Tuesday, May 7, 2013

Who is John Galt? A Capital Strike May be in the Offing.

During the past week the stock market hit several milestones, and everyone appears to be giddy with the improvements in their portfolio values over the past few years. Given this happy state of affairs, it seems timely to take a look at some other signals the market is communicating to us.

The price of gold gets a lot of headlines--more headlines than it deserves in my estimation. It is a non-productive asset, therefore it has very little intrinsic value. Its value ultimately depends on the opinion of the available buyers, much like artwork. I believe the price of gold conveys very little worthwhile information most of the time.

Copper is a different story. This reddish metal can be found in a multitude of finished goods throughout the economy. Pounds of it can be found in every automobile and commercial vehicle, in every commercial and residential building and even in the microprocessors in your computer and cell phone. This ultimate in industrial metals is often called Dr. Copper to those on Wall Street, because it is said to have a PhD in Economics. The price change in copper conveys a great deal of information on the direction of the economy. If you super-impose a copper-price chart over a chart of U.S. or global GDP, you will see that copper is pretty good predictor of economic activity 6-9 months ahead of time. Although copper rallied nearly 8% this week, it has declined about 26% since its mid-2011 high and is down 14% in the past 12 months.

Confirming copper's move are a host of industrial metals-- hot-rolled steel has declined 35% in the past 2 years, nickel prices are down approximately 20% over the same time period, aluminum prices are down about 18% over the past 12 months, and on and on.

The call on these economic commodities are driven by global economic activity. With much of the European continent's economic activity flat-lining or contracting for the past 5 years and with U.S. activity limping along at sub-2% growth over the same time period, any substantive growth in global activity has been driven by the Chinese and those countries largely driven by the production of industrial commodities that are sold to the Chinese. China has been the all-powerful marginal buyer of nearly all raw goods during the last decade, and recently their economy has given the world notable signals of diminishing demand for industrial commodities. The Chinese recently reported first quarter GDP growth of 7.7%, which was well below expectations of 8% and a significant climb-down from a nearly 10% reading as recently as first quarter 2011.

Since it is clear by the above arguments that U.S. stock investors cannot depend on the big foreign markets to provide them with meaningful growth in the near-term, it appears that it is up to the 'animal spirits' of our domestic companies to create new products, new markets, and new demand. How have these great domestic capitalist practicians conducted themselves recently. In the fourth quarter of 2012, the aggregate cash balances of the non-financial members of the S&P 500 hit a record of $1.27 trillion; as of March 2013, there are $1.8 trillion in excess deposits at the Federal Reserve Bank. Both are record amounts. These statistics suggest record levels of risk capital available to the most sophisticated and successful deployers of such capital, and by all outward observations, they are refusing to do so.

Meanwhile, more than half-way through company earnings reports for the first quarter, we are seeing a significant deterioration in their quality. While greater than half of the S&P 500 have beaten their earnings expectations, a majority of the company's have missed their revenue expectations and most companies that do provide Wall Street with guidance have lowered it for the rest of the year. Indeed, so far in the first quarter, U.S. company revenues are down 0.3% compared with last year

I believe the reason for the lack of capital deployment (i.e. the 'Capital Strike') has a lot to do with acceleration in the implementation of the massive regulatory laws enacted several years ago. Only now are financial institutions having to respond to the regulatory stranglehold that is the Dodd-Frank financial regulatory framework. The deadlines for the roll-out the law's various components are continually pushed out, so its strangling effects on capital deployment will continue to constrict for many years. The other law that is just being implemented is the Affordable Care Act, and its effects will continue to be felt through lower labor force participation rates (63.3%--a 34 year low).

All these issues do not bode well for corporate profits, and with the S&P 500 already trading at 16 times the 2013 consensus earnings estimates, stocks are fairly valued. Once the newly lowered 2013 earnings guidance gets factored into the aggregate S&P 500 EPS number, investors may decide that the index is richly valued, given the lack of meaningful earnings growth vs. 2011 and the deteriorating economic prospects that the commodity price action above portends. The increasingly brittle reed of Fed-induced miniscule interests rates is the only legitimate fundamental reason for investors maintaining current equity positions. However, you can only balance a stool on one leg for so long.

My advice would be to short those stocks that are most vulnerable to the continued Capital Strike. These are generally found among the NASDAQ 100. Try QIB--double short QQQ ETF. At worst, this ETF provides a hedge against the crowded trade into these stocks by most of the fund managers that are investing your 401k or mutual fund assets.

Raise cash to at least 20% of your total portfolio and do not own any fixed income securities with greater than 2 years to maturity, because when the Fed begins the Great Unwind of all its QE stimulation, those portfolios heavily weighted toward intermediate to long term fixed income securities will be quickly decimated.

Finally, I would only own stocks that trade less than 2 times their book value, or have a sustainable dividend yield of greater than 3% (payout ratio less than 50%). Deep value stocks have historically held up well in severe bond bear markets, and the initial break of 'trendy stock euphoria'. Those stocks with significant and sustainable dividends that are positioned to continue growing are another group that will hold their value well. For all other stock classifications, I would recommend taking profits now. I promise you, you will not go broke employing these strategies.

1 comment:

  1. Dude, long time no post.
    Safe stocks have outperformed in this bull market, but value stocks rarely outperform in a sharp downturn. Hard to predict how things will work out.