Saturday, June 18, 2011


Watch the 10-year -- if yields are rising, so should equities (and vice versa).

Run, don't walk, to read Nancy Miller's column in this week's Barron's, "All Atwitter With Investment Tips."

Higher energy costs remain the biggest risk to profit and worldwide economic growth -- it is the greatest and most pernicious tax of all. The rapid rate of change in the price of crude oil has historically presaged weakness in U.S. stock prices. A world rolling quickly toward industrialization, with an emerging middle class and goosed by an unprecedented amount of quantitative-easing has conspired to pressure commodity prices (especially of an energy kind). Moreover, Japan's nuclear crisis has likely further increased our dependency on fossil fuels. U.S. policy is on a slippery slope on which oil might be increasingly impacted by the outside influences of Mother Nature and political developments -- all beyond our control.

Besides energy prices, a broadening rise in input prices also threaten corporate profit margins. While Bernanke is unconcerned with rising inflationary pressures and the CRB Index, as the Economic Cycle Research Institute notes, the Fed runs the risk, once again, of being behind the inflation curve and, in the fullness of time, being faced with the need to introduce policies that could snuff out growth with errant policy. HSY, PG, CL, MCD, WMT and KMB have all announced sharp price increases (of 5% to 10%) in the cost of their staple products, running from chocolate kisses to diapers!

The cost of 2008-2011 policy is a mushrooming and outsized deficit. Since the generational low in March 2009, the U.S. dollar has dropped by over 23% against the euro, as market participants have dismissed the notion that the hard decisions to reduce the deficit will be implemented. As Nicholas Kristof wrote in The New York Times yesterday, "This isn't the government we are watching, it's junior high school.... We're governed by self-absorbed, reckless children.... The budget war reflects inanity, incompetence and cowardice that are sadly inexplicable." At the opposite side of our plunging currency is the message of ever-higher gold prices. (Warning: Dismissing the meaning of $1,500-per-ounce gold might be hazardous to your financial and investment well-being.)

Most importantly, policies have placed continued pressures on the middle class, with the cost of necessities ever-rising and wage growth nearly nonexistent. The savers' class has suffered painfully from zero-interest-rate policy and quantitative-easing, policies that have contributed to the inflation in financial assets (and to an across the board hike, or consumer tax, in commodity prices) but have failed to trickle down (until recently) to better jobs growth, to an improving housing picture or to an opportunity for reduced consumer borrowing costs and credit availability. Meanwhile, the schism between the haves (large corporations) and the have-nots (the average Joe) has widened, as best reflected in near-record S&P 500 profits and a 57-year high in margins. Corporations have feasted (and rolled over their debt) in the currently artificial interest rate setting, but the consumer and small businessman has not fared as well. Particularly disappointing has been overall jobs growth (as reflected in the labor participation rate) and the absence of wage growth (as the average workweek and average hourly earnings continue to disappoint). It is my view that ultimately corporations' margins will be victimized by the screwflation of the middle class, as rising costs may produce demand-destruction and an inability for companies to pass on their higher business costs.

Globalization, technological advances and the use of temporary workers becoming a permanent condition of the workplace are all conspiring to keep unemployment elevated and wage growth restrained. The lower the skill grade and income, the worse the outlook for job opportunities and real income growth. (This is not a statement of class warfare; it's a statement of fact.)

Meanwhile, the consumer's most important asset, his home, continues to deflate in value, despite the massively stimulus policies, a multi-decade high in affordability, improving economics of home ownership vs. renting and burgeoning pent-up demand (reflecting normal population and household formation growth). Consumer confidence has continued to suffer from the unprecedented home price drop, which has been exacerbated by the aforementioned (and decade-plus) stagnation in real incomes. The toxic cocktail of weak home prices, limited wage growth and nagging upside commodity price pressures (particularly from the price of gasoline), will likely pressure retail spending for the remainder of 2011.

Key factors guiding me toward expecting a near-term slowdown in the rate of domestic economic growth:

* A low in bond yields: The continued drop in the yield on the 10-year U.S. Note to 3.15%.

* A double dip in housing: A still-large shadow inventory of badly delinquent and foreclosed homes continue to weigh on home prices, which resumed their fall in first quarter 2011.

* Worrisome group rotation: The continued improvement (absolutely and relatively) of the consumer nondurable sector.

* Weakening commodities: We have witnessed a decline in the price of copper (to below its 200-day moving average), oil and other major industrial commodities.

* Economic indicators flash caution: A multiyear low in the Baltic Dry Index, a weak household jobs survey, the ISM nonmanufacturing Index falls to the lowest level in nine months and, for the fourth straight week, we get an initial jobless claim print above 400,000.

* Emerging weakness in non-U.S. markets: A break is developing in the natural-resource-based regional markets of Australia, Mexico, Canada and Brazil.

I continue to see, as I have for months, an inconsistent and uneven economic recovery -- difficult for corporate managers and investment managers to navigate. Tail risk, greater earnings volatility and corporate margin and profit challenges are the headwinds I see above and beyond the nontraditional issues of fiscal imbalances, higher marginal tax rates and elevated structural unemployment caused by globalization, technological advances and temporary employment as a permanent fixture to the jobs market.

However, the preconditions for a market bottom could be falling into place:

1. The strength in corporate balance sheets and income statements. While I see some vulnerability to corporate profits, my estimates are only a few dollars per share below consensus.

2. Valuations are not stretched, especially relative to inflation and interest rates. At 1250, the S&P 500 will be priced at a reasonable 13.5x my 2011 S&P forecast of $93 a share. (Price is what you pay; value is what you get.)

3. Uneven and more volatile economic and profit growth are my baseline expectations. But an extended (yet lumpy) economic up-cycle still appears the most likely outcome. More effective and productive public policy could extend the recovery further.

4. At 1250, the market will be sufficiently oversold technically, and sentiment will have moved to a more negative extreme. Always remember that a public opinion poll is no substitute for thought.

5. Individual investors are relatively uninvolved and hedge funds are conservatively positioned.

When the price of energy products was rising, it was the most pernicious tax of all to the weakened U.S. consumer victimized by screwflation.

Now that the price spiral is being reversed, the positive benefit cannot be overstated.

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