·    The significant increase in government spending, which will exceed 24% of GDP this year and is projected to contract to a still-too-high 23%+, is well above our long term average of 20.7%.  This, combined with a $2 trillion tax increase on upper income individuals and corporations, will shift resources from the highly productive private sector to a much lower value added government sector.  This alarming migration in fiscal policy has serious long term implications for our economic growth, asset values, stature and national security.

 

·    Last year we said buy Washington D.C. real estate – seriously.  That’s the locale where employment is growing the most rapidly.  Maybe in our next life we should return as a D.C. real estate broker.

 

Last Year’s Picks

 

·    We were right that the recession would end; however, it ended earlier than we thought – mercifully.

 

·    We weren’t sure whether equities would enjoy a meaningful rally in a bear market or begin a new cyclical bull market.  We think it was the latter.

 

·    We said reflation plays, i.e. the beneficiaries of improving global economic activity, should lead the way.  They did.

 

·    We were correct when we thought that corporate bonds would produce equity-like returns.  A Barclay’s index of a blend of investment and speculative grade bonds was up +23%.

 

·    We thought equities would be up on the year and possibly, up a lot.  And they were up a lot, bouncing 60%+ off the March 9^th lows.

 

·    We said that the beneficiaries of reflation, specifically the technology sector, should lead the way.  That worked – semiconductors gained +92%, semiconductor equipment +76% and Electronic Manufacturing +81%.

 

·    We said the equities of stable earnings growers would lag.  They did – Food Retail +5% and Household Products +12%.

 

·    We also thought emerging markets would continue to outperform, and a broad index of those bourses was up +75%.

 

·    We were concerned that private sector deleveraging would limit future earnings growth.  We still are.

 

·    We were extremely anxious about the explosion in government spending and the “increasing probability of the public sector becoming a much larger factor in our lives and its participation in overall economic activity.  We are most alarmed at the anti-capitalist vitriol which seems to be gaining momentum.  The history of those societies which embrace large government at the expense of the private sector is not encouraging”.  This remains our biggest concern – by far.

 

The Economy

 

The global economy, led by the developing countries, is solidly in recovery.  China and India are clearly booming but so are most emerging economies.  For example, Thai industrial production has surged at a 40% annual rate over the past 11 months while Korea’s is up 35% year over year.  Emerging economies account for 35% of global GDP and 51% on a purchasing power parity basis. 

 

There’s even some life in the developed economies.  U.S. real exports grew at an 18% annual rate in the fourth quarter, and Japanese industrial production is up 31% over the past year.

 

The U.S. economy is poised to grow, albeit from very depressed levels, at a decent rate in 2010.  Typically, economic growth following severe recessions is strong, ranging between +5 and +7% over the course of the next year.  This snapback won’t be as strong – more likely +4% in 2010.  This Great Recession is a classic balance sheet recession driven by collapsing asset values which have severely impaired highly leveraged individuals and entities.  Recoveries following financial recessions are almost always tepid.

 

Chart I

Source:  BCA Research

 

Most recoveries have been led by a revival in consumer spending.  Not so this time.  As we all know, her debt levels are too high and net worth too nicked to lead anything.  This recovery, at least in its early stages, will be driven by the business sector – inventory replenishment, capital spending and exports.

 

Inventories have been cut to the bone.  Inflation adjusted inventories have declined by -7.5% over the past 7 quarters, the largest decline – by far – in the post-War period.

 

Chart II

Real Inventories Peak-to-Trough

 

Source:  ISI Group

 

Inventory liquidation slowed substantially in the fourth quarter and added +3.4 percentage points to the overall +5.7% gain in real GDP.  We suspect that at least modest stock building is underway and should contribute to GDP growth throughout the year.

 

The corporate sector severely cut capital spending during this recession to a level no higher than depreciation.  To the best of our knowledge, that’s only happened one other time in the post-War period.  Spending on equipment and software – the lifeblood of our competitive advantage – was drastically curtailed.  In fact, the capital stock in that category actually fell in 2009.  We doubt that has happened since the Great Depression.

 

Chart III

Source:  BCA Research

 

The ratio of Equipment and Software capital stock to potential GDP has fallen to the lowest level since the 1970’s.  Firms clearly cut back much more than normal and are now under-invested.

 

There is plenty of incentive to invest in new plant and equipment.  The dramatic drop in capital costs has left them well below the corporate average return on capital.  This gap is back to record levels.

 

Chart IV

Source:  BCA Research

 

Auto sales could add significantly to GDP over the next year or so.  Sales in the last two years have fallen below the scrappage rate, the first time in history.  So, the stock of cars on the road has actually fallen.  As employment, incomes and net worth increase, this pent-up demand for autos should result in a pretty good bump in sales growth.

 

Chart V

Source:  BCA Research

 

Significant headwinds to the expansion remain.  The fragility of the banking system persists, the unsold stock of new homes and vacant properties is daunting, small business owners continue to be very cautious and consumers are over-leveraged and must save more.  The current savings rate is 4.8% and is heading higher over at least the next several years.  We wouldn’t be surprised to see it reach 7-8% as consumers repair their balance sheets.

 

Chart VI

Source:  BCA Research

 

Monetary Policy

 

Monetary policy is set to remain accommodative through most of this year and possibly into next.  The recovery is too young and not likely to be vigorous, the banking system is too fragile, consumers too leveraged and the real estate markets in most parts of the country are just too sick. 

 

Chart VII

Source:  BCA Resource

 

We feel that those who are worried that asset markets have or will soon enter into a new bubble phase are much too premature with their concerns.  Zero cost short term borrowing rates and the record steepness in the yield curve strongly suggest that the Fed is concerned about asset prices – they’re too low.

 

Chart VIII

 

Source:  BCA Research

 

In some ways, monetary policy is dysfunctional.  Despite the massive increase in banking system reserves, banks aren’t lending.  Consequently, the monetary multiplier (M-2÷Monetary Base) has collapsed.  This has happened not only in the U.S. but in the other developed economies as well, resulting in a significant slowing in money supply growth rates.  Monetary authorities won’t worry about withdrawing accommodation until the huge pool of bank reserves gains some traction and the money multiplier rises.

 

Chart IX

DEVELOPED ECONOMIES MONEY

US M2, Eurozone M3, Japan M2

GDP Wts.   Y/Y %  Jan 1.3%  e

Source:  ISI Group

 

Domestic Equities

 

All great bull markets are rooted in easy monetary policy.  And this one is no exception.  At zero short term interest rates there’s nowhere for the prices of stocks and other risk assets to go but up.  Throw in rock bottom valuations and the sheer panic of investors last March, you have the perfect cocktail for a massive rally.  And that’s what we had.  The S&P 500 rose 60+% from its March 9^th low to its January high while the median return for all stocks was a double.  The bull market in emerging equities, which began earlier, was even more impressive as many bourses rose between 100% and 200%.

 

Conditions are largely favorable for equities.  Liquidity remains abundant as Fed policy is still accommodative, retail investor cash positions are high, the stress in the financial system has lessened significantly and earnings gains are surprisingly good.  Only investor sentiment is elevated (a contrary indicator), but that seems to be dampening during the late-January-early-February correction as we pontificate.

 

Chart X

Source:  BCA Research

 

Some pundits believe equity valuations are stretched.  We don’t.  We like to look at a number of valuation tools which contrast their levels versus history, versus fixed income alternatives, etc.  The Bank Credit Analyst has conveniently done that for us in Chart XI.  As we note, most of the seven valuation exercises that they show are pretty much at average historical levels.  Consequently, their aggregate valuation indicator is squarely on its 50 year average.

 

Chart XI

Source:  BCA Research

 

We mentioned that individual cash holdings are still very plentiful.  Although the ratio of cash to the aggregate Wilshire 500 market value has dropped from its March 2009 high – which was entirely due to the huge rally in stock prices – it is still about 65%, well above its historical average.

 

Chart XII

Source:  BCA Research

 

The recovery in profits these last three quarters has been very impressive to say the least.  Corporate net income is rising at close to a +35% annual rate and is being driven almost entirely by unprecedented cost cutting.  Head counts have been chopped unmercifully, so that productivity is soaring even with only modest gains in output.  Consequently, unit labor costs have declined about 3% year-over-year. 

 

Chart XIII

Source:  ISI Group

 

Managements have spread the pain across their entire cost structure.  Amazingly, aggregate S,G & A expense has declined for the first time ever.  And investors have rewarded those companies that have been proactive in slashing S,G & A spending with above average market performance over the past year.

 

Chart  XIV

Source:  Empirical Research

 

Investors are rightly concerned about the vulnerability of the equity market once the Fed begins its tightening phase.  And that is quite likely to occur sometime over the next 12-15 months, but definitely towards the latter part of that timeframe.  So how worried should we be?  An examination of the previous 11 tightening cycles in the post-War period suggests it’s not as bad as one might think.  At least initially.  In the first six months following the onset of the tightening, the market declined in only two of the 11 occurrences.  The range of returns was +19.0% to (5.0%) with a median gain of 7.4%.  The median increase in the Fed Funds rate covering all occurrences was +125 basis points.

 

Chart XV

Source:  BCA Research

 

The long term median P/E for the S&P 500 on forward earnings is14x.  A reasonable 2001 earnings expectation, in our view, is $80-$85.  Fourteen times the midpoint of those earnings would leave the S&P 500 +8.4% higher than current levels (1066) by 2010 year end.  Add the dividend yield to that, and the total return would be +10%.  Not bad.  It should handily beat government bonds and moderately out perform spread products.

 

Of course the multiple could be higher—or lower.   But, we find it difficult to argue for much of a multiple premium over that.  By the end of this year, we’ll be that much closer to Fed tightening, and it’s quite likely that investors will be increasingly concerned as the Federal Government deficits mount. 

 

Last March the level of risk aversion was about as extreme as we’ve seen it.  Credit spreads had exploded, the VIX (a measure of stock market volatility) was extremely elevated and the range of equity valuations was at a record level.  Consequently, on March 9^th of last year the prices one had to pay for the riskiest assets were at rock bottom levels.  Eighteen months earlier there was a big premium for buying risk, so it was those assets that were exorbitantly priced and suffered the most, as many declined (50%)-(90%) in price.  All of that reversed itself in the middle two quarters of last year.  The prices of junk soared while the returns on quality assets lagged pitifully.  So, the worst performers of 2008 were the best last year and vice versa.  The data below calculated by The Leuthold Group shows the perfect monotonic negative correlation of returns by decile:

 

Table I

The Upside Down Market

 

Source:  The Leuthold Group

 

Equity valuation spreads have compressed from near record levels to near normal levels today.  This suggests that there are few concentrated sectors – by industry group, style or strategy – that are deeply under-or-overvalued.  A more level playing field should reward good bottom-up stockpicking, an environment which is much more conducive to the Dalton, Greiner approach to equity management.  

 

Chart XVI

Source:  Empirical Research

 

Valuations are pretty similar across the capitalization spectrum as well.  Normalized the price/earnings ratio for small caps is at parity with that of large caps, which is modestly above its long term average of 86%.  We don’t think this valuation differential is large enough to make a clear cut case for favoring either large caps or small caps. 

 

Small cap companies have been more aggressive than their larger counterparts in cutting overhead.  Consequently, as revenue growth picks up as the recovery evolves, their operating leverage will be greater.  Although their valuations are at a premium relative to history, faster profit growth should offset it.

 

Chart XVII

Source:  The Leuthold Group

 

Emerging Markets

 

There is little disagreement among investors that emerging markets are where the action will be over the next decade.  We would agree.  Economic growth will continue to be superior in those countries, and their capital markets will mature significantly.  Over the past five years those countries in secular bull markets (the BRICs, etc.) share of global GDP increased 10 percentage points to 46%.

 

Chart XVIII

Secular Bulls vs. Secular Bears

 

Source:  Ned Davis Research

 

Reflecting their superior economic growth and massive accumulation of foreign reserves, emerging country stock markets significantly outperformed those of the developed countries, particularly the U.S. and U.K., over the past five years. 

 

Table II

Secular Bulls vs. Secular Bears

 

Source:  NDR Research

 

Foreign exchange reserves, largely dollar denominated, exploded in the emerging economies this past decade to $5 trillion and are about twice those of the developed countries.  This reserve accumulation is a direct result of their very large current account surpluses while the U.S., U.K. and some other developed countries are running deficits.  In the absence of major realignment of currency exchange rates, these surpluses will persist and the foreign reserves will continue to grow.  And we doubt that there will be any serious realignment in the relative values of the major currencies over the next few years.

 

Chart XIX

Source:  ISI Group

 

There are some potential bumps in the road for emerging equity markets near term.  In a recent ISI poll, almost 40% of the participants thought that Asia ex-Japan would be the best performing regional stock market in 2010, while 25% thought Latin America would be, which suggests that what we wrote above is no revelation.  Meanwhile, only 18% thought the U.S. market would lead and only 1% thought Europe would be the best market to place one’s bets.  So, if you’re a contrarian….

 

Chart XX

  

Source:  ISI Group

 

The big run up in the emerging markets over the past 15 months has eliminated all of their undervaluation and then some.  So, their stocks are no longer cheap and have become vulnerable to corrections.  And to this point, those markets have been slammed in the late January-early-February period as we write.

 

Chart XXI

Source:  BCA Research

 

We’ve been predicting emerging market outperformance for a number of years.  And because of their superior economic performance, that, of course, has been the case.  Now, being long emerging market equities has become a very crowded and somewhat over-valued trade.  Normally, that would scare us away.  Maybe it should this time.  But it’s not, and we think those markets should be the best performers – albeit with a much lesser margin – again this year.

                                    

Bonds

 

The yield on the 10-year Treasury bond (currently 3.55%) would normally be higher than it is today.  But conditions aren’t normal.  The huge structural imbalances of the global financial system which have resulted in the very large accumulation of foreign reserves, particularly among developing countries, is the primary culprit.  A substantial portion of those reserves end up in dollar denominated assets – like U.S. Treasury paper.  For the 12 months ended 9/30/09, foreigners bought almost 50% of the net issuance of Treasuries which undoubtedly was a major reason behind the rather benign behavior of longer maturity interest rates.

 

There are some other factors at play which are keeping a lid on government bond yields.  Most importantly, private credit demands have collapsed.  The deleveraging of both the business and household sectors has actually resulted in a net liquidation of privately issued debt.  Consequently, the huge surge in government debt issuance has been more than countered by the plunge in private debt.

 

Chart XXII

Source:  BCA Research

 

The real issue for the longer term maturities markets will surface as private credit demands revive in the second half of the year.  Unfortunately, the alarmingly huge issuance of Federal Government debt will persist and collide with the growing appetite of private borrowers.  The market will only clear at higher interest rate levels.  We expect the 10-year Treasury rate to reach 4% (or more) by the end of the year.  We’d like to stake out a claim that this prediction is in the minority.  That would be disingenuous because it’s not.  A recent ISI survey reveals that 80% of their respondents believe that rates will be at least 4% by year end.

 

Chart XXIII

80% Survey Respondents Believe10-yr Yields Will Be Above 4%

Source:  ISI Group

 

Corporate bond returns were spectacular in 2009 as record high spreads compressed dramatically.  But they’re not quite back to normal levels, and we believe they will head there before this year ends.  The steady improvement in the economy will pave the way for the peaking in corporate default rates, which should serve as the greatest spread depressant.  Also, investors continue to search for yield as short term rates are near zero which makes the corporate bond market inviting.  Somewhat offsetting the further compression of spreads will be the increase in the 10-year yield.  However, corporate bond returns, while well below those of 2009, will better Treasury returns but fall shy of equity gains.

 

Chart XXIV

Source:  ISI Group

 

Commodities & Currencies

 

The secular bull market in commodities is likely to persist until central bank tightening broadens significantly.  But that probably won’t happen until 2011, and the U.S. Federal Reserve will be one of the last banks to remove accommodation.  However, higher commodity prices are very dependent on vigorous emerging economy growth – particularly China.  The Bank of China, as the world knows, has recently enacted its first tightening measure which will surely be followed by others as it attempts to fine tune a modest reduction in accommodation.  Higher commodity prices will depend on skillful execution of their monetary measures to ensure strong economic growth without overheating. 

 

Chart XXV

The Commodity Secular Bull Market and U.S. Stock Market Trends

 

Source:  Ned Davis Research

 

The Chinese have been stockpiling commodities for some time now.  Cheap credit costs, concern about availability and speculators have combined to push commodity inventories to very high levels.  Tighter credit is likely to encourage at least some unwinding of speculative positions which would put some pressure on prices.

 

Chart XXVI

Source:  BCA Research

 

Oil prices, according to Bank Credit analyst research, are close to Fair value of $80-85 a barrel.  However, if global growth is decent over the next 12 months and China and other EM’s keep buying, as we expect, the risks are on the upside.  We think lower oil prices await widespread global central bank tightening.  And that’s probably a year off.

 

Chart XXVII

Source:  BCA Research

 

Currency speculators have flocked to the dollar in recent months as investors have temporarily moved away from the reflation trade and become more risk averse.  This flight to perceived safety will not persist in our view.  While there will definitely be some tightening measures initiated by the emerging market central banks, our Fed will be slow to abandon current policies.  Moreover, the huge current and prospective fiscal deficits are never far from the top of everyone’s list of risks.  And Moody’s recently cautioned investors that if these deficits persist, the U.S. risks a credit downgrade on its debt.  That would be serious.  We expect the dollar to resume its secular decline in the coming months, particular against the Emerging Asian and commodity currencies.

 

What Else Do We Worry About?

 

1.      Global Financial Imbalances

The issues surrounding the global financial imbalances are well known.  However, they persist.  And they will continue to dominate global financial flows until there is a narrowing between the very high savings rates of the emerging countries and the low rates of the developed economies.  The U.S. is far and away the world’s largest debtor as its over-spending and under-savings have resulted in massive current account deficits for a number of years.  These deficits are ultimately recycled back into dollar denominated assets by the surplus countries.  This buying has contributed significantly to the low interest rate level of the 10-year Treasury bond, the instrument off which the world prices its assets.  Lower rates mean higher asset prices for most everything which in some instances, could lead to the dreaded – when they burst – bubbles.

 

Chart XXVIII

Source:  BCA Research

 

World financial leaders understand the importance of reducing these imbalances.  However, the process will be slow and painful.  Savings rates won’t turn on a dime.  No doubt, the U.S. savings rate will rise over time as over-leveraged individuals and corporations address their wobbly balance sheets.  This will naturally slow our overall growth rate, resulting in all of the unwanted consequences – persistently high unemployment, weaker asset markets, lower returns on equity, etc.  But it will help to keep inflation in check.

 

Clearly, part of the adjustment process will be currency realignment.  The currencies of the under-savers must depreciate against those of surplus countries which will further impair our relative standard of living. 

 

2.      China

A well known short seller never misses an opportunity to publicize and bash his favorite short idea.  We heard him recently on CNBC – as well as several times before – and his current area of focus is China.  His thesis, which is not without merit, is that China is in the midst of a gigantic over-investment cycle.  Investment spending in China accounts for about 2/3 of GDP which is huge by any standard.  But China has invested in its public and private capital for years which has produced very desirable productivity growth.

 

Our short seller wouldn’t argue this point.  His concern is that China is now over-investing and will end up with massive over capacity of about everything.  He likens the current China investment bubble to that of 1980’s Japan, which ultimately ended in a long bout of deflation.  And, given China’s position of economic dominance, such a bad ending would have severe ramifications for the global economy and markets. 

 

Our friends at the Bank Credit Analyst recently examined this premise of Chinese over-investment.  Their supposition was that if there were a troubling investment bubble, then it would naturally have bloated the capital-to-output ratio and put downward pressure on the marginal return on capital.  Such is not the case.  In fact, the capital-to-output ratio has been quite stable over the past 15 years.  And it is about six times as efficient as that of Japan and three times that of the U.S.

 

Chart XXIX

Source:  BCA Research

 

Something that we are uncomfortable with is the alarming increase in Chinese bank credit.  The +20 percentage point acceleration in credit has also concerned The Bank of China as it recently implemented its first round of tightening by raising bank reserve requirements.

 

Chart XXX

Source:  BCA Research

 

 

Even when one factors in that 1/3 of the increase in bank credit was to facilitate the government’s stimulus program, it’s still worrisome.  Shanghai real estate prices have spiked in recent months, and the bears have been quite vocal about that.  However, mainland China real estate prices are not particularly out of line with most major urban centers elsewhere.  So, while we remain concerned about the possibility of bubbles surfacing in China, asset valuations are far from there now.  The Bank of China must walk a fine line between accommodating sufficient economic growth and avoiding fueling inflation (which is OK for now) and asset bubbles.  It could be tricky.

                                        

3.      Deficits, Taxes and Other Anti-Growth Initiatives

“The national budget must be balanced.  The public debt must be reduced; the arrogance of the authorities must be moderated and controlled.  Payments to foreign governments must be reduced, if the nation doesn’t want to go bankrupt.  People must again learn to work, instead of living on public assistance.” 

 

Cicero, Roman author, orator and politician

106 BC-43BC

 

“A democracy cannot persist as a permanent form of government.  It can only exist until the voter’s discover that they can vote themselves largesse from the public Treasury.  From that moment on, the majority always votes for the candidate promising the most benefits from the public treasury with the result that a democracy always collapses over lousy fiscal policy, always followed by a dictatorship.”

 

Alexander Fraser Tytler, Scottish lawyer and writer, Cycle of Democracy (1770)

 

How’s that for some very relevant wisdom from the history books?  Developed country governments are in the midst of an unprecedented borrowing binge.  Much of the explosion in borrowing is a result of the various recession-fighting measures and automatic stabilizers.  But not all of it.  In the U.S., the Obama Administration has concurrently launched its very ambitious domestic initiatives agenda which will require vast amounts of new spending. 

 

Government deficits for the advanced G20 economies are projected to reach 9% of their aggregate GDP this year and next.  This contrasts with 1.9% in 2007 and the previous peak of 5% in 1993.  The U.K. and the U.S. are in the worst shape, followed closely by Japan, France and Spain. 

 

The numbers in the U.S. are, in a word, grim.  The OMB estimates a Federal deficit of $1.6 trillion, or 10 ½% of GDP this fiscal year.  While declining, these deficits will remain alarmingly high throughout the forecast period.  R. Glen Hubbard, the Chairman of the Council of Economic Advisors during the Bush Administration, estimated in a recent WSJ Op-Ed piece that if enacted, these budgets would reduce GDP by 4% over the next three years and raise long term interest rates by 100 basis points. 

 

The increase in the Government Debt/GDP ratio that is a consequence of all this spending will create serious problems and challenges.  The OMB estimates that Federal Debt/GDP will increase by 20 percentage points from current levels to 73% by 2015.  Kenneth Rogoff, a Harvard economist, says that 80% is the tipping point.  At that level of debt burden, interest rates soar, asset prices plunge, the currency collapses and the economy is in crisis.  Horrifying to contemplate. 

 

The good news is that almost every serious observer knows that this can’t happen.  The question is how to solve it.  And the gap among the proposed solutions is canyon-like.  The Obama Administration has latched on to a very public populist, anti-business, anti-capital formation and anti-high income earners message.  Its proposed tax increases on the above of $1 trillion on individuals and $375 billion on corporations will get him his domestic program spending initiatives and the horrifying deficits.  So to reduce them, there either must be even more new taxes or significant spending cuts.  So far, we’ve seen no serious, meaningful spending reduction proposals.  It’s reprehensible that Federal civilian full time employment (mostly in our Federal Agencies) has risen by +14.5% over the past two years while the private sector has lost 8.5 million jobs.   

 

The increase in the Federal Government’s share of GDP from 21% to 25% is shifting a huge portion of our economy from the productive private sector to the government sector.  This shift in resources will create a significant drag on our economy as Glen Hubbard noted.  Moreover, tax increases are never good.  Penalizing upper income earners, most of whom own their own businesses, and on the capital providers will discourage investment and hiring. 

 

These serious anti-growth initiatives and their implications are not lost on investors, entrepreneurs, corporate executives and consumers.  In our view, this negative impact on expectations represents the single largest impediment for our markets, economy and standard of living.

 

We’re talking about fiscal projections which extend 10 years.  But to investors, the problem is now. 

 

This will be a more challenging year.  The markets will be more volatile as investors struggle with the anticipation of central bank tightening, deficits, anti-growth initiatives, sovereign debt problems, the further deterioration of commercial real estate prices and the absence of compelling values in most asset markets.  However, the path of least resistance for most financial asset markets is up – for now.