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

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

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.

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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

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

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

Happy Days

Third quarter GDP came in at +2.5%.  That was +2.5% higher than Benjamin Bernanke's prediction as he launched "Operation Twist," his latest brainchild for rescuing the economy.  The figure would have been even higher except for an inventory contraction, which might have stemmed from the Fed Chairman's view itself.  If inventories had stayed unchanged the September quarter GDP gain would have been +3.6%.  The data are preliminary and could be revised.  The basic message is unlikely to change, though.  Modest expansion probably will persist into the December quarter, fueled by solid retail spending and the seasonal holiday push.  Inventory re-stocking may provide additional impetus.  Whether the uptrend will prove sustainable, or at least sustainable enough to justify the recent burst higher by the equity market, that's less certain.

Most economists now have dismissed the possibility of a Double Dip recession.  Their complacency could be premature.  Economic activity in the U.S. may have improved a little over the summer.  But serious structural problems remain.  Productivity has suddenly taken a turn for the worse.  Output per worker rose sharply after the recession originally struck in 2008.  For whatever reason the rate of improvement has hit the wall of late.  If the trend keeps up that will put pressure on profits or wages, maybe both.  Much of the latest improvement in consumer spending came from savings, not expanding income.  External inflation is turning higher, as well.  Petroleum supplies grew tight after the Energy Department ended its program of releasing strategic supplies into the market.  And while the industry would love to expand drilling a thicket of government roadblocks remain in the way.  Foreign producers scaled back over the summer as the government supplies flooded the market.  The vaccuum is being filled but prices remain 20% higher.  A wide range of other commodities are selling at elevated heights, too.  For the moment investors may leave those markets alone and focus on stocks and bonds.  Speculative money could shift over to commodities, though, amplifying the uptrend.

The combination of rising prices, lower personal income, and government austerity measures could stall the recovery all over again.  Unemployment stands at 9.1% and threatens to increase.  The Administration is attempting to pass a Jobs Bill to offset the spending cutbacks likely to emerge from the Super Committee later this month.  That proposal resembles the "Single Wing Offense" that once ruled the day in the NFL but grew obsolete decades ago.  Even if it were pass it wouldn't move the ball in today's economy.

A more pro-active game plan is needed.  The details are negotiable.  But a number of key elements are essential if 4%-6% GDP growth is going to be reestablished.  That's the rate the country needs to lower the unemployment rate, boost personal incomes, create a more dynamic business environment, narrow if not eliminate the budget deficit, and keep inflationary pressures under control.  Lower marginal taxes, less government regulation, greater personal freedom . . . .  There's quite a list of things that could do the job.  At this point it's largely a matter of competing foolishness in Washington, so gridlock might not be the worst thing in the world.  Let's hope the politicians eventually take a page from the emerging growth companies we focus on here and concentrate their fire on new business formation and growth.

The Dow Jones Industrials are up nearly +15% over the last two months.  We advised a fully invested posture back then, figuring the market's ultimate downside risk was -10% at most.  That target hasn't changed.  So today downside risk is more like -25%.  And the day of reckoning hasn't moved, either.  The basic variables are the same as before.  Europe won't destroy its banking system.  But it probably will slip into a recession as the recent bailout's austerity program kicks in.  China continues to slow.  And while the U.S. did enjoy a burst over the summer it's economy remains out of balance.  Government stimulus is off the table due to the extreme debt load already in place.  And a private sector stimulus isn't likely to happen due to political reasons.

A Double Dip recession could emerge in 2012.  Our advice is to remain invested in core positions.  Take advantage of the recent rally to accumulate a cash reserve to use in the future.

Walter Ramsley
Executive Editor

Scary Days

The stock market has pulled back sharply over the past few weeks.  Wild up and down trading signals a major division of opinion among investors.  Chances are both sides are right.  The next few weeks is anybody's guess.  But looking a little farther out, where fundamental variables will be able to exert their gravitational pull on stock prices, the picture seems clearer. 

Benjamin Bernanke and most mainstream economists remain way off the mark.  Conventional theories haven't begun to explain what's taken place since 2006 and there's no reason to listen to them now.  The conventional analysis predicts 3%-4% GDP growth in the U.S. over the last six months of 2011 with further gains next year.  That's not going to happen.  But a major disaster isn't in the cards, either.

The European Central Bank is well positioned to prevent a financial meltdown.  Its bond buying and other support measures will impact economic growth, because the price the Bank is extracting is austerity measures.  If Italy, Spain, Ireland, and the others don't achieve the milestones the Bank has set out as a condition for its support, the support will be withdrawn.  So there's a high likelihood of compliance.  But that will bring down economic activity in the short run.  Japan isn't bouncing back in a big way from the earthquakes, either.  So that's not going to pick up the slack.  And while China has maintained momentum to date it's exports are bound to moderate, which could put the brakes on its import growth as well.

In the United States a downturn began in Q1.  Bernanke and crew didn't anticipate that and now say a rebound will emerge in Q3.  In truth, even slower growth is on the horizon.  The budget deficit negotiations are likely to keep a lid on fiscal stimulus.  And the Federal Reserve is out of ammunition when it comes to monetary tricks.  By the first quarter of 2012 GDP growth could slip all the way to zero, sending unemployment up to 10%.  West Texas oil prices could drop another $15 a barrel to $70.  Personal income could flat line.  Corporate earnings probably will contract despite the management heroics which have kept performance intact so far in the recovery.

A decline to 10,000 on the Dow Jones Industrials is possible.  The average might not go that low, considering the cash and other balance sheet assets that are in place.  But investors should be willing to ride out a move to those levels if they want to stay in the game at this point.  The high potential growth stocks we focus on in Growth Stock Insider might be dragged down with the pack.  But their earnings power is likely to continue rising while much of Corporate America slows down, creating even greater investment opportunity.

Downside risk appears manageable at current market levels.  The payoff for staying in the market could come in 2012.  The economy itself probably will take some time to really get rolling.  But there appears to be an excellent chance that lower corporate tax rates will be one result of the deficit commission.  That could be the rocket fuel the economy and market needs.  Once things start moving in a positive direction, moreover, consumer spending should pick up with the lower gasoline prices, cheap interest rates, and a pile of pent-up demand.  Corporate cash reserves will go to work.  A repatriation scheme could amplify capital spending by allowing companies to bring foreign earnings home at little or no tax liability.  And by then it's possible the housing market may start to clear in much of the country, boosting mobility and freeing up a lot of skilled workers who today are stuck where they are.

External factors could disrupt the rebound.  Global warning is getting worse and could cause unpredictable disasters.  Seismic experts are bracing for a major earthquake along the U.S. West Coast.  A war in the Middle East could start, not necessarily including Israel.  Putting that stuff aside, a fantastic buying opportunity could be in the making.  If you want to try and time the market, go ahead.  But it's tough to buy when the headlines scream trouble.  It's never as easy as it sounds.

Our advice is to remain invested in the type of high performance growth stocks we highlight in Growth Stock Insider.  Plan to start using the cash reserve we built up in the spring.  Valuations already are reasonable.  The long term outlook is tremendous.  The rate of return on technology already is improving and could skyrocket over the next decade.  Most investors today are afraid of the future, and stock prices reflect that.  It would be great time to be an optimist even if prices were high.  Things are going to be great.  The fact you can buy that future at a discount, well, can't beat that with a stick.

Walter Ramsley
Executive Editor