We have been getting a little short-term focused in recent missives. We apologize for this short-coming. We really need to think and act long-term all of the time. What does it mean to think and act long-term? Well, not everyone has the same idea about that, but here is ours: don’t worry about the short-term outlook, worry about meeting long-term goals. No one is going to meet their long-term goals by sitting in cash, especially at 0.10% yields. Very few people are going to meet their long-term goals by buying bonds with coupons of 3%, especially when you have to pay a premium to get them. The math just doesn’t work that way. The only way for anyone with a long-term return requirement of 6% or 7% is going to meet that goal is by owning stocks, real estate and commodities most of the time.
One of the beauties of the planning side of this collaboration is that even if your investment team doesn’t get the timing on the market just right, as a planner you ought to look at your client’s account and see that they are either way ahead or way behind their return requirement. When they are behind, they have to move up to a more aggressive portfolio to meet their goals. When they are ahead, they can lower their risk posture and move down a port or two. Today, when many of our clients are a couple of years behind where they ought to be to meet their long-term goals, they ought to be thinking about moving up a port or two, say from a 2 to a 4 in hopes of catching up. They certainly shouldn’t think about going the other way. It is too late to do that. To paraphrase Warren Buffet: “When others are fearful, be greedy. But, when others are greedy, be fearful.” Today, that argues unequivocally for being greedy, as greedy as you can be. (For those of you who are relatively new to these missives, that is about as close as you’re ever going to get to market timing advice from us.)
But, long-term thinking has to take into account the things that are changing as well as the things that are staying the same. This is why your investment team looks into new investment ideas and products on a regular basis. We have been inundated recently with products that worked during the last couple of years of market distress. It is our general concept that just when these products ‘have worked’ is about when these products won’t work. In the long-term, long-only mutual funds beat long/short mutual funds by a pretty clear margin. In the short-run, the long/short products have worked because we have had that one-third of the time when stocks don’t work. We expect that stocks will work most of the time, but not always.
Besides new products coming along every once in a while, the background investment environment changes ever so slowly as well. The one big change we have been focused on for the last couple of years is the whole ‘new normal’ idea of an aging US and what that means for investors. You could call this trend the ‘Europeanization of the US’. With little population growth as a persistent driver for economic growth, cycles will tend to be less robust on the upside, but potentially just as challenging on the downside. As the huge ‘baby boomer’ cohort retires, there will be a pronounced loss of momentum for the economy. Years of experience, training and productivity walk out the door every time a boomer retires, to be replaced by someone with more energy, more potential and more years to devote to the task at hand.
Issue of the Week
Its earnings season and the reports got started last week. There are a few companies that are traditionally the first to report. Of those, most of the reports were above expectations or in-line. This quarter has all the earmarks of a fantastic display of what corporate America can do when it sets its mind to it. Costs are contained, prices are good, volume is up and the earnings ought to be terrific. We are comparing to the absolute worst quarter from the recession a year ago. By most accounts, the nadir of the recession was either in the second quarter last year or early in the third. The worst earnings quarter of the cycle was either the first quarter, when financials were bailing as fast as they could, or the second when most cyclical companies threw out the kitchen sink. The comparisons start getting tougher after this, so corporate America has got to get its game in gear.
Besides the easy comparisons, the other advantage that corporations have is that they have spent much of the last quarter reducing expectations after a great quarter in the first quarter. Most companies have gone from promising the moon and delivering only one small crater, to hoping for a crater or two and ending up with the Sea of Tranquility. (“Houston, Tranquility Base here, the Eagle has landed” the first words sent from the Moon to Earth by Neil Armstrong in 1969.) Lowered expectations are easier to beat than pumped-up expectations.
One issue that has returned is the focus on revenues rather than bottom-line results. Nearly everyone expects that the earnings numbers will be fabulous this quarter, but in the recent infatuation with bad news, analysts are looking at revenues to try to get something that doesn’t look quite as good. The recent example of Bank of America is a good one for this trend. Revenues for a bank are largely interest income and their biggest cost in interest expense. When BofA reported, the earnings were fine, better than fine, but revenues were down. If revenues were down that was because loans made in 2005, 2006, 2007 when interest rates were higher have either been paid-down, paid-off or refinanced at today’s lower rates. The loan put on the books at 10% in 2006 has been replaced with a loan yielding 6.75% now. That is a huge issue for revenues. But, the earnings are what we own as shareholders. Once the revenues get used to pay the operating costs, the other financing costs, the taxes, the employees’ salaries, the officers’ bonuses, they finally belong to the shareholders when they get to the bottom line. It may have some impact on the outlook if revenues can’t grow, but so long as we make good money, the shareholders ought to be happy.
We have an entire generation of analysts who were brought up during disinflation. Disinflation was chronically lower inflation, but still inflation. We have essentially no inflation these days, so surprise(!), there is little growth in revenues. There is also little growth in prices, little growth in costs and little growth in units, so you get little growth in revenues. But, we still get big growth in profits, be happy with that.
The Producer Price Index fell by 0.5% in June, the core version (which excludes food and fuel prices)rose 0.1%. As you might expect, both energy and food prices fell last month. Energy prices dropped by 0.5% while food prices were down 2.2%. In the past year, PPI is up 2.8% and the core PPI is up 1.1%. The consensus guess was for a fall of 0.1% in the broad PPI and a gain of 0.1% in the core.
The Consumer Price Index fell by 0.1% in June due largely to dropping gasoline prices. The core rate gained 0.2% since the drop in gasoline prices was excluded from that measure. Even at 0.2%, the core rate was quite low. In the last year, the CPI rose 1.1% and the core version 0.9%.
Retail Sales declined 0.5% in June from May, about as expected. Sales ex-autos fell only 0.1% and if one excluded building materials sales were actually up month over month. Retail sales are 4.8% higher than June of last year and for the first half of 2010 are 6.5% higher than the first half of 2009. The softness seen in many other economic reports was mirrored here. Consumers have tightened their spending and increased saving in recent months. However, this should not be enough to stop the recovery, only slow it down.
Industrial production rose 0.1% in June, largely on the strength in utility output. Manufacturing output fell by 0.4% highlighted by a drop of 1.9% in automobile output. Utility output was 2.7% higher likely due to high demand for electricity to run air conditioning to thwart the summer heat. Mining output was up 0.4%. Capacity utilization held steady at 74.1%.
Our trade balance became more negative in May, rising to $42.3 billion more of stuff from foreigners than they bought of our produce. This came as a surprise to Wall Street as the prevailing sentiment was that the trade gap was narrowing modestly from April.
Consumer sentiment fell dramatically to 66.5 from 76 in May. The drop was far larger than anyone anticipated and mirrors a similar drop in the Consumer Confidence index reported in June. Both confidence and sentiment are lagging indicators, so most of this is likely a response to the slowing pace of economic growth, employment and drop in stocks in the April-June period. But, consumers are a big part of the economy and if they start reducing their purchases and raising their savings, it will negatively impact the economy over time.
Friday was one heck of a day. We think that maybe the real issue that had everybody down wasn’t the CPI or Consumer sentiment data, not Citigroup’s or Bank of America’s earnings but Google’s less than stellar report (to think, growth of only 24%!). Combine that with what the folks at Apple are calling ‘antennagate’ and you’ve got the two most favored stocks on Wall Street in trouble at the same time. According to MarketWatch, there were 29 analysts that had recommendations on Google and all but one of them was a buy rating (two of those were merely ‘overweight’). Apple had 37 guesses on them and all but one was a buy or overweight as well. Neither company had a sell rating on it, only one brave ‘hold’ a piece). When something gets as popular as that, there is little hope of making any further progress. All you have is potential for disappointment.
But, since everybody’s favorite duo were in trouble, there was little room for good news at all. It was like mom and apple pie were both slandered in the same sentence and we couldn’t figure out how to respond. (We’ll leave it to you to wonder which is mom and which is apple pie.)
It didn’t matter that most of the actual earnings news was pretty good or that Goldman Sachs bought their way out of their latest legal imbroglio. It didn’t matter than the sun rose in its accustomed place or that the Dalai Lama recently celebrated his birthday, the world could not be right so long as all of Wall Street had there long bets on two stocks that weren’t working.
For the week, we lost only about 1% on the major indexes (but then Google and Apple are only a small part of the major indexes) and 3% on the Russell 2000. Foreign developed markets were generally up but emerging markets were mostly down.
Most bond markets were better on the week, with higher prices in Treasuries, high grade corporates, municipals and mortgages. High yield was modestly higher.
Most foreign bond markets were also gainers. The dollar was down on the week.
Real estate securities were mostly lower in the US, but foreign real estate was mixed with modest gains overall.
Commodity prices were their usual mixed selves with gold down quite a bit and energy down a little bit and enough of the other stuff higher to push the indexes higher.
We almost missed the 221st anniversary of the Storming of the Bastille in France. We have always been a big fan of Bastille Day, being one in a revolutionary group called Americans. It is good to relate to other revolutionary movements when we can. It is helpful to note that the French Revolution was nowhere near as successful as the American Revolution and disintegrated into a dictatorship in only ten years. The second French Revolution kind of worked roughly sixty years later, but democracy finally came to France only with the collapse of the Second French Empire in 1870.
We really ought to be thankful to George Washington for not turning into a dictator. His personal code of honor was all that stood between him and unmitigated power. Washington related the tale of Cincinnatus, the Roman who was made dictator twice but each time resigned once he had delivered Rome from danger. He was the guy that harnessed his war horse to this plow and beat his sword into a plowshare to show his desire to return to peaceful occupations.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.