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Market recap

During the last week we’ve heard from several traders that much of that initial move above 950 was a short squeeze.  Does that mean we’re going straight back there?  Not necessarily.  After today’s action it seems to be headed straight to 1000.

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This week we’ll dive straight in with this powerful market rally, powered to a certain extent by strength and confidence from the bank stocks.  If you’re wondering why these companies are doing so well now after they were on the brink of collapse last year, we’ll make some sense of it for you.

Market Recap

Hopefully you kept a tight stop on that S&P short!  Today the market burst through the 950 resistance level, closing the day at 976, an astounding advance of +12% in the last two weeks.  You’ll hear us talk about this a lot, but a big part of being a successful trader and investor is being able to identify when you’re wrong, and quickly correcting your mistake.  It won’t go straight there, but the S&P is now primed to head right on up and test 1,000.  For the time being, you’re better off  buying dips until we get closer to 1,000 which should then serve as an exit point for your longs if your horizon is limited and a possible entry point to establish a new short position if that’s your thing.

Most impressive has been the tech-heavy NASDAQ, which has now risen for 11 straight sessions.  For the most part, I’ve noticed that specific short-term rallies and broad market strength more generally, have been met with skepticism in the last 6 months.  I’m a little unsure as to the reason why, though I think it’s probably due to two factors, the first and most difficult to quantify is the fact that our predictions about the future are rooted in the recent past.  Last year was a pretty ugly year, and people use that as the basis for their expectations of the future however incorrect and irrational that may be.

The second has to do with flat-out poor fundamentals and a lousy economy.  Even if people don’t understand all the reasons why, they still know enough about stocks and the economy to associate a growing economy with rising stocks and vice versa.  A lot of this rally since March has been good old fashioned mean-reversion.  Why do stocks sometimes go up when the economy is going down?  Simple.  The markets move a whole lot faster than the economy, and most of the time they overshoot in either direction.  Lost amidst all the talk of an economic recovery is the fact that the market is still in the range it was trading in the 4th quarter of last year, about 40% off its high.

The Fed and Treasury have done a good job keeping the banking system together, and that’s helped assuage the fear and panic lows.  But the market hasn’t even begun to seriously fight the longer-term, economically-driven bear trend that you can see above started well before the banking crisis.  That’ll be the next major challenge for the market.

We’re in the heart of earnings season this week, and not surprisingly profits and revenues are way down.  For the most part companies have been beating expectations, but keep in mind that these were based on the disastrous results from the final quarters of 2008.  Analyst earnings estimates are notoriously backwards looking and the market makes its own estimates anyway.  If you need any evidence for the lack of respect the market has for analyst estimates, witness the frequent occasions where a company meets or slightly beats estimates only to have the stock plummet immediately thereafter.

Those firms that are improving are showing improvement on the bottom line due to job cuts, cost reductions, and new efficiency procedures.  The dark side of that, however, is that companies and individuals are simply spending less money.  That’s not great for the economy as a whole, but it’s one way to reconcile an undeniably strong market with less-than-rosy prospects for the consumer and the economy.  At some point way down the road these improvements in efficiency will pay dividends, but the market might be getting a little ahead of itself until top line figures stabilize and start to grow again.

Nouriel Roubini: still bearish

NYU’s Nouriel Roubini, aka Dr. Doom, another outspoken market bear who made a name for himself by accurately predicting a lot of the disaster of 2008, now foresees growth of 1% or less for the next several years.  He made a very interesting point earlier in the week that while 1% growth may technically be growth, it’s going to feel like a recession, especially as the labor market lags to keep up and uncertainty about the future remains high.  That feeling could create a negative feedback loop as consumers act as though they are concerned, saving money and paying down debt, which in aggregate would delay economic growth and thus exacerbate consumers’ current worries and concerns.

It’s our opinion that the actual amount of growth – whether it’s the 1% of Roubini’s forecast, the 2-3% “new normal” of Bill Gross’s forecast, or the 3-4%+ forecast of the Obama administration – is better left to another debate.  The key point to recognize is that regardless what kind of economic growth we may feel over the next few years, it’s still going to feel like a recession.  This will shape both investor and consumer behavior.

Humans are emotional little creatures and act in accordance with their emotions.  Since the economy is the aggregate of individual actions, it’s important to keep an eye on how consumers are feeling as a whole.  Changes to how individuals perceive the future will be the most relevant data points in signaling when better days are actually around the corner.  Hopefully the recent market strength will instill a little confidence in personal behavior patterns.

How Banks Make Money

Slow and steady grumblings have begun to emerge in recent weeks as financial firms – the very banks you and I and all us other taxpayers were scared into bailing out to the tune of $700+ billion last fall – have been reporting some pretty hefty profits.  What gives?

Now, keep in mind that this discussion skirts around the question of whether or not these banks should have been bailed out in the first place.  The economic angle is mixed and fuzzy: Lehman was an economic disaster, yes, but Washington Mutual was a blueprint for a gigantic bankruptcy that caused hardly a hiccup.  The question of “should” is one much better addressed in the framework of politics.

Back in October, surprisingly few seemed to understand that all this money was a loan and not money that taxpayers were just flushing down the toilet.  Given sufficient time it would be paid back, and the rational voices asserted exactly that and even suggested – how’s this for crazy – that the taxpayer could make some money off this TARP-thing.  I very distinctly recall Bernanke and Paulson mentioning this to Congress, who probably would have laughed themselves silly at that very thought if they weren’t so freaked out about their constituents (and if they had a sense of humor in the first place).  All these banks needed was some capital to see them through quarter.  In the future they would make money again and we’d all get paid back.  It wasn’t at all unlike a payday loan.  A really, really big payday loan.

Time to get paid

The good thing about Uncle Sam facilitating the bailout is that Uncle Sam can do a few things to load the deck in his favor when it comes to getting paid back.  You see, implicit in all this was the government’s promise to work to actively manufacture an environment that would allow financial firms to thrive and help them get back on their feet as quickly and as organically as possible.  The Fed lowered short term rates to essentially zero with a pledge to keep them there as long as necessary, while long rates were less aggressively targeted.  Today, if your company’s business model is borrowing money at the short end of the yield curve (where it’s nearly free to do so) and lending it at the long end of the yield curve (where rates are moderate) and pocketing the spread for yourself, of course you’re going to knock the cover off the ball!

On the chance that sounded a bit wonkish or you weren’t familiar with how banks make money, I made the following comic that I hope you find educational:

“Borrow, Lend, Profit!”

Ideally, the powers that be would much rather have these banks work the stinky assets off their books with organic profits than continued injections from the US taxpayer.  Once Uncle Sam stabilized their capital reserves, he really teed it up for them.  On this front things have, for the most part, gone according to plan.  This was another notion that was completely lost on the public in the midst of the panic last fall.

What’s lost on the public right now, as everybody piles back into these bank stocks, is the staggering amount of stinky assets that are still out there and haven’t been dealt with.  Or assets that don’t stink today but might a year from now.  Or the coming train wreck of commercial real estate.  Or the nightmare of yet another massive wave of mortgage adjustments later this year.  And this is to say nothing of hefty unemployment and an economy that will sputter along for some time, loosely held together by a jittery consumer who is now all of a sudden very interested in saving. 

None of that will be beneficial for these banks and their balance sheets.  So let’s all hold our collective horses for a moment before we pile back into these banks.  Our strategy since mid-2007 has actually been to just avoid them categorically until it’s possible to figure out how much these companies are truly worth.  We’ve missed the big move this year, but so far we’re still way ahead.

Backlash brewing

They sure do make it hard for us.  Wells Fargo CFO Howard Atkins boasted yesterday on Bloomberg about back to back quarters of record profits.  Goldman Sachs and JPMorgan have not only been trumpeting their gigantic earnings in 2009, but have been strutting around like peacocks at how quickly they were able to repay TARP funds.  Even Ken Lewis and Vikram Pandit (heads of Bank of America and Citigroup respectively), a pair of guys that have very little that they should be boasting about have been singing about how strong and awesomely profitable their companies are.

These banks need to watch it.  The taxpayer/voter is a more powerful force right now in public policy than even he might recognize.  As much as Wall Street would like to turn back the clock to early 2007, that simply will not happen for a variety of legitimate reasons, the most important being the tectonic shift in the political landscape away from the capitalist pole towards the realm of populism.

Continue to pay attention to the political environment.  The era of laissez faire politics is behind us, and it’s imperative to keep in mind the more active role that sovereign bodies worldwide will be playing when it comes to just about everything.  It means a lot more regulation and stricter standards for these banks.  Yes, it means a lot of public spending too, and more taxation, especially on businesses and the rich.  It means more programs, more laws, and it also means that the average voter will be far less content to sit by while old Wall Street firms, still perceived by the populace as elitists and responsible for their own personal woes, make bundles and bundles of money.

For a long time Wall Street was the seat of power in the world high finance.  The balance of that power has now definitively shifted to Washington D.C.  You will do wise to invest accordingly.

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This week we talk a little history to get some better perspective – always a good thing to have a little more of – on the stock market.  In your mind the “stock market” may have always been synonymous with “investment”, but as you’ll see, maybe it’s time to rethink that association.  We have some fascinating (possibly terrifying) charts to show you.  Then we’ll close out with a quick recap and offer a little insight into what we might see in the market over the coming weeks as we move through earnings season.  Let’s get to it!

A Hundred Years of Perspective

Around here we look at a lot of charts, and this is without a doubt one of the most important charts in the history of financial charts, perhaps even the single most important. It’s a simple chart of the Dow Jones Industrial Average for a little over 100 years.

Any serious student of the markets needs to keep at least a few bits of technical analysis know-how in their investing toolbox. But for the sake of this discussion, it’s only necessary to understand the chief principle of technical analysis: the idea that price reflects everything.  All factors are taken into consideration — history, the economy, levels of fear & greed, the amount of risk present, expectations for the future — by all market participants and the result is a reasonably efficient price that weighs all of that information in appropriate and accurate proportion.  When the facts change, the price reacts accordingly.

The below chart is log scale, so it normalizes price action and eliminates the misleading perception of exponential growth.  It’s also adjusted for inflation by using the CPI (Consumer Price Index), and we’ve highlighted U.S. economic recessions in blue.

This picture is not only worth a thousand words, it tells a thousand stories.  It recites the saga of our country and the economy through all the last century.  Can you think of a single image that better illustrates our collective history as 21st Century Americans than this?

This is the story of the tumult of the early decades and WWI as the US was emerging as a young force in the global economy, a dichotomous adolescence characterized perfectly by the rough & tumble pragmatism of Theodore Roosevelt and the forward-looking idealism of Woodrow Wilson.  It recalls the decadence and speculation of the roaring twenties, only to be followed by the subsequent crash and a decade of depression.  There is the chaos, hope, and fear of the Second World War, and the optimism and conformity of the 1950’s as the troops came home and Eisenhower put America back to work.  This chart illustrates the social and economic turning of the sixties, the fear and rebellion in the wake of Kennedy’s assassination.  And then there is the directionless funk that was the 1970’s, highlighted by the public distrust that would follow Nixon’s resignation.  As dramatic as any decade in this chart is the birth of the long boom in the early 80’s, where the deregulation and tax cuts of Reagan’s presidency ignited the explosion in corporate America.  And of course, we see the recent crash and the sudden uncertainty brought on by the Great Recession which will shape the decades to come.

This chart is who we are as Americans.  It’s the story of where we are and how we got here.

As symbolic as this chart may be and as colorful a story as it tells, it also the tracks the actual performance of an “investment,” the U.S. stock market.  This chart is our personal daily inspiration, our reason for coming in to work every day and researching ways to make the growth of our own portfolios look better than the chart above.  The stock market is the most common investment that Americans make, and as you can see above, it isn’t a really great one.

Adjusted for inflation, an investment in the Dow has doubled only twice in the last 109 years.  It’s an average annual real growth rate of 1.43%.  Yikes!

If that number didn’t surprise you, let’s look at this chart:

How about it?  I mean, seriously, would you buy this as an investment?  Look at it again.  If I took the axis labels off you might mistake it for an EKG meter!  But it’s the growth of stock market, adjusted for inflation, for 50 years.  What, you’re not impressed?  U.S. Gross Domestic Product more than tripled during this period and grew from well under 20% of world GDP to over 27%.

I’m sure there are far more fun or useful things to do with a time machine, but I’d love to travel back to 1950 and see what kind of justification was given for investing in the stock market at that point in history.  That wound up being a fantastic time to buy the market, though I highly doubt that was the mindset at the time.  If any of you old timers out there have some stories to share I would love to hear them and perhaps share them here with the rest of our readers if it’s OK with you.  Send me an e-mail.

That’s a chart of the inflation-adjusted growth of the Dow Jones Industrial Average for the first 82 years of the 20th century.

It travelled a long, bumpy road to basically nowhere.  Hard to believe, isn’t it?

Why people think the stock market is a good investment

The one thing that all secular bear markets have in common is that by their conclusion, investors hate stocks and are disgusted by the prospect of owning them.  (This is a phenomenon that is not just limited to stocks, by the way.)

It has been a long time since investors have collectively hated stocks with a passion.  And as you can see, the last 30 or so years have been a different story:

This is why people think the stock market is a good investment.  All people have known for a large portion of their investing lifetimes is that the market tends to go up over time.  It shouldn’t come as a surprise, because in the 80’s, 90’s, and 00’s, it did!  Aapparently nobody told all these people about the 80 years prior to that chart or how damaging the effects of inflation can be over the long run.

One of the craziest ideas that people developed in the post-1982 long boom was that stocks would earn 10-15% per year or more.  Nearly 80 million baby boomers had this “10% figure” in their heads, and they used it to generate their income projections up to and throughout retirement.  This number makes for easy math, but it’s complete hogwash.

We’ve entered a new era, folks.  If the majority of your investment experience falls into this era, study those charts above and really let them sink in. 

Ask yourself some questions.  Will a continually sluggish economy and rising inflation wipe out all the growth of the previous few decades the way 1970’s stagflation wiped out the last great boom from 1950-65?  Are we in the midst of a 1930’s-style sustained collapse?  Will the Fed be able to keep inflation in check and is the economic stage now set for another long boom, or more accurately, an extension of the current boom after a minor bump?

The more timely question is this: given all the long-term headwinds that the U.S. economy is facing at the moment, do you really think that the next 30 years are going to look like the last 30 years?  Or will it resemble what we saw from 1900 to 1950?

Keep your ears open through the next decade, because you will be hearing more and more on this.  The period between 1982 and 2007 will come to be regarded as the abnormal quartile in the last century and all of what we witnessed during it will be responsible for giving investors a long-term view of the stock market that is both incorrect and, more importantly, dangerous.

Nobody today seems to think that at some point in the future, the stock market could be written off completely as a viable investment for the average Joe, though this is exactly what has happened in the pit of every major bear cycle before this one.  What happens when Average Joe will looks at the stock market and says, “ah that stuff’s for professionals, those Wall Street insider elitists” and just moves along, stuffing his money under his mattress?  Investors at some point are going to need a lot of coaxing to get back in.

What, then, if not the market?

As we’ve mentioned before, long term investors are welcome to wade back into the right stocks (for the record we like good balance sheets, cheap valuations, strong cash flow, and reliable dividends), but make sure you are employing both proper strategy and tactics.  Passive equity strategies are dead.  D-E-A-D.  No more “buy the market and hold it ‘till retirement.”  If you do that, you’ll be scratching your head a hundred years from now and wondering why you only made 1-2% per year after inflation.

Active managers really fell out of favor during the bursting of the dot-com bubble, but more generally, have always been out of favor because of their perpetual underperformance of the market as a whole.  Mutual fund managers are fun an easy to pick on, but in case you didn’t know, about three out of four active managers don’t beat the market in any given year and on top of that, those that do have exhibited poor ability to do it the subsequent year. 

If you read between the lines up here, that’s an argument both for and against active managers.  That makes things really difficult for the average investor – sorry folks, there will be no easy road in the next decade.  You must come to terms with this reality.  Building a solid portfolio is going to take a lot of work and it’s going to require doing a few things you probably have never considered before.

The greedy will be punished, as they inevitably are.  And the fearful will miss out, as they always do.

As for you, abandon your greed and fear and look instead to the teachings of The Buddha and the elegant, powerful lesson of “The Middle Path”.  Approach the problem of investing from a neutral, unbiased perspective and abandon all previous attachment to any extremes.  Generally speaking, you will need to get diversified.  Really diversified.  You’ll need to explore alternatives like commodities and hedge funds in addition to stocks, bonds, and real estate.  You’ll need to educate yourself and pay attention.  You’ll need to know the right people.  Trust is an important asset when things are complicated.

Stay tuned, because the purpose of this newsletter is to help you figure this all out and hopefully have a little fun along the way.  As we get to know each other a little better, we’ll have plenty to say about specific recommendations and how to react to the current environment. 

Market recap

We mentioned last week that if the market holds up at the 875-880 support level we would see a quick rally back into the low-mid 900’s, and that has played out just as expected.  As of this writing the S&P is at about 940 and there’s probably a little bit more life left in this recent move, even though we’ve risen awfully far this week. 

After that it’s a little more murky, though the short/mid-term risk, in our opinion, is mostly to the downside.  Buying dips was working in April and May, but it hasn’t worked as well in June and July.  Selling into rallies is a good way to get out of your long positions or to establish short positions.  You’ve now got your rally, so do it.

Traders, if this market continues to move higher from here, 945-950 represents a fantastic spot to try and get short.  Our preference is for a quick trade using SDS, but if you’re old skool, you can simply sell the market short via the Diamonds or Spiders.  For a little longer-duration short trade, check out some out-of-the-money September or October put options on the S&P.  Volatility has come in quite a bit over the last week and these options are substantially cheaper than they were and probably not as valuable as they could become; it’s a good bet that we’ll retest some lower levels from here over the next few months.  Keep a tight stop on all these trades, though.  A convincing move past 950 should put the market back on its search for finding a new high for the year.  Don’t forget Trader Lesson #1: never fight the market.  And its corollary is equally important: make peace with your mistakes and correct them quickly.

Next week will be the heart of earnings season, and so far earnings for the second quarter have looked good, led by better than expected results from Intel and Goldman Sachs.  The market seems to have become much more optimistic about future earnings prospects, though a lot of this will be sector-specific or led by junky names that were simply decimated in March and are still reverting back to mean.  Keep in mind that most of the bellwethers are still trending down since early June and also that earnings forecasts were really, really pessimistic.

We saw a fairly large tick up in inflation, a 0.7% jump in June CPI led primarily by gasoline and other energy prices, which have come back lower in July.  Keep in mind, though, that the CPI is still down –1.5% over the last twelve months.  Investors also haven’t been jumping out of bonds in a way that might indicate fears about future inflation.  To the contrary, bonds have performed very well since early June, perhaps tilting the current concern a bit toward the deflation pole.

It’s our belief that there is no reason to panic about inflation… yet.  But if you are losing sleep over the prospect of future double digit inflation (Don’t snicker at that possibility!  It wasn’t that long ago that the U.S. CPI was steadily rising about 10%/year.  As Americans, short memories might be both our greatest blessing and curse.) there are a few things you can do.  I’ve been talking about TIPS all year long to anyone who will listen and needs a steady, low-risk, decent-yielding investment.

Right now, the TIPS/Treasury curve is pricing in inflation of roughly 2% per year for the next ten years.  If you think that sounds about right, you’ll be happier elsewhere in the fixed income world, maybe corporate debt.  If that inflation number sounds low to you, load up on TIPS and stash them away for the next decade.  Thank me in 2019. 

I’m having a hard time getting excited about this market if only because I’m a value hound, and stocks still aren’t priced the way they historically have been with as difficult an economic horizon as we’re presently facing.  The short-term technicals aren’t great either, with the market making lower lows and lower highs on weak volume, in search of support.  If you didn’t sell back in May, this is as good a chance as any.  Take the rest of the summer off, work in the garden, go on vacation, and come back when the baseball season starts winding down.  The market will still be here when you get back.

As for me, I’ll be back next week and hope to see you as well.

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*A brief footnote: we talk a lot about “investing in the stock market”, which is technically impossible to do.  The market is a fluid environment composed of individual stocks, which individuals can in invest in.  That being said, a diversified basket of individual stocks has always acted as pretty good proxy for the market as a whole.  Even though it’s technically impossible to invest in an index like the Dow Jones Industrial Average or the S&P 500, there are funds today that seek to mimic the performance of these indices and do a fairly good job at it too.

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We’ve got a lot to talk about after a long 4th of July holiday, so this week we’ll jump straight in with a market recap, briefly talk a little philosophy, and close out by looking at some retail service stocks to see if they can divine the future of the economy.  We’ve got some good tips for you savvy traders, and believe it or not, all you Philosophy and Psychology majors may have a leg up on the rest of us when it comes to investing over the next several years.  If that all sounds like a good time, then welcome to The Draconian!

Market recap

Sometimes these things work out and we call ‘em perfectly.  Previously when we wrote about the market’s 90% down day and the quick subsequent rally, we warned that a lot of the time these things turn back into further declines or even presage extended bear moves.

Take a look at the S&P 500 chart below, a follow-up chart to the one we posted last week.  Awful breadth?  Check.  Brief rally?  Check.  Extended decline?  There it is.

Of course, that’s all yesterday’s news and the real question is where do we go from here?  As far as the technicals are concerned, the S&P has been testing support at the 880 level, and if it breaks there’s room for another 5-10% on the downside before finding the next level of support in the low-mid 800s.  If it holds, we should see another bounce back to the low-mid 900s.

875 is another key number to watch.  The market very clearly bumped its head there in January, February, and again in April.  It also rallied off that level several times back in December.  For whatever reason, 875 is a very important number right now so keep an eye on how the market moves on or off that level.  If the market can’t hold there, 775 is very much in play, which is a thought that should rightfully make investors nervous.  That would be almost a 19% decline from the highs of June, exactly why we said earlier that long term investors are welcome to wade into the market on fair fundamentals, but should buckle up for a possible 20% decline over the short term.

With this wonderful chart, we’d be remiss to point out the last 90% up day which we saw on May 18th.  The market did exactly what that indicator might suggest.  After the powerful one-day advance, the market quickly pulled back and took a breather before ultimately soldiering higher over the coming weeks.  This stuff isn’t nonsense, people, and it can help you become a better investor.

Breadth is a very important indicator and it warrants close attention.  Like any indicator, it’s imperfect and will occasionally generate false signals.  You’ll rarely hear about breadth on the news, usually only on really bad days.  But if you watch it frequently and use it as a tool in conjunction with your trading and investing, you will be doing something that nine out of ten investors aren’t.  It will give you an edge over the average investor.

Before we move on, note how volume has flattened out in June and July, much lower than what we saw back in the first part of the year.  This ties in perfectly with what we were discussing last week, and low summer volume is a normal phenomenon.  You might be familiar with the old maxim “Sell in May and Go Away” and in the next newsletter, we’ll explore that in greater detail.

An ugly week

The last week has been a pretty ugly one.  The market really fell apart on light volume last Thursday, and the selloff has continued through this week.  The big story has been the drop in crude oil and other commodities, which have continued to pull back in unison on anticipations of weak future demand.

We wish we got this newsletter rolling just a little earlier to sound this warning in May and June and advise investors to pick up some insurance in the options market via some out of the money put options or a bear ETF like ProShares Short S&P500 (Ticker: SH).  Funds like this make money when the market goes down.  Traders are welcome to use levered short funds like SDS or QID, but don’t hold those things more than a couple of weeks; because of how they are valued, they start breaking down the longer you hold them and cease to accurately track the index they are designed to follow.

If you’re bearish on the market for the next 3-6+ months and want to make money if the market trends down, we recommend grabbing a bear mutual fund like Stephen Leuthold’s Grizzly Fund (ticker: GRZZX) or David Tice’s Prudent Bear (our preference, ticker: BEARX).  Mssrs. Leuthold and Tice are each very colorful and highly intelligent individuals, as people who are willing go against the market tend to be.  For the record, Leuthold is something of a bull on the market at these levels and actually recommends against buying his Grizzly Fund.  David Tice is one of the most well known “perma-bears” and is something of a cult hero to the bear minority.

After the last week, which has taken the market about 10% off its recent highs, we find ourselves less convinced of a strong economic recovery in the second half of the year.

Spend?  Save?  Philosophize?

There is a major disconnect right now between the market, which has basically been pricing in a return to 2007 levels of profitability and consumer spending, which is down year-over-year and not expected to snap back to previous highs.  The personal savings rate, currently at an 18 year high and rising seems to indicate that individuals are pricing in a permanently reduced level of future spending.

These points have always been intimately conjoined: the record level of consumer spending seen in 2007 had pretty much everything to do with the record levels of borrowing and consumer credit, which had pretty much everything to with the record levels of corporate profitability seen in 2007.  The side effect of all this was a savings rate of zero, which for a brief month in the middle of 2005 actually went negative.  Try and wrap your mind around what a negative aggregate savings rate means.  Both fundamentally and metaphysically.

Yes, we could see improved profitability as companies get leaner and more efficient, clearing out all the detritus that has accumulated since the last recession.  That will help companies’ bottom line but not the top.  It also won’t help the labor market.  Unfortunately, The Land of Economic Truth is a harsh and cruel place, and a lot of that detritus is in the form of unnecessary or unproductive employees.  It’s uncertain where a lot of these individuals will wind up and unlikely that we’ll see unemployment back under 5% anytime remotely soon.  And when I say remotely soon I mean well into the back half of the next decade.

The paradigm of “borrow and spend” has disappeared due to the permanent change in consumers’ balance sheets. The capacity for them to borrow money against their house or keep extending themselves on credit cards has vanished almost completely.  Consumer spending simply cannot return to prior highs without massive appreciation in real estate to support new lending or big-time sustained economic growth to trickle down and put significantly more money in people’s pockets.  Neither of those scenarios sound likely to me right now.

The primary mechanism of American savings, home equity, has essentially dried out. The House is no longer The Piggy Bank.  The personal savings rate, currently pushing 7%, is higher than it has been in almost two decades as people are now forced to take actual cash from their paycheck and set it aside or pay down existing debt.  All the other cushions (home equity, 401k values, stock portfolios) have vanished and individuals are much more reluctant to rely on these vehicles to get them safely to retirement than they once were.

Don’t get me wrong – American consumers are wired to spend money and acquire material goods.  As a nation we are psychologically programmed increase our status, and more importantly, to display it through various symbols.  No, that’s not an original observation.  The French political philosopher Alexis de Tocqueville beat me to it by about 150 years.  But our relentless desire to seek and display status is an underappreciated component to defining and understanding our economy.

For the most part, people will probably continue to spend any way they can unless we do see a permanent shift in American psychology that parallels the permanent economic shift.  But psychology is a little trickier to measure.  Art has always done a pretty good job reflecting the cultural values of society, so keep your eyes peeled for shifts in film, literature, and other forms of media.  Those of you who spent your college years studying English and Art History probably never dreamed that economists might someday find your body of knowledge of practical use – alas! – your time to shine is now!  American psychology is of great relevance to the economy, especially during times of economic distress.  All you social science majors, let me know what you think.

“I’m Debt Free”

In this era where it is fashionable to denounce corporate and executive greed, or lash back against all those fools that bought way more house or car than they could afford, how might individuals display status in the future?  As we become more and more critical of a government that runs massive deficits and bailout-seeking individuals or firms who relied on juggling debts to support their lifestyle, might a personal balance sheet free from any debt be a pretty desirable status symbol?

Could “I’m Debt Free” really supplant the McMansion and the BMW as a chief symbol of communicating status?  This was actually a theory of mine I spent a good time exploring back in 2002 after the dot-com fallout.  But wow, I could not have been more wrong.  The housing boom and all its tangential effects was a near-perfect coup-de-gras, putting the kibosh on that theory.

The idealist in me yearns for a psychological shift like this, but every day reality screams in my face that the odds are decidedly slim.  There’s always a chance, though, and it will be of practical interest to investors and philosophers alike in the years to come should it actually materialize.

Retailers as a leading indicator

On the subject of consumer behavior, let’s look at some consumer cyclical names from the relatively elastic sectors of apparel, AV electronics, jewelry, and recreational equipment.  I did hand pick some of the more interesting names, but pull up a bigger list retail/service stocks and you will notice the same trend.  The table measures how the below companies have performed relative to the rest of the market over the last month.

Now, pay attention.

Stocks are forward looking.  These companies’ stock prices today represent expectations of how the companies will perform in the future.  The previous 4-week change relative to the S&P represents how these companies’ futures have changed over that period relative to the broader economy.

Over the last month, retail stocks have been rolling over as the market believes that consumers won’t be so quick to resume consuming at the pace they had been during the boom years.  As we outlined above, there is a legitimate reason for this.  The paradigm has permanently changed. Consumers simply do not have the ability to consume at the previous rate.

Have you ever bought something from those companies up there?  Have you cut back your spending at those stores in the last year?  Are you in a hurry right now to go out and spend money on those products again?

Brunswick, maker of boats and pool tables, and Callaway, maker of golf equipment, probably bear special mention.  Their businesses depend on selling goods that are about as “discretionary” as it gets.  It’s not uncommon for wives to manage the family finances, and if any of you wives out there are actively encouraging your husbands to go buy a boat or a new set of golf clubs, send me an email.

You might think that iRobot, maker of the oddly-lovable and quasi-anthropomorphic Roomba Vacuum, would fall into the “extremely-discretionary” category and be lagging the broader market but you would be dead wrong.  Niche products like this often display powerful, inelastic demand from a small and devoted consumer base.  Little niches can indeed be recession resistant.

It also worth pointing out that iRobot is outperforming the market by +46% over the last 13 weeks, and +36% over the last year.  The fact that I’ve been personally contemplating a purchase of one of these things for a while is itself a strange indicator and probably warrants further introspection.  I consider myself a fairly thrifty individual.  The last thing in the world that I need is a robotic vacuum.  Yet why can’t I stop thinking about buying one?  What is it about robots?  If you own one and have the answer to these questions, please let me know.

Anyway, this is all bad news for an economy that’s supposedly consumer-led.  If you require further convincing of the shift in consumer behavior, check out these names:

I don’t know if you needed some hard economic data, something more than your own anecdotal evidence to suggest that consumers are still cutting back and changing how they spend money, but now you have it.

Flashy, discretionary spending is out and spending smart is in.  Is your wife doing less shopping at Macy’s and more shopping at Ross?  New cars cost a lot of money, so maybe you’re trying to get some more mileage out of it and are spending a little more money at Pep Boys?  I like to shop at Whole Paycheck Whole Foods as much as the next guy, but Wal-Mart is a lot friendlier on my wallet.  None of that should come as a surprise after the last year.  But never forget that psychology affects behavior which reveals itself in the market.  Always be looking for it.

And now for something really useful

The U.S. economy is large and complicated, but for the most part, it’s led by individual consumption.  Watch all those names above. When discretionary retailers decisively turn around relative to the S&P, we might be getting close to better times instead of times that are simply less bad.

There’s a lot of bunk and hooey floating around the media today about green shoots and the coming economic recovery.  The markets may often speak in riddles, but unlike politicians and Wall St. executives, they never lie.  Listen to the markets.  Right now they’re telling us that the consumer is still in serious trouble and that the turnaround will not be robust.

There is little risk of inflation in the short term, so cash is a fine place to be.  Those with a little more know-how should be allocating to alternative investment funds or hedged mutual funds, building a broadly diversified portfolio.  Traders, there’s probably still a little more life in getting long a value retailer over something high end, but a better play may simply be to nip at the short side of the broader market side through the summer.  Down the road we’ll explore some opportunities in corporate debt and in TIPS.

Thanks for reading, and I’ll see you back here next week.

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