C.A.R.E. Asset Management
and Strategies, Inc.
Economic and Market Update White Paper
August 15, 2011
Summary of Outlook
We believe that the U.S. economy will continue to grow, but not enough to support significant upside in equity markets in 2011. Growth will be restrained by a number of factors. The equity markets could finish the year with little or no gain.
Fiscal Policy
The U.S. outstanding public debt is $14,602,724,198,753, ie. $14.6 trillion, as of August 15, 2011, 12:05 pm. The estimated population of the United States is 311,124,595 as of the same moment. The debt has increased by $3.95 billion per day since September 28, 2007. The White House budget for the next 9 years until 2020 shows 4% to 5% growth every year with no recessions during that period. At the end of the second quarter June 30, 2011, the total dollar value of our gross domestic product was $15.0 trillion. Simply dividing the GDP into the public debt (ignoring the 1 1/2 month varying period) we get a percentage of 97.3%.
As of December 31, 2010, the countries listed below had the following debt as a percent of GDP ratios: Countries
| Debt as a Percent of GDP
| | | Japan
| 225.9
| Greece
| 130.2
| Italy
| 118.4
| Iceland
| 115.6
| United States
| 92.7
| France
| 84.2
| Canada
| 81.7
| United Kingdom
| 76.7
| Germany
| 75.3
| China
| 19.1
| Russia
| 11.1
|
Recently, the President Obama and House Speaker Boehner worked out a larger deal to lower the spending by $4 trillion dollars. At the last moment, President Obama wanted an additional tax increase by $400 billion. This larger deal fell through because of this last minute request after Boehner thought negotiations were complete. Maybe there was no way the House of Representatives would have approved any deal with a tax increase. In the end, a smaller deficit reduction package was passed and Standard & Poor's downgraded all U.S. debt from the highest rating of AAA to AA. This might not be the last of downgrades by either S&P or other rating agencies. However, Fitch, another rating agency, retained the AAA rating, citing broad and diverse ability to withstand economic shocks, the U.S.'s pivotal role in the global financial system, and a flexible, diversified, wealthy economy that provides its revenue. However, it warned that it's opinion might change if politicians "dither" over debt problems.
The new deal called for a "Super Committee" to come up with more spending reductions. Supposedly they will tackle Social Security, Medicare, and Medicaid and make seriously cuts. We don't believe either they or future Congresses will be successful until driven to make radical change by further downgrades in the U.S. debt obligations. The Republicans on the Committee don't want tax increases and the Democrats on the Committee don't want to cut entitlements.
Further downgrades are bound to increase volatility in the stock market and the bond markets. Curiously, the effects on the bond markets were counterintuitive. The rate on the 10-yr Treasury note declined to 2.17%. Thirty-year conventional mortgage rates are now 4.1% and lower. High-yield bond mutual funds lost very little. With the present political constraints on fiscal stimulus, ie. printing money and increased government spending, any fiscal stimulus seems rather remote. To the contrary, if the federal government suddenly develops a serious approach to spending restraint, economic growth and gross domestic product could be cut. Our prediction would be more of the same stalemate in real federal expenditure cuts and therefore little effect on economic growth and gross domestic product. State and local governments are making significant cuts. We are unable to predict that effect on gross domestic product at this time.
Tax Reform
We don't see lower corporate rates, a reshuffling of the individual tax rates, eliminating of the U.S. tax on repatriated foreign earnings, and similar growth-oriented tax changes happening until 2013, and only then if the elections send a message to liberals in Congress that the country wants growth. As we mentioned above, we don't think the Super Committee is going to produce any action either in 2011 or 2012. Accordingly, we anticipate the competitive U.S. global disadvantage due to high corporate tax rates will continue to be a short-term drag on export-driven growth and gross domestic product.
Monetary Policy
The Federal Reserve announced on August 9 that they would keep the Federal Funds Rate, the rate at which the Fed and banks lend to each other, at the 0.25% rate, basically zero through mid-2013. What was unusual about the announcement was that it was the first time in history that the Federal Reserve has ever specified a date. Logically, it follows that the Feds economic forecast predicted the economy will remain weak for the next two years. With fiscal policy out of the question, monetary policy is the only option. While the move by the Fed calmed the stock and bond markets, and may have put a bottom into the stock market, the jury is out as to whether it will stimulate the housing and auto industries. While the 30-yr fixed rate conventional mortgage is at 4.17% or so, and the 15-yr at 3.49%, the increase in documentation, conservative bank appraisals, 20% downpayment requirements, and higher FICO scores are keeping a lot of potential U.S. buyers out of the housing market. Those requirements are not keeping foreign buyers out of our markets though, particularly the Canadians and the Chinese. Citizens from countries with strong currencies, like Canada and China, have the currency exchange advantage. We wonder whether the two-year window of lower rates will keep buyers waiting for still lower home prices. As long as the 30-yr fixed bank mortgage rates are falling, why would potential buyers be incentivized to rush into the housing market, we ask. If not, this could act as a drag on economic growth. Let's hope this is not the case.
Household Debt and Consumer Spending
With high unemployment and higher food and gas costs, consumers have been paying down loans. Since August 2008, household debt peaked at $12.4 trillion. Since then, it has declined by $1.2 trillion. According to Moody's Analytics, the percentage of household income that is spent on debt service declined from 14% in early 2007 to 11.5%. Despite these improvements in household debt, consumers are still reducing debt. Consequently, the amount of discretionary spending has not significantly increased. Therefore, we believe this will continue to act as a drag on economic growth.
Home Prices
Standard and Poor's Case-Shiller Home Price Index of the 10- and 20-City Composites showed price increases for the second month in a row. From April to May, the latest report, prices rose 1%. Critics cite two problems with the report. The first is the seasonality of the report. Prices can be expected to decline in the fall and winter. The second is the unreliability of the report with so many foreclosure properties being sold and not knowing the trend in the prices of foreclosure property sales. In addition, the index only covers 20 cities, not the more lucrative suburban areas. If housing prices as well as housing demand do not increase significantly, this will continue to act as a drag on economic growth. Housing demand as measured by housing starts has seen no significant growth during 2011.
S&P 500 Corporate Profits
Second-quarter 2011 S&P 500 corporate profits are currently trending at $25.12 per share, currently growing at a 17.6% pace over the first quarter 2011 $21.44 with 60% of the companies having reported at the time this report was made. This report includes the historic flooding and tornado activity in the U.S., the tsunami in Japan, fiscal problems in Europe and the general sense of malaise in the U.S.
As of August 12th, the blended growth rate was 11.8% with 92% of companies reporting, and of those reporting, 71% beat estimates, 9% were in line, and 20% were below estimates.
S&P estimates that reported earnings for the third and fourth quarters of 2011 will be $23.93 and $23.54. Adding the four quarters together, the total per share reported earnings for the S&P 500 for 2011 could be $94.15 and for 2012 $96.30. The PE ratio for 2011, using the current index quote of 1200 (August 15 at 3:00 pm) would be 12.7 for the whole year 2011. Historically, the PE ratio has been 14.7.
If the pessimism about the economy would subside, the S&P 500 could rise to 1415 in 2012, about a 17.9% rise from today, August 15th. The fall in equity prices due to the debt-ceiling debates and the S&P credit downgrade has produced a lot of pessimism. The debate over raising taxes and cutting entitlements has raised concerns. The U.S. Dollar
The U.S. dollar will continue to slid downward because of the budget deficits and growing debt. There could be temporary recoveries as other world currencies weaken and investors look for a refuge from currency volatility. However, we don't believe the U.S. will be able to attract dollars unless government policymakers take aggressive action, and we fail to see how and when that could happen. Perhaps the 2012 elections will send a message to Washington, as the 2010 elections did. In the meantime, we think gold investment serve as a protection against the debasement of the dollar as well as protection against economic dislocations.
Job Growth
On Friday, August 12, the government reported that 117,000 private sector jobs were created. The pace of private sector job growth has slowed recently. Net new job creation is low because state and local governments have been laying off workers in order to balance budgets. The unemployment rate is above 9%. The number of unemployed persons was 13.9 million in July, little changed from the previous month. The total civilian labor force is 153.2 million and that has not changed much. At the end of 2010, the total was 153,690 million. At the end of 2009 the total was 153,172 million. At the end of 2008, the total was 154,669 million. At the end of 2007 the total was 153,936 million. These stats come from the Bureau of Labor Statistics. From the end of 2007 to the end of 2010, there has been a slight reduction in the total civilian labor force. Nothing like the truth to dispel certain government claims. The economy is simply not growing enough to give us the kind of job growth needed to drive consumer spending and the stock market significantly higher. The lack of net new job growth continues to act as a drag on the economy. Gross Domestic Product Growth
The following table shows the growth (decline) in gross domestic product starting in 2009. It sort of speaks for itself. Growth is slowing. This is part of the cause for recent market pessimism.
Year
| Quarter
| Percent Change
| | | | 2009
| 1
| - 6.7%
| | 2
| -0.7%
| | 3
| +1.7%
| | 4
| +3.8%
| 2010
| 1
| +3.9%
| | 2
| +3.8%
| | 3
| +2.5%
| | 4
| +2.3%
| 2011
| 1
| +0.4%
| | 2
| +1.3%
|
Blame for the stalling U.S. economy in 2011 has been put on higher prices for food and energy, disruptions in the supply chain caused by the Japanese Tsunami, in turn causing a temporary lull in auto sales.
Trying to predict a decline in GDP and therefore a recession is tricky business. In a chart appearing on the Federal Reserve Bank of New York website, the spread between the 10-yr Treasury note and the 3-month Treasury bill is compared to recessions in the past. The current chart showed a spread of 2.96% (a little outdated) and the probability of a recession in July 2012 at 0.80%...pretty low. Since then, the spread has narrowed to about 2.11%, but the chart shows neither the new spread not the probability percent.
The Conference Board's Leading Economic Index for the U.S. rose 0.3% in June to 115.3, following a 0.8% increase in May and a 0.3% decline in April. The largest positive contributors came from the money supply, the interest rate spread, and building permits. The result points to slowly expanding economic activity in the coming months. The Organisation for Economic Co-operation and Development, an influential Paris-based think-tank, wrote on August 9th that the latest monthly composite leading indicators suggest slowing global growth. We have previously written about ghost cities, malls, and apartments in China, that worked to increase Chinese GDP growth rates, and that eventually the Chinese government can no longer continue to manipulate their GDP growth rate. Slowing global growth could mean fewer exports from the U.S. to their foreign customers. That in turn would affect U.S. gross domestic product negatively.
In the period 1980 to 1982 there was a double-dip recession, the only one since World War II. However, the second decline was due to the Federal Reserve raising interest rates aggressively to fight inflation. There's minimal risk of that now.
Predictions of future economic growth range from 1% to 2.5%. Can the economy achieve overall 2% growth in 2011? The second half would have to produce 6.3% growth to average out at an annual 2% growth. Quite an uphill struggle, we think.
Manufacturing Institute for Supply Management Report on Business
The July PMI index came in at 50.9%. In June it was 55.3. The lower percentage indicates the rate of change is slowing. A reading above 50 indicates the manufacturing economy is generally expanding; below 50 percent indicates that it is generally contracting. The highest index in 2011 was March at 61.2. It has been declining ever since.
New orders came in at 49.2 from 51.6 in June, indicating contraction. This was the first month of contraction in New Orders since June 2009. Other indexes were production, employment, supplier deliveries, inventories, customers' inventories, prices, and backlog of orders. All declined indicating slower growth. Exports and imports were up indicating faster growth in those two areas.
Inflation
The average Consumer Price Index All Urban Consumers increase in 2010 was 1.6%, and the last six months of 2010 the average was 1.2%. Starting in January 2011 the rate was 1.6% and it has been going up ever since. In May and June it was 3.6% each month. In April it was 3.2%. The forecast through July 2012 is for 2.4% inflation. This does not appear to be a drag on the economy nor on decreasing interest rates. The temporary spike in food and oil prices appears to be abating. The USDA expects food prices to rise 2% to 3% overall for 2011. The Libyan civil war could be resolved in a couple of months, bringing 1.5 million barrels back on the market. Exxon Mobil CEO Rex Tillerson believes the right price in this market should be $70 a barrel. That would be stimulative to the equity markets and the economy. We shall see. In the meantime, inflation appears not to be a factor in the increase in gold futures prices, nor do we see it becoming an impediment to growth under present conditions. Retail Sales
High unemployment, stagnant wages , gridlock in Congress, and a stock market slump supported a worsening consumer sentiment in early August. Nevertheless, in July the U.S. Census Bureau reported that their advance estimate of U.S. retain and food services sales was $390.4 billion, an increase of 0.5% above June and 8.5% above July 2010. These figures are adjusted for seasonal variations, holidays, and trading-day differences, but not for price changes. However, the unadjusted figures showed sales of $392.4 billion in July, $396.6 in June, and $401.0 in May. We are not sure how to interpret these numbers other than to conclude that the economy is certainly not going gangbusters.
Personal Income
Personal income for June increased $18.7 billion or 0.1%, the smallest increase in 2011. Previously, personal income has risen 0.2% in May, 0.4% in April, 0.4% in March, and 0.5% in February. At least, for the year-to-date, personal income has increased. In 2010 it was down $167.5 billion or 1.3% and in 2009 it was down $244.7 billion or 2.0%. This appears to explain why consumer spending and retail sales are slumping lately. Economic Cycle Research Institute
The Economic Cycle Research Institute (ECRI) is the world's foremost predictor of recessions and recoveries. The IMF has observed that "their record of failure to predict recessions is virtually unblemished." Unlike most economists, ECRI uses a leading indicator approach pioneered by the founder Geoffrey H. Moore. The data is private, for subscribers only, but there is a public chart. It shows in about July 2007 it reached a peak of 143. Then fell until March 2009 to 105. From there, the index turned up and reached a high on about May 2010 at 134. Then it fell to about 122 from about July 2010 to August 2010. Then it spiked up to about 131 in April 2011. Then it fell until it reached 127.9 for the week ended August 5th. The ECRI is telling us the economy is slowing.
Equity Markets-The Technical Picture
On August 9th, we again reviewed a technical chart for the S&P 500 covering the period from March 2010 until August 8, 2011. For the first time, we saw what we didn't see before....a head-and-shoulders formation. That is not a good formation. According to Fibonacci rules, the S&P 500 is now on track to go all the way back to the July 2010 low of 1010.91 (It closed on August 15th at 1204). When it recovers, it will hit upside resistance at 1250. Since it started the year at 1257, if the market follows this technical "receipe", it could mean no gain for the entire year 2011.
This white paper is general in nature, does not constitute investment, legal or tax advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. Economic and market forecasts presented herein reflect our judgment as of the date of this white paper and are subject to change without notice. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. C.A.R.E has no obligation to provide updates or changes to these forecasts. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than your original investment. While the information in this document is not intended to be investment advice, it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for use by professional investors only and not for onward distribution to, or to be relied upon by, any jurisdiction or in any circumstances that is otherwise unlawful or unauthorized. This document should not be published in hardcopy, electronic form, via the web or in any other medium accessible to the public, unless authorized by C.A.R.E. Asset Management and Strategies, Inc.
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