The economy has been growing for 3 quarters, is expected to continue to grow, and overall corporate earnings and revenues have been beating even optimistic expectations. The jobs data for May was far more positive in its detail than the headline that failed to meet expectations in the private sector. A slower recovery in Europe2 and the sovereign debt issues should have minimal impact on the U.S. economy or corporate profits.
The market fundamentals continue strong, with compelling low valuations especially in the large cap sector. The market is on sale at discount prices by most measures. However, fear based on the memory of the 2008 meltdown is strong despite the strong market fundamentals. Add to that the “flash crash” and many smaller retail investors continue to fear the market. That leaves the hedge funds, day traders, and institutional investors responsible for some of the huge market swings especially in the last hour of trading.
As of June 6 we had a market correction of 11-14% from the April highs. Small company stocks were hit the worst with their ongoing difficulty in getting financing. Individual stock selection is very important, not “dumb” index1 funds with no brains behind selections. However, at times it has been like tidal waves or a tsunami sinking all ships which in the short term has hurt many of the best-selected opportunities.
Zacks Investment Research said regarding the strong corporate earnings: "The market no longer seems to care about mundane things like earnings and revenues when there are such exciting things like a debt crisis in the cradle of democracy (Greece).” Eventually markets historically return to fundamental values and this may be looked upon as a great time to have bought good companies at such discounted prices. It seems that the correction is more based on irrational fears not fundamentals. This could be setting the stage for the next rally.
Although the outlook is favorable there are market risks. We have added alternative opportunities without either stock or bond market risk to reflect a more cautious approach vs. more aggressive recovery opportunities. The bond market continues to have high interest rate risk. We do not recommend U.S. bonds unless held to maturity.
"Stocks aside, U.S. economy is improving"
Arizona Republic - Highlights - “You wouldn't know it from watching the stock market, but the U.S. economic recovery has gathered steam, with gains in employment, consumer confidence, and a host of other indicators.”
“The National Association for Business Economics, revised upward its prediction for economic growth and business activity. Although risks involving Europe have recently escalated, the outlook in this country has improved in most respects. Growth prospects are stronger, unemployment and inflation are lower, and worries ... have diminished."
“Troubling signs remain, however, ranging from doubts about the strength of a housing-market recovery to huge state and federal deficits that could spook investors.”
“The best thing is you have the (business) cycle back in force. Profits are creating jobs. Jobs are creating income. Income is creating spending. We're back to a sustainable economic cycle.”
“Manufacturing data, both domestic and international, are positive and improving month by month. Consumer confidence as measured in a monthly release by the Conference Board improved for the third consecutive month in May, along with consumer expectations about the economy.”
Dave notes in the consumer confidence index for May, consumers’ outlook over the next six months soared to the highest seen since August 2007, before the economy entered in a recession.
Investment News 5/24/10: "People have been so burned that they're missing an epic earnings recovery. American companies are swimming in cash and minting money."
Briefing.com 6/1/10: Stocks are extremely cheap by traditional fundamental measures. The recent sell-off is the incorporation of a very high risk premium. This premium may well be justified, but it may also reflect an emotional reaction based on the 2008-2009 experience.” – Continued back side -
Briefing.com used various valuation methods showing the S&P5001 (dumb index with no brains picking best opportunities) is undervalued by 43%, or with another method fair value is 1870, (using S&P’s consensus estimate of $84.30/share in earnings) or an even more conservative approach gives fair value of 1686, using the “traditional Fed model”.
Based on the S&P500 closing on 6/4/10 of 1065, this would mean gains of 75.6% to get to fair value of 1870, or 58% to get to 1686. This is in line with other estimates of value but an ongoing “fear factor” could keep indexes below these values.
Briefing.com: “The stock market may simply be placing an extremely high risk premium on the outlook for earnings due to potential credit problems, as evidenced by the problems in Greece.”
“The current (strong) consensus is that the U.S. economic recovery will continue in 2010 and 2011. Growth may be below what typically occurs in a recovery, and there will continue to be problems in housing and other sectors.”
“But, even 2% economic growth is sufficient to produce moderate earnings growth in the quarters ahead. As noted above, stocks are very cheap based on current earnings, and even cheaper with any degree of earnings growth through 2010 and into 2011.”
“If Europe and the U.S. manage to muddle through the current fiscal stresses, even if that takes a few years, this may prove to have been an historic long-term buying opportunity.”
Highlights from Zacks Investment research 5/24/10: First Quarter earnings season was very strong.
“Looking at full-year earnings, total net income fell by 6.9% last year, a much smaller decline than the 27.4% plunge in 2008. This year will be one of earnings recovery, with growth of 35.2% expected, but note that that will still leave earnings below 2007 levels.”
“Further growth of 20.2% is expected for total earnings in 2011, which would put them 10.5% above 2007 levels. Note that this will be long before total employment recovers to pre-recession levels. That is not likely to happen before 2013.
History has shown jobs are often the last to recover from a recession. We have had good markets and strong recoveries in previous “jobless recoveries” such as in 1990-1991 and after the recession of 2001.
CNBC Closing Bell 6/4/10: "All the leading jobs indicators are strong…in fact the index or hours worked is rising at the fastest pace since 1997. That generates income.”
On an industry basis, 54% were hiring but this was down from 67% in April. Manufacturing added 29,000 jobs, the fifth straight increase and temporary-help agencies added 31,000 jobs. Construction lost 35,000 jobs, financial industries cut 12,000 jobs, including 7000 lost in real estate. Employment in state and local governments also fell, down by 28,000.
Often overlooked in the jobs report is that the raw numbers were much stronger than the reported seasonally adjusted numbers. CNBC pointed out this is typical in May to have weaker seasonally adjusted figures. The earning power of workers improved with more average hours worked, and average hourly earnings rose to $22.57. This has the same economic results as new jobs as workers have more to spend.
Morningstar 6/5/10: “Silver Linings: Growth in Hours Worked and Hourly Wages Offset Weak Job Gains - These hours worked and hourly wage rates are equally important, or perhaps even more important, in driving total consumer wage income, which in turn drives consumer spending. The hourly wage number turned in one of the best performances of this recovery. Hours worked had the third monthly increase in a row. Total wage income jumped over 7% annualized for May, its best performance this recovery. The trend here is highly positive, with three strong reports in a row.”
The jobs report for May "remains consistent with the theme of an economic recovery that is gradually broadening out and gaining momentum," wrote RDQ Economics' Ryding and DeQuadros.
The most troubled countries in the Eurozone combined, amount to less than 3% of Euro GDP (Greece, Spain, Portugal and Ireland).
Morningstar points out that total U.S. exports account for only 12% of total U.S. GDP, making us one of the most self-contained countries among developed nations (Germany derives almost 40% of its GDP from exports).
The declining Euro makes European products more competitive in world markets. The sky-high productivity in the U.S. will erode some of that advantage since U.S. companies have more efficient (via job cuts and automation). Individual U.S. companies with large European exposures, such as consumer goods companies, could see their profits cut as sales in Euros translate back to fewer dollars of U.S. profits.
The Associated Press reports: "The slide in the Euro's exchange rate could help exports and provide the boost Europe's troubled economy needs…A lower Euro could help offset the dampening effects of spending cuts and tax increases in countries such as Greece, Portugal, Spain and Italy."
The Financial Times (London) reports: “Through this tense period, most economists have remained confident in the world economic recovery. Greece, Spain, Portugal, Ireland, and Italy are simply not big enough to derail the global economy."
Greece is implementing an austerity program. When a rioter was asked by CNN what their government should do about their debt, she said, "I don't know and I don't care." This may be the extreme view of many of the Communist youths reported as the majority of rioters, but that is a part of the problem. The only banks with major exposure are French and German.
Portugal and Spain have announced austerity measures. Portugal is increasing its VAT and corporate taxes, cutting government salaries by 5% and other measures. Spain is relying more on spending cuts than tax increases. Italy is in better shape, but with a much larger economy needs to reduce its projected deficits. An unlikely Italian default without EU help for major European banks could affect many of the largest U.S. banks.
The uproar over Hungary’s crisis announcement seems at this point to be totally without any merit.
Historically major sovereign debt defaults resulted in good long-term outcomes. Today Europe is nowhere near any default, with the huge commitment to back any EU member at risk. Historically debt crises have ended well, with recovery and repayment of bailouts from IMF/World Bank.
Argentine Crisis of 2002 - defaulted on debt and military rule was replaced. IMF funds were repaid from a growing fiscal surplus, on time in 2005.
Asian Crisis and "Flu" of 1997 gripped much of Asia and raised fears of a worldwide economic meltdown. The crisis started with the collapse of the Thai baht. Foreign debt-to-GDP ratios in the four large ASEAN economies shot up beyond 180%. The IMF created a series of "rescue packages,” tied to reforms - just like the EU and IMF are doing today in Europe. With increasing tax revenues Thailand balanced its budget and repaid the IMF in 2003, four years ahead of schedule. South Korea managed to triple its per capita GDP in dollar terms and resumed its role as the world's fastest-growing economy.
The high daily volatility shows a tug of war between bargain-hunting buyers of stocks and scared investors. Much of daily swings are the result of short -term traders (those folks with the multi-million bonuses) and large hedge funds coming in and out of long and short positions. This is why often the biggest price swings occur in the last hour of trading as traders take their final positions: buys, sells and going short for the day.
Many of these traders are not using their own money to take the big risks. They risk their bank’s money or their affiliated brokerage firms.
Eventually markets return to fundamental facts. This is not like 2008 when we were on the verge of a potential "Great Depression." Now we are in an economic recovery, but investors remember the huge losses in 2008-early 2009.
Some of the best advice comes from the Arizona State University Chair of Economics (Edward Prescott, PhD) who says about those undecided about new investments, "Don't wait for a better time to invest. I don't get caught up in trying to time the market. There is no wrong time to save and invest. When stocks are struggling, I tell myself, good - I can buy bargains. When stocks go up, I tell myself, good - investing is paying off."
Unfortunately we do not know how much further the market will fall, but it could rebound just as quickly as it has for short periods recently. However, the current correction after large gains since March 2009 has been tough to deal with.
5/28/10 Yahoo Finance – “The debt crisis in Europe likely spells slower growth across the Atlantic. China is taking steps to put the brakes on its runaway economy and the U.S. housing market still looks weak. There are seemingly plenty of reasons to be a stock market bear, especially after the run we've had over the last year.”
“Nonsense, says James Altucher, president of Formula Capital. The economy and market will continue to surprise. He's calling for a 'checkmark'-shaped recovery, stronger than the ‘V’ we hear so much about.”
As Yahoo points out, even the job market is improving and temp employment has gone up for seven months in a row, the fastest pace since 2004. Average pay and hours worked are up. Plus, Altucher notes, “Jobs in self-employed positions and start-up businesses have jumped by 1.9 million in the past four months.” He is confident all this will translate into record profits and an all-time high on the S&P 500 by the end of next year.
Bill Smead, chief investment officer of Smead Capital Management says “While everyone's worried about what's going on in Greece and Spain, things are improving significantly for U.S. consumers...American corporations are the most flush with cash they've been for 25 to 30 years and profit margins are excellent.”
For the negative view we have the doomsayer Nouriel Roubini. Roubini makes lots of money selling doom and gloom, getting publicity for his latest book.
London Times reports: “Dubbed Dr. Doom for his gloomy views, this lugubrious disciple of ‘dismal science’ is now the world’s most in-demand economist. Do not expect any good news. For all his recent predictive success (his fame is he predicted the mortgage crisis) his critics still urge calm. They charge he is a professional doom-monger who was banging on about recession for years as the economy boomed.
National Post 5/24/10: “The week's plunge in stock markets and the decline of the euro have created a perfect backdrop for Dr. Doom. In the midst of all the turmoil, Nouriel Roubini appeared on CNBC to issue fresh warnings of crises still to come - a double-dip recession and various national crises in Japan, China and elsewhere.”
“The timing is perfect for Mr. Roubini, whose new book -- Crisis Economics -- is just hitting bookstores. If you're in the business of selling economic apocalypse as a staple, having what looks like an apocalypse at hand can only boost sales. Crisis Economics is the perfect handbook for anyone who likes panics and market roller coasters dished up in glib summaries, sweeping generalizations, frequent bouts of self-congratulation and calls for massive doses of more government intervention.”
“Once it gets past tooting Roubini's horn -- and knocking everybody else -- Crisis Economics moves on to Mr. Roubini's grand view of the global economy. By the time we get to page 46, the conclusion is that capitalism is fundamentally unstable and the cause of the world's economic problems”.
The fact that “Crisis Economics has more good to say about Karl Marx [communism] than Friedrich Hayek [free-market capitalism] is a better indication of the direction of Mr. Roubini's thinking. Marx, he says, has not quite been proven right. But his larger point – ‘that crisis is endemic to capitalism -- is a hugely important insight.’"
While terrible for the Gulf, the BP disaster is generating profit expansion opportunities for many companies just like rebuilding after Katrina. "Oil spill may cause boom in boom business” - headline about Applied Fabric Technologies in the Buffalo News. While it will be costly for BP and other companies involved, the billions BP will spend is going into the economy in various ways. However, this is not the kind of economic stimulus we want.
Fortunately BP can afford the billions in costs. BP's net cash provided by operating activities for the first quarter 2010 was $7.7 billion. For 2009 BP reported net cash generated of $27.7 billion down from $38.1billion in 2008.
Latest Data - On June 3, the Institute for Supply Management reported that the non-manufacturing index grew for the fifth straight month in May; the index is at its highest seasonally adjusted level since May 2006.
On June 1, the ISM reported the May manufacturing index expanded again for the 10th month in a row, with the 2nd best reading since 2004. April had the best ISM reading, with May only down a tiny amount and still showing solid expansion. The ISM tracks the breadth of growth across firms. Sixteen of 18 industries tracked by Tempe, Ariz.-based ISM were growing in May. Export orders rose despite Europe's troubles.
On June 3, Thomson Reuters reported May same-store sales rose 2.5% despite poor weather in much of the country in early May and the timing of the Memorial Day weekend shifted some sales into June. While more stores beat estimates than did not, overall sales were 0.1% less than expectations and less than the March spike in sales. Retail sales have risen seven months in a row, the longest streak since 1999.
Foreign Data2 - Financial Times (London) 6/2/10: "Factories around the world have so far weathered the storm threatening the Eurozone economy." Reporting on the ISM numbers in the U.S., FT says, "Strikingly, the sub-component of the index that measures new export orders rose to a two-decade high, in spite of the dollar’s rise and threats to overseas demand sparked by the Greek economic crisis."
"The UK manufacturing sector continued to rebound at a rapid pace in May and export orders jumped. Figures released in India showed that the sub-continent’s manufacturing sector expanded at its fastest rate in more than two years."
China is trying to constrain growth to around 10%. Auto sales were "only" up 25% in May when they had been up 35%. China needs to slow its economic boom to rein in inflation. China stock markets have been down about 25%. China is imposing a tax on real estate sales to try to slow the huge bubble in their real estate market. If China did not reign in its too-high growth rate it could be worse, fueling too-high levels of inflation.
“Participate yet Protect"- Most of our clients need reasonable growth to fund 20-30 years of active, healthy retirement and need some protection strategies from large market losses. A 65-year old American husband and wife couple has a 50% chance that one of them will live at least 27 years to age 92 (Source: On Wall Street, SOA).
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1Investors cannot directly invest in indices. Past performance does not guarantee future results.
2Additional risks are associated with international investing (especially in developing countries), such as currency fluctuations, political and economic stability, and differences in accounting standards
The views and opinions expressed by Dave Hutchison, CFP are as of the date of the report, and are subject to change at any time based upon market or other conditions. The material contained herein is for informational purposes only and should not be construed as investment advice, since recommendations will vary based on a client’s goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy. All economic and performance information is historical and not indicative of future results. Hutchison Investment Advisors, Inc. is an Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given advisory clients and is available upon request and is at www.davecfp.com