Thursday, September 25, 2014
Special Situation Investing
The U.S. stock market has come under renewed pressure. In the short run prices are falling across the board. Before long, though, the fear is likely to dissipate. Investors then will put all that cash back to work.
Special Situation growth stocks thrive in periods like this. Capital always seeks out its highest return. Every once in a while the market loses its bearings and measures those returns in non-financial ways, like website clicks or probable barrels of oil reserves. It invariably comes back to money, though. Special Situation growth stocks produce the best returns because they consistently make money, they increase those earnings quickly, and the price to get into the stocks isn't particularly high. They are under priced in relation to their true value.
Special Situation growth stocks share a number of characteristics. They're in the "Post-venture, Pre-institutional" segment of the market. The companies are out of the development stage. But the stocks still haven't been picked up by the mutual fund community to any meaningful extent. They have several years of experience with clear-cut track records. Finances are solid. Management is proven. The products and services have unique elements, so margin potential is high. The companies are scalable with superior returns on invested capital. Some external financing might be necessary to fund exceptionally fast periods of growth. But dilution tends to be modest because cash flow generation usually is sufficient to support growth internally.
There are three basic types of stocks we focus on. The first are "natural breakouts." These often are the most profitable. They also are the most difficult to find. This group consists of companies that are middle of the pack growth companies -- that catch fire. They've spent years cultivating their business. Now it's taking off. If you wait too long to purchase these shares they get discovered by other investors instead. Get in too early, you run the risk of buying the story instead of the facts. The only way to discover a "natural" is to scan the universe for signs of acceleration, and dig down into every one. Most are aberrations. But a few are the genuine article. In those cases the payoff can be terrific. Examples include Profire Energy ("American") and Highpower International ("Fuel Forethought").
The second group are established growth companies with upside kickers. Investors are inundated with stories about companies that are gonna' do this or gonna' do that. In their younger days those investors probably were swept up by some of these stories. They've learned the hard way that it's a hard world. Very few of these things ever pan out. So investors as a group don't pay a premium for them in the market. Special Situation growth stocks already have a proven business, though. That gives them an edge. The core operation is delivering 15%-25% growth or more. Unlike the start-ups that investors are accustomed to, new initiatives at these companies tend to be well thought out and adequately financed. Their success rate is higher. Not all of those initiatives prove successful. It's still a hard world. But even when they don't you haven't paid for the kicker. And the core business keeps rolling along. Examples include Northern Technologies ("American") and Pure Technologies "(International").
We include a handful of high risk selections, as well. Management at these companies have an established track record, either in development work or at previous employers. But the commercialization phase is just starting. Risk is elevated because there is no core business to pay the bills if things get delayed. It's do or die. But this type of Special Situation growth stock normally has a disruptive technology aimed at a huge industry. Even modest penetration can lead to unusually high stock price appreciation. Because of the risk we have to keep this segment to a low percentage of the entire portfolio. The payoffs can be fantastic, though. Even small positions can amplify the portfolio's entire return. Examples include Tesla Motors ("Fuel Forethought") and Lightbridge Technology ("Fuel Forethought").
Special Situation growth stocks don't grow on trees. You need to know what to look for. And it takes a lot of looking. Computer screens are great at generating leads. Watch the news. Study the IPO market. There's no end to where the ideas can come from. The key is to know what you're looking for and to do the work yourself. Even at the institutional level -- perhaps especially at the institutional level -- the last thing you want to do is listen to a research analyst or broker's buy recommendation. That ship has sailed by the time they figure it out and finally tell you about it. Do the work yourself. Then trust it.
Sound portfolio management controls risk and helps generate consistent, superior returns. Academic studies suggest 5-8 stocks provide sufficient diversification. We generally own 20-25 stocks ourselves, to make sure the volatility is kept in check. Every stock you buy looks like a winner the day you buy it. Experience shows that 10%-20% won't work out as expected, though. And only 10%-20% are going to achieve their maximum potential. The 60%-80% in the middle are solid growth companies. That component frequently outperforms the market all by itself. The super winners invariably are bigger than the losers, moreover, lending further ammunition. Our advice is to equal weight the portfolio. Nobody can predict how each stock will go. Use a systematic approach. Do the basic analysis correctly. The math will take care of the rest.
It's pretty simple. Special Situation growth stocks have a well established track record of success extending back to the mid 1970s. We think that trend will continue.
Walter Ramsley
Executive Editor
Saturday, August 2, 2014
Don't Cry for Me, Argentina
Everybody had a good to reason to explain why the stock market caved in last week. Our comments last month discussed how investors had ignored a series of threats while bidding prices up to record levels. Last week those threats caught up.
Potential policy changes at the Federal Reserve are the greatest concern. The decision earlier in the year to eliminate "quantitative easing" created a sell-off in April. That proved to be a shot across the bow. At last week's meeting, though, the bond buying program dropped to $25 billion per month -- down from the $85 billion pace Ben Bernanke originally set up. That grabbed people's attention. By October it will be zero. Whether it's myth or reality, most investors believe (deep down) that stock prices levitated 30% in 2013 because of quantitative easing's stimulative powers. Now they're afraid valuations will reverse course once the money is withdrawn. Corporate earnings have expanded 15% during the two years that QE-4 has been in place. So even if valuations return to where they began the pullback shouldn't be a full retreat. Still, in this day and age most money managers are graded on how well they do every quarter, if not every month. There are a lot of itchy trigger fingers out there.
Argentina's bond default got a lot of people thinking about the potential for unexpected side effects. That particular situation is small potatoes. Argentina had the funding in place to complete a refinancing -- one that included a substantial write down. An American hedge fund insisted on full repayment and hung up the deal, causing a technical default. The larger question investors began to ask is, "What about Russia?" That's a big time country with complicated and vast financial ties. Might the bank sanctions now going into effect cause some missed payments? And what would that cause? And while we're at it, if the Federal Reserve tightens how's that going affect the Third World? The U.S. Dollar already is undervalued. If it just returned to normal currency values could plummet in some weaker economies, like Brazil. If interest rates go up in America, that would make it even more of a pressure cooker.
Those are genuine concerns.
Lucky for the people who live in America, none of this presents a major problem. Indirectly it sure could, if you're invested in a Philippines rubber plantation or something. But the U.S. economy is well insulated from those financial dangers. And quite frankly, the fighting in Syria, Israel, the Ukraine, and Africa doesn't have anything to do with us, either.
Some economists say the U.S. economy is gaining momentum. Others say that may be true but it doesn't matter because so many idle resources still exist. The official unemployment rate is 6.2%. But if the same number of people were in the work force today as there were in 2007, before the crash, the rate would be 10.2%. Clearly, some people have left the work force and are never coming through that door again. Still, if there was money to be made a lot of those non-workers would be back in a flash. On top of that, corporations have amassed unprecedented cash reserves. Capital spending has been low and the outlook remains mediocre. If a pick up ever does materialize a handful of companies might have to borrow to fund their expansion efforts. On balance, though, the spending would be financed internally, alleviating any pressure on interest rates.
The economy could be slowing down a little, in fact. Consumer spending is going nowhere. Housing is nothing special. Government spending is up in some areas (health care) but down in others (military). Back to school spending is off to a ho-hum start. Things could change. Right now, though, it looks like 2%-3% real GDP growth is here to stay.
The stock market is its own animal. The elimination of QE-4 could exert a direct impact on market liquidity. Then the question becomes, "Where do you put the cash instead?" It's not going into the economy. Dodd-Frank continues to prevent small businesses from starting up and expanding. The Affordable Care Act adds further costs and regulations. The regulatory apparatus in general weighs on businesses of all stripes and sizes. Corporate buybacks will continue. Money created by the European Central Bank will gravitate to America. And quite frankly, the U.S. money supply grew at 7% a year before QE-4 and it grew at 7% a year while it was in place. The extra money was siphoned away and deposited as "excess reserves" at the Federal Reserve. The whole thing has been a smoke and mirrors job. Market liquidity is unlikely to change much, if it all.
We think the market will be fine. We think America will be fine. Over the long haul corporate tax rates are certain to decline, increasing earnings. Economic activity should accelerate once the more onerous regulations are modified to encourage more realistic and productive behavior. That will boost sales growth, leveraging profit margins. The rest of the world should grow. U.S. companies will participate in that, too. American oil and gas production is on the rise. Less money for OPEC. Lower costs for us. And less need to defend far flung oil reserves.
Don't worry about Argentina. Don't worry about the stock market. Remain invested in a diversified portfolio of high potential Special Situations.
Walter Ramsley
Executive Editor
Potential policy changes at the Federal Reserve are the greatest concern. The decision earlier in the year to eliminate "quantitative easing" created a sell-off in April. That proved to be a shot across the bow. At last week's meeting, though, the bond buying program dropped to $25 billion per month -- down from the $85 billion pace Ben Bernanke originally set up. That grabbed people's attention. By October it will be zero. Whether it's myth or reality, most investors believe (deep down) that stock prices levitated 30% in 2013 because of quantitative easing's stimulative powers. Now they're afraid valuations will reverse course once the money is withdrawn. Corporate earnings have expanded 15% during the two years that QE-4 has been in place. So even if valuations return to where they began the pullback shouldn't be a full retreat. Still, in this day and age most money managers are graded on how well they do every quarter, if not every month. There are a lot of itchy trigger fingers out there.
Argentina's bond default got a lot of people thinking about the potential for unexpected side effects. That particular situation is small potatoes. Argentina had the funding in place to complete a refinancing -- one that included a substantial write down. An American hedge fund insisted on full repayment and hung up the deal, causing a technical default. The larger question investors began to ask is, "What about Russia?" That's a big time country with complicated and vast financial ties. Might the bank sanctions now going into effect cause some missed payments? And what would that cause? And while we're at it, if the Federal Reserve tightens how's that going affect the Third World? The U.S. Dollar already is undervalued. If it just returned to normal currency values could plummet in some weaker economies, like Brazil. If interest rates go up in America, that would make it even more of a pressure cooker.
Those are genuine concerns.
Lucky for the people who live in America, none of this presents a major problem. Indirectly it sure could, if you're invested in a Philippines rubber plantation or something. But the U.S. economy is well insulated from those financial dangers. And quite frankly, the fighting in Syria, Israel, the Ukraine, and Africa doesn't have anything to do with us, either.
Some economists say the U.S. economy is gaining momentum. Others say that may be true but it doesn't matter because so many idle resources still exist. The official unemployment rate is 6.2%. But if the same number of people were in the work force today as there were in 2007, before the crash, the rate would be 10.2%. Clearly, some people have left the work force and are never coming through that door again. Still, if there was money to be made a lot of those non-workers would be back in a flash. On top of that, corporations have amassed unprecedented cash reserves. Capital spending has been low and the outlook remains mediocre. If a pick up ever does materialize a handful of companies might have to borrow to fund their expansion efforts. On balance, though, the spending would be financed internally, alleviating any pressure on interest rates.
The economy could be slowing down a little, in fact. Consumer spending is going nowhere. Housing is nothing special. Government spending is up in some areas (health care) but down in others (military). Back to school spending is off to a ho-hum start. Things could change. Right now, though, it looks like 2%-3% real GDP growth is here to stay.
The stock market is its own animal. The elimination of QE-4 could exert a direct impact on market liquidity. Then the question becomes, "Where do you put the cash instead?" It's not going into the economy. Dodd-Frank continues to prevent small businesses from starting up and expanding. The Affordable Care Act adds further costs and regulations. The regulatory apparatus in general weighs on businesses of all stripes and sizes. Corporate buybacks will continue. Money created by the European Central Bank will gravitate to America. And quite frankly, the U.S. money supply grew at 7% a year before QE-4 and it grew at 7% a year while it was in place. The extra money was siphoned away and deposited as "excess reserves" at the Federal Reserve. The whole thing has been a smoke and mirrors job. Market liquidity is unlikely to change much, if it all.
We think the market will be fine. We think America will be fine. Over the long haul corporate tax rates are certain to decline, increasing earnings. Economic activity should accelerate once the more onerous regulations are modified to encourage more realistic and productive behavior. That will boost sales growth, leveraging profit margins. The rest of the world should grow. U.S. companies will participate in that, too. American oil and gas production is on the rise. Less money for OPEC. Lower costs for us. And less need to defend far flung oil reserves.
Don't worry about Argentina. Don't worry about the stock market. Remain invested in a diversified portfolio of high potential Special Situations.
Walter Ramsley
Executive Editor
Wednesday, June 25, 2014
Don’t Look Back… …Something Might Be Gaining On You – Satchel Paige.
If you’re a regular reader of these pages then you know that we harbor a fondness for most things baseball. The game is at once purely American and thoroughly idiosyncratic. It’s a game of inches and it’s a game of wits. A contradictory pass-time: games have no time limit yet speed is highly rewarded. It is a treasure trove of wit and wisdom, too, that at once illuminates both the game and life. Small wonder that it can also provide guidance to students of the markets, as well.
As of this writing, most professionals are
waiting, with some trepidation, to hear about one of the bigger gremlins: first
quarter U.S. Gross Domestic Product (GDP) growth. Markets have been in full
Bull mode for well over a year now, based at least in part on the assumption
that the U.S.
Because so many people are interested in this
number every quarter, the Commerce Dept. actually does this calculation 3
times. A flash estimate is produced once the first 2 months of a quarter are
“in the can.” After the quarter is completed a full quarter estimate is then
calculated. Finally, once all the numbers are in, a final report of the annual
rate at which GDP grew in a quarter is published.
The flash estimate for Q1, 2014 came in last
month at a rather anemic +0.1%. The chill winter weather that brutalized much
of the industrial heartland and the trucking and rail lines that traverse it
got most of the blame for the number being on the light side. It is tough
to get to work when your car is snowed in, frozen solid or your bus doesn't
show up in the morning so most economists looking over Commerce's shoulder
expected this figure to be lower than even the modest recent trend.
Eyebrows shot up like Roman candles when the
full quarter estimate came out at a -1.0%. Cold weather was again blamed for
turning down the thermostat on the
economy. But there were other factors at work, it seems. Investment, one of the
4 main components of GDP, and the most critical one for job creation, was
looking very “molasses in January”-like, too. Since most investing these days,
be it in stocks and bonds or plant and equipment, happens inside of computer
spreadsheets and networks, the weather is not as huge a factor as it is in consumption
(people can't get to the mall) or export (goods can't get to shipping
terminals). Health care services spending also took a surprising dip. This not
a great portent for either the benighted Affordable Care Act or for the final
Q1 GDP growth rate.
We could be in for a lower “real” number than
either of those estimates, perhaps as low as
-2.0%. Many strategists are assuming that there will be a robust
snap-back from what they think is an entirely weather-related phenomenon. We'll
see. Consensus expectations for 3%+ growth this year will need to be adjusted
downward in a major way if Q2 does not show a big reversal. A lower GDP rate ultimately
means that companies' competition for their share of the business pie gets
tougher because there is less growth to go around.
What else might be gaining on the markets?
Inflation, for one. Our main takeaway from the most recent Fed Open Market
Committee meeting is that “Core Inflation” may, in their view, be starting to
heat up. This Core Inflation measure is what the Fed uses to guide them in
fulfilling their mandate to promote price stability; it removes energy and food
prices because of their volatility. Now, when we do our budget every month,
food and energy are pretty big factors in figuring if there will be “any month
left over when the money runs out.” According to the Fed's math, inflation has
been in check for several years, even though most everything that people spend
money on costs more.
Should price inflation by the Fed's measure heat
up, then we're all in for some tough decisions. The Fed, too. They'd like to
keep borrowing rates at the rock bottom levels they've engineered. But higher
inflation could force them to raise those rates, which would translate into an
increase in the cost of capital. Typically, that's not good for stock prices.
However, some believe this could ultimately be a good thing, since the rate
structure we have now is artificially imposed and is grossly distorting capital
investment policies. If forced to decide, we'd join the latter camp.
On the world front, fractiousness in Eastern
Europe and turmoil in Iraq
and Syria Washington , D.C.
Perhaps the biggest something that might be
gaining on us is the national debt. It has now surpassed the nation's GDP and
it is growing at a faster rate. Should the rate of interest that the Federal
government pays to carry this level of debt increase, it alone could blow out
our government's already dysfunctional budgeting capabilities.
So, there are plenty of “somethings” that might
be gaining on us. Moreover, left to themselves, the capital markets are
the best mechanism we have for discounting what may lie ahead and allocating resources
accordingly. Almost by definition, markets don't look back, they look
forward. Normally, a rising market is telling us that all of the somethings
we talk about and fret over are already known, already “built in” and that
something better is coming along. And, normally, we can't ever quite completely
believe it. That's why we always return to our core belief in Special Situation
investing. Government meddling, foreign intrigues, even “Black Swans” come and
go. But there are always Special Situations, companies discovering new needs
that people want to satisfy and devising new ways of making things or doing
things to satisfy them. Dozens, if not hundreds, of such companies. They don't
all succeed but they all go their own way. They don't look back. They don't
have time to.
PS Bonus Satchell Paige quote: “My pitching philosophy is very simple;
you gotta keep the ball off the fat part of the bat.” Can the Federal Reserve
keep our economy off of the fat part of inflation's bat yet keep the ball over
the plate? Sounds like a tough job for a rookie pitcher like Janet Yellen.
R. Russell Last, CFA
Walrus Partners, President
Sunday, April 6, 2014
Déjà Vu - All Over Again
Two years ago we summed up the first three years of the Obama Administration by comparing it to the movie "Groundhog Day." It's hard to believe Washington still is frozen in time. But here we go again. The Federal Reserve kept its printing press running longer than usual on this go around. The bell finally has tolled, though. Commodity inflation is beginning to gain momentum. Monetary policy has begun its pendulum swing in the other direction. At this stage in the economic cycle that normally would be a positive development. Rising prices would signal a pick-up in production, wages, and well-being. Real output is not expanding, though. This is the fourth time the Fed has withdrawn its quantitative easing activities since the economy collapsed in 2008. And it will be the fourth time it's done so without anything to show it. (Except $2.5 trillion in excess bank reserves, which nobody knows what to do with.)
Washington implemented a crackpot stimulus plan in 2009. It didn't prime the pump. The spending went into pet projects instead of tried and true building blocks like highway and airport construction, investment credits, and employment incentives. It's understandable that the Obama Administration paid back its supporters, having just won the election. Once those gifts were handed out, though, it needed to get serious. Regrettably, the pet projects have continued. The Federal Reserve has been hung out to dry. There is no fiscal plan to put all that money to productive work. Here we go again.
The stock market has seen the handwriting on the wall. In January we pointed out that biotechnology and new age software stocks were trading at elevated levels, fueled by Benjamin Bernanke's easy money. The business fundamentals weren't there to support those valuations in the event the cash was removed. In fact, the punch bowl hasn't been taken away yet. The Federal Reserve is continuing to buy $55 billion of bonds every month. The plan is to reduce those purchases over the rest of 2014, though. Wall Street wasn't sure how to respond the first three times that happened. This time it knows what to do. It's selling.
Most market experts predict the pullback will be contained to the high fliers. That could be an optimistic view of things. Earnings and sales have stalled in the March quarter. The weather may have contributed to that. But things aren't picking up that much. Low interest rates probably will support equity prices even if earnings growth flat lines in upcoming periods. But P/E multiples in general are at the high end of their historic range. If investors conclude that Quantitative Easing alone isn't capable of fueling a rebound -- ever -- those valuations may come down. The stock market won't "look over the valley" if all it sees is an endless plain.
"The business of America is business." Today the Government is interfering with that. Pockets of innovation always spring up in this country, though. Energy, medical technology, software, and industrial automation are creating a better life despite the obstacles of regulation, taxes, and ineffective programs. Companies with unique products and services can succeed in virtually any environment. Our advice is to remain invested in a diversified portfolio of Special Situation stocks. Let us worry about the general market.
Walter Ramsley
Executive Editor
Friday, January 17, 2014
Welcome to the New Growth Stock Insider
The stock market enjoyed spectacular results in 2013. Growth stocks were especially good performers. All sectors benefited from the Federal Reserve Board's expansionary tailwind, though. The average stock, measured by the Value Line Geometric Index (which weights every ticker equally), advanced 33.0% during the course of the year. Higher earnings per share contributed 8% (estimated); expanded price-to-earnings multiples accounted for the balance (25%). That's a trend that's been going on since the market recovery began in March 2009. Earnings have been trudging forward through economic headwinds that have made it difficult for companies to expand properly. Rather than invest in new assets and boost hiring most earnings improvement has been the result of productivity gains (layoffs) and financial engineering (buybacks). Stock performance has been good because of the expansion in P/E multiples, a result of easy money policies.
Growth stocks have done better because their incomes have risen faster. The rarity of better than average income growth tended to amplify that P/E expansion, sometimes leading to eye popping results. Acquisition activity reinforced the build-up in speculative fever. Biotech and new age software stocks have been the leading beneficiaries. Many companies have experienced tremendous stock price gains despite not having any earnings at all. Both groups typically spend more on marketing and R&D than they generate in total revenue, let alone cover overhead costs. Cheap money has made it easy for Wall Street to reward that approach, arguing it's a land grab and they can cut back on expenses later. It's kind of the same idea the Federal Reserve has been pursuing towards the whole economy. Lay out the money now and pull it back when everything returns to normal.
We've expanded Growth Stock Insider to include some additional investment options. The central core of the website continues to be fast growing undiscovered growth stocks. Those issues generally perform well in all types of economic conditions. Scott Billeadeau, who recently joined Walrus Partners as a portfolio manager, will help us write those stories. Scott's an industry veteran who has produced superior results in the emerging growth stock area for several decades. Besides bringing us considerable insight and experience he has a deft touch with these stocks, which can be tricky to handle at times when trading them in the market.
We've also introduced three new sections that promise useful diversification potential. Additional Wall Street experts with proven ability have been brought in the contribute those reports. Each of those blogs will be chock full of valuable information that will expand our investment horizons. Overall performance could be enhanced by the wider field of view. Risk exposure could decline, as well.
Fuel Forethought
First off, though, we're going to highlight a blog we launched in 2012 when alternative energy stocks were at their nadir. Overcapacity swamped the solar power industry. Margins were compressed. Sales were barely growing. The headlines were full of bankruptcy stories, government failure, and as much doom and gloom as you could imagine. Along came Eric Ramsley, our web site's producer. As far as he could see -- and we came to see, too -- solar power actually was becoming cost competitive out in the real world. And the electric vehicle investments the Obama Administration made in 2009 looked like they might be bearing fruit, in particular at a tiny unknown California start-up known as Tesla Motors.
Eric took the bull by the horns, started working through the downtrodden green industries, and spotlighted a number of high potential candidates. That move panned out in a big way. And we're sticking with his basic plan. On the macro level oil and natural gas remain the world's primary energy drivers. And the development of horizontal shale drilling techniques probably will make the United States the world's leading energy producer again before long. That, more than any amount of Bernanke Bucks, probably will drive the country's economy forward over the next several decades. But in the small cap neck of woods green energy stocks offer excellent profit potential. Keep a close eye on this blog.
Dividend Growth Strategy
Most dividend investors look for yield and the price be damned. That works great until the interest rate curve starts climbing, causing the underlying asset values to fall. Recent research has demonstrated that a better way to go is to buy companies with a proven track record of increasing dividend payments. That way you get some immediate income. There also is a much greater chance of stock price appreciation. These companies typically are larger, more established growth companies that can afford to pay a portion of their earnings out as dividends while still investing in their operations to deliver future growth. Most are industry leaders will proven management teams and solid finances, similar to our smaller recommendations. They've captured a significant part of their potential markets, though, and have money to spare for shareholders.
Keith Wirtz, who's managed several dividend growth portfolios in the past and currently is forming another one at Walrus Partners, has agreed to write the blog. The companies he focuses on are top flight operations with a clear cut record of escalating dividends. Results have outperformed the general market on an historical basis. Risk also has been contained, below the market's norm.
Corporate Spin-Offs
Everybody on Wall Street talks about "unlocking shareholder value." A few companies actually do it. Analysts love to talk about stocks being worth the sum of their parts. Down in the trading pit, though, that's usually the last thing on people's minds. Companies that are out of favor for one reason or another sometimes have extremely lucrative divisions or subsidiaries that are camouflaged by the holding company's better known problems. Quite often, those nuggets don't receive any kind of credit in the market. Even if investors are aware and nod at them in passing they won't pay up because the units are locked away. The assets aren't worth anything to outside investors. They can't be monetized.
Mark Billeadeau, a contributing editor, has found a way to profit from those mispriced opportunities. Bolstered by the rising tide of liquidity that's become available, more and more companies are spinning off those divisions to shareholders, often in tax efficient distributions. Others take them public, selling a partial interest. The more adventuresome dream up custom tailored vehicles to get the job done. Mark analyzes those transactions to identify spin-offs that are worth more than what they're initially offered at. As investors become familiar with the new spin-off the stock price often improves. There's a gravitational pull moving the starting price up to where the fundamentals say it belongs. Other times Mark plays those transactions in reverse. Those deals benefit the holding company to a larger extent.
Mark manages a portfolio that's built with corporate spin-offs. Results have outpaced the general market since inception. It's impossible to predict when these opportunities will arise. The number of ideas that Mark writes about here may be sporadic at times. But he has plenty of old stories to tell, which are instructive in themselves. And some of those are still going strong. These reports appear in our new "Guest Columnists" section. We will recruit additional writers with unique investment ideas, as well.
Short Cellar
We had to scramble the name a little to prevent Google and the NSA and all the other search engines out there from zeroing in on us. Hopefully you get the picture. There are hundreds of stocks in the market today that trade at fabulous valuations without the benefit of an underlying earnings base. Others rely on accounting gimmicks, perfectly legal under modern S.E.C. regulations, yet gimmicks nonetheless. These reports will be anonymously written, for obvious reasons. And quite frankly, most if not all will offer positive credit to the management teams involved. As we indicated earlier, Wall Street drives a lot of companies to produce short term metrics that don't always prove sustainable over the long haul. And even when a strategy makes sense, conditions can change. The best laid plans of mice and men can come undone for reasons even the mice don't understand.
Most short cellars are grumpy souls who hurl damaging allegations that tend to have elements of truth in them, but often are hyperbolic. Most companies really are on the level and are trying the best they can for shareholders. Still, the stock market is the stock market. Celling short is a good mechanism for hedging a portfolio. And thoughtful research efforts can uncover overvalued issues even when the overall market is advancing. We'll be interested to hear your feedback on this section.
Market Outlook for 2014
We've been researching growth stocks our entire career. When we first began on Wall Street our supervisors taught us, "Don't worry about the market. Find some winning stocks and stay invested in them." That remains excellent advice.
For those of you who want to worry, start with the idea that valuations are elevated and investor confidence is at euphoric levels. That's nearly certain to foreshadow a drop at some point. But conditions like these lasted for years during the Vietnam War, the Reagan Era, and during the Internet Boom. Remember how long it took before housing prices finally declined. In every case you could say it was a fluke the sell-off happened at all. What if Egypt hadn't attacked Israel and set off the oil embargo. What if the banking regulators had figured out a way to transition the S&Ls into the mainstream banking industry. What if the broadband Internet had been deployed a few years earlier. In the 1950s nothing major went wrong and the market just rolled.
In 2014 the United States financial system is in uncharted territory, with all the Quantitative Easing that's been taking place. The easy part of the easing process is over. Now the economy appears to be coming to life. The question everyone has been asking from the start may finally be answered: "What if it works?"
When Benjamin Bernanke initiated the Quantitative Easing program in 2008 the Federal Reserve held $500 billion of securities. The U.S. banking system had excess reserves at the Fed (deposits the banks could demand back at a moment's notice) totalling $6 billion. Today, the Fed holds $3.8 trillion in securities. The banks have $2.5 trillion in excess reserves at the Fed. That money used to trade in the commercial paper market or the fed funds market, financing inventories and receivables and whatever else required short term funding. Today it sits at the Fed earning 0.25% interest, which is higher than a bank can earn in those other markets. The Fed is keeping that money out of circulation by outbidding the market.
During the past 12 months the Federal Reserve says it purchased $85 billion a month in securities in the open market -- $1.02 trillion in total. Over the same time the M-2 money supply in the United States increased by $634 billion. That's a gap right there of $386 billion. But it's worse than that because new money entering the system usually multiplies at a 1.5x rate as banks make loans off those reserves. Before the crash it was closer to 2.0x. So all the talk about "printing money" is technically correct. It's just that most of it has disappeared into the bowels of the Federal Reserve, categorized as excess reserves. It doesn't count in the money supply because it doesn't move.
What if it starts moving? The new Federal Reserve chief, Janet Yellen, could have a challenge on her hands if the economy genuinely accelerates and the banks withdraw the funds it has on deposit at the Fed. It's their dough. They're entitled to it. But if the money comes out quickly the M-2 numbers are going to surge, threatening inflation and who knows what else. Ms. Yellen could start selling the Fed's bond portfolio to soak up the cash. That would address the problem. But it might propel interest rates to unpredictable levels. Alternatively, the Government could freeze the money, Argentina style. That seems unlikely. But who knows.
An interesting twist might occur if some big players in the U.S. financial system figure a way to profit from such a crisis. George Soros brought down the Bank of England in the 1990s. Is there anybody out there today with the gumption and the resources and the brains to create a run on the Federal Reserve Bank of the United States? The Obama Administration has been hammering the banks and hedge funds with gigantic fines, brutal regulations, even prison sentences. As the saying goes, "Friends come and go. Enemies accumulate."
It's an unlikely scenario. But if you want something to worry about, that's not a bad one.
Walter Ramsley
Executive Editor
Growth stocks have done better because their incomes have risen faster. The rarity of better than average income growth tended to amplify that P/E expansion, sometimes leading to eye popping results. Acquisition activity reinforced the build-up in speculative fever. Biotech and new age software stocks have been the leading beneficiaries. Many companies have experienced tremendous stock price gains despite not having any earnings at all. Both groups typically spend more on marketing and R&D than they generate in total revenue, let alone cover overhead costs. Cheap money has made it easy for Wall Street to reward that approach, arguing it's a land grab and they can cut back on expenses later. It's kind of the same idea the Federal Reserve has been pursuing towards the whole economy. Lay out the money now and pull it back when everything returns to normal.
We've expanded Growth Stock Insider to include some additional investment options. The central core of the website continues to be fast growing undiscovered growth stocks. Those issues generally perform well in all types of economic conditions. Scott Billeadeau, who recently joined Walrus Partners as a portfolio manager, will help us write those stories. Scott's an industry veteran who has produced superior results in the emerging growth stock area for several decades. Besides bringing us considerable insight and experience he has a deft touch with these stocks, which can be tricky to handle at times when trading them in the market.
We've also introduced three new sections that promise useful diversification potential. Additional Wall Street experts with proven ability have been brought in the contribute those reports. Each of those blogs will be chock full of valuable information that will expand our investment horizons. Overall performance could be enhanced by the wider field of view. Risk exposure could decline, as well.
Fuel Forethought
First off, though, we're going to highlight a blog we launched in 2012 when alternative energy stocks were at their nadir. Overcapacity swamped the solar power industry. Margins were compressed. Sales were barely growing. The headlines were full of bankruptcy stories, government failure, and as much doom and gloom as you could imagine. Along came Eric Ramsley, our web site's producer. As far as he could see -- and we came to see, too -- solar power actually was becoming cost competitive out in the real world. And the electric vehicle investments the Obama Administration made in 2009 looked like they might be bearing fruit, in particular at a tiny unknown California start-up known as Tesla Motors.
Eric took the bull by the horns, started working through the downtrodden green industries, and spotlighted a number of high potential candidates. That move panned out in a big way. And we're sticking with his basic plan. On the macro level oil and natural gas remain the world's primary energy drivers. And the development of horizontal shale drilling techniques probably will make the United States the world's leading energy producer again before long. That, more than any amount of Bernanke Bucks, probably will drive the country's economy forward over the next several decades. But in the small cap neck of woods green energy stocks offer excellent profit potential. Keep a close eye on this blog.
Dividend Growth Strategy
Most dividend investors look for yield and the price be damned. That works great until the interest rate curve starts climbing, causing the underlying asset values to fall. Recent research has demonstrated that a better way to go is to buy companies with a proven track record of increasing dividend payments. That way you get some immediate income. There also is a much greater chance of stock price appreciation. These companies typically are larger, more established growth companies that can afford to pay a portion of their earnings out as dividends while still investing in their operations to deliver future growth. Most are industry leaders will proven management teams and solid finances, similar to our smaller recommendations. They've captured a significant part of their potential markets, though, and have money to spare for shareholders.
Keith Wirtz, who's managed several dividend growth portfolios in the past and currently is forming another one at Walrus Partners, has agreed to write the blog. The companies he focuses on are top flight operations with a clear cut record of escalating dividends. Results have outperformed the general market on an historical basis. Risk also has been contained, below the market's norm.
Corporate Spin-Offs
Everybody on Wall Street talks about "unlocking shareholder value." A few companies actually do it. Analysts love to talk about stocks being worth the sum of their parts. Down in the trading pit, though, that's usually the last thing on people's minds. Companies that are out of favor for one reason or another sometimes have extremely lucrative divisions or subsidiaries that are camouflaged by the holding company's better known problems. Quite often, those nuggets don't receive any kind of credit in the market. Even if investors are aware and nod at them in passing they won't pay up because the units are locked away. The assets aren't worth anything to outside investors. They can't be monetized.
Mark Billeadeau, a contributing editor, has found a way to profit from those mispriced opportunities. Bolstered by the rising tide of liquidity that's become available, more and more companies are spinning off those divisions to shareholders, often in tax efficient distributions. Others take them public, selling a partial interest. The more adventuresome dream up custom tailored vehicles to get the job done. Mark analyzes those transactions to identify spin-offs that are worth more than what they're initially offered at. As investors become familiar with the new spin-off the stock price often improves. There's a gravitational pull moving the starting price up to where the fundamentals say it belongs. Other times Mark plays those transactions in reverse. Those deals benefit the holding company to a larger extent.
Mark manages a portfolio that's built with corporate spin-offs. Results have outpaced the general market since inception. It's impossible to predict when these opportunities will arise. The number of ideas that Mark writes about here may be sporadic at times. But he has plenty of old stories to tell, which are instructive in themselves. And some of those are still going strong. These reports appear in our new "Guest Columnists" section. We will recruit additional writers with unique investment ideas, as well.
Short Cellar
We had to scramble the name a little to prevent Google and the NSA and all the other search engines out there from zeroing in on us. Hopefully you get the picture. There are hundreds of stocks in the market today that trade at fabulous valuations without the benefit of an underlying earnings base. Others rely on accounting gimmicks, perfectly legal under modern S.E.C. regulations, yet gimmicks nonetheless. These reports will be anonymously written, for obvious reasons. And quite frankly, most if not all will offer positive credit to the management teams involved. As we indicated earlier, Wall Street drives a lot of companies to produce short term metrics that don't always prove sustainable over the long haul. And even when a strategy makes sense, conditions can change. The best laid plans of mice and men can come undone for reasons even the mice don't understand.
Most short cellars are grumpy souls who hurl damaging allegations that tend to have elements of truth in them, but often are hyperbolic. Most companies really are on the level and are trying the best they can for shareholders. Still, the stock market is the stock market. Celling short is a good mechanism for hedging a portfolio. And thoughtful research efforts can uncover overvalued issues even when the overall market is advancing. We'll be interested to hear your feedback on this section.
Market Outlook for 2014
We've been researching growth stocks our entire career. When we first began on Wall Street our supervisors taught us, "Don't worry about the market. Find some winning stocks and stay invested in them." That remains excellent advice.
For those of you who want to worry, start with the idea that valuations are elevated and investor confidence is at euphoric levels. That's nearly certain to foreshadow a drop at some point. But conditions like these lasted for years during the Vietnam War, the Reagan Era, and during the Internet Boom. Remember how long it took before housing prices finally declined. In every case you could say it was a fluke the sell-off happened at all. What if Egypt hadn't attacked Israel and set off the oil embargo. What if the banking regulators had figured out a way to transition the S&Ls into the mainstream banking industry. What if the broadband Internet had been deployed a few years earlier. In the 1950s nothing major went wrong and the market just rolled.
In 2014 the United States financial system is in uncharted territory, with all the Quantitative Easing that's been taking place. The easy part of the easing process is over. Now the economy appears to be coming to life. The question everyone has been asking from the start may finally be answered: "What if it works?"
When Benjamin Bernanke initiated the Quantitative Easing program in 2008 the Federal Reserve held $500 billion of securities. The U.S. banking system had excess reserves at the Fed (deposits the banks could demand back at a moment's notice) totalling $6 billion. Today, the Fed holds $3.8 trillion in securities. The banks have $2.5 trillion in excess reserves at the Fed. That money used to trade in the commercial paper market or the fed funds market, financing inventories and receivables and whatever else required short term funding. Today it sits at the Fed earning 0.25% interest, which is higher than a bank can earn in those other markets. The Fed is keeping that money out of circulation by outbidding the market.
During the past 12 months the Federal Reserve says it purchased $85 billion a month in securities in the open market -- $1.02 trillion in total. Over the same time the M-2 money supply in the United States increased by $634 billion. That's a gap right there of $386 billion. But it's worse than that because new money entering the system usually multiplies at a 1.5x rate as banks make loans off those reserves. Before the crash it was closer to 2.0x. So all the talk about "printing money" is technically correct. It's just that most of it has disappeared into the bowels of the Federal Reserve, categorized as excess reserves. It doesn't count in the money supply because it doesn't move.
What if it starts moving? The new Federal Reserve chief, Janet Yellen, could have a challenge on her hands if the economy genuinely accelerates and the banks withdraw the funds it has on deposit at the Fed. It's their dough. They're entitled to it. But if the money comes out quickly the M-2 numbers are going to surge, threatening inflation and who knows what else. Ms. Yellen could start selling the Fed's bond portfolio to soak up the cash. That would address the problem. But it might propel interest rates to unpredictable levels. Alternatively, the Government could freeze the money, Argentina style. That seems unlikely. But who knows.
An interesting twist might occur if some big players in the U.S. financial system figure a way to profit from such a crisis. George Soros brought down the Bank of England in the 1990s. Is there anybody out there today with the gumption and the resources and the brains to create a run on the Federal Reserve Bank of the United States? The Obama Administration has been hammering the banks and hedge funds with gigantic fines, brutal regulations, even prison sentences. As the saying goes, "Friends come and go. Enemies accumulate."
It's an unlikely scenario. But if you want something to worry about, that's not a bad one.
Walter Ramsley
Executive Editor
Friday, April 5, 2013
Party Like it's 1987
The economic adjustment process we discussed in our previous report is somewhat underway. President Obama tried to avoid it, for reasons that aren't clear. (He didn't follow the customary path in his first term, either.) But Congress forced through the sequester. It also restored Social Security taxes. While the federal deficit remains elevated, it's coming down.
The stock market rallied on the move. But new risks have been introduced to the equation. And several systematic threats remain. Confidence in the future exists but it still is shaky. Investors know stock prices are being supported artificially by the Government. And while they would like to think the stimulus will lift the economy sufficiently to make those bets pay off, there's a nagging worry it won't. If the support is withdrawn before the fundamentals catch up a sell-off could result.
A similar situation existed in Ronald Reagan's second term. Speculation was rampant. Every morning the Financial News Network (as CNBC was called in those days) identified another potential takeover target. Mike Milkin and Ivan Boeske and Carl Icahn and a slew of lesser lights tapped Drexel Burnham and the rest of the junk bond market to finance those deals. As soon as a raider said he was, "Very confident of arranging financing" the bidding wars began. Stock brokers looked for the next takeover target, the same way they looked for the next Internet stock with rising click volume in 1999. The rest of the market was strong. If earnings slowed you'd get bought out.
The excitement level peaked in 1987. At the same time the U.S. and world economy began to slow after the explosive gains registered during President Reagan's first term. China hardly existed from an economic standpoint in those days. But the rest of the world began fighting for jobs and market share, using their currencies. Trade deficits rose dramatically in the United States. The Japanese bought Pebble Beach and Rockefeller Center and a lot of Americans began wondering what was next.
On October 15th the U.S. House Ways and Means Committee approved legislation that eliminated tax deductions for interest costs associated with a corporate takeover. Perversely, bond yields went up. The U.S. Dollar went up. And stock prices started down. The market actually dropped a few hundred points before Black Monday (October 29th). The pressure was on. Once it got high enough the system cracked as program trading and portfolio insurance operations kicked in, amplifying the downturn to record proportions.
None of this means the same thing will happen today. But the correlations aren't that far off. And the people in charge seem to have that portfolio insurance mentality, that everything is under control. The easy money policy is there. The Japanese are disrupting the apple cart in international finance. ETFs provide all the protection anyone would need. And computer trading is more prevalent than ever. The Flash Crash took the market down for no reason in 2010. If an actual catalyst emerges, the next swing could be considerably bigger.
The pressure will build over the next 6-12 months as the economy stalls. If interest rates rise at the same time, fueled by Japan's money printing operation (equal to the U.S. in absolute terms), maybe it will create a phenomenal economic boom, just as they say. More likely, unexpected problems will rule the day. The U.S. got part of it right by starting up the adjustment process. But it left the Federal Reserve Board on the loose. And it has set a poor example. The rest of the world now is following its lead.
Our advice is to maintain a conservative investment strategy. Price-to-earnings multiples for the Blue Chips are at 15x, far in excess of those companies' growth rates. Corporate earnings in general are beginning to moderate, moreover. Profit margins are at peak levels. Small growth stocks are valued at 30x earnings, using the Russell 2000 index as a guide. That includes non-cash stock option and acquired intangible expenses. The genuine valuation probably is closer to 25x. That still is a lofty metric, one that typically marks the top of the range. Individual opportunities remain. Worthwhile gains continue to be available. Still, overall exposure should be measured in light of the macroeconomic situation and the lurking potential for another computer fueled trading meltdown.
Walter Ramsley
Executive Editor
The stock market rallied on the move. But new risks have been introduced to the equation. And several systematic threats remain. Confidence in the future exists but it still is shaky. Investors know stock prices are being supported artificially by the Government. And while they would like to think the stimulus will lift the economy sufficiently to make those bets pay off, there's a nagging worry it won't. If the support is withdrawn before the fundamentals catch up a sell-off could result.
A similar situation existed in Ronald Reagan's second term. Speculation was rampant. Every morning the Financial News Network (as CNBC was called in those days) identified another potential takeover target. Mike Milkin and Ivan Boeske and Carl Icahn and a slew of lesser lights tapped Drexel Burnham and the rest of the junk bond market to finance those deals. As soon as a raider said he was, "Very confident of arranging financing" the bidding wars began. Stock brokers looked for the next takeover target, the same way they looked for the next Internet stock with rising click volume in 1999. The rest of the market was strong. If earnings slowed you'd get bought out.
The excitement level peaked in 1987. At the same time the U.S. and world economy began to slow after the explosive gains registered during President Reagan's first term. China hardly existed from an economic standpoint in those days. But the rest of the world began fighting for jobs and market share, using their currencies. Trade deficits rose dramatically in the United States. The Japanese bought Pebble Beach and Rockefeller Center and a lot of Americans began wondering what was next.
On October 15th the U.S. House Ways and Means Committee approved legislation that eliminated tax deductions for interest costs associated with a corporate takeover. Perversely, bond yields went up. The U.S. Dollar went up. And stock prices started down. The market actually dropped a few hundred points before Black Monday (October 29th). The pressure was on. Once it got high enough the system cracked as program trading and portfolio insurance operations kicked in, amplifying the downturn to record proportions.
None of this means the same thing will happen today. But the correlations aren't that far off. And the people in charge seem to have that portfolio insurance mentality, that everything is under control. The easy money policy is there. The Japanese are disrupting the apple cart in international finance. ETFs provide all the protection anyone would need. And computer trading is more prevalent than ever. The Flash Crash took the market down for no reason in 2010. If an actual catalyst emerges, the next swing could be considerably bigger.
The pressure will build over the next 6-12 months as the economy stalls. If interest rates rise at the same time, fueled by Japan's money printing operation (equal to the U.S. in absolute terms), maybe it will create a phenomenal economic boom, just as they say. More likely, unexpected problems will rule the day. The U.S. got part of it right by starting up the adjustment process. But it left the Federal Reserve Board on the loose. And it has set a poor example. The rest of the world now is following its lead.
Our advice is to maintain a conservative investment strategy. Price-to-earnings multiples for the Blue Chips are at 15x, far in excess of those companies' growth rates. Corporate earnings in general are beginning to moderate, moreover. Profit margins are at peak levels. Small growth stocks are valued at 30x earnings, using the Russell 2000 index as a guide. That includes non-cash stock option and acquired intangible expenses. The genuine valuation probably is closer to 25x. That still is a lofty metric, one that typically marks the top of the range. Individual opportunities remain. Worthwhile gains continue to be available. Still, overall exposure should be measured in light of the macroeconomic situation and the lurking potential for another computer fueled trading meltdown.
Walter Ramsley
Executive Editor
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.
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.
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