More Wall of Worry

We have seen fear come back into the markets with a vengeance. We have rebuilt the so-called “wall of worry” that the market seems to need to climb. As a quick indicator of that, the bullish percentage in the American Association of Individual Investors weekly sentiment poll has fallen to 24% recently from 43% in early April. The bears have grown to 48% from 29% in the same period. Typically, when twice as many people are bearish as bullish the market tends to rise. Just as when roughly twice as many people are bullish as bearish, it tends to fall.

There is always something to worry about. No matter how wonderful life seems to be today, it could get worse, a lot worse, in a hurry. But, we have to weigh the probability of the negative outcomes versus the severity of those outcomes before we react to them. Sure, your teenage son could break his neck playing football next year. That is a real possibility. But, what is the probability of such an outcome? If one kid in twenty was hurt badly playing high school football, there probably wouldn’t be high school football (insurance would be prohibitively expensive). But, if one in a thousand, or one in ten thousand gets hurt, then not only do we have football, we have lots of football.

Traffic accidents are in the same arena. You are much more likely to get into a traffic accident within 25 miles of your home than you are anywhere else. Each time to go to the store, or to Taco Bell, you are literally taking your life in your own hands, and the hands of every driver you meet along the way. But, most of the time nothing happens. When something does happen it is usually minor, a scrape or a dent. Put, hardly a day passes in a large city when people aren’t killed in traffic accidents. Are we all going to give up driving? No.

What are the odds that the US will not raise the debt ceiling? Nil. We will do that because there are no winners in not doing it. Though House Republicans would like to make all the political hay possible about the sad state of our national finances, they won‘t win anything by not supporting some compromise that raises the debt ceiling. All we are witnessing now is the compromise moving slowly towards its conclusion. There will be some limitation put on deficits, some programs cut, some statement about facing our long-term unfunded liabilities for Social Security, Medicare and Medicaid. But, we will raise the debt ceiling.

If we didn’t raise the debt ceiling there would be hell to pay. Lots of promises would be broken, but our bondholders would get paid. There may have to be a cut in Social Security payments temporarily. There would be massive furloughs of government workers, but soldiers would get paid. We’d have a big smirch on our debt worthiness, but an outright default isn’t highly likely. So, the cost of not raising the debt ceiling would be high, but the probability of not raising the debt ceiling is very low.

The same is basically true of the following story re Greek debt. Who wins by forcing the Greeks into bankruptcy? No one, except maybe a few folks who have shorted Greek debt. Unlike in a corporate bankruptcy, where you might just get a piece of heavy equipment or maybe some inventory as part of your settlement, you get no assets when governments go bankrupt. You can’t go and buy a bunch of Greek bonds in hopes of owning the Parthenon when they default. Who wins if we continue to work out compromises that don’t push the issue too far? Everyone.

Issue of the Week

Why can we not stop talking about the European debt issues in all their forms? We are back talking about Greece and their trials and travails. There is a very public debate about how to handle the Greek need for capital to fund the next several years of their budget shortfalls until the expected government austerity will balance their budget and allow for much lower financing needs.

Last year, the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Union all got together and created a package of loan guarantees, direct loans and other financing mechanisms to tide the Greek government over for a few years until they could get their fiscal house in order. The package totaled €110 billion. That works out to roughly €10,000 for every Greek man, woman and child. Though a pittance compared to the $41,000 that is the US equivalent of that debt per capita statistic, the typical American family earns a whole lot more than their Greek counterpart. But, this aid was to be divvied up over several years. We are barely one full year into this process. So, why the crisis atmosphere now?

Well, the Greek electorate doesn’t seem willing to shoulder their part of the solution. The current Greek government is tumbling due to a lack of support for their austerity budget. Greek civil (or should we say uncivil) servants don’t want to take a pay cut or work more years to earn a pension. Other recipients of Greek government largesse don’t want to be part of any solution either. It is turning ugly over there.

The Greeks are trying to roll-over a bunch of debt in upcoming weeks and draw-down their line of credit with the IMF, the ECB and the European Union. The trouble is that some of the European Union governments are having second thoughts about fronting the money. The Germans especially are not fond of lending money at 5% when the real cost of borrowing for Greece is more like 18%. That math implies the lender should take an immediate haircut of roughly 40% on a five-year loan. They insist that the private (non-government or multi-national agency) lenders ought to take a haircut as well before the governments advance any more money. This haircut would probably be worked-out by extending the maturity of the bonds, cutting the coupon or some other recognition that the current deal isn’t working. The problem with this solution is that most of the bonds are held by European banks, especially the Greek banks. So, recognizing the discount would essentially put the Greek banks out of business and ding many of the other European banks.

As with other issues in the European debt debacle, whatever happens in Greece doesn’t stay in Greece but will quickly spread to Portugal, Ireland, maybe Spain and Italy. Crushing the banking system in Europe again, so soon after the mortgage-backed securities issues of 2008-2009 won’t be a lot of fun.

Our best guess is that everybody involved will try their best to postpone any day of reckoning on the debt issues as long as they can. European austerity might actually begin to work in a couple of years with budget deficits turning into surpluses and rising debts turn into shrinking ones. And, if you believe that, we’ve got some land we’d like to sell you on the Oregon coast (and you can see it as soon as the tide goes out). There will be pain for all involved, politicians, bondholders, tax-payers, government workers, pensioners and bankers. Most of the questions now turn on who gets hit how hard, how soon and for how long. So far, the bond holders and bankers have taken most of the damage. They won’t sit still for the tax payers, pensioners and workers not taking their share. There isn’t enough money to go around for everyone to get paid what they think they are owed.

There is a message in there for anyone who thinks the current situation in the US will end nicely with Medicare recipients gladly accepting less service or paying more for treatment, Social Security recipients working longer for lower benefits, tax increases, and program cuts. It just won’t work that way. Everybody will have to give up something for the budget to balance.

Economic News

Retail sales slipped in May, but sales ex-autos actually gained. The shortage of preferred models due to parts shortages from Japan was largely blamed for the weakness in car sales. This is the first decline in retail sales since last June, but that decline didn’t prevent us from having a pretty good last half of last year. Retail sales are 7.7% higher than the same month a year ago.

Producer Prices rose 0.2% in May, the slowest rise in almost a year. Food prices declined in May and energy prices showed only a small increase. In the last 12 months, producer prices are 7.3% higher. Core producer prices also rose 0.2%.

Consumer Prices rose 0.2% in May, with declines in energy costs being more than offset by gains in a broad range of other costs. The core rate, which excludes food and fuel costs, rose 0.3%. For the past 12 months, CPI has risen 3.6%, well beyond most forecaster’s expectations. Last month gas prices fell 2.2% in the government survey, but in the last 12 months gas had risen 22%.

Industrial Production rose 0.1% in May, below expectations but better than the zero for April. The aftermath of the Japanese earthquake and tsunami seriously impacted the April numbers and that effect is fading in May.

Capacity Utilization was unchanged at 76.7% but still well below the 80% level seen as tight and a handicap to further easy growth.

Housing starts were a brisk(?) 560,000 (seasonally adjusted at an annual rate, saar) in May. Though that was better than expected, it was nowhere near levels that would pass for normal in a decent economy with a vibrant housing sector. We have not enjoyed a normal housing sector since about 1996, before we went off the tracks first one way, then the other.

Consumer sentiment fell again this month to 71.8 from 74.3 in May. The survey from Thompson Reuters and the University of Michigan was started in 1966 and based at 100 in December 1964. The survey has three parts, personal economic conditions, national economic conditions, and future economic outlook. The current conditions segments can be quite informative as personal conditions are seldom as bad as what the individuals view as the broader national situation. Also, it is unusual for the future conditions to be less than those experienced currently. It is the second of these that is out of whack today. Most participants in this survey view the future as less attractive than their current circumstances. The sub-index for current conditions sits at 79.6 now versus a reading of 66.8 for future expectations.

Leading Indicators were surprisingly strong following an April reading that showed a decline. The 0.8% increase in May came as a relief to many who now think the future looks a little brighter than April’s reading would have indicated. The future still looks a little choppy, but the trend is still up for this series. The coincident indicators, which just so happen to be the same four indicators that business cycle analysts at the National Bureau of Economic Research use to date business cycles, showed growth of 2.4% at an annual rate in May. So the economic expansion continues apace.

Weekly Stuff

Well, our streak of losing weeks in US stocks seems to have ended, even if only barely. Actually, the streak only ended for the Dow, S&P 500 and Russell 2000, with the NASDAQ failing to reach the prior Friday’s level last Friday. We see a pretty big gap opening up between the performance of the Dow and S&P 500 on the one hand and the Russell and NAZ on the other. Large cap stocks with global reach have definitely outperformed lately. Of course, these names are all the rage among institutional investors, who like that you don’t have to have a vibrant US economy to own Pepsi or Kraft since many of these outfits get a huge share of their revenues and profits overseas. The absolute performance may not be anything to brag about, but the relative performance is starting to add-up.

Funny, the companies headquartered in these brighter economic areas aren’t doing all that well. Both the developed and the developing markets haven’t kept pace with the US large caps. There are all sorts of issues that come up. China is trying to slow its growth, Brazil is doing the same. Japan has the demographic problems and the tsunami and meltdown. Europe is all about the collapse of the monetary union. Where is one to look for relative safety? The land of the free and the home of the brave.

Bonds had a mixed week. The stronger the safety element, the stronger the performance again. Treasury bonds hit new record lows at the 2-year area. But, for the week the 10-year was down and the 30-year also. Corporate bonds did okay at the highest end of the credit spectrum, but high yield was lower.

Foreign bond markets were mixed. Most high-quality developed markets saw a bit of the safe-haven trade work for them. There was weakness in many of the developing markets.

Real estate securities seemed to bounce back from a couple of weeks of correction. There were modest gains last week in US real estate. Foreign markets had a tougher time with dollar strength as a headwind.

Commodities were the big story last week. Fears of global slowing sent waves of sellers into the futures pits across a wide swath of products. Energy prices were down almost universally. Industrial metals were mixed with copper higher but most other metals soft (little humor there). Precious metals saw gold hold its ground but silver decline. The grains were broadly lower. A Congressional (the opposite of progressional) agreement to end ethanol subsidies might hurt corn prices, but wheat, soy and rice also fell. Livestock was a bright spot. The indexes fell 4% to 5% on the week.

Hope everyone enjoyed a happy father’s day weekend.

Have a great week.

Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.