Economic & Market Update: January 20, 2009

“A Wild Week in the Economy”

The Fortigent Investment Research Team

Last Week’s Highlights:

Trade Balance:                            -$40.4 billion – a surprisingly sharp contraction

Retail Sales:                     -2.7% – sixth consecutive monthly decline

PPI:                                   -1.9% – energy leading the way down

Core PPI:                         +0.2% – producers still able to increase prices

CPI:                                   -0.7% – energy leading the way down here, too

Core CPI:                         0.0% – inflation risk gone

Stocks:                               850 – a rash of negative news stories this past week

Bonds:                               2.3% – holding steady

Oil:                                    $36

Dollar/Euro:                   $1.33 – quiet for the time being

Economics This Week:

Date      Item                                  Est.                     Comment

1/22      Housing Starts:           610k                    Slower still

1/22      Initial Claims:              548k                    Expect job losses to continue

The Ever-Shrinking American Consumer

In what proved to be a busy week on the economics front, we came to learn that the US trade deficit shrank to -$40.4 billion in November, from a revised -$56.7 billion in October (and economists expectations of -$51.0 billion for November).  These numbers were reflective of a sharp drop in imports and exports, and represented the largest contraction in 12 years. Trade data numbers have a tendency to be under appreciated by the markets, but it is clear that declines in consumer consumption, the free fall in commodity prices, and a sharp contraction in global trade are issues that are here to stay.

The shrinking deficit should provide a positive boost to GDP for the fourth quarter of 2008, but as Nigel Gault, chief economist at HIS Global Insights put it, “It is slim comfort that the US cut its demand for imports more rapidly than the rest of the world cut its demand for US exports.”  This is clearly not the most effective way to revitalize an economy.  

The Ever-Shrinking American Consumer (continued…)

Supporting the news of the shrinking trade deficit, retail sales in December fell by an abysmal 2.7% month-to-month and by 9.8% year-over-year.  This happened even as retailers aggressively slashed prices in what tends to be their busiest month of the year. 

There is no way to positively spin this news and it does not bode well for upcoming earnings releases from retailers. Analysts are expecting that as many as 200,000 retailers could be forced to shut down in 2009. 

Finally Here to Save the Day

Will the newest residents of the White House be able to save the economy?  Can we actually spend our way out of recession? We have no clue, but details are beginning to emerge surrounding the anticipated Obama stimulus package (officially known as the “American Recovery and Reinvestment Bill of 2009”).

The $825 billion stimulus package calls for $275 billion in tax cuts aimed at middle-class families and $550 billion in public spending. Obama was hoping to sign the bill into law immediately upon becoming President, but it now appears that wrangling over the bill will stretch for a few more weeks, at the least. While we think it is futile to dissect the numbers at this juncture due to the continually evolving nature of the bill, there are several aspects worth noting. 

The projected tax cuts include a $1,000 tax credit for middle class families, with individuals receiving $500. This primarily would be through a reduction in Social Security withholdings. Economists anticipate an increase in the size of the tax cuts as Republicans and Democrats push this bill toward the $1 trillion mark. 

Included in the public spending portion of the bill is $43 billion for an extension of jobless benefits, $39 billion to extend health coverage under COBRA, $90 billion in infrastructure spending, $79 billion in state fiscal stimulus and $6 billion to extend broadband services to rural areas. Most of this stimulus will have a direct impact on sectors that are struggling, but some of these programs seem questionable. 

While we do expect this to be a continually evolving bill, the framework has unmistakably been established for a blockbuster stimulus package.  

Source: NY Times

More Problems with the Financials

In addition to the announcement of the stimulus package, the Senate approved the release of the remaining $350 billion in TARP funds, with the Obama administration promising $50-$100 billion toward foreclosure prevention. 

Over the course of the last week, we found out that Citigroup would be selling a controlling interest in Smith Barney to Morgan Stanley and that Bank of America was taking another $20 billion in TARP funding to offset continued losses from its Merrill Lynch acquisition.  Disappointing earnings from JP Morgan pressured the financial sector even further and sent the clear message that the banking industries woes have yet to improve. 

The Macro-Economy vs. Stock Valuation Conundrum, or, What the Heck Should We Do?

The current market environment is one of a complete dichotomy of opinion between fundamental and valuation-driven security pickers and “long wave” macro-economists. Price targets for the S&P 500 and other market indices from most sell-side analysts are strongly positive – the average seems to be ~20% (back-end loaded in the second half of the year).

Nationally recognized investors (e.g., Jeremy Grantham, Warren Buffett) are claiming to see fair-to-incredible values in the market. And at our annual Winter Forum last week in Austin, Texas, two of the long-only equity managers we employ and highly respect claimed, in essence, that this is the most bullish they have been on equities in years. One commented (paraphrasing), “Don’t worry about large versus small. Don’t worry about value versus growth. Don’t worry about domestic versus international. Just buy!”

And yet…and yet…While not arguing valuations, the outlook on the overall economy is, by almost all accounts, very bleak, and there remains massive uncertainty about the depth and time horizon of the ongoing credit crisis. This phenomenon is not widely understood by many investors and is not widely or appropriately discussed in most mainstream media. But, as exemplified by the ongoing woes at Bank of America, Citicorp, and other financial firms both here and abroad (the UK government just had to step in with massive assistance to shore up The Royal Bank of Scotland, for example), we are far from through with this mess.

This uncertainty, combined with a broad consensus that we are at least six months away (or more) from seeing the bottom of the economic recession, puts us in a very cautious frame of mind. While we agree that valuations and opportunities in the equity and fixed income markets seem ripe for the plucking, we strongly urge investors to give equal consideration to the not insignificant chance that we will witness another market disruption sometime in the next six months.

We’ve mentioned Pascal’s Wager before (To wit, even if you don’t know for sure, once the asymmetrical payoff profile is considered it is better to believe in God), and we close this week by reminding you of the moral of that wager – do not confuse the probability of being wrong with the consequences of being wrong. Regardless of valuations, we would be very cautious about piling into the market until we have a better handle on the true state of the credit crisis and the overall economy.

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