"Risk on" versus "Risk off"
10/31/09
Every day I receive e-mails predicting doom and gloom and promising to show me how to profit from it. Some of these "saviors" sell you oil and gas partnerships, others obscure gold mines and others want to help you to hide your "loot" outside the country. These same types used to come into town on a carriage and sold their "magic potions" from the back of their wagon. They, too, never ran out of customers. I guess it is just human nature. Why am I telling you this - as if you did not know? I am referring to the initial hook that they all use – fear. They all use fear of financial meltdowns, hyper inflation, hyper deflation, war and pestilence. The cure for all of this then is your slice of the last natural resources on earth and a one way ticket out of Armageddon. That type of fear gripped Wall Street this week also. Previously, some of the economic reports (durable goods) had not been so hot, the stock markets had acted sluggishly anyway and doubts apparently lingered in investors mind about the sustainability of this recovery. Profit taking took place, selling begot selling and within 5 days, panic spread on Wall Street. By Wednesday evening the selling had lead to the most oversold market since March of this year. Goldman Sachs had put oil on the flames earlier that day by publicly surmising that the third quarter GDP would come in at 2.7%, which was weaker than the consensus estimates of around 3.2%. Thursday morning then the US Department of Commerce issued the advance GDP estimate for the third quarter. The number was 3.5% and thus much stronger than Goldman's "whisper number". The oversold market rallied back like a manic depressive to slightly below the point of the previous days breakdown. Friday then, the market turned right around and sold off like a manic depressive to slightly below Wednesday's low. Fear and loathing on Wall Street continues.
Third quarter GDP signaled the end of the recession with the first positive quarter since the second quarter of 2008. The better than expected number prompted at least one economist, Deutsche Bank's Joseph LaVorgna, to bump his GDP forecasts for future quarters. LaVorgna raised his forecast for fourth quarter GDP to 4%, followed by 4.5 % in the first quarter, and then 3.5% in the second quarter. He had expected third quarter GDP of as high as 4 percent. "These numbers next year are not strong, relative to history. We're still way below the average," he said. "I don't see stimulus in the numbers yet, so this isn't a government stimulus story yet. We still have massive inventory liquidation yet. At some point, inventories will be positive," he said. The positive GDP surprise also sparked a return of the "risk trade", where assets that thrive in an economic recovery, like stocks and commodities, rise and safe haven plays, like the dollar and bonds sink. This "risk on trade" has a counterpart - the "risk off trade", i.e. US Dollars, cash and Treasury Securities. The "risk off trade" returned on Friday with a vengeance. The bears, who had been wrong all the way up, finally had their day in the sun and they tried to capitalize on it as loud as possible. "GDP was artificial and manufactured by the government. The U.S. has been hollowed out. It no longer manufactures goods. Once the factory of the world, the U.S. now manufactures debt. The high-wage manufacturing jobs have been outsourced to low-wage economies. The demise of U.S. manufacturing is at the core of the decline of America, its chronic trade deficits and growing international indebtedness." ... and so on. I think we should dispense with fear mongering now and look at hard data instead. The first chart above shows you the GDP (annualized) growth rate in red and the absolute value of the real (inflation adjusted) GDP in blue. Within three quarters we went from almost minus 7% growth to plus 3% growth. That does seem like a lot but it really is not. As Joeseph Lavorgna said above, the numbers are still below average. The second chart shows you why he said this. In every post World War II recovery, GDP growth reached at least one quarter of 7.5% annualized growth, except during the last recession. There, we only reached a maximum of 6.7%. I have drawn in the target line at 7.5%. Despite all the headwinds, which are real, and despite all the challenges, I am anticipating that we reach the 6% level at least for one quarter. We were able to grow at 3.5% WITHOUT any inventory build. A rebuilding of inventories is inevitable and it is only a matter of time before businesses are forced to order at least as much as they are currently selling. That will boost GDP by 1% or more for at least a couple of quarters. My guess is that the fourth quarter or the first quarter 2010 will see GDP growth much higher than the annualized 4% that the consensus predicts (now). One argument is the recent rise in commercial paper outstanding as shown in the chart below. Ccommercial Paper can only be used for short term funding of operating expenses or current assets (e.g., inventories and receivables) but not for financing of fixed assets such as machinery or buildings. The increase of the commercial paper outstanding therefore shows that the market is recovering from the crash in confidence and more importantly the business community's willingness to restock inventories.
Rising exports will also add to additional GDP growth. The second chart above shows the US trade balance as a percentage of GDP. In 2006 at the height of the consumption and housing bubble, the US imported $66 billion more than we exported. This imbalance has been improving to about $30 billion in the month of August. Since 2006 this improvement has added about 1% per year to GDP. I think this trend will continue. Each time, a toy factory is built in Vietnam or a semiconductor factory is built in China, chances are 1 in 4 that US companies are supplying the necessary machinery and know how. Contrary to popular believe, the US manufacturing sector is healthier than ever. Read Marc Chandler's recent article if you don't believe me. Just one quick snippet here:
"The value of U.S. manufacturing output in real terms (adjusted for inflation) was a little more than $3 trillion in 2008. That is up from $1.2 trillion in 1972. If the U.S. manufacturing sector were a separate country, it would be the world's fifth-largest economy (behind the rest of the U.S., Japan, China and Germany). The U.S. remains the world's largest manufacturer. Full stop." I know that you think that I am insane, but just think back to the last time you thought that. That was probably around my June 15, 2009 newsletter right? Not only Mr. Lavorgna but also Michael Darda think that we are in a 6 quarter economic sweet spot. Jim Paulsen has been bullish on the economy and the stock market all year and remains steadfastly so. It seems that I am again in good company and that investors should play "Risk On" not "Risk Off". This recovery is just getting started – and this stock market rally is going to continue! Get your shopping list ready to take advantage of this decline.
Hermann Vohs
"For most investors, performance is better achieved with a telescope than a microscope."
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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.
