• Over the last several months we’ve talked a lot about a potential real estate bubble in China, but now we want to deal with the unfairness in how they are playing on the field of international trade.  As you are no doubt aware, they have pegged the yuan to the dollar for a long time and have generally not allowed it to float freely.  In June, they said they would allow it to float upward as much as 3%.  Since that time, it has traded up as much as 1% and now it is almost at the same place it was when the “big announcement” was made three months ago.  In other words, it appears that China continues to manipulate its currency.  Some suggest that the yuan should strengthen against the dollar as much as 40%, although we would say it is probably closer to 30%.  Nonetheless, this is a substantial difference when you consider America’s trading imbalance with China.  Think back to your school days – there was always a bully on the playground and that bully would often pick on a gentle giant who believed it was important to play by the rules and believed that diplomacy, i.e., talking, was better than fighting.  The United States has been talking for a long time and now many have been pushed far enough that they are ready to retaliate.  There is a movement in Congress which appears to be bipartisan in nature to try and level the playing field by slapping tariffs on some Chinese goods.  President Obama and former President Bush seem to resist this idea, but our inaction has not resulted in any progress.  The supposed reason that we can’t do this is the 800 billion plus government bills, notes, and bonds owed by China.  The fact is China needs the U.S. as much as we need China.  China resists upward movement in the yuan due to the fact that if they can’t sell their goods to the U.S. because they have become too expensive, it will likely cause a severe disruption in their own economy.  The “fat cat communists” don’t want to see the flow of money stop.  The problem for China is that this could cause internal inflation and they are trying to avoid just that.  The longer any government controls its currency in this manner, then when it breaks loose it won’t be pretty.  Since all of these things happen very slowly, don’t expect any action from Congress between now and the end of the year even though some influential senators are starting to step up to the plate.  Perhaps a new Congress will address this after the first of the year, but if not, expect it to be a significant issue during the 2012 Presidential campaign.

• During the second week of August, Cisco surprised the investment community by suggesting sales and profits may be weaker for the latter part of this year than the analysts’ expectations.  This caused the markets to tumble the week ending Friday the 13th and once again, conversation started concerning a “double dip”.  Frankly, we still believe a double dip is hard to justify after four quarters of growth, albeit weak growth.  We have talked about this in the past.  Just like in the Wizard of Oz, sometimes it is important to look behind the curtain.  Quarterly earnings have been by 75% of the S&P 500 companies, and 75% of those have exceeded the expectations of analysts.  This is significantly above the 60% historical average.  Nine of ten sectors produced better than expected earnings.  As importantly, not only did earnings increase as a result of cost cutting, but also because of revenue growth.  The analysts expected revenues for the S&P 500 companies to increase by nine percent, when in fact revenues grew by ten percent, with five of the ten sectors posting well ahead of expectations.  Whenever a company does its corporate call the analysts are always interested in what management has to say about the future.  This is important not only at a company level, but at a total economic level as well.  As more companies issue disappointing guidance the optimism for future growth obviously declines and hence the possibility of a recession increases.  In reality the number of companies that suggested lower growth in the future is at an almost all-time low.  It is earnings that will eventually drive the stock market – not the talking heads.  As we continue to look ahead, it is sometimes hard to see through the fog and have faith as to what your instruments are telling you.  At the moment, we see slow growth – not the big return that everyone wants – but nonetheless growth.  

• It came as no surprise when China finally passed Japan as the world’s second largest economy with an economy valued at $1.33 trillion.  Japan slipped in the second quarter with an economy valued at $1.28 trillion.  Both are far behind the U.S., with a $14 trillion economy.  Okay, we get the big news, but what we are struggling with is the math of some economists who predict that China will surpass the U.S. in 20 years as the world’s biggest economy.  We think these economists must be using “funny” math.  If we assume that the U.S. can grow at 3% per year, then in 20 years the economy will be worth $25.3 trillion.  For China to grow from $1.33 trillion and surpass this $25.3 trillion in 20 years, they would have to grow their economy at 15.8% per year.  The torrid pace of the last few years caused China’s economy to grow between 8% and 10% and the government is attempting to hold that growth back because they are afraid it is too “hot” and will lead to inflation and a recession; something China has not really experienced as it has gone through the explosive growth phase of the past 15 to 20 years.  On top of it being unlikely that China’s economy can continue to grow at this rate every year for the next 20 years, one must think that when you’re a young, budding economy, it’s easier to grow.  As the economy gets bigger it becomes increasingly difficult to grow at the same rate.  Look at all of the mature economies around the world.  What makes China think it will be any different?  There is no question that China will become a growing force in world trade, but to assume it will become the largest economy in 20 years seems a little mathematically challenged. 

• We always feel that looking at history is helpful, but not a guarantee of what might happen in the future.  Nonetheless, it does help us sometimes to put into perspective what is going on around us.  In spite of the fact that the U.S. has put together four quarters of growth, there is continued conversation about weakness and the possibility of a double dip.  Although this recovery has not been as sharp as many following a recession, it has been somewhat of a recovery.  We are very concerned that investors might panic because of the anemic results and especially if one quarter of GDP were to be negative, which is a possibility.  That does not mean that there will be a recession.  The traditional view is that you need two quarters of negative growth in order to create the potential for a recession.  For example, back in 1982 GDP declined during the fourth quarter of 1981 at a 4.9% rate and was followed by a 6.9% decline in the first quarter of 1982.  What followed was a mixed bag where the rest of 1982 saw a +2.2%, a -1.5%, and a +0.3% GDP to close out the year.  It might have been easy for the talking heads to comment about the weak recovery and economy and the so-called double dip.  Please keep in mind that the four quarters we have just been through have been better than these numbers.  During the first quarter of 2003, GDP increased at +5.1%.  Following the first quarter of 1983, the next five quarters averaged 8.2%.  It is not unusual for a recovery to go into a resting phase in order to catch its breath.  Given the significant rise in the market from early March of 2009 through early April of 2010, one could expect things to slow down.  It could be a rocky two or three months, but we encourage you to remain focused on the long-term.   

• As the American consumer spends less day to day, they continue to reduce their debt levels.  According to TransUnion for the first time since 2002, during the second quarter of this year, average credit card debt fell below $5,000 (barely), to $4,951.  This represented a 13% drop from a year ago.  That’s really significant.  Perhaps equally noteworthy is the fact that the past-due rate for people more than 90 days late fell to under 1% at 0.92% down from 1.1% at the same time last year.

• Below is another of the articles we mentioned in our last Bullets (from the mid ‘50s):  Biggest and Busiest Machine on Earth

“Our productive system is the biggest machine on earth.  At one end, it takes in the services of employees, capital, raw materials and other necessities of production.  At the other end, it turns out food, clothing, housing and all the other things we want.  When we succeed in improving the efficiency of this machine, we have increased our “productivity”. 

Productivity is measured as output per man hour, yet man hours are just one factor in productivity.  We measure our car engine’s efficiency in miles per gallon but it takes many parts in addition to gasoline to make a car run efficiently.

Millions of things affect the rate of productivity – even the weather.  Some of these are plain enough to see.  Better tools and equipment, and the savings to finance them, are essential.  Some of the skill and cooperation of employees, and such factors as the willingness to take risk and adopt new methods. 

Our economic machine has many millions of parts.  When it runs with increasing efficiency, no single element can claim all or most of the credit.  It takes hundreds of smooth working parts to keep a car on the road and that goes a million fold for our American economic machine.”

• As we journey into the last 60 days or so of the political campaigns, there will be a lot of finger pointing about whose fault it is that the economy is in such bad shape.  The reality is there are millions of reasons why we are where we are, and no one person or institution is solely responsible.  Those that issued sub-prime mortgages and those who took them out, knowing they could never be repaid, are certainly responsible.  Financial institutions that securitized this debt are certainly responsible.  The government under Bush and now under Obama which were/are more concerned about back-biting and partisanship than about helping, is certainly responsible.  The Federal Reserve, although getting a lot of credit for helping to soften the blow, also contributed by making easy money available during the mid 2000s and therefore are certainly responsible.  Speculators in oil, real estate, gold, and even the stock market are certainly responsible.  People who ran up credit card debt and who can now barely make the minimum monthly payments are certainly responsible.  All of us could have saved more money and invested more.  Unfortunately in America today there is a tendency to blame others for our plight, when in fact each of us needs to accept some responsibility for what goes on around us.

• The Dow was down 2.49% in June, in July it was up 7.54%, and in August it was down 4.31%.  The summer rollercoaster has investors sitting on the edge of their seats, especially as we enter September and October.  While October is believed to be the worst month for the stock market, it is really the month of September that on average has produced the worst returns.  Having said that, keep in mind that not every September has negative returns.  Just last year, in September, the Dow was up 4.31%.  The volatility experienced over the last three months, and one could argue for the last six months, is likely to continue.  In spite of it all, the Dow is down by only approximately 2.25% since the first of the year.  Remember how good you were feeling on January 1st?  After the dramatic rise in the markets over the last 10 months of 2009, it is not surprising that the markets have taken a small breather.  A lot of questions will be answered over the next 65 days and we believe the clarity will bring positive news for the economy and markets.  Only now are others talking about the agonizingly slow growth which we have talked about for several months; but that’s much better than agonizingly negative growth.  Over the next 65 days it might be a bit rocky and it will therefore be important to look ahead six months from now rather than to get caught up in the moment.  Investors are shunning equities for bonds, but one day and that day is probably not too far in the future, that trend will reverse.  When it does, we could see a dramatic rise in the equity markets.

As always, we encourage you to give us a call if you would like to discuss anything further.  We will visit again soon.

RAY, KIM, ERIC, BRUCE, and LOU

(c) ProVise Management Group

www.provise.com