Looking For Silver Linings

John Templeton, one of the greatest investors of all time, said that investors should buy at the point of maximum pessimism. Nothing illustrates the adage of something being easy to say and hard to do more than that statement. It is of course at the point of maximum pessimism that our natural psychological barrier to executing that strategy is greatest. Humans have a survival instinct and just when things reach their nadir is when most investors let that instinct take over. And there is nothing that could be more damaging to one’s net worth than allowing fear to take over just when the opportunities are the greatest. How many investors gave up in late 2008 or early 2009, sold all their stocks and still haven’t recovered from the losses of the great financial crisis? Based on the continued high traffic numbers at Zero Hedge, I’d say a lot.

I thought of that Templeton quote last week as I watched the stock market fall another 1.5% based primarily on fears about the outcome of the negotiations over the fiscal cliff. The gloom lifted a bit Friday when Republicans and Democrats held hands and sang Kumbaya in the Rose Garden after a “constructive” meeting on how to resolve their differences about how much of our money to take and spend. I couldn’t help but think that Harry Reid, Nancy Pelosi, John Boehner and Mitch McConnell all must have checked their brokerage balances before that meeting and decided that maybe compromise wasn’t such a bad thing after all. We don’t know the details yet on what the negotiations will yield but a good guess would be that they come up with something that pushes the hard decisions off to next year. If there is one thing our politicians can be counted on for it is to put off until tomorrow anything that might prevent them from taking a vacation.

I think it is fairly easy to predict the outcome of the budget negotiations next year. Taxes will rise. Whether that is due to a rise in tax rates or due to limiting deductions or some combination matters but only at the margin and probably not a lot. Spending will not be cut but the rate of increase, at least as envisioned by the soothsayers at the CBO, will be reduced. Another likely outcome is a cut of some kind in the corporate tax rate as both sides have admitted that the rate is so high now that it puts the US at a competitive disadvantage. There will be loophole closures or at least the appearance of it so the effective rate might not change much but there will be some positive incentive and efficiency effects if the rate is reduced. As for entitlements, I doubt there will be much change in Medicare or Social Security although Medicaid might see some changes. I hope I’m wrong about that but the political challenges on entitlements dwarf those of the haggling over income tax rates.

The point is that we will get some kind of deal on the budget. It probably won’t work as advertised in the long run but at least in the short term the uncertainty over taxes and spending will be resolved. I don’t think we should underestimate the potential positive effect that might have on the economy. Businesses with a degree of certainty about tax rates and benefits costs can adjust and move on. Frankly, I’m not sure how much holding back there has actually been during the limbo days of uncertainty. I hear a lot of talk about how companies are not investing but the economic data doesn’t seem to reflect that. It is true that Gross Private Domestic Investment has not fully recovered from the recession but that is entirely due to residential investment, not corporate investment. Of course, I suppose it could have been even better absent the uncertainty but that is impossible to know.

Regardless of the outcome of the budget negotiations, I think the negative sentiment surrounding the US and global economy might be reaching a crescendo. I don’t know if we are at the point of maximum pessimism yet but I think we might be close. To be labeled optimistic today one only has to believe the US economy can continue to muddle along at the current 1-2% growth rate. The pessimists duel to see who can come up with the most dire outlook. An optimistic pessimist sees a mild recession followed by a return to slow growth. Pessimistic pessimists predict a break down of civil society and world war. No one outside the rose colored glasses wearing folks who put together President Obama’s budget projections believes we can get back to trend growth of 3 to 4%. But what if all the pessimists are wrong? Is there any reason to believe that US growth – and therefore global growth – might surprise to the upside?

Actually I think there are some reasons to be optimistic. I know this will get me all kinds of hate mail from the doom and gloom crowd but here goes. The first and most obvious is the housing market that has held back the recovery. While everyone is concentrating on the Case Shiller index of home prices, the most important metric for residential investment is being ignored. Household formation is recovering and any uptick in employment will only accelerate the process. In the ten years prior to the recession, household formation averaged 1.5 million per year. From 2007 to 2010 that rate was cut by 2/3. Household formation recovered to a bit over 1 million in 2011 and probably rose more this year. Still there is a gap of about 2.5 million households between the number formed in that period and what would be expected based on demographic trends. There is pent up demand for housing (although probably primarily rental housing) that only awaits some job growth to be realized.

The obvious question then is what will accelerate job growth? One answer might be that a lot of companies are deciding for a variety of reasons to bring production back to the US. The reasons vary but there is no doubt that many companies have decided it is in their best interests to reshore operations that were offshored over the last couple of decades. Chemical, fertilizer and other companies that use a lot of natural gas are investing in plants here to take advantage of the cheap gas available due to fracking. There are reasons to believe that the current low price won’t last but even if prices double from here they will still be a lot cheaper than the rest of the world. Another reason companies are relocating back to the US from China and other outsourcing havens is that labor costs, when productivity is taken into account, are equalizing. Labor costs in China have been rising at a 20% annual rate for the last 4 years and when other costs are taken into account – along with corruption and piracy – the US looks pretty good. This trend may just be getting started and if so, it is very good for our long term outlook.

Another reason for optimism is that the external drags on US growth may be peaking as well. Economies outside the US have slowed but there are tentative signs that the worst may have already passed. China’s economy, based on the last couple of months of data, appears to have stabilized and the same is true for the rest of Asia. In Europe, the headlines last week were about a return to recession but the data had some positive aspects as well. The rate of decline in Italy and Spain slowed considerably in the quarter and both countries are now running current account surpluses. Of course, that has reduced the growth rate in Germany but overall Europe may be hitting bottom. Nothing goes on forever. For skeptics of these trends I would just point out that both European and Asian stocks have outperformed the US recently.

If we are to speak about maximum pessimism, we can’t ignore the third largest economy in the world, Japan. The Japanese stock market is at a lower level now than it was in the mid 1980s and bulls are as scarce as Yankee fans in Boston. There are a lot of very smart investors predicting the imminent demise of the Japanese economy but I have a different view. It is true that Japanese government debt is huge and growth has been anemic but both of those problems are related to some degree to the overvalued Japanese Yen. It appears that problem may finally be addressed after elections next month. The Yen has already fallen nearly 8% from its high in late 2011 and could fall significantly if the rest of the global economy picks up and the new government follows through with plans to ramp up monetary stimulus. With most of their earnings coming from outside Japan, a lower Yen would be very beneficial to the Japanese corporate bottom line and the Japanese economy. And a healthier Japan would also be good for the global economy, the US included.

Last but certainly not least is the stabilization of the US Dollar. I don’t know whether it will last but the trend for the dollar has been slowly getting better. The US Dollar index is up almost 12% from its 2011 low and gold has fallen by a similar amount. The future course of the dollar will depend on the outcome of the fiscal negotiations and how the Fed responds. The Fed has spent the years since the crisis creating bank reserves and a burst of optimism about the US economy might give banks the confidence to lend aggressively again. If that happens, we could end up with more growth than the Fed knows what to do with. An inflationary boom is certainly not out of the question, but at the beginning, an inflationary boom will just look like a boom and would likely be positive for our currency as capital flows here to take advantage of higher growth prospects. I don’t know how long the Fed would let the boom last before taking away the punch bowl but it might be a hell of a party until they do.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773.

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