Betting on American Recovery - It's Gonna Happen

Includes: HYG, ITB, IVV, PFF
by: Herb Morgan

The world is in the midst of a very serious economic problem. However, we have survived lots of other very serious economic problems and we will survive this one. There is little doubt the next few quarters will be ugly for GDP, corporate profits and employment. For this, there is plenty of blame to spread around.

We are rightly concerned with the last $350 Billion of TARP and with the mockery that is this “stimulus package”. However, we must not ignore the substantive gains achieved by the Federal Reserve, nor should investors forget the propensity of markets to discount recovery and move higher while GDP and employment numbers remain weak.

The annualized rate of GDP contraction in Q4 will likely be revised slightly lower. Q1-2009 GDP will most certainly be negative, but likely less negative than Q4. I see 2009 as period of negative or flat growth of the industrial economy. However, unemployment (a lagging indicator) will likely rise and remain elevated into 2010. In fact, job loss reports over the next few months will be substantive.

The Clinton administration’s push to expand home ownership and George W Bush’s “ownership society” coupled with the excessively leveraged balance sheets of Fannie Mae (FNM) and Freddie Mac (FRE) were major contributors to our current woes. The Federal Reserve left interest rates too low for too long. Low interest rates and poorly executed regulation allowed companies to leverage their balance sheets to unreasonable levels. There were irresponsible borrowers too. Greed of private sector institutions with puppet boards are also to blame.

The Fed is what will bring us out of this mess. The Fed was slow to recognize the problem but has since acted with great force. The government in all its forms has committed up to $7.8 Trillion dollars to fight this problem, but spent less than 20% of that.

Type Committed _____Spent

Insurer $3.1 Trillion $100 Billion

Investor $3.0 Trillion $650 Billion

Lender $1.7 Trillion $617 Billion

Total $7.8 Trillion $1.37 Trillion

Thus far I see very little risk of loss on any of the US commitments. That may change but only modestly as the second half of the TARP assets are invested. The Fed will have a record year and its profits will be remitted to the Treasury, which is required to remit its profits to the Treasury who must:

supplement the gold reserve held against outstanding United States notes, or shall be applied to the reduction of the outstanding bonded indebtedness of the United States.

The House just passed an $800+ billion fiscal stimulus and the Senate pushed it through with a few tweaks. This is little more than a hollow mockery. It has a whisper of stimulus in it and a lot of special interest legislation, none of which will get us out of the recession. It contains nothing in the way of fiscal responsibility promised by President Obama. There is much more effect that will come from what the Federal Reserve has been doing. A central campaign theme of 2012 will likely be President Obama giving credit for the recovery to this ridiculous spending boondoggle.

Massive fiscal deficits are inevitable in the short run, even with responsible fiscal stimulus. Fortunately, our debt to GDP ratio heading into this is low when compared to other industrialized economies.

To be sure, the economy will stumble for the next couple of quarters but financial markets in general and equity markets in particular will head up well before the recession ends. Many people are calling for a prolonged ten year slump in economic activity or even a depression. Our history is full of periods in which very real obstacles to growth have been successfully overcome. Recalling the generally accepted view that the US could not compete with Japan causes one to rethink the consensus view of India and China destroying our manufacturing sector. Remember when robots and automation would make human labor obsolete? How about the view that the internet would replace bricks and mortar retail? We have survived credit crunches, wars and oil shocks before. If one just steps back and looks at the demographics of the US it’s hard not to be optimistic about her long term prospects.

I have no compelling opinion on the direction the next 1,000 point move in the Dow (NYSEARCA:DIA), nor do I know exactly when new home sales will equal the 900,000 or so required to serve our natural population growth, but they will. (More than double today’s level) I don’t know for sure when our banks will be declared healthy, but they will. I do however believe in the return to growth for the most innovative economy the world has ever known. As such, I patiently wait for recovery and invest in those areas likely to perform well when recovery comes.

Owning the S&P 500 through iShares S&P 500 index fund (NYSEARCA:IVV) is the most reasonable pure play on American recovery. With a dividend yield that exceeds that of the thirty year treasury and is expected to grow over the next decade, it’s hard to imagine anything less than rich rewards between now and then.

More adventurous investors should consider IShares US Home Construction index fund (NYSEARCA:ITB). Clearly not trading with a hint of irrational exuberance in its price, this beauty allows investors to patiently wait for this sector’s recovery over the next couple of years without taking dangerous single stock risk.

For those volatility tolerant income investors, I’d suggest looking to the IShares High Yield Bond Fund (NYSEARCA:HYG). High Yield has gotten so cheap the asset class is priced for a depression and a level of defaults that simply won’t happen. When pessimism subsides, (it will) spreads will narrow. Historically, investing in High Yield when spreads were this wide has paid richly.

I Shares Preferred Stock Index Fund (NYSEARCA:PFF) is another way investors can bet on recovery. Preferred stocks, most of which are issued by financial companies, have gotten very inexpensive as fears of bank nationalization have spread. After Fannie Mae, Freddie Mac, Lehman (OTC:LEHMQ) etc. it's no wonder investors have dumped the asset class. In my view, nationalization is not an option and this diversified portfolio represents a reasonable risk to patient investors.

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