Looking At The Economic Forest
I spend much of my day watching, reading and thinking about the markets and the economy in order to make some rational and logical estimations about potential future outcomes. My view on investing is simply this: "As investors we do not, and can not, control the future outcomes from the stock market. Therefore, we are not 'investors' but 'speculators' in the financial markets. As speculators, our job is to manage the risk of investing in a manner that produces the most favorable future outcome. This is no different than a gambler who plays a hand of poker - the size of the bet is adjusted relative to the odds of winning. The difference between success and failure, of both gamblers and speculators, is understanding the probabilities of success for each and every action and then applying that assessment of risk to the amount of invested capital accordingly. Being 'all in' on every hand, as recommended by the financial community and the media, will lead you to being out of the game far too soon. Knowing when to 'hold' and 'fold' is what separates winners and losers."
In my daily work, and research, I do my best to set aside emotional biases and remain as agnostic as possible when analyzing the data. While there is no doubt that optimism is a much more enjoyable state to be in - the reality is that maintaining an optimistic viewpoint, in the face of declining fundamentals, does not provide investors with the proper information to manage portfolio risk. In other words, maintaining an "optimistic" stance leads to excessive speculation, or risk taking, within portfolios that will ultimately lead to larger than expected losses. The overriding problem with sustaining large losses to capital is that while the capital can eventually be rebuilt - the "time" lost in doing so can not be recovered.
While the media, and Wall Street, jump from one data point hoping for the "never ending summer" for equities - the reality is that economies, and markets, simply do not function that way. While individual data points may offer glimmers of hope it is the only the trend, or direction, of the data that matters when doing analysis. It is this view of the data that drives our asset allocations and portfolio weightings. Our portfolios are, and have been, overweight in cash and fixed income and underweight low risk equities since the beginning of April. As we have been recommending recently we have lifted more equity exposure on the June rally.
With the first half of the year behind us, and important economic reports for June now in, we can get can now make a much better determination of the "hand that we have been dealt" and how we should be adjusting our "bet". Is it time hold, fold or go all in?
The economy as a whole slid from 3% growth in the 4th quarter of 2011 to just 1.9% growth in the 1st quarter of 2012. With the spate of weakness in recent manufacturing reports it is likely that the we will see 2nd quarter GDP closer to 1.5% annualized growth. This will be a very disappointing rate of economic growth a full three years post the last recession. The chart above shows real, inflation adjusted, final sales of the U.S. economy. Final sales peaked in the 3rd quarter of 2010 following the conclusion of QE 1 and have been on the decline ever since.
Historically, when Final Sales has fallen below 2% growth on an annualized basis the economy has generally been in or was in a recession. With this in mind does this look like an economy in recovery to you?
Not Your Fathers Economy
There was a recent posting out by Jeff Saut at Raymond James he stated: "Indeed, 'your father's' recession, and subsequent recovery, saw the two sectors that pulled the economy out of recession, namely autos and homebuilding, recording strong rebounds. Beginning in 2009 autos have done their job since we have gone from roughly a 9 million unit seasonally adjusted annual rate (SAAR) to nearly a 15 million run rate. The laggard has been homebuilding, but that appears to be changing."
Mr. Saut is correct. In the past recessions have been led out of the dark days by strong recoveries in housing and automobile manufacturing. However, while this is not our "father's recession" it is also not our "father's economy." In the past automobile manufacturing and housing were much more crucial pieces to the economic landscape. That is no longer the case today. Globalization, productivity, exportation and technology has led to a conversion of the American economy from a manufacturing powerhouse to a service provider. As such residential investment has fallen from a near 6% contribution to GDP to just over 2.6% today. Likewise, auto manufacturing has fallen from over a 3.5% contribution to less than 3% today. Meanwhile, exports of goods and services have rocketed higher from a 2.8% contribution to over 13% today.
In regard to housing specifically there have been recent upticks in existing and new home sales. Unfortunately, while annualized growth rates provide astounding recovery headlines - a simple look at a chart will tell you more than you need to know. Does this chart of new home sales scream of a housing recovery? The reality is that much of the activity is occurring at the very low end of homes which are being turned into rentals. This activity has a limited life and scope. As I have stated recently - we may have found a bottom in housing but a recovery may be a far more elusive thing.
So while Mr. Saut may be waxing the current bounces in auto's and housing from extremely depressed recessionary levels (both of which have had massive governmental supports from "cash for clunkers", suppressed interest rates and direct investment) the reality is that with the Eurozone and China slowing or in recession what we need to be watching is exports. If exports began to decrease substantially from recent trends it will likely be very hard for the U.S. economy to maintain positive growth.
Speaking of manufacturing - the recent releases have been nothing short of disappointing. The most recent releases of ISM reports show a dramatic slowing in both manufacturing and services sectors. Our composite ISM index as shown are more than just a bit disturbing. We have discussed in the past that it is not uncommon for ISM to tick up just before a recessionary decline just as we have seen previously. The current reading of 50.7 for the composite index is at very critical levels and confirms that recessionary risks are definitely on the rise.
Nothing shows this better than our Economic Output Composite Index (EOCI) which is a composite of several Fed manufacturing releases, ISM composite shown above, CFNAI, NFIB small business survey and Chicago PMI. This composite index is a very broad measure of the overall manufacturing and business climate in the U.S. economy.
When the index has historically declined below 30 the economy either has been, or was about to be in, a recession. At the end of last summer, as the Fed launched "Operation Twist" the EOCI was indicating the onset of an economic recession. The combination of support from Central Banks in Europe as they implemented LTRO's, the warmest winter in 65 years and a huge effective tax credits to the consumer from a drop in oil prices last summer to low natural gas and utility bills in the winter allowed the economy to bounce back from a recessionary fall.
With the degradation in the Eurozone and China, as discussed above, it is very likely that we will see further deterioration in the EOCI in the months to come as the economy continues to struggle. Without the implementation of further balance sheet expansion programs in the near future to fuel some levels of consumption and speculation it is extremely likely that a recession will take root by the beginning of 2013.
Once again this begs the question: "Does this look like an economy in recovery to you?"
With the release of the latest employment figures came further confirmation of an economy on the ropes. With growth of only 80,000 jobs in the latest report the reality is that economy is struggling to grow. There are nearly 85 million individuals that uncounted in the labor force. This is nearly 2 million more than just a year ago - no wonder the employment rate has declined. There are 7.2 million people who are "disenfranchised" who would like to have a job but can't get one. Finally, the duration of unemployment still remains at near record levels while the labor force participation rate continues to plumb levels not seen since the early 80's.
This is clearly a picture of a broken labor market. The problem is not just "jobs" but the impact of such a large mass of unemployed individuals living off government support, now more than 35% of incomes, which impedes both economic and wage growth. Wages have not kept pace with inflation in recent years pushing average wage earners to rely on debt and reduced savings rates to maintain their standard of living. The disparity between income and outflows has now become vastly apparent as the spread between the "rich" and "poor" has grown sharply.
The economic impact of weak employment continues to be felt as aggregate end demand on businesses keeps companies in a defensive position. The reality is that the deviation from normal employment levels is at the lowest point in history. In order to compensate for normal population growth employment would need to exceed 250k jobs a month, every single month, for the rest of this decade just to get to "real" full employment levels. This is very unlikely to happen when you have an economy growing at an estimated 2% annualized rate.
Buy, Sell or Hold
Forget my commentary and just look once again at the charts above. Do any of them signal that you should be heavily invested in risk based assets at the current time? They didn't for us either. This is why we continue to stick with our current allocation model as discussed above.
In our update of our Risk Ratio analysis on May 18th we laid out the following course of portfolio actions at that time. The "sell targets" identified were met with the anticipated June rally:
- Liquidate weak and underperforming positions as the market approaches the 1350 and 1360 levels.
- Rebalance winning positions by taking profits and resizing positions back to original weights at the 1350 and 1360 levels respectively.
- Look for rotation into precious metals as a "safe haven" investment which is currently very oversold.
- Short duration fixed income is still an alternative as rates will likely remain under pressure from the rotation out of stocks.
- Be careful with dividend yielding stocks — while they will likely hold up during a correction they are already overbought in many cases.
- Our call to buy bonds over the past month has played out well. They are currently overbought and extended. Hold current positions but be selective on new additions at this time. Wait for a move in interest rates to 2.2% on the 10-year treasury before aggressively adding more.
- Hold cash for a buying opportunity when the next "buy" signal becomes apparent."
These instructions are tied to our asset allocation model which we post and update each week in the newsletter. From last week's missive: "On Monday it is important to move to the recommended allocation following the guidelines that we have laid out previously:
- Sell laggards and losers and remove them from portfolios entirely. (weed the garden).
- Harvest profits in winners by reducing weights back to original purchase sizes. (harvest the bounty).
- Reweight portfolio allocations to align with recommended target levels - 35% Cash, 35% Fixed Income and 30% Equities. (prune the garden)
The reason I am reiterating these instructions is that the market remains on a sell signal and the June rally took the markets back to an overbought condition within a negative market trend. The rule in a negatively trending market is to sell rallies."
With economics weakening on a global scale it is only a function of time until they begin to more aggressively erode the economic base in the domestic economy. The advice, allocation model and instructions have not changed since May. As investors we are generally left to our own devices to determine when it is "... a time to reap and a time to sow." Whether you are a gambler or an investor, the game is the same - manage risk, conserve investment capital and be patient for the right opportunities.
Currently, the hand that we have been dealt is not a winning hand. Being fully invested at the current time in equities will likely lead to lower portfolio values in the near future. With the markets currently on "sell signals", and our major "sell signal" rapidly approaching, maintaining higher levels of cash will provide the liquidity needed for the next buying opportunity when it comes.