Back to the Future
11/15/09
The month of October ended almost in the massacre that everybody had expected in September (and then in October). Almost, but not quite. After a violent run from March into October, with only one pause in between, the markets seemed to surrender to the bears. The Dow Jones ended that week down 259 points, or 2.6%, to 9713. It swung through six triple-digit moves in seven days, jumping Thursday on the GDP news before falling 250 points Friday, its biggest one-day hit since April. The S&P 500 absorbed its worst weekly drubbing since mid-May and skidded 43, or 4%, to 1036. The Nasdaq Composite had run up the furthest this year and had the most profits to harvest; it tumbled 109 points, or 5.1%, to 2045. The Russell 2000 fell 38, or 6.3%, to 563. It was simply a brutal ending for a bitter month. The markets seemed to collapse on heavy volume and I had a hard time convincing customers (and myself) that this was just a correction in a bull market. Little did I know that the markets had reached their lows even before I was able to send the newsletter out. Monday morning, the 2nd of November saw the market getting ready to make another low, when the ISM index at 10:00 am changed the whole ball game.
The pictures above speak louder than a thousand words. The ISM indices (both manufacturing and non-manufacturing) have a good long term correlation with GDP growth and market participants know that. As soon as the ISM numbers hit the tape, the markets started to stabilize. Of course, selling might have stopped anyway, because the month-end profit taking had come to an end. Many Mutual Funds have a fiscal year end of October 31st and therefore had no incentive to continue to sell into the first day of November. Be that as it may, ISM indices are powerful indicators and the markets stabilized the day the manufacturing index was published. By the way, China published its own ISM data one week later, the numbers were also positive and the reaction in the markets were similar. Stocks all over the world recovered from a nasty two week long selling spree to climb back toward their 2009 highs. It shows that investors have not grown immune to good news -- a departure from the late-October run of remorse and profit-taking, where no news seemed good enough. But progress was halting: The Dow Jones Industrial Average sprinted up 146 points after Monday's manufacturing boost, only to cede half of its gain by sundown. Wednesday's Federal Reserve statement indicated that it intends to keep interest rates low teased a 1.5% rally that petered out by the market close. On the other hand, the unemployment rate's rise to a 26-year high of 10.2% didn't derail the rally either. Bulls took solace in the third straight monthly increase in temporary hiring, a leading job-market indicator. The promise of a better job market to come was also evident in the productivity numbers announced that week. The US reported a eye-popping 9.5% annualized rise in productivity and manufacturing productivity leapt 13.6%. Productivity gains can be achieved in several different ways. Producers can substitute workers with machines, which would mean that the productivity gained is sustainable. Generally though, this kind of productivity gain is incremental and does not make leaps from one quarter to the next. Another way to achieve productivity gains is by producing the same amount of stuff with the same amount of labor. That is what goes on in America right now. The current rise in productivity is happening as businesses have cut costs, especially, labor costs. The gains in productivity coming from cost cutting are not sustainable in the long-term, however. It is in some ways like the inventory cycle. The shedding of unwanted inventory takes away from current production, but at some point the inventories would be slashed enough and to meet current demand, output just has to increase. So far, U.S. corporations have slashed employees and inventories to the bone and have become extremely profitable again. The next phase, which we have entered now is rising production to meet current demand coupled with a slow improvement in the labor market. Three straight monthly increases in temporary hiring shows that labor markets are gradually improving. Sometime during the 1. Quarter 2010 (February is my guess) I expect a falling unemployment rate. Current profitability of businesses and the anticipation of future corporate profitability have kept the stock market running. Gene Epstein wrote in this week's Barron's: "When the economy recovers from a deep recession, profits soar. If this recovery proceeds according to that usual script, profits could leap an average of 10% per quarter. And that assumes the modest consensus forecast of economic growth running 2.9% between now and the end of next year. If growth does better than that, as some economists expect, profits could rise even faster than 10%." Granted, a lot of earnings growth has been anticipated already, but at this point in time, I do not agree with Mohamed El-Erian's statement, that the rally since July was just a "Sugar High" and therefore is not sustainable.
The first chart above shows the US trade balance (exports minus imports) in dollar terms. The same chart was shown in our last newsletter in terms of % of GDP. The US trade deficit is worsening again. The trade deficit has grown to - $36.5 Billion in September, after having improved to - $26 Billion in May. Interestingly enough, China's trade surplus started growing exactly one month after the US trade deficit reached its zenith and turned around. China's trade surplus has been recovering since bottoming in June at $8.34 Billion. The October surplus is expected to be almost $19 Billion, which would be the highest since January. Exports look to have continued their recovery as the pace of US imports seem to have picked up considerably. The second chart above shows the effect that growing trade has on shipping. The Baltic Dry Index shows a series of higher lows and is close to breaking out to a new 52 week high. If this should take place then shipping stocks may turn out to be a good trade. They have for the most part not participated in this year's rally and may catch up to world markets, even though a massive overhang of new ship deliveries is expected in the coming 2 years. The point of it all is this: The US is clearly recovering and the rest of the world, (lead by the export nations of China and Germany) is benefitting. The obvious point here is that if China and Germany continue to export like before while the US continues to import like before, the world will be no more balanced ten years from now than it is today, and a crisis similar to the one we have just been through could happen again. But that is a discussion for several newsletters. For right now, however, investors should continue to buy stocks on weakness.
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.
