Manarin Investment Counsel, Ltd.

By: Brian S. Wesbury - Chief Economist
Robert Stein, CFA - Senior Economist
Date: 8/29/2011

Market turmoil and a cycle of shrill headlines and worrisome “breaking news” convinced many to evacuate the equity markets. That was a mistake. The odds of recession are low, but the stock market seems to have priced one in, anyway.

We use a capitalized profits model to value stocks, dividing corporate profits by the 10-year Treasury yield. We compare the current level of this index to that from each quarter for the past 60 years to estimate an average fair-value. Not only are 10-year yields low (2.2%), but corporate profits are growing strongly. As a result, and hold onto your hats, this top down model says that the fair-value for the Dow is currently 40,000.

 However, we think the Treasury market is in a bubble. So, instead of a 2.2% yield, we use a more conservative discount rate of 5% for the 10-year Treasury. This generates a “fair value” of 18,500 on the Dow and 1,940 for the S&P 500. In other words, the US equity markets are currently undervalued by about 65%.

 Obviously, there are many moving parts to this model. Interest rates could go higher than 5%, profits could fall or both could happen. Profits, for example, are now 12.9% of GDP, the highest in measured history (back to 1947) except for one quarter in 1950.

 So what does our model say if profits revert to the historical mean of about 9.5% of GDP? Even in that scenario, and assuming a 5% yield on the 10-year Treasury, equities are about 21% undervalued, with fair value at 1430 for the S&P 500 and 13,700 for the Dow.

  The problem with this scenario is that it takes the worst of both worlds: a major decline in profits and a surge in interest rates. In the real world, a large decline in profits would normally be accompanied by a drop in bond yields. In other words, our model says the risk of investing in equities today is very low.

 This is the opposite of what was happening back in 1999/2000. Back then, the market was over-valued and an ounce of gold traded for roughly 4 shares of Intel (INTC). Today it is trading for about 75 shares. Stocks look cheap and we think fears about the economy are overblown.

 Yes, it would be good to trade the ups and downs of this market, but we don’t know anyone who can do that consistently. Rather, we focus on valuation, risk and reward. And right now, we believe the reward outweighs the risk by more than many people seem to believe. Fear will not disappear overnight, but the model says it is overblown and stocks are extremely attractive. 

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This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy

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Government action saved us from the recession, right? Not so fast

Click Here

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Not quite. With all the doomsday reports about a down day on Wall Street, we wanted to provide you with a level-headed commentary on the market. Enjoy.

Dow Down 500, But Fundamentals Still Strong To view this article, Click Here
Brian S. Wesbury - Chief Economist
Robert Stein, CFA - Senior Economist
Date: 8/4/2011

Major stock market indices are down 4-5% today as investors move into panic mode.  There is no single piece of news driving the sell-off; rather the market seems to be gathering downward momentum on its own.  Selling is creating more selling.

Like 1987, the sell-off does not appear to be driven by fundamental factors.  In fact, the fundamentals suggest the market is undervalued and getting more so as it drops.  Many investors assume (or wonder) if the sell-off is indicating deep economic problems.  However, there is no evidence that this is true.

The Federal Reserve is still running a very accommodative monetary policy.  Money supply data shows no contraction – M1 is up 13.8% and M2 is up 8.3% at an annual rate over the past thirteen weeks.  The Fed is holding the funds rate near zero, while nominal GDP is rising near a 4% annual rate recently and “core” inflation is at 3%.  In other words, interest rates are very low in comparison.

If you are worried about a cut in government spending – don’t be.  Federal spending in 2011 is still rising and according to the OMB and CBO it will rise each and every year over the next 10 years.  If you are worried about the size of government and think the budget deal was terrible – you shouldn’t.  Supertanker America is turning and government spending as a share of GDP is scheduled to fall by about 2% of GDP over the next 10 years.

Corporate earnings are rising rapidly.  According to Bob Carey, First Trust’s Chief Investment Officer, with about 80 companies left to report, S&P 500 earnings are up 20% over last year and the S&P 500 P-E ratio (on forward earnings) is roughly 12.  The market is cheap.

Economic data are not tanking.   Initial claims are at 400,000 (down from 478,000 at the end of April).  Car and truck sales were up 6.9% in July (over June) and chain-store retail sales were up 4.6% in July (from last year) versus 2.8% year-over-year growth in July 2010.  Taken together, retail sales appear to have increased by about 0.7% in July even though gasoline prices fell.

Yes, the ISM manufacturing index was just 50.9 in July, but that is the 24^th consecutive month above 50 and is consistent with 2% or more real GDP growth.  Finally, the ADP employment report showed 114,000 new private sector jobs in July, which was the 18th consecutive monthly gain.  In other words, there is absolutely no evidence of a recession at this point.

This leaves us at perhaps the best explanation for the decline: European debt problems, specifically Italy.  It is clear that hot money is moving as investors worry about money market funds and bank solvency.  The euro is falling, European bond yields are rising, US Treasury yields are plummeting and gold is up.  Italy says that it does not face imminent default, but the market acts as if it may.

European countries have spent themselves into a corner, but correcting this mistake will be good for long-term growth, not bad.  While some financial institutions may take losses, government debt itself is water under the bridge.  It’s a sunk cost.  As a result, it has little effect on the economy unless losses create financial contagion.  With mark-to-market accounting now fixed to allow cash flow to be used to value assets, the odds of contagion are minimized and the cost of immunizing America from contagion would be small when compared to 2008.

In the end, the sell-off looks as if it is more of a technical correction in the market, not a fundamental change in direction.  This does not mean that it will end soon.  Corrections run their course and then end.  We wish we could trade each and every move in the market, but we can’t and we don’t know anyone who can.  We are investors, and the market is more undervalued right now than it was when it opened for trading this morning. 

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This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

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The numbers prove time and again that the economy and job growth do not improve during these spending sprees. So why do they keep trying?

Comments from First Trust Portfolios' Brian Wesbury

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It may require some patience, but for the long-term value investor, market history suggests that after a 65% drop in stocks and after earnings have been adjusted downward, the stage is set for higher than average annualized rates of return over the next five years.

- Jim Cullen, president of Schafer Cullen

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Work with us:  Manarin Investment Counsel

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The economists at First Trust made some encouraging comments in their recent article about the recession.  Here are the highlights I want to share with you:

• The economy and stock market are floating on a sea of liquidity.
• Through Friday, this sea of liquidity had lifted the Dow Jones Industrial Average by 22.5% in less than a month, with the NASDAQ up 27.8% and the S&P 500 up 24.5%.
• If jobs were the catalyst for all economic change, then the economy would never stop expanding if jobs increased; nor would it ever stop contracting when jobs fell ... in the past, the unemployment rate has been much higher than it is today and yet the economy recovered and the stock market boomed anyway.  Unemployment is a lagging indicator.
• It takes about six months, but when the Fed injects money into the economy, spending increases.  It always works.  And this time, there is also a rebound in velocity taking place at this time.
• Very soon, the recession will officially end.  This is not a dead cat bounce, and it's not government spending.  It's easy money, plain and simple. 

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In order to prosper in your financial life and get through this economic environment with the greatest peace of mind, you must rid yourself of any short-sighted thinking that may negatively impact your financial life. 

Every major downturn has its own unique characteristics.  This frightens investors into making the wrong decision at the wrong time.  For example, over the past 18 months I've witnessed investors dump their stock market holdings regardless of how well-managed the companies might be.  

A classic short-sighted decision.    

"But Roland," you say. "Shouldn't you move more of your money over to cash until you know the market recovery has arrived?  Isn't that the safe thing to do for now."

Nope, and here's why:  For 95 years now the Federal Reserve has destroyed the buying power of our dollars.  With the massive amount of money that's been created in recent months, I expect inflation to continue being the dominant, long-term trend throughout my lifetime. 

Cash is the LAST place I want my long term savings to be.  For more on this see my previous posts on derivatives. 

Knowledgeable investors I know realize that putting money in the bank today that could buy a loaf of bread will one day be given back those same dollars but this time they will only buy a few crumbs after inflation has taken its share.   

See, there is a difference between money and wealth.  Money is just the tool society uses to measure and trade wealth.  The true wealth: businesses, stocks, land, real estate, and precious metals cannot be created without limit; money can. 

My suggestion is that you recognize the difference between the two and if you have not done so already, start dipping a toe into the market by taking money and buy up the abundance of wealth that so many of your peers are ignoring. 

Here's one last bit of common sense that explains why now is not the time for cash:

 

FINAL NOTE: I could be wrong but the chance we saw the market bottom back in the early part of March grows by the day.  Don't get too excited yet because the windbags in Washington could quickly change that with a speech or a new piece of legislation.  But please stay tuned - the remainder of the year will likely be filled with many twists and turns.  

 

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The below charts are referenced in the video (click for a larger image):

 

 

 

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1. The Conference Board's index of leading economic indicators has risen for two months in a row.
2. Producer prices have increased for two straight months.
3. Consumer prices rose in January - the first monthly gain in six months.
4. The Baltic Dry Index, which measures the cost of shipping key raw materials like copper, steel and iron, has more than doubled from its recent lows.
5. Existing-home sales rose in December, and participants in our weekly survey think that another rise took place in January.
6. Pending home sales went up in December.
7. Builders' confidence inched up this month.
8. Thanks to lower interest rates, applications for both new mortgages and refinancings of existing mortgages are rising.
9. Real hourly earnings rose 4.5% in December following a 3.3% increase in November.
10. An index of consumer expectations rose in January.
11. Retail sales shot up by 1% in January - the first monthly rise since June.
12. The decline in consumer credit moderated in the latest month.
13. New orders for consumer and nonmilitary capital goods went up in January.
14. The ISM index of manufacturing went up last month.
15. The ISM index of services rose last month for the second month in a row.
16. The money supply is soaring, a sign that there's plenty of liquidity in the economy.
17. The 3-month London interbank offering rate, a measure of banks' willingness to lend each other, has dropped to 1.2% from close to 5% a number of weeks ago.
18. Other measures of the state of the financial markets, like the TED spread and the 2-year swap spread are down, as well.
19. Prices of credit default swaps for banks have fallen from their peaks.
20. The corporate-bond markets are thawing out, too; some $127 billion in dollar-denominated debt was issued in January, the most for any month since last May.
21. Some securities on banks' books are starting to recover in value.

From Irwin Kellner at MarketWatch.com

 

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Chicago - Any recession is a cruel event, and this one may turn out worse than most.  Many Americans are suffering, and their numbers are sure to rise in the coming months.  But recessions are also an inevitable part of the economy, and they do end up being reversed.  Since 1945, the average length of a downturn is 10 months.  This one will not last forever, and growth may well resume this year. 

Nor is it likely that the current crisis could turn into anything resembling the Great Depression.  The Federal Reserve has acted quickly on a vast scale to prevent the brutal deflation that occurred in the 1930s.  Bank deposits are insured, and people who lose their jobs can count on far more help than was available then, in the form of food stamps, unemployment insurance and welfare. 

In some ways, the downturn may do the economy some long-run good.  Like every recession, it has forced companies to cut costs and operate more efficiently, which will raise productivity.  It has boosted the puny American savings rate.  It has begun a transition away from overinvestment in housing, freeing capital for other sectors.

It has brought down inflated home prices.  It has caused banks to exercise more care in lending, while discouraging Americans from resorting to credit to live beyond their means.  But these changes are a big adjustment, and they won't happen without pain.

Some critics think it's dangerous for a president to make dire predictions, lest he spook consumers into hysteria.  That fear is also greatly exaggerated.  When major companies are filing for bankruptcy, the stock market is sliding and home values are falling, Americans feel poorer - because they are poorer - and nothing their leaders say is likely to have a big impact on their mood.

For the time being, the most important asset Americans have is patience, keeping in mind that bad as they are, things will eventually get better.  Bankers and investors will tire of putting all their money in low-yield Treasury securities.  Credit will thaw.  Home prices will stabilize.  Consumers will come out of their shells.  Sales will pick up.  Companies will dare to hire again.

 

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