Email – #279
**Slight GDP positive surprise point to stronger second half. We see some compelling valuations.
Dear Reader,
There is little comfort coming out from government economic figures: while second quarter 2009 GDP contracted 1 percent, some components, especially those related to personal spending, were worrying. In addition, the Bureau of Economic Analysis released revised economic data going back to 1929. These showed in general downward revisions to the 2008 and subsequent data. Therefore, the recession of late last year was deeper than previously thought. Very importantly, the first quarter of 2009 dropped 6.4% instead of the previously reported 5.5%
What does it matter? We care about the coming six months, so looking in the rear-view mirror only helps to the extent that we can translate this into predictive knowledge. What is coming across is a clear trend of stabilization in the drop, shown in reduced weekly jobless claims, housing prices and a pattern of companies reducing capacity to meet reduced demand.
Companies have been laying people off and reducing inventories strongly, as we have been describing here. The “success” of this earnings season has been that they were very disciplined in cutting costs faster than their drop in sales, or in the case of most consumer staples, reduced outlooks, thus beating reduced estimates. This trend was most evident in two sectors: consumer discretionary and consumer staples. But make no mistake in that unemployment, a lagging indicator, has and will continue to climb, even though at a reduced rate.
Where do we go from here?
As we explained last month, companies are now faced with a paradigm: once you have cut to the bone you are left in a position where outperforming by cutting some more becomes extremely difficult. In fact, companies were outstanding in their commitment to cutting inventories:
Inventories dropped a record $141 Billion. This means that even no demand increase or a mild pick-up in demand will make them run to boost production, just to keep up with ongoing demand. This projection, not lost to Wall Street and other economists, has been driving expectations of a positive GDP growth in the third and fourth quarter and market valuations higher this month. This market revaluation, which we profited from in full force until May and much more timidly since then, seems to be running its course.
Where is the REAL growth going to come from? Sure, the massive injection of monetary steroids and quantitative easing from the Fed has helped shoulder some of the burden of reduced leverage at existing financial institutions, the death of many banks and the demise of the shadow banking system.
But there is little evidence of traction from the government stimulus. Steve Henke, a renowned economist from Johns Hopkins University and the Cato Institute confirmed an intuition well-known to experienced emerging markets investors: his work shows that when fiscal deficits exceed 5%, the Keynesian multiplier drops below 1. What does this economic mumbo jumbo means?
That when the government the fiscal deficit exceeds 5%, one dollar of government spending generates LESS THAN ONE DOLLAR in economic activity, as opposed to the 1.6 – 1.8 that you get in defense and social spending during regular times. I should know, because I grew up in an economy where government grew consistently to become at one point 60% of GDP. In the US we are at roughly 20% of GDP and growing to some 24%-25% of GDP. Fiscal deficits are projected to be 13%, 9% and 6% in the current and next two years.
His explanation is that investors and other economic agents become so scared about the massive uncertainties that a huge government poses on private activity, and very importantly the prospects of almost certain increases in taxation levels due to growing government spending, that they are less prone to invest. It becomes a situation where the government starts crowding the private sector out and imposing a higher and higher tax burden on it.
So, how do we play it?
In the absence of REAL, non-government-induced growth, one of the main ideas is to be ahead of the game in the imbalances that governments will increasingly be creating with their stimulative policies here and abroad, which will markedly alter demand in certain sectors. A case in point is the “cash for clunkers” program.
The program became a resounding “success:” their $1 Billion limit has been already reached in less than one week. The government pays you $4,500 when you sell your old clunker with a mileage of 18 mpg or less and apply it towards the purchase of a new fuel-efficient car.
Obviously, those old cars have to be replaced at some point and getting $4,500 from the government (really from all the individuals and corporations paying taxes) is a bribe to go in and make that decision right away. For most people with clunkers, it becomes a compelling proposition. Thus, this will show in sales of cars, which will dutifully surprise analysts in the next reporting cycle. Unfortunately, local and foreign brand stocks have been on a tear, and I have some more valuation work to do on the sector this weekend. But the program could be expanded (or not), as we hear that they are considering using TARP money for this. Rather than making a political judgment, about its merits, I will stay tuned on this possibility to realize whether we should play it or not.
Similarly, we are seeing many signs of real progress in some areas around the world, where I have found very compelling valuations. Again, this weekend I am in the process of filtering through the noise and prospects and doing the detailed company-specific work.
Our current positions have both moved forward. Taiwan Semiconductor (NYSE: TSM) gapped up and hit resistance in the 200-day moving average. When it breaks the average, it will fly. Remember that we are the very beginning of a multi-year tech rally. Our iShares Barclays 20 plus Year Treasury Bond ETF (NYSE: TLT), despite this week’s brief weakness, is back to almost breakeven. The indirect bidders at the US Treasury seven-year auction, which the market interprets mainly as foreign central banks and other foreigners took 64% of the auction, was brilliant. Therefore, after the US Treasury places the tens and thirty year bonds two weeks from now, we should see a renewed push towards lower yields. Since we are now almost back to breakeven, we look forward to making good money in this trade.
Stay tuned for compelling valuation plays that I am researching right now.
Enjoy and profit,
Horacio Marquez
Current Portfolio:
Stock: iShares Barclays 20 plus Year Treasury Bond ETF (NYSE: TLT)
Current Price: $94.32
Comments: Buy
Stock: Taiwan Semiconductors (NYSE: TSM)
Current Price: $10.63
Comments: Buy
