Stocks continued their losing ways last week, with the S&P 500 falling 1.71%. What’s all the hubbub about? Yes, the range on the market was a trifle wider than in most weeks but our portfolios ended the week about where they started (our World Allocation portfolio was down 0.03% last week). Alright, I admit it; there was a deja vu all over again moment last week when I wondered why the hell I owned any stocks at all but it is moments like that when a diversified portfolio is your best friend. More than anything, a diversified portfolio allows one to take the time to properly consider what moves – if any – one needs to make at times like this rather than making an emotional decision based on fear. We used last week’s volatility to rebalance our strategic portfolios – our bond allocation had grown too large – and also to slightly reduce the cash position in our tactical portfolios. Nothing dramatic in either case but small changes made at the right time can make a big difference over the long term.
The volatility last week was not, in my opinion, a product of the S&P downgrade of US debt. S&P had warned months ago that a downgrade was coming – and our chief economist, John Chapman told you two weeks ago to expect it – so no one should have been surprised. I’ll leave it to others to opine about whether the downgrade was politically motivated or whether S&P needs a new calculator, but whatever the motivation, I do hope the downgrade serves as a wake up call for the newly announced members of the Super Duper Congress known as the fiscal commission. The US economy is still not functioning at anything near its potential and only major fiscal reform offers any hope of changing that for the better.
Monetary policy is essentially impotent and the Fed’s announcement last week that they would continue to rip off savers in favor of debtors for another two years is, if nothing else, a commentary on the moral imperative of better fiscal policy. Low interest rates and a weak dollar have hurt the incomes and purchasing power of the weakest members of our society while supporting bankers and speculators. That is not only bad economic policy but morally bankrupt as well. The only way out of our economic predicament is higher growth and as QE2 proved to everyone except the willfully blind, it won’t be produced from the Fed’s printing press. If the fiscal commission ends up deadlocked, so will the US economy.
It is growth or rather the lack of it, that produced the volatility of last week. Emerging market economies, source of considerable growth for US multinationals, are slowing. Europe’s economy is also slowing and last week the slow motion banking/debt crisis added to the market fear factor. The big European banks are facing a liquidity squeeze as US money market funds have dumped their short term debt and the interbank lending market has dried up. That leaves the ECB as lender of last resort, a function for which it was never intended. It seems more and more likely that Europe will need to recapitalize its banks via a mechanism similar to TARP but there is a fear that the political will for such a solution doesn’t exist. If not, outright nationalizations will be the likely next step. Whatever happens, Europe was never the engine of global growth and that won’t change.
As for the emerging markets, they have been on a monetary tightening round over the last year that I think is likely coming to an end. As commodity prices fall, their central banks will see room to cut rates. The Chinese allowed the Yuan to appreciate nearly 1% last week and have indicated that monetary tightening is coming to an end. The Australian central bank is also probably done raising rates and may cut sooner rather than later as their economy weakens. Brazil and other Latin American countries also have room to cut rates. Assuming the US and European economies don’t fall off a cliff, emerging markets may be the best bet for growth. We raised our very modest exposure a bit last week and may do more if their central banks enter an easing cycle as we expect.
Lastly, for this update, I’d like to say a bit about gold. The recent run to new highs has caused quite a stir, not least here at Alhambra. We have had an exposure to gold for several years now and it has done what we expected it to do – provide a hedge against bad economic policy. It isn’t just monetary policy that affects the price of gold; fiscal policy affects the demand for money and therefore exerts an influence over gold as well. Bad fiscal policy also produces bad monetary policy as the Fed attempts – wrongly in our opinion – to offset the growth killing policies of the politicians, which further raises the nominal price of gold. Gold is a real time indicator of the public’s perception of economic policy and I can’t argue with the gold market’s verdict right now. Economic policy is about as bad as it has been in my lifetime.
Having said that, I am also skeptical of raising our allocation to gold at current prices. There is a scent of panic buying in the market right now and I don’t like buying an asset that everyone tells me I must own. I suspect the current growth scare will fade in coming months and with it the fear that is producing the current gold mania. If I’m right, gold could see a significant correction and owning too much would be just as painful as owning too many stocks was last week. Investing is in many ways about moderation. We don’t want to be too dependent on any one thing and that includes gold. If policy changes for the worse – if the Fed starts QE 3 for instance – my opinion might change, but until that happens, gold appears to me to be too well loved to merit further investment.
Economic Data Review
Last week’s economic data was actually pretty good despite the market turmoil. Markets are discounting mechanisms though so last week’s drop in stocks was more a judgement about future growth than past. I’ve been warning for months now that the economy was slowing and that is proving true but so far, I see nothing to indicate a new recession and the deterioration to date probably doesn’t warrant the selloff in stocks. There is an old saying on Wall Street that the stock market has predicted 9 of the last 5 recessions so the market is not infallible. I sure hope it’s wrong this time.
Productivity fell in the second quarter which isn’t surprising given the poor growth. Weak output and rising unit labor costs are the very definition of weak productivity. With most of the rising cost of labor in benefits such as healthcare it also shows that lousy government policy has an effect in the real world. It isn’t coincidence that the two areas of the economy with the most rapidly rising costs – health care and education – also happen to be areas with heavy government involvement. The drop in productivity is worrying since rising productivity is the real source of wealth generation in the economy.
Retail sales were better than expected in July, up 0.5%. Auto sales were a major factor up for the second month in a row. Year over year, retail sales are up 8.5%. As I’ve said many times, it isn’t consumption that is the problem with our economy. The Goldman and Redbook reports indicate the sales momentum continued into August too. Redbook showed same store sales up 4.8% year over year and 0.7% month to month. I suppose that could change with the market turmoil last week but I have my doubts. Consumer sentiment did fall rather precipitously last week with the U of Michigan index falling to 54.9. The last time it got that low was during the Iranian hostage crisis. On the other hand, consumer sentiment changes with the wind and doesn’t correlate that well with economic growth.
Falling interest rates are having an impact in one area – mortgage refinancing. Mortgage applications for purchase were down 0.9% but refi applications were up a whopping 30.4%. I doubt lower rates will have much impact on purchases though; jobs are more important.
Two reports on inventories were also encouraging. Inventories at the wholesale level were up 0.6% exactly matching the rise in sales. The inventory to sales ratio stayed the same at a low 1.16. Business inventories were up just 0.3% with sales up 0.4%. The inventory to sales ratio stands at a still low 1.28. Businesses seem to be managing inventories very well and a pickup in economic activity would mean a pick up in production as well. Unless sales slow dramatically, production is about matching demand at this point.
The trade deficit worsened last month with exports falling 2.3% and imports down 0.5%. That isn’t a surprise as it just confirms the slowdown in foreign economies I’ve been warning about for months.
Jobless claims fell under the 400k mark again at 395K. There has been a steady if unspectacular improvement in claims over the last 6 weeks. The absolute number is still too high but it is moving in the right direction. There have been some high profile layoff announcements recently though so major improvement from here will be more difficult.
Overall, the US economy is still struggling but growing. I don’t think it would take much to push it either way at this point. A bad shock would put us right back in recession while a positive change in economic policy could get us back up to 3% growth pretty easily. I just hope we get the latter before the former.
The same could be said for stocks by the way. The S&P is trading for a reasonable multiple if the economy doesn’t get worse. It’s damn expensive if we are headed into a new recession. We’ll need more clarity on the economic outlook before making any major moves in either direction.
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