Market Believes in Economic Positives, We Remain Skeptical

While economic figures have been improving, we believe unsustainable stimulus programs are the drivers behind most of the progress to date, and significant moves from current market levels require stronger 3 to 5 year growth than the economy is likely to deliver. We reiterate that the easy money has been made via allocation to equities, and picking stocks will be much more important for the rest of the year, as valuation of the overall market is becoming less attractive.

It has been a great summer. After pausing during the month of June, the S&P500 continued its year-long upswing with monthly gains of 7.4% and 3.4% respectively in July and August. While the July rally was largely attributable to better than expected Q2 corporate profits and the seemingly stalled passing of Cap & Trade legislation and Healthcare overhaul, the August rush resulted largely from better than expected housing data, consumer confidence, and a newly built consensus that the recession is virtually over. Fed Chairman Bernanke was reappointed, but that didn’t surprise anyone.

There has indeed been good news on the housing market. New home and re-sales increased for the 4th consecutive month. Resale of U.S. single-family homes and condos grew 7.2% in July, suggesting a seasonally adjusted annual sales rate of 5.24 million, exceeding economists’ projections of 5 million. New US home sales grew 9.6% in July, and suggested a seasonally adjusted annual sales rate of 433,000. There were 271,000 new homes for sale at the end of July, representing 7.5 months of supply at the current sales pace, the lowest since April 2007. Separately, the Conference Board reported that its Consumer Confidence Index rose to 54.1 in August from an upwardly revised 47.4 in July, significantly exceeding the consensus expectation of 48. On August 14, both Germany and France announced Q2 GDP growth of 0.3% from Q1, unexpectedly becoming the first major industrialized nations to technically pull out of the global recession. Naturally, investors are convinced a recovery must be in budding in the US.

While the market seems to concur that many aspects of the economy are positive and indeed improving, we remain skeptical. The market believes: the housing market seems to have bottomed; financial markets have stabilized; the recession’s end is around the corner; and although the unemployment rate will continue to rise and reach double digits, the economy will just adjust to that reality. While those beliefs may not be wrong, there are two powerful offsets that give us pause as to how sustainable the current good news is likely to be.

First, the $8,000 tax credit for first-time homebuyers that supported many house sales will expire in November and the Fed’s $300 billion long-term treasury purchase program, which has helped to keep interest rates low, will end in late October. Like our thoughts for the Cash for Clunkers program, we suspect those stimuli have expedited future house purchases to the present. In addition, despite robust sales, foreclosures and short sales reflected 31% of existing homesales in July, and mortgages either in foreclosure or with at least one payment past due hit 13.16% in the second quarter, the highest percentage ever recorded by the Mortgage Bankers Association.

The inventory for existing homes still represented a 9.4-month supply at July’s sales pace, unchanged from June. Regarding financial markets, while banks are no longer on the brink of collapse, the FDIC recently announced it had 416 banks on its "problem" list at the end of June, up from 305 at the end of March. Further, the FDIC has closed 87 banks so far this year, on top of the 25 in 2008. Fortunately, the total assets of banks on the problem list was just $299.8 billion, approximately 15% of the total assets of Bank of America, the nation’s largest bank in terms of deposits. Ironically, this speaks volumes of the systematic risks of those mega banks, with one potential failure essentially eqivalent to thousands of small banks. However, such an increase in problem banks does foretell additional problems for the sector.

While Bernanke cheered the economy in advance of his re-appointment, the minutes of the Federal Reserve's Aug. 11-12 policy meeting published last week further fortified the belief that the US economic recovery will start in the 2nd half, though it is likely to be weak. At this point, it is irrelevant arguing about the technicalities of defining the inflection point between a recession and a recovery, as that is best left for politicians pitching their elixirs. We think the important question is: What normalized growth rate can the US economy deliver over the next 3 to 5 years? Given that consumer spending accounts for nearly 2/3 of GDP, we think it is only logical to believe the recent stubborness of a rising unemployment rate suggests things are not yet ok with the economy. Combined with current fiscal policies, present valuation levels indicate things will not be ok for the stock market in the intermediate term.

In last month’s letter we discussed how we believed the easy money in this market is over. Assuming the vast majority of companies would not go bankrupt, heading into Spring 2009, all investors had to do was buy stocks – almost indiscriminately to book impressive gains. For those that were particularly choosey the gains were “generational”. A poster child for such trades is Las Vegas Sands (LVS), which traded at $1.42 in March and now trades above $15, as an improved capital market helped relieve investors’ fears of it going broke and news of the company’s Macau IPO gained traction. As we pointed out during the depth of the market lows, the market irrationally priced fear, symmetrically to how it irrationally priced prosperity just years earlier. During the November and March lows, the average implied 5 year annualized sales growth to the S&P 500 was –8.6% and -6% respectively, saying corporate America would shrink by 36% and 27% respectively 5 years from now. That simply was not realistic. As we wrote in November 2008:

Fear has dominated the investor mindset and when we look at the factors driving returns in the past month, the past quarter and the past year, we find price momentum, dividend yield, and financial leverage are the most powerful factors. Investors found comfort in stocks with high dividend yeild, low leverage, and bought into the theory that “stocks do well for a reason” by chasing stocks that have done well. In addition, investors also stayed away from companies with poor earings quality, as those stocks consistently underperformed their universes in different time horizons. Our belief is that it is almost impossible to time the bottom but fortunately the important issue is not finding the bottom but finding the point at which as investors we can earn superior returns. If you missed our recent look at this topic, please refer to Investor Psychology and Market Expectations, and Then and Now: Buyer Remorse Versus Sellers Loss, where we discuss this concept in greater detail. The bottom line is that while the emotional cost of commiting capital is very high today, the financial environment has become much more attractive and investors who are willing to take an intermediate perspective and invest now and/or over the next few months in stocks with attractive valuations are likely to be rewarded very nicely in the years ahead.

Year to date (1/5/09-8/31/09), the AFG’s large cap buys outperformed the S&P500 by 13.4% while the AFG’s mid cap buys outperformed the R2000 by 22.42%, which speaks volumes of the outpeformance of stocks with attractive valuation.

How do we view the market today? Before we share our thoughts, let us frame a few points for perspective. When we look at the price range of the S&P500 index during the past 3 decades, we find that corresponding to the big bull market from the beginning of 1980 to late 2007, the S&P500 grew 15 times from 100 to 1500. During this same period, both US GDP growth and unemployment averaged approximately 6%. In general it was a period of strong economic growth, although marked by many economic upheavals such as four recessions, a tech boom and bust, 9/11, and a rising real estate market.

In general, Wall Street and Main Street prospered and suffered together. Thus it is no surprise that as the economy started to sour at the end of Q4 ’07, so did the market. In fact the Great Recession has brought consecutive quarterly GDP declines, and averaged 5.9% in Q4 ’08 and Q1 ’09. Furthermore, unemployment has sky rocketed to 9.4% from 5%. Not surprisingly, the S&P 500 dropped more than 50% to below 700 in early March of 2009. Since then, however, the index has rebounded nearly 50% to 1000. Again, Wall Street and Main Street were more or less aligned. Ultimately, the macro economy will put the conditions in place that lead to overall market valuations as those macro conditions frame two of the long-term value drivers (sales growth and margins) that generate economic profitability and thus market valuations.

Examining the growth expectation imbedded in the latest S&P500 prices, we feel valuation levels are rather troubling. Based on Aug 28’s close of 1029, the S&P 500 was priced at an implied sales growth of 5% for the next 5 years. While this is below the long term average expectation of 7%, and not unreasonable relative to the S&P’s historical average 5 year annualized sales growth of 12.5%, we do not think our economy will likely support a nearly 30% expansion of corporate America over the next 5 years, as the curent macro policies coming from Washington are not likely to support such growth.

First, a 30-year trend of falling income and capital gains tax rates will reverse in the next year. It will be difficult to grow an economy as investors begin charging higher and higher rates to supply capital. It is interesting to note, that during Clinton’s term, capital gains taxes fell approximately 30%, making the cost of capital cheaper and growth easier to finance and not surprisingly a very accommodative period for economic growth and prosperity. While tax policy points to a negative on the growth front, fiscal policy is likely to lead to higher discount rates as well.

In late August, the Obama administration raised its 10-year budget deficit projection by $2 trillion to approximately $9 trillion, reversing its earlier protests against the Congressional Budget Office’s (CBO) forecast that deficits between 2010 and 2019 would total $9.1 trillion. Based on the $9 trillion deficit projection, the national debt will likely reach $18 trillion, and account for 80% of the projected GDP in 2019, up from the current 60%. The CBO said deficits would remain high beyond 2013 in large part because of spending on Medicare, Medicaid and Social Security, simply as baby boombers age, rather than being tied to the recession.

This will force increasing government borrowing, and in turn “crowd out” private investment. Further, as evidenced by strong increases in the price of gold recently, inflation fears are growing over these projected structural deficits – also likely to drive up the cost of capital. We believe these policy issues and fiscal realities will lead to a period of below average economic growth, which naturally will translate into below average corporate growth as well. Bottom line – we think at 5% required growth rates, the market does not offer superior rates of reutrn relative to the risk of falling short of such expectations. While we do not believe the market is grossly over-valued, we would like to stress the need to carefully pick stocks rather than just buying market exposure through index or ETF purchases. The AFG 50 and 100 portfolios are a great place to start your stock picking research as these are stocks that comply with our long, proven concepts of buying stocks with reasonable expectations, solid fundamentals and non-wealth destroying management teams.

We conclude with an interesting observation from our 2nd Market Forecast Project conducted in mid August. Investment professionals are very torn about where the economy is likely headed. Currently the nod goes to those predicting another dip, with 52% voting that they expect another GDP decline in the year ahead. But note that is not a very convincing majority, and explains why there is still such a feeling of uncertainty about our current economic condition. We continue to get more participants into our survey and welcome your input as well. If you have not seen the results for August, visit AFG’s Market Forecast Project 2 for the complete survey and its results. To participate next month, visit AFG MFP and join our survey roster to receive next month’s questions. For the month of August 2009 (7/31/-8/31), the returns are the following:

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Comments

[Moon Kil Woong:]

The bond market is starting to point to no real recovery. Even though government printing presses are running at full stream the short and nmid-term rates are trending down. That is not indicative of people wanting to risk $ in a economic recovery.

If I had to choose between what the stock market says and the bond market, I'll go with the bond market. As for listening to the experts, psshhawww, do I look like a fool?

Sep 10 06:04 AM

[markfl:]

"The CBO said deficits would remain high beyond 2013 in large part because of spending on Medicare, Medicaid and Social Security, simply as baby boombers age, rather than being tied to the recession." The same CBO's projections for GDP growth beyond 2012 should scare people. The American economy is entering a period where its potential is not as intense as it was.
The CBO Director said, "Projected growth from 2015 to 2019 is also below historical average growth rates, a difference that is more than accounted for by slower growth in the labor force because of the retirement of the baby boom generation." cboblog.cbo.gov/?m=200903

Sep 10 06:05 AM

[chap08:]

When you listen to the bond market, do you really think that what it "says" is all about the domestic economy? Do you not think that there are some domestic and international political factors in there too? What do you think yields would be without government buying?

What the bond market says to me is "buyer beware".


On Sep 10 06:04 AM Moon Kil Woong wrote:

> The bond market is starting to point to no real recovery. Even though
> government printing presses are running at full stream the short
> and nmid-term rates are trending down. That is not indicative of
> people wanting to risk $ in a economic recovery.
>
> If I had to choose between what the stock market says and the bond
> market, I'll go with the bond market. As for listening to the experts,
> psshhawww, do I look like a fool?

Sep 10 08:24 AM

[Roger Knights:]

"the FDIC has closed 87 banks so far this year, "

Correction: 89.

Sep 10 08:56 AM

[TheFounder:]

I can see the market continuing to climb up to 1150-1200 based on the stimulus and positive momentum. Also 1200 would be an important technical point of correction - 61.2% of the decline from 1575 to 666.

Therefore I am planning to short the market at some significantly overbaught point at or above 1150.

Sep 10 10:15 AM

[NUCLEAR1929:]

market doesnt believe in anything, but fear, greed and pressure

Sep 10 10:51 AM

[RiskAverseA...:]

The July rally, much like the March rally, was largely attributable to a massive short squeeze. You say "Market Believes in Economic Positives," but I beg to differ. In fact, I say the ugly consumer credit report of the other day is the reality that's baked into the market's advance off March bottom (believe it or not). As proof I offer the aforementioned short squeeze (whose reality was confirmed by atypical RSI behavior) as well as the diminishing volume of trade over the interim. In other words, the market's advance largely has been a technical rebound whose basis in reality is the fact that, the worst is yet to come, making the present moment one's last chance to batten down the hatches offloading risk to weak hands.

Good news on the housing market? While foreclosures continue setting records?

Sep 10 11:24 AM

[bricki:]

Healthy skepticism is a valuable attitude in life, but it should not interfere in acceptance of reality. That acceptance of reality has made me a lot of money in the long side of the market this year.

Sep 10 12:27 PM

[hksche2000:]

One of the most encompassing and cogently reasoned overviews in a long time. Could agree with just about all its conclusions and predictions on the rational level. Unfortunately, therefore, those predictions are probably a better way to lose your shirt with your investment decisions, because Wallstreet doesn't use "reason", as you point out. There, between the crazy "overbought" and "oversold" extrems, it's all about MANIPULATION (= market making) and TIMING (= technicals). Hence, smart analytical guys rarely make, rather mostly lose money on WS. It's those who put their money into the "Sands" @ $1.42 (or Genworth or just about anything in 3/09), who do. Try buying into Nat Gas as your "Sands" surrogate right now? Good luck!
Loved your article anyways for the "Big Picture". Kudos & Thanks!

Sep 10 01:22 PM

[TxTim:]

Yes I kinda think you are onto it. I would add that the running of the printing presses being used to buy treasury/ agency securities is artificially keeping rates low. What surprises me is that the "bond vigilanties" (the rest of the real investors in the market) don't see this treachery for what it is and bid the bonds to a lower price thereby extracting a yield that compensates for the inflation that will surely come. Just how will the Fed "mop up" all that freshly printed money, sell the securities in open market operations? Rates would rise quickly and the Fed would take losses. Guess it really doesn't matter if the Fed loses money on ANY transaction does it. Seems like "the rules" are out the window when the Gov't is on the playing field.

On Sep 10 06:04 AM Moon Kil Woong wrote:

> The bond market is starting to point to no real recovery. Even though
> government printing presses are running at full stream the short
> and nmid-term rates are trending down. That is not indicative of
> people wanting to risk $ in a economic recovery.
>
> If I had to choose between what the stock market says and the bond
> market, I'll go with the bond market. As for listening to the experts,
> psshhawww, do I look like a fool?

Sep 10 10:23 PM

[Peter Daska...:]

I have a technical (chartist) observation, worth sharing.
The $USD index is in positive divergence according to a standard MACD oscillator, since early August.
The $SPX index is in negative divergence during the same period.
I examined charts as far as 10 years back, I couldn't find such coincidence.
This may indicate that money will move from stocks into bonds and the $USD for a while.

Sep 11 01:09 AM

[rick12345:]

The market broke a major technical hurdle yesterday when the S&P went over 1040. If this holds, then up she goes.
Also, who are "we", and when exactly did "we" become the market. Please don't include me in your rantings. Instead, use a noun such as " I " or "value expectations ?" in its plural sense, to extrapolate your beliefs.

Sep 11 05:23 AM

[Jaysan:]

Jack McHugh called attention to a very important commentary by Credit Suisse, which is carefully optimistic based partly on evidence that

".... the 2007-2009 episode is more akin to a 19th century banking panic, one that isn’t necessarily destined to lead to some dark, “new normal”. CS thinks we’ll find a way to muddle through, that stocks could advance a further 20% to 30%, and that risk assets in general can remain firm. In considering risks to their forecast, they allow that all the fiscal and monetary stimuli forced upon the markets could some day lead to a funding crisis — should investors start to question the credibility of policy makers. CS even backs up their somewhat hopeful view of the future with some statistics, though, for them, it all comes back to psychology: The bears demand more punishment for the credit sins committed during the great boom ...."

See the full CS argument at

www.credit-suisse.com/...

Sep 11 01:24 PM

[Lilguy:]

I appreciate the thorough and balanced data-driven assessment of the markets presented here. It's a pleasant change from some of the more opinion-driven views that appear on this blog (altho some of them are informative & even entertaining).

Sep 12 10:13 AM

[Plant the s...:]

Interesting data and charts. Need to digest it.

Sep 14 04:37 PM