but it didn’t happen.  People feared an increase in the capital gains tax above 15 percent, but the vast majority of filers will pay the old rate.  Most of the tax increase was limited to “fat cats,” who will see their tax rates jump pretty significantly by the time you factor in the total impact from increased tax rates, capital gains taxes, phasing out of deductions, and additional Obamacare tax burdens.  All told, however, the $60 billion raised isn’t that significant.  In fact, about a week later, roughly that same amount of additional spending was pushed through Congress for Hurricane Sandy relief.

The “new normal” in Washington looks a lot like the spending binge we’ve been on for the last two decades.  In the long run, this spending is an issue.  In the short run, however, the market has little reason to fear contractionary fiscal policy.

It is true that there are some “new” facets to this upcoming “normal,” but it merely represents the ever-present “change” that provides both a hurdle and an opportunity to investors.  While not chosen thematically, companies in the May-Investments core portfolio are well positioned to benefit from many of the same changes about which many conservative Western Colorado voters complain.  Dodd-Frank, which is limiting borrower choice and forcing small lenders out of the market, should lead to market share gains for the mega-lender we recently purchased.  The same natural gas glut that is keeping a lid on local economic growth is a boon for energy companies we own in Pennsylvania and North Dakota.  Solar subsidies and the political push for renewables may be inflating the budget deficit, but they also create opportunities for vendors that sell solar components to major utility companies and for electronics vendors whose components hook these systems up to the grid.

While investors have complained about empty product pipelines at the major pharmaceutical companies, hurt by drug approval processes that take ever longer, our biotech companies are focusing on developing and cashing out on the launch of new products purchased by the big companies for distribution in their marketing system.  While stock guys complain that no one cares about equities anymore, annuity vendors are growing nicely by providing “income for life” solutions for the millions of baby boomers transitioning from the accumulation phase to retirement’s distribution phase of investing.

During the 12 months following the 2011 Economic Forecast, the stock market provided many investors with double digit returns, largely for the reasons that we had anticipated.  Corporate earnings grew a bit, but much of the appreciation came from an increase in the market Price/Earnings multiple from 12.8-times earnings (in January of 2012) to 14.3-times in 2013.  In 2013, it wouldn’t shock us if the P/E ratio continued to improve, on top of another small increase in corporate earnings, which could again provide investors with another nice year of appreciation in equities.  In the meantime, cash equivalents provide little return and bonds could force losses on investors if interest rates rise much.

2012’s 4th Quarter Gross Domestic Product (GDP) growth will be reported in about a week and we believe that our year-ago forecast for 2 percent real GDP growth will be on target.  It is likely that consumer spending will be a little weaker than anticipated – largely due to the year-end spending pause as consumers weighed the impact of the fiscal cliff – but foreign trade and U.S. government spending are both likely to be a little stronger than expected.  For 2013, we are forecasting slow growth, but slightly faster than a year ago.  The 2013 forecast for 2.5% growth in GDP factors in slightly slower consumer spending, resulting from tax increases impacting both very high and very low wage consumers, but offsetting this would be greater business confidence now that the divisive and tumultuous 2012 political campaign is behind us.  Companies have the financial resources to increase their rate of investment and we believe that they will do so as 2013 continues our slow move back toward normalcy.

Of course, “normal” does not mean a problem-free, peaceful, predictable status quo.  Uncertainty, after all, is normal.  For us, we think it means that markets will continue to move beyond crisis mode, price volatility will stay low, asset class correlations will diverge so we move away from the politically driven risk-on/risk-off trading environment of 2008-2012.  In a normal environment, there are both winners and losers and it is no longer just a question of “fully invested” or “in cash.”

Normalcy is a figment of our faulty memory.  Markets climb a wall of worry.  Once things have appreciated, the anxieties experienced on the way up are mostly forgotten.  If we are right and 2013 takes us one step closer to normal, it doesn’t mean that our political problems will be resolved, that our economic concerns will melt away, or that robust global growth is just around the corner.  However, it is an improvement from the dark days of the Great Recession, not too long ago, and we were happy to again be able to provide a positive outlook at our annual forecasting event.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Fiscal Tiff

The Lame Duck Congress (emphasis on the word “lame”) thinks that they “resolved” the fiscal cliff with a late night New Years day vote.  In fact, all they did was raise taxes, but there is some good news buried in those actions of incompetence.

First, looking at the late December retail sales figures, it looks like consumers ignored the political grandstanding and kept right on spending.  In spite of the uncertainty, and potential anxiety, shoppers were not so put off that they stopped spending.

Second, most of the “fiscal cliff” drama is now behind us.  I think we’ll find that there was more (negative) impact to the economy during the 4th quarter, than there will be in 2013.  The melodrama was costly.  Economic activity did slow as the year ended, but now there are some rules for income tax planning and estate planning that can form the basis for decision making in the future, so maybe it will allow investors to begin making decisions, once again, and start moving forward.  We almost hit stall speed during 3Q 2012.  Personally, I am really happy to put 2012 behind me.

Third, it appears that Congress has re-learned how to compromise.  Rather than letting extremists hold Congress hostage, the Administration (Biden, mostly) and Congressional leadership figured out how to find some agreement near the center, involving both sides of the aisle, in order to forge a majority.  Previous administrations haven’t had such difficulty doing this, but the agreement surrounding tax hikes was the closest thing to a traditional compromise that we’ve seen in at least four years.  That is, after all, how Washington D.C. is supposed to work.  I thought that they’d forgotten.  Maybe now they can repeat the process and come to some agreement on the spending reduction side of things.

Fourth, most of the tax rates determined are “final.”  The accountants have been dealing with temporary estate planning rules since 2001.  Many of the rules established in the fiscal cliff negotiations are actually supposed to be permanent.  Wow.  What a concept. The Alternative Minimum Tax (AMT) fix, indexation, is also permanent.  It’s great to have some sense of finality to the negotiations.

Fifth, in my opinion, the GOP was more successful than I would have predicted.  Especially given that they lost the election in November, so taxes were bound to go up, the impact of these tax increases negotiated over the New Year holiday are relatively limited.  Given a trillion dollar annual deficit, if the tax increases account for roughly $60 billion (only 6% of the gap), that is pretty minimal.  If the rest of the gap gets filled from spending reductions (Ha!), then that would be about $16 spending reduction for every $1 of tax increase.  In reality, I think the deficits will continue ad nauseum, but the basic point remains; given the size of the deficit, the extent of the tax increase was pretty minimal.

There are plenty of things not to like about the upcoming potential for a constitutional crisis related to the debt ceiling debate we’ll be hearing over the course of the next few months.  Still, there are a few good things that came out of the final package that will help investors going forward.  It doesn’t hurt to notice them, too.

Addendum(dtd 1/7/2013):  Fidelity Investments just published a good summary of the recent changes.  Let us know if you would like us to e-mail you a copy of their Crisis Averted report.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Fed To Punish Savers For Three More Years

Last week, after completing a set of grueling meetings in Jackson Hole, the honchos at the Federal Reserve announced to the market a new round of money printing and extended its policy of denying savers a fair return on their savings.  They worded the announcement slightly differently, but that’s the gist of things.  Faced with deteriorating economic statistics, the Fed decided to continue its current policy of “financial repression” at least until mid-2015.

Critics of this latest round of Quantitative Easing (QE3) accuse the Fed of bowing to political pressure from the White House in advance of the upcoming election in pursuit of policies that debase the dollar and have not helped reduce unemployment or restimulate business investment.  Contrasting current policies with the polar opposite policies successfully implemented by Paul Volcker in 1979,  Obama critic Larry Kudlow wrote, “It’s like history is repeating itself, but in reverse.”

I do believe that the QE3 announcement is confirmation to what the May-Investments Leading Indicators Index is showing; economic fundamentals are deteriorating rapidly and the Fed is worried.  While the critics charge that QE3 will be no more successful than the first two attempts, I believe the evidence on Quantitative Easing is unclear.  While it is clear that interest rates can’t go any lower, so the normal Fed tools aren’t working, it’s hard to know where we would be absent this digital printing press, which is working overtime.  It is entirely possible that absent “Helicopter Ben’s” herculean efforts to spread money we don’t have to random companies throughout the financial sector, we might already be in a Depression.

One reason that Bernanke is doing just the opposite of Volcker is that the 1979 Fed was fighting rising and persistent inflation.  Today’s Fed is petrified of deflation, inflation’s polar opposite.  No wonder it is using a different set of tools.  Rather than blaming the White House, it is fair to say that there is real uncertainty, and honest differences of opinion, about the efficacy of current Fed policies.
 
The real problem is that something other than low interest rates is holding back confidence and business investment.  Indeed, the current policy of keeping interest rates unrealistically low, which boosts bank profitability at the expense of retirees, just forces the elderly, foundations, and other savers to take more risk than they’d like with their nest eggs.  This policy of “financial repression” punishes retirees who had hoped to live off of their savings when they are too old to work.  It is a cold-hearted subsidy of U.S. government borrowing that is forcing people to put off retirement, take more risk than is appropriate, cut back on day-to-day spending, and forces more dependence on Social Insurance programs.  Is it any wonder that confidence is waning?

Most readers don’t spend a lot of time thinking about U.S. government fiscal and monetary policy.  These subjects seem like dry, “intellectual” pursuits with little bearing on daily concerns.  For May-Investments, however, these political economic policies, known in economics jargon as “macroeconomics,” have clear consequences and we see the impact on our friends and neighbors on a regular basis. 

Households forced to choose between lowering their standard of living because their bank savings no longer pay a decent return, or taking on additional risk, are moving out the risk spectrum into securities that have hard to interpret risk associated with them.  When these investments decline in value, as they almost certainly will, scared investors will lock in losses as the frightened herd heads for the door.  While millions blame “the banks” for today’s ills, in reality it is government policies, bureaucrats at the Treasury, and economists at the Federal Reserve who are largely responsible.  True, bankers are the beneficiaries – but it is current macroeconomic policy which is largely to blame.  When we look at this economy and try to assess what “excesses” might lead to a new recession, the clear and obvious candidate is the bond market, which has been pumped up by Federal Reserve policies that have inflated the value of income paying securities.

Markets are a mess, and it is the hyper-regulated banking sector that is mostly to blame.

The politicians in Washington D.C. are focused on arguing about social issues and tiny steps that don’t begin to solve the country’s economic problems.  “Nero fiddles while Rome burns.”  The Fed’s policies of financial repression are doing more harm than good.  QE3 is, at best, a narcotic designed to get us through the next few months.  No matter what your party affiliation, May-Investments urges readers to make your vote count, pay special attention to voting for candidates whose top priority is getting the economy working again, and remember that “all ties go to the challenger.”  Both parties are guilty.  Incumbents really aren’t going to turn the ship around.  If we want a better future, we have to do things differently.  If we want this brain damage to stop, we need to stop letting the folks in power beat our heads against the wall.  If we don’t want the punishment that the Fed has laid out for us, then rather than continue to mask the symptoms, we need to take whatever macroeconomic medicine will lead to a cure.

Vote early.  Vote often.  Make it count.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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2012 Mid-Year Forecast Update

On August 16 May-Investments updated its January Economic Forecast lunch.  The bottom line was that our optimistic January forecast, which called for continued slow economic growth but a much better environment for the stock market, seems to be on target as of mid-August.  While the equity market remains pretty skittish, strong earnings power and reasonable market valuations combine to provide solid upside opportunity for equity market investors unless conditions in Europe and China continue their downward slides and eventually drag the U.S. market down with them.

While May-Investments leading economic indicators are getting slightly weaker, as of mid-August our January forecast for the year remains virtually unchanged.

We’ve been waiting for the “fear bubble” to pop, which would likely allow both interest rates and the stock market to rise.  For the most part, we’re still waiting for that eventuality, but one important place where we did see some sense of normalcy return to the markets was in how the U.S. market reacted to the European sovereign debt crisis.  While the problems in Europe continue to crescendo, the U.S. market’s response has been more muted than it was in 2008, when Lehman was at the center of the world financial crisis, or in 2010 and 2011 when the sovereign debt crisis first appeared, only to be denied by Europe’s Central Bankers and governmental leaders.

In 2012, with Greece having paid creditors less than 20 cents on the dollar and on the verge of being kicked out of the European Union, and despite the problem of high and rising interest rates in Spain and Italy and threats that the crisis would extend to now AA rated France, volatility in the U.S. market (as measured by the so-called “Vix Index”) was much lower than in previous years.  True, the market did, by our measures, go into a downturn in May.  Although the downturn was severe enough to get us into risk reduction mode, it was not as severe in the past and the daily volatility was much lower than in previous incarnations of the EU debt crisis.  In our view, the liquidity measures put in place in December of 2011 are having a positive impact and have prevented the crisis from jumping over the pond and spreading to the U.S. financial sector.

Nonetheless, the markets (generally and) in the second quarter (particularly) are trading as if we are already in a recession.  The top performing sectors in Q2 were telecommunication services, utilities, consumer staples and healthcare – precisely the sectors which typically fair best in a recession.  But instead the U.S. economy continues in its slow growth mode, with consumers continuing to spend, businesses afraid to invest, governmental entities cutting spending while imports and exports having very little impact either way.  In the same fashion as predicted in the January forecast, the economy keeps moving forward, albeit at a modest pace.

Of more concern, the May-Investments Leading Economic Indicators have turned down, slightly, and need to be watched closely.  Whereas in January, 9 out of 10 of the index segments were indicating healthy growth, by mid-August only 4 of 10 sectors were moving up, while half were beginning to decline.  If those trends continue, May-Investments would be inclined to pull its optimistic forecast.  As of mid-August, however, the down trend was too new to warrant a change in the forecast. 

The biggest concerns are in the areas of global economic activity, where the slowdown in Europe is impacting economies in Latin America and Asia as well.  The outlook for small businesses declined as well, and the Institute for Supply Management “New Orders Index” fell precipitously, very recently. 

As a result of these mixed economic signals, the U.S. stock market rallied in a very unique way.  The U.S. equity markets have risen during 2012 (so investors with 20-20 hindsight should have been aggressively positioned, “all in” as it were, yet the sectors which are performing best are the “defensive” industries that typically do best when the market is weak.  Leuthold Capital Management’s research folks have noted how unusual this market is from an historical perspective.  The 2012 rally is unique in many ways, but we believe it all ties back to the “all in and maximum defensive” nature of this current phase of the bull market.

Updating our industry work, the sectors with the most upside potential appear to us to include technology, healthcare, basic materials, energy, industrials, and financial stocks.  High dividend yield stocks, and utility stocks in particular, are among our least favorite sectors.

Overall, it felt good to optimistic again, and it feels particularly good to be optimistic while the equity market remains in a bubble of fear, generally.  While there are excesses in the bond market, and in unique sectors like the social media stocks and REITs and Master Limited Partnerships, in general the level of investor interest in the market is very low, trading volumes are low, and optimism is in short supply.  It is exactly the sort of market that whets the appetite of a contrarian investor.

In the short run, contrarians often have to fight the current trend, so our contrarian interest in equities is certainly no guarantee that our positive short-term forecast won’t have to be changed.  In the long-run, however, the contrarian nature of our portfolio holdings really is an encouraging sign.  It means that the years of swimming upstream, as investors have had to do since valuations first got stretched in 1998, are nearing an end.  Good riddance!
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Rising Portfolio Cash Speaks to Market Concerns

Don’t ask market gurus for their opinion; ask to see their portfolios.  Bullish advisors that sit in cash have little credibility.  Fully invested advisors with “cautiously optimistic” opinions don’t strike me as being very cautious.  At May-Investments, with most “red money” (growth oriented) portfolios now sporting cash positions of 20% to 30%, our concerns about recent market activity have shown up in portfolio holdings.

 

In the short run, there are numerous technical indicators that have forced us to a more cautious stance.  In the long run, there are still many reasons to be optimistic – but recent events are suggesting that the possibility of a bad surprise has increased.  Rather than cross our fingers and hope that things don’t get worse, in the past few weeks we have shifted portfolio holdings to cut back on the amount of risk to which portfolios are exposed.

 

• While stocks (the S&P 500, at least) are still up 3.8% year-to-date through the end of trading today, the market direction has shifted enough that momentum investors are heading for the exits.
• Investor interest in the stock market is flagging, which shows up in very low trading volume. 
• Moreover, on days with greater activity, the market trend is often lower – suggesting that when trading volume returns, it won’t lead to an upsurge in the market. 
• Money flow indicators, which have been positive for most of 2012’s rally, appear ready to go negative. 
• Defensive sectors, by and large, are outperforming the broad market while commodities, technology, financials, and cyclical stocks lead the market lower. 
• Investors Business Daily’s “Market Pulse” indicator switched to “market in correction” on May 4, which is when May-Investments began reducing our stock weighting in some portfolios as well.

Perhaps the action which has us most concerned has been the very dramatic sell-off in the commodities sector, reminiscent of July 2008.  While newspaper headlines focus on the political and banking situation in Europe, a more compelling explanation to me is that the situation in China continues to deteriorate.  The chaos in Europe, while unprecedented, really shouldn’t be surprising to anyone.  The banks over there need to be recapitalized, which means that this week’s takeover of a bank in Spain is just the first step in a long line of dramatic steps that result from the sovereign debt problems over there.  Maybe the market is just responding to the unfolding of the inevitable, but what worries me more than Europe is that the bad news out of China keeps coming.

 

Our hope, as the year began, is that the U.S. and China would avoid the recession which had already begun in Europe.  If China continues sinking into recession as well, it is very hard to imagine the U.S. avoiding a similar fate.  That, to me, is the real news that the market is digesting.  Throw in a little uncertainly about our own political incompetence, and it’s not too hard to imagine that a correction (or worse) might be just around the corner.

 

As always, however, it is important to look at both sides of the coin.  There are a number of long term factors which still favor continued growth, unless China does continue toward an implosion of its own.

 

First, our portfolios have very little direct exposure to the problems in Europe, and haven’t for over a year.  The U.S. market, generally, has performed much better than the international markets and client portfolios have been focused on domestic stocks.  Most of our international exposure comes through our gold and precious metals holdings. 

 

Second, as in 2008, having a significant amount of cash on the sidelines gives us significant buying power should a market correction unfold.  We have always said that corrections feel a whole lot worse when investors are fully invested.  If there is money available for investment at “the bottom,” then a correction becomes an opportunity which can be a silver lining to the otherwise cloudy sell-off.

 

Third, the May-Investments U.S. Leading Indicator Index remains pretty strong.  It flattened out for a few months, but the preliminary numbers for the month of April show continued growth in U.S. economic activity.

 

Fourth, regulators have had some time to prepare for the financial crunch sweeping across Europe.  Even in the midst of this week’s angst, Spain was able to sell bonds at auction.  Banks, using money borrowed from the European Central Bank, can buy bonds at 6% and pay just 1% on the borrowed funds.  True, as in the U.S., this funny money is being created out of thin air, but the plan hatched late in 2011 does provide liquidity to the system.  It is my guess that the U.S. will soon be asked to tap into the Federal Reserve balance sheet for a trillion dollars or so.  We will lend money to the European Central Bank, which will lend it, in turn, to banks on the continent.  Japan and other countries may also make funds available.  This rescue has been at least a year in the making, and the printing presses aren’t even close to running out of ink.  (It helps that all of this fiat money is being created digitally, on electronic balance sheets on both sides of the pond.)

 

Fifth, May-Investments new custom wealth management approach has been working well.  Last fall, we tweaked some disciplines around our portfolios’ “flexible middle” to make the decision to move to cash more objective, less stressful, more gradual and less disruptive to the portfolio.  Beginning in early May and continuing step-by-step as the warning signs began to accumulate, we gradually reduced our risk exposure to the point where now we have a significant stash of dry powder in the event the sell-off continues.  The sales were made more quickly.  The main problem with 2011 was a delay in August as we wanted to get past the budget impasse – a decision which meant that we weren’t reducing risk until too late during the sell-off.  The process was more objective and less subjective.  It will also be easier to reverse, if and when markets begin to recover.  Thus far, the portfolio tweaks made late last year have worked very well.

Sixth, market valuations remain very attractive.  Note that these valuations are a function of forward earnings estimates, which are themselves a function of what the U.S. economy does during the remainder of 2012 and into 2013.  At this point, however, the domestic indicators remain strong, so corporate profits may stay the course.  If the U.S. indicators start going down, it will make sense to take even more risk out of the portfolio.  In 2008, the economic indicators lead the market decline.  This time, the market is weakening in advance of any decline in U.S. economic fundamentals.

 

The technical indicators that are waving red flags are too numerous to ignore.  It is possible that we could be whipsawed again, as happened in 2011 when we reduced our equities at the height of the European crisis but, when solutions finally began to appear, the markets surged higher and our portfolios missed out on the recovery.  We will be quick to buy back in if things settle down (because of the numerous long-term positives mentioned above), but it is easier for us to risk the opportunity cost of a market recovery than it is to think about the losses that could accrue to investors if these red flags are right, this time.

We remain long-term optimists, but the news coming out of China also can’t be ignored.  We are reminded of John Maynard Keynes response to criticism for changing his mind, who replied, “when the facts change, I change my mind.  What do you do, sir?”  The slowdown in China is morphing toward something worse, which would put the U.S. recovery at great risk.

 

If, as I hope, the European markets settle down and China starts showing signs of stabilizing, the market would likely go back into rally mode and we will put the cash to work.  At the moment, however, we are concerned that the market has enough downside from here that it makes sense to reduce the amount of capital at risk in the long-term portfolios.

 

It almost goes without saying, but we’ll say it anyway, it’s also appropriate to be absolutely certain that only long-term money is invested in the “red money” portfolios.  At this point, from the market’s high water mark, the S&P 500 Index is down less than 9%.  At this point, volatility has not spiked and the downturn is well within the range of normal market ups and downs.  No one should consider it “too late to sell.”  Investors should be certain that long-term portfolios have only long-term money invested in them.

And remember that this, too, shall pass.  But buckle up.

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

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Signs Point to Further Growth

Emotional markets are often irrational markets. In both real estate investing and in the financial markets, investors without a discipline can be easily swayed by fear and greed. By developing a discipline and anchoring decisions to specific facts, investors can maintain their bearings amidst uncertainty and turbulence. Many facts, today, point to continued growth in the U.S. economy.

However, in 2011 the level of angst and vitriol in the markets and the political arena caused markets and fundamentals to disconnect. While the economy moves up at a modest but consistent pace, the stock and bond markets seem to be priced for drama and despair. In spite of impressive growth in corporate profits, last year, the U.S. stock market went nowhere. While European leaders assemble trillions of dollars in rescue funds, the markets contemplate the impact of a colossal meltdown of the global financial system. These worries seem overblown.

The May-Investments Leading Economic Indicator keeps climbing, forecasting continued growth into 2012. Of the ten indicators that comprise the May-Investments LEI, all but the export sensitive Baltic dry freight index are positive, or strongly positive. The collapse of the freight index indicates a slowdown in global shipping activity, probably as a result of a recession in Europe and possibly Asia. The rest of the indicators focus more on domestic economic activity and suggest continued growth in the U.S. economy. If the markets begin reflecting a return to economic “normalcy” and we can get out of this “bond bubble,” or “fear bubble,” or whatever you want to call it, the stock market could do very well in 2012 and interest rates could shoot higher.

Locally, there are additional reasons to be optimistic. Dale Beede, Managing Director of Coldwell Banker’s Grand Junction commercial properties division, notes that the local real estate market looks like it can improve. “We’re starting to see more investor traffic which is creating new opportunities for sellers.”

Commercial real estate prices have adjusted down, but to reasonable levels, not to fire sale price levels. Taking advantage of the lower prices while interest rates are very low creates opportunities for potential real estate investors. The stock market is also inexpensively valued, especially compared to alternatives such as bonds, TIPS, and bank certificates of deposit. We would not argue that “savings” should be invested in more volatile “investment money” alternatives. However, it is getting harder to argue that “investment money” should be on the sidelines invested in savings accounts.

In 1979, Woody Allen wrote that, “mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.” Allen was wrong, in 1979. And we think that the financial markets, priced as if they are caught between a rock and hard place, are wrong today.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Economy Still Indicated To Grow Through Summer

The stock market’s ups and down, and economic growth – or lack thereof – are not random, but they are difficult to understand at times. May-Investments developed its own Leading Economic Indicator that helps the firm understand the current economic environment. Today’s LEI readings forecast continued economic growth during the months ahead.

May-Investments developed its in-house indicator rather than rely on the more traditional LEI, which is published monthly by The Conference Board. With the Federal Reserve adopting Enron-style off balance sheet financing vehicles in order to move the government’s new bond issuance out the doors into buyers’ hands, the old economic indicators are at risk of becoming obsolete. Investors are having difficulty understanding whether today’s economic growth is a mirage, an encouragement, or a house of cards about ready to fall and take investors down with it.

The resulting economic uncertainty causes many investors to remain on the sidelines for fear of a repeat of the 2008 banking panic. Unfortunately, “the sidelines,” as represented by bank and bond interest rates, pays investors little or nothing, so savers are being hurt by the Federal Reserves’ low interest rate policies, which have been crafted to benefit bankers instead of savers. Long-term investors are being asked to use yesterday’s economic indicators in spite of the apples-to-oranges comparison between the economic environment that preceded the 2008 collapse of Shearson Lehman, and the capital-starved world that we’re in today.

Investors could ignore the big picture, but 2008 proved that approach is too risky. Investors could remain on the sidelines, but inflation is persistently destroying the value of money held in the bank while food, energy, and import prices soar higher. Some investors will decide to use the old indicators, ignoring the sea change in monetary policies that have been adopted since 2008. That approach has worked fairly well since the market bottomed in March of 2009. On the other hand, ignoring the new reality won’t make it go away, and doesn’t mean that it won’t eventually matter (a lot).

May-Investments responded to the new economic realities by replacing outmoded economic indicators with a new Leading Economic Indicator of our own. Built in-house and updated monthly, it shows that the economy began a sharp decline in mid-2008, a few months before Lehman’s bankruptcy and the Wall Street implosion. Through 2009, the economy remained mired and didn’t actually turn up until mid-2010, despite traditional indicators that showed the economy recovering a year earlier. The old indicators put too much emphasis on low interest rates, a traditional indicator of stimulative Fed policy. In fact, low rates were put in place to bail out the distressed banking sector, but bank regulators were busy tightening bank capital requirements and lending rules that left banks shrinking loan portfolios, firing commercial loan customers - even those that were current on their loan payments. The world had changed, but the old indicators weren’t reflecting this new world.

As a result of developing our own indicators, we can say with more confidence that the recovery that began in mid-2010 is still underway, and is not a mirage. Retail sales and drilling activity turned up early and are still positive. Corporate profits have fully recovered. In contrast, small business confidence remains spotty. Even bank lending, which held back the recovery for months, recently turned up. These are healthy signs that give us confidence to invest for the long-term, rather than hiding on the sidelines.

There are certainly concerns, and our indicators help us know where to look for them. Overseas activity has been weakening for several months as higher interest rates abroad slow down the rate of recovery in our export sector. More recently, the technology sector has dropped a bit, presumably (but who knows for certain?) as a result of problems facing the tech sector related to the tsunami crisis in Japan.

When we build client portfolios, we can design them to reduce exposure to some risks (we currently have little foreign stock exposure) while embracing other types of risk, where evidence of the recovery gives us more confidence that risk taking will be rewarded. Most importantly, it has helped us keep our foot off the portfolio brakes when the market began rallying last Fall. We still think that the brakes are important. Our best guess is that we remain in a “trading market” that could go down, a lot, just like it has soared off the 2009 lows.

At times we want to be playing offense, while at other times it makes sense to be more defensive. Our Leading Economic Indicator helps us make sense of this new monetary world in which we find ourselves. As I write this, the view is still encouraging.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Is The "New Normal" Normal?

Someone asked me the other day if I’m still in the “double-dip” (recession) camp, which led to an embarrassing confession that though I once believed that higher rates would choke off the nascent recovery, the current recovery has lasted long enough, and been strong enough, that I think those of us who were double-dippers ought to confess to being wrong. Do I think that the current recovery will eventually turn down? Of course. But if it turns down next year, or even next month, I think it would be disingenuous for the double-dip campers to claim that they accurately forecast this cycle.

In fact, thus far the “new normal” feels pretty normal, when you look at the strength of the current recovery and if you study how the market has responded to these statistics.

Our May-Investments Leading Economic Indicator remains strong, with 8 of 10 indicators showing improving conditions. Even bank lending has turned up, if only barely, indicating that since banks have stopped buying Treasury securities, they now have enough funding available to pay both their exorbitant CEO bonuses and make the odd loan here or there to small businesses who desperately need it. While overly tight bank regulators remain focused on denying capital to just about anyone who might need it to do business, forestalling job growth and pushing former pillars of the community into the hands of better-financed Fortune 500 competitors, at least (statistically speaking) the problem has finally stopped getting worse!

The two current areas of concern are export growth, which seems to be stalling, and a bit of a slowdown in the technology sector, probably related to the economic trauma suffered by Japan which may be impacting the greater Asia region. In any case, with 80% of the indicators improving, it’s hard to see why it makes sense to run for the hills. Economic growth appears to be real, significant, and ongoing.

Fidelity's Market Analysis Research & Education group published an analysis that shows that from the perspective of the stock market, the post-Recession recovery has followed a very normal path. Early in the recovery, financials and consumer cyclical stocks led the way. Now in the mid-cycle of this expansion, energy and industrials are leading the rally. The sector rotation we’ve experienced has thus far behaved exactly as a textbook on the investment cycle would have forecast.

Strictly observing sector performance, the failure of the banking sector to either write-off or in any way digest its bad loans is not apparent. The de-leveraging of the consumer sector, and the degree to which many small business owners and consumers have been cut off from access to credit, doesn’t really show up. Nor has stubbornly high unemployment seemed to matter. As far as the market is concerned, the economy put in a typical V-shaped rally and robust expansion by businesses is leading to a resurgence in inflationary pressures, which would typically result in a modest mid-cycle rally in stocks, especially by the business sector.

I think “the market” is wrong. I think the banks put in a “dead cat bounce” where those banks that didn’t go belly up, beneficiaries of an enormous wealth transfer from savers and taxpayers to incompetent financiers, rallied strongly on a faked recovery in banking sector earnings. It restored consumer confidence, but the systemic cancer remains. I think that corporate America has taken important steps to cut costs, especially in the area of interest expense, but historically high profit margins seems out of step with the economic realities facing the country. Finally, I think that to the degree that the market recovery was stoked by an end to distressed selling, mostly because bonds and cash no longer pay a competitive return (there’s no place else to go), today’s zero interest rate environment seems like an ingenious deception rather than solid long-term rationale for investing in stocks.

But sometimes it’s best to keep the alternative scenarios in mind, especially if you are writing only seven paragraphs after confessing to have blown it with my “double-dip” forecast. The investment business is, if nothing else, a humbling enterprise. I still expect inflationary pressures to get worse, interest rates to move high enough to shut down expansion, and at that point I believe that today’s deferred problems will resurface so that the next cycle down will be severe – hopefully not as severe as 2008, but nonetheless a severe recession, when put in historical context.
 
Let’s hope I’m wrong again.  

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

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Leading Indicators Still Point To Expansion

Updating the May-Investments LEI shows some moderation in the rate of growth, but the trend in the index is still higher. Preliminary global semiconductor billings join export indicators and bank lending in the negative category, but 7 of the 10 indicators still point to future economic growth.

Retail sales and the Institute for Supply Management “New Orders” index provided the greatest encouragement. Retail sales have more than recovered from previous peak levels, and are setting new highs. As consumer sentiment improves, spending on both basics and big ticket items is recovering. After a couple years of pent-up demand, auto sales are recovering and there is room for even more impressive growth going forward. Spending on new homes and appliances, however, remains weak, as we have anticipated.

Shipping prices are another very weak sign. While they may be more indicative of an oversupply of shipping capacity than weak exports, the indicator suggests that exports are an area of concern. Given the weakness we’ve seen in most foreign stock markets, relative to the U.S. market, it raises the possibility that tensions in Egypt and restrictive banking policies in China may combine to slow down the rate of growth in emerging market economies.

Overall, the economy still seems to be growing. May-Investments forecast for 3.5% real growth in the Gross Domestic Product suggest that growth in 2011 might be just about right – neither too fast or too slow. Recent statistics show employee layoffs are running at very low levels, which helps build consumer confidence for all but the unemployed.
 
However, capacity utilization rates in the manufacturing sector, at just over 73 percent, are still low enough to suggest that companies will be slow to expand production or start hiring. A 73 percent rate of utilization is the level you typically have in a recession. Historically, the CapU rate has to rise to about 80 percent before executives begin to really ramp up hiring and expansion plans. It will likely take another year or two of growth before we reach those levels. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Improvements to LEI Index Continue

Economists tell us that the Great Recession ended in June 2009, but for many it doesn’t feel like that. More importantly, where does the economy go from here? The May-Investments Leading Economic Indicator has been rising steadily since March of this year, indicating that the recovery we’re experiencing is real and, possibly, sustainable.


Some economist say we’re recovering, but to a “new normal” level of activity that is significantly below the prior peak. The traditional economic indicator suggests that things are better now than they were when the economy topped out in October of 2007. Still others view enormous upside from here, primarily because the sell-off two years back was so severe. In reality, no one really knows for certain, which makes it hard to make any decisions based on economic forecasts.

The most common result of this controversy is that many investors make investment decisions based on emotion, rather than economic fundamentals. Lacking perfect information, the vast majority of investors either throw out all of the data or only pay attention to facts that support their current beliefs. Here in Western Colorado’s conservative country, anger at the Federal government’s fiscal and monetary policies has led many investors to conclude that the recovery is an illusion.

May-Investments has been measuring and monitoring events all year, having been forced to develop a proprietary Leading Economic Indicator to help us objectively track the direction of this economy. The indicator shows that we aren’t anywhere near the prior peak, which supports the view on Main Street that we have a long way to go before we have really recovered from the 2008 financial panic. On the other hand, the May-Investments Leading Indicator suggests that the recovery in corporate profits is sustainable, the worst of the unemployment situation may be behind us, and a spirit of optimism may soon return to America’s entrepreneurs. Never underestimate the resilience of the American economic system!

Of our ten indicators, only exports, bank lending (still the most negative indicator), and manufacturing orders are waiving red flags. For several months, now, 70 percent of the indicators are positive. Since these are leading indicators, these suggest that the current recovery can continue through much, if not all, of 2011. For investors, it means that outperforming cash and bond investments might not be too difficult, at least for the first few months of the year. Looking back, it appears that 2010 will go down as a pleasant surprise as compared to expectations, even if it’s not a banner year in absolute terms.

Hopefully it also means that every reader will have a Merry Christmas and a Happy New Year celebration in the coming weeks.

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

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Struggling Economy Stuck in Neutral

“The May-Investments Leading Economic Indicator was flat in September.  Continued contraction by lending institutions and weakening new order activity in the business sector offset increased drilling activity. The economy remains on the brink, with economic growth too slow to reduce the unemployment problem but not slow enough for economists to conclude that the economy has fallen back into a new recession.

“The monthly indicator increased from 1184 to 1187, which is less than a rounding error.  By next month, revisions to the data points, alone, could reverse that growth. Retail sales, money supply growth, small business confidence, corporate profits, and capacity utilization have all flat-lined.

Retail sales strength remains key. Sales growth started in June of 2009, but in September retail sales started falling again, albeit only modestly. Global export activity may also be slowing.  During the financial panic, sales slacked off but production came to a halt, so inventories were drawn down.  Since then, rebuilding inventories has helped turn things around. To much inventory restocking can force companies to cut back production. We need confidence and retail sales to start growing, or this recovery will be very short-lived.

The modest economic growth the country has enjoyed has been a consequence of low interest rates, lower housing costs, a more competitive manufacturing sector and continued innovation in the technology sector. Fortunately, those factors are still in place. Investors would be wrong to let today’s political pessimism lead them to conclude that the current recovery will necessarily be short-lived, or that continued growth is out of the question. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Dips and Double-Dips

Market Chatter about back-to-back recessions, double-dipping back into a weakening economy, is causing the stock market to be more volatile. Our view depends on whether we’re talking about the stock market, the traditional Leading Economic Indicator, or the real economy.

The stock market followed the traditional Leading Economic Indicator up.

The Conference Board organization publishes this indicator which bottomed in the spring of 2009 and has subsequently moved to new highs, perhaps indicating that the current economic rebound is much stronger than the economy we experienced in 2006 and 2007. But does that sound reasonable to you? It doesn’t to us.

For a number of reasons, we’ve been suspicious that the traditional Conference Board indicator has been overstating the magnitude of the recovery. The traditional LEI, for example, considers current monetary policy to be extremely stimulative. In reality, banks continue to restrict access to small business, especially, which has made it nearly impossible for companies to expand and provide jobs for the unemployed.

May-Investments was an early proponent of finding an alternative to the traditional LEI, but many other firms have joined the chorus and a few alternatives to the Conference Board are gaining support. In January, May-Investments was forced to develop its own proprietary LEI in order to have some objective tool to monitor the timing of this economic recovery.

The May-Investments LEI ignores the low level of interest rates, but instead emphasizes whether or not banks are starting to lend. (They aren’t.) Our LEI focuses on areas of potential strength, such as exports and energy independence, but ignores typical industry stalwarts like construction which were ground zero for the last bubble, and are extremely unlikely to drive expansion during the next cycle.

The May-Investments LEI never regained altitude, so we don’t think the real economy will experience a “double-dip,” primarily because we never really thought that we started a new recovery.

We have continually described this economy as having stabilized, in a recession. We’re still waiting for a real recovery to begin. Others have described the economy as having entered a “new normal,” well below previous levels of activity and neither growing nor contracting significantly. Things aren’t getting worse, but they’re not getting better either.

The most important question to me, in the short run, is whether the stock market has acknowledged this sluggish “muddle through” reality. It seems to me that the market soared higher along with the recovery in the misleading Conference Board indicator. In reality, we have merely stabilized in recession, which suggests that the stock market might be assuming a stronger recovery than we will ultimately experience.

Although the level of the May-Investments index has remained reasonably stable, behind the scenes the indicators have been weakening. Just a few months ago, eight out of the ten indicators that make up our LEI were improving. A few months ago, only commercial banks and the slow growth of the money supply showed signs of weakness. Since then, the outlook for small business owners, global shipping rates, and manufacturing new orders have all raised red flags. Retail sales are still a positive, but one more month like June and that indicator will flip to the negative as well.

Dip and double-dip worries highlight the single most important focus for investors is the Economy.

Stock market valuations are not worrisome. The market is reasonably priced.

Liquidity is no longer a big concern. The big banks have been bailed out by seniors, mostly, who are being paid virtually nothing on their life savings so that banks can rebuild balance sheets that were decimated by a unique combination of arrogance and incompetence.

The Conference Board has been publishing research for 94 years and traditionally its Leading Economic Index has provided a helpful guide to when the real economy is turning around.

This time is different.

The factors that the Conference Board LEI tracks are not the things that matter most in the new normal post-Lehman world. It doesn’t matter to me if the Conference Board LEI double-dips or not, because that indicator hasn’t been providing an accurate view of the economy on the way up, so it matters little to me where it goes from here.

The stock market, which is theoretically an important leading indicator in its own right, just might double-dip if the real economy weakens from here. If the real economy could start a real recovery, then stocks are reasonably cheap and the market could see a decent rally. If the real economy turns down again, however, I think that the fear will spread that today’s corporate earnings rebound won’t be sustainable, and the market will fall.

I still hope that there is no reason for the market to revisit the March 2009 lows, when our new President was busy nationalizing the auto industry in order to hand it over to the United Auto Workers, and considering nationalizing banks as well. I think his wings have been clipped, and the economic shock and awe that greeted the new administration’s policy ideas has abated somewhat, along with his ability to push through some of the most radical ideas.

The bottom line, though, is that the economy never spiked up, so it isn’t really dipping down. The stock market, however, might just double-dip (go back down) if the economy can’t sustain today’s corporate earnings rebound. Earnings have been much stronger than I’d anticipated. I don’t know whether they can be sustained at current levels, much less keep going up.

The term that others use is that we are “data dependent.” We are not positioned defensively because we anticipate that the economic indicators will turn down. We don't know which direction they're headed.  That's why we're watching with such interest what happens to the Leading Economic Indicator.

We are positioned with money on the sidelines because volatility (risk) is so high that we don’t think we’re being paid enough to take on normal market risk, given the uncertainties we face.

If the market falls significantly from here, we’ll go out and add risk to the portfolio at a much more attractive price. If the uncertainty would fall, or the level of volatility would decrease, we would be willing to add risk to the portfolio, at today’s prices and even at slightly higher prices. But without seeing things improve from current levels, it is hard for me to dip, or double-dip, into the reserves we built up after the market rebounded from the 2009 lows. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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