Further Gains in 2010
12/31/09
This year's rally was easy to miss. Bears are mad and bulls feel vindicated. The S&P 500 tumbled 38.5% in 2008, its biggest loss since a 38.6% plunge in 1937. The following year, then the largest decline was followed by an equally impressive 23.5% gain. Twice this year, the market tried to shake off the weak holders like a bucking bronco. The first time in July and the second time in October. Both looked at the time like perilous technical breakdowns. A weak market, however, would have continued to sell off. This market, however, did not sell off but turned right around and continued to march higher, leaving the prudent (and technically inclined) investors in the dust. The final shakeout came in October after the Dow ran past 10,000 and then turned down to 9600. After that spike down, it just didn't seem worth it to stay long. The huge run off the bottom was in the bag and it looked like there just wasn't that much more to gain. Little incentive was left for money managers to incur any sort of risk for an extra couple of percentage points. Long only stock managers therefore locked in gains or got shaken out only to watch the beast run another 10% without them. Needless to say, bulls and bears hated this year's rally, just like bears and bulls hated last year's decline. Some wise man said: "Consistency requires you to be as ignorant today as you were a year ago." Far too many people had left the stock market in October as they decided that the market was simply done going up and when the market continued on upwards they could not bring themselves to become bullish again. Costly mistake to sacrifice performance at the altar of consistency. Is this a wall of worry we can continue to climb in 2010? It is more possible than many expect. While many observers are still concerned about the serious problems facing the U.S. and global economies, it is possible that a business-led recovery -- which we currently have -- turns into an eventual consumer recovery. In many ways that would be much more desirable than what we have been seeing for decades now in the U.S., with consumers bearing too much of the recovery weight and leveraging themselves up as a result. Corporations on the other hand kept more cash on hand than was necessary and thus have the wherewithal to invest and keep the recovery going.
The chart above has been shown many times before, but I must revert to it again, because it gives a very good longer term perspective on the state of the U.S. non-financial (!) business sector. Fourth quarter data are not included because all data except S&P 500 data are updated only quarterly. Corporate cash flow has reached new highs, after tax profits are also recovering but are still below previous highs, whereas capital investment has just now flattened out. One of these days, corporations will start investing again and not because somebody decided to lower taxes again but because it makes sense. During the 2001 recession it took corporations a full 10 quarters before non-residential investments increased in the 3. Quarter of 2003. Investments are stagnating right now at the level they had first reached in 1999, while cash flow has doubled and after tax profits almost tripled since then. Corporations do have the cash to invest. Investors who buy stocks today, purchase $1 in cash for every $10 worth of market capitalization. This is a very nice cushion of safety and shows how well financed US companies are. They will invest again, I have no doubt, as soon as the economy shows them that it is profitable to do so. I believe that this time is approaching fast and for this reason I continue to believe that investors should seek exposure to stocks rather than to bonds. One more argument:
The CFNAI is a weighted average of 85 existing monthly indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of one. Since economic activity tends toward a trend growth rate over time, a positive index reading corresponds to growth above trend and a negative index reading corresponds to growth below trend. Given the volatile nature of this index, the three-month moving average is typically quoted. You can see that national economic activity is approaching trend-line growth and improved further in November. The Index suggests that growth in national economic activity was below its historical trend. The level of activity, however, remained in a range that has historically been consistent with the early stages of a recovery following a recession. With regard to inflation, the amount of economic slack reflected in the 3-months moving average of the CFNAI indicates low inflationary pressure from economic activity over the coming year. This too does not look like an index that is about to fall off a cliff. So why would you want to be in bonds? To add insult to injury for the bears, there is more good news. Look at the second chart above. Inventories have been declining for 13 months in a row and started to stabilize just this past October. GDP growth takes a hit each time inventories are liquidated in a quarter. Despite this headwind GDP has been able to increase for two quarters already. Barron's Gene Epstein estimated this weekend that the degree of inventory liquidation is so huge, that if it came to a halt in a single quarter (October being the first month) its contribution to 4th quarter GDP growth could amount to 4%! OK? I am glad people are finally realizing how much juice this recovery has. Stocks certainly have anticipated just this development all year. Get ready for a reading of 4% or more when the advance report on fourth-quarter GDP growth is released on Jan. 29. It may jolt bond investors again, but Bernanke is sure to keep the pedal to the metal at least until the end of the second quarter. Stocks should therefore enjoy their nirvana-like state of ignorant bliss a little longer. Will it all end in tears? Not necessarily. It is possible that the well financed business sector will pick up the baton from the consumer. Let's therefore not get too bearish just yet in 2010.
Hermann Vohs
"Consistency is the last refuge of the unimaginative."
Oscar Wilde
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
