Believe it… This Market is Rising!

david —  February 17, 2011

Egypt and other recent geopolitical news aside, this year is already shaping up to reveal what looks like a nicely recovering economy, with strong indications that the economy will grow at its fastest pace in eight years during 2011.

Job growth is expected to double last year’s mark (granted a low high bar), leading to more income and spending, a cut in the Social Security tax should give an additional goose, and banks are loosening up business lending standards.

Late January’s advance reading of fourth quarter GDP showed it expanded at an annual rate of 3.2% — the third best quarterly showing of the recovery to date, revealing six quarters in a row of growth. We would not be surprised to see a GDP growth of 4% this year.

And last month’s official results from the Federal Reserve’s survey of economic conditions revealed the U.S. economy ended 2010 on an encouraging note, with all parts of the country showing improvements – factories produced more, shoppers spent more and companies hired more.

This week Home Depot said that they will be hiring 60,000 temporary employees for the next few months to handle the spring season which is their busiest time of the year. Granted temporary jobs are not permanent jobs. However, it has been a long time since we have seen that in the headlines!

Stocks have been rebounding and investors who stayed in the market have seen some of their wealth restored. In fact, in January, stocks had climbed to new 2-year highs, with the Wilshire 5000 at a 2 1/2-year high. The broad market had nearly doubled since the March 2009 low. S&P 500 earnings for 2010 are currently expected to be $82.18, which would represent growth of 42.6% from 2009. Current estimates expect 2011 S&P 500 earnings to be $95.06, which would be a new all-time high if it occurred. Based on the current outlook, S&P 500 earnings might reach a new record as soon as mid 2011.

All of this — more jobs, more income, more spending by consumers and businesses – is bullish for the economy. And it is a good landscape in which to be an investor.

Yet most investors are still plenty fearful. They wonder how stocks are still rising when the economic news is so bad. They’re waiting for the other shoe to drop.

And why shouldn’t investors be fearful? The story told by the 24-hour cable news services is overwhelmingly pessimistic. Why? Because if it bleeds it leads, generates high ratings and sells a lot of advertising time! If you consider more deeply why this is, you will realize that this negative narrative is attractive because it dumbs down complex issues into simple sound bites. News producers find two “experts” with violently opposed opinions, put them in little boxes on the screen, and have them verbally duke it out for exactly 3 1/2 minutes. Seriously, have you seen CNBC, the financial network, lately? It has taken this concept to an extreme, featuring up to 10 little heads in 10 little boxes on screen at a time. The Brady Bunch visual may be amusing, but the information content is zero.

GDP

The (advance) GDP fourth quarter results of 3.2% show that the recession officially ended in June 2009, when GDP stopped contracting. This is according to officials whose job it is to mark the beginning and end of financial cycles. So we have had six quarters in a row of growth. According to the Commerce Department, real GDP (adjusted to reflect inflation) ended 2010 at $13.383 trillion. Back in what was considered the trough of the recession (second quarter 2009), GDP totaled $12.810 trillion, so it has grown by more than 4.5% since then. Put another way, the total output of the U.S. economy is now at its highest level in our country’s history.

Some analysts called the latest GDP number weaker than expected, because they were looking for a growth rate of 3.7%. However, it bears recalling that it was only in the past few weeks that the higher number was expected; a month or so ago, they expected it to be 1.5%-2.5%. You see, it’s all in how you spin it. Did 3.2% GDP disappoint, or should we instead say that fourth quarter GDP grew at more than double the pace that many economists were expecting as recently as October 2010?

As we wrote in December, back in 1994, the nominal/current dollar GDP was $7.25 billion; it might pass the $15 trillion mark in 2011. Join the club if you didn’t know that U.S. GDP has nearly doubled since 1994. No one in the media appears to be paying any attention to this modest fact. The financial news is busy focusing on any negative that can be found about the economy – the choice du jour being unemployment, followed by a growth rate that had slowed a bit since the first two post-recession quarters.

Second quarter GDP came in at 1.6%; third quarter hit 2%. However, a gyrating growth rate at this point of the business cycle is typical. The prominent investment newsletter firm Van Eck reports that, “Every recovery of the past two generations has followed a similar pattern. Things get off to a fast start as companies restock inventories and then there is a lull as businesses and consumers size up the situation and wait for signs that they can go ahead and make planned and needed purchases.”

Now many economists are talking about GDP growth of 3.2% for all of 2011. If that happened, it would make it the strongest year for the economy since 2003, when GDP grew by 3.8%. And if things go even better, as some economists expect it might, 2011 may see the strongest GDP growth since the economy expanded by 4.8% during 1999.

Obama’s third year

There is another stock market fact I found persuasive. Barrack Obama has entered his third year as president. Third years of a president’s term are usually a good time for the economy and the stock market. The stock market has gained ground during every third year of a president’s term since 1939-before we entered World War II, a period of time covering three generations. Presidents have sat in the Oval Office (FDR in 1940 to the current president) and tried to compress as much bad news as possible into the first two years of their term and then hit the accelerator for the third year. President Obama is doing the same.

Housing

In prior articles, we have discussed that housing has led the U.S. out of every recession since 1960. I am encouraged by the fact that we have managed to climb out of this recession without the benefit of strong home sales. In fact, perhaps home sales will lead the next leg of the recovery.

Housing usually lags, and recovers after much of the rest of the financial system. So yes, housing now might still be in recession conditions, with the pace of new home sales slow and home construction weak, and prices still down by more than 20% nationally from their peak in 2006. But this has been factored into the markets already.

Think about it this way: There was a period of overbuilding during the last decade. Then home sales, prices and construction all tanked during the past two years because the economy tanked as the mortgage and real estate bubble burst. People were laid off, couldn’t make their rent or mortgage, and banks tightened up on who they would lend money to. It was a ripple effect. With a more stable economy and more liquid cash, things should trend in the right direction.

During the next one to three years, some estimates expect 2-3 million foreclosures, with 2011 expected to be the peak year. While that number seems daunting, there is a flip side relating to supply and demand. There may actually be enough demand to snatch up that supply, and thus prevent further erosion in housing prices. For example, during the past two years, the marketplace sold about 5 million existing homes annually, plus new home sales of about 350,000. All together, that was about 5.4 million homes sold per year during 2009 and 2010. With the economy recovering and likely to gain strength, annual sales may even top that level. The large pool of buyers who have been sitting on the sidelines waiting for their chance to enter the housing market will likely do so. Look for foreclosure auctions to be jammed with potential buyers.

Remember that there is a finite supply of homes available at any given time, and it takes a substantial investment of time and (usually borrowed) money to produce new homes. Historically, the housing industry usually produces about 1.5 million homes per year, but 2009 and 2010 saw the lowest annual production since the government began keeping records in 1959! Builders began production on 554,000 homes in 2009 and 587,600 in 2010. It has already been nearly three years since the industry has produced more than 1 million homes annually, and so rather than focusing on the glut of foreclosures, perhaps we should consider the perspective that new home construction has been drying up. Simply put, the market has been missing 500,000 to 1 million new homes per year for awhile, and that trend is going to be reflected in the price levels for existing homes.

So instead of prices collapsing during the next year or so, we are more likely to see prices stabilize and recover. Foreclosures are going to provide the immediate housing stock buyers are seeking.

We also noted this in December: According to the “Chart of the Day,” affordability of the median single-family home has risen. The housing affordability index (HAI) measures whether a family earning a median income could qualify for a mortgage loan on a median-priced, single-family home. When the HAI equals 100, it means that a family earning a median income has exactly enough income to qualify for a mortgage on a median-priced home. When the HAI equals 130, for example, it means that a family earning a median income has 130% of the income necessary to qualify for a mortgage on a median-priced home. Home prices have tended to appreciate when the HAI was above 120. Due to a three-month drop in the median price of a single-family home as well as a continued decline of long-term interest rates (i.e. mortgage rates), the affordability of a single-family home has spiked back up to a level only briefly seen at the tail end of the financial crisis. As interest rates rise, we may see that homebuyers who have been sitting on the sidelines rush in to find homes before mortgage rates go up.

Also, mortgage delinquency rates also portend a more stable housing market than many think. According to Transunion, fewer mortgage holders have been falling behind on their payments, with delinquencies (payments more than 60 days late) in the third quarter making their biggest decline in the last four years. National delinquencies fell to 6.44% in the quarter, compared to 6.67% in the second quarter, although the number still represents in increase from the 6.25% rate in the third quarter of last year. That marks the largest quarterly decline since the fourth quarter of 2006, more than double the declines in the first and second quarter of this year. This is a sign that more homeowners have shored up their finances enough to make their house payments.

Additionally, homeowners have gradually cut their outstanding balances. The average third-quarter debt per borrower was $190,176, which was 0.6% less than the second-quarter average and a 1.5% drop from the average a year earlier. Finally, the latest report from RealtyTrac contained some encouraging signs. While foreclosures were up year-over-year, the number of properties that received an initial default notice fell by 19% from October 2009. Foreclosures are going to remain a potent force in the housing market during 2011 and likely into 2012 as well but the trend is now in the right direction.

Finally, a factor that no one has focused on is rising interest and mortgage rates. While rising rates do hurt the affordability index they may also have an effect that has not been looked at. It is quite possible that buyers who have been sitting on the sidelines will jump into the market now trading the fear that home prices will decline more for the fear that interest rates will rise and they won’t be able to afford the home they want.

Pension plans

Another positive for the stock market is that big companies are beginning to make contributions to their pension plan. The “Wall Street Journal” reported in October that big employers are stuffing bigger-than-needed contributions into their pension plans to head off troubles in the future and to cut their taxes at a time of ultra-low investment returns elsewhere. A few examples:

  • Honeywell International Inc. said it would make a $600 million cash contribution to its pension fund, on top of a $400 million stock contribution made earlier in the year.
  • Lockheed Martin Corp., Boeing Co. and Parker Hannifin Corp. also are plowing funds into their plans.

The WSJ says rising pension liabilities are the flip side of low interest rates and borrowing costs that have benefited many companies and helped lift the nation out of recession. Lower interest rates from investments mean companies must set aside more cash now to cover higher, future obligations. It works this way: corporate bond yields have fallen nearly a percentage point to about 5%. Companies use corporate bond yields to estimate future liabilities for accounting purposes. So low interest rates increase pension burdens even if a plan is well funded.

Additionally, contributions are tax deductible, which helped to ease companies’ end-of-year taxes. Credit Suisse expects pension costs to rise, creating a drag on earnings at more than half of the companies in the Standard & Poor’s 500-Index. Though some companies might have to increase contributions, many are sitting on a lot of cash, or could borrow money at low rates and use the proceeds to fund their plans, Credit Suisse notes in a recent report.

Lockheed Martin contributed $2 billion in 2010. Parker Hannifin recently made a discretionary $200 million contribution to its plan, a move that likely saved it more than it would have earned with the cash.

However, the contributions will be a boon to the market in general even if they are a drag on a few of the companies making them! U.S. corporate earnings are expected to show solid growth for 2011:

  • 16.3% for Q3 2010
  • 24.1% for Q4 2010
  • 15.6% for 2011

This leaves U.S. stocks undervalued by 24%-39% according to the Fed Model?

Are stocks the ticket for next 10 years?

But are stocks the most likely winners for the next decade? That is the question posed by David Edwards of Heron Capital, and he thinks yes.

Listen as he takes us through what he sees as the likely scenario: “About 20% of hedge funds were closed in 2010, while others will struggle, because 55% are below the ‘high water mark’ that allows them to deduct performance fees. Private equity firms – the darling investment class of 2000-2008 – are also struggling with illiquid investments and the inability to finance new purchases. Commercial real estate looks flat line for the a few years at least. Gold looks like a bubble, and most other commodities are at reasonable levels. Venture capital activity is at about the same level as 1995. Investors chasing yields have bid up the prices of corporate bonds and preferred stock (which means low yields), while treasuries, near post-war lows, barely yield more than inflation. Emerging markets stocks and bonds are doing well, but don’t expect to see the 2008 returns again. Could it be, could it be? After a decade of pariah status, perhaps the only asset class that offers a reasonable risk-adjusted return is U.S. stocks.”

Manufacturing

Just days ago, the ISM manufacturing reading for January registered its 18th straight monthly gain. The index is now at its highest level since May 2004, a bullish sign of an economy that should continue to improve during the months ahead.

Recall also that manufacturing activity in the mid-Atlantic region unexpectedly surged back in mid-November. The Federal Reserve Bank of Philadelphia’s Business Outlook Survey index rose to 22.5 in November, from 1 in October, the highest reading since December 2009. Economists had expected the index to rise to 5.6 in November; it was at negative 0.7 in September. (Readings above zero indicate an economic expansion in the manufacturing sector, while those below zero reflect a contraction.)

Where do we look for perspective?

So now, when many investors still feel pessimistic about the U.S. and global economies, scared by daunting headlines, fearful of economic growth drying up, depressed housing prices, high unemployment and deficit problems in the U.S. and Europe, where and how do we find a balancing perspective?

Try “The Big Sky Conference: Looking past short-term issues,” a mid-September meeting of 2,000 business and political leaders in Montana. Here are two pertinent speakers and their thoughts from that gathering of minds:

Warren Buffett: “I’m a huge bull on this country…we won’t have a double dip recession. I see our businesses coming back almost across the board. It’s night and day from a year ago. I’ve seen sentiment turn sour in the last three months or so, generally in the media. I don’t see that in our businesses. I see we’re employing more people than a month ago, two months ago. The things that worked for the country through a century of two world wars, a depression and more – all while increasing the standard of living – will work again.”

Steve Ballmer, Microsoft: “There soon will be more technological advancement and invention than there was during the Internet era, and that will help drive business growth.

I am very enthusiastic about what the future holds for our industry and what our industry will mean for growth in other industries.”

Our Vote

Employment and housing remain tricky. However, jobless claims continue to improve, and we are seeing relative stability in housing sales and prices, and a housing market that is dealing with 1 million+ foreclosures a year.

We think Steve Balmer and Warren Buffett’s reports about their company’s business bear out the growth reports and positive news we have mentioned, not the constant negativism of the mass financial media. Neither of them are given to exaggeration or hyperbole.

The stage is set for the economy to grow during the current year or more, which should be bullish for investors. An improving economy translates to more jobs, more disposable income and more consumer and business spending. It looks like GDP will expand by 3.0% or more this year, and if that happens, it would mean the strongest year in terms of GDP in the past 8 years.

As the broad U.S. economy improves during the coming year, this brings us to one of our favorite truisms: “A rising tide lifts all boats.” Our opinion is that business will continue to improve and the market will see another up year in 2011. Instead of dark investment clouds overhead, the skies appear to be clearing. There will be a correction or two along the way but the trend is up for the economy and the market!

But here’s our thinking: If IBM is a great indicator of when interest rates are at a low, and interest rates are going to start to increase, it means a couple of things.

  1. Refinance the house or car now if you are thinking of it and have not yet done so. In fact, any borrowing that you are contemplating should be done sooner rather than later as rates are likely to go up.
  2. If you have long-term bond holdings, you need to be sure that you don’t care about the quotation value of the bonds as that is very likely to decline. If the dividend income from those holdings keeps you happy, you are fine. However, if you may need the principal, then it might be a good time to sell debt, just like IBM is doing.

IBM’s thinking in taking advantage of cheap rates is reflected in a statement from Direct TV. Just days ago, DirecTV, the largest U.S. satellite-television provider, sold $3 billion of debt in a three-part offering to capitalize on record low borrowing costs to refinance bank loans and buy back shares. The CEO wants to use the company’s free cash and debt for share repurchases. “We look forward to tapping into what is currently a relatively strong debt market,” the company’s CFO said. DirecTV repurchased more than $1.7 billion of stock in the second quarter and has authorized an additional $2 billion for its stock buyback program. The stock has gained 18.2% this year and is a buy candidate in our managed accounts.

IBM stock yields about 2%. As an investor, if you think the company is solid enough to lend money to and the common stock yields twice as much as the loan, then why not buy the stock? Of course, one of the possibilities for the loan proceeds for the company is that they can earn 1% by repurchasing their stock that yields 2%. That’s a good spot for them to be in. IBM has repurchased about 3.8% of its outstanding shares over the last year. IBM has said only that it will use proceeds for general corporate purposes.

The debt issuance in general seems to indicate investor confidence that the economy will be good enough for the companies issuing debt to be able to repay those loans. Some 77% of companies in the Standard & Poor’s 500 Index that have reported second-quarter earnings beat analysts’ estimates and manufacturing growth in the U.S. and Britain slowed less than expected in July, increasing confidence in the economic recovery.

david

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