Market Musings Blog

The Future of the US Economy

The other day I read an article bemoaning the state of the US economy. I read pieces like this every day, but one comment stuck in my mind. The author pointed out that the American consumer might be in a permanent pall, and without all that buying power reinforcing demand for the junk we accumulate, what else would power US GDP in the coming decades? We could debate whether the premise – the death of the American consumer – is correct, but let’s not. It’s more interesting to ruminate on the answer to the author’s question regarding our future. If we don’t consume, then what?

We think the answer is manufacturing. Contrary to popular opinion, the US manufacturing sector is alive and well. We produced around $2 trillion of goods last year, much of it high value, technology intensive goods. China produced a similar amount, and just edged the US out of top place according to some figures, but their production is focused on cheap, easy to make items such as apparel or commodity items such as steel.

No other country comes close to the manufacturing output of China or the US. So the claim that we don’t make anything any more is false.

While the US pumps out goods right and left, employment in the sector has only recently begun to edge up, after decades of decline. That’s because US plants are incredibly efficient, thanks to advances in plant design and management; US plants just don’t need much labor. But we still think employment trends will accelerate in the sector, and that more manufacturers will build plants in the good old US. Here’s why:

  • Transportation costs are rising, and will continue to do so. It’s expensive to move stuff, especially large items, across the ocean.
  • Potential supply disruptions from natural disasters, such as the tsunami in Japan and the floods in Thailand, have proved that depending on one location for all your hard drives or auto parts isn’t such great planning.
  • Labor costs in China particularly, and Asia generally, are rising. Many Asian nations have instituted minimum wage laws and/or increased minimum wages recently. Additionally, China is becoming more aware of the social costs of being the world’s cheapest manufacturing site – in terms of worker safety, pollution, and other social disruptions. As a result, the country is gradually becoming less friendly towards foreign corporations.
  • The gradual rise in the renminbi, China’s currency. Historically, China’s currency has been kept artificially low, making its goods cheap. Likewise, the Chinese can’t buy US goods – the high dollar/renminbi makes such transactions very expensive. But as China’s currency rises, its populace can consume our goods at a cheaper price.
  • A growing awareness among states – especially in the rustbelt – that they must be competitive not just with other states but the rest of the world in order to attract jobs. Like it or not, we live in a global economy, and we must begin to think that way.

Shifting the tide in US manufacturing won’t happen overnight, but change is afoot.

 

Playing “Chicken” in Greece

The Great Bond Swap is underway for holders of Greek debt. In this exercise, Greek bondholders “volunteer” to let Greece default on the bonds they own now in exchange for fewer new bonds structured with lower interest rates and longer maturities. To be effective, over 90% of the holders of Greek debt need to agree to take a beating. At that level of participation, The Great Bond Swap can be called an “orderly default” wherein life as we know it is not supposed to change much, as opposed to a “disorderly default” wherein all hell breaks loose. To be sure, we don’t quite quite understand the nuance. A default is a default. Furthermore, everyone is Greek-fatigued, and has likely accommodated the idea of default over the last two years, so we suspect even a disorderly default won’t have a lasting (a key word!) impact at this stage of the game.

In any event, the Bond Swap agreement is meticulous and complicated, but the general idea is to inflict pain on those who do not participate. Bond holders, of course, are eyeing each other to see what the next guy is going to do or whether they can all stonewall the process to garner better terms. From that perspective it is an interesting economic event for econo-geeks like us, but probably boring for anyone who is normal. But there’s one hole in the Swap agreement that is worth pointing out: many of the holders of Greek debt also bought insurance against default for the debt. These are called credit default swaps, and they pay if Greece defaults. But under the contract, the CDS’s only pay if the default is not voluntary! These people have no incentive to play ball. In fact, they will probably gain more if there is a disorderly, “involuntary” default because their bonds might become worthless but the insurance they bought will pay them back, and more than the Greeks are willing to offer under the terms of the Bond Swap.

Witching hour is this Thursday, roughly 3 pm Eastern time. That’s when the terms of the swap expire. If there’s a shortfall in the number of participants, look out for a rough time in the markets as everyone adjusts to the uncertainty. Unfortunately, there’s no countdown clock tabulating the number of participants who have signed up, so we’ll just have to wait for the news tomorrow.

The Great Compression

A stock’s price/earnings ratio describes how much an investor pays for that company’s earnings. The math is simple: it’s the price of the stock divided by recent earnings per share. If the stock price is $20 and the earnings are $2, then the PE is 10. In this case, an investor is paying $10 for every one dollar the company has earned. Value investors prefer to pay less for earnings rather than more, so a PE of 10 is more attractive than a PE of 20. A dollar is a dollar, after all, and we don’t much care who’s earning it.

Over the last twelve years, PEs have compressed, big time. In the late 1990s, the average PE of the market was over 30. That is stupendously high, as the average PE over several decades has been just 16. Now, part of the reason the market PE was so high was because technology stock valuations were beyond unreasonable. But many mundane stocks have suffered, too.

This compression has happened two ways. First, stock prices are down or at best, flat. Second, earnings have increased. Here are a couple examples:

  • Intel. Earnings were $1.53 in 2000. The stock’s high was $76; its low was $30. Fast forward to 2011: the company is now earning $2.31 – about 50% more; but its stock price ranged between $19 and $26 in 2011. Why are investors willing to pay so much less for Intel’s stock, even though its earnings power is so much greater now than ten years ago?
  • Ok, ok, so that’s a tech stock. Special case. How about something falling into the “mundane” category? Emerson Electric earned $1.65 in 2000 and its stock price averaged $30 during the year. Now, it earns $3.24 – 96% more than back then – but the stock sells at $51.50. Why isn’t it closer to $60?
  • Kroger. Earned $1.34 back in 2000. Average stock price was $21. Now, Kroger earns $2.00 – that increase is about the same as Intel’s 50%. But Kroger is barely hanging onto a $24 stock price. Why isn’t it $30?
Not mentioned here is the fact that all these companies have raised their dividends handsomely in the last several years, so not only do you have the benefit of higher earnings power, you’re also receiving more cash into your pocket from owning the shares.
PE compressions happen after periods of overvaluation. It’s as if the market must recover from all that excess – like a multi year hangover. Additionally, one can find all sorts of reasons to dislike stocks right now: politics, poor economies, general uncertainty, and so forth. But those reasons always exist. The real question is: what makes people decide to “like” stocks again? Why did the market take off in the summer of 1982, not to look back in any substantive way for over a decade? Why not 1981? or 1983?
The market was cheap in 1982. It was also cheap in 1981 and 1983. The triggers for a bull market are complicated and no one really understands them. But one trigger is cheapness, no doubt about it. The longer earnings continue to progress without commensurately higher stock prices, the cheaper the market will become, and the closer we will come to another bull market.

Heavyweights Opine on Stocks

In the last two days, two headline investors have opined on the stock market, and their bias is positive. Larry Fink, who runs BlackRock, one of the largest investment companies in the world, is on Bloomberg news indicating that investors should be 100% invested in stocks. Particularly interesting is that Mr. Fink is a bond guy. Read the article here.

On the heels of that pronouncement, Warren Buffet, in a mild twist, says “bonds should come with a warning label.” In this article, Buffett – who is frequently bullish on stocks – indicates that both gold and bonds will not likely produce much return going forward.

Nouriel Roubini, Mr. Super Bear, is also mildly bullish, saying the current rally might have some staying power, but his bullishness extends only through the first half of 2012. Then all bets are off.

While stocks are, overall, pretty cheap, they’ve also run up some 15% in four months. That rally, coupled with the continuing disarray in Europe, warrants a note of caution. We’ve sold more than we’ve bought lately, and are finding it tough to pass stocks through our relatively strict valuation screens onto our “buy” list.

A Public Service Message

As I was reading The Girl with the Dragon Tattoo, a Kuwaiti billionaire was turning livid. Bassam Alghanim discovered that brother Kutayba had paid to have his computer hacked and all the details of his private life – emails, financial details, legal affairs – were now published on the web. Those of you who have any familiarity with Lisbeth Salander, the heroine of Dragon Tattoo, will understand why I decided to do a little research to find out exactly how hard it is to get into someone’s computer. We have a lot of information to protect, and I want to be sure that we stay state-of-the-art in the way of keeping prying eyes OUT.

Turns out, it’s very easy to snoop someone’s computer. You can hire a hack job on the web for a few hundred dollars. You can buy software to install on your own computer to record keystrokes on a remote computer that’s working on the web. You can download YouTube videos that will show you how to hack any gmail or yahoo email account, or how to trick other entities into sending you strangers’ passwords. In this way, you could reap credit card or Social Security numbers, passwords to bank or brokerage accounts, etc. Here’s a great article on the subject:

http://onemansblog.com/2007/03/26/how-id-hack-your-weak-passwords/

Test your passwords here:

https://www.microsoft.com/security/pc-security/password-checker.aspx

Improve your passwords here:

http://www.microsoft.com/security/online-privacy/passwords-create.aspx

Alternatively, if you have too dang many passwords to remember (no, DON’T write them down!), you can use a password vault like Roboform:

http://www.roboform.com/

If just a few of the folks who read this blog will take some action to improve their computer security, the whole web will be a little safer. Do your part.