Much churn but no progress in US stocks until the budget impasse is settled. The gist of the conflict is that the Obama administration wants tax increases AND spending cuts to accomplish deficit reductions. The Republican controlled House of Representatives wants no tax increase AND dramatically larger spending cuts. In essence, Democrats want the pain of deficit reduction to fall on the wealthy, while Republicans want the pain of deficit reduction to fall on the young, the elderly, the jobless and the uninsured. We don't generally think of ourselves as "socialists," but right now we're rooting for the Democratic package. Historically there's little evidence that reducing the tax burden on the wealthy increases employment, so we'd take a risk that increasing taxes on the wealthy (obviously our own clients) would have little negative impact on economic growth. Our bigger concern is the societal impact of not taking care of our own citizens.
Theoretically, the 2008-9 recession ended two years ago. US GDP is at an all-time high of $13.44 trillion through Q1 2011, which exceeds the previous record of $13.340 trillion through Q4 2007. This output was achieved with 7 million fewer workers than 4 years ago, as businesses substitute automation and job outsourcing for employing Americans. Corporate profits are nearing the record high seen Q3 2006. If we as a society cannot figure how to get 8 million (the extra 1 million includes population growth) unemployed back to work, we risk permanent injury to our status as a world power.
Data points from Nantucket Island
Successful investment analysis requires examining thousands of data points/month from the macro (the US unemployment rate) to the micro (the operating margin of a specific company) to the anecdotal (personal observations of economic activity.) One our favorite anecdotal laboratories is Nantucket Island, 30 miles southeast of the Massachusetts coastline.
Nantucket is one of the least representative localities of the United States. First settled by Europeans in 1659, Nantucket through 1840 was the "energy capital" of the United States. Sperm whale oil harvested by Nantucketeers traveling as far as the Antarctic Circle was prized for its bright light and smokeless character. Within two decades, the whaling industry collapsed as whales were hunted to extinction and kerosene derived from Pennsylvania petroleum discoveries proved cheaper and easier to extract. The town, and surrounding sand dunes, entered a state of hibernation which did not end until Nantucket was rediscovered as a vacation destination in the 1930's and then after World War II. Nantucket maintains a year round population of 10,000, which swells to 56,000 over a 10 week summer season.
Why do we find Nantucket so interesting? Generally speaking the families that "summer" on Nantucket represent the top 1% of incomes and assets of any families in the entire country. These visitors, whether corporate chieftains, media moguls or political operatives, are the decision makers and opinion shapers for the rest of the country. In the summer of 2009, these decision makers were so frightened that families with $10 million in the bank were afraid to buy a T-shirt on Main Street. In the summer of 2010, families unwound a bit and actually went out to dinner, though the reduced patronage put a number of island restaurants and retail stores out of business.
- A local carpenter mentioned he was working 6 days/week plus overtime.
- A boat builder mentioned he was working 7 days/week through August
- Local restaurants reported record sales over 4 of July weekend, with lines of 30 or more outside most bars
- Tourists on Main Street are staggering with shopping bags
- The yacht club parking lot fills up by 11 AM on a weekday
- The Stop and Shop parking lot fills up by 10 AM everyday
- The owner of a graphics store reports revenues are up 30% year over year. Why? Construction blue prints for $1-7 million homes to be built starting September 1
- A local organization, Nantucket Community Sailing reported record corporate sponsorship for Nantucket Race Week and solid individual contributions.
So what? The big picture question we want to answer is whether the slowdown in economic growth and the uptick in unemployment we saw through the first half of 2011 means a double-dip recession, or a pause before a surge of growth in the second half. Based on what we see not only in Nantucket but from hundreds of other data points we have collected around the country, we believe that economic activity will increase over the next 12 months. We believe that the Americans that make decisions have crawled out of their bomb shelters, looked around the landscape and realized that the country is still standing. These American still have jobs, their houses still have value, if not the peak values we saw in 2007, and their stock investments have doubled from the low. If anything, there is an opportunity for smart companies to invest in people and physical plant and steal market share from warier competitors. There are certainly plenty of competitors in China and India investing aggressively now to steal market share from American companies.
What can the US government do to promote economic growth?
The answer is: the US government already saved the banking system, the automobile industry and the hundreds of industries that depend on cars. The Federal Reserve lowered short and long term rates to levels not seen since the 1930's and flooded the market with credit even as conventional banks have rationed credit. At this point, further efforts by government agencies are like "pushing on a string." We like the idea of rebuilding or upgrading national infrastructure including highways, bridges and railroads, but it will take years if not decades to get those projects off the ground. For sure, cutting entitlement spending such as Social Security, disability pay or unemployment insurance would have a crippling effect on the economy today, as those funds get spent immediately. Tax cuts are generally absorbed into savings, unless permanent. The Reagan era tax cuts significantly boosted economic growth. Who even remembers the one-time tax rebates handed out in 2009?
We expect (hope) reason will prevail in Washington and that the debt impasse will be resolved by August 2. In November 1995, House Speaker Newt Gingrich went head to head with President Bill Clinton over the national budget and succeeded in shutting down the government for 5 days in November and then for 21 more days in December 1995-January 1996. Average Americans were so disgusted by this performance that Republicans lost control of Congress and Gingrich stepped down from office in 1998 after 11 terms in the House. President Obama knows this history, as does current House Speaker John Boehner. We believe when push comes to shove, the Republicans will extract the proverbial "pound of flesh" and then settle with hours to go before the deadline.
About ¼ of S&P 500 companies have reported earnings. Bank earnings are poor, especially considering the $12 billion loss experienced by Bank of America to dispose of its mortgage problems related to the Countrywide Financial purchase (worst trade of the decade!) The materials sector saw a huge gain as commodity prices doubled in the last two years. Technology earnings impress with year over year gains of 34.0%. Excluding financials, S&P 500 earnings grew 27.2% while revenues are running above expectations with growth of 7%. As we have pointed out with ever more frequency is recent years, the earnings of US companies depend on world conditions, not domestic conditions.
On that basis, we have started investing recent cash deposits.