Making Sense of Employment Data

Lot's of information is reported regarding "employment".  Data comes from the government's BLS and some private firms like ADP.  There's the "unemployment rate" or the % of people looking for work that can't find it--a figure that can really be misleading as the number of people "looking" for work can change depending on economic conditions and outlook.  To make more sense of the unemployment rate, one must also look at the "labor participation rate" which gives the % of "potentially available" that are actually working. Again, it can be misleading as people retire at different ages.  In addition, people "drop out" when employment conditions are difficult and "return" when finding jobs becomes easier.

Perhaps the most meaningful data is from the BLS and shows the total number of full time jobs. See chart below:

The "take-away" here is that employment is improving, but is still significantly below the 122 million in 2007.   Almost 5 million fewer full time jobs now than in 2007, despite a growing workforce and trillions of dollars spent to "stimulate" the economy.

How this affects markets is that it creates "slack" in the labor market
and depresses labor costs---resulting in higher corporate profits but lower corporate revenues.  This is exactly what were are seeing during this and previous earnings seasons.  My take is that people are having increasing difficulty dealing with existing prices of many products and services, causing demand to be restrained, but because of low costs, corporations are able to increase profits, even with lower than expected sales.

This is not a trend that is sustainable in the long term and is one more reason why I recommend being very selective in what segments and companies to own in your portfolio. I tend to prefer companies that provide "essential" and "necessary" products and services that are less "price sensitive".  Every product and service is subject to declining demand with higher prices or slower economic growth; but some are more sensitive than others. 

Part of the market sees a continuation of corporate earnings growth, primarily because they believe that demand will soon accelerate as we get back to and rise above 2007 levels of employment.
Others see that with present rates of employment growth, those levels will not be seen until 2016 and that this slow rate of growth does not justify current stocks prices for many "hot" segment and stocks.

My "take" is that we should expect growth, but that continued stock price increases will increasingly require corporate profits that grow along with increasing revenue.

Danger Signals—Yellow Light

I am an admirer of Alan Greenspan. But, I am also a bit skeptical of comments by anyone who survives a lifetime career working in the political environment of Washington DC.  Alan has written a new book telling us what he has “learned” during his period of reflection after retirement.  In a recent interview, he made this statement about bubbles: “But a bubble in and of itself doesn't give you a crisis. It's turning out to be bubbles with (debt) leverage." He also said, "If you're looking at the distribution of outcomes, fear is hugely more important than euphoria or greed," Greenspan told CNBC. "Bubbles go up very slowing and then they go bang."

 Admittedly, my career as an economist is not as long or as storied as Alan’s, but I guess Alan and I disagree about the definition of a “bubble”. It is my strong belief that a “bubble” is caused by (debt) leverage.  And, it is the spending of money that people don’t have that creates the fear that ultimately causes the bubble to pop.

Without excessive debt, asset prices can rise significantly, but they seldom crash. Think of a rocket versus an airplane.  Rockets rise rapidly until they run out of fuel—then they crash. Airplanes rise too, but even when they run out of fuel, they can still glide back to the surface.  Bubbles are like rockets and the required rocket fuel is excessive debt.

Everyone pretty well understands that the 2008 crisis was caused by excess debt related to housing. Less well understood is that there are people who speculate in the stock market using borrowed money. It’s called “margin”.  http://en.wikipedia.org/wiki/Margin_(finance)

Many people believe the stock market crash of 1929 was caused by excessive margin debt with some borrowing as much as 90% of the stock’s price.  After the crash, the Fed has limited margin to a maximum of 50% of the stock’s price—still a very risky investment strategy.

You will see from the figure that high margin debt rises and falls with the rise and fall of stock markets.  Is it a leading or trailing indicator?   I think it is a leading indicator---people using increasing amounts of money they don’t have to buy stocks causes stock prices to rise beyond the “reasonable” price that a “cash” buyer would pay based on the investment value of the stock. 

Speculators use margin to increase their short term profits—it is leverage—more “lift” with less effort.  But, they know it is risky.  At the slightest sign that prices are falling---they ALL run for the door at the same time, trying to sell and protect their gains or to avoid huge losses.

 Rising margin debt in 2013, fueled by Fed Quantitative Easing pretty much explains the exceptional performance of the S&P500 this year. Prices have now risen beyond the “reasonable” price that a “cash” buyer would pay based on the investment value of the stock for many stocks.   

If you are a “cash” buyer/investor, then it is not necessarily a time to sell, but it is certainly a time where prudence calls for caution when it comes to buying most stocks. (Sort of like 2007 when home prices had risen to a high level because of excess borrowing by buyers spending money that they did not have and could not pay back—not necessarily a time to sell your home, but not a very good time to be buying a new one!) We are currently at record levels of margin debt--every major correction in the past (1929, 2001, 2008)  has been preceded by record levels of margin debt. This time might be different because interest rates are so low, but although history does not repeat itself--it does tend to rhyme. High margin debt is a warning signal to pay attention--there is a potentially dangerous situation forming.

Keep in mind that investors don’t typically own the “market” but rather a unique collection of specific securities. Bubbles tend to cause all stocks to rise, but most of the “froth” shows up in only certain stocks and “hot” sectors.  e.g. Google and Amazon.  Many “solid” companies are still not significantly overvalued and it is likely that quality stocks are still very good long term investments.  (For example, home prices in Las Vegas rose to ridiculous levels and crashed in 2009, but home prices in like York, PA, Texas and Tennessee did not rise or fall as much.)

We do advise clients to hold a higher than average “cash=short term fixed income” balance in anticipation of buying opportunities that present during future market downturns.

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Long Range Strategy Given Present Political Scenario..

With the government shutdown averted, pretty much as expected, with only a short term “truce”, it looks like the “war” in Washington DC is likely to continue for a very long time.  Even if Republicans win the Senate in 2014 by gaining several seats, no faction will have the 60-75% majority needed to make major changes.  Gridlock and continued “drama” is likely until the next Presidential election in 2016. (Elections do have consequences!)

Everybody knows that deficits and our long term debt levels, along with ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) by the Fed are not sustainable in the long run. So far, because of unemployment and a slow growth economy allowing low interest rates, deficits and debt have been easy to bear. The question is: How long will this last?  And, what comes next?

This link will take you to the governments records of revenue, spending and deficits since 1930.  http://www.whitehouse.gov/omb/budget/historicals  It is a remarkable picture and provides little hope that deficits will ever end.  It simply appears that the American system of government does not encourage a balanced budget.  Also, there are way too many so called Economists who foolishly argue that Federal Debt as a % of GDP is the only thing that matters—not the total debt per see. Hence, it is likely that the debt will continue to grow. You should know that the White House now predicts that the debt will “level off” at around an enormous 105% of GDP.

Now to put that into perspective, some think that would be like a family with $100,000 of annual income maintaining a debt level of $105,000. So if that family was able to increase their income by 3% to $103,000, using the “maintain the debt level” concept, they would increase their debt by $3,000—spending $3,000 more than their income.   But wait!  GDP is the income of the entire economy and debt is only the Federal Government’s.  If government income is now 20% of GDP, then the National Debt is really 525% of the Federal Government’s income.  So in reality, it’s more like a family with $100,000 of annual income having a debt of $525,000. Using the argument that it is only important to maintain debt as a % of GDP, that 3% increase in debt caused by the $3,000 “deficit” goes entirely to the Federal Government that would then have an a spending rate of 22% of GDP. This is the argument put forth by some Democrats including Austan Goolsbee, former Chief Economist for the Obama Administration--he regularly reinforces this with appearances on CNBC.  Republicans argue that the Federal Government’s share of GDP should remain the same 20%, meaning that over time the debt as a % of GDP actually decreases. The “deficit” in this example would be no more than $600=20% of the GDP increase. And debt as a % of GDP would go down to 102.5% in the one year of the example given here—decreasing each year over time.

This is really what the struggle regarding the debt ceiling was and is all about. No matter what the media says about polls regarding approval ratings and public opinion, those that just want to “get along and go along” are really not doing the country any service. Democrats want the Federal Budget to go up and are comfortable with a lot of debt. They are convinced that higher taxes will solve the problem. Moderate/Traditional Republicans, even those who call themselves "Fiscally Conservative" are OK with the Federal Budget and Debt rising albeit at a slightly slower rate. They are against higher taxes.  Conservatives are demanding that the Federal Budget be restrained with spending AND taxes at somewhere around 18-20% of GDP--This would actually result in taxes  slightly higher than they are today. The present stalemate with big deficits and rapidly rising debt is a very serious threat to our future prosperity. The argument supporting high debt levels (100% of GDP) is like the assumption made by borrowers and lenders that led to the 2008 Financial Crisis—that nothing bad would happen unexpectedly and that incomes would rise steadily. (The assumption that a person with $100,000 income could carry a $525,000 mortgage----Certainly possible as long as they don’t lose their job or get sick and as long as their income rises over time---and as long as interest rates don't rise too much.)

As an investor, you should hope that the Conservatives continue to argue their position as they at least restrain the other groups to some degree. History teaches that US prosperity requires a Federal Debt as a % of GDP in the range of 30-60%--a substantial reduction from present levels.  Failure to move in this direction will surely lead to slower economic growth due to inflation, substantially increased taxes, or both. Since it is unlikely that this substantial reduction in debt will occur before 2016, it seems wise to prepare your investment portfolio for a slow growth economy with both rising inflation and rising taxes expected--sooner or later. This calls for a conservative strategy of owning a portfolio of high quality stocks—highly diversified by industry and geography, but with a focus on profitable companies that increase their dividends regularly.

We have been focused on risk of recession with resulting deflation for several years. I humbly submit that the risk of slow growth with inflation and rising interest rates along with much higher taxes is the most likely future scenario to prepare for at this time. (Think 1970’s and Jimmy Carter--sort of.)

 

The Real Source of Argument

Important to understand why so much fuss about spending and debt..

This graph is alarming to some....especially since the federal government is still spending 20-25% more than it takes in each year.

At what point does DEBT AS % OF GDP reach crisis levels where interest rates rise causing deficits to increase significantly faster than revenue?  Nobody is quite sure.

Even if budgets were balanced with no more deficits, at an economic GDP growth rate of 3% per year, it would take 24 years of fiscal discipline for the debt to return to "normal" historical levels!

What to do as Shutdown lingers..10/16/2013

Just want to assure our clients that I am paying close attention to the unfolding budget/debt drama and am ready to recommend and take action as necessary and appropriate to manage your investments according our clients’ goals and objectives.   As always, I stand ready to answer questions, process transactions, and put forth best efforts to manage portfolios with the same dedication, diligence, skill and judgment demonstrated over the past several years.

You will recall my repeated observation that investors always have one of three choices in response to external factors—buy, sell or hold. Hold is another word for “do nothing” or “stay the course”.  Since 2011 you will note that I have advised the best course of action is “be cautious” and for the most part “stay the course” during this period of “stormy weather”.  So far, that has proved to be good advice. I firmly believe it is still the right advice today.

Despite the media “hype” and “public despair” and predicted doom from a government “default”, today (10/16/2013) the S&P500 reached a near all time high on “hope” of an uncertain “deal” to end the current crisis. Why is the market up during all this? 

First, markets expect a “kick the can down the road” temporary truce---i.e. more of the same. US Treasuries are still expected to be the most safe and liquid investments in the world—for the most part, competing securities are still seen as more risky. China, Japan, and Germany all need a place to invest the money they earn from exporting to the US—either US Treasuries, US Corporate Bonds, US Real Estate—or US Equities. Actions that make US Treasuries look less attractive may actually make US Equities rise in value.

Second, markets expect that the Fed will “do what it takes” to continue the stimulus needed to inflate stock and real estate prices—i.e. more of the same.

As strange as it may seem, markets like “more of the same”---change or a fear of change is what causes markets to fall.

So what to do?

Since you are a long term investor and not a gambler---no action is recommended to anticipate any deal or lack of a deal. Predicting an uncertain outcome is like picking the winner of a horse race—it is gambling.  Markets could suffer a brief panic and a significant decline (maybe back to early 2013 levels) over an unexpected delay in reaching an “deal” but history teaches they will recover quickly.  In this case, our recommended reaction to a down market would probably be to increase ownership of equities—but let’s wait and see.

P.S. About the politics of all this….

The Media reports that Republicans have lost a lot of support because of this shutdown. Yet, it is doubtful that this will change the outcome of House elections in 2014.  Few regular voters are unhappy with their own representative despite some “throw them all out” polls. The most recent Gallup poll shows the leader of the House (Republican Boehner) and the leader of the Senate (Democrat Reid) tied with a low 27% “favorable” rating. The President seems to have done better, maintaining a 49% “favorable” rating.  There is a philosophical war going on in Washington. It used to be a just a struggle about how Big Government would spend our money along with whether deficits would be funded with increasing taxes or increasing borrowing.  There is now a strong and growing group who want the federal government to get smaller—a lot smaller. (The Tea Party is only a small part of the "we want smaller government" group. The larger and underestimated group is probably the Evangelical Christians that are less vocal but still irritated by the actions of a large "secularized" central government.) They really don't like the traditional Republican program any more than they like the Democrat's program. This group sees the present course of deficit spending leading to a catastrophe and they believe that raising taxes to cut the deficit would also end in catastrophe. (An analogy would be the actions of the passengers on the Titanic if 20% of them had been absolutely sure that the ship was headed for an iceberg.)  I don’t see this group “surrendering” so I would predict continued and perhaps even increasing turmoil in Washington----and I predict that markets will adapt to this new uncertain environment. Perhaps they already have. I also predict that the most likely future is that bond markets will force government spending to be cut and taxes to be raised—this will occur when interest rates rise significantly from present low levels.

Historical Perspective of Washington Dramas

Please keep in mind, that although I do have strong political views about the proper role of the federal government in our lives, my commentary about clients’ investments focus NOT on how politics “should” be, but rather the best strategies for dealing with current political realities.

The present political reality is that we have a government influenced by sharp political differences. And, the electorate has allowed one side to have “veto” power over the other.

One only needs to read the biographies of Alexander Hamilton and George Washington as well as other historical writings to learn that our present situation is not much different from that in 1790 and most of our history as a nation.

Our founding fathers “compromised” to create the system where a 55% majority (53% in the 2012 presidential election.) vote does not give the “winners” the right to force the “losers” to submit.  (Only once in our history did our leaders fail to compromise—when the minority decided to secede and the majority sent an invading army to subdue and conquer them.)  As evidenced by the US Constitution that requires 75% approval for an Constitutional Amendment to pass, generally unless one side controls 66-75% of the electorate—some form of “negotiation” is required for anything of any importance to get done. (Many believe that this protection of the minority from the will of the "mere" majority is what makes us a great country.)

Unfortunately, some negotiators choose confrontation rather than consultation as a strategy. One side makes a demand, and the other states “I will not negotiate”.  In Game Theory, this is called “Chicken” where the loser is the one who gives in first.  It is a proven fact that most mature and rational people hate to “deadlock” or “fail” in a negotiation. But, for some reason, our centralized federal government has always been full of people who believe that when playing Chicken, even if there is a “crash” because of a deadlock, they can still win…in the NEXT ELECTION. (Perhaps we should elect people who are great negotiators rather than great orators and campaigners.)

Both sides of the present argument believe that they can gain control of BOTH the House and Senate in the next election in 2014 if they can paint the other side as “Bad” or the “Most Worse”. Since control of BOTH the House and Senate is a big deal—especially with a lame duck President, expect a very serious fight.  I think the probability is that it will be as big as 2011. Our massive debt and deficits magnify what is at stake.

So let’s see how the threat of default and a “historic” downgrade of US Credit has affected investors:

In June 2011, the S&P500 was at 1345. It fell 18% to 1099 after the deadlock on raising the debt ceiling. It recovered back to 1345 by February of 2012.  Basically, a seven month long headache.  For those that did nothing from June 2011 to February 2012, nothing really changed. 

The negotiation and “settlement” in 2011, set up another confrontation in late 2012---the Fiscal Cliff and Sequestration. The S&P500 peaked at 1465 in September 2012 (falling 8% by December)  but quickly recovered to 1465 by January 2013. The S&P500 reached 1700 in September 2013.  In two years of almost never ending Washington drama, the S&P500 rose 26%.

Trying to profit by selling before the crises and buying at the bottom is not an investment strategy—it is a gambling strategy. Nobody knows exactly what will happen and when. Most of my clients are not gamblers—so other than being conservative and patiently waiting and looking for buying opportunities with surplus cash—my general advice is to simply watch the drama play out.

It is impossible to predict the exact outcome. But, history teaches that markets USUALLY recover remarkably quickly and those that continue to hold a diversified portfolio of good quality investments get wealthier over time.

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

When the Press warns of all the bad that MIGHT happen...

My advice is to avoid any anxiety related to the political comedy in Washington DC.  Short term market reactions to the recent “2011 Debt Downgrade” crisis and “2012-2013 Fiscal Cliff and Sequestration” crisis have proven to be overdone—essentially buying opportunities WHEN looking back from a long term perspective. It is impossible to predict the market reaction to the present shutdown and debt ceiling controversy, but the end result is probably that we simply return to the market realities of a long term slow but steady growing economy where inflation begins to become more of a problem.

My greatest fear STILL continues to be real inflation over the longer term and a diversified portfolio of good quality assets is one of the best strategies to address that risk.

 

Just look at the rising cost of groceries, medicine, health insurance, college tuition; and government reports of low 2% inflation seem laughable. I think fixed income markets are still underestimating inflation risks and bonds continue to look potentially dangerous—an environment that is very different than what we have been used to for twenty plus years.

 

 

On the Government Shutdown…

As investors, we should be thankful for politicians who stand by their convictions and struggle against actions they believe result in our sacrificing freedom for security—even when the “majority” condemn them for “causing trouble”.   

Here is some wisdom about the subject spoken nearly 50 years ago during a time of similar struggles regarding the expansion of central government and welfare programs.

“You and I are told we must choose between a left or right, but I suggest there is no such thing as a left or right. There is only an up or down. Up to man's age-old dream--the maximum of individual freedom consistent with order -- or down to the ant heap of totalitarianism. Regardless of their sincerity, their humanitarian motives, those who would sacrifice freedom for security have embarked on this downward path. Plutarch warned, "The real destroyer of the liberties of the people is he who spreads among them bounties, donations and benefits."”

Ronald Reagan  1964 “A Time for Choosing” speech

No matter what your politics…if you are an "investor"....

For those that rely on income from savings, through wise investment and free markets, it is important to remember that success of such investment requires a society that values and protects individual freedom/s and free markets.  Without the ability to earn an income from savings accumulated from past labors, we would ALL become wards of the centralized government, dependent on that government and those who run it for our welfare. ..in other words, no longer “free”.

Being reminded of the importance of “the maximum of individual freedom consistent with order” and the dangers of too many “government bounties, donations and benefits” is the value of having a “loyal opposition” to those who claim to represent the “majority” currently in power. It is necessary protection against excess power--however well meaning.