Tuesday, September 13, 2011

This Little Piggy Went to Market...

From the Desk of Joe Rollins

Treating financial market volatility lightly is never my intention, but the current sell-off in the equity markets appears to be confusing to the average investor. My feeling is that things are not nearly as bad as they are being represented by the media, but undeniably, your account balances are going down almost daily. Undoubtedly, the wild swings in the equity markets are upsetting and confusing, especially to those who may not fully comprehend all the economic terms being used by the financial press. In this post, I’ll give you some background information to help you understand the economic impacts of the global sell-off.


The difference between a hockey mom and a pit bull? Lipstick.” That was one of the memorable quotes from Sarah Palin’s speech at the 2008 Republican National Convention. Shortly thereafter, Obama ridiculed McCain and Palin’s promises of change by stating, "You can put lipstick on a pig. It’s still a pig.”

What happened next? An uproar ensued with some insinuating that Obama is a sexist who called Palin a pig. He didn’t, of course, call Palin a pig; the “pig in lipstick” metaphor is fairly common and there are several examples of its use from decades ago.

Using this adage in the context of today’s financial woes, I would say that lipstick has been slapped on the pig that is our economy to make it more attractive. Is it working? And who is right – the bulls or the bears?


Last Friday, the equity markets sold-off over 300 points. Many have attributed that sell-off to the resignation of the European Central Bank’s chief economist, Jürgen Stark – the second German ECB official to jump ship in recent months over policy differences. Stark disagreed with the ECB’s increasing market interventions; he feels it is up to the Eurozone governments to bailout the distressed regions.

There’s almost no question that Greece will be forced to default on their obligations, and many publications have reported that it only has a few weeks of cash left in its budget. It’s also been reported that Greece has failed to meet the austerity goals it agreed to follow under the aid package. Even though Greece has significantly increased its taxes, there are very few people who actually do pay taxes in Greece. And so, increasing taxes on the few people who pay them may force them to leave the country, worsening the problem.

Additionally, Greece’s “cradle to grave” philosophy simply isn’t working. A majority of Greece’s citizens are government employees (directly or indirectly), although none of them have been laid off to this point. It seems apparent that the measures Greece is taking to close the budget shortfall are not enough. It’s no wonder that Germany is now unwilling to help Greece avert default.

This story is interesting, but it doesn’t explain the dramatic impact on the Dow Jones Industrial Average – a loss of almost $1 trillion in equity values in the U.S. financial markets on Friday alone. Many argue that Greece’s default would reportedly cause severe financial implications to the United States, but U.S. bankers have stated that they have little exposure to Greek sovereign debt. In addition, since this crisis has been ongoing for several years now, it’s unlikely that banks do not have credit insurance on these Greek obligations. As such, assuming that the U.S. financial banks would incur a huge hit from a default on Greek government bonds makes little sense.

Moreover, even if there were a default on Greek government bonds, it would not be a 100% loss. Presumably, the Greek government would be forced to abandon the euro and issue its own currency. Since Greece’s own currency would be highly inflated with “funny money,” the debts would be repaid with deflated Greek currency, almost ensuring that Greek government bondholders would suffer a loss. But by no stretch of the imagination would these losses be 100% of the bonds’ face value.

My point is that the U.S. banks have almost no exposure to Greek debt. And to the extent that they do have exposure to Greek debt, the banks almost assuredly have credit insurance against that debt. Finally, even if Greece were to default, it would certainly not be 100%. Therefore, I’m still baffled by the sell-off in the U.S. markets due to this situation.

Many have argued that the major European banks in France and Germany will become insolvent from to the situation concerning Greece. This argument is naïve, and it baffles me whenever I hear it reported in the financial press. So far, the ECB has purchased $75 billion worth of sovereign debt from various countries in the EU. This was done to stabilize the bonds of these countries, but it still hasn’t worked. The bonds have continued deteriorating and its yields have skyrocketed.

The analysts seem to forget that these European banks exist in the heart of Socialist economies. Neither Germany nor France is hesitant to invest money directly in their banking system in order to stabilize the banks. In fact, before 1980 almost every major bank in France was owned directly by its government, not the private sector. It would be much less expensive for these particular governments to invest money directly into their own banking systems rather than purchase the government bonds of a country with no financial controls such as Greece. To say that the reason the equity markets in the U.S. are going down is because the banks in Europe run the risk of insolvency is an uninformed statement.

The equity markets sell-off on Friday, September 2nd – which was attributed to the jobs report reflecting a net zero increase in employment – is also confusing. The financial press again failed to report all the pertinent information, which caused a volatile market response. For instance, 45,000 Verizon workers were on strike during August, and those workers were included in the unemployment figures. During September, these workers returned to work without a contract and will be counted as employed for this month. If you add-back these workers, the actual jobs report would have indicated a 45,000 increase in employment during August.

These employment levels certainly aren’t stellar, but they’re hardly as devastating as reflected by the performance of the equity markets. After all, it wasn’t that long ago that the employment reports were reflecting 400,000 to 600,000 negative jobs each month. The fact that the numbers have increased to zero should indicate that the economy – even if it’s not robust – isn’t worsening.

Time and time again I point out the excellent earnings of major U.S. corporations. Many reported this week that if the U.S. falls into recession, corporate earnings would be cut dramatically. But that statement doesn’t appear to be supported by the facts.

In reviewing the first quarter of 2011, the economy functioned at a less than robust 0.7% GDP. Basically, this represents a flat line on economic activity. However, the S&P Index of 500 Stocks reported record earnings during this muted GDP growth. Therefore, if you assume that the third quarter of 2011 GDP was essentially zero, then why has almost every analyst forecasted record profits during this same quarter?


The inconsistencies in the financial markets right now are overwhelming. Although it seems much worse, the S&P 500 is only down 7% for 2011 through Friday, September 9th, but is up over 20% for the last year. In long-term investing, a 7% decline should not be unexpected by investors; a true 20% movement in the market isn’t that unusual, so a 7% decline clearly isn’t that extraordinary. Due to the extraordinary volatility in the markets, it certainly feels like the losses should be significantly greater.

As of Friday, September 9th, the S&P 500 was at 1,155. Yesterday, a Bank of America/Merrill Lynch strategist, David Bianco, reconfirmed his year-end target for the S&P 500 at 1,400. This means Bianco expects the S&P 500 to increase 21% in the next 3½ months. He stated that the market has priced in an 80% chance of recession for 2011. Also, neither he nor I believe a recession is in the near future. Most investors would find it inconsistent that on the same day the financial media is reporting chaos in the financial markets and a worldwide sell-off, the chief market strategist for the largest brokerage house, Merrill Lynch, is actually reconfirming his year-end target of the S&P 500 being up 21% from the current level.

These are not the only inconsistencies being reported by the media today. Ironically, almost all states are currently reporting higher revenues from sales tax, state income taxes and other income sources. It is illogical to assume that sales tax revenues would increase without corresponding sales increases. The Federal government is also reporting higher payroll tax receipts in 2011. If employees weren’t earning more, then payroll taxes wouldn’t be increasing.

In August, the Department of Commerce reported a large increase in U.S. exports. This can only mean that U.S. manufacturing is increasing, reflecting that U.S. exports is one of the bright stars in our economy in recent months. This can mainly be attributed to the lower dollar and the higher efficiency of the U.S. worker. For instance, German automobile manufacturer, Daimler AG (maker of Mercedes-Benz), is producing cars in South Carolina that are being exported around the world.

As I’ve indicated in prior posts, analysts are projecting that the earnings for the S&P 500 for 2011 will be approximately $100/share. Even if the analysts are off by 10% and earnings are only $90/share, given a conservative multiple of 15, the S&P 500 would have a current valuation of 1,350. Given the S&P’s current level of 1,155, then that index would be undervalued by 17%. With the low yields on U.S. Treasury bonds at 1.9% today for the 10-year bond, a multiple of 15 is quite conservative. Furthermore, even though the markets continue selling off, valuations are more than fair – and perhaps even undervalued – at the current time.

There’s also been a drastic movement in the bond market. As I mentioned above, the 10-year Treasury bond sells today for 1.9% even though inflation is forecasted to be close to 2% in the coming decade. It’s difficult to imagine why any knowledgeable investor would buy a Treasury bond that would most assuredly lose money in purchasing power over the next decade. Unfortunately, many seem to have done so.

The financial media is reporting that the U.S. is falling into a serious recession. Meanwhile, the National Association for Business Economics slashed their potential growth forecast for 2011 and 2012 this week. These economists are forecasting that the economy will grow at 1.7% for 2011 and at 2.3% for 2012. While the media talks about a recession, NABE economists are talking about reasonable growth over the next two years. Should investment decisions be based on what the financial media reports or on projections from economic experts?


Clients have asked me to comment on President Obama’s new jobs plan and the potential for QE3 by the Federal Reserve. While the jobs plan will help GDP growth some, it’s hard to imagine that it would help enough to offset another half trillion dollars in debt. If Congress approves this plan, we should expect some GDP growth in 2012 from this bill. Hopefully the growth will be enough to offset the additional money that will need to be borrowed to finance the plan. Regardless of what the president says about the plan being fully paid for, it will clearly be an outflow of cash in 2012 and an inflow of cash in some later year. In other words, it may be paid for, but not in the same fiscal year it’s spent.

Last Thursday night, President Obama gave his speech on his American Jobs Act plan. In it, he indicated that everything in his proposal has been supported by both Democrats and Republicans. Yesterday, Obama outlined how the $447 billion jobs bill would be paid for – by various tax increases that have been systematically turned down by Congress a number of times over the last three years, even when Democrats controlled both the House and the Senate.

Frankly, I don’t understand why President Obama’s solution is to increase taxes. I find it even more distressing that while the money would be spent in 2012, the tax changes would not go into effect until January, 2013 – two months after the November, 2012 presidential election.

As for QE3, the most recent proposal is that the Fed will sell some of their short-term Treasury bonds and buy longer term Treasury bonds. It would take another post to explain the rationale for this approach, but my opinion is that QE3 wouldn’t hurt. Why? Because the Fed wouldn’t be printing any new money or expanding their balance sheet; rather, they’d be selling some items on their balance sheet and buying others. I can’t imagine this having a negative effect, and therefore, bring on QE3!

I recognize that these news items are inconsistent with the stock market’s continuing decline, and frankly, that’s the reason our firm isn’t selling. Instead, I’m holding out for sanity to return to the markets. With the volatility in Europe and the constant fear of a recession in the U.S., I don’t expect the wild swings in the market to stop anytime soon, but I still believe that the markets will eventually increase. In my opinion, 2011 will still reflect double-digit positive numbers when all is said and done.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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