Call us old fashioned, but we think fundamentals still count. Yes, this is like part IV of our rant about stock markets versus a market of stocks. Fundamentals are the revenues, earnings, dividends of companies that allow us to separate the wheat from the chaff in stocks. We recently read an article that quoted a dire prediction that the US stock market will have to go below 1000 (Dow points) before it completes some super-duper cycle target based on what the market did back in 1871 (or was it 1873?). What happened back in the deflationary latter 19th century probably won’t have much immediate impact on what happens in the early 21st century. We could be wrong there, but we don’t think so. These comparisons to history are just that, comparisons. Whether right or wrong, the dire predictions sell newspapers and newsletter subscriptions, but they don’t make anyone any money in the long run. Rather than focus on this or that occasion from a century or two ago, what we ought to focus on are some persistent trends in equity results. Over the last two hundred-plus years, stocks have persistently, though not consistently, grown their earnings and dividends decade by decade. The fundamentals keep getting better most of the time. We have set-backs, recessions, bouts of inflation, wars, crises and such, but we always return to higher revenues, earnings and dividends sooner or later, usually sooner.
Okay, we are facing a somewhat different outlook than we’re used to these days. We do have this ‘new normal’ outlook wherein the optimum economic growth potential of the US is diminished from what it was over the last 50 or 75 years. The demographics aren’t as good as they used to be. The ‘baby boomers’ are going to retire in record numbers over the next couple of decades, taking their decades of experience in the workforce with them. They are also going to go from being FICA paying members of society to being Social Security receiving members of society. Luckily for us, today we have 10% unemployment so as the retirees leave; there will be plenty of folks anxious to take those positions. We didn’t have this luxury even a couple of years ago.
The great trend of American families increasing their standard of living as they have for generation after generation is in jeopardy. The last couple of decades have increased the debt the average family carries and kept virtually constant the real income the family earns. With the topping-out of women entering the workforce, so too was the gain in family earnings. Unless we fundamentally change that dynamic, our children aren’t going to have it as nice as we did.
Lastly, the vast expanse of the welfare state might almost be reaching its limits. Now that America has mimicked Europe’s public health system, we can expect that there isn’t enough private economy available to pay for the public expenditure. The example of Portugal, Italy, Ireland, Greece and Spain, the infamous PIIGS, may put the brakes on expansion of the welfare state for a while at least. The limits of what we can afford collectively may have been reached at the same time our individual debt ceiling was breached.
From our vantage point today, it looks like a Golden Age in America is now a thing of the past. However, as one who lived through most of that golden age, it never looked anywhere near that easy from the other side. In the past fifty years, this country faced one crisis after another, stared them down and went on. We will guess that twenty or thirty years hence, the situation will be much the same: the Golden Age will be now and the future will present more problems than we can enumerate. They’ll be wrong then too.
Getting back to fundamentals for a minute, we’re pretty sure that the fundamentals will be better next year than this and better yet the year after that. We may have periods when progress isn’t quite as certain, but those will be brief and the periods when the future looks brighter will be long and pleasant. That will justify our children and our children’s children buying little slices of great American businesses by owning shares in them.
Issue of the Week
Whether you noticed or not, we’ve changed the title for this little section to ‘Issue of the Week’ from ‘Crisis of the Week.’ That is largely because the crisis moniker isn’t really all that accurate and tends to vastly overstate the issues. So, in a bow to moderation in tone, we have renamed it. So, what is the issue this week?
The Gulf Oil Spill remains in the news. British Pete has agreed to getting politically mugged in Washington. As a goodwill gesture, the company will set aside $20 billion in escrow to satisfy Congress’ and the Administration’s desire to control the divvying up of the booty from BP’s accident.
There is an ongoing debate about just how much oil is flowing into the Gulf from the blown-out well. Scientists keep outbidding each other with estimates of the oil flow. The initial guess from BP was between 5,000 and 9,000 barrels a day. A later guess from the Minerals Management service was 12,000 to 19,000 a day. Now there are guesses of 35,000 to 60,000 barrels a day and even up to 120,000 barrels a day. This last one would make this the biggest gusher in the history of oil drilling, surpassing the Spindletop Gusher in Beaumont, Texas back in 1901. If these latter volumes are accurate, and we’ll never likely know for sure, this would make the Gulf Oil Spill one of the biggest energy disasters yet. So far, the biggest oil-related disaster was the torching of the Kuwaiti oil fields by Saddam Hussein as he retreated in the First Gulf War. That series of fires and flows took over two years to get under control and wasted untold millions of barrels of oil.
The thing with gushers is they are the product of some very interesting natural conditions. First, you have to have tremendous pressure in the oil reserve and then you have to prick that reserve in a spot where the oil is right at the top (many oil reserves have a large deposit of natural gas sitting atop them). So, hitting the reserve in about the right spot is crucial to getting a big gusher. Also, once the well has pricked the top of the reserve, the pressure ebbs fairly quickly. The Spindletop Gusher noted above ran for over two months before the pressure ebbed and the well could be capped. It could very well be that the Mocondo zone that is leaking into the Gulf was under tremendous pressure and that it will drain for a long time. But, physics argues that the pressure will abate and the flow rate diminish. Probability argues that BP wasn’t lucky enough to hit just the right spot on their first try.
Producer prices fell 0.3% in May on lower energy and food costs. The core version of the PPI, which excluded food and energy (conveniently), was up 0.2%. Producer prices are heavily influenced by materials costs and only about half of the index reflects labor inputs. The drop in crude oil from roundly $80 to $70 was the big driver behind this result. Gasoline prices fell -7.0%, broadly energy fell -1.5%. Over the last 12 months, PPI is up 5.3% and the core is up 1.3%.
Consumer prices fell 0.2% in May as energy prices dropped 2.9% in the month. Food prices were flat. The core version of the index, which excludes food and energy prices, rose 0.1% for the month. Anecdotally, as the PPI above is about 50% imbedded labor costs, about 80% of the CPI is imbedded labor. That makes the CPI a lot less volatile over time as labor costs tend to be a stabilizing element.
Housing starts were down 10% in May from April as the expiration of the home-buyer tax incentives expired. Given the overhang of unsold new units and existing housing we are unsure if this decline is bad news or good news. Despite the recent decline, starts in May were higher than in May 2009. But, we are at a pace that would produce only 593,000 new homes this year if we kept it up. That pace falls far short of the fundamental demand for new homes from population growth and other demographic trends, and also doesn’t account for the persistent shift of people from north and east to south and west.
Industrial production rose 1.2% in May as the nation’s factories, mines and utilities continued to operate at higher levels. Manufacturing output rose 0.9% and utility output 4.8%. Capacity utilization rose to 74.7% from 73.7% as more facilities returned to operation. We watch capacity utilization as one significant indicator for potential inflation pressure.
Leading indicators rose 0.4% in May after no change in April. The LEI is supposed to foretell changes in economic growth several months in advance by monitoring many of the leading indicators of US economic activity. Growth in the LEI has slowed lately after rising rapidly since last April. The index will often slow its trajectory after the initial surge when the economy begins to turn-around. This may indicate that the pace of growth may slow, but it is unlikely that the recovery will end prematurely. The coincident indicators (the same four economic series that the National Bureau of Economic Research uses to define economic recoveries and recessions) rose 0.4% as well with contributions from all four series.
Volatility remains an important element on Wall Street, last Monday was a good case in point. We started the day with unadulterated good news on the improving health of the European economies and the market reacted sensibly by rising. Then, we got some retread news about credit ratings for Greece being lowered and we gave back all our gains and then some. This is insane behavior. The new news ought to outweigh the old news and the improvement across Europe ought to be more important than the credit issues of one small economy. But, we don’t see things that way, at least last Monday.
Cooler heads prevailed over most of the rest of the week and we ended with good gains. US stocks were largely higher with gains of 2% to 3% on the week. By now, we’ve clawed back about half of the decline we suffered in late April and May. You wouldn’t know it from the sentiment indicators, which all are pretty much right where they were two weeks ago, near the bottom. Since we have started what might be called a stealth rally, it would be good to keep this one under wraps as long as possible. Confidence is the curse of all rallies. As long as the broad investing public looks askance at the gains, we’re probably okay.
Foreign markets also gained broadly last week. The only real exception was China, where shares are still reeling from the Chinese government’s policy shift to slow down the growth in the economy. On Saturday, the Chinese government said they were going to let the Yuan (also the Renmimbi) adjust in a slightly wider band, which can be translated into a higher band, against the dollar. They also said they were going to shift the dollar peg for their currency to a peg to a wider basket of currencies, this translates into a still wider band versus the dollar. Most foreign markets were higher to the tune of 2% to 3% with a few over 3% and a couple under 2%. But the world was a pretty benign place for stock investors last week.
US bonds weren’t all that bad last week. Most sectors actually gained a bit. Treasuries were about unchanged as the week past, a basis point here or there difference. Most of the rest of the high grade areas were similarly okay. High yield bonds rallied with stocks.
Foreign bond markets were mixed with some gaining a freckle while most were down a smidgeon. Quiet would be the way to frame that experience. The dollar slipped on the week.
Real estate securities were generally higher everywhere with foreign real estate gaining somewhat faster than the US version.
Commodities were also better. Crude oil gained nearly 5%, we’re back to $77 a barrel and probably going higher. Gold set new all-time highs in dollars last week, leading most precious metals higher.
Hopefully, all dads had a great Father’s Day. It is also the end of the regular school year in many parts of the country. So, be careful driving around the neighborhood because those kids will be out enjoying the summer.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.