THE FEELING IS … MUTUAL!

One cannot read the headline on page 15 of the FT — U.S. Retail Investors Return to Equities On Back of Price Rises — and not be reminded of Bob Farrell’s Rule #5: The public buys most at the top and the least at the bottom.

Now ain’t that the truth!

Indeed, as they chase performance, retail investors plowed a hefty $6.54 billion into equity funds in the week of January 12. TD Ameritrade has reported that margin lending has soared 31% from year-ago levels. Uh oh.

The one industry that is being hammered right now is the municipal bond fund space — with net outflows last week of $2.37 billion, the tenth week in a row. It would seem as though there has been a reallocation not just to equities but also to other income-oriented strategies because taxable bond funds did see a $1.39 billion net inflow during the week and hybrids took in a net $2.14 billion and that followed a $549 million intake the week before that. So our strategy of SIRP still has many believers — Safety and Income at a Reasonable Price. While there is no doubt that we remain cautious on the equity market as an asset class, we like the large-cap, blue-chip, cash flow generators and reliable dividend payers.

So we continue to advocate income-oriented strategies that deliver an economic rent to investors until such time as a very nice buying opportunity emerges in the more cyclical capital-appreciation vehicles. That time will come.

As an aside, there are now long-term, closed-end muni funds yielding in excess of 8%. So the question then becomes: when do potential rewards start to outweigh the risks? No doubt there are major financial problems among state and local governments but the sector has cheapened up radically in recent weeks and months. We are more worried about the economic impact from the spending cuts and tax hikes than we are about a wave of defaults, which could well be overblown. But the economic damage is going to be severe and catch the bullish economics community by surprise this year.

But the editorial board at the FT won’t be surprised — see U.S. States Face a Fiscal Crunch on page 10 of today’s paper): “Undue budget tightening will jeopardize recovery whether applied at federal level or lower down … The squeeze is now upon them; the federal stimulus is fading away, and the gimmicks are all used up. For state finances, the year of reckoning has arrived, and the timing could hardly be worse.”

Wow, talk about hard-hitting stuff. See what the current drag looks like below on the economy and how important state/local government spending is — second largest contributor to GDP.

IMPACT OF HIGHER COMMODITY PRICES

Currently, the industries most affected by the surge in commodity prices are the airlines and the retail food industry. The airlines are nudging prices higher and we are even seeing the discounters (i.e. Southwest) follow suit for a change, but not nearly enough to prevent margin compression. There is a great article on page B7 of the WSJ — As Food Prices Soar, Eateries Scramble — showing how anyone who sells food for a living (including the hotels and the cruise lines) is having a really tough time passing the higher costs through to their customers.

EARNINGS RESULTS

Another interesting feature of yesterday’s market action was that it took place with most of the news coming in positive. Perhaps not housing starts or the weekly chain store sales data, but most of the earnings results are being spun very positively. We have 24 S&P 500 companies reporting thus far and 17 have topped consensus views on the bottom line and — get this — 18 have topped on the top-line too (though the banks look pretty shaky in terms of revenue growth).

I see that S&P’s investment committee just lifted its 12-month target on the S&P 500 to 1,370 from 1,315, basically stating that $95 on operating EPS this year is a lock. Unlike March of 2009 when the bar was extremely low, the bar has now been set very high for the year and that is likely the largest hurdle for Mr. Market as far as 2011 is concerned — it is going to be tough to generate upside surprises in earnings from where the consensus is right now.

BUY THE DIP?

Well, was it really that much of a surprise to see a giveback in the equity market yesterday? This has to be the most overbought market in at least three years and investor sentiment is so nutty that the latest Investors Intelligence survey showed there to be three times as many bulls as there are bears — even at these three-year highs. Talk about chasing performance. We are at the point now of maximum bullishness and we say this when at least one venerable market pundit publishes a report questioning whether this is in fact a secular bear market.

With policy rates at zero for over two years now, the Fed feeling the necessity of having to embark on QE2 after it hinted loudly a year ago of an exit strategy, and then the government feeling compelled to extend a tax-rate cut that was brought in a decade ago to fight a recession two cycles ago, are rather telling. Maybe Wall Street and Main Street can stay divorced forever. Somehow, we doubt it. Perception and reality will meet up once Wile E. Coyote starts to look down. All the bulls in the past four months were saying to buy the dip. Well, in all honesty, there was no dip to buy. It was a straight line up as the shorts got squeezed in an unprecedented fashion. Maybe now we'll see if this is a dip to buy, now that we actually saw one — for a single session.

STARTS FINISHED

U.S. housing starts slid 4.3% MoM in December to 529k units at an annual rate which was short of the 550k mark that the consensus had penned in. This was the lowest reading since October 2009 when the economy was struggling to emerge from the recession.

What was even more disconcerting was the 9% plunge in new single-family construction (multi-family is more prone to sharp fluctuations and popped 18%) to a mere 417k annualized units — this was the second decline in the past three months. The past weakness in single-family starts is also filtering into units under construction, which sank 1.1% MoM in December, and down seven of the past eight months. This spells bad news for the residential construction component of the GDP accounts.

With four million foreclosures widely expected this year and next, an already enormous backlog of six million homes in serious delinquency and four million housing excess units already sitting vacant for sale, we can look forward to ongoing weakness in new sales activity and construction, as the National Association of Home Builders revealed yesterday.

Yes, yes, building permits did surge 17% MoM in December but consider that to be a one-month wonder because of a builder rush to get applications in ahead of some building code changes that were going into effect on January 1 in New York, Pennsylvania and California. This is why permits soared 81% in the northeast and 44% in west. In the rest of the country, building permits sagged 5%.

Housing has always been the quintessential leading indicator for the broad economy — on the way up, and on the way down. It is the proverbial canary in the coal mine. While its direct share of GDP has always been small, the multiplier impact through the rest of the economy is huge. So, as everyone seems to think that some semblance of normality has returned, the answer is “no” ... nothing is normal. We merely have a central bank that has decided for the greater good (for those that reside in the here and now) that jeopardizing the sanctity of its balance sheet is a good thing and a federal government that has continued to probe the outer limits of deficit finance in order to keep the spending psyche alive.

Policymakers have done an admirable job of creating the illusion of recovery, and it has worked because it would seem based on asset pricing that the vast majority of investors have bought into this illusion hook, line and sinker. Doubters are either cast aside as traitors, idiots or stubborn perma-bears who don’t get it ... the “it” being that the government will simply not allow another bear market or downdraft in economic growth from taking hold again!

The business cycle has miraculously been repealed, and the shorts have been scared off for good. But you can’t tinker with human nature for very long. What people should put in their back pocket is how surreal this so-called recovery really is. With yesterday’s data, housing starts are now down 9.3% since the recession apparently was stopped in its tracks in June 2009. Go back to every other post-WWII economic recovery, and never before — 18 months into it —were housing starts still down from the point that the recession ended … until now, that is. On average, starts were up 33% at this juncture, with the median increase at +29%. If housing starts being negative 9% at this stage of the cycle is not a “new normal”, then frankly, I don’t know what is.

LOOKING SOFT FOR JANUARY RETAIL SALES

The Redbook and ICSC (International Council of Shopping Centers) survey data through mid-month are not looking particular encouraging. It could be part weather but most likely it reflects a post-holiday hangover as well as “consumers appetite for clearance bargains” as the Redbook put it in its press release. How you get an inflationary outcome out of that is truly a mystery. Month-to-month sales are flagging a 0.6% decline and the YoY trend for the ICSC data is down to +1.4% from over 3% at the start of the year.

Maybe there was something to that unexpected decline in consumer sentiment that we saw last week. And maybe the hike in food and energy prices is taking a bite out of the Fed-led equity market rally. Just to remind you — real wages have declined outright now in three of the past four months. That is not good.

In another sign that January sales will likely be soft, the ICSC reported that it expects that only 36.3% of gift cards will be redeemed this month, down from 45% last year and 46.4% in 2009.

SOME GOOD NEWS HERE

The architectural billings index jumped 3.2 points in December to a three-year high of 54.2. We have done the statistical work and found that this index leads the growth rate of non-residential construction by just over a year and with an 80% historical correlation. This is very positive for the design and construction industry in general.

CANADA UPDATE

We received a mixed batch of Canadian economic data. Today’s wholesale sales were better than expected. We focus on real wholesale sales (which feeds into the monthly GDP accounts) and on that score, they were up 1.3% MoM in November. This helps temper yesterday’s very disappointing manufacturing shipments, which on an inflation-adjusted basis collapsed by 1.4% MoM, the second such decline in three months. It’s worth noting that real manufacturing sales are at the lowest level since February 2010 — so it’s clear that the strong loonie is taking a toll on the manufacturing sector. All in, we continue to track fourth-quarter GDP at below 2%, slightly off from the Bank of Canada’s (BoC) new (downwardly) revised Q4 GDP forecast of 2.3%.

The BoC also provided some more colour to its thinking after Tuesday’s press release (where it kept interest rates on hold as expected) in yesterday’s Monetary Policy Report. For this year and next, we saw major upgrades to forecasts outside of Canada especially in the U.S. They now expect U.S growth to come in a full percentage point higher than expected a few months ago at 3.3% for 2011. And it wasn’t just the U.S. that was updated. It was across the board, with forecasts for the Euro area (now 1.5% growth), Japan (1.4%), China (9.3%), and the rest of the world (4.0%) all being lifted. Even with the material increase of U.S. growth prospects, Canadian GDP was increased by a scant 0.1% to 2.4% for this year (in other words, underperforming the U.S. by nearly 1%).

We continue to believe the BoC will be on hold for some time, especially after the Federal Government announced more restrictive mortgage lending measures, which takes some of the pressure off the Bank to hike rates.

 

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