Navigating Through Uncertainty

Includes: BK, GS, HCBK, JPM, PH, PL
by: John Buckingham
Believing that the global economy might benefit from a quicker pick-up in business activity in Japan (following the March earthquake and tsunami) as well as from lower energy prices after the recent drop in the price of crude oil, St. Louis Federal Reserve President James Bullard said Saturday in Jackson Hole, Wyoming, “I think there are good reasons to be optimistic even though when you look around these days there is a lot of gloom and doom.” Mr.Bullard continued, “The probability of a recession is somewhat higher but most models would tell you that it is not extremely high.”

His comments echoed those contained in the Friday morning’s Jackson Hole speech given by Ben Bernanke. In that widely-anticipated address, the Fed Chairman commented on the near-term and long-term prospects for the U.S. economy.
Of course, there was plenty of pessimism on display at the annual Jackson Hole gathering of central bankers and private economists, with several of the latter suggesting that we are already in or that we are headed for a double-dip recession. World Bank President Robert Zoellick said, “I’m concerned about a risk of events this autumn.” And the International Monetary Fund's managing director, Christine Lagarde, commented, “We risk seeing the fragile recovery derailed. We are in a dangerous new phase.”
No doubt, there is plenty about which to be concerned, especially as we learned last week that German business confidence tumbled, that Chinese manufacturing had slowed modestly and that euro-region factory orders fell. Here at home, first-time claims for unemployment insurance rose to 417,000 for the period ended Aug. 20 and second quarter U.S. GDP growth was revised down to 1.0% from 1.3%, putting growth for the first half of the year at just 0.7%. To be sure, there were a few silver linings as the GDP report showed that corporate profits climbed by 3% in the second quarter, improving on the 1% increase seen in the Q1, while overall orders for durable goods jumped by 4% (thanks to autos and airplanes) in July, the biggest increase since March.
Obviously, the health of the economy remains the big question mark, but the consensus forecast of economists is still of the mind that a recession will not come to pass. That is not to say that the sensationalistic financial headline writers won’t continue to suggest otherwise. For example, ran a widely-read story with the headline, “Chance of Recession Is as High as 80%,” which cited data from Bank of America Merrill Lynch that showed that the latest plunges in the Philadelphia Fed and University of Michigan sentiment surveys have those gauges signaling an 80% or greater chance of recession.
The actual headlines related to the Merrill Lynch report were as follows: “We urge caution regarding forecasts of another recession. While we concede the risks are rising - we now see a 40% chance of a contraction over the next 12 months - a recession is not baked in the cake. If the economy can avoid further shocks, we would expect a modest bounce in growth into the end of the year. An easing up of the negative news flow both here and from Europe would help financial markets to stabilize and reduce the magnitude of an 'uncertainty shock.' Looking systematically across a number of indicators reveals that some measures are flashing red, while others point to a rising risk but do not pass the tipping point.”
Clearly, “80% chance of recession,” will attract many more eyeballs, even as one could also choose to shout that the Philly Fed figure is flashing a major buy signal as it has only been lower in Mar ’70, Nov ’74-Jan’75, Apr ’80-Aug ’80, Dec ’81, Sep ’90 – Jan ’91, Jan ’01 and Oct ’08-Mar ’09, generally all very favorable times to be buying stocks. Same thing could be said for the Michigan numbers, considering that it has only plumbed the current depths in 1975, 1980 and 2009.
Indeed, fear (if the earthquake and hurricane don’t get you, the market will) remains the emotion to which most in the media and the investment advisory business are playing. As Parker Hannifin (NYSE:PH) CEO Donald Washkewicz recently said, “There is always the risk that we can talk ourselves into a recession, and we seem to be working pretty hard at that.” Still, he added that the maker of hydraulic parts for aircraft and other machinery hasn’t seen any significant change in demand for its products in recent weeks and his company is proceeding with plans for increased capital spending in its fiscal year ending Jun 2012.
It is interesting, however, that we are not seeing capitulation-type numbers in the measures of investment sentiment that we watch. Given the pervasive negativity, one would not expect to see $1.1 billion in net inflows for domestic equity mutual funds, compared to a massive $23.5 billion net outflow in the week prior, for the most recent (as of Aug. 17) weekly data from Investment Company Institute (ICI). And it was surprising to find that the latest (as of Aug. 24) Bull/Bear survey from the American Association of Individual Investors (AAII) showed that the number of bulls inched up to 36.4%. There were still more bears (41.0%) and normally the differential is 39%/30% in favor of the bulls, but the AAII reading was much better from a contrarian perspective (i.e. many more bears) three weeks ago when the comparison was 27.2%/49.9%. On the other hand, newsletter writers became more pessimistic as the latest read from Investor’s Intelligence found that bullish sentiment decreased to 40.9% from 46.2% and bearish sentiment increased to 33.3% from 23.7%.
While we could argue that both ICI fund flow and AAII data hit capitulation levels a few weeks back, perhaps we can look at gold as a current contra-indicator. Incredibly, the precious yellow peaked (for now anyway) at $1,891 on Monday, which just so happened to be the trading day after the day that the SPDR Gold ETF (NYSEARCA:GLD) became the biggest exchange-traded fund, surpassing the SPDR S&P 500 ETF (NYSEARCA:SPY), which tracks the Standard & Poor's 500-stock index. The GLD ETF hit $77.5 billion in assets on Monday, at which point the underlying precious metal beat a hasty retreat, plunging to $1,757 on Wednesday before bouncing back some by the end of the week . Stocks, for their part, enjoyed a terrific week, with the S&P 500 gaining 4.7%.
Ironically, the only day that the market failed to gain ground last week was the one that saw Warren Buffett invest $5 billion in Bank of America (NYSE:BAC). Now, it is true that the Oracle of Omaha was able to finagle a fantastic deal for himself via the same kind of preferred stock/warrants package he obtained from Goldman Sachs (NYSE:GS) and General Electric (NYSE:GE) back in 2008, but he is in the business of making solid long-term investments. Mr. Buffett commented, “Bank of America is a strong, well-led company, and I called Brian (CEO Brian Moynihan) to tell him I wanted to invest in it. I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them. Bank of America is focused on their customers and on serving them well. That's what customers want, and that's the company's strategy.”
He added that this is not 2008, thus BofA received better terms than what he was able to negotiate with Goldman and GE. And perhaps his final point is most germane for long-term oriented equity investors. When asked why he wanted to buy into Bank of America now, Mr. Buffett responded, “Because the stock price has gone down a lot!”
While we aren’t interested in the common stock of Bank of America, we are very pleased to see Buffett putting more money to work in such a visible fashion. We prefer financial stocks like JPMorgan Chase (NYSE:JPM), BB&T Corp (NYSE:BBT), Bank of New York Mellon (NYSE:BK), Hudson City Bancorp (NASDAQ:HCBK) and Protective Life (NYSE:PL), all of which sport dividend yields above that of the 10-year Treasury. And we think dividends will continue to be a big draw. After all, as Barron’s reported this weekend, “The S&P's dividend yield recently matched that of U.S. 10-year Treasuries, when the norm since 1981 has been for Treasuries to pay a yield 2.7 times richer.”
Disclosure: I am long PH, GLD, SPY, GS, JPM, BBT, BK, HCBK, PL, BAC.