Third Quarter, 2006
Investment Outlook
July 1, 2006
Running on Empty!
The most recent energy crisis reminded us again how empty of political leadership the United States has become. Neither party has any fresh ideas and most politicians don’t have a clue. The Democrats continue to run off the fumes of the “New Deal” and “The Great Society.” The Republicans stopped being the “party of ideas” shortly after they regained the House and Senate when they decided that staying in power was more important than doing anything they promised.
While both sides of the aisle have done everything in their power to entrench incumbency (i.e., themselves), the public seems fed up with the whole kit and caboodle. The press dwells on President Bush’s dismal approval ratings, but he is wildly popular when compared to Congress’s even lower ratings. Politicians are always harping on their experience but with politicians like ours, who needs experience?
Our elected officials prefer inter- and intra-mural political infighting more than addressing problems, and while gridlock is often preferable to political action, the current partisan climate in Washington is getting old. When the public talks of “throwing the bums out” it usually excludes their own local bum, so political sea changes are rare. Nevertheless, the November elections look to be more competitive than they’ve been in a long time.
Both the Republicans and Democrats have trotted out virtually every previously failed energy policy proposal, but we were especially impressed by Bill Frist’s lame-brained $100-a-vote gasoline tax rebate. This guy is the Republican leader of the Senate and a candidate for President? (See who needs experience above.) But wait, there’s more! The total bankruptcy of politicians was driven home recently when Arnold Schwarzenegger, former darling of Republicans, abandoned any pretense of philosophical direction when he declared, “I always like to win. I don’t get hung up on ideology. Whatever it takes, I will do.” This could be the motto for either, or both, parties.
The political noise will only get shriller as we approach the election. Worries of the Democrats recapturing the House and/or Senate will increase. But when neither party is willing to address the easier issues, such as ethics or pork barrel spending, what are the chances that difficult issues such as Social Security, Medicare, and Medicaid might be faced?
Economic Outlook
Meanwhile after five years of expansion and seventeen consecutive increases in the Fed funds rate, economic growth is, unsurprisingly, slowing. Shown below is a chart of the (annualized) quarterly growth of GDP during this decade/century/millennium.
Having snapped back from the 4Q’05 hurricane-induced slump, we aren’t too, too worried about a slowdown from 1Q’06’s torrid pace. The Blue Chip consensus forecast is for GDP growth to slow to only slightly below its 30-year average of 3.2% and its 3.4% average since the current recovery began in 2002.
Actually, the economic outlook remains decent and far from the doomsday scenario portrayed by the press and implied by the recent slump in the stock market. Montgomery Brothers views much of the statistical data skeptically to begin with. It’s collected by the government (which “saves” money by shortchanging its data collection efforts); it’s seasonally adjusted (which is a bit like race-norming SAT scores); and it’s subject to huge revisions (every month). We use moving averages to smooth out the swings and to identify trends. We also use data which is less widely followed and, at least we’d like to think, is less distorted.
For instance, nobody likes to pay taxes and few, if any, pay more than they have to. Therefore, MBI scrutinizes the monthly U.S. Treasury budget data for trends in tax collections and government spending. In spite of all the carping about the budget deficit, it’s poorly reported on, especially when it’s declining. Shown below is some of the data.
As you can see from the Federal Budget chart above, the budget deficit has been declining. However, as you can see from the Federal Receipts and Outlays chart, it is declining because taxes are rising at almost twice the rate of increases in spending. We view this as a cyclical plus but a secular negative. Shorter-term momentum in tax revenues is indicative of economic strength, but longer term, we see no reason to believe that federal spending will slow. Importantly, if the political climate changes after the election, any tax increases would probably lead to less revenue and economic growth, and a widening budget deficit. This is somewhat beyond the current attention span, not to mention investment time horizon, of most Wall Streeters. Mercifully, other indicators of near-term economic growth such as unemployment claims, factory orders, purchasing managers’ surveys, retail sales, and consumer confidence continue to show positive trends. These will offset some of the less positive trends such as the high flying housing market (which is rapidly losing altitude), weak stock market, and still poor trade balance. Net, net, it should hardly be surprising that the economy is slowing, but unlike our politicians, it’s still got gas in its tank.
Interest Rate Outlook
To: The Federal Open market Committee (FOMC)
From: John Montgomery
Re: Monetary Policy and Economic Forecasting
SHUT UP!
For a long time, it has been Montgomery Brothers’ belief that only Trappist Monks should be appointed as governors of the Fed. It has always been a mystery to us why the Fed itself or anybody else for that matter believes that the U.S. economy can be fine-tuned by jerking around a single short-term interest rate. We do feel, however, that the Fed has the obligation, not to mention the legal requirement, to fight inflation. Shown below are two indicators of nominal inflation.
Regardless of whether you feel that these are good or bad indicators of inflation, or if they over- or understate inflation, the trends are pretty obvious. Up! Prices are rising because of all the money that the Fed created when it was fighting the mild recession of 2000/2001 and the phantom threat of “deflation.” We believe that another 25–50 basis points now beats 100–200 basis points later. But that’s just us!
At least part of what’s been going on in the markets since Ben Bernanke assumed the chairmanship of the Fed seems to be a test of his inflation fighting resolve. A similar test was given to Alan Greenspan when he took over from Paul Volcker in mid-1987. Shortly after being sworn in, Bernanke started making noise that the Fed might “pause” its interest rate increasing program. While the stock market liked it, commodity prices (especially gold) soared, the dollar tanked, and longer-term interest rates rose. Following some ill-advised (and poorly timed) comments to Maria Bartiromo, Bernanke reversed his verbal course. Then the stock market tanked, commodity prices (especially gold) declined, the dollar stabilized, and longer-term interest rates dropped a bit. It appears that Bernanke has gotten the message that he and the Fed should get back on the inflation-fighting reservation. Hopefully, he won’t need an October 1987 stock market message to drive the point home.
So here we are, 17 consecutive interest rate hikes and 425 basis points later, wondering if the Fed might overdo it yet again. There was a time when Fed watchers poured over the weekly monetary aggregates and watched the Open Market desk for clues to what the Fed was up to. Now they scrutinize the minutes of the FOMC meetings and dissect every word of every Fed governor’s speech. We, frankly, liked the old system better. It increasingly seems that FOMC stands for “foot in open mouth committee.” Transparency might be valuable but silence might be golden.
MBI remains cautious on bonds.
Stock Market Outlook
Before retiring, Alan Greenspan spoke often about how the finance markets were mis-pricing risk. While virtually everything has done poorly during the past six weeks or so, that which had done better earlier in the bull market has done worse during this “correction.” Junk bond yields have risen and quality spreads have widened. Commodities declined in price, especially gold. The dollar actually went up. Foreign stock markets, led by emerging (or is that submerging?) markets, declined more than U.S. equities. And smaller capitalization, lower quality stocks underperformed their larger cap, blue chip brethren.
As you know, Montgomery Brothers does not believe the press is very helpful to investors, but we are especially impressed by the Wall Street Journal’s recent ability to showcase its contribution to investor fog. Shown below are two headlines, both front page articles. The first headline was produced on May 11th with the Dow Jones up 9% for the year and within striking distance of its all-time high. The second was produced after the Dow had declined 8% in just a bit over a month.
At least the same guy didn’t write both articles!
It is fairly common for investor sentiment on Wall Street to swing wildly since fear and greed are the primal stock market forces. Nevertheless, the rapid ascent of bearishness and abandonment of bullishness (or was it complacency?) was startlingly fast this time around.
At 15.8 x trailing 12 months earnings and 14.6 x forecasted earnings, the S&P 500’s P/E (Price ÷ Earnings) valuation is about 25% below its averages of the past 5, 10, and 20 years. Unfortunately, corporate profit growth is slowing and interest rates are rising. Both should provide significant headwinds for stock prices to advance against. Additionally, volatility has rebounded, as you can see from the chart below, even though it is coming off a long period of very low readings. Nevertheless….
People seldom think that they’re taking undue risk when the stock market is going up but almost always feel that they’re taking too much risk when it goes down. Volatility drives home this belief.
Fortunately, merger and acquisition activity is high. Corporate acquirers as well as cash laden private equity funds are buyers, especially into market weakness. Additionally, many companies continue to buy back their own shares in an effort to produce the kind of earnings progress and stock price advances demanded by Wall Street in general, and hedge funds in particular.
These hedge fund “players” are increasingly impacting the markets and not necessarily for the better. Even though “hedge fund” is a nebulous term, and hedge fund strategies vary widely, more often than not their investment horizon is short term. In general, they’ve changed, or a least altered, many aspects of investing, especially time horizons and momentum. When combined with other factors such as narrowed “spreads” and lower commissions, hedge fund tactics have helped increase volatility for individual issues even while possibly reducing it for the market as a whole, at least until recently. Other market developments such as Exchange Traded Funds (ETFs) have similarly “moved the cheese” and further muddied the market waters which have always been murky at best. Many of the tried and true tricks of the trade simply no longer work.
The Energy sector has taken a drubbing during this correction, but the stocks look cheap to us and their outlooks seem pretty decent. Health Care and Technology also look cheap, but the stocks are, in general, acting awful. Nevertheless, individual stocks in both Health Care and Tech look interesting. Consumer Non-Durables and Utilities look expensive, and their charts look increasingly “toppy.” The Materials and Infrastructure sectors are a real mixed bag. Our portfolios are over- and under-weighted accordingly.
The returns from stocks and bonds were pretty meager during the first half of this year, and cash outperformed both stocks and bonds. Nevertheless, MBI continues to believe that stocks will out-return cash equivalents, which will out-return bonds for 2006 as a whole, but we continue to forecast only upper-single-digit total returns from stocks. And even with that meager expectation, the stock market will have to “step on the gas” during the second half of 2006 merely to reach our forecasted returns. MBI’s bottom line is that while the economy has downshifted and the stock market may have stalled, it’s only the political system that has totally run out of gas.