Merry Christmas !

Carol and Wayne wish you and your family a Merry Christmas and a Happy New Year.

 

http://www.youtube.com/watch?v=LMYm8C6XYlk

 

Market Commentary 11/29/2010

End of Month and End of Year Volatility--International Turmoil

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http://www.youtube.com/watch?v=et81jKq6Ne8




Please remember that Market Commentary for Friends and Clients is for educational purposes only and is not investment advice for any specific individual. Please contact Wayne for any personal investment advice.

This new "Wayne and Carol" interview has been created using new xtranormal.com software that allows typewritten input to be converted to speech. We hope it is more interesting that just printed text, but just as informative and valuable.

Market Commentary 11/15/2010

A Week with a Great Deal of News!

Click on this private YouTube link:

http://www.youtube.com/watch?v=GeREW-atmAU



Please remember that Market Commentary for Friends and Clients is for educational purposes only and is not investment advice for any specific individual. Please contact Wayne for any personal investment advice.

This new "Wayne and Carol" interview has been created using new xtranormal.com software that allows typewritten input to be converted to speech. We hope it is more interesting that just printed text, but just as informative and valuable.

The Paradox of Global Recovery

"Originally a paradox was merely a view which contradicted accepted opinion. By round about the middle of the 16th c. the word had acquired the commonly accepted meaning it now has: an apparently self-contradictory statement which, on closer inspection, is found to contain a truth reconciling the conflicting opposites. . . . “ (J.A. Cuddon, A Dictionary of Literary Terms, 3rd ed. Blackwell, 1991)

Even optimistic Americans seem to become a bit uncomfortable when facts and projections about a global “recovery” are discussed. We are used to, since 1945 being the “dominant” economic force in the world and are skeptical when we are told that the world is growing without us being the dominating force for that growth. How can corporate profits be increasing when there is record unemployment in the US and real estate is depressed?

Here’s part of the answer…

The US economy is very big. Even after the recent contraction, it still represents more than $14 trillion per year. (In other words, $14,622 billion.) On an inflation adjusted basis, it is now more than twice as large as it was in 1980. In 1980, a 3.5% annual increase in GDP represented an increase of $227 billion. The US economy in 2010 will probably grow by more than $227 billion. To put this in perspective—the economic output for the entire US will grow more in 2010 than the entire annual economic output of the State of Maryland. In percentage terms, that is slower than in 1980, but in total dollar terms, it is a very big number.

The biggest story however….

Global Trade is now arguably bigger than the total US economy and growing rapidly. Global Trade was in excess of $15 trillion (2009) and forecast to grow by more than 9% in 2010. Companies that are successful and participating in Global Trade are earning profits and the value of their equities (stocks) are rising. But, Global Trade is very competitive and requires a high degree of productivity; It may not contribute to local employment as much as “domestic” business, like residential construction.

The US economy and the economies of some European countries overdosed on residential and retail/commercial real estate during the last 10 years. (Speculation fueled by debt always ends in disaster.) The current difficult part of the US economy in terms of unemployment and declining real estate prices is the “hangover” from that overdosing and binge.

In addition to current Global Trade, consumption outside of the US is growing fast. We used to think of the world economy as three equal parts: the US, Europe, and The Rest of the World. Now, the world economy is four equal parts: the US, Europe, Asia/India, and The Rest of the World. There is now more total wealth in Asia/India than in the US—and therefore, more potential customers for goods and services made by global companies that you can invest in.

Economic activity, estimated to reach nearly $50 trillion for the entire world in 2010 will be the highest in history, having recovered completely from the big drop in 2009—probably exceeding 2008 in real terms by at least 1%. This is despite the fact that the US economy, while “recovering” is still not “recovered”—with GDP for 2010 in the US still slightly below 2007.

Keeping things in perspective: The US has been the world's largest national economy since 1870 and remains the world's largest manufacturer, representing 19% of the world's manufacturing output. Contrary to popular belief, the US was still the largest exporting country in the world for 2009, although Europe as a region, counting only exports outside of Europe exported about 25-30% more. In 2010-2011, China will probably be exporting at levels equal to or higher than the US.

Can the stock market go up and investors prosper, even if the US economy grows slowly?

The answer to that question depends on whether the rest of the world can and will grow without the US in the lead. This has been the debate about what has been termed “economic decoupling”.

My view is that the world will not decouple, but the world economy will become even more inter-dependent. Slow growth in the US will be a drag on global growth. But, the wealth that has been created and accumulated in other parts of the world will no doubt begin to increase demand for US products/services and ultimately bring growth and employment back to historically normal levels. The change is that instead of focusing on producing goods and services for US consumers, our businesses (and their stockholders) will have to shift focus toward satisfying consumers and customers in other countries. The rest of the world will help us to recover from our binge on residential real estate and excess debt.

The paradox of global growth and domestic stagnation is in the truth and simple fact that the huge US economy is having to, and will have to continue to adapt to the reality that for us to prosper, we need to focus not just on selling to and serving ourselves, but the other 95% of the human population living elsewhere as well.

The economy outside the US has recovered and is growing—and the best companies and their stockholders focused on this global economy are prospering accordingly. History teaches us that absent global military conflict, that trend will probably continue.

One caveat is that this global growth could be hurt by ill-advised government actions around the world. Unrestrained real estate speculation and excessive government intervention in China as well as a growing socialist agenda in Brazil are concerns. The growing countries must recognize that continued growth requires an expansion of global trade, which relies on increased imports as well as exports. The US has reached its limit in terms of capacity to absorb the world’s exports without a corresponding increase in reciprocal trade.

Let’s also hope that our government soon wakes up and recognizes that our future leadership in the world lies not in wealth re-distribution and expensive military adventures, but wealth creation in a very competitive world. A competitive, productive workforce, supported by a business friendly government and a superior infrastructure, creates employment and prosperity.

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.

Is This Time Different?

In a past issue of Forbes Magazine, Gabriel Wisdom wrote an article titled “The Four Phases of Market Cycles”. Phase I: Pessimism and Abject Fear; Phase II: Skepticism; Phase III: Optimism; and Phase IV: Euphoria.

I wrote last month that “Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet.” I think that it can be safely said that for the most part we are in Phase II: Skepticism. Markets have risen dramatically from their lows, but recent declines in June and August had caused some to even fear that we had fallen back into Phase I.

According to Mr. Wisdom, “If you wait for optimism, you missed it.” This is sort of like Warren Buffet’s quote: “If you wait till you see the Robins, Spring has already arrived.”

The important point to remember, is that your investment strategy must ANTICIPATE the movement from one phase to another. If you wait until the markets enter Phase III: Optimism—then you will have missed most of the upside. The time to be fearful is during Phase IV: Euphoria.

Many investors are rightly disturbed by the negative uncertainty of high unemployment, a terrible real estate market, excessive debt, government deficits, and potentially rising tax rates. Even though corporate profits have risen back to pre-crisis levels, the market is skeptical that the numbers are wrong, rigged, or that they are not sustainable. (See graphs in 09/17/2010 weblog entry.) Few investors or pundits can clearly indentify the catalyst that will cause the whole thing to “turn around”.

Corporate Profits Recover

 

Time for a review of the basics of how equity prices are determined. Let’s start with the question, “How much would you pay for a security that promised to pay you $2500 per year, forever?” The answer for most people is that it would depend on the credibility of the institution making the promise, so let’s assume that probability of the promise being kept is very good. Most people would also need to know the rates of returns being offered by comparable investments.

So, for this example, let’s assume that comparably “safe” investments are currently paying 5% which is comparable to a price equal to 20 times the earnings or a 20 P/E ratio. So, most people would consider paying $50,000 for the security promising to pay $2,500 annually. (Based on current US Treasury Bond rates, buyers are paying more than $60,000 for 30 year bonds with a similar annual return.)

Next, how much would you pay for a security where the annual payment is likely to grow or increase over time? Let’s assume that the payment grows by only 3% per year—in 24 years the annual payment would have doubled to $5000. Since the “average” annual return over 24 years would be $3750, most people would be willing to pay 20 times $3750 or $75,000 for this security with a growing return. This would translate to a current 30 P/E ratio.

So, for a security with a stable return, a 20 P/E or price to earnings ratio is acceptable, and for one with a growing rate of return, a 30 P/E might be reasonable. The only reasons the P/E offered would be reduced is fear or belief (hence the risk) that the return or annual payment will be less or less certain in the future. The price of the “market” is clearly Earnings multiplied by Price/Earnings Ratio (P/E). The lower the P/E Ratio, the higher the perceived risk.

During Phase I, both Earnings and P/E Ratios (based on future earnings) fall, causing dramatic market declines. Typically, during the first stage of recovery, Corporate Earnings improve—as has been the case in this recovery. But during Phase II: Skepticism, even though earnings have improved, P/E ratios have not yet risen. Historically, the big market moves have been when earnings become stable (steady gradual growth) and P/E ratios expand dramatically. This will indentify the move to Phase III: Optimism. Essentially the P/E Ratio is a measure of Investor Sentiment.

The problem with trying to predict market movements is that one must predict or “guess”: Average Annual Earnings, Growth Rate and Relative Certainty (Risk). Then the P/E must be determined based on prices for “comparable” investments. When interest rates are low, then P/E Ratios for stocks tend to be higher. Finally, in order to predict market movements one must predict or “guess” likely changes in Sentiment which indicates how others (the market) have processed the same data.

As I wrote last month, “It seems that we are in a bubble of pessimism.” Without a doubt, there are many legitimate reasons for pessimism, but history teaches us that things will get better. As Jeremy Siegel, Wharton Professor and Author has written: “Over the past 200 years, we’ve gone through a Civil War, the Great Depression, two World Wars, and double-digit inflation in the 1970’s. There’s a long list of tragic events, but we always come back to the same trend of long-term stock returns.”

It seems likely that in the long run, Sentiment improves and P/E Ratio’s rise, creating an attractive rise in the market and a move to Phase III: Optimism. When it will happen is unknown. For those who have a long term perspective of 5 years or more—be prudent but start to get ready. “If you wait for optimism, you missed it.” And, “If you wait till you see the Robins, Spring has already arrived.”

In other words, markets will continue to fluctuate, and while one must always consider unknowable geo-political or natural disaster risks, the probability that markets will be significantly UP three to five years from now is significantly higher than the probability that they will be down.

Our economy may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits and sentiment improve are stocks.

Market recoveries are never a straight line up, and at each dip, fear will return. (Remember that September and October tend to be very volatile.) Chicken Little types will yell “Double Dip” and declare bizarre warnings of things like the “Death Cross” and the “Hindenburg Omen”. The media uses this hyperbole to entertain—not to inform.

While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect. We are in the middle of the Skepticism Phase, but Optimism is coming, sooner than later.

I suggest that you review my January 31, 2009 posting: “Early is on time, on time is late, and late is unacceptable”. Since then, the S&P500 is up about 5%, corresponding to a 7.5% annualized return.

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.

Corporate Profits Show "Recovery in Aggregate"



Anemic Real Estate is affecting and is affected by Sentiment



Unemployment, like housing is affected by and is affecting Sentiment



Corporate Profits Show "Recovery in Aggregate"


Along with sentiment regarding the future, corporate profits are fundamental in determining the value of corporate equities.






 



Are we there yet?

Human beings are not known for being patient. According to the internet Wikipedia article on Patience, we “are inclined to discount future rewards—the present value of delayed rewards is viewed as less than the value of immediate rewards.” On a long trip, our children want to know, “Are we there yet?” and “How much longer?” will it be until the destination is reached.

Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet. During the initial stage of the recovery, it appeared that we were making rapid progress and we hoped that our destination was in site. Over the past few months, it has become clear we are moving slower than we thought and that the journey back to “recovered” will be longer than we hoped.

Data indicates that we have now had 15 straight months of unemployment at 9 percent or higher, 12 months at the current 9.5 percent level or higher. Of the more than 10 million currently unemployed, almost half have been unemployed for more than 6 months. To some, the most impatient and the most pessimistic, it seems that we are moving so slow, that it will take forever to reach our destination of being “recovered” and comfortable. These folks are not only worried about the present headwinds of unemployment and a weak housing market—they are also worried about future headwinds, like higher taxes and bigger government.

It seems that we are in a bubble of pessimism. We can be so focused on the fact that the trip is longer than we hoped, that we fail to recognize that we are still moving toward the destination. As I have written, markets value stocks based on future earnings. Future earnings are unknown, so they are estimated based on present earnings (E) and investor sentiment regarding the future, sometimes measured by the price/earnings ratio (P/E).

Many still estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or almost a 10% increase above the 8/13/2010 close. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)

In addition, when we finally reach “recovery” and return to the S&P500 level reached nearly three years ago in 2007, the market will have risen by 45% from it’s present level !

Corporate profits are clearly recovering. Earnings reported in July have indicated that corporate earnings continue to exceed expectations. Our excessive pessimism tends to discount the importance of these higher earnings with an attitude that the improvement is only temporary.

My prediction is: corporate profits are on the road to recovery. This road may not be straight and it may be uphill, but it’s general direction is toward improvement. We may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits improve are stocks.

While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect.

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.