Emotions and Facts – US Economy and Markets

Bugra Bakan

“We are in the business of making mistakes. The only difference between the winners and the losers is that the winners make small mistakes, while the losers make big mistakes.” Ned Davis, Market Analyst

It feels like the markets are coming close to a critical juncture, which makes the opening quote from my favorite market researcher Ned Davis, all the more meaningful. During times of change, it is easier to make mistakes. The key question becomes how big is the mistake and how long has one resisted correcting it? What I can add to the Ned Davis’ quote, is that the biggest difference between the winners and losers is that the winners correct themselves quicker than the losers, and learn from their mistakes. As the US stock market might be approaching the end of the cyclical (short term) bull cycle that started in March 2009, the winners will be those whose tactical moves will reflect the tidal changes as opposed to fighting them.

First quarter 2013 real Gross Domestic Product (GDP) annualized growth rate came in at 2.5%, below the expected 3%-3.5% range. To give you a perspective, the post WW II average is 3.5% and the current reading is significantly lower than the historical average; 28% less.

There are many reasons for this but I blame deleveraging (paying down debt). By the end of 2009, US total debt was 386% of GDP, today it is 355%. That 31% drop corresponds to about $48 trillion in the last 3 years. To have fun with numbers, this is 5.5 times the annual GDP of China, 9.5 times Japan and 16 times that of Germany’s. In other words, it’s a lot of money that would otherwise circulate in the economy and contribute to the economic output. The latest sequestration (budget cuts) is one example of how we have started to pay down the debt load that has been steadily built since the 1950s (that time total debt to GDP ratio was 130%) and how this is shaving off from economic growth. Is this necessary? Yes. Is this hurting the economy? Yes. We are all paying for the home mortgages of our parents, reckless government spending and all the fancy cars and boats that shouldn’t have been purchased with credit.

To add more to this healthy pessimism (if there is such a thing), since WW II, an average business cycle lasted 18 quarters. The current cycle we are in started in June 2008 with four quarters of recession and fifteen quarters of growth, adding up to 19 quarters. Now of course, the average is just that, an average and there are many cycles that exhibit much different behavior but still, this raises some serious eye brows.

One last comment on why the economy is growing at a slower pace: too much consumption, too little investment. Looking at the components of US GDP, personal consumption has been on a steady up trend since the 1950s and is currently 70.9%. This ratio was 62% in 1979. Gross private domestic investment to GDP ratio is only 13.2%, which was 20% in 1979. You can see how the components of the GDP are shifting from investments to a consumption based economy, which could also explain why US imports are increasing while exports are dropping and the borrowing has been on a steady uptrend.

Now, thank God that the stock market and the economy may decouple time to time and exhibit different trends. May be not for good reasons but nevertheless, I don’t make policies, I invest for my clients.

Interestingly, the stock market usually performs better in slower economic conditions than strong growth because: 1 – In slower growth periods, the FED is more accommodative and cost of borrowing goes down 2 – Cost of labor also goes down in such periods. Under stronger economic conditions, interest rates rise and so does the cost of borrowing and labor, both of which chip away from corporate profits.

Year to date, the S&P 500 Index is up approximately 10%. If you have been waiting on the sidelines, that’s what you’ve just missed. How come Q4 2012 GDP annualized growth was 0.4%, Q1 2013 2.5% AND we have been in the midst of a stock market rally? Corporate profits, FED and greed answers most of it.

Corporate after tax profits as a percent of nominal GDP is 9.9%, an all-time high, while wage and salary disbursements as a percent of nominal GDP is 44.2%, an all-time low. Add the fact that many corporate tax incentive programs started to expire in 2012 and 2013, meaning corporations have been paying less in taxes for their profits. Your take away from this, is that one key indicator to watch is the cost of labor and hourly wages, because when this starts to climb up, corporate profits start to climb down.

The good and bad news is that we are still far from rising wages, at least for another year or so and most likely the end of this cyclical bull market that started in March 2009. One other headwind waiting to cause the economy heartburn is the rising interest rates. Those who have been angry at the FED should know: just like you have debt interest payments, so does the US government. Current US Federal debt load is $16.7 trillion and interest payments on this debt is $331 billion, which is just about 2% of debt. Historical average is 4.51% and at this rate, interest payments would swell up to $756 billion a year. In other words, the FED has been saving the Federal government about $420 billion a year on interest payments. Yes, there is no free lunch but at least, let’s get to know more about the meal on our plate.

Now, let me touch on why I have included “Emotions and Facts” in the title of this month’s issue. I hear comments like “the markets are so volatile” and yet the problem is (in some ways) the lack of it.  We are driven by our emotions more so than reason, which is not a luxury a successful investor can afford. One measure of volatility is the VIX index, which looks at the changes in the option prices to gauge what investors see in the future. In plain English, it aims to measure the implied volatility. So…when folks claim there is so much volatility, you would think this measure would be high and would raise a red flag, right? Wrong. Current VIX is actually at 13.71 which is quite low. In fact this index has been signaling complacency as opposed to volatility and unfortunately investing is like driving, you get into accidents when you’re complacent.

Except one day on Dec 28 2012, since mid-June 2012, VIX has been below 20, which is considered low. My point: buying a car, a house, a dress or a vacation in the Bahamas on emotions is quite all right (I guess) but investing on emotions (in the absence of luck) will likely yield losses. In this current US stock market regime, we are experiencing a lack of volatility not the other way around, which in and of itself may signal complacency and a pullback in the near future. A counter intuitive assessment may be, but at least it is not based on emotions but rather facts.

Here we arrive at my favorite topic: a potential pull back. Ray Dalio, a successful investor says “He, who lives by the crystal ball, will eat shattered glass.” Well, I don’t want to eat shattered glass, but I can’t stop but look at how far we have come in stocks, along with the signs of getting tired and more than 10% corrections in some international segments. Here is a strategic Q&A session to clear the fog:

-Is a pullback due?

- Maybe.

-Would this start the next bear market in stocks?

-Unlikely. Indicators point to continued bull market strength so any pull back should be seen as a buying opportunity.

- Are we coming close to the end of this cyclical (short term) bull market in stocks?

- Maybe. Based on historical standards, most likely we have another year or a year and a half more to go.

- Then what?

- That’s the best question raised so far. By then, we will either find ourselves in the makings of the next secular (long term) bull cycle or a cyclical (short term) bear.

- Which one?

- Now, that wasn’t a good question. Who knows? Do yourself a favor and get comfortable with the unknown.

- What to do now?

- Keep some dry powder (cash) to fire away in the case of a pull back. Focus on sectors with momentum such as health care, financials and consumer discretionary (supported by auto and housing).

- You’ve been talking about a crash in the bond market.

- No I haven’t. I have been talking about the conditions brewing for the “great rotation” from bonds to stocks. So far, this is still an immature call as most of the pessimism about bonds has been factored in. Inflation is still tamed and so the interest rates, as a result it’s early to call the end of the bond bull market.

- Is it a good time to sell gold?

- You haven’t already?

- Is it a good time to buy a house?

- If your cash flow remains healthy with your new debt and mortgage payments, as long as you’re not stretched, yes. Otherwise no. There are three financial statements: income statement, balance sheet and cash flow statement. Of these, by far the cash flow statement is the most important. Pay attention to cash flow and timing. It’s hard (or impossible) to get the timing right so stick with cash flow.

- Is this a good time to buy Apple?

- Get me a glass of gin and tonic please. Thanks.


The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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