Feb. 11, 2010: Open Letter

PIGS, U3 and the MANcession

Eric Linser, CFA | Feb. 11, 2010

Bulls make money, bears make money, but pigs get slaughtered. -- Wall Street adage

Punxsutawney Phil was scared of his own shadow and so were investors as we tacked on an additional six weeks of winter. Over the past four weeks, the markets have become unhinged. As I mentioned in my January 26^th newsletter, I suspected that a pullback to the 200 day (exponential) moving average (EMA) was possible. For the Dow that's around 9,800 (~ 1,000/1,013 EMA for the S&P). The Dow fell below 10,000 on Monday (Feb. 9^th) for the first time in 3 months. Unfortunately, the Dow has had a long term battle with the 10,000 level. Going back to 1999 we have crossed above and below that mark over fifty times. Another way to look at this struggle is to say the stock market has produced no gains for investors the past decade. That's not good. We saw a rebound from the 10,000 level on the Dow the past few days. I believe that we would need much, much worse economic news than we have now to fall below those support levels. I know it doesn't feel like it now, but pullbacks like these are healthy tests of investors' convictions. I believe their convictions will point out that a market trading at a forwarding looking price-to-earnings multiple (P/E) of 12 is attractive and a rebound will commence. So don't let this dip scare you out of your good stocks just before they move higher.

What’s been driving the markets lower? Angst about sovereign (government) debt levels of PIGS (Portugal, Ireland, Greece and Spain) are the main culprits with a lackluster jobless claims report as a cherry on top. This has decreased the risk appetite for stocks by some large institutions. However, I don't believe that it has truly altered the case for continued economic recovery and higher corporate earnings which fuels the bull story.

Where to from here? Dow 10,000 is a level of strong psychological support. If we fall through, then the next safety net for investors is the 200 day EMA at 9,800. I believe one or the other should protect our downsides. But if we do fall through the 200 day moving average, then unfortunately it could spell big trouble. Let's hope that won't be the case. But I'm here to keep you posted either way.

So, today we are back above 10,000 again. Perhaps because the debt problems in Greece should soon be under control; perhaps just a relief rally. The interesting question is whether this is our last time crossing that important level? I hope so, but given the results the past ten years, its best to proceed with some caution.

In the bullish column we have strong corporate earnings and reasonable market valuations on a forward looking P/E basis. Also nearly every important economic indicator is pointing towards recovery. In the bearish column you have ridiculous levels of government debt (read my article on our national debt: Observation of Deficits on Democracy: The Tytler Cycle). And as governments around the world potentially default on that debt or squeeze their constituents to pay more taxes it could turn off the engines of growth leading to declining earnings and lower stock valuations.

The Great Deleveraging by Consumers, The Great Leveraging by Governments

Debt has been a part of American capitalism since Christopher Columbus went hat in hand to Queen Isabella I in 1488. Today, however, debt is providing a significant headwind in our economic voyage. Banks, consumers, and the US government are all straining under the stress of a generation of gathering debt. Our debt crisis unfortunately led us to the Great Recession. Now we are unwinding that debt, that is banks and consumer are. Debt loads are being worked down by banks and consumers alike, which are two very important aspects of our economic system. While consumers are unwinding their debts, governments are taking on more debt. Take a look at President Obama’s budget proposal and the projections of the US government’s debt load. Hey, what’s a few trillion between friends?

Unemployment – U3 & U6

January jobs report came out last Friday (February 5^th) from the Bureau of Labor Statistics (BLS). The official unemployment rate (U-3) came in at 9.7%, down from 10%. But there is a whole other group of people who're holding on to work by a thread. They're called underemployed -- people who've been laid-off, and who can now only find part-time jobs or fewer hours (U-6). If you count them, the full measure of slack in the labor market is at 16.5%.

As I pointed out in my January 26^th e-newsletter, heeding John Crudele’s words of the New York Post, the numbers were going to be bad in part because the BLS subtracted 824,000 jobs from the workforce (an adjustment for April 2008 – March 2009). In the announced report, there was some room for optimism, particularly with respect to the number of hours worked (or length of the work week) and the increase in temporary hiring (showing a trend over the past few months of continued temp job creations) and length of the work week. Read more at 824,000 Jobs Gone in One Fell Swoop – Government Magic or Manipulation.

We would typically see these trends (more temp hirings, higher productivity, more hours worked) play out in a jobs recovery. Companies tend to first increase the work hours of existing workers and hire temporary workers before getting confident enough to start hiring full-time employees. So, while the overall picture still remains quite bad, there are clear signs of improvement

Mancession

In the employment report in the A-1 table, there is a heading "Men, 20 Years and Over." When the Labor Department called people's homes for its January survey, it determined through actual calls and estimates that 70.251 million men had jobs in December 2009 but only 69.337 million were working last month. When you do the math that means 914,000 fewer men said they had jobs.

Why should we care? It’s always better to know the truth even if self-deception feels better. This recession is very deep and strange and by some it is being dubbed the “man-cession” for this recession has hurt men much more than women, allegedly the worst mancession in recent history. 80% of job losses in the last two years were among men, said AEI scholar Christina Hoff Summers, and it could get worse. This is far greater than any of the previous five recessions that we had in the U.S. So this problem has become extraordinarily intense, especially if you’re a man!

PIGS

Now that I’ve found somewhere safe to bury my bone. And any fool knows a dog needs a home, a shelter from pigs on the wing. – Pink Floyd, Pigs on the Wing (Part 2)

Investors have turned their attention away from the optimism of BRIC’s fortunes (the acronym for Brazil, Russia, India & China) to the pessimism of PIGS -- the barnyard acronym for Portugal, Ireland, Greece and Spain. Some analysts include another “I” to include Italy, Europe’s long-standing biggest debtor.

Greece has dominated the apprehension of investors since late last year, when concerns over whether it will be able to pay off ~ US $420 billion in government debt it currently owes. The euro has been battered over the past month as some investors started to fear the break-up of the eurozone. The euro was on a tear last year driving the US dollar to new lows versus the euro currency and on a trade-weighted basis.

The tide has turned and now the euro has fallen to a seven-month low against the US dollar as investors continue to fret over the fate of several highly-indebted countries within the Euro zone. I pointed out that the dollar was due for a rally in my November 23^rd article US Dollar Carry Trade. The explosive dollar rally over the past six weeks has been in part because of the reversal of the dollar carry trade. Investors borrowed in US dollars and invested in places like Brazil, China, and New Zealand and now it is unwinding. I don’t believe the dollar rally will last much beyond the first quarter because we are witnessing rotating sovereign crises – it’s Greece right now but it could be Japan next, followed by Great Britain, and then the US. We have yet to take any steps at all to tackle our own federal fiscal deficit (and this precludes issues at state and local levels).

Currently for the PIGS, it appears that the only possible outcome would be either bankruptcy or a state-sponsored bailout. Naturally, neither result is ideal, but one thing that is certain is that the longer the fate of the PIGS serves as a distraction, the greater the negative implications for the entire euro zone.

The European Union announced that it would continue to work with Greece to help the struggling nation cut its out-of-control deficit. Naturally, this resulted in two very predictable actions; investors continued to avoid Greek securities, and Greek workers took to the streets to protest any cut in government spending. Meanwhile, Spain and Portugal struggle to find buyers for their debt. Spain was forced to raise premiums on a sale of three-year notes while Portugal actually pulled back its auction for treasuries due to a lack of investor interest.

Am I calling for breakup of the euro? Absolutely not. The costs of undoing the thing would be immense and hugely disruptive. I think Europe is now stuck with this creation, and needs to move as quickly as possible toward the kind of fiscal and labor market integration that would make it more workable. I believe a bailout is in the works for Greece and that the European Union will remain intact; I don’t doubt that. I’ll bet you some francs and d-marks!

A bad economy generates a lot of pessimism and it spills over to the market. Right now, there is a 30% off sale (compared to 2007) in the market. If the market were treated like a sale at Macy's, people would be buying like crazy. But you know and I know that people treat the market very differently. Instead of being drawn to low prices, they get scared. Low prices mean that companies are going through bad times. It doesn't mean that they are bad companies. This distinction gets lost in the tidal wave of fear and pessimism which periodically sweeps over investors. But I say that investing in the "good" companies will never be as profitable as it will in 2010. If you can hate the economy and love the market, you should invest in these "good" companies. As their very low price-to-earnings (PE) multiples grow, their share prices could rocket higher.

Don't forget that we are in the midst of the worst economy in decades. Strange things are happening, but it will eventually return to normal. Don't miss out on long-term investment opportunities by focusing too much on current conditions -- we'll do that for you. NOW is the time to pick up some quality stocks for your core holdings portfolio. We can help you invest in quality companies at reasonable valuations for long-term wealth building right now.

Wishing you much investment success in the Year of the Tiger,

Eric J. Linser, CFA

Chief Investment Officer

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