Monarch Article 07/01/10

With the S&P 500 now 16% below its high on April 23, the market sits firmly in “correction” phase. A drop of more than 20% technically begins the “bear market” phase. Not that we’re technicians, but we’d all certainly rather be in the midst of a bull market rather than a bear market. Note that if this bull market is about to end, it would be by far the shortest bull market ever, as the Strategas chart below shows:

What we’d all like to know is whether we should be worried about inevitably slipping into a “double-dip” recession, meaning a 2^nd recession that happens just after the previous recession ended. This has happened only once in modern times, in 1982. In 1981, after Reagan was elected as President, he teamed up with Fed Chairman Paul Volcker to exterminate inflation, which was running rampant. Volcker jacked up short-term interest rates in order to produce a downturn which would kill inflation. It worked. Fast forward to today, where all forces in the U.S. are going for growth, but budget austerity in Europe runs the risk of throwing that continent into recession.

Our bottom-line take on another recession is that it’s possible, of course, but there are too many factors pushing the economy the other way. These would include resilient consumer spending, modest consumer income growth, consumer balance sheet repair already done, record low interest rates, corporate wealth, and the biggest of all: corporate capital spending that has the potential of exploding upward.

You might notice that nowhere on this list is anything to do with the government. We have NEVER before the recent financial crisis witnessed as much attention paid to government budgets, debt, spending, and stimulus. That attention has only increased since the beginning of 2010, to the point that most casual observers of our economy could be forgiven for believing that companies and individuals no longer have anything to do with running the economy. We believe this is a critical error that people are making. It doesn’t help that we have a government that has vacillated between: 1) not caring about corporate America, and 2) antagonizing corporate America. However, we feel that the impact of the government has been dramatically overstated. And, come November, the tenor coming from Washington might finally change as voters come to the realization that government has failed to stimulate the economy (although we do believe the government, particularly the Fed, played a significant role in rescuing the financial system from potential Armageddon), and that the best thing government can do is to allow the private sector to do its thing, rather than getting in its way.

That said, corporate America does need to take its cues from Washington, and the current lull in the economy can be largely explained by corporate America waiting to see how many times legislators will “change the rules of the game” before companies commit resources to growth. This gets manifested into the economy in the following ways:

On the 3^rd item on the list, banks have obviously been keen to learn how their industry would be affected by the massive financial regulatory reform package now working its way through Congress.

In sum, the pause in corporate activity inevitably will lead to a freeze in growth. Resolution of their concerns about Washington would lead to a massive thaw. If this were ever to be achieved, what will cause our economy to grow?

As a background, the U.S. economy has produced record productivity growth in recent quarters. Companies have seen sales go up, but have not yet started hiring. Here’s an interesting statistic: early in 2010, U.S. GDP surpassed its previous peak from 2008 (yes, you saw that right—our economy is now producing more goods and services than it ever has), yet with a work force of only 130 million, down from 138 million. Companies have already started adapting to rising sales by doing everything but hiring new full-time workers, including increasing hours worked, hiring more temps, and even boosting wages. These are temporary, and eventually lead to growth in full-time workers. Why? Because companies NEED TO GROW. If they don’t, they may lose out on opportunities to their competitors. If they don’t, their stock will suffer, as investors seek out true growth companies, especially in a low-growth world (example at end of this tome). So, here’s how this plays out:

While we wish we had the magic “crystal ball” to help us see whether the growth lull will escalate into a recession, at least we have some leading indicators. Just remember, there are no perfect leading indicators, but the sum of them should paint a picture that seems to belie how the stock market is acting.

Small-cap stocks would be underperforming large-caps as investors seek out safer companies. They’re not: small-caps even outperformed in the 2^nd quarter.
Cyclical stocks would be underperforming defensive stocks. They’re not. In fact, Strategas has an index called the “Bellwether Index” which is comprised of the 15 stocks most correlated to GDP growth. As the chart below shows, these stocks are performing in-line with the market, as opposed to 2008 – early 2009, when they underperformed the market by a cumulative 35%.
The yield curve would have been inverted in the last 1-2 years. In fact, it’s been steep since late 2007 -
ISM indices would be nearing 50 or already below. The June reading came out today at 56.2, down from 59.7, but still reading in the “strong growth” category:
LIBOR would be skyrocketing. It started bumping up in March as the ECB headed towards rescuing Greece, but stopped rising in late May at 0.54%. During the financial crisis in late 2008, LIBOR hit 4.82%.
Financial stocks, and their preferred stocks, would be tanking. Financial stocks have held up relative to the market, and most preferred stock prices haven’t even fallen since April.
Risky bond yields would be spiking. In fact, spreads of junk bonds to treasuries have bumped up only about 1% from their lows in April, pretty small in the context of the 15% “bump” seen in 2008.
The U.S. Dollar would be soaring as a flight to safety ensues. In fact, the trade-weighted $ peaked on June 7 and is down 4.5% since then.
Oil and copper prices would be tanking. While copper is down about 20% since early April, that pales to the 182% increase in prices that preceded the 20% drop.

These all seem to point to a similar story—a slowdown in growth, but no recession.

In the effort to present a “fair and balanced” story, some data seem to legitimately support claims of an economy headed closer to recession:

So if the recession argument isn’t terribly strong, why is the market now down 15% from its April 23 high?

Was it irrational exuberance, as investors pumped stocks up 83% over 13+ months? If stocks were overvalued at the “peak” in April, we should have seen a spike in mutual fund flows into stocks, right? Nope—the retail investor continues to file absentee ballots: no new money into stock funds, all the new money going into bond funds, the opposite of 1999:

Speaking of 1999, how close are we to the peak of the bond bubble? It would appear pretty close:

In fact, the biggest factor in the market right now is the “risk on-risk off” hedge fund trade, which is a variant of the “carry trade” that blew up many hedge funds in the last bear market. In the carry trade, hedge funds borrowed money at low interest rates (like in the U.S. in 2002-2004, or in Japanese yen after that), and reinvested in higher-yielding investments, such as long-term bonds, emerging market bonds, or even real estate. Side note: many people have indicted former Fed chairman Alan Greenspan with creating the asset bubbles of the 2000s because he kept interest rates too low for too long. The carry trade was largely the vehicle which created these asset bubbles, which only got bigger as mutual funds and retail investors bought into them. The story ended as the “buy” side of that trade tanked, and the leverage from borrowing came back to haunt them.

As the stock market started recovering in 2009, many hedge funds quickly pivoted from a short or neutral position on the market to the “risk-on” trade. With interest rates very low, hedge funds once again borrowed at favorable rates. Instead of buying long-term bonds, this time they found value in stocks. As the market continued to advance, more and more hedge funds bought into the “risk-on” trade. Let’s not forget that the S&P 500 was up 83% by April 23 (from the low in March 2009).

The core stocks fared better than the S&P 500 in the 2^nd quarter, but not by much. This market has not favored defensive stocks, making us think the market correction has less to do with the recession than it does a simple fear of holding a volatile financial asset like stocks. Growth stories stood out during the 2^nd quarter. 3 of our large holdings actually went up in the quarter—EMC, McDonalds, and Lakeland Financial—and all 3 are legitimate growth stories. Note that these are not in defensive industries—technology, consumer discretionary, and banking.

This market does not care about valuations, but we point out that valuations on many of our largest holdings are nearing where they were at the trough of the bear market, which we should all agree were completely irrational levels. We’re again seeing P/Es at 10 or under on stocks that never traded below 20 until the last few years. Here are some stocks trading at P/Es of 10 or less, using “forward earnings” which means an estimate of earnings the company will earn in the next 4 quarters. While the company’s actual earnings could be more or less, they’re still decent predictions:

Going out another 4 quarters, into 2012, another batch of companies trade around 10 P/E. While this may seem too far away to consider, just remember that 1 year from now, investors will be anticipating 2012 earnings:

As we know, the 2000s weren’t a kind decade to investors, and since 2010 hasn’t started out much better, we’ll refresh the historical context for 10-year periods with no gains in stocks: it happened once before (1929-38), and the return was similar to that of the past 10 years (INCLUDING the strong 2009 performance!!!):