One of the important unknowns that investors must grapple with currently is when the recovery will become self-sustaining allowing the government to reduce fiscal and monetary stimuli. Japan has tried several times since their asset bubble burst in the early 1990s to reduce the government’s support. Each time the economy stumbled badly resulting in 20 years of economic stagnation.

After the stock market crash of 1929 our economy responded to major stimulus and galloped ahead by 17% in 1934, 11.1% in 1935, and 14.3% in 1936. Over this period unemployment fell by 30%. Logically in response to this strong growth spending was cut back and monetary policy was tightened to improve the fiscal condition of the Federal government. The economy promptly stumbled into another downturn in 1937.

These experiences suggest that after an asset bubble it takes a long time and a lot of support before private sector growth becomes self-sustaining.

Below are quotes from Fox News Channel’s interview with US President Barack Obama.

ON THE ECONOMY:

“There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we’re taking a look at those.”

“I think it is important though to recognize that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy in a way that could actually lead to a double-dip recession.”

“[O]ne of the trickiest things we’re doing right now, is to on the one hand make sure the recovery is supported and not withdraw a lot of money either with tax increases or big spending ... at the same time, making sure that we’re setting up a pathway long term for deficit reduction. It’s about as hard of a play as there is.”

President Obama seems to be more in tune with the fragility of the economic recovery than the stock market. Unfortunately his policies take us down the path of more taxes, more spending, and more debt. If that is indeed the case, it is hard to see the robust earnings growth expected by the market which is why we are playing defense. Stick with reasonable-priced, high-quality, dividend-paying multinational corporations.

Real Estate remains the biggest risk to the budding worldwide recovery and strong stock markets. A recent report from the Mortgage Bankers Association was filled with red flags:

• The combined percentage of loans in foreclosure and at least one payment past due was 13.16 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey (1972).
• As a sign that mortgage performance is once again being driven by unemployment, prime fixed-rate loans now account for one in three foreclosure starts. A year ago they accounted for one in five.
• “As for the outlook, it is unlikely we will see meaningful reductions in the foreclosure and delinquency rates until the employment situation improves.” Unfortunately, most economists don’t expect unemployment to peak until mid-2010.

Link to report: http://www.mbaa.org/NewsandMedia/PressCenter/70050.htm

Likewise, commercial real estate is wobbly. According to The Moody’s/REAL national commercial property price index, the US commercial property market has declined by 35.5% from its peak. Sales volumes are very low suggesting that prices could fall further if there is an increase in distressed sales.

Realpoint, a credit-rating agency, says that nearly $29 billion of commercial mortgage-backed securities, around 3.5% of the total, have become delinquent in the past 12 months. Analysts project the delinquency rate will peak somewhere between 6% and 12%. Most of these loans are held by banks. Experts are predicting many small banks will go under as a result.



Investors need to keep a close eye on the real estate markets as further deterioration could harm the economy, consumer sentiment, and stock prices.

"Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn."

http://www.economics.harvard.edu/files/faculty/51_Aftermath.pdf

Bespoke: Goldman Sachs raises year-end price target - should we care?

“Goldman Sachs’ David Kostin raised his year-end S&P 500 price target from 940 to 1,060 this morning [Monday]. While this means Kostin has become more bullish since issuing his prior target, it’s important to remember that he started 2009 with a year-end price target of 1,100 (which would have been a 2009 gain of 18.6%). A couple of weeks before the March 9 index bottom, Kostin lowered that 1,100 target to 940 on February 26. At that time, the S&P 500 was already down more than 15% for the year at 752. Now that the S&P has moved back up to meet his 940 year-end level, he has upped the target to 1,060, which would be a gain of 12.55%.

“Below we highlight a chart and table showing Goldman’s year-end price targets going back to the start of 2008. At the start of 2008, Goldman’s Abby Cohen (who was replaced with Kostin in March of last year) predicted the S&P 500 would finish 2008 up 15.74% at 1,675. By the end of 2008, that price target was 85.44% above the actual year-end S&P 500 price level. When Kostin replaced Cohen in March of ‘08, he lowered Goldman’s 2008 price target from 1,675 to 1,380, which at the time would have meant a change of 4.33%. That target ended up being 52.78% above the index’s actual year-end level. On July 21, 2008, Kostin actually raised Goldman’s year-end 2008 target from 1,380 to 1,400, but then the market crashed in September and early October, and Kostin was forced to lower the target all the way to 1,000.

“From the time Kostin upped his ‘08 target from 1,380 to 1,400 to the time he lowered the target from 1,400 to 1,000, the S&P 500 fell 28%. In terms of market calls, 2008 was just as tough of a year for Goldman as it was for most.

“Today’s news that Goldman has raised its year-end 2009 price target is making headlines and potentially impacting the market on the upside. But based on both Cohen’s and Kostin’s recent calls amidst the current market environment, their prognosticating alone should not suffice to arouse the bulls.”

Source: Bespoke, July 20, 2009

As of this commentary 75% of companies reporting earnings have beaten expectations providing a lift to the stock market and encouragement to investors. However, does this statistic suggest blue skies ahead or just a good job of corporate America managing earnings expectations?

There has been a fairly consistent pattern this earnings season: top line (revenue) comes in below expectation and is generally poor, while the bottom line (earnings) beats estimates due to cost cutting. The quality of earnings has been poor and does not build the case for a sustainable, self-reinforcing economy. Our economy is still being propped up by our Federal government and the Federal Reserve. The minor pullback that ended on July 10th, at the bottom of the recent trading range, coincided with the highest level of bearishness from individual investors since the bottom of the market in early March. This contrary indicator has probably reversed itself not that we find ourselves at the top end of the trading range.

While improving sentiment and fund flows into the stock market could push prices higher, current fundamentals suggest the most prudent course for investors is further caution. Volatility is here to stay and we suspect there will be a better opportunity to get aggressive on stocks in the future. In the meantime, attractive yields on high-quality corporate bonds are a great choice.

Many bullish pundits argue there is a ton of cash to drive the stock market higher, while bearish pundits claim the U.S. consumer is up to their eyeballs in debt. Each camp has good evidence to back up their claims. The value of money-market funds exceeded stock funds earlier this month for the first time in 16 years. By comparison, the value of stock-fund holdings was more than three times greater than money-market funds in the summer of 2007, just before the market peaked that October. On the other hand total private and public debt in the US rose from about 155% of gross domestic product in the early 1980s to about 340% by the middle of 2008. Average household debt rose from about 75% of annual disposable income in 1990 to very nearly 130% today.

Interestingly, these two concepts are contradictory: in aggregate, either our economy is deleveraging due to excess debt or we are flush with cash. These statistics are a great example why investing can be so difficult. There is a lot of conflicting information in the market place. The best antidote to this problem is for investors to challenge their investment assumptions and be open to information that opposes their viewpoints. This is a critical but difficult task due our behavioral bias.

For what it is worth, our position is that there is a higher chance the cash on the sidelines is not destined to rush back into the stock market but will more likely be used, in aggregate, to pay off debts.

Everyone has an opinion about the government’s response to the economic crisis so we thought we might as well have our say as well. First of all, virtually no one is blameless. Democrats irresponsibly supported and defended Fannie Mae and Freddie Mac. Republicans irresponsibly allowed our financial institutions to leverage to the hilt and spent like drunken sailors during the Bush years. The Fed totally failed in its regulatory role of financial institutions and fueled the housing bubble with too much liquidity. Banks and mortgage companies made trillions of questionable loans. The ratings agencies failed to properly assess the risks in these securities. Institutions that bought these toxic assets failed to perform prudent due diligence. And finally, many Americans bought homes they couldn’t afford.

Let’s be frank: we are in a deep recession that could get worse especially if there are policy mistakes. In the fourth quarter of 2008, gross domestic product shrank at an annualized rate of 20.8% in South Korea, 12.7% in Japan, 8.2% in Germany, 5.9% in the UK and 6.2% in the US. Alarmingly, declines in industrial production in these countries were even worse. The first quarter of 2009 will not be any better.

The financial crisis morphed into an economic crisis with shocking speed last year. Governments around the world should be focused on two items: stimulating aggregate demand and freeing up finance. The Fed should be given credit for attacking the credit crisis aggressively. The various programs they have enacted have provided needed liquidity and helped heal wounded credit markets.

The recent stimulus package has come under much criticism especially from Republicans who are worried about adding to our deficit. While this concern is laudable, the fact is our deficits are going up regardless of the stimulus package. We are in a deep recession which means tax receipts are plummeting and automatic stabilizers, like unemployment insurance and Medicaid, are rising. The result is expanding deficits. Currently we are experiencing a negative feedback loop: the credit crisis causes banks to limit credit to businesses, businesses cut staff as demand declines, the unemployed stop spending and default on their credit cards and mortgages, banks shut off more credit to businesses, businesses lay more people off, etc….The stimulus package is an attempt to shock our economy and break this negative feedback loop.

Done correctly a stimulus package can work and ultimately keep our deficits from getting larger than they otherwise would. While there were some questionable items in the stimulus package the majority of the package is good policy. The largest part at 38% is tax cuts. This fact doesn’t seem to be getting any attention. Aid for states and the unemployed represents 25% of the total and will most certainly be spent quickly. Infrastructure and education spending is the next biggest and should pay benefits well into the future.

We are very pleased that the Democrats did not raise taxes which would be disastrous. At some point we will have to address our deficits, but we cannot tackle that issue until our economy is on firm footing. And when we do everyone will have to sacrifice through higher taxes, lower spending and fewer benefits.

The stock market experienced a truly horrible day yesterday falling almost 9%. This action was in response to the House of Representative’s shocking failure to pass the $700 billion plan to bolster the financial system. There is serious stress in the credit markets and in our banking system making government support critical at this time.

The natural reaction for many investors is to end the pain of losses and sell stocks. While we can give no guarantees on what will happen in the short term, selling into panic markets usually ends up being the wrong move.

Historically, when fear and panic are rampant like today, stocks should be bought, or at least held onto, not sold. A common gauge of investor fear, the VIX index, is near an all-time high. Even money market funds are too risky as investors pull their money to buy T-Bills that pay virtually nothing. The cardinal rule of investing is to buy low and sell high. Please remember that the average stock has fallen by 29%. Stocks are low and should be bought for investors who can withstand the volatility and don’t need their money in the next few years.

Stepping back from the current nuttiness of the market should bring comfort in this time of uncertainty. We are very confident that the group of stocks we own in your portfolio is worth more than the current market prices. Our stocks have strong balance sheets, good long-term growth prospects, and low valuations. Unfortunately this doesn’t mean that prices can’t go lower in the short term. However, eventually markets calm down and stock prices gravitate to more reasonable valuation levels.

We are pleased that we’ve avoided all the collapses in the financial arena. However, recently companies connected with the global growth theme have come under extreme selling pressure. While we do not deny that current economic conditions will keep growth from reaching its near-term potential, growth will continue at attractive rates making current valuations unreasonably low.