May You Live in Interesting Times

Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

Economist CoverWith the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

SPY is oversold

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.

Back to the Numbers

The last few weeks has produced a cornucopia of reviews, forecasts and other opinions about where the markets are going in 2011. The year end is a great time to gloat about trades that worked well, make excuses for trades that did not work and rework old investment arguments.

The titles of most of the recommendations are designed to get the heart racing. Will the US “Empire” collapse over the next ten years? Will Gold and Silver climb to new heights? Or, are they already in a bubble that is about to pop? Is the Euro doomed? Will China overheat and collapse? Will China be the largest economy in 2020? Peak Oil again? Inflation? Deflation? Hyperinflation? All of the above? Investors are too bullish? Baby boomers are never going to invest again?

Top-down look

As a very astute strategist once showed me, when in doubt, one needs to junk most of your preconceptions and start with the basics. Two great places to start are the Economic Cycle Research Institute and Shadow Government Statistics websites. We will also look at a newish contributor to the economic puzzle, Consumer Metrics Institute.

The place to worry about is the US economy and the numbers are suggesting that things are not as awful as some of the doomsayers would have one believe.

Economic Cycle Research Institute

Economic Cycle Research Institute

Source: ECRI Website

When this well followed index plummeted in the first half of last year, a number of investors were ready to crawl back under their rocks. Throughout, however, the tea leaf readers at ECRI insisted that the dip in their leading indicator meant a slowdown and not a double dip. So far, it looks like they have gotten it right once again. With the ECRI leading indicator moving back into positive territory we look set to experience a mildly positive US economy in 2011.

Will that mildly positive economic backdrop include a revitalized US consumer, ready to ramp up newly issued credit cards? With consumptions still responsible for 70% of the GDP equation in the US, this is a critical issue. If the US consumer decides to return to old trends, most of the forecasts of US growth out there are wildly conservative.

There are two places to check the likelihood of that without too much of a lag and both suggest that the US consumer will continue to be the “dragging anchor.”

Shadow Government Statistics

The first place is the money supply growth figures from I prefer Shadowstats to the excellent St. Louis Fed site because Shadowstats continues to plot the M3 series (amongst many other useful economic statistical feats). Since government statistics tend to lag badly at turning points, any consumer revival at this point will first show up in the money supply figures (ie. consumers releveraging and more demand for credit). As banks open up revolving credit facilities and start selling those collateralized obligations to the market, we should see sharp pick-ups in the M2 and M3 measurements. Obviously, we have not seen anything impressive yet but there is no doubt that the crunch has started to taper off. That supports the forecasts that are looking for moderate US growth (say 2.5%-3%).

Money Supply Figures from Shadow Government Statistics Website

Although M3 is still in negative territory (the shadow banking system is still deflating), M1 and M2 are starting to make forward progress.

While the Money Supply figures will show us how a renewed demand for credit will flow through the system and may give us early indications of what is going on, it is a blunt instrument. To gauge the health of the US consumer, we need to look at more precise measurements.

Consumer Metrics Institute

The third data check comes from the Consumer Metrics Institute which attempts to use modern methods to capture consumer data in a near real time fashion.

In their main chart, the consumer sector is still contracting. We see a bit of improvement but not the strong bounce one usually sees coming out of the previous few recessions. This should not be too surprising since the end of the “home as ATM machine” phenomenon was theme song of the Global Financial Crisis.

Chart from Consumer Metrics Institute webpage

So, what does it mean?

To put this all in perspective, we need to look at the global economy’s different parts.

The US is just under 25% of the world economy and an important engine of growth. That engine is sputtering today because the US consumer is still weak. However, we are still seeing some recovery and growth this year should come in around 2.5%-3%. Looking at that rest of the developed world, the EU is just over 25% of the world economy and likely to grow at somewhere around 1.5% this year. Although parts of the EU (Germany) are doing well, for the most part, it is suffering from the sovereign debt crisis which will mean austerity programs on the periphery and more damage to bank balance sheets in the core. Add in a graying, two decade non-grower like Japan (just under 10% of the world economy) and you have most of the developed world (60% of the world economy) in sluggish growth mode.

So, while there are bright spots of consumerism in the emerging markets, the “global consumer” as a whole is not likely to come charging back in 2011. However, that does not mean 2011 will be a slow news year. Demand for commodities grows apace in the big developing economies. Currencies will continue to realign. And cashed up corporations are set to increase the tempo of Global M&A deals by almost 30% this year according to Thompson Reuters.

What to look for this week

OK, now that we have a framework for the year, here’s what looks good in the here and now.

Over the past few weeks, there has been a definite shift from Asia and Emerging Markets in general back towards Commodities (Metals and Energy in particular), the US and Technology.

Some of that strength is due to inflationary pressures but part of the strength is definitely due to the increased pace of M&A activity. As one might expect with weakened consumers in the developed markets, producers of globally traded consumer goods will have trouble pushing through price increases but demand for resources will put pressure on costs. That will lead to margin squeezes which will compel corporations to seek fresh productivity gains. Therefore, it is no surprise that corporations with cash are looking to buy competitors, integrate vertically and invest in IT systems to streamline and drive down the costs associated with production and fulfillment.

As one might expect in January, we are also seeing improved numbers for most small cap ETFs and Funds in the US. From our perspective, the January Effect is just another indication that the Efficient Market Hypothesis continues to fall well short of its boosters’ goal of explaining financial markets and providing a comprehensive tool to invest with.

Seeking Alpha Portfolio

Seeking Alpha ETF Portfolio RankingAs we end the 8th week, the SA Portfolio has kicked Hong Kong (EWH) out of the top ranking in favor of Global Energy (IXC). If EWH can hold up, we should be leaving with a tiny profit and we should be able to afford 250 shares of IXC at Monday’s closing.

If you go to the always informative iShares holdings page, you can see that IXC is a who’s who of the big names in big oil around the globe with ExxonMobil and Chevron at the top of the list. If you prefer a more US oriented ETF, XLE (SPDR info page) is also headlined by ExxonMobil and Chevron but also boasts a number of US Exploration & Production names that are rumored to be at the top of the M&A target list for 2011.

The performance for the week was up 0.9% which leaves us a bit underwater since the beginning of the exercise at -3.88%. In 20/20 hindsight, I should have started up this portfolio in a less volatile part of the year (August, say) but I am still confident that the “System” will keep us invested in the “sweet spot” of our universe. On the subject of investment universe, as we approach week 12, it is time to indulge in a quarterly review of the universe to see if we need to make any adjustments.