Review and Outlook
December 15, 2009
To my Clients, Friends & Observers:
Last year at this time I talked about how the broad market can’t outperform the economy as a whole over the long run. I also suggested that we would see a 25% gain in the S&P 500 this year, mostly inferred by a return to historical norms. The S&P was up 23% as of this Tuesday.
As I look around today I don’t recall ever seeing such a wide disparity between the underlying economy and the stock market, although 1982 is possible - when the great bull market was just starting. This recovery that we’re experiencing will be jobless. Productivity means job cuts. Strong productivity growth is killing demand for labor in the private sector and fiscal pressures should force a reduction in public sector payrolls – particularly at state and local levels.
Things are going to slow down here in the states for two principal reasons, (1) the demographic of aging baby boomers and (2) the increase in the savings rate from zero 18 months ago to 6% currently. There is not enough consumer demand to generate the level of economic activity to which we became accustomed. Without growth in consumption this recovery is inevitably lame.
This generational reduction in consumption, which had become 70% of U.S. GDP, should help mitigate the inflation potential of all the excess currency in circulation. The dollar is now 62% of world central bank reserves. It is not in those banks’ interest to see the value of those dollars collapse. The dollar is still the safest currency.
The concept of free trade between a currency that floats (the dollar) and a currency that is fixed (the yuan) is simply ridiculous. It cannot be sustained and will have to change. If it can’t be negotiated then so-called “protectionism” is inevitable. There is much to protect.
Recently I asked Roger Bootle, President of Capital Economics in London, a research firm, about the reliability of Chinese economic data. Roger is an alumnus of HSBC, the former Hong Kong Shanghai Bank Corp. He said that the Chinese government used to send out preliminary estimates of quarterly economic data three weeks in advance to the bank and when final quarterly results were officially posted, sure enough they were exactly as predicted “to three decimal places.” The general rate of growth in China can be estimated by measuring freight shipments, trade, commodity and energy consumption. But if you (quite rightly) suspect that economic data provided by our own federal government is manipulated, it can’t compare with the machinations of a politically irreproachable Chinese administration. It will be interesting to see how China manages its inevitable financial bubbles. Despite the recent hedge fund disasters, there is no greater financial transparency than in the U.S. and no better accounting standards. There are enormous risks investing in developing economies.
The U.S. is run by a Business Government. There is a widening gap between a wealthy ownership class and a declining middle class which will rely more and more on socialist government subsidies as the present administration prescribes. For owners the U.S. is the safest place in the world to invest and American multinationals are the safest way to participate in global economic growth. There is enough back-filling to be done to generate another 10% to 15% gain in the S&P in 2010. The market overshot on the upside this decade and overshot on the downside. All things revert to their mean. Third quarter S&P 500 earnings exceeded analysts’ estimates by factors of 2 or 3, and were 15 times earnings of a year ago.
There are a lot of wild cards: the two wars that we cannot sustain, let alone win; the massive expansion of public debt; any number of disincentives to manufacturing and improved trade balances; Iran and disruptions to oil flow resulting in cost-push inflation and stagflation.
It is estimated (forgive the lack of a citation) that there is enough oil, natural gas and coal in the United States to sustain its historical growth rates for the next 100 years at least. That is more energy in the ground than in Saudi Arabia and Canada combined. Oil imports account for half of our trade deficit. The U.S. refuses to employ its own people to develop its own oil, preferring instead to transfer money from the employed to support the unemployed – now estimated at 17% of the population.
The Brae Head equity composite is overweight in manufacturing. Upwards of 30% of products imported into the U.S. are American manufactured. This is a major reason for the disparity of the performance between the market and the economy. The downsizing of American manufacturing has been overdone.
Our taxable fixed income composite has an average maturity of 2 ½ years. Our municipal fixed income composite has an average maturity of 7 years. When rates increase we will extend maturities.
Merry Christmas and Happy New Year,
Dennis M. O’Connor