V-Shaped Earnings Recovery in 2009?

We have said repeatedly over the past year or so that earnings expectations are too high among both stock analysts and market strategists (but especially analysts). Analysts in general are notoriously slow to adjust expectations at inflection points in the business cycle. Since stocks are valued based on earnings forecasts, we have turned our attention to analyst expectations for 2009. What we found is that double-digit earnings growth is expected in every sector — except, perhaps ironically, Energy. What jumps out most is the greater than 50% rebound expected in Financial earnings coming after just a 17% decline in 2008 (also too optimistic in our view). Earnings from Consumer Discretionary stocks are expected to jump 18% next year after just a 4% decline in 2008. The recent sell-off in stocks indicates pretty clearly to us that stock investors don’t believe these numbers. But we believe that stocks will still struggle to bounce back meaningfully until these expectations come down.


Source: Argus Research Market Watch, June 30, 2008

Inflation Expectations Surge

The Conference Board released its latest index of consumer confidence — and to no surprise, consumer attitudes were miserable. The headline confidence measure fell to a reading of 50.4 during June, down from a revised 58.1 in May. This is the lowest level since February 1992 (47.3). The business press was quick to cite slumping housing prices and rising energy prices as the primary culprits. But of all the sub-components in the survey, we found the inflation expectations index to be the most meaningful. The inflation expectations index hit 7.7% in June, equaling the record high registered in May. It’s easy to see how difficult the Fed’s job is; raise rates to cool inflation or cut rates to boost economic activity. Ultimately, we believe the Fed will opt for a rate hike as inflation may be the bigger issue.


Source: Argus Research market Watch, June 27, 2008

Mortgage Rates Higher, but Still Low

Amidst all the debate about when housing prices will bottom, rates on 30-year mortgages have been quietly inching higher in recent weeks. In large part, the increase follows recent increases in long-term bond yields — as bond investors have gotten increasingly nervous about the outlook for inflation. According to Freddie Mac, the average rate for a conventional 30-year fixed rate mortgage was 6.42% on June 19. However, as the chart below demonstrates, the average rate was 8.5% as recently as 2000. Still, rates have been near current levels, or below, for most of the past five years. So higher rates are no doubt adding to pressure on home prices, which are already impacted by excessive inventories of homes for sale.


Source: Argus Research Market Watch, June 26, 2008

Fed's Focus Shifts to Inflation from Economic Expansion

The Fed left its target rate unchanged at 2%, as expected. It said economic activity continues to expand, but labor is weaker and financial markets remain under stress. Analysts said its statement was skewed more to inflation than to lack of growth: "Uncertainty about the inflation outlook remains high," making a rate hike by September more likely now than before. Analysts said the Fed's statement is moderately bullish for the stock market: there is nothing that suggests an imminent rate hike, and no evident panic over inflation. The decision wasn't unanimous: Dallas Fed president Richard Fisher dissented for a fourth straight time, favoring a rate hike to 2.25%.

For now, Fed vice chairman Donald Kohn says, headline inflation (which includes food and energy costs) has barely embedded itself into core inflation and long-term inflation expectations. "However, policymakers around the world must monitor the situation carefully for signs that the increases in relative prices globally do not generate persistently higher inflation," he said this morning in Frankfurt. Kohn says emerging market growth was likely due to stronger earnings for commodity exporters.

Fed Meets Today

The Federal Reserve will meet today and tomorrow to discuss the economic outlook and the near-term direction of interest rates. The overwhelming majority of the Street expects no move from the current 2.0% overnight borrowing target rate. The tone from recent Fed chatter is that there’s a rate hike in the offing just a few months down the road. To date there’s been no conclusive evidence of economic recovery. Positive signs, yes. But a definitive rebound, not yet. The Fed will not have a green light to raise rates until the economy has clearly returned to a path of prosperity. There are still too many uncertainties out there regarding the credit markets, the housing recession and the labor market. We anticipate a 25-basis-point hike is likely in December, after the election.


Source: Argus Research Market Watch, June 24, 2008

The Manufacturing Tide May Be Shifting Back to The USA

Business Week recently published a story (see link below) which highlights in greater detail our belief. That at a certain point the cost of production in China would increase to a "push" between manufacturing in China or the USA. It looks as though that is starting to occur. Oil is the primary catalyst. Secondarily, China's developing middle class is inflating the human capital cost.

This shift, if managed correctly, should bring back some manufacturing to USA shores. Competition will determine where the manufacturing will end up over time. The biggest issue is USA's investment in human capital and technology. These investments will improve productivity and keep the USA competitive in the global market place.

The glass is half full.

http://www.businessweek.com/magazine/content/08_26/b4090038429655.htm?chan=top+news_top+news+index_top+story

Stock Performance in Recessions

We expect the U.S. economy to skirt recession — though this has become a closer call of late. Still, it’s important for investors to understand that stock prices have behaved very differently in and after previous downturns. In the two recessions that occurred in the early 1980’s, the Dow Jones Industrial Average gained both during the recession and in the year that followed. While GDP was contracting during those periods, the Fed was also hiking rates to break an inflation cycle that had wreaked havoc on the markets in the 1970’s. Stock prices were also very cheap. The major market indices traded at single-digit P/Es, with dividend yields approaching 4%. By contrast, stocks lost ground both during and after the short and shallow recession of 2001. Stocks were more expensive then though there was stimulus on the way from Fed rate cuts and from tax breaks. Today, fiscal and monetary stimulus are also in the pipeline. Valuations for U.S. stocks, however, are somewhere in between the extremes of the early 80’s and the late 90’s. Inflation remains a concern as well.



source: Argus Research Market Watch, June 19, 2008

Import Inflation a Concern

Make no mistake about it, the sinking U.S. dollar has engendered a fair amount of inflationary pressure. U.S. import prices jumped by 2.3% in May, which followed 2.4% and 3.0% increases in April and March, respectively. Most of these gains were the result of record-high crude oil prices, but the nonpetroleum import price gauges weren’t exactly comforting either. Non-petroleum import prices were up 0.5% last month, or 2.9% over the last 12 months. According to the Bureau of Labor Statistics, the prices of imports from China rose 0.6% in May. Over the last year, the volume of imported goods from China ballooned 4.6% — the greatest annual pace since the index was first published in December 2003! There’s an inflation problem mounting, and a good portion of it is related to weakness in the currency. This is why the Fed chairman has decided to break with tradition and speak about the U.S. dollar.


Source: Argus Research Market Watch, June 17, 2008.

On The Plus Side - Corporate M&A Projected to Grow

With economic downturns come some pluses. Corporations with strong balance sheets are at an advantage in terms of being able to pursue strategic acquisitions. The second half of 2008 and 2009 will be marked as the return of strategic buying. Pepsi Co's and Heinz's CEOs are becoming increasingly vocal about opportunities they see.

Private equity(PE) firms drove the deal flow over the past two plus years. With the credit crunch, PE deals are sidelined. This marks a shift from financial opportunities to strategic based transactions.

Corporate buyers are looking at smaller dealers; chasing companies worth less than $1billion, for a EBITDA multiple of 11.1 times. This is down from the average multiple of 11.4 times in 2007.

Historically, according to the Boston Consulting Group report last month, of deals completed since 1981, acquisitions made during downturns were twice as likely to produce returns of more than 50%. Deals completed during periods of stress produced an 8.3% total shareholder return on average, after two years versus a -6.2% return after two years for deals done during upswing years, according to Alexander Roos of Boston Consulting. This difference of 14.5% can mostly be explained by purchase price paid. It seems Warren Buffett has the right idea - "buy low, hold and only sell high". This explains Buffet's interest in the bond insurers earlier this year.

According to Andy Schmidt the target area is bolt-on private companies, because smaller companies dovetail nicely with where we're focused. In addition he noted that the environment is much better and continues to get better than just a year ago.

So if you have a successful private company be prepared for the coming knock on your door. It my behoove you to target the coming knock.

"The worst is over (for the U.S. economy) if the financial crisis is over," Greenspan said.

In a speak given in Mexico City recently former Fed Chairman Alan Greenspan spoke about the end of the US financial crisis and the beginning of inflationary concerns.

"If you're going to keep inflation rates down ... the Federal Reserve is going to have to put increasing pressure on the money supply and reserves, and as a result we're going to see interest rates rising," Greenspan said.

The former Fed Chairman said "weakness in financial markets probably peaked in March but that it was hard to say how long the crisis would last." He predicted some financial crisis fallout though the rest of the year. "It can struggle along for a while. It could get worse, it could get better," he said. Greenspan said the financial market problems could continue until the stated value of those assets fully reflect the fall in house prices in the United States. "Until prices are clarified ... we will be dealing with a not fully functioning financial intermediary system," he said.

Current Fed Chairman Ben Bernanke echoed this same sentiment with a shift from credit crisis and recession concerns to a harsh inflation hawk tone. CPI recently grow at its fastest rate in six months. Though core inflation (ex food and energy) remained tame. In addition, bond traders are looking for an increase in rates this coming August.

The fed's tone on inflation should alleviate the pending "Next Bubble" with commodities. But only time will tell.

Bernanke Signals Shift From Stimuls to Inflation Concerns

Chairman Ben Bernanke says the Fed will "strongly resist" any indications of growing inflation -- his clearest message yet the Fed's rate-cut cycle is over. Bernanke played down a recent 0.5% jump in unemployment, and said the risk of a "substantial downturn" has receded. Meanwhile NY Fed president Timothy Geithner unveiled a 17-bank pact that creates a central credit-default swap clearinghouse capable of absorbing the failure of one of the market-makers.

Economy Sheds 49,000 Jobs

Businesses eliminated a net 49,000 nonfarm payroll workers last month, with most coming from the limping construction and manufacturing industries. The three-year (plus) housing recession continued to strain the jobs market as 34,000 construction workers were furloughed. Meanwhile, the manufacturing sector eliminated 26,000 positions. The ugliness didn’t stop with the usual suspects, as retailers dismissed 27,000 workers and business services laid off 39,000 employees. A reduction in consumer spending has resulted in severe job cuts at retailers. The silver lining in this cloudy report is that the job loss last month was not profound in historical comparison to other economic downturns. Education and healthcare services added 54,000 new workers, while leisure and hospitality boosted payrolls by 12,000. A very discomforting event was a jump in the unemployment rate, to 5.5% from 5.0%.

What Is The Long-Term Outcome of March's Fed Action???

Two regional Federal Reserve Bank presidents warned about consequences from the Fed's March decision to lend to securities dealers. Richmond Fed President Jeffrey Lacker and Charles Plosser of the Philadelphia Fed added to worries expressed earlier by colleagues in Kansas City and Minneapolis that the move could weaken market discipline. "The effect of the recent credit extension on the incentives of financial market participants might induce greater risk-taking," Lacker said, adding that this "could give rise to more frequent crises."

Fed Chairman Bernanke's Remarks - Class Day 2008

On June 4, 2008, Chairman Bernanke spoke to Harvard's 2008 graduating class. As you read his speech, note the similarities and differences that exist today versus his own graduation in 1975 from Harvard.

http://www.federalreserve.gov/newsevents/speech/bernanke20080604a.htm

Similarities:

1) Oil price shock
2) Sharply Rising Prices for food and commodities
3) Subpar economic growth

Differences:

1) Subpar economic growth is dramatically different - "it differs in large part because our economy and society have become much more flexible and able to adapt to difficult situation and new challenges."
2) Economic policymaking has improved - we have learned from our mistakes

What is most glaring some 33 years later is that the United States has not enacted an energy strategy. In 1975 crude oil prices increased 4.5X. During the past year we have seen roughly a 2.5X increase. I hope we focus on the longterm and motivate our policymakers to develop strategies instead of focusing on how they are going to get re-elected.

Daily Spotlight: Gasoline Prices

While oil prices pulled back from their highs last week, gasoline prices have continued to reach new highs nationwide. Futures indicate that traders expect the upward trend to continue. The price of a gasoline futures contract one year from now easily exceeds the price of a gasoline futures contract for next month. However, we believe that there is mounting evidence that consumers are finally making meaningful changes to reduce consumption. For the first time that we can recall, AAA actually forecast a slight decrease in travel over the Memorial Day weekend. Commuter rail and bus lines are reporting significant increases in ridership so far this year. Sales of large SUVs and trucks continue to plunge and more are being returned as leases expire. Argus expects last week’s pullback in oil prices to continue and to filter down into gasoline prices. For 2008, we expect West Texas Intermediate to average $115 per barrel.

Source: Argus Research Company, Market Watch, June 2, 2008

Daily Spotlight: Gasoline Prices

While oil prices pulled back from their highs last week, gasoline prices have continued to reach new highs nationwide. Futures indicate that traders expect the upward trend to continue. The price of a gasoline futures contract one year from now easily exceeds the price of a gasoline futures contract for next month. However, we believe that there is mounting evidence that consumers are finally making meaningful changes to reduce consumption. For the first time that we can recall, AAA actually forecast a slight decrease in travel over the Memorial Day weekend. Commuter rail and bus lines are reporting significant increases in ridership so far this year. Sales of large SUVs and trucks continue to plunge and more are being returned as leases expire. Argus expects last week’s pullback in oil prices to continue and to filter down into gasoline prices. For 2008, we expect West Texas Intermediate to average $115 per barrel.