Market Insights – May 10, 2012
“The evening news on television is where they begin with ‘Good Evening’ and then proceed to you why it isn’t” —– Author unknown.
Dear Clients and Friends,
As if we haven’t had enough of politicians and politics here in the United States, we now have to sort out the ramifications of Socialist (and disruptive) victories in France and Greece. In France, Francois Hollande became the new president, riding into office on a wave of anti-German and anti-austerity sentiment. Rather than cut spending in a country where there has not been a balanced budget since 1974 and government expenditures are 56% of GDP (the highest % to GDP of any emerging or developed country in the world), he wants to further raise taxes on a population that already has a top income tax rate of 45%, a wealth tax of 0.5% and a VAT (Value Added Tax) of 21.2%. In Greece, 37 year old Alexi Tsipras (leader of the Coalition for the Radical Left) won the right to form a new coalition government in Greece. In his “acceptance speech” he promptly pronounced that last fall’s bail-out agreement (brokered by France and Germany), was null and void. He proposed nationalization of all Greek banks, called for the restoration of all government pensions and salaries back to the prior and highest levels, the reinstatement of all collective bargaining rights and higher taxes on the rich (in which he actually quoted Warren Buffet and the Buffet Rule). Exactly the wrong medicine for a country where government spending is 49% of GDP and taxes (income and VAT) take 68% of every Euro earned.
Once again we are reminded of why the Euro doesn’t work any longer and why it must ultimately be re-structured or abandoned all together. No doubt the U.K. remains thrilled that they chose to “opt out” when the currency was being designed, whereas at the same time on the other side of the Channel, it’s likely that German Chancellor, Angela Merkel is on her third pint of Pilsner in utter frustration over these election set-backs. The Germans have empathy for Spain and Italy but have about had it with Greece, a corrupt country which lied its way into the E.U. Peter Bookvar, Chief Fixed Income Strategist from Miller Tabak sums up the world’s view of Greece when he says, “As for Greece, who cares? Greek bondholders have been body slammed – their debt is trading at 15% of face value. It’s over for these guys. Kick them out of the Euro.” Predictably, the global markets have become unsettled and nervous over these new developments however, as long as the ECB and IMF continue to provide an open-ended stream of liquidity to the European banks, I don’t think we will see a climate change that would trigger a larger correction similar to last year’s European induced swoon.
Those of you who read my regular postings know that I am a big fan of Doug Kass at Sea Breeze Partners. Doug is the most unemotional, intuitive, and successful investor I have known. When the news and sentiment are bad, he is a buyer. When euphoria is in the air, he is a seller. Nobody does their home work better. Right now Doug likes what he sees. The global investment community is over-invested in bonds and under-invested in equities at a time when the fundamentals would suggest just the opposite. He recently gave us 15 reasons why he thinks most people are leaning the wrong way so……..with his permission, here are his thoughts:
1.) Economic growth – Most observers are more cautious regarding domestic growth today, even though the recovery’s breath is better – employment has improved and there is a recovery beginning in the residential real estate markets. Consensus (worldwide) GDP forecasts (here and abroad) are far more reasonable and realistic today. I do not view the April payroll report as a start of a weakening trend (March payrolls were revised up by 53,000) but rather a consolidation after warmer weather lifted payrolls well above trend line growth in the December – February interval. Moreover, the combined manufacturing and non-manufacturing ISM numbers in April remain above the long-term average and is consistent with real GDP growth in excess of 2.5% in the second quarter of 2012.
2.) Profits – Corporate profit growth remains positive and is gaining momentum. Combined first quarter profits beat expectations by over 5%. Historically, this magnitude of earnings revisions has been associated with an 8% rise in the U.S. stock market over the next six months.
3.) Housing – The outlook for housing is markedly improved. Household formations are growing and the NAHB Index and buyer traffic are at five year highs while inventories are at a five year low. The role of residential real estate markets cannot be overstated. Representing about one-third of household wealth and nearly one-half of bank assets, housing could add 1% to GDP in 2013.
4.) Durable spending – Auto industry and farm machinery sales have risen sharply to a four-year high.
5.) Household wealth/health – Household wealth has increased with the recovery of the stock market. Household leverage has moved lower – household debt/GDP has returned back to the long-term average.
6.) Employment – Employment indicators have improved dramatically from a year ago. Jobless claims continue to trend lower and ISM employment components are consistent with monthly job creation of 200,000. Hours worked are expanding at a 4% annualized rate.
7.) U.S. Monetary Policy – 2012 will go down as another year of “easy money” policies from the FED resulting in continued excess liquidity in the economy.
8.) European Monetary Policy – Europe’s central bank has lost its obsession with inflation and austerity and has begun to pay more attention to an easier monetary policy, capital markets signals and economic growth generating ideas. (Last weekend’s elections in France and Greece almost insure more easing of policy from the ECB and could result in aggressive pro-growth initiatives.)
9.) U.S. Banks – Banks have materially recapitalized and passed very stringent stress tests. Pretax and pre-provision income is at near record highs.
10.) Commodities – Costs of raw materials are continuing to fall. The price of oil has fallen by $12 per barrel over the past two months and gasoline prices have come down $0.20 – $0.30 per gallon. These price moves should serve as a tax cut for the consumer and strengthen corporate profit margins.
11.) Balance Sheets –Corporate balance sheets continue to improve and remain rock solid. Debt is at an all-time low and cash on hand is still over $4 trillion.
12.) Valuations – Equity valuations remain very cheap compared to historical averages. Staring at the edge of the abyss in November of 2008, the S&P 500 stood at 900 and earnings were $65 per share for a P/E ratio of 13.8. Today, the S&P trades at 1357 with earnings of $102 per share for a P/E ratio of 13.3. Over the last 50 years the average P/E ratio of the S&P 500 has been 15.8. In other words, stocks are cheaper today than they were at the “end of the world” in 2008 and 20% cheaper than the historical 50 year average. Something has got to give sooner or later.
13.) Investor sentiment – This is the reason that valuations are so low. Investors remain very risk-averse and are not positioned for economic growth. A lost decade full of “black swans” continues to haunt investors and has driven them from the markets. Bond mutual fund flows continue to rise while equity fund flows continue to fall month after month. (Steve Leuthold observes that the Yale Crash Confidence Index, which measures how fearful large investors are of a crash in the next six months, is sitting on exactly the same reading which has marked four important market lows over the last 20 years.)
14.) Europe – European stress indicators are lower even after last weekend’s elections. The ECB has ring-fenced the sovereign debt problem and facilities have been put in place (similar to the U.S. in 2008) to insure funding needs for several years to come. In other words, the EU debt crisis has morphed from a near-fatal affliction into manageable condition that must be monitored. Greece….who cares?
15.) Black swans – In 2011 we had: floods in Thailand, earthquakes in Japan, a U.S. debt downgrade and an economic implosion of the E.U. – we’ve used up our quota…..let’s hope.
In summary, the outlook for worldwide economic growth and corporate profit expansion is nowhere near as bad as the markets fear. Based on a stable economic picture, reasonable valuations and low investor expectations, the risk/reward picture for equities has markedly improved. There you have it, now buy in May and go away. —– Doug Kass.
Thank you again Doug for your permission to spread the love.
Sources: First Trust, CNBC, Real Money and Doug Kass.
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.