What a difference a day makes!
Yesterday I opined that a better-than-expected GDP reading today could turn the market around and send stocks up again. That’s just what happened: 3rd-quarter GDP came out at +3.5%, better than the +3.3% “consensus” estimate. Stocks shot up right out of the gate and did not look back. By the time the closing bell sounded, the Dow was up 200 points (+2.1%) and the S&P 500 had jumped 23.5 points (+2.3%). Today also represents the biggest one-day rise since July 23.
So is the correction over already? It could be, as the length and depth of the drop has been similar to the several we have seen since March. Also, we are entering a seasonally strong period (November through May), which typically sees the best gains of the year. On the other hand, the market is much pricier now than it was just a few months ago, meaning that the bar is moving higher for good news to have a positive impact. Though I personally believe that we will see more positive surprises than negative ones over the next few quarters, that doesn’t mean we won’t have periodic setbacks.
You may have heard in the news that a lot of the growth in GDP last quarter came from government programs, such as “cash for clunkers” and the home buyers’ credit. One article said that “stripping out auto output, the economy would have expanded at only a 1.9 percent rate in the third quarter.” There are at least two problems with these statements. One is that it doesn’t matter why people buy something: a purchase is a purchase. Government incentives may be driving some sales now, but once they fade, other reasons could take over. The argument that consumption will suddenly stagnate without government incentives is specious.
The second problem with these statements is that they are just plain wrong. My own calculations from actual government data show that if one stripped out all auto sales directly attributable to the cash for clunkers program (670,557 vehicles at an average price of $28,400 = $19 billion), the economy still would have expanded by $93.5 billion last quarter, or 3.0% annualized. This is still a respectable advance, and well above the 1.9% claimed above. (You could calculate a growth of just over 2% if you stripped out all durable goods sales, including not just cars and trucks, but washing machines, furniture, heavy equipment, iPhones, etc.) On top of this, a large percentage of people who bought cars under the government’s program said they would have done so anyway.
What about the homebuyer’s credit? This is harder to calculate, because only new home construction and real estate commissions affect GDP; sales of existing homes or new homes sitting vacant since the prior quarter are not counted. It’s difficult to discern whether the home buyer credit caused an increase in the construction of new homes, and by how much, but I’m going to try. A study by Goldman-Sachs estimates that the tax credit has enticed about 200,000 more homebuyers to enter the market. About 1.5 million homes sold in the 3rd quarter. Let’s assume that all 200,000 of those first-time homebuyers bought a home last quarter; this would mean that 13% of sales were from these government-incentivized buyers. Let’s further assume that home construction increased proportionately.
According to the government GDP release, new home construction added 0.53% to GDP last quarter. (This is, by the way, the first time that residential construction was a positive contributor to the economy, rather than a drag, since 4th quarter 2005, when it added a whopping 0.1%!) If 13% of that was caused by the home buyer credit, then this government program added all of 0.07% to GDP. So without the credit, GDP growth last quarter would “only” have been +3.43%.
Take out both programs, and GDP would still have risen by about +2.9%, considerably better than economists were estimating just a month ago. What about direct government expenditures, or the rest of the stimulus program? Non-defense federal expenditures and investment added all of 0.17% to GDP last quarter, about the same as 2nd quarter; this is actually less than it contributed during several quarters in 2003 to 2006, when the economy was doing well. So direct government expenditures are not driving our economy, either. (As a comparison, during WWII military expenditures added a whopping 29% to GDP in 1942 and 19.5% in 1943; today they add between 0 and 0.4%.)
So those who say that government stimulus is primarily supporting our economy are misreading the data. Interestingly, these are often the same people who say that government stimulus programs don’t work. Now I’m not going to get into the economics nor the politics of this hot potato. I’m just going to conclude that the recession is over, the economy has started growing again—with or without government help—and good times will eventually follow.
Friday, October 30, 2009
Wednesday, October 28, 2009
Why is Wall Street spooked?
Judging by the talking heads in the news media, you’d think the nascent recovery has come to a grinding halt. Despite over 80% of S&P 500 companies beating their earnings estimates, with many also showing higher sales than expected, gloom is everywhere. Consumer confidence has fallen for 2 months in a row. Forecasters are starting to ratchet down their 3rd-quarter GDP growth estimates. And the equity markets have taken back their October gains, putting us about flat for the month. This many be disappointing, but after last October, when global markets plunged –20%, a merely flat month should be something to cheer about. After all, even in a roaring bull market, stocks never go up every month. But why is this happening in the context of mostly positive news?
The obvious answer is that stock prices already incorporate the good news, while the few pieces of unexpected bad news (an earnings miss here, a surprise drop in new home sales there) are drawing everyone’s attention. During periods of economic growth, there are times when growth stalls or even backtracks. This has been the case in every recovery. Stocks tend to follow a similar pattern, with an overall uptrend punctuated by periodic setbacks. A drop in stock prices tends to reinforce the pessimism that triggered the drop in the first place. Eventually, pessimism peaks and the markets hit a near-term bottom. At this point, the uptrend can start again.
There’s clearly no way to know exactly when this will occur. If I did, I’d buy only on the days when each downtrend reversed and do all my selling just before each drop started. So although I claim no special clairvoyance (never have, never will), I sense that we’re close to a reversal back toward the upside, which could start as early as Thursday or Friday. A lot will depend on how the “flash” GDP number looks tomorrow. It it’s much better than expected, stocks could soar; if worse, they could fall some more before turning up again.
This GDP number is particularly important because it will likely represent the first quarter of economic growth in well over a year. Investors and economists are anxiously awaiting the “official” number, even though this initial estimate will be revised 2 or 3 times over the next several months, and “flash” reports are notoriously inaccurate. Even so, people will parse the details behind the aggregate number looking for clues to the future trajectory of economic growth in the US (despite the well-known fact that predicting the future by examining the past is futile).
On top of anxiety of tomorrow’s GDP report, and ongoing fears regarding bank solvency and the commercial real estate market (universally described as “the next shoe to drop”), we’ve had a couple of well-regarded investors call a near-term top to the current bull market. These include Bill Gross, chairman of PIMCO and one of the best bond managers in the word, and Jeremy Grantham, a well-known equity investor who supposedly predicted the 2008 downturn. Not surprisingly, many people take these pronouncements seriously, even though the smartest person is as likely to be wrong as right when predicting the future. And by the way, Bill Gross, despite his expertise in bonds, has a terrible track record in predicting the stock market (good thing he sticks to bonds when investing). And Jeremy Grantham not only predicted a bear market in 2008, but also in 2003, 2004, 2005, 2006 and 2007. (Nothing like being 5 years too early!) And by the way, despite being an avowed bear, Grantham still has 62% of his clients’ funds in equities. Go figure.
In sum, nothing that has happened recently has convinced me to change my intermediate- and long-term view that the economy, and along with it, risky assets such as stocks, bonds and commodities, will continue their general uptrend for quite a while. Until pervasive fear is eventually replaced by pervasive greed (something we are not likely to see for several years), every brief downturn and setback will scare the daylights out of most investors. But this sudden increase in the underlying level of fear only serves to form a base for the next leg upward, which these frightened investors will likely miss.
One last note: Americans continue to focus on their own country to the relative exclusion of the rest of the world. This is even more of a mistake today than it was in years past. The US stock market now represents only 42% of world market capitalization, and our GDP is just 25% of world production. And much of the world is growing far faster than the US. South Korea, for example, just reported a surprise 2.9% increase in GDP last quarter (equivalent to 15.4% annual growth). US economists would be giddy if we could produce an annual growth rate of just 6% in a single quarter. Thus, much of the opportunity in investing lies outside the US. This is why over 55% of our clients’ equity investments, and more than 20% of their bonds, are in non-US countries. Why not take advantage of the relative rise of the rest of the world?
Halloween should spook you; Wall Street should not.
The obvious answer is that stock prices already incorporate the good news, while the few pieces of unexpected bad news (an earnings miss here, a surprise drop in new home sales there) are drawing everyone’s attention. During periods of economic growth, there are times when growth stalls or even backtracks. This has been the case in every recovery. Stocks tend to follow a similar pattern, with an overall uptrend punctuated by periodic setbacks. A drop in stock prices tends to reinforce the pessimism that triggered the drop in the first place. Eventually, pessimism peaks and the markets hit a near-term bottom. At this point, the uptrend can start again.
There’s clearly no way to know exactly when this will occur. If I did, I’d buy only on the days when each downtrend reversed and do all my selling just before each drop started. So although I claim no special clairvoyance (never have, never will), I sense that we’re close to a reversal back toward the upside, which could start as early as Thursday or Friday. A lot will depend on how the “flash” GDP number looks tomorrow. It it’s much better than expected, stocks could soar; if worse, they could fall some more before turning up again.
This GDP number is particularly important because it will likely represent the first quarter of economic growth in well over a year. Investors and economists are anxiously awaiting the “official” number, even though this initial estimate will be revised 2 or 3 times over the next several months, and “flash” reports are notoriously inaccurate. Even so, people will parse the details behind the aggregate number looking for clues to the future trajectory of economic growth in the US (despite the well-known fact that predicting the future by examining the past is futile).
On top of anxiety of tomorrow’s GDP report, and ongoing fears regarding bank solvency and the commercial real estate market (universally described as “the next shoe to drop”), we’ve had a couple of well-regarded investors call a near-term top to the current bull market. These include Bill Gross, chairman of PIMCO and one of the best bond managers in the word, and Jeremy Grantham, a well-known equity investor who supposedly predicted the 2008 downturn. Not surprisingly, many people take these pronouncements seriously, even though the smartest person is as likely to be wrong as right when predicting the future. And by the way, Bill Gross, despite his expertise in bonds, has a terrible track record in predicting the stock market (good thing he sticks to bonds when investing). And Jeremy Grantham not only predicted a bear market in 2008, but also in 2003, 2004, 2005, 2006 and 2007. (Nothing like being 5 years too early!) And by the way, despite being an avowed bear, Grantham still has 62% of his clients’ funds in equities. Go figure.
In sum, nothing that has happened recently has convinced me to change my intermediate- and long-term view that the economy, and along with it, risky assets such as stocks, bonds and commodities, will continue their general uptrend for quite a while. Until pervasive fear is eventually replaced by pervasive greed (something we are not likely to see for several years), every brief downturn and setback will scare the daylights out of most investors. But this sudden increase in the underlying level of fear only serves to form a base for the next leg upward, which these frightened investors will likely miss.
One last note: Americans continue to focus on their own country to the relative exclusion of the rest of the world. This is even more of a mistake today than it was in years past. The US stock market now represents only 42% of world market capitalization, and our GDP is just 25% of world production. And much of the world is growing far faster than the US. South Korea, for example, just reported a surprise 2.9% increase in GDP last quarter (equivalent to 15.4% annual growth). US economists would be giddy if we could produce an annual growth rate of just 6% in a single quarter. Thus, much of the opportunity in investing lies outside the US. This is why over 55% of our clients’ equity investments, and more than 20% of their bonds, are in non-US countries. Why not take advantage of the relative rise of the rest of the world?
Halloween should spook you; Wall Street should not.
Tuesday, October 6, 2009
Third quarter, 2009: Best in 11 years
Stocks keep going up, with only minor setbacks, despite all the well-advertised problems with the global economy. The quarter just ended was the best one for the Dow Jones Industrial Average since 4th quarter 1998, and the best third quarter since 1939. For those who like numbers, the MSCI ACWI rose +17.9% during the 3 months ended September 30. The best performers were those very stocks that fell the most in 2008: financials, materials and consumer discretionary companies. This is typical of the early stages of a bull market: those stocks that are hit hardest rebound the fastest.
Why are stocks doing so well? For that matter, why are bonds on a tear as well? We all know that the economy is on the skids, the financial system is still shaky, the real estate market is moribund and unemployment is nearing post-Depression highs. Banks are failing on a weekly basis owing to continuing loan defaults, particularly residential mortgages. Everyone knows that commercial real estate loans are next. US consumers remain stretched, and instead of borrowing more against their homes, are paying down debt and cutting back, both voluntarily and in response to tight credit. Massive layoffs, and fears of being laid off, are naturally exacerbating consumer cutbacks.
Yet through it all, stock prices continue skyward. Even the pullbacks have been relatively short and mild. The deepest drop since the March bottom was about –8%; the current one has only been about –4% so far. This, again, is typical of early bull markets: the first real correction of –10% or greater doesn’t usually occur for 12 to 18 months or more. By now you know that the stock market doesn’t react to the economy; rather, it anticipates it. Thus, the sharp rise in equity prices over the past 7 months points to an improving economy, and recent data confirm this view. So a rising market at this point should be no surprise.
Many people, however, worry that stocks have come too far, too fast. After all, a +69% jump in just a few months seems overdone. Surely, we must be due for a substantial drop, even if the economy continues to recover. And if we have a “double dip” recession, then a drop must certainly be in the cards.
The problem with this logic is that all of these risks are well known. Stock prices don’t react to known information, but only to surprises. And by definition, a surprise cannot be anticipated. Thus, the only thing that should cause a major change in the direction of the market is something bad that happens out of the blue. A major war with Iran could be in this category, although even that risk is starting to be discounted by the market. Continuing loan defaults and home foreclosures, lousy corporate earnings, sluggish consumer spending and rising unemployment are widely known problems that no longer have market-moving power.
Moreover, most of the surprises over the past several months have been of the positive variety. Corporate earnings are mostly better than predicted. GDP growth worldwide is coming in higher than expected. And the status of the banking industry is no longer dire. In fact, the European Union recently completed a “stress test” of its 22 largest banks (accounting for 60% of deposits in the EU) and found that they are in surprisingly good shape. None are likely to need additional capital even if the economy does much worse than expected (and yet, many are raising additional capital anyway, and successfully at that).
The other thing to keep in mind when looking at stock prices is that using the March 9 low as an anchor can be very misleading. Yes, stocks are up hugely since then, but the global bear market that took them to those lows was more severe than any since 1721 (and worse in the US than any since 1932). At the levels of this March, stock prices were pricing in a total meltdown of the financial system that never occurred. At their present levels, they are predicting a gradual recovery from a severe recession, yet remain –31% below their highs of 2007. Just to get back to those levels, the MSCI ACWI needs to rise +45% from here. This return trip will probably take another 3 years, which means the economy won’t be back to early 2008 levels until 2013. This may seem painfully slow, but it represents an annual return of over +15% including dividends—far more than you’re likely to receive from most other investments.
Over the past week or so, people have been focusing on the lousy employment numbers and what the very slow recovery of the job market might mean to the economy. The reasoning goes that we can’t see meaningful GDP growth while unemployment continues to rise and the consumer holds back. But history shows the fallacy of this reasoning: employment is one of the last indicators to turn positive, well after GDP has started growing again and the stock market recovered. During the past 4 recessions, employment didn’t start growing again until an average of 8 months after the stock market bottomed.
But job recovery keeps taking longer, for a variety of reasons. After the 1990 recession induced by the S&L crisis, for example, unemployment didn’t peak until 16 months after the market started to rebound, by which time it was already up +40% (and this after a relatively mild –20% bear market). Job recovery this time will likely take at least that long, meaning that we’re not likely to see a peak in unemployment until next July. And by then, stocks could well be significantly higher than today.
So while the gains in all asset classes have been impressive over the past several months, most investors missed it. They opted for “safe” investments such as CD’s, US Treasuries and money market funds, happy to earn 1% or even less. On top of this, most investors that were willing to take some risk did so with bonds rather than stocks: from March through mid-September, mutual fund investors put 20 times as much into bond funds as stock funds. (In contrast, during the preceding bull market, stock mutual funds received 2.5 times more money than bond funds.) One has to wonder what stock prices will do when individual investors finally switch into the stock market, given how well it’s already done without much of their money.
So now we’re entering a new phase of the bull market. That the global economy is improving is now common knowledge (Australia raised interest rates in a surprise move today because the economy there is really heating up). This time around, the US is likely to be pulled up by other countries rather than leading the rebound. Where you invest, and what kinds of investments you choose, will become progressively more important. Just being bold and buying any beaten-down security is not likely to be so remunerative as it has been. And that’s a major reason behind the portfolio rebalancing that I’ve been doing lately, and will continue to do until I’ve positioned everyone as well as I can.
As always, somehow the world has made it through yet another financial crisis. Things should be a lot better for a while, until the next crisis, which likely will be far less severe than the one we just survived. But no amount of regulation will prevent bear markets, or financial panics, or recessions. You just can’t regulate human behavior, especially when ruled by emotion.
Maybe we should put Prozac in the drinking water instead of fluoride (just kidding).
Why are stocks doing so well? For that matter, why are bonds on a tear as well? We all know that the economy is on the skids, the financial system is still shaky, the real estate market is moribund and unemployment is nearing post-Depression highs. Banks are failing on a weekly basis owing to continuing loan defaults, particularly residential mortgages. Everyone knows that commercial real estate loans are next. US consumers remain stretched, and instead of borrowing more against their homes, are paying down debt and cutting back, both voluntarily and in response to tight credit. Massive layoffs, and fears of being laid off, are naturally exacerbating consumer cutbacks.
Yet through it all, stock prices continue skyward. Even the pullbacks have been relatively short and mild. The deepest drop since the March bottom was about –8%; the current one has only been about –4% so far. This, again, is typical of early bull markets: the first real correction of –10% or greater doesn’t usually occur for 12 to 18 months or more. By now you know that the stock market doesn’t react to the economy; rather, it anticipates it. Thus, the sharp rise in equity prices over the past 7 months points to an improving economy, and recent data confirm this view. So a rising market at this point should be no surprise.
Many people, however, worry that stocks have come too far, too fast. After all, a +69% jump in just a few months seems overdone. Surely, we must be due for a substantial drop, even if the economy continues to recover. And if we have a “double dip” recession, then a drop must certainly be in the cards.
The problem with this logic is that all of these risks are well known. Stock prices don’t react to known information, but only to surprises. And by definition, a surprise cannot be anticipated. Thus, the only thing that should cause a major change in the direction of the market is something bad that happens out of the blue. A major war with Iran could be in this category, although even that risk is starting to be discounted by the market. Continuing loan defaults and home foreclosures, lousy corporate earnings, sluggish consumer spending and rising unemployment are widely known problems that no longer have market-moving power.
Moreover, most of the surprises over the past several months have been of the positive variety. Corporate earnings are mostly better than predicted. GDP growth worldwide is coming in higher than expected. And the status of the banking industry is no longer dire. In fact, the European Union recently completed a “stress test” of its 22 largest banks (accounting for 60% of deposits in the EU) and found that they are in surprisingly good shape. None are likely to need additional capital even if the economy does much worse than expected (and yet, many are raising additional capital anyway, and successfully at that).
The other thing to keep in mind when looking at stock prices is that using the March 9 low as an anchor can be very misleading. Yes, stocks are up hugely since then, but the global bear market that took them to those lows was more severe than any since 1721 (and worse in the US than any since 1932). At the levels of this March, stock prices were pricing in a total meltdown of the financial system that never occurred. At their present levels, they are predicting a gradual recovery from a severe recession, yet remain –31% below their highs of 2007. Just to get back to those levels, the MSCI ACWI needs to rise +45% from here. This return trip will probably take another 3 years, which means the economy won’t be back to early 2008 levels until 2013. This may seem painfully slow, but it represents an annual return of over +15% including dividends—far more than you’re likely to receive from most other investments.
Over the past week or so, people have been focusing on the lousy employment numbers and what the very slow recovery of the job market might mean to the economy. The reasoning goes that we can’t see meaningful GDP growth while unemployment continues to rise and the consumer holds back. But history shows the fallacy of this reasoning: employment is one of the last indicators to turn positive, well after GDP has started growing again and the stock market recovered. During the past 4 recessions, employment didn’t start growing again until an average of 8 months after the stock market bottomed.
But job recovery keeps taking longer, for a variety of reasons. After the 1990 recession induced by the S&L crisis, for example, unemployment didn’t peak until 16 months after the market started to rebound, by which time it was already up +40% (and this after a relatively mild –20% bear market). Job recovery this time will likely take at least that long, meaning that we’re not likely to see a peak in unemployment until next July. And by then, stocks could well be significantly higher than today.
So while the gains in all asset classes have been impressive over the past several months, most investors missed it. They opted for “safe” investments such as CD’s, US Treasuries and money market funds, happy to earn 1% or even less. On top of this, most investors that were willing to take some risk did so with bonds rather than stocks: from March through mid-September, mutual fund investors put 20 times as much into bond funds as stock funds. (In contrast, during the preceding bull market, stock mutual funds received 2.5 times more money than bond funds.) One has to wonder what stock prices will do when individual investors finally switch into the stock market, given how well it’s already done without much of their money.
So now we’re entering a new phase of the bull market. That the global economy is improving is now common knowledge (Australia raised interest rates in a surprise move today because the economy there is really heating up). This time around, the US is likely to be pulled up by other countries rather than leading the rebound. Where you invest, and what kinds of investments you choose, will become progressively more important. Just being bold and buying any beaten-down security is not likely to be so remunerative as it has been. And that’s a major reason behind the portfolio rebalancing that I’ve been doing lately, and will continue to do until I’ve positioned everyone as well as I can.
As always, somehow the world has made it through yet another financial crisis. Things should be a lot better for a while, until the next crisis, which likely will be far less severe than the one we just survived. But no amount of regulation will prevent bear markets, or financial panics, or recessions. You just can’t regulate human behavior, especially when ruled by emotion.
Maybe we should put Prozac in the drinking water instead of fluoride (just kidding).
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