Well I stepped out the tub Put my feet on the floor I wrapped my towel around me And I opened up the door and then Splish Splash I jumped back in the bath well how was I to know there was a party goin’ on?
Bobby Darin
That must be how the bears felt last week. How were they to know the world’s central banks were about to splash the market with another wave of liquidity? Ben Bernanke and his fellow central bankers not only set out the punch bowl last week, they filled it to overflowing and spiked it with grain alcohol. And maybe a little something leftover from Ken Kesey’s Merry Pranksters bus tour. How else to explain a market rally based on lowering an obscure interest rate that most investors didn’t know existed before last Wednesday? To convince oneself that the only thing standing in the way of robust global economic growth was a 50 basis point change in the rate charged on US Dollar swap lines requires either a leap of faith or the ingestion of mind altering substances. My lack of faith in central bank orthodoxy is well known and for the record, the only mind altering substance allowed in our office is the occasional batch of Cuban coffee.
The size of the stock market rally last week was more a function of the cloud of pessimism that has encompassed markets for the last month than a comment on the efficacy of the rate cut. No doubt a considerable number of the shares bought last Wednesday were needed to cover short positions established in advance of the end of the world – now rescheduled for this week, or next at the latest, if the bears are to be believed. European leaders will meet this week in an effort to establish a regime to enforce more fiscal discipline. The only thing I’m certain will happen as a result of those meetings is a press conference announcing a plan crafted by Europe’s courageous politicians to save Europe from its politicians.
Whatever plan is announced with respect to Europe’s fiscal planning, ECB chief Mario Draghi made it clear last week – as clear as mealy mouthed central bankers ever do anyway – that more monetary easing is likely on the way. The ECB has hidden behind the veil of its single mandate for price stability until now but price stability works in both directions. With money supply contracting in the periphery, Draghi can easily make the case that purchasing Italian and Spanish bonds is within his mandate and necessary to stave off deflation. Obviously, he would prefer that a fiscal agreement be in hand before he announces large scale bond purchases but I find it hard to believe he would just stand by and allow the Euro he is pledged to defend evaporate on his watch.
I am also convinced that fiscal discipline is coming to Europe regardless of whether a supranational body is empowered to enforce it. As Herb Stein said long ago, “if something cannot go on forever, it will stop” and if the EU doesn’t enforce budget discipline then surely the markets will. It would less painful in the short term if a political agreement for enforcement is reached and the ECB supports bond markets while the transition to smaller government is effected, but government budgets will shrink regardless and in the long run that is a positive development. Whether Europe’s banks could survive without government intervention is another question entirely. That was obviously a motivating factor in the central banks actions last week and underscores the global nature of the risk. While I cannot predict the outcome of the fiscal negotiations, I do believe the banking system will be vigorously defended. For the US and global economies, that is of much greater importance than recession in Europe. It would also seem that if the outcome in Europe is merely a recession – and not a depression as some are predicting – then share prices there likely already reflect that likelihood.
Underscoring the limited impact of the European situation on the US economy was the stream of better than expected economic reports last week. As I’ve pointed out before, the future course of the US economy is dependent on what happens here, not in Europe or anywhere else in the world. The US economy is not completely immune to a slower global economy but it is certainly better able to absorb it than any other country. So far, the slowdown in China and Europe has had no noticeable effect on a US economy that seems to be accelerating modestly. If it continues to do so, that would also likely limit to some degree the depth of any recession beyond our borders. One can’t help but wonder how much better the US economy would be right now if we had had better economic policy over the last few years (or to be fair to Obama, the last 10 years).
Three reports from last week indicate the real estate market continues to slowly recover. New home sales rose modestly, up 1.3% for the month to a still depressing 307k annual rate. Median prices fell 0.5% on the month but are 4% higher than a year ago. Inventory remains lean at 6.3 months at the current pace of sales. Pending home sales also rose last month, jumping 10.4% but that probably won’t translate into that large a rise in actual sales since the rate of cancellations is still running high due to problems with credit and appraisals. Nevertheless, the report does indicate that lower prices and interest rates are generating a rise in demand. Construction spending also rose in October, up 0.8%. Outlays are now down just 0.4% year over year and have risen for three straight months and six of the last seven. It is rising from a very low base but it appears construction is now adding to overall economic growth. All the gains, by the way, were on the private side with residential up 3.4% and non-residential up 1.3% while public spending was down 1.8%.
On the consumption side of the economy, retail reports were somewhat mixed. Goldman and Redbook reported big gains with year over year same store sales clocking in at a +4% and 5.4% respectively. Actual chain store sales reported Thursday, however, were more mixed with gains of about 2.5%. In addition, auto sales for November came in at a 13.6 million annual rate and the high end of estimates. Sales are up strongly over the last three months but still well below the 15+ million rate before the recession. As I’ve said many times, consumption is not what ails the US economy.
On the production side, the Chicago PMI and the national ISM manufacturing surveys were also reported better than expected. The Chicago report, which includes both manufacturing and services, rose to 62.6, well above the 50 level that indicates expansion and also above last month’s 58.4 as expansion accelerated. New orders rose to a very strong 70.2 and backlog orders rose 4 points to 55.1. Those are the highest readings since the spring. Growth in payrolls however slowed to 56.9 from 62.3. The national ISM manufacturing survey was also higher at 52.7 but not as positive as its Chicago cousin. New orders were up strongly at 56.7 but backlog is still falling. Hiring also slowed but the new orders will hopefully change that trend in coming months. We get the non manufacturing ISM survey on Monday and the strong Chicago report may point to a good number.
The news on the labor market was mostly positive but the situation is still far from healthy. Jobless claims rose back above the 400k level but I don’t pay much attention to claims in holiday weeks as they are often distorted. The headline from the full employment report Friday was a drop in the unemployment rate to 8.6% but that only tells part of the story. The main reason for the drop was a reduction in the size of the workforce which appears to be concentrated among women and specifically, single women. I don’t have a good explanation for that and would just note that it is a fairly volatile variable and I wouldn’t be surprised to see it reversed in coming months. In addition, the quality of jobs that were created leaves quite a bit to be desired with a large part of the rise coming in retail trade. Our chief economist, John Chapman, has a more detailed look at the report which can be found here. Suffice it to say we are encouraged by the report but still unsatisfied with the current state of the market.
Despite the rally in stocks last week, markets remain in limbo technically with all the indexes we follow residing just below their respective 200 day MAs. With the US economy continuing to expand and possibly accelerating, I am maintaining a bullish bias. Our portfolios do still have a larger than normal allocation to cash and absent a change in fundamentals, I would likely be a buyer of dips. For the other asset classes we follow, gold continues to look best technically but I find it interesting that there wasn’t more of a rise based on the central bank actions last week. One would think that further monetary easing would have been a big motivator for commodity and gold speculators but the action was muted in both. REITs remain underweight in our portfolios for both fundamental and technical reasons.
Outside our ETF portfolios we continue to find good value in both US and foreign large cap stocks. Bear markets – and yes I think we are still in a secular bear market – are when good investors make their money because it is when assets can be had on the cheap. With earnings yields on many blue chips hovering around 10% and Treasury notes trading at fractional interest rates, I continue to believe that long term investors should be concentrating on accumulating stock positions whether in individual companies or index funds. The US dollar continues its bottoming process and that means to me that investors should be placing less emphasis on commodities, gold and real estate. We will eventually get better economic policy and the bear market will end. When it does, investors who have spent the bear market accumulating high quality positions will be rewarded in an outsized manner. As for the exact timing, I have no idea but using history as a guide we are probably in the final three innings of the secular bear market. Let’s just hope we don’t go into extra innings.
For information on Alhambra Investment Partners' money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com
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