Editors' Note: This article covers micro-cap stocks. Please be aware of the risks associated with these stocks.
Underlying economic reality remains much weaker than Fed projections. As actual economic conditions gain broader recognition, market sentiment even could shift from what now is no imminent end to QE3, to an expansion of QE3. The markets and the Fed are stuck with underlying economic reality, and, increasingly, they are beginning to recognize same. - John Williams, Stadowstats.com
Based on more bearish economic data released this week, it's becoming increasingly clear to me that the U.S. economy is headed toward a recession. Although it's my view that the GDP estimates by the Government use unrealistically low inflation estimates and therefore Government GDP numbers overstate the real level of economic output, I believe that it is likely that the U.S. economy even by Government measures will soon start to show a state of contraction, possibly by the end of the Q4. And the possibility of a temporary Government shutdown increases this risk. Based on this view of the economy, I see no chance of the Fed tapering QE this year. In fact, given the likelihood that Janet Yellen will be the next FOMC Chairman, I think the probability of any policy change by the FOMC is skewed toward an increase in QE.
I have presented my analysis of why I think the economy is weaker than is being discounted by the market in several previous articles, with my most recent article examining specific economic and corporate reports: Tapering Will Be Irrelevant, If They Do. In addition to this, there was even more economic data this week which shows that the underlying fundamentals of the economy are getting weaker.
First off was the Richmond Fed manufacturing index for September, which came in at zero vs. an expected index level of 10.5. This index shows a comprehensive set of indicators of business conditions for the Richmond Fed's region. Of particular note were the sub-indexes which showed declines in shipments, new orders and employment. The zero reading came in well below even the low end (8 to 16) of the Wall Street range of estimates. The previous index level for July was 14. The size of the drop and fact that it came in substantially below the lowest Wall Street estimate underscores the fact that the economy is far weaker than the expectations that have been built in to the markets.
The second significant indicator of impending economic decline, for me, was the pending home sales index released by the National Association of Realtors. This index dropped 1.6% from the July reading and July was revised lower from its initial reading. This index is based on contract signings and is supposedly a barometer of future home sales. The fact that it was revised lower for July and declined even more in August is a bad sign for the housing market, since July and August are supposed to be two of the four best months for home sales. If the housing market is rolling over, like I believe it is, this is bad news for the economy as the housing sector has been one of the primary contributors to economic activity over the last 18-24 months.
In what could be the most significant indicator that the economy is getting ready to experience a recession, measures of both consumer confidence and consumer sentiment released this week showed unexpectedly big drops. Gallup's Economic Confidence Index, a measure released weekly, dropped to -21 this week and it was the lowest reading in 6 months. This reading of the consumer's outlook was further confirmed today (Friday) when the Michigan Consumer Sentiment index (final reading) came in at 77.5 for September, which is significantly below the 82.1 reading for August. The expectations component of this index dropped to 67.1, five points below the August reading and Bloomberg News attributes this to lack of confidence in income prospects.
I say that the big drop confidence/sentiment could be the most significant factor affecting the direction of the economy because, ever since Greenspan took over the reins at the Fed in 1987, one of the primary drivers of Fed policy has been the goal of targeting and maintaining "confidence" in the consumer. Since 2000, consumption has been roughly 70% of GDP. If the consumer loses confidence and spending goes into a decline, the economy will be in serious trouble.
Given my outlook for the economy, I'm confident that there's very little chance that the Fed will implement a QE taper at all for the rest of 2013. In fact, based on my view of the economy, I did not expect that the Fed would taper at last week's FOMC meeting. Earlier this week NY Fed President Bill Dudley confirmed that the economy was too weak for the Fed to taper. In addition, this morning the Chicago Fed President Charles Evans issued a comment that suggested there will be no taper until 2014. It's actually my view that the next FOMC policy change will be an increase in QE.
For better or worse, analysis is useless unless we can trade and make money off of our convictions. With my view that the economy is going into the tank starting now and that the Fed will not taper this year, I have two trading strategies that I think will be quite profitable. First, the general stock market, as represented by the S&P 500 (SPX), is overvalued relative to my outlook for the economy and therefore my outlook for earnings. Interestingly, the SPX currently is lower than it was just before the FOMC released its no-taper announcement last week. A "no-taper" should have been bullish for stocks, which is why the SPX spiked up initially. But the fact that the SPX is now lower than it was before the announcement tells me that smart money is seeing the same things I am with regard to valuations relative to earnings expectations and they are selling stocks.
There are a lot of ways to express a bearish view on the stock market. Because the homebuilder stocks are leveraged to the economy - as evidenced by their positive beta to the stock market - I have set up short positions in DR Horton (NYSE:DHI), which has a beta of 1.6, and KB Home (NYSE:KBH), which has a beta of 2.35. If I'm right about the stock market going a lot lower soon, both DHI and KBH will significantly outperform to the downside.
Conversely, because I believe that the Fed will keep printing at the $85 billion per month rate through at least the end of this year and well into 2014, the precious metals are very cheap here. Just like the SPX is lower than before the no-taper announcement, both gold and silver are above their pre-FOMC announcement level. To me, this not only confirms that gold and silver have bottomed from their more than 2-year correction, but they have started a new uptrend that will eventually lead to new bull market highs for both metals.
While I always advise accumulating positions in physical gold and silver, the best way to play a move higher in the sector is to get long the mining stocks. Just like homebuilders have a positive beta to the stock market, the mining shares have a positive beta to gold and silver. And the junior mining shares, Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ), have a positive beta to the overall mining shares sector. If you're willing to bear the risk, individual junior mining shares are the best way to take advantage of a bullish view on the precious metals sector.
My two current favorites, which I own personally and in the fund I manage, are Exeter Resources (NYSEMKT:XRA) and Almaden Minerals (NYSEMKT:AAU). I recently published an article on AAU based on my analysis of the Company and my conversations with the CEO, Duane Poliquin. In fact, I met the management of both companies earlier this week at the Denver Gold Forum. This year's conference was the most well-attended in the history of the event. This alone tells me that institutional investors are looking at this incredibly oversold sector of the market with an intent to get invested before a big move higher.
Interestingly, the CEOs of both XRA and AAU told me that most of their one-on-one investor meetings were with analysts and portfolio managers of large macro-oriented investment funds. This is the first time in 13 years of my involvement in this sector that I have heard about "generalist" funds looking at mining shares and it reinforces my confidence in my outlook for the sector. At some point soon I will update my analysis of AAU, as I gained some new information that is not in my last report, and I will publish a report on XRA. Both stocks are incredibly undervalued relative to their proved gold/silver deposits and I expect that both will be acquired by large mining companies sometime in the next 18-24 months.
Disclosure: I am long XRA, AAU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short DHI and KBH. The fund I manage is long XRA and AAU