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“Let me tell you how it will be there's one for you, nineteen for me ‘cause I'm the taxman, yeah, I'm the taxman. Should five per cent appear too small be thankful I don't take it all ‘cause I'm the taxman, yeah I'm the taxman.”
. . . The Beatles
Well, it’s that time of year again when, as the Beatles state, “There's one for you, nineteen for me ‘cause I'm the taxman.” For the record, mandatory tax withholding began in 1943 and as one of the crafters of that event said – I wish we had never allowed the government to automatically withhold the tax from peoples’ paychecks because by doing so folks just don’t realize how much they are actually paying! To be sure, taxes are going up, especially on the alleged “rich.” Now as I understand it, “the rich” is defined as anyone making more than $200,000 per year, or $250,000 for a couple. While that certainly sounds like a lot of money, I challenge you to examine a family of six, four of which are kids in private colleges, combined with a mortgage payment/two car payments/ state and city income taxes/etc., and see how much money is left over at the end of the day. Still, “tax the rich” plays well politically despite the fact the top 1% of wage earners pay roughly 29% of the total taxes, while the top 5% pay a bit more than 47%. Shockingly, that leaves only 53% of the tax load for the remaining 95% of wage earners. As philosopher, economist, and journalist Henry Hazlitt wrote:
“When people who earn more than the average have their ‘surplus,’ or the greater part of it, seized from them in taxes; and when people who earn less than the average have the deficiency, or the greater part of it, turned over to them in hand outs and doles, the production of all must sharply decline. For the energetic, and able, lose their incentive to produce more than the average; and, the slothful and unskilled lose their incentive to improve their condition.”
Ladies and gentlemen, we don’t have a tax shortfall problem; we have a government spending problem. As the Washington Times writes, “For the first time since the Great Depression Americans took more aid from their government than they paid in taxes.” Manifestly, our government is becoming an increasing “spender” in the economy and that should worry you. Indeed, a recent study from the sharp-sighted folks at the GaveKal organization shows what occurred in the United Kingdom when the government became an increased “spend” in that economy. By examining the nearby chart:
“(Where) the top red line represents the ratio between central government expenditures and GDP (on an inverted scale), and the grey line on the bottom panel represents the ratio between the value of the UK stock market and the operating surplus for UK companies as reported by the national accounts (a PE ratio of sorts), something emerges quite clearly. A rise in government spending (the red line declining) leads, over time, to a decline in the structural growth rate of the economy and to lower PEs.”
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Whether GaveKal’s UK analogy “ports” to the United States is a reasonable question; but if so, it implies we are in for a lower structural economic growth rate and lower P/E multiples for the major market indices.
More importantly, although I consider myself fortunate to have forgotten most of the economics I leaned at university, the current $12.2 trillion national debt, plus the other commitments and contingencies that bring the total to $13.5 trillion, is alarming. Let me size that for you, if you spent $1 million per day since the founding of Rome (~2700 years ago), as of today you would have accumulated “only” $1 trillion in debt. Now take that $13.5 trillion debt figure, and add the ~$42.9 trillion in unfunded obligations figure (Social Security, Medicare/Medicaid, etc.), and you have a $56.4 trillion “debt hole;” and, that hole is only getting deeper! As Ray DeVoe writes:
“In conclusion, Columnist Thomas Friedman had an article in the New York Times titled ‘Never Heard that before’ that I found rather disturbing. He was attending the World Economic Forum in Davos and had discussions with many of those attending. As he wrote ‘I heard a phrase being bandied about by non-Americans – about the United States – that I can say I have never heard before: political instability’.”
Nevertheless, while the bond market seems to be reflecting some of these concerns (read: higher rates), the equity markets are not sensing the degree of fiscal tightening that is going to be needed as last week the S&P 500 (SPX/1178.10) tacked on another 0.99%. That “weekly win” left the SPX’s three-week skein at +2.4% and us with “egg” on our face once again. Obviously, we have been wrong-footed (on a short-term basis) for the fourth time since our “bottom call” of March 2, 2009, having turned cautious, but not bearish, three weeks ago with the SPX in the 1150 – 1160 zone. That “cautionary counsel” was driven by numerous indicators we have come to trust over the years. Yet, those indicators have been trumped by the near-term upside momentum. Fortunately, while trading accounts are not fully engaged, investment accounts are. That strategy is based on the simple thesis that booming corporate profits are fostering an economic recovery, which is leading to an inventory rebuild and a capital expenditure cycle. In turn, said sequence should promote a hiring cycle, and then, a pickup in consumption. We think, in the intermediate-term, such a sequence should bolster stocks into mid-summer, even though we remain cautious as the second quarter begins.
In any case, despite our near-term caution, the aforementioned “virtuous cycle” should persist until the markets begin to discount the 2010 mid-term elections next November. Through our lens, those elections may well serve as a referendum on the liberals’ versus conservatives’ agendas. If the liberals prevail, it could spell a pretty tough year for stocks in 2011. If, however, there is a conservative backlash (read: no tax increases combined with spending cuts), it could provide the footing for a decent 2010 year-end rally. Meanwhile, our “call” for the return of inflation is playing with crude oil and copper breaking out to 20-months price highs. To put it simply, the U.S. has only three options: sovereign default (unimaginable); severe economic contraction (unlikely); or currency debasement, which has been the preferred political strategy for decades. Inasmuch, we choose door number three and have/are positioning accounts for inflation. Further, our long-standing recommendation of “buying” Japan is finally bearing fruit with many Japanese centric closed-end funds and ETFs tagging fresh reaction highs last week as Japan’s new export orders hit a six-year high. We also think technology stocks should continue to outperform. Most tech companies don’t have significant retiree healthcare obligations, nor do they have a lot of debt on their balance sheets. Verily, tech companies tend to be cash rich because they retain their earnings. Some such names from Raymond James’ research universe, all of which are Strong Buy-rated, include: Radiant Systems (RADS); CA Inc. (CA); Micron Technology (MU); Nuance Communications (NUAN); Harris Corporation (HRS); NVIDIA Corporation (NVDA); and Sybase (SY).
The call for this week: For 13 months we have heard the bears growl that this is just a rally in an ongoing bear market with a double-dip recession surely in the cards. Meanwhile, we have clung to our belief in the aforementioned “virtuous cycle.” Plainly, the data suggests the growth in factory orders, shipments, production, payrolls, and capital spending are likely to stay perky in the months ahead. That is the way profit recoveries work and why the stock market continues to rise. Accordingly, while we have been too cautious for the past three weeks, we have never abandoned our belief the equity markets would trade higher in the intermediate to longer term. Still, there are some “cracks” beginning to appear. For example, last week Warren Buffett’s Berkshire Hathaway issued bonds that commanded a lower yield than those offered by the U.S. government. Also of interest was Social Security’s revelation that it will show a deficit this year rather than in the projected deficit year of 2017. Those topics, however, are for a future billet doux.
“The Berkshires seemed dreamlike on account of that frosting with ten miles behind me and ten thousand more to go.”
... James Taylor, Sweet Baby James, 1970
Obviously when James Taylor wrote the song “Sweet Baby James” he was referring to the snowcapped peaks of the Berkshire Mountains, which is where I spent most of last week making presentations to some of Raymond James’ retail clients before jaunting off to Boston to speak with institutional accounts. Interestingly, the institutional accounts wanted to know what retail accounts were “doing,” while the retail accounts wanted to know what the institutions were doing. Accordingly, at least from my observations, order flow from retail investors suggests that they have under-played the current equity rally and are instead buying bond funds. In fact, ~70% of retail order flow into mutual funds has been into bond funds, and not short-term oriented bond funds, but long-duration bond funds. In their attempt at “desperately seeking savings,” in a perceived conservative manner, I believe retail investors have little idea of the risk they are incurring. Having seen a few market cycles, I can recall what happened to the price of long-term Treasury bonds when interest rates rose throughout the 1970s. While I feel somewhat better about corporate bonds and distressed debt than Treasuries, I am not nearly as aggressive on those vehicles as I was some 18 months ago. Instead, I have actually been counseling accounts to scale back (read: sell partial positions) in such vehicles now that yield spreads have narrowed so dramatically.
There is, however, one Boston-based family of mutual funds that is advising retail clients NOT to buy long-dated bond funds. That is a pretty rare message for any mutual fund family because selling funds is how they make money. Said company is MFS, and its mantra is – if you buy bond funds, they should be short-term bond funds – which we think is pretty sound advice. During our meetings with some of MFS’s portfolio managers (PMs) we espoused the market views so often chronicled in these missives. Yet, part of the fun of such sojourns is hearing what the PMs have to say. For example, our friend Thomas Melendez, captain of the MFS International Diversification Fund (MDIDX/$12.07), which we continue to recommend, gave us an interesting sound bite. He asked, “China has 1.3 billion people, so how many cars are on the road?” The answer is only 26 million! Thomas then concluded that the CEO of the Chinese car manufacturing company he recently met was not counting sheep to put him to sleep, but rather cars; as well as the money he was going to make from them. My takeaway from those comments reinforced the recommendation of the Chinese car and battery company BYD (BYDDF/$9.85), which is followed by our research correspondent, and is 10% owned by Warren Buffett.
Another MFS portfolio manager, namely Jeffrey Morrison, was recently asked to assume oversight of the MFS Sector Rotational Fund (SRFAX/$14.51), another fund we embrace. To be sure, for the market environment we envision going forward, sector rotation should have a place in most investors’ portfolios.
Some of the other comments that caught our ear were quips like:
1) “Don’t tell me to buy Proctor & Gamble (PG/$63.69) because Wall Street is going to expand Proctor’s P/E multiple by one point. Just give me stock ideas that are turnaround situations, with operating leverage, like Atlas Pipeline (APL/$13.75).”
2) “Be cautious on Brazil short-term because the upcoming elections could throw their markets a curve ball. As well, with 9%-yielding Brazilian bank CDs the hurdle-rate for Brazilian equities is high; and, Brazil looks as if it just might just raise interest rates.”
3) “India is a great long-term investment. It has by far the best management teams I have ever seen! But in the near-term, valuations are expensive and inflation is running around 15%, which is why India has recently been raising interest rates.”
4) “I like your insight that non-financial American corporations have over 5% cash on their balance sheets. But, did you know corporations ended last year with 11.4% of their ASSETS in cash? In fact, just to get back to ‘norms’ would require ~$500 billion to be spent?”
5) “I like your agriculture theme and particularly your ‘spin’ on soybeans.”
To this last point, soybeans are a member of the legume family. Legumes, it should be noted, have an affliction called “nitrogen fixation.” That means, unlike corn, you don’t grow more soybeans per acre by throwing fertilizer on them. Manifestly, the only way to grow more soybeans is to plant more acres. Enter China, which has a voracious appetite for soybeans given their protein content. Yet, China’s farming acreage is shrinking due to the scarcity of water. Moreover, it takes a great deal of water to grow soybeans. China, therefore, imports roughly 50% of the world’s production of soybeans, which is one of the reasons we have recommended Archer Daniels Midland’s (ADM/$28.42) convertible preferred shares for the past 18 months. Despite its rally, and the fact that there are no near-term catalysts, the convertible preferred shares continue to possess an attractive dividend yield and are followed by our research affiliate. Coincidentally, Jim Grant, eponymous captain of Grant’s Interest Rate Observer, recently wrote about Benjamin Graham’s seven metrics for investing in a stock. While on December 12, 2008 there were eight such companies meeting Graham’s requirements, today there is but one. That company is Archer Daniels Midland.
Speaking to the stock market, while the intermediate/longer-term outlook remains positive, the shorter-term environment continues to counsel for caution. Granted, we may be “talking” our position, having been too cautious since recommending that strategy on March 15th with the SPX at 1150. However, as Charles Dow stated – The successful investor needs to be able to ignore two out of every three money making opportunities. Or as Warren Buffett puts it, “The market is very efficient at transferring assets from the impatient investor to the patient investor.” Anyhow, we are patient, and our indicators are still well overbought. Also, the MACD indicator is on the verge of flashing a short-term “sell signal,” the number of NYSE new highs has narrowed noticeably, the upward revisions in analysts’ earnings estimates has narrowed while analysts’ Buy ratings relative to Sell ratings is at an eight-year high, and last week saw the S&P 500’s (SPX/1166.59) first 1% downside session in weeks – the longest such skein of the current “bull run.” Further, last week there were two sessions of “negative key reversals” (Thursday and Friday), which by our pencil is a sign of distribution of stocks (read: caution). As our technical analyst Art Huprich observes:
“Within the context of the current intermediate-term uptrend, on a short-term (trading ) basis, and similar to what occurred on September 23, 2009 and October 21, 2009, the S&P 500 recorded a negative key reversal formation (last Thursday and Friday)! The intraday high to intraday low decline for each previous instance was 5.6% and 6.5%, respectively.”
The call for this week: The bond market is at kiss-and-tell levels as the 10-year Treasury yield approaches its reaction high of ~4% (see chart). As repeatedly stated, we think this “higher rates” mindset is what’s behind the U.S. Dollar Index’s strength as it broke out to new reaction highs last week. We also believe both of those events are responsible for the Reuters/CRB Commodity Index’s weakness. Still, we are able to find good risk/reward situations for the investment account, even though we are on the sidelines in the trading account. Last week three more stocks followed by our Canadian research team became of interest: North American Energy Partners (NOA/$8.58/Strong Buy); Northern Dynasty Minerals (NAK/$9.04/Strong Buy); and Fortress Paper (FTPLF/$18.69/Strong Buy). As always, Blue Sky issues should be checked before purchase.
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“There was a Chemistry professor in a large college that had some exchange students in the class. One day while the class was in the lab the professor noticed that one young man (an exchange student) kept rubbing his back, and stretching, as if his back hurt. The professor asked the young man what was the matter. The student told him he had a bullet lodged in his back. He had been shot while fighting communists in his native country who were trying to overthrow his country’s government and install a new communist government. In the midst of his story he looked at the professor and asked a strange question. He asked, ‘Do you know how to catch wild pigs?’ The professor thought it was a joke and asked for a punch line. The young man said this was no joke. ‘You catch wild pigs by finding a suitable place in the woods and putting corn on the ground. The pigs find it and begin to come every day to eat the free corn’.”
“When they are used to coming every day, you put a fence down one side of the place. When they get used to the fence, they begin to eat the corn again and you put up another side of the fence. They get used to that and start to eat again. You continue until you have all four sides of the fence up with a gate in the last side. The pigs, which are now used to the free corn, start to come through the gate to eat, you slam the gate on them and catch the whole herd. Suddenly the wild pigs have lost their freedom. They run around and around inside the fence, but they are caught. Soon they go back to eating the free corn. They are so used to it that they have forgotten how to forage in the woods for themselves.”
...Anonymous
Another part of the “fence” got erected yesterday with the passage of the healthcare bill. Not that I don’t think healthcare needs reforming, it does. Indeed, about a year ago my healthcare insurance provider refused to continue paying for Nexium, forcing my physician to prescribe a generic drug. It is half the strength of Nexium and therefore does not work nearly as well. The solution is to take two of the generic pills, which makes the cost more than that of Nexium – go figure. I also don’t understand how you reform healthcare without addressing tort reform, but that’s a discussion for another time. Anyhow, with the passage of said bill the government becomes even a larger component of the economy as it offers us more “free corn.” Yet Milton Friedman once stated, “There are no free lunches,” and there will most certainly be a price to pay for the policies of the past year. As the must read folks at the GaveKal organization write (as somewhat paraphrased by me):
“The best example of the long-term damage to an economy done by overtly interventionist policies can probably be found looking at the United Kingdom (UK). This for a very simple reason: the UK economic policy was Keynesian from 1966 to 1979, supply-side driven from 1979 to 1998, and Keynesian again under the wise guidance of Mr. Brown. And the results speak for themselves. In the (nearby) chart, the top red line represents the ratio between central government expenditures and GDP, on an inverted scale. In other words, the lower the red line is, the higher government spending as a percentage of the economy. The black line in the top panel is the seven-year moving average of the annual UK GDP growth rate. Finally, the grey line on the bottom panel represents the ratio between the value of the UK stock market and the operating surplus for UK companies as reported by the national accounts – a PE ratio of sorts.”
“Looking at the chart, something emerges quite clearly: a rise in government spending leads, over time, to a decline in the structural growth rate of the economy and to lower PEs. So it seems that the price that the system is paying for policymakers’ attempts at stabilizing the economy in a recession, or for allowing an unchecked growth in government spending, is a much lower structural growth rate.”
Currently, however, the U.S. equity markets don’t “see” the potential for a lower structural growth rate, and lower P/E ratio, as the Dow Theory “buy signal” of last year was reconfirmed last Wednesday. Indeed, the DJIA finally confirmed the DJTA by registering a new reaction high. That upside action also left the DJIA above the “50% level,” meaning the Dow has recaptured more than 50% of the points lost in the October 2007 to March 2009 decline, which is likewise a bullish occurrence. At the same time, last Wednesday there were 601 new 52-week highs on the NYSE, a new high total, and well above the 523 new highs of January 11, 2010. All of this caused one Wall Street wag to exclaim, “Is this a breakout, or a fake out?!”
Clearly it is a breakout, but it comes pretty late in the rally that commenced from the “hammer lows” of February 4/5th, and, has a lot of “hair” on it. For example, ~89% of the S&P 500 (SPX/1159.90) stocks are above their respective 200-day moving averages (DMAs) and consequently overbought. Likewise, ~86% of the SPX’s stocks are above their 50-DMAs, leaving the SPX, in the aggregate, roughly two standard deviations above its 50-DMA. Maybe that’s why the NYSE Overbought Indicator tagged a rare 90+ reading about a week ago, or why the S&P 500 relative strength index is above 90, both signaling that stocks are overbought. Now maybe this week’s end of quarter “window dressing” will keep institutional types engaged on the buy side, but with mutual fund cash positions at a paltry 3.6%, much of their firepower has already been used. Perhaps that realization, or Friday’s quadruple witch-twitch, is what finally rendered a “red candlestick” downside-day in the charts after the somewhat historic 14-day upside skein without any such “red candlesticks.”
Still the overbought condition, as of yet, has been outweighed by the upside momentum. When the “momentum mash” wanes is anyone’s guess, but as stated – I am not a very good momentum investor. Accordingly, in the short-term I remain cautious thinking the best strategy is to continue to pare some positions and/or raise stop-loss points. Longer-term, I maintain this is not the “new normal,” but rather the typical economic cycle. That is, corporate profits surge, which drives an inventory rebuild. Currently, profits have indeed surged with the largest ramp in corporate cash (y/y) since 1983. Combined with the increased activity at seaports, and the rise in shipping prices, it suggests inventory restocking has begun. Following an inventory rebuild comes a capital expenditure cycle and then companies begin to hire people. Then, and only then, comes a noticeable increase in consumption. It is important to note that hiring and consumption come on the back end of the cycle, not the front end. To be sure, the stock market believes this is the way it is going to evolve given that the Consumer Discretionary sector is the third best performing sector year-to-date (+8.34%), behind Industrials (+10.97%) and Financials (+8.98%).
All considered, while cautious in the short-term, we are moored in the belief that the current backdrop will allow the SPX to fill the downside vacuum created in the charts by the Lehman bankruptcy over the next few months. That yields an upside target between 1200 and 1250, as can be seen in the following chart from our friends at Bespoke Investment Group. Inasmuch, we continue to like the strategy of accumulating favorably rated names, preferably with dividends, in the investment account. Some names for your consideration include: CenturyTel (CTL/$34.86/Outperform), Leggett & Platt (LEG/$21.47/Outperform), and Brinker (EAT/$19.74/ Outperform).
The call for this week: The recondite healthcare bill passed last night and yet another “fence” has been built around the “wild pigs,” causing them to lose a little more of their freedom as they increasingly feast on the “free corn.” Meanwhile, the equity markets are pretty overbought, the SPX is at the top of its Bollinger Band, India joined China in monetary tightening, the yield curve is compressing because short-term interest rates are rising, and the number of analysts revising companies’ earnings estimates upward is thinning. Hence the question this week becomes, “Does quarter’s end institutional window dressing turn into an undressing?” Thus we are cautious, but not bearish, in the near-term. However, we remain bullish over the longer-term due to the fact that in nine of the ten bear market troughs since 1926 the SPX has gained an average of 9% in year two following said trough.
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