Two weeks ago we wrote about the often tenuous connection between economics (the production and consumption of goods and services) and financial markets. The intersection lies in the changing patterns of company earnings. But economics can look backwards and financial markets tend to look forwards. Thus, deducing market action from economic data - especially employment data - is dicey.
This week, the much vaunted "recovery" off the March lows came to a skidding halt, at least temporarily. How will this skid affect you? Do we think the skid is anything to worry about, to pay attention to? Many of you are just lifting yourselves from the mat of worry and fear that pervades serious bear markets - the opposite of the boundless optimism people feel at market tops. As such, it's important for us to show you the course we are following. After all, the last course proved to be successful, even if there were ambushes along the way.
"The normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to undo it" - Jeremy Grantham in his 4th Quarter 2009 GMO letter to clients.
In retrospect, the 1930's had gold standard hands at the helm and, together with raising of interest rates, rising of taxes and protectionism in the Smoot-Hawley Tariff, those hands brought down what had been a booming U.S. economy, simply beset by stock market speculation. The recent crisis had none of the sort - just wads of tax money thrown at the economy, ultra low interest rates and a lot of prayers that the effort would be enough.
The markets were the first to respond - and they did so mightily, all over the world. The liquidity boom that low rates and plentiful money engendered set off a wave of speculation (yes folks, the very thing that got us to the brink) in risk assets. Now, the wave some eight months old and at lofty heights, market participants are beginning to wonder if the economy will be good enough to provide the corporate earnings to justify the upward move. Actually, it's something else.
Corporate earnings have been terrific for about three quarters now but not for the reasons you might think. Earnings are a function of taxes, revenue and expenses. Revenue has actually declined but expenses, not very high going into the crisis, have been slashed to the bone. Long story short - we've had about as much of the expense-cutting fun we're going to have. Markets are now looking to revenue growth to make a long story short - they ain't getting it.
Visualize an economic and earnings trend line - a line that generally moves slightly upward over long periods of time. The crisis has forced a downward dislocation of this line and I don't think markets have yet figured out where the dislocation will end.
Remember - markets can price risk but they cannot price uncertainty. It is the latter which caused the big drop this week.
But the situation is NOT serious. It's natural for markets to advance and to decline too much. It's for us to navigate these rough waters safely. So what are we doing?
About a month and a half ago we began selling consumer-related names and holdings which were quite economically sensitive. We bought preferred stocks (more like bonds than stocks) at very good prices and we bought a power producer/utility, a funeral and cemetery company and some more high quality junk bonds (highly rated junk - almost investment grade). We also bought a closed end fund that is actually up 2% from its summer 2007 launch - it moves little in price but pays a 10.6% yield. The fund is not meant to be a long-term holding, just to give us income until we meet the next "jaws of descent" in markets, perhaps next spring or a bit earlier. In short, we are prepared for what we see as the eventual testing of the idea that revenue will again grow. It will, but the test could be a bit tough as "hot money" exits.
The economy? Jobs still don't look like a growth industry as yet, but the rate of loss has flattened. We are probably officially out of the recession due to some increases in exports and government pump-priming. This said, next year is a Congressional year - look for some great fireworks on the political front as well as in the markets. We are largely insulated from severe, serious shocks - our income payers are not very economically sensitive. There is one giant silver lining.
Once you get used to the idea that markets are cyclical (they go up and down in cycles), you will benefit from the following. Every third year of the U.S. Presidential election cycle since the 1920's has been the best of the four year cycle, beginning with the last quarter of the prior year. We last saw the cycle turn in 2006 - with the stomach turning drop from April to July. Well, folks, that was a great buying opportunity - until the fourth quarter of 2007. The good news - 2010 is another 2006. Let's see if our cycle treats us yet again. The treat? Being defensive at the right time and buying more income producing securities at rock bottom prices - with the effect of increasing income into your accounts, the wells of prosperity. Wishing you lots of treats tonight and rich benefits from our work.
