Sin and Forgiveness
12/31/10
What a year it was. Fed Chairman Bernanke had saved us from the brink of the abyss in 2008 by applying liberal doses of money, called quantitative easing or short QE. The Fed's newly printed dollars were used (for the most part) to purchase illiquid assets such as mortgage backed securities from the large commercial banks. The financial system stabilized slowly and the economy generated momentum in 2009 aided by the extra liquidity and the first time homebuyer credit. As soon as QE1 ended at the end of March 2010, however, the economy started sagging again and the stock market with it. "Double dip recession" was on everybody's lips, political profiteers and professional doomsayers dominated the playing field reveling in the "correctness" of their predictive powers. The economy seemed to stall while European problems, political shenanigans and continued high unemployment clearly depressed even the most exuberant personality and the animal spirits of most entrepreneurs and business managers. Bernanke was under siege all summer long. His speech reflected the downbeat mood of the time at the conference in Jackson Hole, Wyoming, which lasted from August 27th through August 29th. There, Bernanke outlined the Federal Reserve's options, should the economy loose further altitude. Two days later the stock market reached its low and never looked back. Was Bernanke's announcement of QE2 the necessary jolt needed to revitalize everybody or was it merely coincidence? Let's look at the charts before we commit to an answer.
The first chart above shows you S&P 500 index in red and the weekly leading index of the Economic Cycle Research Institute (ECRI) in blue. The video on their homepage shows an interview with Lakshman Achuthan, Co-Founder and COO of the institute. I find his contributions always insightful and right on the mark. He maintains that the break at the end of April and the subsequent softening in the economy was a normal "mid-cycle slowdown" and that we would have recovered from that (as in previous recessions) without QE2. I am not so sure about that. Recoveries from recessions are frequently interrupted by mid-cycle slowdowns that last a quarter or two before transitioning into expansion mode again. This fact is well known. However, the clear break that is visible at the end of April came 3 weeks after the Fed stopped the purchase programs of QE1. This break is too sharp to be a mere slowdown. The second chart shows us the leading index again with the growth rate calculated by the ECRI. While the index contains some proprietary data, the general composition of the index is explained on their homepage. I respect their approach, but to me it looks like QE2 was not only necessary but did what it was intended to do, revive the animal spirits and push us out of the doldrums "by any means necessary". The developments after that memorable Jackson Hole conference can be gleaned from the charts above. No sooner was Bernanke quoted in the media and economic indicators and the stock market rose in unison. The rest of 2010 was dominated by improving headlines on both fronts. Forgotten were the nagging doubts, the second guessing and the dreadful cries of CEOs and shareholders alike. Stocks and profits rose and the dwindling numbers of disenchanted shareholders received a Christmas gift in the form of nicely growing portfolios. What a year indeed. Moving right along, we have now entered the year 2011 and predictions are plentiful. Everybody has a favorite approach. Notable among them is professor Robert Shiller, who guessed at the stock market level in the year 2020. His approach is valid, but not actionable for investors. He looked at the past 120 years and found that earnings growth averaged 1.5% per year. He extrapolates today's earnings to the year 2020 and then applies the long term average Price-Earnings ratio of 15 and comes up with a target price of 1,430. No kidding. He is smarter than most people and probably right (or not?), but what do you do with this information? How do you invest on it? For example, on Friday, Oct. 23, 2009, the current Shiller's Cyclically Adjusted Price Earnings ratio (CAPE10) was 24.08 while the long term average CAPE10 (since year 1881) was 16.34. This implied that the U.S. stock market was 35% overvalued on that day. On Nov. 26, 2010, (after a 14% rally) the ratio of Real Price to the average of last 10 year Real Earnings (CAPE10)(22.47) to its long term average (16.38) was 1.37, meaning we were overvalued by 37% a month ago. Do I have your attention? Shiller's approach is purely academic and valid from a historian's perspective. As a practitioner, I can find nothing actionable in his approach. If I want to keep my customers happy I have to figure out other ways to create value and performance.
Let us take the Chicago Purchasing Managers index, for example. The index reached its highest level in 5 years. Production climbed to its highest level since October 2004, new orders improved to 2005 levels and employment reached its highest level in more than 5 years. While professor Shiller undoubtedly has many historical arguments on his side, stock investors do not look at the past for future guidance (even though sometimes they should). The Chicago PMI numbers indicate booming business conditions and stocks are unlikely to realize anytime soon that they are overvalued by 37% by someone's historical standards. The same is true for the second chart above. Regular readers recognize it as our representation of the weekly unemployment insurance claims. The seasonally adjusted numbers reached with 388,000 new claims the lowest level since July 12, 2008. Experts say that the benchmark is 400,000. If new claims drop below that benchmark the unemployment rate starts to drop. So the labor market also went out with a bang. Even the unadjusted numbers, which typically spike higher towards the end of the year have not spiked as high as in previous years. The spike from the beginning of October to the end of December amounted to 290,214 in 2008, 193.586 in 2009 and only 148,153 in 2010. By virtue of my chosen profession, I must take the data as they come and readjust my posture accordingly. Long term predictions are for academicians, fools or conspiracy theorists, who believe that some entity is manipulating events and markets. Monetarists may criticize Bernanke for juicing the economy with the same medicine that got us into the housing debacle in the first place - easy money. There are certain fiscal conservatives, who would sacrifice a generation of job-seekers for the purity of their monetarist beliefs. I do not belong to that club of the "righteous", mainly because I consider Bernanke a very prudent and circumspect man. It seems to me that his sin of erring on the side of caution is more than offset by the forgiveness of the unemployed masses. Happy New Year!
Hermann Vohs
"You can't trust anything the government says. Wait, I knew that already. Thanks for nothing, Julian Assange."
Paul Vigna
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.
