Market Insights – February 1, 2012

“He who lives by the crystal ball, soon learns to eat ground glass” — Edgar R. Fielder, “The Three R’s of Economic Forecasting – Irrational, Irrelevant and Irreverent”

Dear Clients and Friends,

According to Brian Westbury, Chief Economist for First Trust, there are three types of people involved in the prognostication business these days. They are: the EOTWT’s, better known as the “end of the world” types, the IASPAWT’s, who are known as the “it’s a slower, post- apocalypse world” types, and finally the EIGTBOT’s, otherwise known as the “everything is going to be OK” types. As we start a new year, those who embrace the EOTW concept, are still chewing away on the ground glass, the IASPAWT’s are enjoying a satisfying Kobe beef burger, and the EIGTBOT’s are just sitting down to a thick and juicy 16 oz. New York strip. Throughout 2011, the EIGTBOT’s invited the EOTWT’s and the IASPAWT’s to join them for dinner. Sometimes the IASPAWT’S would join the EIGTBOT’s for steak whereas the EOTWT’s would always decline the invitations with excuse after excuse as to why it wouldn’t work for them.

2012 has gotten off to an impressive start for the markets so let’s examine some reasons why the EOTWT’s may continue to require a little steak sauce for that ground glass:

1.)    Europe – The European Central Bank (ECB) injected massive liquidity into the European markets and banking system through a long term refinancing operation (LTRO) in December. This move has given European banks access to an unlimited line of credit for up to 3 years at very low and discounted interest rates. Consequently, these banks are being re-liquefied, lending to one another again and….now have been given breathing room to dispose of riskier assets in an orderly manner. In other words, the risk of major European bank failure is now off the table and a real “game changer” according to Jim O’Neill of Goldman Sachs. This was the most dangerous and system threatening event that could have developed from the European sovereign debt crisis. Much credit for de-fusing this bomb should be given to ECB President Mario Draghi and his new leadership team. They are not bureaucrats, void of critical expertise, rather they are economists trained in state-of-the-art monetary policy at MIT, where Ben Bernanke was also educated. Their intellectual godfather is Stanley Fischer, currently the head of the Bank of Israel and previously the leading MIT professor on monetary policy issues when this team did their graduate work there in the late 1970’s.

2.)    China —  In late November China’s central bank lowered its equivalent of our fed funds rate by 0.50%.  At the same time, they lowered their member bank reserve requirement. These moves signal that China is ready re-accelerate economic growth, after achieving a “soft landing” from an inflationary induced slow-down. We all know by now that when China expands its economy, the rest of the world benefits from that acceleration of demand.

3.)    The U.S. – The economy grew at 2.8% in the 4^th quarter of 2011 (the fastest pace in 1 ½ years) while generating only a 1.2% rate of inflation. The Fed has forecast GDP of 2.5% in 2012. While +3%  is needed to have a meaningful impact on the unemployment rate, the forecasted rate will nudge unemployment downward and keep corporate profits at high and sustainable levels. Furthermore, on Tuesday of last week the Fed announced that it would leave short-term interest rates at or near ZERO until 2014 at the earliest. If you are a CFO or COO, this is great news because you now know that you can inexpensively finance an expansion or acquisition without fear of being caught in a rising rate environment for at least 2 more years. Look for bank lending to accelerate on this kind of news (bank loans to the private sector are more profitable to banks than keeping those same funds on deposit at the Fed earning a near 0% rate of return). It is also possible that the Fed may embrace round 3 of quantitative easing, sometime in 2012. If that were to occur, they would probably buy mortgage backed bonds. This action would ensure that mortgage rates would remain at historically low levels through 2012. This is important since at its peak, housing and construction represented 25% of GDP. In the 4^th quarter of 2011, housing starts hit the highest level since 2008 and were up at a 32% annual rate compared to Q2. This activity was not all apartment buildings; single-family housing was up at a 13% annual rate in the second half of 2011. Finally and most recently, 4^th quarter earnings are now coming in. With about 25% of the S&P 500 companies having reported, 65% have beaten estimates and guided higher for 2012. It appears that U.S. companies continue to remain very competitive, very strong and highly profitable.

4.)     Politics – The political landscape is never civil and never completely clear, but within weeks we should know who will challenge Obama for the Presidency. Forecasting models show that if the election were held today, Barrack Obama would receive 54% of the vote. Any narrowing of that percentage as we get closer to the election will be positive for the markets. Having said that, it seems apparent that corporate America is no longer as pre-occupied with the administration’s anti-business posture. The 2010 mid-term election served to balance the power in Congress so, this fall if the Republicans can control both the House and Senate, the markets should celebrate that outcome.

I would like my steak medium rare with baked potato (all the fixins) and sautéed spinach please.

Best wishes,

Ken

Sources:  First Trust, U.S. Trust, CNBC and Real Money Pro

Ken Beach, President of Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.