News on the Economy
The economic data that was released last week on the surface is signaling that the economy is firing on all cylindars. Factory orders, the ISM report on US manufacturing, personal income and productivity as well as the Chicago PMI were at their best levels since the financial crisis began back in late 2007. On the other hand, construction spending and the employment situation were not consistent with the manufacturing sector or with what the financial markets were anticipating. Overall, its seems the US economy is steadily impoving, but because of the unstable geoplolitical conditions in Egypt and Middle Eastern countries,the United States budget and national debt conunderum, as well as a continued contraction in construction and housing, there remains substantial headwinds in the way of any meaningful long‐term economic expansion.
First, the good news. The Chicago PMI, which is a business barameter index in the Chicago area, came in stronger than expected in the month of January at 68.8. The consensus veiw was 65, and the index came in higher than any estimate given by the economic community. Any reading over 50 signals an economic expansion, and below 43 signals the economy is in a recession. Probably the most impressive aspect of the report was that new orders surged to 75.7 and manufacturing output was at its highest level since 2006. In addition, the employment component of the report increased 6.0 points to 64.1, recording its best results since 2007. Every aspect of this report was positive, and based on new orders surging to 75.7, its seems there is plenty of room for futher expansion in the months ahead.
On the heels of the Chicago PMI, the national ISM Manufacturing Index reached its highest level since May of 2010 at 60.8. The consensus view was 57.5; slightly above the November results of 57. Most economists last year thought the ISM topped out during May at 59. The January reading was above all estimates, and surprised even the most bullish forecasters. The employment component was consistent with the Chicago PMI improving to 61.7; the highest level in seven years. Of the 300 companies surveyed, there was an overwhelming consensus view that the latest rise in stock prices is fueling global demand for manufactured goods in the US.
Because of corporate cost cutting and more efficient means of creating goods and services, US employees continue to be more productive in the workforce. The reading on quarterly worker’s productivity exceeded the consensus view (2.0%) at 2.6%. Most companies continue to cut costs while keeping wages in check. In the final quarter of 2010 unit labor costs actually decreased 0.6%. In order for US firms to increase earnings on a consistent basis, wages paid are going to have to increase and more jobs need to be created. Earnings cannot continue to expand by merely cost cutting; overall sales need to increase. In order for this to occur, management needs to create new jobs and reinvest in infrastructure.
Now, the not so good news. The US employment situation continues to disappoint. The monthly jobs report came in much weaker than expected, with only 50,000 new jobs created in January, with the expectation of 150,000 new jobs. On the bright side, the unemployment rate fell to 9.0% from 9.4% in the latest survey of 5,000 households. Probably the most disappointing aspect of the report was the inconsistent nature of the Chicago PMI report and the ISM report on employment, which both suggested that a significant improvement in job creation would take place. Private sector jobs in manufacturing and retail continued to improve, but these gains were offset by job losses of 14,000 at the state and local government. The Chicago PMI report and the ISM report do not reflect the changes in government entities, hence the discrepancies.
The bad news. Construction spending continues on its downward trajectory, with December new construction decreasing by 2.5% from November and year over year decreasing 6.4%. The majority of analysts expected a rise of 0.2%, but the main negative factor was that private residential construction fell another 4.1%. Foreclosures are on the rise and the amount of existing homes for sale continues to increase. To make matters worse government spending on construction was down 11.6%. (Our taxpayer dollars at work?)
The Federal Debt Ceiling
For the better part of the last decade, we have heard the political rhetoric regarding the United States Federal Deficit, and what a problem it has become. I have yet to read a good explanation to why the US debt is such a problem, besides the moral issue that you should spend less than you earn. A couple of weeks ago, I had an interesting conversation with a colleague of my mine at the university, and he made an interesting observation regarding the national debt in the US. He said, “The debt itself does not matter.” I paused for a moment and looked at him puzzled wondering why he would make such a comment. I said to him, “Eventually the debt will be the demise of the United States.” He agreed, but he then asked the question, “Why?” Over the last week, I have been putting some thought into the problems associated with our national debt. In any basic level corporate finance course, you will learn that a borrowed dollar should increase overall assets or revenue in the future, if invested wisely. The proceeds of the borrowed funds should be invested in future revenue‐generating projects that will ultimately improve the overall wealth of the enterprise. On the contrary, the debt burden accumulated by the US over the past three decades has funded the operating expenses of the country (i.e. wars, entitlement programs, interest payments, etc.). Moreover, these borrowed funds have not created additional wealth. Instead, the federal government has created a fiscal nightmare that no politician is willing to sacrifice their office to correct.
The US debt burden is the equivalent to a limitless credit card, which enables poor spending habits, and lack of fiscal constraint. At the end of 2010, the United States government has accumulated nearly 14.3 trillion in debt, in which the CBO (Congressional Budget Office) is projecting another $1.43 trillion annual deficit for 2011. Each month the treasury department offers international and domestic investors the opportunity to buy on average between $70 and $120 billion in new treasury bills, notes, and bonds. For every dollar the federal government spends, nearly $0.40 comes from new debt creation. In addition, last year the estimated interested payments on our national debt exceeded $200 billion. One can only wonder how long this behavior can continue before the US goes bankrupt.
Portfolio Strategy
The overall financial markets remain overvalued, overbought, and extremely bullish. The yield on the S&P 500 remains at an all‐time low of 1.75% (average is 4.35%). The VIX, which measures investor’s fear of an overall market decline, is between 16.5 and 17.0, suggesting a significant market correction is highly unlikely in the near term. Price to earnings ratios are at levels not seen since early 2000, and the yield curve, the difference between the 10‐year Treasury note and the 3‐month Treasury bill is 3.5%. Morevoer, it seems that a good majority of investors believe that the recession is behind us, and good times are here to stay.
As most of you are well aware, I have been extremely cautious on this market over the past 6 months. Every historical instance of over‐confidence in the financial markets usually ends with a surprising major market decline. I will admit the economy is improving, the job situation is improving, and our current political leaders and the Federal Reserve are doing everything in their power to accommodate future growth and prosperity. However, this recovery has not been built on sound fiscal policy but rather through bailouts and transfer payments from our insatiable appetite for foreign borrowing. This has been the slowest and most insignificant recovery in the history of the United States after an economic recession. The significant gains experienced over the last 18 months have been impressive and could continue another 18 months, but as soon as the government stops printing money and the economy is off of life support (QE2), the markets will have to pay back the artificial gains they experienced over the last several months.
Of course, I do not have an exact date or time when the markets are going to sell‐ off, and we will continue to enjoy the gains we are experiencing in the market. On the other hand, we will continue to hedge the growth and income portfolios with Puts on the S&P 500 and Calls on the VIX in order to safe guard against unforeseen portfolio declines. In these types of markets with extreme bullishness and valuation metrics that do not deserve high stock prices, the best way to preserve wealth is to be a contrarian and not let greed get the best of you.
