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Past Commentaries

1/15/2016

Current Commentary

To My Clients, Friends & Observers:

The stock market experienced its first correction in almost 4 years last August, recovering completely in 10 weeks. Corrections are declines greater than 10% from a high. They occur on average every two years. Now we are experiencing the 2nd correction in 4 years and the press would have you believe the world is ending. This is not a crash, bull markets don’t end this way. Corrections and volatility create trading opportunities and the revenues they generate. The two bogeys most often identified in the media are China and Oil. The greatest problem, domestic and global, is debt. It is unacknowledged. We are whistling past the graveyard.

I came across the following today, written by Greg Bresiger for Financial Advisor magazine. Speaking at the school’s 2016 Economic Outlook in Manhattan last Wednesday, University of Chicago distinguished professor, Dr. Amir Sufi, forecast a major economic slump for a nation whose government has pursued egregious economic policies. He cites bad planning, efforts to prop up the stock market, fudged economic data, lack of transparency, and rising household red ink. “When household debt levels rise precipitously and huge amounts are spent on public sector projects, then an economic downturn is inevitable.”

Considering the $3 trillion pork roast budget passed and signed in Washington last month, one would assume he’s referring to America, but in fact, it’s China. While China’s economic incompetence is increasingly apparent it is disturbing that the U.S. is guilty of many of the same errors. There are some absolute limits to debt, money is not worth whatever the Feds say it’s worth, and the impact of runaway debt is starting to crush the American economy.

At Schwab’s annual Impact meetings in Boston last November a question was directed to a panel that included 3 of Schwab’s top analysts, Liz Ann Sonders (chief investment strategist), Jeffrey Kleintop (chief global investment strategist), and Greg Valliere (politics). The question, loosely paraphrased, was: “Do any of you have any concerns over the $18 trillion U.S. debt? How long until it becomes a catastrophe? And is anybody addressing it in Washington?” The collective response was that it should be a concern, that in 8 or 9 years it will be critical, and that no one is actively addressing it in D.C. at this time. I’m reminded of the saying “bankruptcy comes slowly - and then suddenly.”

China’s woes are not affecting the U.S. economy to a significant degree. After all these years of “free trade” our total exports to China amount to less than 18% of GDP. They send us manufactured goods; we send them cash, treasury IOU’s, and manufacturing jobs. They buy very little of what little we produce. That will probably never change. It seems to me the nature and strategy of the middle kingdom. China’s economic malaise has little or no direct effect on our stock market. It is Dr. Sufi’s opinion that the American consumer, which represents 75% of our economy, is presently doing well. He predicts 2% annual growth for the next few years.

So what about oil? The party line here is that it is in everybody’s best interest that the price of oil stays high, that low priced oil and gas is a disaster for the economy. That is not necessarily so. The downside is that low oil prices make green energy and recycling technologies economically unviable. In addition, the oil industry has shed a total so far of over 125,000 relatively high paying jobs.

The upside is that those job losses are not that significant in light of the normal creation of over 200,000 (albeit low-paying) jobs every month for almost 2 years and that the average American driver is pocketing an extra $1,000 a year in gasoline savings and/or home heating oil. Low priced oil also directly enhances the profitability of every heavy industry where energy is always in the top 3 cost inputs. So why isn’t all this extra cash resulting in a burst of economic activity?

Evidence mounts that crushing debt is absorbing all this windfall cash. Student debt has reached $1.2 trillion. “Health insurance” and medical costs have become predominant household burdens. Per capita disposable income (in 2009 dollars) has increased at an annual rate of 0.9% from 2004 -2014 (Bureau of Labor Statistics) while Federal Social Benefits increased at a rate of 6.3% annually for the same period. Without these transfers of income, which increased at double the inflation rate, real disposable income would have decreased.

Because of these worsening financial constraints, millennials find themselves unable to secure down payments for first homes, which has resulted in home ownership declining to the lowest rates since the ‘70s, and rents at all-time highs, a vicious cycle. The value of the average American home has still not recovered to 2007 levels. What will support the future market for dying or retiring baby-boomers’ homes? It seems to me there is real potential for average home prices to decline.

Globally, growth is slowing. Rates of interest, income, inflation, imports, exports, freight shipments, manufacturing, housing, even population (1.2%) are in long term decline. U.S. GDP (Gross Domestic Product) may total less than 2% for 2015. Industrial earnings are not immune to the decline. S&P 500 Index earnings were 107 in 2013, 113 in 2014 (a record) and will end 2015 at approximately 106.

An examination of commodity cycles since 1925 suggests that periods of scarce commodities and high prices are followed by periods of oversupply and low prices that last twice as long. The climb in commodities prices from 2002 to 2011, may take 15 to 20 years to unwind. The CCI index has fallen from 680 to 500 in a long-term trading pattern that may consolidate as low as 350 to 400. The price of oil has fallen to $29 a barrel this week and new Iranian supply is coming on the market.

Allocating

Although several Fed governors have suggested 3 or 4 more rate hikes this year, I’d expect the Fed to hold off if a recession seems imminent. When interest rates are this low, the retail investor can’t afford to lend for any extended period. The risk is too great. Interest rates will likely remain low for a long time regardless of Fed action.

It is almost perverse that as rates rise, portfolios reallocate to fixed income securities, pushing prices up and yields down. The five year U.S. Treasury yielded 1.8% at year-end. It yields 1.45% today. The ten year has dropped from 2.3% to 2%. It is hard to get better than 1.5% from investment grade munis. And ever-looming ahead are the unfunded, unbudgeted, social transfer obligations including social security and medicare but also pension obligations on the state and local levels. Governments’ solution to all these obligations has always been to borrow. Rates must stay low. But low rates alone will not cure the debt problem.

From 2000 to 2014, total GDP increased from $10.2 trillion to $17.3 trillion, a 69% increase. At the same time Government Consumption Expenditures and Gross Investment (included in GDP) rose 93%. Federal Debt as a percentage of GDP rose from 57.6% to 101.5%.

Since 1933 the average annual GDP growth rate is 8.36%; the median is 6.44%. For the 16 years 2000 to 2015 the rate has declined to 3.8%. For the years 2008 (-.92%) through 2015 (est. 2.5%) the average has declined to 2.6%. Strong economic growth could mitigate the debt. But when debt is growing at a multiple of the rate of GDP, even the debt service at 2% becomes unmanageable. 2% of a trillion is a thousand times 2% of a billion. That is why there are absolute limits to debt.

With everything so close to zero, risk is amplified. It is risk-off time. The S&P 500 is overvalued 15% on an earnings basis, but fairly valued on a price to book basis (2.6 times).

There are opportunities to invest in energy stocks and the reliable dividends they provide. The same goes for good quality utility companies. Yields from 3% to 4.5% are common in reliable, regulated utilities. The Utilities Index, down 6% in ’15, is up 2 ½% so far this year – the only index in the green. ExxonMobil, which has paid cash dividends every year since 1882, earns $4.74 and pays out $2.92, for a yield of 3.8%. There are many others.

APolitical Cycle

Since 1925 there have been 22 4th year of presidential terms. The S&P has been positive 18 of those years (82%) with an average gain of 11.1%. It has been negative 4 times with an average loss of 16.3%.

Regarding Global Trade

In the November 4th Wall Street Journal, George Melloan wrote an article comparing Donald Trump to Herbert Hoover because of Trump’s proposal to tax Chinese imports until fair trade policies are enacted and enforced. Mr. Melloan recalled correctly that the Smoot-Hawley trade tariffs imposed by the U.S. on imported goods sparked a chain reaction and a trade war that only magnified the global depression. He suggests Trump’s tariffs would do the same. The comparison fails because America was by far the world’s largest manufacturer and exporter in the 1920’s. America had everything to lose and little to gain from a trade war. Today conditions are exactly reversed. As noted above, there are not enough imports from the U.S. for China to tax. A trade war would hurt China. Retaliation would be insignificant to the U.S.

I responded to the article and the Journal printed my (abbreviated) letter on November 9th. I post the original here, in full.

To The Editor:

Regarding “Donald Trump, Meet Herbert Hoover,” (George Melloan, WSJ OpEd 11/4/15) doubtless Mr. Trump knows all about Herbert Hoover and the Smoot-Hawley tariffs. Mr. Melloan needs reminding that trade conditions in the 1920’s do not correspond to conditions today. In the 1920’s the U.S.A. was by far the largest manufacturing exporter in the world, underscoring the error of Smoot-Hawley. Retaliation was inevitable. Today the American manufacturing base continues to decline and China manufactures just about everything. Mr. Trump has often said that the U.S. has built China and he is right. China will continue to grow financially and militarily, thanks to American trade policy. America has exported its manufacturing base at the cost of millions of jobs and their exponential multiplier effects. Those jobs have been exported to a nation with few if any protections for labor, the environment or the consumer, and which costs of production are consequently impossible for the U.S. to match. There is nothing in sight that can correct this trade imbalance. This is a terrible price America is paying for cheap Chinese goods. America isn’t selling its productive heritage, it’s giving it away. Mr. Trump is bold enough and patriotic enough to take a stand in the public arena against this foolish, regressive inertia.

Sincerely,
S/N

This is not an endorsement of Mr. Trump or 45% tariffs on Chinese imports, but it is a criticism of poor American trade policy. Just as an investor should have a diversified portfolio of non-correlated assets, the U.S. should have a diversified portfolio of industries, including and especially manufacturing.

Best regards,

Dennis M. O’Connor