Thinking Things Over    July 29, 2012

Volume II, Number 30:   Sell Now and Buy Again This Fall, or Don’t Fight the Fed?  

By John L. Chapman, Ph.D.       Dallas, Texas

Nostalgia is a word in the English language borne of precision: it needs no definition in context because everyone knows immediately what it means.  It refers of course to a wistful desire one has to return to a former time or situation in one’s life, say to one’s former home or homeland, school, or youthful romance – in general, it evinces a longing for the happiness of a bygone era.

But a friend of ours has called to our attention a “reduced form” definition that well-defines current investor sentiment: nostalgia, he said, is the simultaneous holding of both happy and sad feelings.  Precisely so, evidently, in the case of global investors, who bid up global equities late last week on a will-o’-the-wisp thesis that things are on the mend in the Eurozone, and the Federal Reserve will act to loosen the money supply (“Are you kidding me?”) again as early as its Open Market Committee meeting this week.

What else, pray tell, could have caused the S&P 500 to reverse days of losses and soar 3.6% in two days, alongside the Dow reaching 13,000 once again?  If anything, many signs in the U.S. point the other way: stunted retail sales, decelerating profit growth, negative regional Federal Reserve reports, deceleration in construction and home improvement spending, a stalling in durable goods spending, particularly in the confidence-revealing auto sector, and so on.

And of course now, to top of the round of glum indicators, a “print” on second quarter GDP growth in the United States of 1.5%, on top of the first quarter’s revised 2.0%.  The 1.75% growth rate so far in 2012 is, sadly and coincidentally, almost exactly the average growth achieved in the U.S. since January 2001 and the advent of the Bush 43 Presidency.  Where are we now and moving forward, for the rest of the year?  Let us offer a concise scorecard for investors based on a few important considerations:

(1)  We continue to believe we are in the midst of a long-term secular bear market, with years of sideways action – that is to say, the S&P Index closed Friday at 1385, and there are solid reasons why it may well be at the same level a year from now, if not lower.  The palpable nostalgia seen in investor circles for the ‘80s and ‘90s is at this point perhaps best described charitably as cognitive dissonance – the policy mix and global debt levels are dramatically worse now, virtually everywhere.

(2)  We fear a volatile fall for U.S. markets this fall as the election season heats up. The $400 billion tax increase set for January 1, which includes dramatic growth-killing hikes on business incomes and investors’ capital gains, is already weighing on the minds of economic agents. And, the uncertainty surrounding both the U.S. debt limit, breached again in the next 6 months or so, coupled with the path for comprehensive tax reform all make for subdued business sector spirits. (For the record, we are anticipating helpful policy changes and an ultimate roll-back of much if not all of the January 1 hikes, but the 70-30 odds of this are not high enough to kill investor disquiet).           

(3) GDP growth in the U.S. was dramatically lowered in revisions for 2010, from the level reported now for nearly 18 months, 3.0%, down to 2.4%  — a twenty percent downward revision.  We cannot fail to note that the U.S. Commerce Department, which has developed this revised data and had it in its possession for months, chose the late July summer vacation season data release to come out with this (2011 was revised up to 1.8% from 1.7%).  The news was subsumed by everything from the Olympics to European developments, but in our 30 years of following this data series, we have no memory of such a large downward revision, one that would be so clearly unfavorable to political incumbents.  If nothing else, the newly-weak growth for 2010 merely confirms the limits of “stimulus spending” to stoke a recovery (in this case, $831 billion from 2009). 

(4)  And based on current news, prospects for the rest of the year look to be hard-pressed:   

·       Consumer durable purchases in the second quarter shrank at a -1.0% per annum rate from the first quarter (the second quarter is quite often stronger for this data series). 

·       Fourth quarter 2011 GDP was revised upward to +4.0% from +3.0%; this occurred during a few months of strong six-figure job growth gains and some mildly encouraging news out of Europe at the time, but of course now makes the downdraft in the first six months of this year look even worse by comparison.

·       Anecdotal discussions we have had with business owners while traveling this past week heighten our caution for the rest of this year.  U.S. businesses are burdened by rising (and unknown) tax and health insurance costs, Europe’s deepening recession, and stunted growth across much of Asia.  In addition, while we like a rising dollar, in the short run, some exporters complain, the weaker euro hurts U.S. corporate profit growth.

·       The downward revision in GDP was driven partially by an inventory accounting change, but ominously, by declines in most spending categories, particularly for business equipment and software (from +14.6% to +8.9%).  This will impede growth estimates moving forward thanks to declining productivity, and again, marks the 2009 spending legislation down in terms of its efficacy.  

(5)  Corporate profits were revised down in this benchmarking process and now show a more pronounced decline in corporate profits in the first quarter of 2012, from the peak in the fourth quarter of 2011.   Corporate profits are always – always – an excellent indicator of economic growth and relative health, though the time series is somewhat volatile and subject to revision.   But the news last week from the Commerce Department was not good: corporate profits in the first quarter of 2012 were revised down to a $1.90 trillion per annum growth, from $1.98 trillion.  This involves a decline of some $53 billion decline in the first quarter from the peak of the fourth quarter of 2011, or in market capitalization terms, represents the loss of some $700 billion in capital wealth.

In short, we have a weakly growing economy in the United States, in “fits and starts”, that is hardly conducive to job growth or increasing real incomes. It is not a recession, and the stellar productivity gains of recent years, strong profit growth, and continuing private sector innovations in the United States are earning the American business community our never-ending marvel.

But the idea that more Fed easing will provide a permanent floor on stock prices in the U.S. is in our view a shibboleth, thinking of the long term.  Nothing – nothing – was solved in Europe last week after pronouncements from first the ECB’s Draghi and then Mrs. Merkel and France’s Mr. Hollande that they would all “do whatever it takes” to “protect” the Euro.   Europe’s economy has been falling due to the anti-growth nature of the structural reform choices in Greece and Spain (there has been no meaningful pro-private sector growth measures, and no real cuts to government expenditures there yet), and for that matter, no real pro-growth agenda elsewhere, either; nothing last week changed this materially.  The machinations involving ESM leverage and even foreign direct investment in the rescue fund (from, say, China) might prove interesting, and even a bit hopeful if they were to come with pro-private sector features, but at the end of the day we still know nothing concrete.

What does all this mean?  We think stock will trade in a sideways range into the fall, and may well be down from current levels.  We do expect a fall rally based on a belief for pro-growth policy in the U.S. after the election, and still see U.S. equities ending the year about where they are now.   Like the 1999-2012 era itself, therefore, a flat market, with plenty of stomach-rending volatility.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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