December 2010 |
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Our primary reason for maintaining a defensive investment strategy over the last 18 months has been that we were not confident that the economic recovery was self-sustaining. The U.S. economy became a very sick patient after many years of overindulging on credit. Despite the huge rally in the stock market, our analysis of the data showed that the economy was still on life support in the forms of fiscal and monetary stimulus as recent as a month ago. However, recently it has shown some vital signs of sustainability that we think will allow it to grow under its own power, which is a necessary condition for us to increase our clients’ exposure to the stock market.
We are not believers that the fiscal and monetary medicines that have been provided by the government and the Federal Reserve are going to rapidly cure what has been ailing the U.S. economy. It took many years of questionable policies by these institutions, flawed business practices by banks as well as irresponsible choices by many individuals to get our economy into such an unhealthy state.
We acknowledge that the treatments might temporarily make the patient feel better but we do not think they are effectively curing the country’s balance sheet disease. When the effects of them have worn off the symptoms have reappeared.
We actually witnessed this happening in the second quarter of this year. As the various stimulus programs that targeted certain areas of the economy like home and automobile purchases came to an end, the economy relapsed and growth slowed dramatically.
Following one of the deepest recessions since 1981, real GDP growth peaked at 5% in the fourth quarter of 2009 and then fell to 1.7% by the second quarter of 2010. That was considerably weaker than the 8% to 9% growth rates we saw in the economic recovery in 1983. That was a big concern for us. It did improve somewhat to 2.5% in the third quarter.
To add a little perspective to this discussion, the economy needs to grow at a minimum growth rate of 2.5% just to keep the number of unemployed from rising. Obviously when the economy slowed so dramatically after only six months into the official recovery, a double-dip recession looked like a real possibility.
As we have mentioned in previous commentaries, the leading economic indicators that we follow reversed course last April and were still declining coming into August. In addition, when the indicators began to increase again in late summer most of the improvement was due to the improvement in the stock market and the shape of the Treasury yield curve. The “real” economy indicators were still declining.
With the economy getting worse and gridlock preventing any new stimulus treatments, Dr. Bernanke and his colleagues at the Federal Reserve decided on another dose of the only medicine they had left at their disposal…Quantitative Easing (or better known as QE2). This was a controversial action by the Fed because QE is still considered an experimental drug by many economists with some potentially serious side effects.
As Jason stated in last month’s Insights, the Fed’s objective in administering such a treatment is to push longer-term interest rates and the value of the dollar down and to “encourage” investors to put money into riskier assets and get stock prices up and stop real estate prices from falling further. Making many Americans wealthier by getting asset prices up would improve their confidence in the recovery and get them spending again…at least in theory.
We have taken the position that QE2 will not help the economy in any significant way and that seems to be the case so far. While the stock market has rallied as expected, intermediate and long-term interest rates are increasing, making mortgage loans more expensive. Conventional mortgage rates have increased from a recent low of 4.2% to almost 5%.
Oil and agricultural prices have also jumped making driving a car and heating a home more expensive. It is also putting pressure on profit margins as costs are rising faster than retail prices. This has reduced the wealth-effect somewhat from the rising equity prices. These are some of those unfortunate side effects of QE2.
The good news is that beginning in the third quarter and more evident over the last few weeks, the economy’s vital signs have started to suggest that it can sustain growth without additional treatment, at least for now. And frankly we would attribute this improvement more to the passage of time than the efficacy of some of the treatments.
With the help of stronger exports and sales to the booming Asian economies like China and India, many U.S. companies have begun to hire. Unfortunately it is not enough to prevent the unemployment rate from rising but at least enough to begin to increase personal income and consumer spending.
According to a recent survey by Manpower Inc. out of Milwaukee, “companies are feeling the demand and getting a bit more confident and more of them are planning to boost payrolls in the first quarter of 2011. The survey included 18,000 employers. The increase is expected to be small but it in the right direction.
We are encouraged by the increase in retail sales over the last two months, especially since “Black Friday”. So far, it looks like holiday sales will be better than the 2% to 3% improvement from last year that was expected by industry trade groups.
Large corporations are sitting on a huge pile of cash that will be used for investing in new equipment and additional employees when the managements have enough confidence in the sustainability of the recovery. These companies were quick to cut costs, especially labor costs, when the recession started. Many of them are getting to the end of doing more with fewer people and are rapidly approaching the point of having to hire people to increase sales.
This is happening in the auto industry. The increase in automobile sales over the last few months has caused the manufacturers to raise production schedules and begin to hire workers. The same thing is happening for many of their suppliers. If this improving sales trend continues for the first quarter of 2011 and beyond then it would be an important sustainable boost for the economy.
Credit is starting to flow again for small business, which is also another important vital sign suggesting a sustainable recovery. Lending rose in the third quarter for the first quarterly increase in two years, according to the FDIC.
So we have jobs, income, spending, and lending all improving, not by a lot but at least in the right direction. The rally in the stock market has also made those people invested in it feel better.
As long as the leading economic indicators that we watch continue to forecast growth, we will assume that the economy is on some sort of a sustainable growth path. Our fear of a relapse has been put aside for now. This is giving us more confidence to slowly and moderately increase our clients’ exposure to the stock market when we see attractive investment opportunities. We are starting from very low levels of exposure, so this is a process.
We will also be closely monitoring the economy’s vital signs because of our belief that none of the treatments so far have cured what is ailing the economy. If the economy’s vital signs begin to fail again, our job is to decisively react.
