Market Notice From Our Cheif Investment Advisor

Market Notice

Dated: April 16th, 2011

By: David Gimpel, MBA, CWPP, AAMS

Chief Investment Advisor, The Maddox Group and President of Rational Capital Management

The Coming Breaking Point:

(Hopefully) The End of Quantitative Easing 2

In the last 2 years, the market has had a strong positive rally. In previous letters, I made the case that the upward market was driven primarily by two forces:

1.) Public Sentiment. A significant portion of this rally was due to the fact that there was dramatic overreaction on the downside in late 2008-2009 in response to the perceived “end of our financial lives.” It was not, of course, and the strong rebound in the second half of 2009 and the first half of 2010 was reasonable and proper.

2.) Continuing Government Intervention.

Public sentiment is by its very nature bipolar. When things look bad, we assume the economic damage will be dramatic, irreparable, and irreversible. This is what causes crashes to be rapid and rabid. On the other hand, when things look good, we feel that the economy is bulletproof. This is what allows us to discount or even completely ignore the warning signs.

Both views of the world are dangerously flawed and give rise to behaviors that undermine investment success. In other words, when sentiment is at extremes, the profitable thing to do is go against the grain.

As you know, I have been bearish on the markets since August, when the S&P 500 was at 1120. At the time, a slew of sentiment, market and economic indicators were at historically bearish levels. But in the last six months, the market has shaken off, quickly recovered from, or completely ignored these indicators and continued to creep ever higher.

This has happened specifically because of continuing governmental intervention which at this point is the primary driver of the stock market. This cannot continue indefinitely. Indeed, Quantitative Easing 2 is due to end in late June, and many of the luminaries in the fixed income world, including Bill Gross (manager of PIMCo’s largest bond fund), are not only dumping their Treasury bonds in anticipation of an interest rate spike, but have gone so far as to short treasuries. As I have stated before, this could be the thing that finally sparks the reversal I have been expecting.

If QE2 ends on time, the ramifications could be widespread. One likely scenario would be rising interest rates, falling bond prices, a stronger dollar, falling stock prices (especially for companies that export), and crashing (yes, crashing) commodities prices.  Why is this a likely scenario? Here’s the story:

Interest rates rise in part because without the QE2 backstop, true default and purchasing power risk will have to be priced into bond yields. Furthermore, as inflation fears continue to loom, the Fed should raise short term rates in order to slow the growth of the money supply. If rates rise, bond prices will fall. But on top of that, because our rate of inflation will be relatively lower than other country’s rates, the USD will strengthen on a relative basis. A strong dollar, while good for importing, will severely damage our nation’s exports. And as almost 50% of the revenue of the S&P 500 is generated overseas, this will be difficult on the stock market. Finally, commodities will truly be at risk of a strong crash.

The last point on commodities is important to understand and deserves a little more attention since many of you have commodities investment, including gold and silver.

The way QE2 was supposed to work was that the Federal Reserve printed money and bought back Treasury bonds from banks. The banks were supposed to turn around and lend that cash to individuals and businesses. Unfortunately, with most banks having much higher lending standards, and less individuals and businesses having any desire to take on additional debt, much of the cash that banks received simply sat there.

But banks, like all businesses, are interested in making money. And if they weren’t going to make money through the traditional loan process, they also certainly weren’t going to let all that cash sit in their vaults, collecting dust and returning 0%. So they invested significant sums in derivatives tied to equities and commodities.

While “commodities” is a general term, most of you can relate in one way or another with the run that gold and – even more dramatically – silver have had over the last two years. Since late 2008, silver is up a staggering 345%. Silver is driven by similar (though not exactly the same) forces as gold, such as inflation hedging and speculation. As QE2 drove much of the inflation fears, it seemed only logical to banks and other financial institutions to take that cash and invest it in inflation-hedging precious metals.

But if QE2 ends, interest rates move to address inflation fears, and speculation dies down because the Fed stops providing banks with what is effectively and interest-free loan, gold, silver (and many other commodities) could come crashing down.

That’s IF the powers that be make the right decision and end QE2. And IF at the end of QE2 the Fed allows interest rates to rise to reasonable levels. A continuation of QE2 or the initiation of QE3 will not only delay, but exacerbate, the inevitable.  (A move to extend stimulus also has ramifications in the market, but they are not discussed in this letter since the current policy calls for a termination of the program.)

Exacerbate? Yes. In previous letters, I have compared our new stimulus-based economy to the behavior of an addict. In short, the more drugs/stimulus you take, the less effective it is. Furthermore, at some point, not only is further drugs/stimulus ineffective, but it is actually damaging.

This chart shows that, based on the Z.1 data directly from the Treasury, at the end of 2008, each new dollar of stimulus created roughly $0.19 in additional GPD. More importantly, that has trended down ever since Lyndon Johnson. In other words, it’s simply not possible to stimulate for eternity. At some point, stimulus entirely loses its potency.  This chart, which was produced in late 2008, projected that, given the trend, the “Zero Hour” would occur around 2015.  But then something happened: The Credit Crunch.

As the second chart shows, the “Zero Hour” actually happened in late 2009. For every additional dollar of Q3 2009 debt, GDP was actually reduced $0.15 cents.  Though the chart doesn’t show it, in Q4, the number plummeted to a reduction of $0.45 per additional dollar of debt.  Because the data from the Treasury is posthumously released, I do not know what the current number is, though the number is much closer to zero.

Either way, the point is this: stimulus is no longer stimulating. The technical term for this is “Total System Debt Saturation (TSDS).”  It’s the point where our economy no longer responds positively to stimulus spending. At best, it has no effect, at worst it’s akin to giving an addict a fix.

How can this be? The economics are a bit complex, but the idea is simple. The government borrows money to spend, which it does. But the people and institutions getting that money hoard it rather than re-spending it. When you add in the transaction costs of collecting and transferring the dollar in the first place, in the end, we’re left with less than we started with.

An even simpler way to think about debt saturation is that in order to service the debt, we must redirect money from investments in long-term productivity gains, entrepreneurship, infrastructure, and other economy building activities.  At the point of TSDS, additional debt is propping up the economy, not building it, and further debt increases the likelihood of future defaults and sustained unemployment.

This is not a sentiment I convey flippantly: The age of stimulus is effectively over.  That’s not say the powers that be won’t try (Japan has been stimulating for over 20 years, and their market is still down 77.1% since 1989 in inflation adjusted term); but it simply won’t work like it used to.

Profits and Profit Margins: Why Capitalism Matters

I am more convinced now than ever that the bear case is strong, because we are coming to a point where, if the market doesn’t turn back, we are allowed to question whether or not our economic system is even capitalist anymore.

According to the Bureau of Economic Analysis (BEA) and Standard & Poors (S&P), the financial data firm, average after-tax profit margins for S&P 500 firms between 1947 and 2010 were 6.2% of GDP. To give that context, over that same time period, 96% of all profit margin/GDP measurements were between 4% and 8%.

Profit margins are one of the most mean-reverting data series in all of finance. In other words, when profit margins are high, they always come down, and when profit margins are low, they always rise. ALWAYS. Why this happens is easy to understand when you think about the very nature of capitalism. Our economic system is predicated on the idea that financial capital gets allocated in an efficient way. Investments are made in the people, ideas and businesses that have the highest return potential.

In the business world, this means that when there are huge profits to be made, competitive businesses will enter, causing price wars and driving down profit margins. If this doesn’t happen, and profit margins stay extremely high for extended periods of time, this means that on a fundamental level capitalism is broken.

On March 14, Bloomberg reported that profit margins are already near 8.2% and will reach 8.9% later this year, the highest level in 18 years. This is in the 99th percentile in historical terms.

Profit margins will fall. That is not in question. But before we jump to the conclusion that stock prices must fall as well, consider the following: what happens if revenues grow faster than profit margins are falling? In other words, even during historical periods when profit margins fell, there were times when the stock market continued to advance because revenues were growing even faster than margins were falling. So, if we are confident that profit margins must fall, then in order to estimate what will happen to stock prices we need to look at projected revenues.

According to Applied Finance Group, As of January 1, the implied revenue growth over the next 5 years is 13.25%. The median since 1998 has been roughly 7.3%, meaning that the current projections are an incredible 82% above average…for the next 5 years! But we’re not done quite yet.

In order for an analyst to isolate one variable, such as implied revenue projections, they must hold everything else constant. The easiest and most common way to do that is by maintaining the status quo on all other variables. In other words, when analysts project out the implied revenue growth, they hold tax levels, inflation, and profit margins constant. Of course, I just told you that profit margins are impossibly high right now, and they will revert one way or the other. So what happens if we start screwing around with the profit margin?

Of course, the lower margins go, the higher revenue growth must be to sustain the same dollar amount of profits. But without going into the mathematics of it all, it’s not a linear relationship; small drops in profit margin require relatively larger increases in revenue growth. And this further fails to account for potential increases in corporate taxes, the potential for a strengthening dollar (discussed above), or any other looming risks.

These numbers seem daunting to me. Especially with the official unemployment rate still hovering around 9% (or, if you’ve seen my previous writings on this, more realistically measured at around 22%). In particular, I find the number daunting because much of this unemployment is structural in nature, not frictional. Frictional unemployment can be reduced, but structurally, many of the jobs lost in the “Great Recession” have now found permanent homes overseas. They won’t be coming back.

Recovering from structural changes in an economy is a long-term process, not one that can be remedied with short-term, debt-funded make-work programs. It requires long-term commitments to retraining people for jobs that may be vastly different than they previously held.

Outlook and Action Plans

What I find encouraging, however, is that since January 1 the S&P 500 seems to be in a trading range between 1257 and 1343 (a 7% channel). I expect this to continue until the markets get clarity on whether or not QE2 will actually end.  It is my hope that it will and that leading up to the end we will continue to see faltering, and that at the program’s conclusion we will finally start to see some of the corrective action this market, and our economy still desperately needs.

If you want to discuss the specific ways I am addressing these concerns in your accounts, simply reply to this post to set up a time for a phone call or meeting with Dave.

I thank you for your continuing commitment to my investment thesis. As always, I am available to answer any and all questions you may have, and welcome your feedback.  Have a safe and happy Easter and Passover.

Rationally yours,

Dave Gimpel, MBA, CWPP, AAMS

 

***** Update 4/18/2011 *****

The notice that you just finished reading has been in the works for about a week.  I started writing it Tuesday, April 12 and have been updating it in an attempt to make my thoughts more coherent, digestible and useful.

This morning, the following story was released in every major news outlet:

“NEW YORK: US stocks slid at the open on Monday after Standard & Poor’s downgraded the credit outlook for the United States to negative.

The Dow Jones industrial average dropped 177.25 points, or 1.44 percent, to 12,164.58. The Standard & Poor’s 500 Index fell 19.35 points, or 1.47 percent, to 1,300.33. The Nasdaq Composite Index lost 41.14 points, or 1.49 percent, to 2,723.51.

The rating agency said it believes there’s a risk US policymakers may not reach agreement on how to address the country’s long-term fiscal pressures.”

CNN expounded on this, saying:

“ ‘The outlook means that there is one-in-three likelihood that it could lower the long-term rating on the United States within two years,’ S&P said.

‘The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012,’ said S&P credit analyst Nikola Swann.

The move puts additional pressure on Congress to come up with a plan to bring down long-term deficits, which lawmakers from both political parties say are unsustainable.”

At the time of this writing, the market is down about -1.75% in early trading, but more to the point, it’s about time that the ratings agencies made this move to recognize the nations’ poor financial health, poor fiscal and monetary policy, and poor policy outlook.

 

 

Securities offered through FolioFN Investments, 8180 Greensboro Drive, 8th Floor McLean, VA 22102. Rational Capital Management LLC is a Registered Investment Advisor. Rational Capital Management is an independent firm from the Maddox Group.

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