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Investing in Large-Cap Stocks:Rafael Resendes Interview Wall Street Transcript (PDF)
A year later, the capital markets are in a much better shape and investors are searching for answers to long term fundamentals of the US economy. In the mean time, the outcomes of those rescue efforts are being hotly debated:
1. We have had two consecutive quarters of GDP growth in the 2nd half of 2009 in the US, 2.2% in Q3 and 5.9% in Q4, on an annualized basis. Q3 GDP growth was driven largely by government programs, with both Durable Goods (helped by Cash for Clunkers) and Residential Fixed Investments (helped by First Time Home Buyer Tax Credit) up double digits. Q4 GDP growth was mostly driven by businesses boosting spending on equipment, software, and restocking inventory, while consumer consumption was weaker than expected, registering a growth of just 2%, down from a 2.8% growth rate in Q3. It is widely believed the brisk pace of GDP growth in Q4 is unlikely to continue, unless personal consumption picks up substantially to provide support for consistent business spending.
2. Unemployment was 9.7% in February 2010, flat from January, but was much higher than 8.1% a year ago. The Federal Reserve members forecast the jobless rate would remain in a range of 9.5-9.7% in 2010, improve to 8.2%-8.5% in 2011, and fall to a 6.6%-7.5% range in 2012. Economists say it will take until the middle of the decade for the job market to return to normal, after losing 8.4 million jobs in the Great Recession.
3. Stimulus Bill: Based on the Administration's sales pitch in January last year that US unemployment would exceed 8.5% without the bill, the stimulus bill has failed miserably. The $93 billion tax cut given out in 2009 in the form of tax rebate geared towards lower income people, didn't do much about consumer spending. The $159 billion given out to local governments to plug holes in local schools, Medicaid payments, and unemployment-benefits budgets, have relieved some budget pressures at the local level and saved some jobs. Among the remaining 65% of the stimulus money, $190 billion will be tax cuts and $150 billion will be local aids, which we can rather safely expect to generate the same old results witnessed in 2009. Hope is now on the $180 billion for infrastructure spending, which will be stepped up and possibly provide some real boost to the economy in 2010. That said, the bulk of the money for projects such as rail and water will take years to be spent.
4. The $75 billion Home Affordable Modification Program (HAMP) has been widely recognized as a failure. Almost a million homeowners have been on trial mods, ie, short term payment plans. About 25% that received trial loan modifications through the plan are failing to keep up with their new reduced payments, and at least 196,000 borrowers have missed some or all of their required payments. Only one in ten has had their mortgage permanently modified, although HAMP is designed to help 3-4 million Americans. Mortgage servicers were permanently modifying around 100,000 loans a month before HAMP started, and HAMP's highest monthly total was the 50,000 additional permanent modifications achieved in January 2010. In addition, instead of declining, the number of foreclosed homes increased to a record 2.8 million in 2009, a 21% rise over 2008 and 120% over 2007, according to RealtyTrac. Despite the obvious failure, it is reported that the administration may ban all foreclosures on home loans unless they have been screened and rejected by HAMP.
5. Budget: After generating a $1.4 trillion deficit or 9.9% of GDP in FY09, the US is well on its way to generate deficit of another $1.4 trillion or 10.6% of FY10's GDP. The White House's FY11 budget released in early February called for $3.834 trillion in total spending, with a projected deficit of $1.267 trillion or 8.3% of GDP. The Senate extended the nation's debt limit to $14.3 trillion to accommodate the projected gap for the current spending year, which ends September 30, but with another $1.3 trillion hole next year, the nation's debt could reach $15 trillion by October 1, 2011, or about 95% of GDP. The projected $1.3 trillion deficit in 2011, assumes $122 billion extra revenues on overseas earnings from multinational firms, and letting Bush Tax cut expire, which according to the White House will generate $1.2 trillion revenues in the next 10 years. It is important to know that, the FY2011 budget has pension, welfare, and health care outlays accounting for 21%, 12%, and 23% of total spending respectively. In 1950, those percentages were 2.2%, 3.6%, and 2.2% respectively. In 1975, those percentages were 21%, 10%, and 8% respectively. Keep in mind, social security was initially signed into law in 1935 with the first payment issued in 1940. Medicare and Medicaid were established in 1965. History has proved it over and over that entitlement programs don't just grow in absolute sizes, but grow faster relative to GDP and become larger shares of the overall economy as time passes by. That is exactly why the final push democrats are currently giving to the $1 trillion healthcare bill is extremely disturbing. The last thing the country needs is more deficits and more debt. Deficits can only be tackled through spending cuts and increased tax revenues, driven by GDP growth and tax increases (which we oppose). It is believed median economic growth rates fall by 1% once debt exceeds 90% of GDP, which the US will "accomplish" next year. The $1 trillion healthcare reform program, if passed and implemented, will just make it even harder for the US to reduce debt, in an economic environment with likely slower growth.
6. The Fed's Quantitative Easing: Becoming the main purchaser of the mortgage market securities, the Fed has successfully kept the average 30 year fixed mortgage rate around 5% in the past year. Together with the government's first time home buyer tax credit program, low mortgage rates has been widely credited for stabilizing US housing prices, which will have risen 7 consecutive months by December. The Fed will end the agency backed mortgage securities purchase program by the end of March as planned but doesn't currently anticipate selling any of the mortgage-backed securities in the near term. Questions and doubts abound regarding the Fed's exit strategy, though the latest 30 year TIPs auction(the 1st auction since Oct 2001) implies a long-term inflation rate of 2.5%, providing some relief to the urgency of Fed's draining its excess liquidity. Regardless, Fed took its first step of exit by hiking the Fed discount rate by 25 bps in mid February, increasing the difference between the discount rate and the federal-funds rate to 75 bps, although still lower than the 100 bps before the current crisis.
And of course, the world is now flat as we know it and what happens in other parts of the globe is exerting increasing influence on the US economy and capital markets. Late last year, we had a brief shock from Dubai World, the state-controlled company of Abu Dubai, which announced it was seeking to delay debt payments as it negotiates to extend maturities. The event was viewed by some as the start of the final leg of the financial crisis, which had travelled from household default, to bank default, and to sovereign default. Unfortunately, the leg has since increased in size, as the sovereign debt crisis in Portugal, Italy, Ireland, Greece, Spain (PIIGS), has rattled the global markets since last December and accelerated this year centering around Greece.
Last week, the Institute for Supply Management reported that its services index rose to 53 in February, up from 50.5 in January and above the average estimate of economists for 51. The ADP Employment report showed U.S. private employers shed 20,000 jobs in February, fewer than the 60,000 jobs cut in January. The US economy is improving, despite largely failed policies of the Administration. The "unintended" consequences of those policies, however, will still take time to show their impact. In the months ahead, we await to see: how will the housing market react to the end of the Fed agency mortgage security purchase program and the expiration of the home purchase tax rebate incentive? Will private businesses start to hire if the healthcare reform passes which puts stricter requirement on employers to provide health insurance? The 10% comparable store sales gains in February for Nordstrom helped to cheer the market last Thursday, but will wealthier consumers keep their current spending level when a higher tax rate hits their wallets 10 months from now? Answers to those questions will determine consumer confidence, which will in turn affect consumption, the ultimate driver of sustainable GDP growth. Outside the US, will Spain or Italy become the next center of sovereign crisis now that Greece will be bailed out by Germany and France after it agrees to additional spending cuts totaling $6.5 billion? With this much uncertainty, we believe investors should sit tight.
So where does the market go from here? Recently, the market has continued rewarding the speculative companies, lending credibility to the belief that a sustainable recovery is underway. While that may indeed be the case, there are many portents that say otherwise. First and foremost is the battle of wills taking place over the health care reform. While the public is clamoring for something, the majority of the polls indicate that the currently proposed legislation is not the change most desire. The outcome of this legislation in the coming weeks will be important, as it could very well dictate the momentum and tenor for Obama's remaining term. Put very simply, we think a big driver for the market in the months ahead will be determined by the outcome of this last push for health care reform. Should it pass, we think tougher times are ahead for the market. Our logic is simple: if health care reform passes in its current form, taxes will increase on profits and capital gains beyond the expiration of the Bush tax cuts. Further, a win here by the Administration will likely embolden it to pursue its "Cap and Trade" bill which will create new energy taxes and further reduce corporate profits. Between the current health care reform and a new run at global warming legislation, corporate Economic Margins will be squeezed via lower cash flows and higher cost of capital. That double shock combined with what is currently a fairly priced to over-valued market will likely result in declining multiples and thus share prices. Among the hardest hit stocks under such a scenario will likely be the winning momentum plays of the past 6 months, and high growth stocks. Should this legislation not pass, we expect the economy to continue moving forward, albeit quietly with high single digit unemployment being the norm. In such an environment, the current high beta stock wave may very well continue until a new catalyst reminds investors about the importance of valuation and risk.
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Value Expectations Equity Research, provides institutional quality stock research through its investment newsletters and stock blog using AFG’s Economic Margin Framework.
The term Value Expectations is derived from our ability to calculate market expectations embedded in stock prices, sectors and indexes.
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