Recovery trends.

How bad are things in the country today? You still have people who talk like the economy is completely dependant on Government stimulus and that when the stimulus ends it will collapse or have the second dip.

Now, the question that no one seems able to answer is how effective the stimulus actually was. If it is indeed propping up the economy, it would have had to be quite effective. However, much of it is still unspent and in other ways it was poorly targeted and potentially ineffective.

Now, clearly adding a great deal of money to the economy, even if done inefficiently will have some impact. However, was it enough to create all the economic activity we are now seeing? I'm not sure if there is any way to actually measure this, but it certainly doesn't seem so. We see that companies have reduced costs to return to profitability at lower revenue levels. We also see a rise in foreign demand that has helped the economy. Consumer spending, while not what it was is showing some signs of strength and we are starting to see some stability in housing.

The other factor is that the stimulus infused into the economy is not going to be withdrawn. It is there and will stop at some point but it will actually end much more gradually than many seem to think. Much of the stimulus went to prop up shortfalls in state government budgets and as economic activity picks up the increased taxes will eliminate the need for the stimulus.

Now, how strong will the recovery be? I think it will be stronger than many believe as a number of trends help the US economy more than most analysts predict. First, as we develop local and renewable energy sources the balance of trade will be better as we need less foreign oil. This will be gradual of course, but each increment of improvement will help to keep energy costs down and improve the balance of trade. Second, the dollar which has returned to levels it was at about two years ago, will probably weaken a bit more and make manufacturing more competitive in this country, especially with reduced energy costs. Finally, the changes in health care will lead to lower costs for small business and will also lead to lower rates of increase in health care costs.

As these trends progress, we will see them build on each other and the recovery will strengthen.

Thanksgiving thoughts.

One may wonder as we approach Thanksgiving Day if the country in general has much to be thankful for. We are still in the throes of an economic crisis although it is starting to improve. The actions we took to ease the crisis have increased our deficit and combined with the high unemployment rate and reduction in business activity, the deficit was increased even more so due to the loss of tax revenues. We are still engaged in Iraq and Afghanistan and have thousands of young Americans at risk. We see a rising economic threat in China and we see a rogue country like Iran on the verge of developing Nuclear Weapon capability.

So, what is there to be thankful for? Of course each of us has our own individual situation and most of us can probably find many good things in our lives to be thankful for. However, as a Nation, what is there?

First, despite the current hostile activities, in most ways the Nation's defense has never been more secure. Yes, there is the threat of terrorism and we need to remain vigilant, but there is no real military threat to the country as a whole.

Second, most Americans still have a higher standard of living than almost all of the world's inhabitants. The issues we face will be challenging but we should never forget the great wealth and potential of this nation. We have the capability to solve our problems, we merely need to develop the resolve. We always have in the past and I believe we will again.

Third, we are on the verge of providing health care to all Americans. We need to be smart about it but I can't imagine anyone who thinks we shouldn't do it. Without addressing the issues on the implementation of this, we will find a way to pay for it and we will join the rest of the developed world in improving health care access.

Fourth, most (not all) of the racially divisive issues of the country's history are behind us. Yes, there are still pockets of segregation and it will never go away completely, but society as a whole treats all our citizens equally. We have also made great strides in gender equality.

Fifth, we seem to have grasped the need to protect the climate and improve the environment. There is a long way to go, but I believe the tide has turned and more and more we will see improvements in how we treat the world we live in.

Finally, we still enjoy the benefits of freedom that our country was founded upon. There are some who think our freedom's are being threatened and we need those people to keep the system honest. There is a constant challenge related to freedom which is best expressed by the old adage that states, your freedom to swing your fist stops where my nose begins. We can have freedom and individuality while respecting the rights of others.

I believe all Americans should keep some of these things in mind this Thanksgiving and enjoy this very American holiday.

Valuations

Recently the estimate for earnings for the S&P 500 was raised to $80 for 2010. This estimate projects earning growth over the year, meaning profits will be better in the second half of 2010 than in the first half.

If you use a P/E ration of 15, this earnings forecast equates to an 1200 level on the S&P. Now 15 is a little low and in effect represents a 5.33 rate of return. If you consider what you can get in short term bonds, this is a significant risk premium. However, be that as it may, it clearly shows that if you accept this earnings forecast, the current S&P levels still have a 10% upside.

Of course, the speed at which the economy grows, either based on domestic demand or export demand and the speed at which the world economy does or does not grow will play a significant role in whether these earnings are on target or not. Still, while there are always those people who argue that "this time is different" and articulately spell out there reasons, it generally turns out that this time is very much like all the other times.

It is a bit odd that some of the same people who argue that the economy is too weak and that unemployment will drag the economy down, also argue that we have great danger of inflation because of the supposed increase in the money supply. However, so much money was effectively eliminated from the system as assets values collapsed that until we see some increase in real estate the money supply is actually not very much increased at all.

Generally, this recovery, like most recoveries that preceded it will start off slowly and have fits and starts until the point that the growth rockets fully ignite. I believe the fuses have been lit and while I don't think we should or will see significant new housing, I believe that existing home values will start to rise and energy efficient renovations will be one of the driving forces for new jobs.

Picking stocks

There are many uncertainties in what is going to happen in the future. Because of this, investors like to analyse every piece of data to try to determine the best way to profit. Now, of course information is power, but the more important old saw may very well be that a little information is a dangerous thing.

As we see companies report profits or we see data such as monthly jobless claims, the reactions are often very swift and very violent at times. However, if you look at the same data in a long term series, it sometimes shows a very different scenario.

Clearly each company in an industry has some impact on the industry as a whole. But if you consider two companies that both report earnings one may do well while the other may not. Further, the two companies may give us very different projections based on how they see the market they are in. It certainly says a lot more if both of them do well or both do badly, but we do have to realize that in the current environment competition has increased and consumers are more selective. You need to offer the better value and perhaps be in the better location to succeed.

Similarly with much of the economic data. We still have many companies failing because they were unable to adjust to the changing economic climate. Other companies are grabbing their market share. However, a failed company will fire 100% of their employees while a company that grabs share will never hire all of the losing companies employees. Generally they can absorb much of the business with slack in their own company and only after they do that will they hire some of those that lost their positions.

This will lead to more new claims and less hires but it is greatly increasing the productivity of the survivors. So as the economy improves, it will be a while before it has absorbed all of the slack in the workplace in most industries. This will result in greater productivity numbers and greater profitability, the trick is simply to invest in the survivors.

Society's future

Any number of things may happen in the next year or so and because of the uncertainty created by that any predictions can be difficult. It is how the society responds to these events that determines success or failure.

Now when you talk about success or failure, the terms are somewhat meaningless unless you define them. Clearly each individual needs to decide what the terms mean to them but what is harder is what they mean to the society as a whole. The reason that becomes difficult because the overall society benefit is sometimes contrary to the benefit of part of that society.

If you ignore the problem of individual interests for a bit, you could probably get broad agreement on the following goals:

Educational opportunities for everyone.
Health Care for everyone.
Full employment.
National Security against foreign aggression
Clean air
Affordable energy
Good transportation systems

Now this list is certainly not all inclusive but it covers quite a bit. Now, in each of these areas the big arguments often become an argument between the haves and the have nots.

If you have a job, you don't want to pay higher taxes in order to get someone else a job. The immediate impact of that is that you are poorer. Now, ultimately, having more people employed creates greater demand and in some way the increased economic activity will probably have a positive impact on you at some point, either a better raise or more security or possibly increase house valuations, but that long term impact is vague and the short term impact is vivid.

As a society we have to decide if we can get past the short term self interest and take the actions needed for long term success.

Cost cutting

In the latest round of earnings from retailer's some analysts noted that the decrease in the cost lines was less than it had been. This led to some comments that profitability was in jeopardy because you can't cut cost indefinitely, and that the top line revenues had to increase.

Now mathematically speaking, the statement about cost cutting is clearly accurate in that it has a clear bottom limit. However, if you substitute the idea of efficiency for cost cutting, there would probably still be plenty of room for further efficiencies and I'm sure they will continue. Especially in retail, where better use of online advertisements and sales will reduce the cost of brick and mortar and to at least some extent the need for printed materials, as well as leading to improved inventory control and the need to carry less inventory, there is plenty of room for cost cutting in the future.

However, cost cuts once implemented do not go away. Now, if you want to see profit grow, ideally a combination of efficiency improvements and increased sales would be optimal. However, if you have reduced your costs by 85% and seen revenue declines of 90%, you have increased profitability, not only in the current period but also into the future.

I continue to maintain that we are in the middle of an ongoing technological revolution (maybe that is a bit strong) in many American businesses, where the trend to more technology and less employees is growing. This is clearly not a good thing for employment, but it is a good thing for profitability. We need to develop additional growth industries in order to address the unemployment issue, but, if you are a commercial enterprise, you are discovering ways to become more and more profitable without the need for increased personnel.

Its not a short term thing.

Nostalgia

There are some people who really seem to want to live in the 1930s. Perhaps they look at the old newsreels and feel fondly about the small town values they seem to portray, the lack of modern conveniences and the general good time feeling you see in a movie such as "Its a Wonderful Life".

Now I didn't live in that period, but from what I can tell, the people who did live during that period didn't really like it very much. Now, this was my parents generation, and as they aged, they did sometimes decry what had happened to the society related to morals and general changes. However, with very few exceptions, they certainly didn't want to return to the depression. In fact they developed habits that were designed to assure they would never have to live like that again.

Now, we have had another bad recession. This recession was clearly linked to a tremendous drop in real estate valuations. Of course, the drop was more dramatic in places where prices had escalated far out of proportion to sustainable demand, California, Nevada, Florida, Arizona. This is of course the very definition of a bubble and the bubble did burst.

Now, some look at this and have decided that the American economy and the way of life it has created is profligate and people need to be punished. Of course, many people have lost a lot, but in reality, some of these people who lost their homes, which they couldn't have afforded in a normal situation, are not really that much worse off then they would have been anyway. Those who own houses and haven't lost them, are somewhat restricted in how much they can borrow against their equity, but if they are still employed, they are not materially worse off.

Yes, there were many real and paper losses, but the losses are not going to be permanent. To some extent, the hand wringing over the Government policies to ease the pain and the dire predictions related to the debt we are running up, have some validity, but really as the economy recovers and the tax basis increases, we will see this level become less problematic as we see increases in tax revenues.

Investing morality.

There are some people who seem to think that there is a moral element in finance. You often hear these folks talk about how "other" people have taken on too much debt, or that the profits or goods they are enjoying are based on unsound economic activities and are too risky. Last week I heard a TV analyst talk about how he is on the sidelines during the current run up in the market, and implied that he will miss the downside. Of course, one would think it would be smarter to simply sell on the way down and pocket profits.

Yes, there is risk in the market and there is a chance that riskier investments will lose money. Of course there is also the chance that they will make money. A few months ago there was a lot of consternation over how the buy and hold investor was not making any money. Of course this depends on the point you started and the point you are at.

Since the late 1990s, the market has gone up to 1500 twice and down well below 1000 twice. If you have been investing money regularly over that period without withdrawal, you probably don't have much of a return. Of course if you started investing 20 years ago, in the late 1980s, you are doing quite well right now. In fact if the market returns to and passes its prior highs, you are still potentially going to do well.

Now clearly, if you have been a little more active and invested more at the bottoms and took some out near the tops you have made quite a bit of money. Simply put, the risk of investing in the stock market is very dependant upon timing. If you have a long enough investment window, it is likely that you will do OK. If you need to take the money out at an inopportune time, you have significant risk and probably should make sure that money is protected.

There is no morality involved in investing. You can of course use your own morality or beliefs to dictate how you invest, but financial decisions don't really care. If you borrowed a ton of money in 1990, bought tech stocks, sold near the top, bought real estate, sold near the top and then bought gold, you would be a very rich person today. The fact that you did it using borrowed money wouldn't really have much to do with it.

ARMs

As long as interest rates remain as low as they are, a number of fears that get expressed frequently are not really major concerns. The first of these is the concern related to resets on Adjustable Rate Mortgages. Yes, these often came with teaser rates that were significantly below market at the time and many of them are going to reset in the near future. However, if the current reset rate is as low as the teaser rate was, what exactly is the impact?

Now, if the ARM had negative equity provisions or other exotic factors, yes there might be an impact. However, one would like to think that financial institutions, who have mortgages that are current, would be smart enough not to force them into delinquency at no benefit to anyone.

Extending current terms or agreeing to modify these mortgages would be easy enough and clearly more profitable in both the short term and the long term then imposing terms that simply create additional foreclosures, unless, the market goes up significantly.

One of the things we are going to see in the next few years is a tremendous explosion in asset valuations held by banks. It doesn't require that real estate recover to the levels it had at the peak, merely that it increase from the lows. Many of these assets were written off as toxic with effectively no residual value to the banks. However, as the real estate market stabilizes and these assets increase in value, we will see banks start to look healthier.

Oil

There are many who think that the demand for oil is an indicator of the health of the economy. This was a reasonable link in prior years but following the tremendous increase in oil prices a year ago, I believe there has been a fundamental change in the way Americans will use foreign oil.

Americans have started to drive less, use more energy efficient products and start to increase the use of domestic and renewable resources. Now, these changes are not going to look very dramatic. However, you have to realize that an awful lot of economic impacts are at the margins. Often the bulk of data is in fact relatively irrelevant to price changes, it is the rate of change or marginal data that has an impact.

Consider a basic supply and demand scenario. If the supply of an item is at 100 and the demand is also at 100, you have equilibrium. At that level there will be a price set. Now if you reduce the demand by 5%, meaning that 95% of the demand stays unchanged, you go into an oversupply situation. This will lead to a reduction in prices and the theory says that the price decrease will either increase demand or drive suppliers out of the market until we reach a new equilibrium.

The market reacts to these marginal changes depending upon the elasticity of supply and demand. Now, to expand a bit on the theory, you have to consider cyclical demand swings versus secular demand swings. Cyclical demand goes up and down based on relatively short term economic conditions. Those who are linking oil to economic health are using it as a cyclical indicator and it certainly is to some extent. However, if I am right and the secular forces are pointing to a long term decrease in oil use, the cyclical increase will be blunted by the secular decrease.

Now, the question that has to be addressed is whether the secular trend is strong enough to overcome short term cyclical demand. Of course we also are seeing increases in cyclical supply and I believe a misguided secular increase in supply as technology shows new potential oil sources.

Short selling

When people discuss short sellers, they sometimes argue that they serve a "policeman" like function in the economy, pointing out companies that have significant problems earlier than others would. Now this may have some validity but it is basically the same argument that you could make about bank robbers, they point out the banks with the worst security.

Short sellers do it for the money. I'm not saying this is a bad thing, profit motivation is what drives capitalism after all, but lets understand that no one sells a stock short as a public duty. They do it to make money.

There can be many arguments related to whether short selling is a good practice. There is however one thing that has to be carefully watched. As we have seen the development of funds that are in many ways not subject to regulation that manage large amounts of money we increase the possibility of individual stock manipulation.

Now, if hedge fund managers as a group take the same position on a stock we can see significant moves. Buying and selling real shares has a impact that moves with the fundamentals of a stock. However, if you have significant short selling in a stock, the simple fact is that you increase the number of shares being sold, beyond the actual number of shares owned. Yes at some point the short sellers have to cover their positions, but in the meantime, it exerts a downward pressure that wouldn't exist if there were no shares available.

Clearly, this can be played and I have no doubt that is is played on a regular basis. Society has to decide if that sort of behavior is what we want to see in our market exchanges.

Health Care

While the country continues to move to some form of universal health care, you continue to hear fear mongers and well to do conservatives decry the reform as a form of socialism or even sometimes communism.

One of the things that a society needs to decide is what exactly does each participant get in return for abiding by the societal rules. If you consider modern society, each member of the society does their part by following rules, paying taxes, and participating in our representative government. Our basic national documents state that each individual has certain inalienable rights. One of these is the right to life.

Now, as health care has progressed, we have seen life expectancy expand. However, clearly access to care and especially preventive care is of utmost importance to such life expectancy. A significant number of our fellow citizens do not have access to this care. The dividing line is not simply between rich and poor. Oddly, the poor tend to have access via Government programs already. Those who don't have this care tend to be our lower middle class citizens or in some instances our blue collar workforce who are not employed by major corporations.

We have evolved into a system where health care and employment or wealth are linked. Now, if there is some justification for why an employee at an auto manufacturer, or other large corporation should get better health care than a construction worker or day laborer I would be curious as to what it is.

Often I hear analysts claim that Americans with health care are happy with it and don't want to see changes. Of course, that is similar to saying people who have anything of value are happy with it. The question that Americans have to answer is do they want to deny their fellows the same care? Another question to ask is do they want to leave their future access to care up to chance that they will remain employed?

The current state of health care is simply unfair and expensive. If you are wealthy or secure in your employment, you are one of the haves. Whether you are there because you are deserving or lucky is really irrelevant. We need, as a society, to extend health care to all.

Market valuation

There is currently a high degree of nervousness over the short term direction of the stock market. Now, of course, the market direction is generally questionable on a short term basis, but there is a clear sense right now that despite the rise in market prices the economy's condition does not justify current prices.

Now, many analysts base this opinion on the rise in the market since the March lows. To use the March lows as the basis of the increase, you have to assume that valuations in March were accurate. Clearly the drop that occurred between October 2008 and March 2009 was the result of extreme fear. If you consider the market prices using a different starting point, say January 2009, you get a different picture. The S&P was about 933 in January so what we have seen is a rise of about 14% this year. If you go back one year, you see the S&P last November was also near 930 so we have a 12 month increase of 14% as well. Is this increase unjustified?

If the Stock Market is predicting economic conditions to come, it would indicate that current predictions are about 15% better than they were at the end of last year or a year ago. Considering the problems that had been uncovered and the Lehman bankruptcy, it was a very uncertain future for the economy. The stock market was predicting a very rough period accompanied by drops in valuations and high job loss. This was an accurate prediction. Now as those events unfolded, the market continued to drop and in March was effectively predicting Armageddon. However, the financial collapse did not happen and whether due to the tremendous stimulus or the natural business cycle, the economy bottomed and started to improve.

So how bad is the current valuations? Do things look 15% better than they did a year ago? I think most people would agree that they do. In fact, if the market was predicting Armageddon in March it is not unreasonable to argue that things today look infinitely better than they did in March. However, March is simply a terrible comparison point and outside of providing a wonderful buying opportunity was an abnormality.

So if you compare current valuations to a year ago of look at YTD returns, the 15% increase coming off what was already a down period is by no means outrageous. It all depends on where you start your comparison.

Jobs

As we consider the job issue, the growth in jobs will not be in the areas where we have just lost millions of jobs. Clearly, as the economy grows, there will be some fractional return of jobs, but it will not be at the same rate as the job losses were on the way down.

Clearly, if you are a business, faced with the degree of uncertainty the current economy is faced with, will only hire new people considered essential. This is a good thing for long term business stability but will result in an increase in unemployment for the foreseeable future unless we can promote new job growth areas.

As I've said before the best strategy to do this would be to greatly expand both our domestic and renewable energy efforts and to reform taxes and health care to eliminate the unfair advantages of doing business overseas. Our current system of employer provided health care has increased the cost of each employee to the point that each hire is in some ways critical.

Clearly job growth in domestic and renewable energy, including greater exploitation of natural gas would create jobs in this country. Removing the burden of health care costs from small and large business would certainly make hiring easier. Finally, we need to change our business tax system to go to one based on sales would share the tax burden based on what is sold in this country as opposed to what is produced in this country. This would help reverse the trend to moving jobs overseas.

Long term investment

If you look at any chart of the S&P 500 for any significant period of time, the one thing that stands out is that whether the long term trend is up or down, the line does not move smoothly. Now to define the period of time you are looking at is possibly the most important aspect of an analysis. If you had somehow bought into the S&P in 1960 when it was about $60 you would have experienced a significant increase by now. However, if you only started when it was at 14000, you have lost a third of your money.

So how do you invest to maximize returns on an index that has significant variations. If you follow dollar cost averaging, you would invest a standard amount on a regular basis. This theory says you will of course end up buying at both highs and lows, but if you believe that the trend is ultimately up, you will have a nice return at the end of the day. Of course, this requires a belief in the overall trend and an time period that allows you to weather the deep dips.

A better alternative is to have a strategy that allows you to invest when the market is low and reduce investment when it is high. This of course can be applied to a stock index or it can be applied to individual stocks. Now if you were to follow this strategy, you could restrict purchases to a point when the average falls below a pre-determined point, say the 200 day moving average. Of course in considering this strategy it only works as a long term strategy and is effectively the reverse of a short term trader strategy that buys when it crosses to the upside and sells when it hits it on the way down. it also requires you to believe in the long term upward trend.

Index thoughts.

In many ways it is fairly easy to predict things in the future. Certain trends have a sense of inevitability about them lead to fairly reliable predictions. We don't always see, or understand these trends, but when we do see them and understand them, it makes a future situation inevitable.

However, knowing that is often of very limited use in the short term. It has been clear since at least the 1970s that at some point in the future we will run out of oil. However, that is potentially a distant outcome and if in 1970 you had invested in that outcome, you would have potentially lost a lot of money, and then potentially made a lot of money, with a lot of uncertainty yet to come. The inevitability of oil becoming scarce is not immediate enough to dictate short term behavior.

Similarly, the US economy is going to recover. Whether it has already started to recover, or if recovery will be delayed for a period of time, it will inevitably recover. In the meantime, many investments will have up and down periods.

So, when you listen to economists giving predictions, the reliability of what they predict in the near term is extremely uncertain. Generally, assuming they accept the same data, in the long term their predictions will end up being very similar. It is what is going to happen next month, next year, that is uncertain.

If you can ignore short term fluctuations, you can invest in very long term trends that will ultimately pay off. If you consider the stock market, the simple fact is that over its long history, it has gone up on average approximately 6% per annum. However, this rise is terribly unsystematic with periods of much higher than average growth followed by periods of malaise or decrease. In 1960 the S&P 500 was around 60. It is now around 1050. Of course, we are coming off a period where is has dropped from its highs by 33% and if you had measured it at that point the return would have been somewhat higher. Of course had you measured it at the March lows it would have been worse.