INTRODUCTION

The year 2011 started with much promise for the U.S. economy. Economic activity accelerated in the fourth quarter of 2010, and on the strength of strong real final sales, the first half outlook was promising. But that optimism quickly evaporated as the world started coming to grips with a series of unexpected shocks that totally throttled the economy.

Energy prices spiked, sending prices at the pump to $4 a gallon creating a significant headwind for consumers and draining discretionary incomes. Next came political turmoil in the Middle East, creating major uncertainty in the global landscape. Devastation struck Japan in the form of an enormous earthquake and tsunami which triggered a nuclear disaster and major supply chain disruptions in the automotive and technology sectors of the economy. Then the European debt crisis raised its ugly head, with Greece on the verge of default and economic collapse. And if all that was not enough, the ongoing pathetic saga in Washington continues with the rating agency Standard & Poor's reminding our "leaders" that the multiple-act play of "Let's Kick The Can Down The Road" is about to be demoted from Broadway to the highway.

In the face of all these many crosscurrents, the stock market remained relatively calm, trading within a 121 point range from peak-to-trough and ending the first half with a total return of +6.02.%. Stocks began with a strong seasonal advance in the first quarter(up +5.92%), but the markets began to sag in May as economic growth sputtered, the Euro Zone's debt problems grew, and anxiety increased regarding the end of the Fed's QE2 on June 30th and their firm message that a QE3 was not to be. The market bottomed on June 16, and swiftly reversed course, wiping out the 'Spring Swoon'. Anticipation that the second half would bring somewhat better economic news and the continuation of strong corporate profits brought investors back in to stocks.

Standard & Poor’s 500 Composite Index

Source:  Daily Graphs Online, 2011 William O’Neil & Co., Inc.

 

 

Looking ahead, sentiment will be influenced by five wildcards that we refer to as the Five Horsemen of the U.S. Economic Malaise: the debt overhang, jobs, consumer spending, housing, and the lack of confidence and absence of leadership.  All of these issues surely add to the negative sentiment facing our economy.  Like many of you, we have serious concerns about the economic outlook.  Keep in mind that these economic factors can play an important role in influencing both the fixed income markets and the equity markets given the likelihood that these problems can lead to higher interest rates and inflation in the future.  This prompts us to be very selective when adding new fixed income investments in our portfolios.  Conversely, we are finding equity investments in companies that are equipped to combat rising inflation and interest rates.  Next, we don’t have to look too far back to identify a disconnection between the economy and the stock market.  Just remember how dour the economic outlook was at the beginning of 2009.  Stocks eventually rallied off their March lows despite the severely negative outlook at that time.  Hence, we believe we can continue to find attractive equity investments despite the overarching economic problems we face.  An optimist might say that the increased market volatility provides more opportunities to shop for items on sale.  As value investors we find it difficult to pass up a good sale!

 

• THE DEBT OVERHANG

 

America has too much debt. When added together, the combined level of debt from the consumer sector, local-state-federal government, and corporations represents 350% of GDP based upon Q1 2011 data.

 

The corporate sector in general is in good shape. Cash alone totals $1.8 trillion, and the debt-to-total capital ratio is about 37%. The real problem resides with consumers and the government. It took many years to get in this predicament, and it will take a long time to bring debt service-levels back to manageable levels such that they are not sucking the life out of our economy.

 

• EMPLOYMENT

 

The second factor contributing to the malaise is the lack of job creation. The June employment report was truly dismal. Consensus expectations were for the creation of 125,000 private sector jobs, but the result was an alarmingly low 18,000. If that were not enough, the previous two months saw downward revisions of 44,000, and the unemployment rate jumped to 9.2%. Almost 7 million people remain unemployed, down from 8.7 million at the peak in February 2010. The broader U-6 rate - that accounts for those unemployed and under-employed - rose to 16.2%. The employment-population ratio stands at 58.2% down from the peak level of 64.7% achieved in April 2000.

Clearly job gains face several structural issues as businesses focus on cost controls and efficiencies, the governmental sector shrinks, and Washington stacks up more rules and regulations.

We do expect an improvement in the employment numbers in the back half of the year as Japan slowly recovers, supply chain issues diminish, exports remain steady, and companies continue to spend on capital equipment.

 

 

 

 

• THE CONSUMER

 

Saddled with high debt and an uncertain job market, it is no wonder consumers are behaving conservatively and confidence is low. In late 2007, total consumer debt (mortgage debt plus installment debt) accounted for almost 130% of consumer income. Today that number stands at 110.8%. Progress has been made through debt reduction and no doubt defaults. Consumers are also saving a larger share of their income. The savings rate now stands at 5%, up from the early 2008 level of 1.2%. This increase in savings means consumers are repairing their balance sheets, but it also subtracts from monies that would normally be spent on goods and services. But in this jobs environment it is unlikely that the consumer will be a significant contributor to economic growth for several more years.  Accounting for 70% of GDP this places significant pressure on the remaining 30% of the economy to take up the slack.

 

 

• HOUSING

 

Residential construction's contribution to GDP peaked in the fourth quarter of 2005 at 6.1%. In the first quarter of this year it represented only 2.2%. From the peak, the decline in housing alone has subtracted $483.5 billion in economic growth. Single family housing starts are down 77% from the peak of 1.8 million units in January 2006.  This is the longest slump in the housing sector since the high interest rate-induced decline of 1978-1982 that lasted 46 months. Today we stand at 64 months and counting. The housing stock continues to experience pricing pressures. It will take  stabilization in  home  prices and  growth  in jobs  before the  housing  sector  will  begin to contribute to economic growth.

• CONFIDENCE and LEADERSHIP

 

In a 39-year career I cannot remember a time when confidence in the future for our country and in the political leadership has been so low, with the possible exception of the Watergate era and the period of the late 1970s. The leadership vacuum in the United States is enormous. This too contributes to our economic malaise. The political parties can find no common ground and very few have the best interest of the country in their gun sights. There is no willingness to work together and civility has been relegated to the garbage bin. One would be hard pressed to find anyone that classifies as a statesman in the purest definition of the term.

Who in their right mind would attempt to operate a business or a household - much less a country - with a debt ratio of almost 100% of revenues (debt-to-GDP), a deficit of $1.5 trillion, and borrowing 40 cents of every dollar spent? And they continue to submit budgets that perpetuate the problem, and we continue to re-elect them. The solutions to the problems require leadership and tough decisions. It's the spending, stupid! This can be fixed over time. You cannot spend more than you take in. And you cannot tax your way out of the hole...it will tank the fragile economy. Ask Greece. With the fragility of the economy, one has to be careful about cutting spending too deeply or too quickly. But the public and the markets need to see a credible plan that reverses this insane course. They are playing a dangerous game, and time is running out. Proposals that lay the foundation for serious structural fiscal reform exist including the President's own Simpson-Bowles Commission, Wisconsin Paul Ryan's plan, the Domenici-Rivlin recommendation, and the so-called Gang of Six…..all ignored. Meanwhile we continue to race downhill to August 2 based on ideological differences as opposed to doing what is right for America.

There are two other issues that deserve mention: The end of QE2 and the sovereign debt problems in the Euro zone. The Federal Reserve completed its second round of quantitative easing on June 30, after adding $600 billion to its balance sheet through an asset purchase program. But an accommodative monetary stance will remain in place as they will continue to reinvest principal payments in Treasury securities in order to maintain the aggregate amount of the domestic securities portfolio at $2.6 trillion. The Fed is adhering to its dual mandate of maximum employment and stable prices. There is no doubt that if the economy falters the Fed will once again initiate another stimulus program. And should Congress and the Administration eventually agree on a credible debt and deficit reduction, the Fed - if needed - would step in to assist the economy as stimulus is withdrawn.

The European debt crisis once again has roiled the financial markets as the EU attempts to restructure the fiscal issues of Greece. Debt represents 143% of GDP, and the deficit stands at 10.5% of GDP. And other countries are not too far behind such as Spain, Italy and Portugal. Like the U.S., the regions suffer from too much debt, not enough economic growth, and political paralysis. This will continue to be a problem for the global markets as there are no easy solutions. At some point in time defaults are inevitable.

 

THE MARKETS

 

As for the stock market, the conditions described above will and have "capped" price- to- earnings multiples. This is not an environment conducive to P/E expansion. Since 2000, we have witnessed a massive compression in stock valuations from significant over-valuation back to the historic long-term average. From here, returns will be dependent upon growth in earnings and dividends.

With continued growth in earnings, it is possible for moderate gains in stock prices through the end of the year. Investors will be paying close attention to the second quarter earnings reports and in particular what managements have to say about future business trends. At roughly 14X 2011 estimated earnings and 13X 2012's, valuation for the S&P 500 is reasonable. Share prices could easily follow the expected gains in profits, but any roiling of the investment waters from the economic data, the Euro zone or from Washington could easily undermine the trend. We expect modest gains within a volatile market.

Meanwhile, the fixed-income markets present a real dilemma. The Federal Reserve continues to have its foot on the neck of short-term rates. The yield curve is one of the most positively sloped in history with 90-day US Treasury Bills yielding 0.02% and the 30-year bond at 4.22%. Value is very difficult to find. We continue to pursue a balanced strategy utilizing government agency step-up notes as a hedge against rising interest rates and somewhat longer maturity taxable municipal and tax-free securities at the opposite end of the barbell.

 

 

 

 

JUNE 30, 2011 vs. JUNE 30, 2010

CONCLUSION

The unwinding of the economic malaise will take years, and it will be a painful - but necessary - process. There is much fear and anxiety reflected in the financial markets. Many of the world economies are in a state of disequilibrium, with too much debt, facing high unemployment and sluggish growth. Policy options are limited, and politicians lack the courage to act. But out of such times come opportunities. We live in a world of instant news and an acute short-term focus. But we have been shown many times that one of the keys to investment prosperity is to manage money with a long-term perspective while balancing risk and return. We will maintain our perspective: positioning equity portfolios in a diversified global multi-cap structure, placing an emphasis on cash flow production and balance sheet strength while investing in high-credit quality fixed-income instruments.

 

 

(C) Hester Capital Management

www.hestercapital.com