Warren Buffet has often said that investors should be greedy when others are fearful. If one considers that good advice – and generally I do – then last week may have been at least the beginning of a time to put that bon mot to the test. The press is rife with stories of investors abandoning their long term strategies, moving to cash and generally exhibiting signs of panic. While many seem to have taken the previous week’s post downgrade volatility in stride, last week’s downdraft was met with widespread disgust. Stock mutual fund redemptions have accelerated while gold, municipal bonds and Treasuries – alleged safe havens – have surged in popularity. If the whole world is zigging, it might be time to at least consider zagging.
The market was rattled last week when Morgan Stanley downgraded their outlook for global growth to 3.9% this year and 3.8% next. Why anyone would pay any attention to a firm that at the beginning of this year predicted US growth would approach 4%, US stocks would outperform bonds and emerging market stocks would outperform developed markets – all of which, in case you missed it, have so far turned out to be spectacularly wrong – is a bit of a mystery but according to press reports the MS downgrade played a major role in last Thursday’s selloff. While I think Thursday and Friday’s nearly 600 point swan dive had a lot more to do with European banking system fears than the pronouncements of the wrong way wonks at Morgan, we here at Alhambra do share some of Morgan Stanley’s concerns about the global economy (see John Chapman’s weekly commentary for more detail). Of course, we’ve held those views all year so if the Morgan news caught you by surprise, you might consider signing up for our free weekly newsletter. (Even better, you might consider giving us a call.) What Morgan Stanley or any other Wall Street firm says usually has little impact on our views but considering their track record, Wall Street’s new found pessimism may be a sign that we should start looking for the silver lining in our economic cloud.
To be sure, there are plenty of reasons to be worried right now. The economic data released last week certainly did nothing to improve our mood about the prospects for growth. Retail sales, at least according to the weekly Goldman report, are slowing due to the angst surrounding the US fiscal troubles and stock market volatility. The Redbook report by the way, showed no such slowing and based on the crowd my wife encountered at the mall this weekend, they might be right (of course, I live in South Florida where Brazilians have been using a strong Real to buy anything that isn’t nailed down and some things that are). If the consumer confidence numbers are of any use (and by the way, the track record on that is mixed at best) then Goldman probably has the better take on things.
Manufacturing, which has been the star of the economy since the end of the recession, may be slowing as well although reports last week were somewhat contradictory. Industrial production for July came in much better than expected, up 0.9% as the auto component jumped 5.2% after three consecutive months of decline. On the other hand, the more forward looking Empire State and Philly Fed surveys were both in negative territory with the Philly version downright ugly. There was no good news in the reports with new orders, shipments, unfilled orders, backlog and employment all contracting.
Housing also continues to struggle although that hardly qualifies as news. The homebuilders index remains depressed at 15 with present sales and traffic somewhat higher but the six month outlook declining. Housing starts fell 1.5% in July to an annualized pace of 604,000 units. That was slightly better than expected and still up 9.8% from last year’s rate. In a continuation of the recent trend, single family starts were down 4.9% while multi-family starts rose 7.8%. Permits fell 3.2% to a 597,000 unit rate. Permits are up 3.8% versus a year ago. Existing home sales were also down last month by 3.5%. Prices fell and inventory rose to 9.4 months at the depressed pace of sales. Housing is slowly – very slowly – improving but not enough yet to create significant economic activity. That may change over the next year – if the economy can avoid recession.
As if the production data wasn’t bad enough, the inflation data released last week puts the economy firmly in the stagflation camp. Import prices were up just 0.3% in July but 14% year over year. Export prices fell in July by 0.4% but are up 9.8% year over year. Paying more for imports and getting less for our exports. Yeah, thanks Mr. Bernanke, that quantitative easing is working wonders. Producer and Consumer prices were also hotter than expected up 0.2 and 0.5% respectively. Producer prices are up 7.2% and consumer prices are up 3.6% year over year. Can you say, margin squeeze? I knew you could. Thanks to the Fed – and some incredibly inept politicians – we’ve got the worst of all worlds – higher prices and lower production. Mr. Bernanke is allegedly an expert on the Great Depression but one can’t help but wonder if he spent any time at all studying the 1970s.
Jobless claims poked back above the 400k level at 408k for the week. Believe it or not, that was the good news on the week. Claims at this level are consistent with the punk rate of job growth we’ve seen all year. I am afraid this might be as good as it gets for a while with layoff announcements recently spiking. Bank of America announced another 3500 layoffs in addition to the 2500 announced earlier this year. Total layoffs, according to a leaked internal memo, may total as many as 10,000. Of course, reducing the size of the financial sector is something to be cheered for the long term health of the economy, but in the short term it surely isn’t good news.
US Stocks were down about 4.5% on the week with Europe doing quite a bit worse (Euro Stoxx down 6.7%) and emerging markets generally a bit better. As I mentioned above, gold and Treasuries were the preferred safe havens on the week with gold making new highs and 10 year Treasury note yields hitting new lows. The real catalyst for last week’s renewed selling was probably the European debt crisis and its potential effects on the banking sector there and here. I believe this crisis will eventually result in Greece and some of the other PIIGs being ejected from the Euro but not before the core countries figure out a way to either recapitalize the banks or relieve them of their holdings of peripheral debt. How long it takes for Merkel, Sarkozy and the other EU bureaucrats to figure that out is something I can’t predict but if they want to preserve the Euro as a viable currency, I see no other way. In the meantime, expect more volatility.
So, after all that gloomy commentary, you must be wondering about our search for a silver lining I mentioned above. Believe it or not, there are some potential positive developments. Commodity prices, particularly oil, are falling thanks to the stabilization of the dollar index. Yes, the dollar is still falling against gold and this is certainly bad news but at least it has stabilized against other currencies. I expect oil prices could fall considerably more in coming months if Bernanke can suppress the urge to turn on the printing press again. The Libya situation appears to be climaxing and Gaddafi (or Qadaffi or however they’re spelling his name this week) may soon be applying for a slot in the retirement home. With WTI inventories at Cushing ample, a return of Libyan production could push down world prices considerably. Lower oil prices would be a major positive for the global economy.
Another potential positive could be renewed growth in the emerging markets. Most of these countries have been fighting inflation with higher interest rates but they should be entering an easing cycle soon. China has already indicated they are probably done tightening and they have allowed the Yuan to rise recently. In Brazil, bonds have been rising in price and with the official rate at 12.5% the central bank has plenty of room to ease. Australia’s central bank may also be easing soon as commodity prices come down.
Lastly, stocks are not terribly expensive unless the world is really entering a new recession. Emerging market stocks are actually cheaper than US stocks based on next year’s estimates. Emerging markets are trading at a collective forward P/E of about 10 while the S&P 500 is at about 12. Of course, estimates are exactly that and another recession right now would make stocks look considerably more expensive. Further encouragement can be found in renewed insider buying and new stock buybacks. I would also note that the dividend yield of the S&P 500 is now higher than the yield on the 10 year Treasury note. That has only happened twice since 1958 – at the bottom in 2008 and now.
For now, we remain conservatively invested although we did add some incremental exposure to stocks two weeks ago during the first bout of volatility. We added some to US and emerging market stocks as well as emerging market bonds (which may perform better than stocks as emerging market central banks start to ease). We still have almost 45% of our World Allocation model in cash, gold and short term Treasury ETFs. We did not escape completely unscathed last week; the World Allocation model was down 1.38% last week while the S&P 500 dropped 4.69%.
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