Equity markets

The glass is half empty

In conversations with other managers and investors over the past few months, there has been a consistent narrative that goes like this:

·        The economy has avoided a depression and is starting to recover.  

·        This recovery, however, is almost entirely due to government stimulus and there are few signs of organic growth.

·        Companies are beating relatively easy earnings estimates entirely through cost –cutting; revenue growth is non-existent (although we started to see some signs of it in the third quarter).

·        There will be limited sources of organic growth when the government withdraws the stimulus.

·        At that point, the stock market and credit markets could retrace.

·        Post-stimulus, the economy will be left with trillion-dollar deficits as far as the eye can see and will experience a weak dollar and/or inflation.

 The glass is half full

There is more optimistic narrative as well that goes like this:

·        The economy has avoided a depression and is going to recover.

·        Companies are beating their earnings and there are starting to be signs of revenue growth.  Earnings will explode once revenues start to grow since cost structures have been cut to the bone.

·        The government will be able to gently withdraw stimulus and hand off the reins of growth to the private sector. 

·        Growth will be driven by exports to Asia and greater efficiency now that companies have cut their businesses to the bone.

·        Third quarter GDP growth of 3.5 percent shows that the economy is healing.

·        The stock market and credit market will remain around their current levels for a sustained period.

·        Post-stimulus, the economy will grow steadily albeit at a below-trend rate of 2-3 percent.

 What is in the glass?

Both narratives must account for the following facts “on the ground” in the economy.²

·        While third quarter GDP was up 3.5 percent, vehicle sales (‘Cash for Clunkers’) accounted for 1.6 percent of the growth; housing (the $8,000 first-time buyers tax credit) contributed another 0.53 percent; inventory restocking added another 0.9 percent.  Government spending increased by 7.9 percent overall.  According to John Williams (Shadow Government Statistics), one-time stimulus and inventory build represented 92 percent of third quarter GDP growth.  By way of comparison, Bridgewater Associates, Inc. estimates the contribution from stimulus alone at between 1.0 and 1.5 percent.

·        There are currently 18,843,000 vacant homes in the United States (out of a total of 130,302,000 homes).  This is an increase of 395,000 over a year earlier.  In the category of homes that are occupied year-round, there are 14,227,000 vacant homes compared to 13,707,000 a year earlier.

·        The unemployment rate officially stands at just over 10 percent and when discouraged and underemployed workers are included, the figure is in the 16-17 percent range.  The real figure is probably closer to 20 percent.  Today, the U.S. employs the same number of people it employed in 2000 – 131 million.³  Our country has added no net new jobs in almost a decade. Unemployment remains a glaring weak spot in the recovery, although in fairness the most recent employment component of the ISM release showed a sharp increase from 46.2 in September to 53.1 in October.  We will have to watch this figure closely to see if this jump was a statistical aberration or the beginning of a reversal in the steady stream of negative employment news.

·        The American consumer continues to struggle. In August, consumer credit shrunk by $12 billion following a $19 billion decline in July.  Revolving credit (i.e. credit cards) fell by $9.9 billion in August compared with $2.4 billion in July.  Consumer credit was down 4.4 percent year-over-year as of the end of the summer, the biggest decline since June 1944.  HCM views this as a coincident, not a lagging indicator.

·        After every previous crisis since 1974, the U.S. current account deficit has increased dramatically as a result of a rebound in consumer spending.  According to the folks at GaveKal research, the current account deficit will continue shrinking until the U.S. is in surplus within two years. This means that the U.S. is no longer providing liquidity to the rest of the world.  The U.S. consumer is no longer serving as the spender-of-last-resort in the global economy.

·        Large financial institutions are focusing their efforts and capital on risk-taking in the markets and intend to continue to engage in many of the same practices that led to the crisis.

·        The global carry trade has migrated from the Japanese Yen to the U.S. dollar and remains alive and well, allowing investors to employ significant amounts of leverage in their investments.

·        There is virtually no indication that the U.S. government will be successful in reining in spending or effectively reforming the financial system.

As one very smart investor posed the question to us recently, the question is whether these significant economic headwinds should result in the stock market trading at fair value or below fair value.   It is difficult to believe that these headwinds will not catch up to the market sooner or later and terminate the historic rally that began in March 2009.  Companies may continue to beat earnings estimates for the next couple of quarters (against historically weak comparisons and beat-down expectations), but the market looks to be at least fairly priced on a multiple basis in terms of the macro-economic risks.  There remain individual stocks and bonds that offer attractive risk-return profiles, but on an overall basis the market remains very vulnerable to macroeconomic risk. 

This vulnerability was apparent during the last week of October, when the stock market exhibited some good old fashioned volatility and ended the week with a 250 point loss.  Many market observers view increased volatility as a sign of a change in market direction, but it is too soon to make that judgment.  Liquidity remains robust and there are few other places to invest with interest rates as low as they are.  The real question is how much higher the stock market can go from here in view of the considerable economic headwinds that are blowing, and that will depend on whether those headwinds maintain their velocity or begin to dissipate.

Armageddon may be off the table, but the table is standing on extremely shaky legs.  Not to put too fine a point on it, but the fiscal and monetary situation of the United States is profoundly troubling.  By 2020, the cumulative U.S. budget deficit will likely exceed $20 trillion.  The Congressional Budget Office is currently projecting the budget to reach 76.5 percent of GDP over the next ten years.  While there is considerable talk about this, it is difficult to point to a direct impact on the markets at this time.  The demand for Treasury debt remains robust, and Treasury rates have continued to drop even while Treasury issuance has exploded (with little prospect of diminution in sight).  Accordingly, fears about foreigners turning away from U.S. debt, legitimate or not, have simply not materialized to any meaningful extent despite evidence during the last quarter that foreign governments are diversifying their currency holdings. 

The question remains when the long-term will become the short-term, and of course nobody can answer that question with any certainty.  One thing can be said with certainty, however - by the time we find the answer to that question, it will be too late to do anything to prevent the instability that will follow.  That is why, rather than push the problem off to the future, it remains incumbent upon our current leaders to promulgate a meaningful program for budgetary discipline as soon as possible.  While the Obama Administration is promising that its next budget will include a program for deficit reduction, such promises are difficult to square with the premise of healthcare reform and the realities of dealing with Congress.  Markets are psychological organisms, so at any time they could throw their hands up in frustration at the lack of progress on this front. Investors should keep this in mind as they decide how much risk they want to take with their capital.