Wall Street Steward Blog

Will Santa Claus Bring Higher Stock Prices?

There are two types of people in the financial business:  those who don’t know and those who don’t know that they don’t know.  After 17 years in this industry, this statement makes even more sense to me today than it did initially. In my opinion, it is useless to forecast what the economy/stock market might do because nobody has shown the ability to accurately do so.

With that being said, welcome to my 4th quarter overview.  I guess I just “don’t know that I don’t know.”

Think of the entire U.S. economy as a large pizza, and while our leaders in Washington argue about how much of the pizza should be eaten by taxation, they really should be focusing on how to grow the pizza from a large pie into an extra-large pie.  That is GDP growth.

Most economists agree that 3-4% annual GDP growth* is what we need to have a healthy economy.  Any less than that, and we risk falling into stagnation (no growth), but too much growth is inflationary.  A recession is defined as two consecutive quarters of negative GDP growth, and we want to avoid that at all costs.  Currently, there are experts throwing around the term “double dip recession,” but I do NOT see that happening.

The first 2 quarters of 2011 have offered GDP measures of 0.4%, and 1.3%, and analysts expect the third quarter to produce a 2-2.5% figure**.  There is a risk of a double dip, but my guess at the final GDP number for 2011 is 1.7% (consensus is 1.6%), which is not great but far from recessionary.

You may ask “how do we increase our pizza size from 2% up to 4%,” and the answer is simple:  create jobs.  Speaking of….

Our national unemployment rate is currently 9.1% as of 10/7/2011, but two things that number doesn’t account for are the “underemployed” people who exist and the growing mass of people who have just stopped looking for work.

Underemployed people are folks that might have held an “A” job in a normal economy, but considering this mess, currently have a “B” job.  This means that they are not earning as much as they used to and been forced to cut back on their lifestyle and spending.  As a result, people who would normally get that “B” job cannot compete because there’s a pool of overqualified candidates.  When that happens, those people have to settle for the “C” job.  Eventually, when you get to the bottom of the totem pole, people who COULD normally find work are unable to do so, and stop looking.  This leads to higher unemployment and jobless claims.

I think we have seen the bottom of unemployment, and are starting to create jobs S L O W L Y.  Layoffs remain low, and unemployment claims have improved slightly.  The further we get from rock bottom, the better our chances that the economy will improve and lead to a job recovery.  My guess is that one year from now the unemployment rate will be 7.9% although the consensus is gloomier.  Even the White House believes unemployment will remain at 9% for 2012, according to a Sept. 1 report.

According to the Bureau of Labor Statistics, core CPI (consumer price index) is currently 1.95%, but that does NOT count food or energy.  I am not sure about you, but I like to eat…a lot.  Also, I tend to drive a car when my family needs to go somewhere, so the core inflation figure doesn’t do it for me.  The figure that I prefer is the “headline CPI,” which is not adjusted for seasonality and includes food and energy prices.  As of Sept. 15, the Bureau of Labor Statistics published a headline CPI number of 3.8%.

Some inflation is good because it encourages people to buy now rather than wait:  “Sally, we better buy this car today because once the 2011 versions are gone, we will have to buy a 2012 and those are 5% more expensive.”

The opposite of inflation is deflation, which is deadly to an economy.  During the Great Depression, we had deflation, which convinces the consumer to believe that if they wait long enough, prices will fall. “Bart, I know the salesman said that the house is $125,000, but if we just wait a year, we can get it for $75,000.” Currently, deflation is not on our radar, but some economists mention it so I wanted to explain why it is bad.

To me, a healthy inflation number is a real 3-3.5%.  According to Ibbotson, inflation has averaged 4.1% annually since 1950, so we are not THAT far from average.  However, when you consider that 1-Year CDs are currently paying 0.38% and that the 10-Year treasury is yielding around 2%, inflation of 4%+ is a dangerous proposition.

That wraps up my take on the economy, so now let’s discuss something interesting like the…

In my opinion, stocks are very cheap.

Long term, the most accurate predictor of stock market returns is the S&P 500 Index price-to-earnings ratio.  If we look at the S&P 500 and the trailing earnings of companies over the past 12 months, we are trading at 10.6 times those earnings.  According to LPL Financial Research, the last time we traded at this level was 1989 – 22 years ago.

The “bears” (people who are negative on the market) argue that corporate earnings are going to fall off a cliff soon.  I agree that earnings will pull back some, but if we apply a 10% reduction from the current consensus earnings estimate of $110/share, we still have a market price-to-earnings ratio of around 12. With a 20% drop in earnings, the ratio would be around 13, which is more normal but would not be considered overvalued.

The market is pricing in a lot of fear of potential risks, which we will cover later. Once level heads prevail, I believe earnings will matter again. When that time arrives, I believe the market will appreciate substantially.

As of 10/11/2011, the 10-year treasury is yielding 2.14%, and the 30-year treasury is yielding 3.06%.  These are the lowest yields (and highest prices) in history.  To make money in investing, one must buy low and sell high, so it stands to reason that treasuries are not the best place to be placing money now.  However, they have appreciated recently due to the FEAR gripping investors, institutions, and countries.  Despite the downgrade of the U.S. debt, most agree we are the safest country to invest in, and because of that, treasuries are seen as a “safe haven.”  I would not buy treasury bonds at these levels, unless bound by an investment policy to do so.

Corporate bonds look less rich than treasuries, but still look slightly overvalued to me.  According to ValueLine, an “A rated” corporate bond with a maturity of 25-30 years is paying only 4.31%, while the same bond with a 10-year maturity yields only 3.59%.  I believe that corporate bonds have a place in a portfolio in this environment, but they likely won’t repeat their performance over the last 10 years.

High-yield or “junk” bonds look to be the most reasonably priced.  This makes sense because these bonds are typically tied to the performance of the stock market, which means they also have been beaten up. The major risk is the chance the underlying company won’t survive. When the economy is bad, you’ll see an increase in companies being unable to pay their bills – which presents a good buying opportunity if you can stand it.

Municipal (or “tax free”) bonds, issued by individual states, also look attractive.  About a year ago, an analyst predicted “hundreds of billions” of defaults in the municipal marketplace, and states have had nothing near that, causing this asset class to appreciate substantially.  Despite that, I still believe this is a good place to add money.  Currently, a South Carolina “A rated” muni bond with a 20-year maturity yields around 4.5%, according to LPL Financial.

The European debt and fiscal crises have deteriorated over the past three months to the point where people have begun to openly question the sustainability of the European Union.  Euro-zone members have yet to ratify changes proposed to the European Financial Stability Facility (EFSF), but LPL Research believes they will do so soon.  Even though this coverage would be limited to around 440 billion euros, there is growing support for a plan by U.S. Treasury Secretary Geithner that would allow the EFSF to borrow from the European Central Bank (ECB).  This would essentially extend the credit line and increase the impact it could have.

In layman’s terms, the problems in Europe are big and need to be addressed, but I believe they will be addressed and that the market has priced in the downside risk to this crisis.

The left and right sides of the aisle have never particularly liked each other or agreed, although I struggle to remember a time in history when the two sides were so divided on just about everything.

Although I do not agree with everything from either party, I am encouraged they are now at least discussing the debt issue.  A congressman recently told me, “We should pass a balanced budget amendment, but Washington currently does not have the political resolve to fix this issue. Folks are more worried about getting re-elected than what the economy might look like in 20 years.”

Although I do think we have progressed recently, there is still a wide gap between the LEFT and RIGHT.  Things will get interesting as we approach the 2012 election and I will have a front row seat – watching on TV from my couch.

Just to summarize, I am bullish on stocks, high-yield bonds, and muni bonds.  I am bearish on treasury bonds, while being neutral on corporate bonds.

Obviously, every nook and cranny of every asset class cannot be covered in one commentary.  This gives you an idea where I stand, and I hope it made sense to you. Next stop: first quarter 2012.

according to www.useconomy.about.com
*according to www.consensuseconomics.com

Important Disclosures
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.

The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

CD’s are FDIC insured and offer a fixed rate of return if held to maturity.

Stock investing involves risk including loss of principal.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.