Tuesday, September 8, 2009

Seven Consensus Opinions

The following financial market commentary was written by Matt Malick and Ben Atwater. Matt and Ben recently started their own firm, Atwater Malick LLC. Matt was a student of mine and has a really insightful take on what's happening in the market. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers.
“We are standing by a wishing well / Make a wish into the well / That's all you have to do / And if you hear it echoing / Your wish will soon come true.” – Snow White, from Snow White and the Seven Dwarfs (1937)

Today we are examining what we perceive to be the most widely held consensus opinions among business journalists, economists, analysts, and investment managers. Below are seven thoughts that nearly everyone seems to agree on regarding the present market and economy:

1) “The American consumer will never be the same.”

Clearly, the average American’s personal balance sheet has taken a significant hit over the last couple of years with lower home values and diminished investment accounts. Americans have also accumulated bloated home equity and credit card debt, and now a rising unemployment rate is adding insult to injury. But, it is also true that many Americans have now deferred substantial spending for nearly a year. Consumers have cut clothing purchases and vacations, neglected to update household necessities, haven’t replaced aging cars or upgraded housing. It is difficult to quantify this pent-up demand, but it could uncoil like a spring.

We would also venture to say that spending has become ingrained in our national culture, for better or worse. While a higher national savings rate would be a healthy long-term phenomenon, you can’t change a zebra’s stripes and we are not convinced that Americans will sustain high savings.

2) “A ‘V’ shaped recovery will not happen.”

As the United States has emerged from previous recessions, GDP growth has gone from a negative reading to an above-average annual reading because many people and businesses defer purchases during a recession and manufactures and retailers permit inventories to deplete. When we begin feeling more comfortable, we tend to start buying again. But after this recession, most observers predict that we will emerge with below-trend GDP growth, i.e. less than 3% annual growth in the year after the recession; whereas a “V” shaped recovery would lead to annual GDP growth of 5%-plus during the ensuing year, which is more in-line with other post-recession periods. There will undoubtedly be a struggle between the competing forces of postponed purchases and the need to save more.

3) “The federal deficit is out of control and will only get worse and worse and worse.”

The prospects are certainly dim, but with an improved economy and structural changes on the revenue and expenditure side, hope is not lost. Many people do not fully understand the federal budget. The vast majority of federal expenditures can be attributed to Medicare, Medicaid, Social Security and national defense. Moderate, but intelligent, structural changes in these four areas can go a very long way toward changing our long-term fiscal outlook. Couple this with improving GDP growth, which leads to an expanding tax base, and the federal budget takes on a different complexion. Don’t forget, ten years ago, the Treasury was running budget surpluses and even “retired” the 30-year bond as a funding mechanism. Unfortunately, this turned out to be a Brett Favre-like retirement.

4) “The stock market has rallied too far, too fast, and September is historically the worst month for the market. Watch out below!”

We are somewhat skeptical because nearly everyone thought and still thinks that the market will lose substantial ground in the near-term (i.e. a 20% correction). Investors most likely withdrew funds from the market in anticipation of this predicted swoon. If decent economic news prevails and asset managers think they are missing something, they will undoubtedly flood more money into the market.

We agree that the market rally is overdone for certain speculative stocks. But, in our view, quality is still underpriced in this market. There are many legendary franchises “on sale” with price-to-earnings ratios below fifteen times and dividend yields is excess of 3%.

5) “Problematic inflation is nearly inevitable as a result of the immense fiscal and monetary stimulus.”

This viewpoint is wildly inconsistent with the other opinions on this consensus list, but many people hold them in concert nonetheless. If a weak economy were to prevail for the foreseeable future, the probabilities favor a deflationary environment, not an inflationary one. Post-bubble periods are indicative of deflation, i.e. the United States in the 1930s and Japan in the 1990s.

The Federal Reserve and other central banks around the world have the tools at their disposal to fight rising core inflation, as long as the political will exists. However, if we do experience a more robust recovery, we believe that commodity-driven inflation is a distinct possibility. We foresee inadequate capacity in world commodity supplies to support even modest worldwide economic growth.

6) “Unemployment will exceed 10%.”

This is certainly looking highly probable. But in a note to clients at the near-term market bottom on March 9, 2009, we wrote:

“While it is impossible to predict the precise future of labor markets, we can all but guarantee that the unemployment rate is going to get worse, probably considerably so, before it gets better. But what does this imply for the markets? As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” Our last truly dire economic situation was in the early 1980s when unemployment was not only high, but inflation was also rampant. In November of 1981, the unemployment rate crossed the 8.0% mark to land at 8.3% (similar to today [March 9, 2009]). At that time the Dow was trading around 850. Over the next 14 months, unemployment continued to rise, finally peaking at 10.8% in November and December of 1982. While the Dow temporarily dropped to around the 800 level, the stock market took off while unemployment continued to rise. By the end 1982, an awful year for employment in the U.S., the market was over 1,000 and it never looked back.”

If history does indeed rhyme this time around, we would not expect a market decline strictly as a result of a rising unemployment rate. However, if unemployment does continue to rise over the next 6-12 months, it will inevitably be a roadblock to a sustainable economic recovery.

7) “Commercial real estate is the next shoe to drop.”

We find it amusing that only a small handful of market pundits were able to predict the first shoe that dropped (residential real estate), but now, all of the pundits believe they can predict the next shoe to drop.

Contrarian investing does not mean disagreeing with every opinion in the marketplace. Without a doubt, we expect some of the above consensus predictions will come to fruition. But, we are highly skeptical that all of these will ultimately materialize. Overall, our reading of sentiment is that many people continue to be very negative on the economy and the markets. To us, this means there is still opportunity to make smart, long-term investments that precede future money flows into the stock market.

View our previous market commentaries at www.atwatermalick.com.

1 comment:

  1. The economic climate and the territory has changed. All the bubbles burst, it was just a matter of time. It is just not America, the whole world has to change their behavior. Once again there are going to be victims of this reconstruction. Right now it is too premature to make a complete and full statement. The crystal ball is a little fuzzy.
    Joe Troy