Hermes Bancorp Examines the August Numbers

From George Haligua – Hermes Bancorp –
Even though there have been strong earnings reported this season the stock market has still been struggling this month. Nasdaq and the S&P hit new lows for the year this week before rallying, and the Dow broke 10,000. Direction has moved from the cyclicals to the utilities and consumer staples stocks. Some technical analysts have declared the beginning of a new force.
What has scared investors is the indication of a synchronized global economic slowdown, led by China and the United States. The latest buzz on the street is talk of the “June Swoon” in the economy, caused by gloomy jobs report, disappointing ISM data, and diminishing retail sales, a slowdown confirmed this morning with the announcement that Q2 GDP grew just 3% – far below what economists had forecasted. Many well-known economists are scattering to cut their forecasts for future growth in order to avoid possible criticism. We have reallocated our asset mix to position ourselves in a manner to take full advantage of the ever changing economies and geopolitics.

The old saying goes “We are what we eat”, and in periods of weak stock markets it can be argued that investors are actually what they fear. When stock markets soared in January the only fears that investors had were about high-energy prices. Crude was selling at the astonishing level (for Wall Street oil analysts, economists and strategists) of $35, instead of $26; natural gas was selling at the disturbing level (for Wall Street oil analysts, economists and strategists) of $7.25.
When stock markets slid into May, the fears were worse than ever: how high would energy prices, GDP levels, inflation and the fed funds rate go? When stock markets worsened into July, a new uncertainty emerged: a fear of rising oil prices and a fear of a falling economy. Suddenly the global economy was at risk. China got the process started with its highly publicized blunderbuss approach to reining in its runaway economy. This was considered good news (by all except holders of mining, shipping, coal and steel stocks) because, for the first time in history, China was the driver of global inflation, rather than the West, or the Arab world.
Industrial metals were the first group of stocks to feel the pressure from China’s slowdown. Shares of leading mining companies sold off worldwide, even as metal prices were continuing to rise, or were consolidating near multi-year highs. Other cyclical stocks, particularly techs, remained strong. By mid-June, there was no mistaking that the slowdown that began in Beijing was migrating across the world.
Investors’ fear of the economy’s flying too high (the Icarus syndrome) switched suddenly into the fear of its falling too low (the Orpheus syndrome).
This was no simple turnaround, the economic data changed fast. First came reports from the Chinese authorities that their tightening was working, with second quarter GDP said to be growing at about one-fifth the rate it had reported for the first quarter (but still 9% higher than the year earlier). Those estimates confirmed external statistics long used as stand-ins for evaluating the Chinese economy, including prices of key raw materials and the Baltic Freight Index.
Then, just as it began to look as if Bush would finally have a string of great economic numbers to offset all the terrible news from Iraq, the June Nonfarm Payroll announced only 112,000 net new jobs, and May’s optimistic number was thrown away. Since economists expected at least 175,000 jobs, that small number was a huge disappointment. It followed weak ISM numbers—both for manufacturing and service companies.
The figures for retail sales data were not far off. Wal-Mart and Target blamed their poor results on $2 gasoline prices, which they said hit their customers particularly hard: they had less money to spend at the cash because they were spending more of it at the pumps. This new pattern of data was no longer causing uncertainty to economists about where they were headed. In mid-July it was announced that the US Leading Indicator had turned south, joining Leading Indicators in Europe and Latin America. Since the LEI is made up of a range of statistics, its exposure hit the stock market hard, especially cyclicals.
One of the only positive numbers released through mid-July was existing home sales, which increased significantly in both number of homes sold and in median price. But even this number didn’t impress the market, because, as economists observed, when mortgage rates start to climb, there’s a rush to close deals before rates get too high.
Then, a ray of light: on July 27th, the Conference Board’s Consumer Confidence report illustrated a surge in confidence, particularly on the outlook for jobs. This resulted in the best day for stocks since June. However, the following day the Durable Goods report showed that the good news was not a long-lasting pattern: it came in well below forecasts, and the stock market carried on its slump.
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Then, this morning we learned that Q3 GDP was up just 3%, which meant June was at least as weak as the most apprehensive feared. It is important to understand that the sentiment sway among equity investors is no mere spastic jolt. It is based on a major swing in the economic data that occurred simultaneously and suddenly.
A similar shift in attitudes occurred at the same time of the year in 1988. It wasn’t among equity investors: it was among commodity traders and farmers. In Spring, they feared there would be such perfect growing conditions that there would be huge crops of corn and soybeans. But the rains that relieved fears of drought just kept coming. By July, the Mississippi-Missouri border area looked as if Lake Superior had moved south. The flood shocked people. Lucky farmers outside the flooded areas who had held back corn and soybeans from last year’s crop and were anticipating buffer crops could hardly believe their gains. Those who had sold their output last fall and saw their land under water could hardly believe their losses.
This mood swing has not been that dramatic, but one question to be answered is what caused the economy to slow down so fast? By the time the Fed got around to raising the funds rate to 1.25%, the economy was already decelerating. Why?
Reasons Cited for the Unexpected Slowdown:
1. Public Enemy #1
With the price of oil these days, Americans are spending about $400 million a day, and most of it is going to countries such as Canada, Venezuela, and Saudi Arabia. This is an obvious drain on the American economy: not only does it not stay in the country to circulate within the US and stimulate job creation; it is also a strain on consumers’ discretionary spending. Even though the short-term impact of high gas prices is a constant negative for the American economy, there is a remote possibility that these times of struggle could lead to longer-term gain.
Seeing that Americans are famous for their appetite of gas guzzling SUVs, it could turn out that $40 oil will help in the long run. The price system is the best method to get Americans to start buying fuel-efficient vehicles. Americans pay less for gasoline at the pump than almost anyone in the industrial world. Europeans have not had gas problems this year, because (1) crude oil accounts for less of the cost of fuel at the pump than taxes, and (2) the strength of the euro offset most of the price increase of imported oil. Rather than talking of boosting taxes on savings, those tax-hungry Democrats should suggest a significant boost in the gasoline tax, with a tax credit for low-income people who have to drive cars to get to work.
Why is a significant tax increase recommended? Simply because people are firm believers in the logic of tax cuts. By ensuring that the 2001 recession was the mildest in 80 years, Bush demonstrated that income tax cuts stimulate economic growth, by promoting work and investment. To encourage behavior beneficial to society, it seems obvious to reduce the tax on it. By the same logic, to discourage behavior detrimental to society’s interests, tax it.
The question at hand right now is the fact that $43 oil is too obvious an economic nuisance to disregard. Leading US forecasters have used oil price changes in GDP forecasts, as well as money growth and interest rate changes, as the bases for their forecasts. For the past 35 years, every US recession has been preceded by a quick rise in oil prices. The Clinton era was described by cheap oil: it was $20 when his Presidency began, fell to a low of $15 in 1994, and only reached $32 in the last few months of his term. GDP growth in Q3 2000 turned from boom to bust, with real GDP actually down, in turn starting the process of the recession that started just as Bush was elected. That slump is being described as “The Bush Recession.”
After the US fell into what looked to almost everyone like a recession, oil prices dropped to a low of $18, setting the stage for what everybody knows as “The Job Loss Recovery.” (Woody Brock comments that if productivity since 2001 had been at the level of Clinton’s first term, instead of at the shocking rate of 4%, the US unemployment rate would be well below 5% and Bush would be credited with creating millions of jobs. Instead, people say that Bush has headed over the worst economy since Herbert Hoover, and has thrown millions of American workers out of their jobs. Brock, mocking Bush’s words, said that what he should do is run television ads showing a donut shop with four employees. The manager says that, due to a lot of competition, she is installing a new machine that will make donuts faster and cheaper. This is great for customers because the shop will stay in business, and good for the two employees that will still be needed. Too bad for the other two, but if all businesses are doing the same, eventually the economy will be growing fast enough that they will find new jobs.)
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What about the argument that oil isn’t expensive compared to previous $40 peaks, when adjusted for inflation? This is one of those statistical facts that looks good on paper but misses the point. Those previous experiences were horrible for the economy, really bad, but they were short. They were moments. In 1990, oil began and ended the year at about $22, with just two months in the mid-$30 range after Saddam invaded Kuwait. In 2000, oil stayed above $30 for just four months, then began a plunge that took it to as low as $19.
Since then, even though almost all predictions from the Street were that oil prices were going to fall into the low twenties in the very near future they have been constantly increasing. Consumers have been suffering and it is only getting worse. If the Street and the most well known forecasters had not kept assuring people that prices were about to drop, then far fewer people would have gone deeply in debt to buy SUVs and other gas-guzzlers, and far fewer would have second and third mortgages based on optimistic views of their discretionary incomes.
This is another example of Shared Mistake. When all the prominent people agree on an important economic or financial forecast, and they are all wrong, the consequences are huge, and usually very painful. $40 oil is definitely not positive for the stock market, however it is the oil companies that are increasing the overall S&P earnings.
Consider the following fact. Presently, oil stocks are trading closely with the price of crude and crude and natural gas are up in similar percentages. However, also note that investors do not believe that the high prices will last, because they are not moving stock prices up faster than the prices of crude and natural gas. Think of what would be happening to the prices of tech stocks if the prices of their products were climbing by 35%, rather than falling at double-digit rates.
Look at Exxon Mobil’s Q2 earnings per share, up 42% this year and 59% last year. However, the seers forecast a 22.7% decline next year. Exxon’s P/E is 13; were it not for heavy stock buybacks it would be roughly 14; current dividend yield is 2.4%, and the company has boosted its dividend faster than inflation for more than two decades. XOM and its oil are the main reason why the P/E multiple on the total S&P looks reassuringly modest these days.
The fact that economists say that price increases in oil stocks are simple random increases, while the price increase of oil is so overwhelming means that the consensus continues to expect a decrease in oil prices but believes that high oil prices are reason to be worried about overall economic growth, particularly in consumer spending. Even though leading economists have for years made incorrect forecasts, they still earn huge incomes that allow them to fuel their SUVs. They recommend a switch from cyclical stocks to staples and utilities because of slowing growth, which they blame on high oil prices, which they say won’t last. So if the for the first time in three years the Street were to be right about their prediction of oil prices, strategists will be calling for a back-to-boom economy in the near future.
2. Capital Spending Peak?
The temporary 50% increase in capital spending depreciation allowances expires only 59 days after the election. The question is will companies continue to acquire or upgrade physical assets when Washington is not helping them out as much? Enterprise software companies were the first to indicate that rapid growth in capital spending might already be at a high. It was shown that during Q2, competition forced this industry to discount products by as much as 89%, and that customers they expected to sign at the end of June were no longer interested.
Larry Ellison said, “I told you so,” to the rest of the industry this week, when it was revealed that business software sales, which had risen 14% in Q1, were up just 5% in Q2. He has always been sure that the little companies would never survive.
Andrew Corporation, a global designer, manufacturer, and supplier of communications equipment, services, and systems announced record sales and earnings in Q2 this week. He also stated that the company’s US customers have “paused” their equipment orders. Writing about the company’s conference call in the Chicago Tribune, Bill Barnhart quotes the CFO, “You’re going to see a little hiccup.” The stock suffered the biggest percentage decline in the S&P 500 on July 26th, down 22.9%. This was horrible news for stockholders, and forecasters began to worry that the same problem would happen to the traditional capital spending leaders.
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3. Motown Blues
General Motors, Ford, and Chrysler are continuing to lose market share to the Japanese. Even though they keep discounting, their sales continue to decrease. Ford and GM are reporting good earnings, but from their finance divisions. They justify these earnings by saying that they are really in the business of making money, not making cars. Their inventory of SUVs at this point is over 110 days old. On the other hand, Toyota’s Prius, a very fuel-efficient car, is back-ordered through 2005.
In summary, car sales have been low, and the companies being hit the hardest are the American ones. The question remains, are sales down because $40 oil makes most cars look expensive to operate, or is it because $40 oil hurts consumers’ discretionary incomes? The fact is that oil prices are up 55% from their low reached in Spring 2003, and there is no sign that they are headed back there. Those suffering the most are those who have to drive to work, and within these millions of people are many who find a 33% rise in gasoline costs a serious dent to their family finances.
The Election and The Stock MarketSince the Democratic Primaries began, the International Statistical Institute has been releasing a table showing Bush’s rank in the polls compared with the S&P 500. The correlation is remarkably precise. As Bush’s standing has been dropping, so has the market. Bush’s brief bounces in the polls have corresponded with bounces in the stock market. The stock market rally on July 27th followed overnight polls showing that the Bill Clinton’s speech did not help John Kerry. That obviously does not mean that Democrats do not invest in Stocks, but the group that pollsters identify as “investors” (those with at least $10,000 in stocks) has always been pro-Bush. So if these people modify their investing in line with their political liking, that would be a powerful influence on the stock market.
As interesting as this correlation is to market observers, it remains not credible to some, and these are the reasons why:
– Charts show both the S&P and Bush peaking at the time Howard Dean was going to be the Democratic nominee. Since “the investor class,” (and many other onlookers) considered Dean an unconventional activist, he was going to be an easier competitor for Bush than Michael Dukakis had been for his father. This meant that people no longer had to think about politics. They had more time to concentrate on what they really care about, economic and financial news. That is when investors are usually happiest and liveliest: when they are keeping an eye on what they enjoy, rather than what they fear. So when Kerry was nominated, instead of an assumed wacko, people were looking at a proven war hero, which meant that Bush was not necessarily going to win. Since then, Kerry has united the Democratic Party to a degree it hasn’t seen since the Roosevelt era, and he has pulled to a lead in the polls. His climb has meant investors have had to reconsider a whole range of investment topics they thought were closed. That reconsideration is happening at a time when news from Iraq was discouraging for Americans in general, not just Republicans or investors. Saying that Kerry is benefiting from all the bad news overseas and suggesting that voters wish to sell stocks because they think Kerry will be President is not fair. The situation is more complicated than that.
– Kerry now sounds like a serious man with a serious resume who could be a serious President. He talks of how to ensure that employers can continue to provide health care for employees, and his policies on Iraq now sound almost impossible to tell apart from what Bush is actually trying to do. He is an intelligent man who was a college debating champion and is sounding more and more like a credible President.
– Kerry’s night at the end of the Convention was a brilliantly-scripted presentation of the candidate as the perfect Commander in Chief. His biography film set the stage for his appearance. It had incredible footage of war in Vietnam. Kerry’s “Band of Brothers” who had served with him in the boats, appeared to praise him as a cool, gutsy hero who courageously risked his life to protect his men. His own speech began with a military salute, now all over the cover pages of newspapers. He came across as a man who really knows what war is about, a man who chose to serve in an unpopular war because of family values of national service. (The unstated subtext was that Bush, another patrician, had arranged to serve in air national guard, exempting himself from joining the fighting.) He looked like a leader comfortable in his own skin, the type a nation can trust at a time of national crisis.
– He now has overwhelming media support, greater than any Presidential candidate since Jimmy Carter, and because of tax-exempt “527s” like he is matching Bush in spending.
– Stock markets are not only looking bad in America, the same thing is happening all over the globe.
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It is absurd to suggest that these markets are being affected because people are realizing that Bush might not be reelected, he cannot be that influential.
There are two stock groups that do risk losing from a Kerry victory, dividend-heavy stocks and property & casualty insurance stocks. The dividend-heavy stocks are at risk from his tax program, but he would have to negotiate a tax deal with Congress, so as long as it looks as if Republicans will be in control, these stocks should not be affected.
The problem with the stock market is that investors were shocked by the sudden change in the direction of key global and US economic indicators. They wanted enough slowing in growth to hold back the Fed from draconic tightening in May. What they seem to be getting is a slowdown induced by China, extra-expensive oil, heavily indebted consumers, and the onset of the next phase of problems for technology companies. Oil was $32.50 at the end of the year, and seven months later it is up 33%. Until this latest heave calms down and reverses, the economy and the stock market will be stressed.
INVESTMENT RECOMMENDATIONS 1. Remain overweight energy stocks. Putin’s recent behavior guarantees that Russian oil production is not going to grow as fast as the world is expecting. The International Energy Agency says the global petroleum deficit in the fourth quarter will be more than a million barrels a day. The oil companies’ shares are still inexpensive compared to the rest of the market.
2. Remain overweight base metals stocks. Even at its current level of economic activity, China will continue to be a big buyer of commodities, and worldwide inventories of industrial metals have declined significantly, with no sign of significant new production starting soon. The latest data from China suggests that an overtaxed infrastructure of electricity plants, railways and port facilities could be a bigger problem for growth than new controls from Beijing. If so, then commodity demand to build the needed facilities will remain very strong—a conclusion reinforced by the renewed surge in prices of industrial materials.
3. Remain overweight gold stocks. The dollar’s weakness could resume at any time and the total risk level in the global economy is rising, so if the economy continues to weaken, the problems created during the era of rapid debt buildup will begin to appear.
4. Within the financials, place more emphasis on regional banks and consumer banks, and less on global investment banks. The business of banking remains profitable, and is not too volatile. Betting billions of investment banks’ funds has been very profitable, but is a risky move that could go bad if the economy disappoints and today’s narrow spreads on corporate debt revert to normalcy.
5. The fact that Kerry is leading in the polls is undoubtedly bad news for the dividend-heavy stocks. However, as long as Republicans look likely to maintain control of Congress, there should be no rush to get rid of them because he would have to make a deal in terms of his tax increases. On the other hand, Bush as president is very good for oil stocks. At the moment, polls show the Republicans have a good chance of maintaining Senate control, and a better chance of maintaining control of the House.
6. It has been advised for a long time to avoid over weighting large pharmaceutical stocks, because they have short “reserve life indices.” They are like oil stocks: it costs $900 million to get a new drug approved and there is about ten years to make money on it before it goes generic. This is equivalent to a new oilfield with a 10-year life. But these stocks always sold at growth stock multiples. Now they could face political problems. Kerry’s drug proposals would be bad news for the big pharmaceutical companies, who have, in recent years, lost considerable support with the public and Congress.
7. Finally, the most positive news of all is that Kerry demonstrated that he has the leadership qualities that will help America to be strong in the War on Terror. If investors really have been selling stocks because they feared that Kerry would not be able to take care of Al Qaeda, they will be reconsidering their negativism.
Safe Harbor Clause The opinions, estimates and projections contained herein are those of George Haligua and do not necessarily represent the opinions of Hermes Bancorp as of the date hereof, and are subject to change without notice. Hermes Bancorp and the other Global Asset Managers believe that the contents hereof have been prepared by, compiled or derived from sources believed to be reliable and contain information which are accurate and complete. However, Hermes Bancorp make no representation or warranty, express or implied, in respect hereof, take no responsibility for any errors and omissions which may be contained herein and accept no liability whatsoever for any loss arising from any use or reliance on this report or its content.
Source: Hermes Bancorp

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