Blame it on Congress!
On Friday, July 22nd, US stocks were within 1.4% of the high set for the year April 29th. Over the weekend, Republican Congressmen rejected a deal crafted between House Majority Leader John Boehner and President Obama. The resulting uncertainty caused stocks to drop 6.7% over the next 7 trading days. When agreement was achieved August 2nd, stocks fell another 4.3% in three days (11% or $1.8 trillion in market cap over 9 days) as investors agonized whether the fumbled legislation would turn US GDP negative in the second half of 2011 (the dreaded "double-dip recession.") In a recent New York Times/CBS News poll, when asked "Do you approve or disapprove of the way Congress is handling its job?" a record 82% of Americans disapproved, only 14% approved. When asked, "What are your feelings about the ways things were going in Washington, "56% were "dissatisfied but not angry" while 28% were "dissatisfied AND angry."
Naturally, we are fielding a number of phone calls and e-mails from clients who worry that the 11% selloff is a prelude to the 55% selloff we saw in 2008-9. As we have mentioned frequently over the last two years, with the system substantially deleveraged, there's very little chance of margin calls creating the cascade of sells that characterized the financial crisis three years ago.
Buy stocks like cans of tuna fish!
Instead, we have a garden variety correction (decline of at least 10%,) which creates opportunities for investors willing to look past the headlines and sound-bites. We have created an investment culture where the whole world gathers at 8:30 AM EST to debate whether the "risk trade is on or off." If the risk trade is "on" then we're supposed to buy stocks, commodities, corporate bonds, real estate, while shorting the dollar, gold and US treasury bonds." If the risk trade is "off," we're supposed to do the opposite. Yes, we can readily accomplish these transactions through various ETF's but what we actually achieving? We're buying assets that are rising in price, while selling declining assets. Isn't that "buy high/sell low?" Won't that lead to wealth destruction?
We believe that our job is to buy assets that are well discounted, while selling assets that trade at a premium. For example, the ten year treasury yields 2.47%, which is a whisper above the 60 year low of 2.17% set December 26th, 2008. A near record low yield implies a near record high price for the ten year. There's no way we would lock a client into a ten year return of 2.47% given almost no chance of further upside, and big chance of a capital loss if we sold that bought a year from now (our expectation is that 10 year yields will approach 4% within a year, which would cause the purchase price of that bond to drop 10.7%.)
What is the tuna fish analogy? Normally, three cans of tuna fish retail for about $5. But sometimes tuna is on special - 4 for $5 dollars. So the logical consumer buys 4 cans. Unless that consumer was facing starvation, he or she would never buy tuna at a convenience store, where the cost is about $5 for 1 can! Investors should buy shares like cans of tuna. Investors should buy MORE shares when stocks are priced at discount, and FEWER shares when stocks trade at a premium.
Right now, stocks are discounted 11% from three weeks ago and actually trade at a level last seen December 1st, 2010. The decline could be justified IF earnings were declining. In fact, unremarked in all the angst of the last month, earnings reports were strong. Including Bank of America's $12 billion write-off, S&P 500 companies, with 64% reporting, grew 10.8%. Excluding BOA and the rest of the financial sector, earnings grew at a 21.5%, which is phenomenal! Revenues grew at a year over year rate of 7.1%, while net margins expanded from 5.9% in 2008 to 9.3% at present. In the environment of near record low interest rates, stocks are at DEEP discount to fair value. According to the Moody's Stock Market calculator, stocks are undervalued by 24-35%, while according to the Morningstar model, US stocks are undervalued by 15%.
The US jobs report gave a glimmer of hope as July payrolls grew more than expected and numbers previously released in June and May were revised up. Still, the gains of 117,000 were only enough to reduce the unemployment rate by 0.1% to 9.1%. Manufacturing gained for the 24th straight month, and the US now produces a record amount of GDP with 7 million FEWER workers compared to 2007. How is this possible? Construction, which obviously employs a lot of people, remains depressed. Automation replaces high quality blue collar jobs in factory settings. Employment in the US auto industry peaked at 1.3 million in 2000 versus the present 712K. Domestic production in 2000 was 13 million cars versus about 10 million expected for 2011. In 2000, the average worker produced 10 cars, while in 2011, the average was 14! Quality meanwhile is remarkably improved over the last two decades.
Following the positive jobs report today, stock prices swung between gains and losses, and closed at the low for the year. Where have we seen this before? April-July 2010. In that time frame, stocks fell 15.6%, erasing all the gains of that year, but still closed out 2010 with a gain of 15.1%. Our forecast for 2010 remains at plus 8%, which would be 13.7% above current levels.
So what are we doing this week and next? Buying stocks!