The Markets Unplugged – II

Transcript for November 12, 2009 Conference Call

Let’s pick up from the last time we were together; our April 2009 phone meeting, our first Unplugged Conference call. At the time we suggested a market move up from the lows we faced in March; 666 on the SP500 Index and 6,500 on the DJIA. We postulated a price move to 975 on the SP500 and 9,000 on the DJIA. As conservative as those numbers sound now, a few of our “bearish” callers questioned our view and one even asked, “Why should we believe you?” We went on to support our reasoning behind those targets, addressing each one: (1) Primarily, the perception by investors that the U.S. banking system would stabilize thanks to TARP and a Federal Reserve policy of “easy money.” Secondly, we cited home inventory being worked off as a sign for a more stable real-estate environment. If you remember, real estate got us into this mess in the first place.

Third, and the real catalyst that would continue to move the market higher, we voiced, was our view that our global partners would pick up where they left off, from the summer of 2008; buying commodities, infrastructure inputs and personal care items that would buoy the equity markets here in the states and around the world. We cited continued GDP growth in India and China.

Since sinking to a 12-year low in March of 2009, price has moved up, rather meteorically. In fact, not since 1932, in the U.S. equity markets, have we seen such a quick move higher in price than we have seen since March 2009. News for the majority of the time in 2009, up until a few months ago has been, as we suggested to some of you who attended our Town Hall Meeting back in October of 2008, the worst economic news since the early 1980’s. Yet, price is moving higher and has climbed to levels we saw last October. Our real concerns now are the lack of true fundamentals to support the recent move off the March low. This recent move we would categorize as technical; more psychological in nature, a “got-to-get –in-before-I-miss-out” move.

Why are we concerned? In terms of market pricing, we are at the same juncture we were in late 2008, but in terms of company fundamentals we are not. There is a good-news, bad-news scenario that goes along with the fundamental outlook. Let’s deal with the bad news first:

The basic model in American Business is an ROI or Return on Investment model. ROI is made up of two inputs: revenues and expenses. To increase ROI and therefore, increase EARNINGS, a company has to (1) either sell its product or service or (2) keep its expenses under control, or (3) both. Earnings drive stock prices up or down. That is basic Stock Market 101. Companies have met or beat most of the earnings projections thus far in 2009, leading to higher stock prices because of cost cutting.

Have the increase in earnings come from the revenue side of the ledger? No, not really. Year-over-year sales are down across most industry groups. Earnings have grown because companies are laying off people, closing down plants and manufacturing units, depleting their inventories, suspending expansion and new projects. Those economic benefits to the ROI model occur on the expense side of the ledger. Therefore, earnings are going up because costs are going down.

That’s good for a while; at least for the last few quarters. But how much cost cutting can a company cut until it runs out of items to slash?

And why aren’t revenues going up? Because nobody is buying anything, at least not to the extent America was purchasing in 2006-2007. True, the number is relative; but, it is the rate-of-change from quarter to quarter and year- to- year that stock prices and earnings key off of. That, in a nutshell, is the problem the markets face going forward! You have heard this concern reported in the news as “top-line growth.” Currently, the lack of “top-line” growth, the lack of an American consumer spending on a relative basis is the bad news scenario.  So the question is: “If there are no more expenses to be cut, what, if anything, will feed a rise in earnings and stock prices going forward?”

The answer to this question comes in parts and make up the “good-news” scenario. So here are the components of the “good-news:”

  1. Top-line growth will come from demand overseas. The good news for U.S. investors is that unlike the 60’s, ‘70’s, ‘80’s or ‘90’s, the 21st century investor can take advantage of global growth through a greater variety of financial instruments; whether it be U.S. multi-national equities, ADR’s, foreign exchange traded funds or international mutual funds. The GREAT news is that the United States is not the only consumer in town. Other countries not only have the demand, but the money to pay for goods and services that drive a developing world. Presently, even though the demand many not be as strong from Americans, wealthier sovereign entities will pick up the slack for the United States’ lack of demand. It becomes a matter of targeting what industry groups will be the recipients of future demand. We have a discipline that targets select industry groups for purchases. For example, domestically, railroads appeared on our buy screens back in 2005 and we took advantage of the U.S. and global demand for commodities that railroads support and made the appropriate purchases. In fact, that investment idea is still getting attention; Warren Buffet just added to his railroad holdings by purchasing the rest of Burlington Northern; a company some of you own. Also, we cited the rise of a global consumer middle class back on the April conference call. Most of the “top-line” growth for the large U.S. multinational companies we recommended earlier in April has come from the overseas consumer this current earnings quarter! People overseas are drinking Coca-Cola, eating more McDonald’s hamburgers, putting Johnson’s baby powder on their infants…well, you get the picture.

  2. The second part of the “good news” comes from the Federal Reserve, continuing to conduct an easy money policy “for an extended period.” That was the language from last week’s Fed meeting. It was a 10-0 vote among the Fed governors to leave interest rates at record-lows. The Fed is satisfied with “subdued inflation trends and stable inflation expectations.”  The Fed has been an integral safety net for the financial markets since August 2007 when we saw the first signs of trouble with the demise of two Bear Stearns real estate hedge funds. The Fed would rather see an orderly market decline rather than wholesale panic. Every major bounce in the market from August 2007 to the March low in 2009 has been facilitated by a Federal Reserve action. From the facilitated purchase of Bear Stearns in March of 2008, to the public support of Fannie and Freddie in July of 2008, to the provision of TARP money and the $300 Billion loan to Citigroup last November, to the mandated suspension with the help of Congress of key mark-to market accounting elements in March of this year. All those moves supported our economic system and spurred the equity markets. The Fed has been there to preserve and protect. The market axiom is “don’t fight the Fed.” The Fed will continue to provide stability going forward for the U.S. financial system. Whether you agree or disagree with its involvement, the Fed has been a positive in mitigating market volatility and helping to create more stable price action in the equity markets over the past 12 months.

  3. These two pieces of good news will contribute to a third piece of “good news.” Both global consumption and an accommodative Federal Reserve will buy America the time it needs while it works off the overhead supply created from the recent asset bubbles. Also, time is a valuable element needed for the “de-leveraging” of the real-estate and credit markets. “De-leveraging” means simply, paying back, if possible, one’s debt. Buying time has allowed business inventories to shrink; setting U.S. companies up to run more efficiently to meet future demand. Time will allow the American consumer to de-leverage their personal balance sheets; save more money and get their financial house in order. We have likened America to a patient recovering from trauma. America has moved from the gurney, to the hospital, and now to the convalescence home where she is recovering. Recovering from trauma takes time. Global demand for goods and services and an accommodative Federal Reserve has and should continue to help mark the time needed for our recovery.

These are 3 pieces of positive fundamental news that should put a floor under prices between here and the March 2009 low over the next 6-8 months. That would argue for a continuation of a backing and filling process and a trading range. Since no U.S. equity market has recovered from a “V” bottom, we argue for a higher low to be formed above the March 2009 low. Since the top of the market in late 2007, the market has NOT experienced a higher low; each break down in price has penetrated the previous low. It means, technically, we are still in a down trending market. We are saying that the next low should be higher than 666 on the SP500 and 6,500 on the DJIA. The stock market’s recovery will be similar in appearance to the recovery we saw in 2000-2003. The higher low will anchor the equity market recovery thanks to foreign demand, an accommodative Fed, a stronger American consumer relative to their personal balance sheet and leaner, more competitive U.S. companies, located here and abroad.

This is a process and will take time. So, in the time it takes for the fundamental news, relative to “top-line” growth to catch up with price, price will come back down over time to meet “top-line” growth. News and price is like a see-saw. Recently, we have been bumping our head up against 1100 on the SP500 and 10,000 on the DJIA and cannot seem to get through. After the move off the 2003 bottom, guess where the market treaded water for most of 2004? Between 1,050 and 1,150 on the SP500 and between 9,800 and 10,500 on the DJIA; approximately where we are now. That level will be hard to get through, because psychologically, lots of owners of stock that have held on to their equities since 2004 will get tired and maybe scared if price does not move through that zone. Market’s, as you well know, like to test one’s intestinal fortitude. Investors get tired of waiting, they become impatient and may be a little nervous; consequently, that all feeds into “retracements” after large moves up in price, like the one we have had since March. That’s why this recent price move since March has been positive; because it has taken 9 months. The 1932 move we alluded to earlier took only 2 months, before falling back to a higher low later in 1933. Nine months is better than two months; the longer price remains higher in time, the greater the likelihood of sustained positive price action in the equity markets. Also, our last bear market from 2000-2003 took 32 months in duration. Since October of 2007, when the markets initially fell, we are now at the 25 month mark.  We are getting through this.

To summarize, for the positive, we have a flatter price in the benchmarks over the past 12 months, a recovery in global infrastructure and global spending, room to give up a bit on price to the downside and still sustain a higher low, an accommodative Federal Reserve and on a time continuum, are at least 25 months down the road to recovery. The point: the longer the markets can go without moving to a new lower low, the better it is for our patient in convalescence and for our portfolios. A higher low over time will anchor price and stabilize the market while waiting for the fundamentals to “catch up” with the recent extended price move up since March.

One last point looking out: In April during our last conference call, we targeted mid-2010 before we saw a real economic recovery.  We hold to this mid-2010 for the reasons we stated last April. Coincidentally, within the past few weeks, mid-2010 seems to be a consensus time frame by the Federal Reserve Board to explore, if they feel comfortable enough, a raise in interest rates as the economy starts to pick up. The economic news, when this occurs, should be much better than it is now, but we will need to remain vigilant to see how the market responds to the news of a more robust economy. Robust economies don’t necessarily mean higher prices on Wall Street. How the market responds to the change in Fed “language” and most importantly, how the market responds to the actual act of the Fed raising interest rates will speak volumes about the future direction of the market. We will speak more to that when the time comes.

On behalf of our team, thank you for your listening time.

I’ll turn this back over to our moderator for our question and answer session.

Carl Perthel

November 12, 2009