Wednesday, July 20, 2011

Stay Focused!

From the Desk of Joe Rollins

The global financial news has been terribly negative over the last several months. There’ve been reports of several countries in the Eurozone sinking in debt one-by-one – first Greece, then Portugal, then Spain, and the bankrupt country du jour is now Italy. All of these countries had basically adopted “cradle to grave” benefits for their people without the corresponding tax revenue to pay for it. In other words, they’ve been writing bad checks to their residents.

In addition, the debate to increase the debt ceiling in the U.S. is ongoing with politics permeating the debate. Republicans and Democrats are ramming heads to see who can get the most political mileage out of an issue that they will likely vote for anyway. Many report that the government’s inability to pay its bills will jeopardize our fragile economy if the debt ceiling isn’t raised, but I believe the debt limit will be increased either just before or soon after August 2nd, the date Treasury Secretary Timothy Geithner told Congress he will no longer be able to do any legal finagling to cover the bills.

For 2011, Congress has been in session a total of 87 days out of about 137 work days so far (64%), and as in years past, they are scheduled for a recess the entire month of August. I rather doubt they’ll miss their summer vacation for something as important as a $14 trillion liability. In short, the debt ceiling will probably be raised in the nick of time, and just before Congress adjourns for its summer recess.

All of these headwinds tend to distract investors from what is really important. In my view, it means little to U.S. taxpayers that Italy can’t manage its own finances. Moreover, how is it relevant to the U.S. that a good portion of Greece’s residents are government employees who pay no income taxes? While their economic situation is depressing and they are clearly facing financial disaster, the potential impact on the U.S. is minimal. I suspect that Greece, Portugal, Spain and Italy will eventually be bailed out by France and Germany anyway, as they are financially and economically sound. Who was it that wanted the U.S. to be more like Europe economically? For investors to fret and sell stocks like mad over this issue makes little sense from a long-term perspective.

I repeat that earnings are the most important element to stock market valuation. Have you noticed the earnings that have already been reported for the 2nd quarter of 2011? They’ve been nothing short of breathtaking! The earnings reported by Google, Coca-Cola, JP Morgan Chase, Wynn Resorts and IBM are worth taking a look at, and the only major corporation reporting negative earnings so far was Bank of America. Of course, their reserves are close to $10 billion in additional bad debts, but they have a capital position greater than the behemoth banking institution, JP Morgan Chase. It’s hard to fathom earnings being any better – and of course, it’s earnings that lead to higher stock prices. Earnings this quarter will be at the highest level ever in the history of the S&P 500 index.

After the yesterday’s closing bell, Apple (AAPL) posted blockbuster earnings for its fiscal Q3 at $7.79 per diluted share – up 122% from their prior year-ago quarter earnings. Apple posted revenue for its fiscal Q3 of $28.57 billion with net profits of $7.31 billion. Its price per share is currently approaching $400. In addition, Apple acknowledged that they currently have over $76.2 billion in cash on hand – a figure that’s almost one-third the GDP of Denmark. That’s incredible!

It’s also relevant to note that approximately 40% of the S&P 500 corporations’ earnings are earned outside the U.S. Therefore, even if you invest in these U.S. corporations, a significant portion of their revenue stream comes from non-U.S. sources.

The two major components of stock values are earnings and comparable interest rates. Interest rates for investors are essentially at zero right now. As such, few CDs, money markets, or other short-term investments, if any, are earning interest at the current time. Investors can purchase numerous stocks with dividend rates well in excess of the 10-year Treasury bond yield (2.97%). Right now, an investor can purchase a stock with growth potential that actual provides a return almost double the 10-year Treasury bond which will only be worth its face value at redemption.

It’s estimated that the S&P 500’s earnings in 2012 will be in excess of $100/share. A rather normalized multiple on these earnings reveals that the S&P 500 should have a valuation of 1,500 – 15% higher than its value today. Those who try to divert attention from earnings being the most important component to stock market investing have an ulterior motive: they are simply attempting to get you to sell at a low price so they can take advantage of investor naiveté.

Some may think I’m being too optimistic about the U.S.’s problems – but believe me, I’m well aware of the enormity of our issues. However, the ongoing debate about raising our debt ceiling is not something that has me preparing for the apocalypse. The budget deficit, on the other hand, is a topic that concerns me.

Our Congress continues to argue over rounding errors on the deficit and President Obama has proposed budget cuts that are insignificant to the total deficit. It appears to me that this administration intends to spend as much of your money as possible as long as they are allowed. Here are a few examples:

As I’ve stated in other posts, I believe that Keynesian demand-stimulus economics has not been a success. During the Great Depression, President Franklin D. Roosevelt tried his hand at this theory. Many people believe that the reason the U.S. was able to pull out of the recession of the late 1930’s was because of the money spent by Congress on work programs. But as history documents, for a 13-month period from 1937 to 1938, there was a reversal of the 1933 to 1941 economic recovery from the Great Depression attributed to spending cuts to balance the budget. Unemployment had reached a staggering 25% as FDR took office, but even with the massive spending on work programs, unemployment never got better than 14.2% until the U.S. geared up for World War II.

Much like the Keynesian efforts taken in the 1930’s, the American Recovery and Reinvestment Act of 2009 has also been a disappointment, and it’s fairly simple to see why. One-third of the stimulus money was given to state and municipal governments to keep employees they probably did not need anyway. As such, rather than using the stimulus money to create jobs, it was used to retain jobs. Once the stimulus money was no longer available to the states and municipalities, those jobs were eliminated. President Obama recently remarked that, “shovel-ready was not as shovel-ready as we expected.” I don’t know about you, but saying we were unprepared seems to be an understatement.

Compare these examples of the utilization of Keynesian economics with Ronald Reagan’s utilization of supply-side economics, wherein his economic policy aimed to reduce income and capital gains taxes, government spending, government regulation, and inflation by controlling the money supply. Reagan embraced the theory that if taxpayers were able to keep more of their money by paying less taxes, the economy and employment would improve. Reagan’s tax cuts undoubtedly had a meaningful impact on the U.S. economy, creating an economic boom that endured for more than 20 years.

Lots of ideas have been coming out of Washington as to how to fix the Federal budget. Many argue that there’s no way for the Federal budget to be cut 25%. Why isn’t that possible?

The Department of Commerce is the government agency in charge of promoting economic development and technological innovation in an effort to improve the living standards of all Americans. There are several bureaus under the department (the Bureau of Economic Analysis, the U.S. Census Bureau, the International Trade Administration are a few), and the department as a whole has approximately 38,000 employees. Could employment at the department be decreased by 25% to only 30,000 employees? Can we afford all of these employees doing whatever it is they do?

What about the Department of Education? In the United States, state and local school districts determine curricula and educational standards, not the U.S. Department of Education. With 5,000 employees, its primary functions are to "establish policy for, administer and coordinate most federal assistance to education, collect data on U.S. schools, and to enforce federal educational laws regarding privacy and civil rights.” Can these tasks not be done with 3,500 employees instead of 5,000?

How about the Department of Housing and Urban Development? Could its program offices function with 25% fewer employees? What do they do? To my mind, there’s no question they could.

While putting 100,000 Federal employees out of work would do little promote employment, it would be a positive change at least in the psychological sense. If we could demonstrate to the rest of the world that the U.S. has a grip on its deficit issues and is actually moving forward in trying to solve those problems, the positive economic impact to businesses would be enormous. The reason unemployment continues to be so high is because of the ongoing uncertainty created by Washington. If someone in Congress for once had the political nerve to promote a program where the Federal deficit was actually addressed, business confidence would skyrocket, the economy would improve, and 100,000 Federal jobs would only be a rounding error to new employment.

Yesterday, the Senate “Gang of Six” unveiled a new bipartisan budget that would reduce the deficit by $3.7 trillion over the next 10 years that was subsequently endorsed by President Obama. However, some members of Congress still apparently don’t understand how strongly the American populace feels about this subject. If Congress adopts the Gang of Six proposal in full – which is highly unlikely – we might cut $3.7 trillion from our deficit over the next decade. But the cumulative deficits even after these reductions over the next decade would be a mind-boggling $15 trillion. That’s totally unacceptable!

In any event, the reason I’m not pessimistic about the U.S. economy is because it’s clear that the public sees that Washington is on the wrong path and will soon make necessary changes. Unlike Greece, Portugal, Spain and Italy, we are nowhere near insolvency – not yet, anyway. Moreover, the U.S. economy is many times the size of all the EU countries combined. We can – with less Federal regulation, lower taxes and a better business environment – solve the deficit issues. If we continue voting for representatives who do not understand finance, however, we will have missed our opportunity to fix it in the next few years.

In summary, it’s important for us to stay focused on the components that truly impact stock prices – earnings and interest rates. I can’t recall another time where both components were so favorable for higher stock prices as they are now.

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

Best regards,
Joe Rollins

No comments: