Research & Advice

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2011 Mid-Year Update

 

Saturday, July 2, 2011

(Data as of June 26, 2011)

 

 

Economic Re-cap of H1

  • Real GDP has grown at around a 2% rate in the first half of 2011, far below the pace projected at the start of the year. Real GDP will be just below 3%, at best, for the full year.

  • The slowdown stems mainly from surging energy and food prices and the fallout from Japan’s disaster.

  • Recent shocks have been amplified by the post-recession fragility of business and consumer confidence.

  • Assuming oil keeps receding and that Washington resolves the debt-ceiling issue (both of which we believe will happen), growth should accelerate later this year.

 

The U.S. economy’s recent performance has been both surprising and disappointing. Real GDP growth during the first half of 2011 is set to come in close to 2%, less than projected at the start of the year. The shortfall is largely because of an unexpected surge in oil and food prices and the fallout, which was more serious than anticipated, from the catastrophe that struck Japan in mid-March.

The impact of these negative shocks was magnified by the fragility of the U.S. psyche. Consumers, businesses and investors remain extremely skittish; spending, hiring and investing freezes up whenever anything goes even slightly wrong. The severity of the Great Recession appears to weigh heavily on the general mood. Policy uncertainty in Washington regarding the federal debt limit and how to address the nation’s daunting fiscal challenges hurts as well.

Further blows to sentiment could ignite a negative feedback loop, undermining growth and raising the odds of a new recession. More likely, however, confidence will stabilize long enough for the impediments to growth to fade and for the economy to reaccelerate. Indeed, oil prices have already receded somewhat, and the Japanese economy is rebounding. Assuming energy prices don’t jump again (we do not believe they will) and that federal policymakers come to terms soon on deficit reduction and the debt ceiling (we believe they will), growth is expected to be back on track by late this year.

We do understand that there are economic headwinds. Gasoline prices had jumped from around $2.75 per gallon for regular unleaded to near $4 in early May. Every one-cent increase in the cost of a gallon of gallon of gasoline costs U.S. consumers about $1.25 billion over a year. Even though gasoline has since retreated to around $3.75 per gallon, consumers will likely spend an additional $100 billion or more to fill their tanks this year than they spent in 2010. Add in higher grocery costs, and consumers have effectively used up their payroll-tax break to fuel their autos and put food on their tables. Without the payroll tax cut, growth would have essentially ceased this spring.

Fallout from the Japanese earthquake and tsunami has also been more serious than first thought when the disaster struck in March. U.S. vehicle production in particular was significantly disrupted by a cutoff of essential parts and materials from closed Japanese factories. Considering all ancillary effects, the incident likely subtracted almost a percentage point from real U.S. GDP growth in the second quarter. This is significant given the importance of vehicle production and manufacturing more broadly in the current recovery.

Bad for the First Half, Better for the Future

  • Some negatives for economic growth in the first half allow for the prospects of better future growth.

  • Corporations are flush with cash.

  • The disruption to Japan’s economy is coming back online.

  • Oil prices have come down dramatically.

 

Skittishness is evident in businesses’ desire to hoard cash. With profit margins about as wide as they have ever been, many firms, particularly large and midsized ones, are effectively minting money. Compared to a year ago, companies are investing more, raising dividend payouts and stock repurchases, and boosting mergers and acquisitions, but still the cash piles up. The quick ratio for nonfinancial corporate businesses – liquid assets as a share of short-term liabilities – is at a post-World War II high. Yet firms can’t seem to shake the fear that they will be caught short if they take a chance and deploy their cash reserves more aggressively.

The economic expansion is officially two years old this month, and despite growing concerns about a new recession, economic growth is expected to remain intact for the foreseeable future.

A supply-chain effect from the March earthquake in Japan caused the Asia-Pacific region to lose some steam in the second quarter and disrupted production across the globe. Yet the loss of momentum is expected to be temporary; supply chains are being restored and production has started to bounce back in Japan, suggesting that global manufacturing should regain momentum in the second half.

The recent pullback in oil prices bodes well for a global growth revival in the second half. The International Energy Agency’s (IEA) move to release 60 million barrels of crude oil from global inventories has helped push crude prices down and reduced the risk of another oil spike. If sustained, lower oil prices will work like a tax cut in many countries, boosting discretionary spending and confidence.

Real GDP growth should reaccelerate soon from its current 2% annualized rate to near 4% by year-end. Job growth will also revive: looking beyond seasonal and short-term volatility, U.S. payrolls are adding between 100,000 and 150,000 jobs per month. Net job growth should consistently top 200,000 per month by 2012.

Investment Strategy

  • The U.S. stock market is oversold and we expect a rally into the Summer months, with a possible short-term peak in August.

  • The cyclical bull market is extended and mature. A change toward more defensive sectors and asset classes will be warranted over the months to come.

  • The recent correction (the second meaningful correction of 2011, and the sixth of the last thirteen months) has not yet displayed signs that a major top has been formed.

  • BREAKING NEWS (July 2, 2011). Friday’s rally represented a 90% Up Day. This strong demand suggests a new up leg in the bull market has begun. Our earlier expectation of a stock market rally into August has gained likelihood.

 

As 2011 enters its second half, the U.S. stock market faces challenges (six months ago in our 2011 Economic Outlook we forecasted that it would). The cyclical bull market appears extended in comparison to past cyclical bulls. As of the high at the end of April, the cyclical bull had lasted 781 days since its start on March 9, 2009, versus a historical median of 614 days. Of the thirty five bulls since 1900, this one has been the fourteenth longest. And the Dow Jones Industrial Average’ gain of 96% is well beyond the historical mean of 69%, ranking 10th. You can see that it was not a brave call for Berkshire Money Management to make – the stock market does not move in a linear fashion. There are always corrections (there have been two in the range of seven percent in 2011 alone; and about six in the last thirteen months. It is ordinary. Not comfortable, but ordinary.

In addition to cycle maturing, Berkshire Money Management created a composite which combines the historical path of the markets based on their one-year cycle, four-year Presidential cycle, and ten-year decennial cycle. Using that composite (and other tools), in our Economic Outlook for 2011 we suggested that the mid-year challenge could start in August. (Currently the equity markets are oversold and looking for a rally, so if we get that rally into August, we may have to consider how to approach the possible weakness in the August – October period). But that doesn’t mean that a new downtrend has already started calling for cutbacks in US equity positions, even if it has called for a subtle shift in asset classes (ex. preference of a higher portfolio weighting of Dividend Payers, and a lesser portfolio weighting of Small Caps). (As you may recall, for our more conservative portfolios we had started the year with a barbell strategy, having already included Dividend Payers).

A rally from here through August is justified based on markets that have reacted badly to worries about the ramifications of a Greek bond default, the end of QE2 (the second round of the Federals Reserve’s quantitative easing program), the budget ceiling deadline, and a bad month of payroll numbers. Yet, U.S. economic contraction levels for leading indicators have not been reached; a recession is a conversation for another year. As long as any economic slowdown can be more accurately described as a “soft patch” than a contraction (and we believe it will), then the stock market’s primary trend remains intact. In the same way that an economic downturn will be viewed as a temporary slowdown rather than a lasting contraction, the current market drop is viewed as a normal correction. Tape conditions are not telling us that a bigger drop has started:

 

  • While tape damage is evident when compared to ten-week moving averages, longer-term measures have not gotten any worse than neutral. Unless longer-term measures deteriorate and turn bearish, the shorter-term breadth weakness is only a sign of an oversold condition within the longer-term uptrend.

  • Among 45 markets globally, 91% still have a rising 200-day moving averages (including the U.S.). And one of those markets is China, which has had a leading tendency over the last few years.

  • Market tops don’t just appear. They appear because selling enters the market. Looking at data going back to 1933, there has never been a case where selling pressure has been at a new low and it marked a major market top. And Selling Pressure was at a new low on April 29th. There was a bump up in May and into June, but the rise of Selling Pressure at major market tops will typically have a sustained move up (and usually more than one move, but at least one). An example of that would be the 2002-2007 bull market, where Selling Pressure doubled from mid-2006 through late-2007 (when Berkshire Money Management started selling equity positions even as the markets were making new highs). So there is simply no selling right now that would suggest that this is anything more than a correction.

 

Significant market tops appear when selling comes into the market, and that’s just not evident currently. Since late April, there have been a number of instances of panic selling (June 1st, June 6th, and 15th were 90% Down Days). But what is notable is that these bursts of selling have been the exception to the correction, as the move downward in prices have been largely a function of contracting Demand (i.e. Buying), and not expanding Supply (i.e. Selling).

90% Days

For those who might not know, a 90% Day consists of four components; Points Gained, Points Lost, Up Volume, and Down Volume. A 90% Downside Day reflects intense selling. The event occurs when Down Volume expands to 90% or more of the Up plus Down Volume, coupled with Points Lost equaling 90% or more of Points Gained plus Points Lost. A series of 90% Down Days is usually evidence of panicked investors liquidating their positions with few buyers available to absorb their supply. Typically this constitutes emotional selling, often times seen near the end of a market decline.

On the other side of the equation, a 90% Upside Day reflects intense buying and strong Demand. And, after a series of 90% Downside Days in a protracted decline, a 90% Upside Day often appears as evidence that sellers have been exhausted and buyers have emerged in sufficient strength to rejuvenate Demand.

BREAKING NEWS (July 2, 2011). Friday’s rally represented a 90% Up Day. This strong demand suggests a new up leg in the bull market has begun. Our earlier expectation of a stock market rally into August has gained likelihood.

 

Defining the Current Correction and What’s Next?

  • Investor pessimism has priced in an economic slowdown that is not likely.

  • We expect the market to rally, but we are concerned about the duration and the health of that rally.

 

In selling off, the market appears to have priced in an economic slowdown that would be more severe than is probable. The excessive pessimism has left the market poised to rally when future economic reports in most regions fail to support the contraction case. Our concerns about the year’s second-half challenges are not off the table. If the correction gives way to rallying on the realization that economic conditions will be better than expected in the second half, the return of excessive optimism and overvaluation could set the stage for renewed earnings disappointment and/or worries about the economic outlook for 2012.

But until our indicators warn otherwise, we will give the benefit of the doubt to the cyclical uptrend. Our current approach is to maintain an overweight allocation to equities, expecting a rally to start soon. If it doesn’t, and the weight of the evidence turns broadly negative, we will downgrade our outlook and reduce exposure.

There are three market possibilities from here, each representing a certain range of probabilities:

 

  • 40-60%: Oversold conditions lead to a continued cyclical bull. In this instance, the downtrend would likely give way to a broad advance with strong breadth, contain optimism, and diminished worries over a hard economic landing. We would likely prefer small-caps and low-quality stocks, be neutral regarding dividend policy, and look to move back to high volatility stocks.

  • 65-85%: Market rebounds, but a weak advance suggests a cyclical bull market peak. A failed rally (but a rally nonetheless) would likely be defined by poor breadth, and a quick return to excessive optimism. In such a scenario we would reduce our exposure to small caps and low-quality stocks, and move decisively into Dividend Paying stocks (This best explains our current portfolio positions and expectations. If the cyclical bull continues then we still make money; if the market behaves more bearishly then we have already moved toward protection.).

  • 15-25%: Downtrend accelerates, suggesting cyclical bear is underway. If the market moves lower with accelerating downside volume and worsening breadth, then we would shift our portfolio positions to something more defensive.

 

The market, seemingly as always, is at a crossroads. Regardless of which scenario unfolds, we will rely on our objective indicators to identify equity leadership trends.

 

Implications of Recent Defensive Leadership

  • Any very near-term gains in the market could be offset by countering weakness.

  • A greater emphasis of Dividend Payers is warranted.

 

While we have remained overweight U.S. stocks, consistent with our 2011 Economic Outlook Report, we have taken some of the risk off the table within equities to reflect a more defensive leadership as of late (more specifically, we have done this with portfolios that have a skewed mandate toward growth; more conservative portfolios already maintained this barbell approach).

There have been ten rallies of at least five percent since the March 9, 2009 cyclical bear trough. The latest rally, from March 16 to April 26, was the first during which low volatility stocks (stocks of the so-called “defensive” sectors) outperformed high volatility stocks.

Defensive sectors of the S&P 500 are SHUT (Staples, Health Care, Utilities, Telecom). It is very unusual for rallies of 5% or more in the market to be led by SHUT. Since 1974, there have only been seven (7) prior cases (out of 77) where 3 or the 4 SHUT led the rallies by outpacing the S&P 500. Most recently this happened from mid-March through April. Following these cases the market returns were, on average, zero for the next three months and only slightly positive for the next six months. Market leadership during those months was mixed, exhibiting both cyclical and non-cyclical industry leadership.

The defensive rally leadership can be taken as a warning that we are entering a flat to weak market environment, with mixed leadership, but not of the end of the bull market. This makes sense as market tops typically take months to formulate, and correlations amongst stocks have declined, lending to mixed leadership in industries. Thus, a greater emphasis on Dividend Payers would be warranted.

 

Significance to Under-performance of Financial Stocks

  • The timing suggests that maybe August would be a mid-year peak.

It is likely that the relative weakness of financial stocks is telling us something. The sector’s relative performance tends to peak out about 8 months before a bull market peak. The sector’s relative under-performance started in December and, in recent months, has accelerated. The timing suggests that maybe August would be a mid-year peak.

Also, the Financials tend to begin to lag about one year prior to a Fed tightening. So if there is to be an August peak, and if the Fed is going to tighten in 2012, then Financials are doing what we would have expected them to be doing by under-performing.

The U.S. is not Greece.

Unlike Greece, the average maturity of Treasury debt has lengthened to over five years, the most since 2002. Another way of gauging U.S. liquidity is to look at the percentage of debt maturing in the next one, two, and three years. Each has fallen to its lowest level in over twenty years. By locking in low interest rates and lengthening its portfolio maturity, the U.S. has bought time to get its fiscal affairs in order.

BOTTOM LINE: Berkshire Money Management continues to display a meaningful amount of caution as we go through the summer months. The Rewards of the markets are not ignored, but at the same time we are intently focused on the Risks. In the shorter-term, risk management is not terribly exciting. But it does allow us to preserve portfolio capital for when the big opportunities present themselves.

We continue to lean bullish, but “safely” so. An opportunity is expected in the coming months where growth-oriented investors can take advantage of a shift that is away from “yield”, “safety”, and “low-beta” and toward an allocation that is more consistent with a rejuvenated cyclical bull market.