May Outlook Newsletter

Greetings,

There’s a lot of optimism out there.  Personally I really appreciated a break from endless bad news – or at least less bad news than what we had for the first three months.  Or maybe I’ve just become numb to it all and the market’s continued upside sprint gives hope that the world is not coming to an end.  That said, there still lies enough uncertainty that I vacillate between cautions optimism and guarded pessimism. So let’s look at where we are.

The Fifth Inning

Part of the optimism has come from the latest GDP report that showed a bump in consumer spending for Q1.  That, however, could prove to be a false start therefore I think it serves us to wait a bit before doing an end-zone dance.

The first quarter GDP numbers were stunningly bad showing the economy contracting at an annual rate of 6.1%.  The consensus view was a milder -4.3% but economists missed the huge inventory correction which accounted for roughly 3.4% of the contraction.  That’s actually good news inasmuch as businesses are adjusting their balance sheets more rapidly than what was expected. In the mean time personal spending increased by 2.2% – which many took as a sign of the beginning of the end.  Regarding that, I don’t know if we can take that as a real sign of progress.  Personal spending was so dampened in the prior quarter due to credit constraints on durable goods that this bump could be nothing but a bit of pent up demand being released.  It’s hard to tell for sure – even though some retailers have reported modestly higher sales – but one quarter does not a trend make.  Furthermore, it appears that most of the spending happened in February while March turned back down.

As noted above, however, the sharp reduction in inventories bodes well for an uptick in manufacturing.  Now this certainly won’t be true across all sectors and industries – like automotive, which still has huge levels of unsold cars on lots across the country.  In contrast, while listening to Intel’s conference call, they projected that a bottom has been reached in the PC market and demand was showing signs of picking up. This general trend in IT looks more positive than most sectors.  From a cyclical standpoint this makes a lot of sense inasmuch as when businesses run into hard times they look for ways to increase efficiencies through technology.

Now, don’t get me wrong.  Not a single indicator, besides the perhaps anomalous blip in consumer spending, was positive. When economists talk about “green shoots” what they are really talking about is an upturn in the 2nd derivative.  In other words, a slowdown in the rate of deterioration.  If your interested in knowing more about that I blogged about it a few days ago and you can find it here.

Calculated Risk has a good take on where we are in the business cycle and particular attention should be paid to residential real estate.  I don’t think we’ve come close to a bottom yet and that has everything to do with consumer spending.  The good news is that, according to Mike Shedlock, low interest rates will help those with variable rate mortgages thus, at least, won’t make foreclosures worse in the near future.

Speaking of interest rates, no matter what the Fed is doing to keep long term rates down there seems to be more external forces than they are willing to deal with.  The 10 year bond has increased it’s yield from just over 2.5% to 3.17% since the Fed announced its quantitative easing in March.  At the same time the good news is that high yield commercial bonds spreads are narrowing quite significantly as credit starts to flow again in the capital markets.

The Fed also announced yesterday that it was creating a lending facility for commercial real estate mortgage backed securities.  I’ve been calling commercial real estate the next shoe to drop in the credit fiasco.  Apparently the Fed agrees and is working to bolster liquidity in that market.  By some estimates the amount of CMBS refunding through the end of the year is near $700 billion.  Combine that with the huge amount of Treasury borrowing that is projected and liquidity is an issue.  In fact, the country’s third largest commercial REIT, General Growth Properties (NASDPK GGWPQ.PK) filed bankruptcy in April because they weren’t able to refinance their debt.

To summarize the state of the economy I’d say we’re roughly half way through the cycle.  I reserve my right to change my position, however, and if I was to make a bet on the over/under on my prediction I’d take the under.

Investment Outlook

From a macro view I think that the broad markets are quite a bit overbought right now.  Many technical analysts set upside resistance for the S&P 500 at 875.  Although, on a intraday basis, we breached that number by 13 points yesterday morning, the market has failed to break it on a print at the close.  The funny thing about technical analysis is that, since so many people use it, it can be a self-fulfilling prophecy. According to a Barron’s survey of institutional investment managers last week  a good majority think that the S&P 500 will see 1,000 by year’s end.  A similar percentage likewise think that we’ll test the March lows before that happens.  Todd Harrison of Minyanville is of that mind as well. He’s calling 2009 “The Year of the W” and given that I think he’s the best prognosticator on the street I have to give his opinions the respect they’re due.  Another great Minyan, Vinny Catalano, thinks that stocks are overvalued  here.

From a fundamental valuation perspective, there are an increasing number of reasons to be more cautious - most notably, the high P/E levels. At current price levels, the S&P 500 operating earnings for this year must come in around $60 to justify an average times P/E of 15 (15 x 60 = 900). While there may be a good case to be made for an average times P/E of 15, it’s hard to deny that these are anything but average times. Fraught with many unresolved problems, I find it hard to buy the average times P/E as being prudent. A number more like 13 or 14 times (thereby producing an S&P 500 fair level of 780 and 840, respectively) seems more appropriate. .

Accordingly, although I don’t have a crystal ball, I think he’s right and so I have stops on most, but not all, of the assets in the portfolio under the heading of asset preservation.

My bias has been to move into longer positions in certain commodities such as copper and natural gas and I’ve taken positions in a couple of tech names – with really strong balance sheets – as well as low-end retailers who should hold up in the event of a downturn.

As I write this the portfolio is up about 5.47% year-to-date against a loss- in the SPX of 3.19%.  I’ll admit that I missed much of the big rally from the March lows but I also missed much of the big bear that preceded it in January and February.  Caution was and still is the order of the day.

But going forward I see there is probably some money to be made as inventories start to be rebuilt.  I’m looking at things that are used as input goods to component manufacturing such as makers of polysilicone used in micro-chip and solar applications.  I also think that companies will be investing in technology process improvements in both the data hardware and software spaces. In every economic downturn surviving companies look to increase operating efficiencies through technology and I don’t suspect that this time will be any different.

As I’ve written before, we’ll really have a better understanding of the end of the downturn when “things that come out of the ground” significantly increase. Everything starts with raw materials.  Right now I like copper mostly due to the massive infrastructure projects on the drawing boards worldwide and it soon might be time to look at aluminum as well.  I still think that infrastructure engineering companies are an interim good bet but many of them have had their run and they’ll back off  providing a better entry point.

Over the longer term I suggest that we all look to how we eventually get very long in both stocks and commodities.  While we may be seeing some deflation right now – which is good for cash – I doubt the Fed’s ability to pull back the money supply in time to choke off eventual inflation.  That may be a year or two out but my best guess, having been a Fed watcher for a few decades, is that the dollar is at risk of being clobbered at some point.  The last thing we want to have is a lot of cash when that happens. But on a cautionary note, I still think gold will prevail in the long term as the best dollar protection, but I’m not ready to go way long in it right now since I think we have some time before the great deleverging is finished and the risk of higher deflation passes.  So if you’re a gold trader that’s fine, but as a core holding I think there’s a better entry point.

I guess the moral of the story is that there still is significant risk out there and the need to balance the downside is equal to need to keep in the game for whatever upside eventually comes about. In order to profit one must be nimble.

If anyone would like to talk about their specific circumstances please don’t hesitate to drop me a line or call. And don’t hesitate to pass this forward to anyone you know who may be interested.  It’s a tough environment and sometimes we need all the help we can get.