Saturday, February 6, 2010

Ding-Dong! The Recession is Dead.

From the Desk of Joe Rollins

The evidence that the recession that began in the 3rd quarter of 2007 is over is now overwhelming. While we’re not back to a roaring economy, it does look like we’ve established a base and are moving forward. It is somewhat perplexing to the average investor to see the stock market sell off over the last few days, but I think that should be dismissed as more of a trader’s mentality than logical moves by long-term investors.

In recent days, we’ve seen enormous evidence that the economy has turned the corner. For the 4th quarter of 2009, the GDP grew at a rate of 5.7%. Almost all of the commentators have tried to dismiss this percentage as meaningless since it included a fairly large component of GDP that was created by rebuilding inventories. Prior to the 4th quarter of 2009, inventories had gotten to historic lows, and at some point, manufacturing would have to be increased to replenish these inventories. Much of that occurred in the 4th quarter of 2009.

It’s difficult for me to dismiss any type of increase in manufacturing activity when it comes to putting more people back to work. When inventories are not replenished, the GDP goes down, so why are we dismissing them when inventories are increased? It is presumed that the increase in inventories added roughly three percentage points to the GDP numbers, and therefore, the true growth (taking out the inventories) would’ve only been 2.7%. Those numbers notwithstanding, we still ended 2009 with two strong quarters of GDP growth at 2.2% and 2.7%.

The Federal Reserve is now estimating that the GDP growth for the 1st quarter of 2010 might be as high as 5%. I’m not quite so optimistic, but I’m not too far off. I believe a more likely number is around 4%. If either of those numbers ends up being true when all is said and done, that means that we will have recorded in April, 2010 three consecutive very positive GDP quarters. By any economic definition, the U.S. economy is no longer in recession.

I’m blown away by the negativism I hear these days in the media reports regarding the economy. While it’s true that there continues to be approximately 6 million Americans who are unemployed, there are still well in excess of 100 million Americans who are employed. It seems like we should be more focused on the glass being half full (90%) rather than half empty (10%). As we all know, it will be months, if not years, before the employment base gets to a reasonably full level, but the decline is definitely at a stop.

The most recent labor report indicates that only 20,000 jobs were lost in December, and the unemployment rate moved down to 9.7%. However, if you read the report closely, you will see that virtually all of these jobs were lost in the construction business. If those jobs hadn’t been lost, the month of January would’ve reflected a net positive employment report. I can’t help but believe that a considerable amount of the loss in construction jobs in January had more to do with the miserable weather than a lack of jobs.

The Atlanta Business Chronicle reported on Friday that there is a shortage of new homes in the Atlanta area. It was only a matter of time before we knew this condition would occur. At this time, almost no new homes are being built in America except on a pre-purchase basis. New home permits continue to fall, and builders seemingly see little hope of recovery. While we will see foreclosed houses continue to flood the market for some time, this is the type of market cleansing that is required. We need to finish this foreclosure cycle and new homes will start to be constructed again. As new home construction starts, Americans will be put back to work to further stabilize the economy. Given the long lead time between a house starting to be constructed to when it’s completed, you should expect to be seeing new home construction occurring sometime during the summer of 2010.

The Federal Reserve, up to this point, has been the buyer of virtually all real estate mortgages produced by Freddie and Fannie in recent months. The Federal Reserve has already announced that they will discontinue the purchase of these mortgages in March of 2010. At the current time, it’s still possible to get a 30-year fixed-rate mortgage at less than 5%. I can almost give you 100% assurance that will no longer be the case once the government is not the only buyer of these mortgages. If you planned on refinancing your mortgage at a rate below 5%, you need to do so now.

Rates are increasing and they may increase dramatically. I would expect that as soon as the Federal Reserve is no longer the ultimate buyer of these mortgages, we will immediately see long-term mortgage rates jump up above the 5% range. Given the potential for inflation in the coming months, it would not surprise me at all to see mortgages closer to 7% than 5% by the end of 2010. Again, now is the time to refinance if you have been considering doing so lately.

I’ve written extensively on the subject of the TARP and how it was necessary to stabilize the banks and the American economy. Please refer to my previous post, "This is Not a Bailout" for my prior discussions on the subject. I have also repeatedly commented that the TARP has been extraordinarily beneficial to the banks and to the taxpayers. At the current time, all the major U.S. banks have repaid their TARP money along with interest, and in many cases, an equity kicker in the form of warrants paid back to the government. Interestingly, the Federal Reserve made a cool $6.4 billion on the assets during 2009 that they were required to purchase during the economic downturn. The Federal Reserve has never made a profit anywhere close to this large sum of money in the past. They turned this profit over to the U.S. Treasury to reduce the deficit

One of the major benefits of the TARP was that it specifically set out that when the money was repaid by the banks, the money would be returned to the Treasury to reduce the deficit. You may recall that the $700 billion was never even utilized. Only $350 billion of it was authorized, and the remaining portion was never even spent. At the current time, the outstanding amounts are almost all owed by Chrysler, General Motors and AIG. There are numerous loans from other small banks, but these amounts are relatively insignificant.

It’s troubling that Congress seemingly cannot keep their hands off this money. It’s been proposed and is working its way through the House that they use $100 billion of this TARP money for an additional stimulus bill. More interestingly, President Obama, in his State of the Union Address, has essentially committed to spending $30 billion of the money returned by the banks to fund a small business lending program for regional banks. It seems to me that these people cannot stop spending money at any cost. It is important to point out that the use of this TARP money for these programs is specifically outlawed under the bill as written. Spending this money is like crack to this Congress – they just can’t keep away from it!

I have also openly criticized the stimulus plan, since it didn’t accomplish what it was set out to do. It was supposed to immediately improve the economy. Over a year after its approval, only $180 billion of the over $700 billion has been spent for job creation. Maybe we are finally getting to the point where this stimulus money will be beneficial to us. As we start to work off these projects that are funded by the stimulus this summer, they should improve the economy and make things better by putting construction workers back to work.

All of that being said, it is fairly clear to me that we need neither the second stimulus bill nor do we need the assistance to regional banks for small business lending. Banks are currently flooded with money and have both the capacity and the ability to make these small business loans. Even today I am seeing a much improved borrowing market for small businesses than only six months ago. Once one bank is brave enough to make the first business loan, they all will; competition will require it. The U.S. economy will recover in a much more stable manner if we just get government out of every day business and let small businesses and entrepreneurs grow the economy rather than use the artificial government stimulus.

The average investor is baffled by the market’s sell-off over the last few days. The S&P was down 3.6% for the month of January, 2010. The average of all of the accounts under our management was down 2.6% during the same relative timeframe, about 33% better due to the bond positions we hold. While it is troublesome to incur any month with a loss, it could easily be argued that this was not unexpected. Since the low in March of 2009, the S&P is up close to 60% on a relative basis and a pull back of 5% to 15% should never be unexpected. Even after this week’s losses, we are nowhere close to that reasonable pull-back in the averages.

What confuses people the most is that the market has pulled back in the face of extraordinarily good economic news. Profits for the 4th quarter of 2009 have been nothing short of spectacular. Interest rates are at historic lows and it is relatively impossible to earn anything on cash these days. If you have money invested in a money market account today, you are earning virtually zero. Therefore, we are in a time where stocks should be moving up, not down. Let me summarize the items we know about the economy at the current time…

  • GDP growth is accelerating in 2010.
  • Earnings for the 4th quarter of 2009 have been extraordinary, and earnings projections for 2010 are being increased significantly.
  • Interest rates are historically low and are not expected to move up dramatically anything soon.
Basically every component that you could ever want for higher stock prices is now in place. It is my prediction that any short-term decline in the major market indices will be short-lived and will be a buying opportunity for your future. It makes little sense to trade out of positions for this short downturn only to reinvest a few months later. If there ever was a good time to invest for a more secure financial future, now is that time. Have you contributed to your IRA for 2009 and 2010 yet?

I saw something in Friday’s paper that I couldn’t help but point out. The provincial governor of Newfoundland and Labrador, Canada, Danny Williams, is taking a leave of absence to get heart surgery in the United States. Even though he is an independently wealthy elected official, he fully realizes that if he is going to get world-class medical care, it could not be in Canada. Therefore, he is coming to the United States at his own cost to pay for this care. I cannot imagine that the vast majority of Americans really want the type of inferior care that Canada provides in its single-payer system. If their elected officials do not want it, then I can imagine how the rest of their populace feels. Fortunately, we dodged that bullet since even the President has already admitted that healthcare reform is likely dead in Congress.

Lastly, I’d like to leave you with the following point to ponder. Warren Buffett was asked at a CNBC Town Hall Event at Columbia University in November of 2009 what he thought the best year has been for the market since 1942. He responded:

“The answer is 1954. In 1954, the Dow, counting dividends, was up 50%. Now if you look at 1954, we were in a recession a good bit of that time. The recession started in July of 1953. Unemployment peaked in September of 1954. So until November of 1954 you hadn’t seen an uptick in the employment figure. And the employment figure more than doubled during that period. It was the best year there was for the market. So it’s a terrible mistake to look at what’s going on in the economy today and then decide whether to buy or sell stocks based on it.”

As always, the foregoing are my opinions, assumptions and forecasts (I cannot speak for Mr. Buffett). It is perfectly possible that I am wrong.

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