Risk-On Risk-Off The Sequel

We were speaking with one of our many advisors last week and the conversation turned to the fears that permeate the market these days. We are supposed to worry about the budget deficit, the trade deficit, global warming, financial instability, inflation, the social safety net and all sorts of general problems facing Americans and a similar set of concerns for most folks around the world. Yet, we made new recovery highs last week. There are lots of well-known pundits telling anyone who will listen that the market is either fully valued or overvalued. Yet, we made new recovery highs last week.

This is what is called the ‘wall of worry’ that all bull markets like to climb. There are two ways to look at this: first, when the wall disintegrates, we all should start to worry; second, how many of these worries mean stocks can’t still go up. Both approaches today yield the same conclusion, stocks can still go up.

Nothing about the budget deficit, the trade deficit, global warming, financial instability, inflation, or the deteriorating social safety net means we aren’t still going to buy a box of Post Toasties this weekend at the grocery store. It doesn’t mean we won’t invest in a new car, or fix our dripping water faucet. Life goes on and the companies that provide us with the everyday essentials keep selling stuff to us. If we catch cold, we still take some Nyquil. If we break an arm, we still go to the hospital. The big issues facing us seldom mean we really change our way of life substantially or suddenly.

There will be subtle effects of the slow movement toward a more austere fiscal policy if we really do address our budget deficit. There will be a subtle shift in who makes what if we try to narrow our trade deficit. All these worries will still be there next year, some with a modicum of progress to point to, most with nothing of the sort. And, we’ll still be worrying about them and more likely than not the stock market will be making new recovery highs, maybe even new all-time highs. Why? Because earnings will be at all-time highs, interest rates will still be comparatively modest and the future will still look pretty good for most folks.

All we can tell you is that back in 1982, at the greatest buying opportunity of our career, there was a list of worries a mile long and many of them are still with us today. The only one we really seemed to get rid of was the Soviet Union, and now it’s back as Russia. But, over the next 18 years, we saw the biggest bull market in at least a half century. Could we do that again? Probably not as the list of problems isn’t quite long enough yet.

Try to keep in mind that almost every day, 90% of American workers get up, get dressed, go to work and produce more goods and services than ever before. As we add more workers every month, that product just keeps getting greater. The income earned by these workers is the fodder for more sales across a slew of products. That demand creates demand for more workers and this virtuous cycle has only just begun to reap benefits in this cycle. This can go on for years, which will foster all sorts of growth for all sorts of products. No wonder the stock market can keep going up!

Plus, the balance sheet of American corporations keeps getting better. Not only are they building cash, they are paying down debt, buying back shares, growing dividends and investing in their businesses. While government balance sheets have gotten worse in the last few years, bailing-out one industry after another, paying for social safety nets and maintaining the infrastructure, corporations have been getting stronger. Corporations are slowly adding workers, but are benefitting from productivity as their revenues grow. It has only been in the last six months that small businesses have started growing again in any meaningful way according to surveys. We are a long way from the economy doing as well as it can and as we progress, stocks will do better and better.

Issue of the Week

The dollar has been dropping recently as there are all sorts of worries facing the greenback as well. Tough talk out of China about making their Yuan a more international currency might take some demand out of the dollar. If the Chinese ever decided to allow the Yuan to float, that would mean a higher Yuan, and more demand for that currency.

Is this the dollar crash that many pundits have been forecasting for so long? It could be. The budget deficit arguments (no sense calling them debates) aren’t really making any dollar holders sanguine about their positions. The impending end to the Fed’s QE2 and the debt ceiling question all point to a serious point of decision for the dollar near term.

We wouldn’t expect this to be much of a long-term issue. More than likely, this is just one modest aspect of a lot of people (hedge funds mostly) putting on the risk-on trade and taking-off the risk-off trade. In the risk-off trade, people buy bonds, the dollar and sometimes gold. In the risk-on trade, they buy stocks, other currencies and other commodities (like oil). Better economic numbers prompt the risk-on trade. Surprising crises prompt the risk-off trade. If we look at the world in this light, it looks much more reasonable.

When you suddenly have a couple trillion dollars wanting to move from risk-on to risk-off, like we did last Monday, funny things happen. Even though Standard and Poor’s was warning of dire consequences for bond holders if we didn’t address the fiscal deficit and argued that Treasury bonds would be worth less in the future given the extant trends, the bonds went up because of all those trillions flowing into bonds, dollars and gold. By Wednesday, all those trades were shown to be somewhat foolhardy as better economic statistics and blow-out earnings from Intel triggered a risk-on trade.

When Greece announces that their bonds aren’t worth as much as most banks currently have them on their books for, that will be a crisis that will support the dollar. When tragedy strikes in Bangladesh or Uganda or somewhere else where tragedies strike fairly often, that will be good for the dollar. When we have car sales or machine tool orders that aren’t up to expectations, that will be good for the dollar. But, when employment statistics are improving, or when trade data improve, or when revolutions are resolved, that is bad for the buck. We live in a difficult world to understand at times. This is one of those times.

Economic News

But, first a little housing rant to get you started:

This is a week where we get a lot of housing related economic numbers, housing starts, permits, home sales data and data on home prices. We hear a lot about housing all the time and many pundits and newsreaders still blame housing for the latest recession. Fact of the matter is, housing is a cyclical part of the economy – always has been and probably always will be. The factors that influence housing are dynamic and include demographics, interest rates, jobs, incomes and consumer sentiment. Most of these influences are actually pretty attractive right now, relative to the current level of housing activity.

These days, residential construction makes up about 2.5% of GDP, give or take. This is a remarkably low level for the US. Back in the 50s and 60s housing seldom got much below 4% of GDP even in deep recessions and could get to 7% on occasion during booms. By the 70s, 80s and 90s the pace had slowed so that roughly 4% of GDP would come from housing within a band of 3% in tough times to 5% in good times. (Over this stretch about half of spending on residential construction was for repair and remodeling, so figure about 1.5% to 2% goes into that part of spending pretty much all the time, kind of puts that 2.5% of GDP into perspective, doesn’t it?) Then in the early 2000s housing just sort of spontaneously came alive and grew to be over 6% of GDP in 2005 and 2006. Frankly, we didn’t need that much housing, but the speculative burst of enthusiasm for homes, the new era in housing finance and regulatory initiatives to expand home ownership helped boost housing to a new peak.

Given the demographics, we ought to be building 1.5 million new housing units a year, a number which approximates new household formations. But, instead we are building only about half a million. There probably weren’t enough excess housing units built during the boom to provide all the space needed during the bust. So, where is all this pent-up demand for housing going? A lot of people are not living alone anymore. Single adult children frequently continue to live with their parents rather than live alone. Mature children will live with elderly parents or the parents live with the children. Many young adults live in non-family group settings. There are stories of unhappy couples postponing divorce just because they can’t afford to take the hit on the old family manse.

One huge difficulty is that housing still isn’t all that affordable in most urban areas. Our classic calculation there is whether the average family can afford the average home in an area. If it takes more than three years of the average family income to match the price of the average home, that’s not affordable. Recognize that even at today’s low interest rates you will pay almost 2.5 times the stated purchase price by the time you pay all the principle and interest payments on the house, so that is 7.5 years worth of income out of the next 30 years. (That doesn’t include taxes and insurance, but what the heck.)

The other issue is finding the right kind of house. During the boom, most of the new construction was aimed at upgrading homeowners, not first-time buyers. The 3000 square foot mini-mansion just isn’t what the usual newlywed needs. But, the economics of housing construction make it hard to build 1000 square foot starter homes and make any money for the builder. Hence, row houses and condominiums are often the way to start on the ownership ladder. If builders can’t afford to build the homes that today’s first-time buyer needs, then they won’t build them.

For many people, owning a home is probably a better deal than renting, so they ought to buy a home. But, if you can’t convince yourself that you want to live in an area for the next ten years, won’t have to upgrade or downgrade your accommodations during that time or just want a change, then home ownership may not work-out for you. If you may have to move to advance your career, or just to keep your job, it works against home ownership. The round-trip transaction costs of selling one home to buy another can easily add up to 10% of the purchase price. Back when homes appreciated 20% a year that didn’t sound so daunting, but today?

Now we feel a lot better.

Housing Starts were higher in March as we began construction on about 549,000 homes (seasonally adjusted at an annual rate), a rise of 7.2% from February’s pace. Given the low absolute level of construction activity, it is hard to imagine much further room to decline. If you take the March pace, adjust for the quarter of housing that is multi-family, divide by 12 to get a monthly pace, divide again by 50 individual states, you get 686 homes started per state last month. Does that seem all that farfetched? Maybe for Rhode Island, or Delaware, but not for Colorado or South Carolina. A few custom homes and a slow pace by builders to keep up some activity will explain all of that and more. Bottom line is this pace can’t really stay much lower for any extended period of time, so it won’t.

Existing Home Sales rose a little bit in March from February. That was to be expected as March has 31 days in which to buy and sell houses while February only had 28 days. The rise was a bit stronger than expected to an annual rate of 5.1 million houses versus the 4.92 million in February (originally reported as 4.8 million). Along with the volume increase, the price of homes sold in March continued to slide, now down 5.9% from the March 2010 to $159,600. We now have 8.4 months inventory of unsold homes at the recent sales pace. There is a supposed ‘shadow inventory’ of homes either in foreclosure or waiting to come on the market.

Weekly Stuff


Wow! Who could call this a boring market? Well, the result kind of looks like a boring market. The weekly gain started-off as a weekly loss as Standard and Poor’s dropped the big warning on the Treasury that without some sort of fix to our fiscal issues, the Treasury would get downgraded someday. Oddly, that threat actually resulted in Treasury bonds rising in value, falling in yield, as what most people heard was that the risk trade had to come off, so they sold stocks, commodities and foreign currencies to buy dollars, bonds and the like. Stocks settled down over 1%, which was pretty good considering they were down almost 2% at the worst levels of the day.

Then, on Wednesday, we more than reversed all of that when Intel had better than expected earnings, revenues and outlook. Does that make sense to anyone? Our government is on borrowed time (pardon the pun) but its okay since Intel was doing better. It does make sense that stocks don’t really care whether the Treasury gets downgraded except as that impacts the general rate environment (see above). What matters to stocks is that they have fundamentals and those are getting better, still.

This is the year when the earnings progression starts getting a little tougher. For the last two years, we have had fairly easy comparisons, but now we are facing a decent year in 2010 to compare to. The gains in year-over-year earnings aren’t going to be as terrific as they have been, but they will be safely positive. Instead of 30% or better gains, we will see 10% or 12% improvement. That is plenty to get a decent continuation of the bull market this year. That doesn’t mean we won’t see more days like last Monday, but it will also mean that for the time being, we will recover from those episodes, just like we did last week.

Stocks managed to gain over 1% on the holiday shortened week. The NASDAQ did even better, but then most of the really good news was centered in those stocks. Foreign markets came along for the ride and benefitted from the drop in the dollar as well.

Bonds faced generally benign circumstances with most central banks on hold and the news very quiet. This week we get the Fed meeting with their announcement on Wednesday and the first of what may be a regular news briefing after the Fed announcement by Chairman Bernanke. We’ll see if that makes things better or worse.

Real estate securities were broadly higher with evident improvement everywhere. Since the securities have priced in a lot of improvement already, this may be one of those instances where the news had better be good or else.

Commodities had another strong week. Energy prices are now being driven by the action in the commodities pits rather than by any news events or actual information. The risk-on trade throws a lot of money at energy futures whenever it comes. And those futures prices are driving the physical markets. Grains, industrial metals and precious metals also advanced with few exceptions.

Have a great week.


Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.