Is Confidence In The Consumer Waning

The Commerce Department released their second estimate of third quarter Gross Domestic Product (GDP) last week.  The number was revised down to 2 percent from the first estimate of 2.5 percent.   The result was weaker than the 2.3 percent economists had expected as average on average.

Digging further into the report, the Commerce Department tagged weaker inventory building by businesses as the main culprit.  According to the report, additional data from the private sector showed weaker restocking of inventory than seen in the first estimate.

As for the numbers, inventories fell by $8.5 billion in the third quarter, after rising $39.1 billion in the second quarter.

Basically this tells us that confidence in the American consumer by U.S. businesses is not high.  If businesses were expecting strong demand in the current quarter and those ahead, they would be more willing to stockpile inventory so that they have product on hand.  

Rather, by staying lean, business costs remain lower which can help the bottom line.  There are two ways to increase profits; generate more revenue or cut costs.  Lower stockpiles of goods fits in the latter.  Businesses are basically more confident that keeping costs low is a better bet than on consumers buying more.

What’s a bit troubling, consumer spending, which makes up two-third of GDP, came in at 2.3 percent for the quarter, down slightly from the first estimate of 2.4 percent.  So it’s not like spending is dead, it just looks like businesses are betting it is going to slowdown.

There is one caveat here, the tsunami in Japan.  Many tech companies struggled to get parts as a large chunk of semiconductor components are manufactured there.  So in that instance, lower inventory was not really a choice.  How much of an impact it had on the overall softening of inventory levels remains to be seen, we likely won’t know the full affect until the first quarter.

Additionally, the Commerce Department reported that Americans after tax incomes fell by the largest amount in two years, due to high unemployment and lower pay raises.  That being said, I guess we cannot be surprised businesses are slow to restock inventory.

Let’s revisit a point that has become a staple in this letter, year-over-year GDP.   As for the latest reading, third quarter year-over-year GDP growth now stands at 1.5 percent, following the 1.6 percent registered in the second quarter.   Remember, whenever this figures falls below 2 percent a recession follows.  We are now going on a second consecutive quarter of sub 2 percent year-over-year growth.

Please see the below chart for reference:

I don’t want to sound like a broken record, but if I see a data trend, I am going to play it till it breaks.  Yes, I expect the U.S. economy will fall into another recession in the near future; a double-dip is very likely.

When this occurs is up for debate, especially considering fourth quarter GDP estimates call for a rise from third quarter GDP.    However, we need to keep an eye on the year-over-year figure an that 2 percent threshold.

My portfolio is still in defensive mode; high yielding utility type stocks and gold related securities.

NOTE:  I will be traveling to Australia for a few weeks so there will likely be a delay between letters.  I apologize for the delay on this one.

Your waiting to see the final GDP reading analyst,

Mitch Jaworski

The Schizophrenic Economy

The current state of the U.S. economy can be defined by one word; paradox.   The definition of a paradox is a seemingly true statement that leads to a contradiction or a situation which seems to defy logic or intuition.

This seems to be the appropriate label for the economy after we analyze the economic data released last week, coupled with the consumer sentiment data.

The Commerce Department released retail sales figures last Friday for the month of September.  The 1.1 percent increase was much better than the 0.6 percent expected.  Excluding autos, sales were up 0.6 percent compared to an expected increase of 0.3 percent.  Both figures were ahead of growth rates from a month ago.

In addition to this data, last week the Labor Department reported a 0.2 percent increase in workers’ hourly earnings in September, compared to a 0.2 percent decrease the month prior.  Nonfarm payrolls showed a 103,000 increase (though the number did receive a boost from the 45,000 striking Verizon workers going back to work) so there were some positives there as well.

What totally throws me is if people or spending more money and making a little more money in addition to jobs being added; then why is consumer sentiment getting worse, especially in regard to employment outlook?

The Thomson/University of Michigan preliminary index of consumer sentiment for October showed a drop to 57.5 from 59.4 in September.  The result was a disappointment as economists expected an increase to 60.2 (which seems justifiable considering the data mentioned earlier).

According to the survey, the gauge for current economic conditions fell to 73.8 from 74.9.  Additionally, consumer expectations fell to its lowest level since May 1980, at 47 from 49.4.  What’s more is the expectations gauge has faded more than 20 points since the beginning of 2011. 

So my question becomes this; if consumer sentiment is falling in regard to the current state of the economy and their outlook is worsening as well, who exactly is spending more money?

In addition to that contradiction is the fact that 39 percent of consumers said that income declines were the reason for their finances worsened.  Recall, this report come out after a month showing an increase in average worker earnings. 

If you are confused about the outlook for the U.S. economy, don’t sweat it, because I am too!

The below chart muddles it up even more:

Do you see the trend starting around 2008, retail sales soaring and consumer confidence languishing?  Apparently the economic paradox has been going on for some time now.

I don’t want to discount the strengthening retail sales numbers of late, but a quick top level analysis may give us some clarity on why sentiment is not matching results.   A majority chunk of the sales growth came from autos and gas.  When looking further into those sales, data (produced by Goldman Sachs) shows roughly 70 percent of growth in vehicle sales have come from businesses, not consumers since the auto sector bottomed a couple years back.

Along with that bit of information, I plan to keep an eye on the September consumer credit number to see if it increased after Americans cut down on debt in August.  If spending received a bump from U.S. households taking on more debt, that would not be a positive.  Hopefully this will not be the case, the change in revolving credit (credit cards) in particular is what to watch.

Your anxiously waiting end of the month data analyst,

Mitch Jaworski

Twisting Your Retirement Away

This letter we are going to touch on a bit more than usual as there are three topics that need to be visited:  Operation Twist and its negative impact on Pension Funds; Sector Returns for Q3; and Final Q2 GDP.

Twisting Your Retirement Away

The Federal Reserve did what most expected and announced Operation Twist on September 22.  However, what many do not realize is the Fed also released a stealth anchor on the nation’s largest pension funds.

Underfunding is already a big issue for pensions around the country as they seek a low risk investment that supplies an ample return to service future outlays. 

 

The 100 largest pension funds of U.S. companies had assets covering 79 percent of their liabilities at the end of August, down from 86 percent at the end of 2010. The all time low for the funds was 70 percent in August 2010.

A large chunk of pensions invest in U.S. Treasuries as not all capital can be risked in equities given the guaranteed payouts that must be made by pension funds.  Remember, most of these pensions are defined benefit plans that work on a future payout target.  Generally, it is believed that each 1 percent drop in yields increases a pension’s liabilities by 10 to 15 percent.

Plain and simple, the Fed is now pushing down yields on longer-term bonds as it goes further out on the curve with its purchases.  Fund managers get a whopping 1.92 percent on 10 year treasuries right now.  So, the question becomes:  Do funds raise their risk appetite to try and make up some ground or do they watch as the underfunding gap expands further.

Please don’t think this is just an issue for corporate pensions either.  See the below chart referencing state government underfunding on pension and healthcare liabilities.

Relative Returns in Q3; A Quick Sector Analysis

In a prior letter we discussed if U.S. equities were now a “value” based on P/E ratio as many talking heads would have you believe.  In that letter we talked about the strongest sectors in market downturns and economic recessions (Utilities & Consumer Staples) and especially how those stocks were offering solid dividend yields (better than U.S. treasuries!) as their stock prices became depressed.

The below chart of Q3 results tells us what we need to know; it was an ugly quarter but the utility and staple names held up best, while again, paying a decent dividend (more than 3 percent).

Q2 GDP and The Y-O-Y Recession Indicator

Below is a chart that has become a staple in a our recent letters.

Remember, as the chart shows, every time the year-over-year GDP growth rate has fallen under 2 percent a recession has followed (shaded area).

After the final Q2 GDP estimate, year-over year GDP growth sits at 1.6 percent.  As I’ve stated before, the writing is on the wall.

Your preparing his portfolio for the slowdown analyst,

Mitch Jaworski

Is European Crisis About To Set Off 2008 Type Market Sell-Off?

 Although the economic picture in the U.S. is less than rosy it is currently in much better shape than that of the European Union (EU).  I say this simply because the U.S. is not at threat of a credit crisis; granted, because we had ours in 2008.

What we really need to ask ourselves is how is my portfolio prepared for a European credit crisis?  Just like the U.S. credit crisis dragged down foreign markets, believe a European crisis will do the same to the U.S. markets, especially the financial sector. 

With recent debate over the need to aggressively ramp up the bailout fund of the European Financial Stability Facility in order to be prepared for bailout needs of EU members, the question is no longer when countries will need more bailout help but when?

Though Italy and Portugal’s financial troubles have come to the forefront recently, Greece still remains the main concern as the catalyst for a credit crisis.  Last Tuesday, the yield on one-year Greek government bills hit 60 percent, yes, you read that correctly 60 percent! 

Call me crazy but doesn’t it almost seem like Greece is borrowing from a loan shark, you know, at such a ridiculous rate that is basically impossible to service or ever pay down principal on.  The Greek debt to GDP ratio is already 140 percent and climbing, the writing may already be on the wall.

I plan to keep my eye on the coupon payments due Tuesday, September 20 for the Greek 4.5 percent 2037s and 4.6 percent 2040s.  The payment for both totals 769 million Euros.   An interesting coincidence is that the September 2011 credit default swaps (CDS) expire on the 21^st, therefore banks that have purchased insurance against a missed payment would be covered still and be paid out on that.

The real chances that Greece misses a payment is for anyone to guess, but something unpleasant will have to occur in order to progress towards a debt resolution.  Maybe the IMF will continue to provide bailout funds so that Greece can make payments, but is that a good thing for the markets?

With that said, how do we prepare our investment portfolios for a potential downward shock?  Well, remember that CASH is a position and it’s a position you may want to currently be in.  There are dozens of quality dividend paying stocks out there and there dividend yields are only going to go higher with any subsequent declines in the market.

Think about this; you can buy quality utility stocks that are paying a better yield than U.S. Treasuries.  If you buy them after large market sell-offs then possible price appreciation is now also in the mix

SIDENOTE:  As I finish up this letter news has just hit that the S&P ratings agency has downgraded Italy to A from A+.  Guess we should be watching more than Greece carefully after all.  It will be interesting to see how/if this impacts markets tomorrow morning.

GDP In Recession Zone

This week’s letter we will circle back to the latest year-over-year GDP numbers and the increasing evidence that a recession is near, if not already upon us.  However, we will also discuss gold; its merits for investment and whether we should look at it as an investment or rather as insurance.

As I have stated a few times previously (see prior letters for supporting chart) every time year-over-year GDP growth falls below 2 percent the U.S. economy falls into a recession.  Thus far, second quarter GDP is showing 1.6 percent growth.  See chart:

We still have a second a third estimate to go before the second quarter GDP numbers are final, but considering first quarter numbers were revised lower, not higher, we are likely not getting out of the woods.

If you recall, last letter we spoke about price to earnings ratios on stocks and how for every 0.5 percent drop in GDP roughly a $2 drop occurs in S&P earnings.  Based on the recent trend in GDP and the fact that the U.S. deficit continues to grow we are still a sizable selloff from where you will see me writing that stocks are cheap.  High yielding stocks, like those of utility companies, is where I'd rather be overweight while the next year and a half plays out.

Speaking of the ever growing U.S. deficit (the debt deal just slowed down the expansion of the deficit over the next 10 years, not cut it) it is clear that the fiscal policy of our leaders is yet to change, so that keeps gold very much in play.

There are two ways to look at gold; is it an investment or insurance?  The answer really depends on what you are trying to accomplish.  If you are putting a percentage of your portfolio in gold as a store of value or "safe haven" as many put then you want to buy physical gold, like gold coins for example.
This option is for those that are looking to protect (insure) there money against a weakening US dollar, which is due to the anti-dollar fiscal and monetary policy of our current government (QE and deficit spending).

If you are speculating on gold as an investment because you believe there will be further price appreciation then you want to look at the gold ETFs, such as GLD, or investing in the gold mining stocks.  We have previously reviewed the gold miners and how they have lagged the appreciation in physical gold over the last three years. (See May 30th letter for more detailed thoughts on gold miners).

I will be keeping my eye out for the July consumer credit data due out September 8^th.  Consumer spending is the key driver of our economy and this data helps us gauge if U.S. households are saving or racking up more debt, and which type of debt they may be taking on to make purchases.

Your hoping people are balancing their budgets better than Washington analyst,

Mitch Jaworki

Buy The Bottom (Not Yet)

In recent months the majority of S&P 500 companies have reported better than expected second quarter earnings.  This has led to many talking heads on the financial networks to say stocks are now cheap on a P/E (price to earnings) perspective following the recent sell-off.  Earnings per share (EPS) estimates for 2012 are all over $100, putting the S&P 500 P/E ratio below the historical average of 15, hence the “stocks are cheap” argument.

However, what is troublesome with this outlook is it assumes the “E” in the P/E ratio will continue to grow over the next year.  As more and more economic indicators show a weakening U.S. economy, what will happen to the earnings power of companies?  Just like anything else related to the economy, corporate profits tend to run in cycles as the economy grows and contracts.

Several studies have shown a correlation between the GDP growth rate and EPS growth.  In fact, accordingly to Goldman Sachs’ EPS estimates, for every 50 basis point change in GDP growth there is a $2 EPS change in the S&P. 

Goldman’s 2012 earnings estimate for the S&P 500 is $102, however this is assuming GDP growth continues its current rate, which is roughly 1.3 percent as of Q2.  If GDP stays flat in 2012 on a year-over-year basis, that forecast would equate to $94 in earnings.  If you are estimating a contraction in GDP in 2012 (as many now are) of let’s say 2 percent, then earnings estimates drop to $84.

Do you see what is happening here?  The “E” in the ratio is getting smaller, which in turn pushes the P/E ratio higher making the mirage of cheap stocks quickly disappear.  For a great "cheap stock" buying opportunity what we need to see is a P/E ratio well under 15 based on real current earnings, not forecasts. 

If GDP is likely to weaken over the coming quarters, which is our point of view from previous letters. (Please recall from earlier letters the topic of less than 2 percent year-over-year GDP growth and the recessions that follow) The smarter bet is that S&P earnings begin contracting in 2012 as opposed to growing further compared to 2011.

The key is recognizing which sectors hold up best during the downturn to trough period of an earnings cycle.  Below is a chart that shows the peak to trough change in S&P earnings by sector.

As you can see consumer cyclicals hold up best, which has always made sense since people need to eat, babies need diapers and so on and so forth.  However, since these are necessities growth is also limited as not much excess is going to be purchased.  Hence, the smallest profit growth among the sectors during expansionary or “good” times.

Finally, with this said I would look to by heavier in the “defensive” names (consumer cyclicals) over the next year as earnings begin to come down sometime in 2012 since the pullback is not as volatile in that sector.  Then when the P/E on the S&P 500 gets down toward the 10 mark calculated on real earnings, look to get aggressive with other sectors such as financials and tech.

Sidebar:  I've mentioned gold as a safehaven investment several times, especially when the debt debates were occurring in Washington, however, the recent run is finally looking parabolic after a nice steady rise over recent years.  Gold could very well hit $2500 an ounce at some point, but I would be a lot more cautious going forward and only look to add on sharp pullbacks as the chart is starting to look like a dot com stock in 1999.  However, so long as the U.S. continues running up debt and the Fed has a anti-dollar fiscal policy I will remain bullish on gold.

Your getting ready to ride out the earnings downturn analyst,
Mitch Jaworski