Wednesday, December 26, 2012

The Adjustment Process - 2013 Outlook

The "Fiscal Cliff" is stealing the headlines as 2012 comes to an end.  That's a side show in our view.  It's virtually certain today's Congress will retain almost all of George Bush's tax code, rather than return to Bill Clinton's.  It's also a sure thing that any spending cuts will be spread over ten years, and that none will occur right away.  The political conflict is simple show business.  Higher tax rates on affluent Americans might briefly impact the country's growth.  But with a complete arsenal of loopholes still in place it won't take long for them to rearrange their affairs to avoid paying the government any more cash than they are now. 

The genuine economic variables are more complex.  Parts of the economy gathered momentum over the second half of 2012.  Housing and construction were especially robust.  That trend appears likely to continue.  Employment figures improved, too.  Productivity bounced back after a temporary swoon.  Exports were solid.  Corporate profit margins remained at elevated heights.  And the U.S. economic engine continued to be fueled by record setting federal deficits and even more amped up financial engineering by the Federal Reserve. Consumer confidence improved.  Households in general continued to deleverage, freeing up discretionary income.  Corporations accumulated cash.  China rebounded.  Japan promised to accelerate growth.  Europe stabilized.  A reasonable foundation was being created despite the political uncertainty.

Plenty of headwinds rose up, as well.  Most of those are natural developments that occur at this stage of the business cycle.  This time around, though, they present greater than normal danger because the initial recovery was so subdued.  The Obama Stimulus in 2009 failed to prime the pump.  Instead, the country's deficits and debt continued to escalate while GDP growth stagnated at 2% on average.  That was 1% below the customary U.S. trend line.  It should have been 1% above, considering the immense stimulus provided.  Under normal circumstances an adjustment process would take place to pay down the debts incurred and end the stimulus, returning the country to a normal everyday situation.  Unfortunately, the economy still is "fragile" by the President's own admission.  A huge shortfall between where we are and where we should be still exists.  But the debt and deficits are forcing an adjustment process, nonetheless.  It just will take place from a weak position, instead of a strong one. 

The upcoming year may be more challenging than some people expect.  The "Fiscal Cliff" negotiations are bound to cause some drag in the form of higher taxes.  Restoring the Social Security tax alone could lower personal income by $100 billion.  High earner taxes might pull away another $150 billion.  And the waiting around is likely to cause significant delays in receiving tax refunds, deferring disposable income further.  ObamaCare taxes will add $25 billion.  Health care costs in general are likely to rise as the law unfolds, moreover, pressuring inflation.  Most economists predict no inflation in 2013.  That forecast could prove optimistic.  The "Quantitative Easing 4" program now being conducted by the Federal Reserve is driving up inflation in foreign countries.  Those nations are buying Bernanke Bucks to prevent their own currencies from rising in value.  That guerrilla trade war could escalate, leading to a larger bubble.  Higher interest rates, higher inflation, higher unemployment, and lower corporate profits all could arise in 2013 as the adjustment process unfolds.

The stock market could react to those unanticipated developments.  Volatility already is climbing, even on positive days.  New issues are performing erratically.  If the Federal Reserve sticks to its guns and withdraws its bond buying program when inflation hits 2.5%, investors could beat a retreat.  Alternatively, the stock market could roar ahead if the central bank keeps fueling the system as inflation picks up.  Our guess is that the economy will slog ahead and fight through the policy obstacles.  A setback is possible as the new taxes and rules and regulations are absorbed.  But there's no reason why the long term outlook should be anything other than bright.

Our advice is to remain invested in a diversified portfolio of high potential growth stocks. 

Walter Ramsley
Executive Editor

January 2, 2013 Update - Congress passes the "Job Protection and Recession Prevention Act" last night.  The legislation looks terrific considering the parameters the lawmakers had to work with.  Our basic view towards 2013 is unchanged.  A poorly written law could have made matters worse.  Fortunately, that does not appear to be the case.  Income tax rates remain at low levels.  The hike on high earners begins at $400,000, twice the level expected.  Capital gain and dividend taxes remain low by historical measures.  Small business depreciation remains accelerated.  The estate tax threshold stays at $5 million.  While social security and health care taxes will rise the overall impact is unlikely to be severe.  Everybody likes to complain about Congress but this time it looks like it came up with a good compromise under difficult circumstances.

Friday, October 5, 2012

The Replacements

We kind of liked the "replacement refs" the NFL hired.  They called the game completely different than the regular refs did.  There was more contact on the receivers as they went out, making it harder to complete all those short Brady-to-Welker type passes.  It was tougher to get open.  That caused the offense to run more often, which was becoming a lost art under the "Fantasy League" rules the regular refs applied.  (We like the running game.)  The replacements also called more pass interference.  They made it easier for the defensive backs to cover the receivers.  But once the ball was in the air they had to play it straight.  The regular refs did it the other way, making it easier to get open but they gave the defensive backs more latitude if they could get to the ball.  All that is a generalization, of course.  The replacements missed a lot of calls.  They had a hard time keeping the game under control.  And they didn't coordinate with each other very well.  It was fun while it lasted.  But once they began to determine the outcome of games, everyone knew it was time for them to go.

The lasting image of the "replacement refs" was in the Green Bay game.  On the final play the defender and the receiver came down with the ball in the endzone.  Either it was a winning touchdown.  Or it was an interception that saved the day.  One ref called it a touchdown.  The other signaled interception.  It's kind of the way Barack Obama and Benjamin Bernanke interpreted the latest economic numbers.

Two weeks ago the Fed Chairman termed the unemployment situation "criminal" and launched another round of monetary stimulus.  He already had leaked his intentions over the summer, provoking a massive stock market rally.  The Federal Reserve Board's intervention probably lifted the Dow Jones Industrials by 1,000 points or more.  Left to its own devices the market might have stayed put, perhaps even declined.  It's impossible to say.  But corporate earnings were peaking and turning lower.  GDP and employment were trudging along, but at unspectacular rates.  And Washington was perfectly happy to continue the "New Abnormal" economic environment.  The politicians were figuring out ways to postpone the "fiscal cliff."  But nothing practical was on the table.

This week President Obama trumpeted the economic data as verification of his team's outstanding performance.  The unemployment rate declined.  The stock market remained at elevated levels.  Interest rates were low.  Everything was looking good.  The country was on the right path.  Re-elect the president.

Touchdown.  Interception.  Whatever.  Our view right along has been that Barack Obama and Benjamin Bernanke have been delivering mediocre results.  It could have been worse.  But in light of the phenomenal resources at their disposal, let's face it, mediocre is terrible.  Up 'till now the two have worked together, perhaps unwittingly, to create an unprecedented fiscal and monetary stimulus that should have resulted in a Super Boom.  In reality, the economy is barely keeping its head above water.  And when the bill comes due for all the stimulus, it's hard to figure what might happen -- but it probably won't be good.

If the Free Market is allowed to operate the United States could zoom ahead to the next exponential level.  There's tremendous technology waiting to be exploited.  There's ample wealth available to finance the required investment.  Despite all the bellyaching it's obvious America's youth is more talented than any generation that's come before.  They'll do it. Just get out of the way and give them the chance.

The stock market is artificially high at this point.  Earnings are pointed down.  The political scene could swing towards a European model for the next four years.  Despite the obvious negatives, our advice is to not worry about it too much.  The regulations and the rules and the intervention into the market and all the rest of it is a pain.  Of course, it would be better to get the real refs back in the game.  But as the Mighty Belichick would say, "It is what it is.  We will deal with it."

It's a problem.  But it's not an insurmountable one.  Stay invested in a diversified portfolio of Special Situation growth stocks.  The future is bright.  It might take longer if the "replacement refs" who run Washington keep interfering.  The long term outlook remains a good one, nonetheless.

Walter Ramsley
Executive Editor

Friday, August 10, 2012

Follow the Money

In our last report we postulated the Federal Reserve would force the U.S. Government to face reality.  Most investors have taken the opposite view, figuring another round of "quantitative easing" will soon be implemented instead.  The cover story there is that more money creation will reduce interest rates further, lift economic activity, and propel stock prices higher, reinforcing the uptrend via the so-called "wealth effect."  A lot of investors also have gained confidence from the prospect of quantitative easing in Europe.  That would entail printing up piles of new cash and using them to finance government deficit spending. 

The money printing might be necessary to keep Europe afloat.  The Continent certainly is in dire straits.  But it won't turn its economy around.  The Europeans will have to get serious and restructure away from their welfare states.  In the United States, more easy money probably would exert a negative effect.  The Federal Reserve appears to be aware of that.  While it might have to provide some liquidity if the Government goes off the fiscal cliff in December, chances are interest rates will begin rising later in 2012 no matter what happens.  The real world fundamentals just don't exist to support any more declines.

Energy costs have turned back up.  Food prices are starting to percolate.  Productivity has been declining for a while and that trend is continuing.  The Federal Government deficit remains elevated.  Medical spending is slated to surge next year as the Affordable Care Act's negative elements start taking effect.  Mortgage write-offs, retirement spending, welfare costs, disability costs, and a wide range of other mandated overhead expenses are surging.  Manufacturing unit costs are climbing as volume stalls and costs continue to advance.  Foreign bank bailouts and other rescue measures promise to strain the capital markets further.

Inflation is set to rise.  The demand for money also is poised to increase.  And it won't be practical to print endless amounts of new cash any more.  That will just make a bad situation worse.  The United States, and perhaps Europe, too, is headed for an adjustment process.  Chances are it won't be nearly as bad as everybody fears.  But it's something we'll have to work through.  There's no free lunch.

How the markets will react is beyond prediction.  If earnings remain on a downward path, though, portfolio allocations likely will switch towards bonds as long term interest rates become more attractive.  Our advice is to remain cautious until evidence develops that the current strategy will succeed; or the adjustment period gets underway.  Change creates opportunity.  An attractive buying opportunity could emerge.

Walter Ramsley
Executive Editor

Friday, June 22, 2012

Sink or Swim

We have been complaining about the Obama-Bernanke Groundhog Day Economic Cycle for a while.  That’s over.  Last Wednesday (June 20) Benjamin Bernanke -- the George W. Bush appointed Federal Reserve chief, who was reappointed by Barack Obama, God only knows why, he’s a Republican after all, and he supervised The Crash, he was in there 2 ½ years before it happened -- decided he’d had enough.

The previous three years he’d given the Obama Administration zero interest rates, $2.7 trillion in created money, a Wizard of Oz type of mind control over Wall Street – “We’ll just print up some more money, don’t worry, be happy” – on top of the $5.5 trillion and counting the President had deficit spent.  And they still couldn’t prime the pump, jump start the economy, just sit down for a day or two and figure out a solution.  Bernanke had seen enough.

Sink or swim.  The better choice would be to swim.  But that’s up to you.

We’ll see how it goes.  If Barack Obama wakes up, “What am I listening to these people for?” and starts thinking for himself.  He’s got a good chance.  This is a crisis situation.  If he takes charge, he wins. 

But if he keeps yacking about the 99% and the 1% and higher taxes and everything is great in America, it’s just a bad income distribution, we need more Latinos, it’s terrible that women doctors earn 12% less than male doctors, we need more gay Marines, let’s put biofuel in our jets, “Well, yes, it does cost $148.00 a gallon compared to $5.00 for normal jet fuel.” 

Maybe that’ll work. 

We’d say the better bet would be, “We got a problem here.  Enough with the niceties.  We’re going to fix things and we’re going to win.”

Walter Ramsley
Executive Editor

Monday, March 12, 2012

Groundhog Day

Groundhog Day Bill Murray played a weatherman who was doomed to repeat February 2nd over and over, at least until he fell in love.  Barack Obama and Benjamin Bernanke could have written the script, except for the falling in love part.  The President and Federal Reserve Chairman have been sending the United States economy around in circles since 2009.  And by the looks of it, Punxsatwaney Phil could be in the picture again this year.  Every year President Obama jacks up the economy with a federal deficit equal to 8%-10% of the country's entire GDP.  (That's a lot.  Jimmy Carter peaked out at 6%.)  In 2012 it's predicted to be $1.3 trillion out of $16 trillion in total output, or 8%.  That's four years running.  Approximately $5.5 trillion of total new debt obligations have been issued over than span.  Doctor Bernanke just unleashed Operation Twist in late 2011, moreover.  In 2009 he cranked up QE-1.  In 2010 he did QE-2.  Last year he also shipped $500 billion of cash to Europe to smooth out their problems.  But all that money hasn't been directed to the American people.  Per capita inflation adjusted income is down -6% since the President took over.  It's gone into the bond market instead -- anyone wonder why Warren Buffet is such a huge supporter -- and from there to every other market, particularly hard assets and commodities.

Print.  Stimulate demand.  Inflate commodity prices.  Crush demand.  Print.  The Obama-Bernanke Groundhog Day economic cycle. The fact most of the money being created is being steered into the capital markets, well, that's good for stock and bond prices.  And it probably was a solid strategy from an economic standpoint at the beginning.  Regrettably, the administration focused all its efforts on a variety of pet projects instead of high rate of return programs like housing, controlling China, and energy.  All that "stimulus" money has gone down the drain, from a practical standpoint.  But it has remained in circulation, pushing consumer prices higher.

 ( Click on Image to Enlarge )

The federal deficit has shoveled $5.5 trillion of new money into the system since the current administration took over.  The Federal Reserve has created at least $2.5 trillion more, probably $3.0 trillion after the latest gambit in Europe.  Despite all that, plus renewed stimulus efforts in Europe and China, real growth in the U.S. is stuck at a 2.0% annual rate.  Personal income growth is zero.  ("You can have a performance review if you want one.  But either way, you won't get a raise.") 

Maybe the American people will fight through the Government's policy obstacles.  The Federal Reserve recently indicated the economy was looking good and more stimulus won't be necessary.  But that's what they said the last three years, as well.  What if the economy can't get rolling?  More deficit spending and QE-3, most likely.  Groundhog Day!

Walter Ramsley
Executive Editor

Saturday, January 7, 2012

Corporate Earnings Outlook

S&P 500 earnings are predicted to rise 7% in the December quarter.  Three months ago the forecast was 15%.  Over the same time the economics community raised its outlook for GDP growth and employment.  Part of the shortfall stems from weaker than expected bank earnings.  The main culprit, though, is declining productivity.  The number of units is going up, bolstered mainly by a pick-up in consumer spending.  But unit costs are increasing, too.  Since early 2009 profit margins had been expanding, driving up profits faster than sales.  That trend has now reversed, at least temporarily.  Analysts predict that S&P 500 earnings will grow 4% in Q1 and another 4% in Q2.  Then they see things accelerating in the second half of the year, which is a customary way of looking at things on Wall Street.

It's a complicated situation with plenty of cross currents.  It's possible the conventional view will prove correct.  The U.S. Dollar has appreciated in value by 10% against the euro over the last two months, though.  That alone could throw today's predictions off the mark.  Foreign profits will be translated at less favorable rates going forward, if the new scenario holds.  Plus U.S. exports will be placed at a competitive disadvantage to European producers.  The tailwind exports are providing to U.S. business could slow in upcoming periods.  Slower growth around the world could amplify the impact.  We'll see how that goes but with every country in the world except the United States driving its currency down to protect its industry, American earnings might take it on the chin a little harder than most people expect.

The situation in China is another wild card.  That country probably will perform well over the long haul.  But most countries in early stages of development experience a variety of booms and busts.  And it looks like China could be in for at least a modest pullback.  The realization might be postponed for a year as the old government exits the scene in October, ideally on a positive note.  But significant adjustments appear to be in the cards.  All that might not have a material effect on U.S. corporate profits.  But it isn't likely to have a favorable one, either.

If earnings stall it's hard to see U.S. stock prices advancing sharply across the board.  They might, if it's just a brief slowdown in growth, not a reversal.  Still, our advice is to focus on high potential growth companies that are capable of producing superior results even if the overall economy flattens out.  P/E multiples are a little on the high side now, fueled by the Federal Reserve's easy money policy.  Worthwhile gains remain possible, nonetheless.  And the companies we focus on here are likely to reinforce their competitive advantages in today's uncertain business climate, laying the foundation for even larger gains ahead.

Walter Ramsley
Executive Editor

Friday, January 6, 2012

Deja Vu All Over Again

Hope springs eternal in the investment world.  A few curmudgeons may make their mark as curiosities.  But optimists rule the day on Wall Street.  And rightfully so, most of the time.  Over the long haul U.S. equity prices have appreciated 8% in value per year on average, including reinvested dividends.  That's outpaced bond portfolios by 3%-4% a year, depending how it's measured.  And even bonds have beaten inflation by a point or two, again depending on the time frame and the particular indexes used.  Looking at things one year at a time, the U.S. stock market has gone up three years for every one year it has gone down.  Wall Street makes its money by selling to securities, and it's easier to sell them when prices are rising.  Plus the odds actually are in favor of an advance, just looking at the long term data.  So it's not surprising the investment community is bullish today.  It's a natural instinct.  Whether there's any logic to it remains to be seen.

Prices are floating higher on the wings of Benjamin Bernanke's latest money printing scheme.  Let's call it "QE-squared" (Quantitative Easing - Europe).  The Federal Reserve shoveled half a trillion Dollars to Europe to support the banking system there.  It also persuaded the European Central Bank to "exchange" $600 billion of bad debt held by European banks for freshly made euros, propping up their balance sheets even further.  All that new cash is driving the euro down in value, which actually is making Germany and France quite happy because it's boosting their export competitiveness.  It's all looking good right now.  Same as it did when the Federal Reserve undertook its QE-2 routine last year.  Everyone thought they'd found an easy way out.  But there wasn't a genuine improvement in economic activity.  Inflation picked up.  Real incomes declined.  And that was that.

Here's our prediction.  The price of gasoline and other commodities will jump, just like they did the last time.  Last time the economy was cushioned by rising labor productivity.  That peaked in Q3 of 2011 and is still declining.  So the inflation impact might be harder this time.  Maybe some of the pressure will be alleviated by a warm winter, reducing heating bills.  But unless the supply of goods and services picks up the leap in the money supply is bound to show up.  That will nip consumer spending in the bud.  Maybe Europe will avoid problems.  Maybe China will keep it together while a new government is formed.  But whatever happens, the world is not going back to normal.  The zero interest rate policy and the massive deficit policy will continue.  That's going to scare people, and keep progress under wraps.

Our advice is to remain cautious.  Right now monetary policy is amazingly expansionary.  The Obama Administration is just creating money like crazy.  The monetary base, which usually grows 5% a year in normal times, is up 30% over the last 12 months.  Free reserves at the Federal Reserve, which usually total $3-$5 billion, are now over $2.2 trillion.  The federal budget deficit, which normally is 2%-3% of GDP and temporarily peaks at 6% for 1-2 years when the need arises to prime the pump, currently is 9%-10%.  And it's been there for three years.  And the Government wants it to go up in 2012.  Maybe it will all just blow over.  Our recommendation is to prepare for an adjustment process, though, one that might involve some material pressure on the financial markets. 

Walter Ramsley
Executive Editor