2010Sep12 Week In Review

Forecasts for economic growth through next year continue being scaled back. Even after recent negative revisions, it is becoming clear that the housing tax credit accelerated sales that would otherwise have been expected in the last half of this year. Slower growth in future quarters is the result of the federal “stimulus.”

 

U.S. exports improved earlier in the year adding to profits and an anaemic GDP. However, smaller economies will not replace the U.S. consumer penchant for spending which continues to wane reducing the incomes of our global suppliers. Slowing global economies reduce our ability to export goods and services. This will continue impacting GDP and profits in the year ahead. It can lead to a vicious circle of deflation.

 

Not only are consumers shedding debt, they are shunning it. Even if home owners still have equity, they are not using it as a piggy bank to support life style choices. The result is lower total sales, GDP, persistently high unemployment and under-employment. Part of the driving force in debt reduction is the changing stage of life for Boomers rapidly facing under funded retirement. Another is the economic fears in the rest of the population over income insecurity. Neither of these is solved by government fiat or policy.

 

Financial uncertainty is not good for households or businesses, especially when the issue is taxes. Presently, tax rates are going to rise significantly for everyone at year’s end. Unlike the assumptions used by Congress and the Administration, families and businesses change their behaviour with changes in the tax code.

 

Just as Cash for Clunkers and housing credits accelerated purchases from the future into the present for tax advantage, we should expect increasing tax rates to change behaviour. If a choice is available, everyone who is paying attention will accelerate earnings into 2011. There is no way to know for certain how much corporate earnings will be driven by tax planning this year. Like the absence of sales for cars and homes, the impact isn’t visible until we are further downstream.

Even if current tax rates are extended for two years by legislation after the elections, will President Obama sign the bill? So far, his response has been negative. Will two years be a catalyst for business expansion? Unknown.

 

Real Estate:

 

Many investors, economists, the Administration and Congress are trapped in “anchoring.” Behavioral finance studies have shown that we cling to the highs of our portfolio to return and advance even higher. We do this naturally even when the facts have changed.

 

For example, why should home prices rise in the midst of excess supply and shrunken demand? Because “they always do?” They did if one’s life experience was the last quarter century. That is anchoring. Home price appreciation was nil from the late 20s to the mid-70s when demand began to increase and supply was limited. The facts have changed.

 

Stock Market:

 

Another “anchoring” problem occurs when assuming federal fiscal stimulus will re-create the benefit of Boomer spending in the past several decades. The facts have changed.

 

America has lost industries that will likely never recover. Sate and local governments are in the early stages of “down sizing” employment that is in full swing within industries such as home construction, auto manufacturing, pharmaceuticals, telecom, newspapers, airlines, realtors and bank tellers.

 

Portfolio modeling software uses long-term market returns including the industries just listed. History repeating or “reverting to the mean” is a cornerstone of Modern Portfolio Theory. Building a portfolio on the history of post-WWII faded or fading industries is “anchoring.” The facts have changed.

 

The days for the Ron Popeil Portfolio – “Set It & Forget It” – are no longer. Buy and hold and peek once in a while for fun or reassurance function in a bull market. Today, most investors are not prepared to be as attentive to a portfolio as a short order cook is to incoming orders or as flexible as an Iron Chef with the secret ingredient.

 

Price/Earnings ratio is a traditional tool to determine whether the market is expensive or a bargain. With the market down 9% since the April high and corporate earnings up, the P/E ratio has fallen back to early 1990’s level. IF earnings can continue to grow, the current P/E means investors will be rewarded for owning equities rather than bonds. That may be a big bet given investor behavior with real estate and the tax issue addressed above.

 

Further, the P/E trend is more important than the economy. Economic growth affects earnings, but the assumption that the economy and stock market are married is another “anchor.”

 

Relative strength, or momentum, provides an indicator of “changing temperature” in sectors and direction of the market.

Presently, emerging market fundamentals surpass developed markets with generally better economic growth, fiscal balance sheets and monetary policies. Currencies and interest rates in emerging markets appear, to us, to be more favorable than in developed economies where sovereign debt is increasingly burdensome. We added exposure to emerging markets in our ETF portfolios this week.

 

“When the facts change, I change my mind. What do you do, sir?” - John Maynard Keynes

Our plan is “the plan will change.” What is your plan?