Calm after the storm, or eye of the hurricane?

Of the dozens on economic reports we receive each month, many, particularly consumer and business confidence, were hitting lows not seen since the 1991 recession.  Many economists claim that the US economy is in, or about to enter recession, and certainly the general public feels that way.  Yet, compared to the mild recessions of 2001 and 1991, and certainly the major recession of 1982, we wonder if people are over-reacting.  A quick comparison between current conditions and the trough values of previous recessions shows:

The obvious notable exception between this and previous slow-downs is the remarkable fall in home prices.  Reliable data from 1982 is not available, but generally speaking home prices were flat in that time frame.  If we create an "Ultra-Misery Index" of the unemployment rate plus the inflation rate minus the decline in home prices, we quickly understand why the American consumer is so disconsolate.

US stocks gained in April and May, with the S&P 500 up 5% and the NASDAQ up 9.5%.  Energy stocks rallied the most, at one point up 20% on the quarter and even now remain up 14.8% on the quarter and up 6.5% on the year, along with materials.  Financials gave up recent gains following the March 17^th, low, down 15.5% on the year and up just 12.3% over the last 5 years (that's total, not annualized) versus a gain of 251.8% in energy stocks and 57.1% in the S&P 500.  Remarkably, the simple price appreciation of the S&P 500 over the last 10 years has averaged 0.3%/year.  Include reinvested dividends and the total return of the S&P 500 rises to 1.8%/year (i.e. less than the return on CD's over that time frame.

We think that the long period digesting the excesses of the 1990's is coming to an end.  In the last 5 years, investors have flocked to every alternative of US large cap stocks including emerging market securities, hedge funds, commodities and above all real-estate, only to get burned very badly in the last 6 months.  General Electric, with a P/E of 14, a dividend yield of 4.1% and a Price/Sales ratio of 1.8, looks like a safe bet relatively speaking.  US banks, brokers and other financial intermediaries sold off in recent weeks as fears that more bad news is due out on credit write-downs.  The institution most at risk right now is probably Lehman Brothers, currently the subject of the same rumors that took out Bear Stearns.  We'll know more as we get into the July earnings reports, but bottom line March 17^th still looks like the bottom of the current crisis.

Energy

We've been dead wrong on oil prices over the last two years.  From a November 2001 low of $18/barrel, oil marched to an inflation adjusted all-time high of $75/barrel by June 2006, fell briefly back to $59 by year end, but then more than doubled to last week's all-time high of $135.09.  Abruptly, oil fell $13 to a recent low of $122, exploded $16 higher to a new record of $138 on June 6^th, eased back to $134 earlier today (oil was at $109 one month ago.)  Sudden increase or decrease in supply?  No.  Sudden increase or decrease in demand?  US consumers are driving less, so consumption is down 2% year over year, and sales of Hummers are down 30% year over year, but that's hardly enough to account for the swing given surging demand in developing markets.  A sudden exit of commodity hedge funds?  Short covering?  Hmmm.  As we've noted several times in recent months, the price pattern looks much like the Internet stocks index in late 1999, early 2000.  Bottom line we're underweight energy, concentrating primarily in drilling companies and high yielding storage and transport companies.  It's also worth noting that other commodities are 5-15% off recent highs, including gold 15% off the March 14^th high of $1002/oz.

Finally, the US Dollar is at a 3 month high, which helps hold down surging oil prices.

US Presidential Election

Barrack Obama clinched the Democratic nomination on June 3^rd, Hillary Clinton suspended her campaign, and the general election began in earnest.  It's hard to believe that after two years of campaigning and a $1 billion spent, none of the three finalists for the US presidency would be considered a short list candidate to run, for example, General Electric or Harvard University. 

Only a handful of US presidents have ever been elected directly from the Senate, with the most recent being John F. Kennedy.  Nixon, Johnson, Ford and Truman all were Senators, but also were seasoned as Vice-President before reaching the highest office.  More commonly, presidents have administrative experience derived from governorship (George W. Bush, Clinton, Reagan, Carter, Roosevelt), or other government work (George H.W. Bush was, among other posts, Director of the CIA and Ambassador to the UN, Eisenhower was Supreme Allied Commander in Europe during World War II.)

The Republican nominee, Senator John McCain, served in the US Navy 1960-1981, including 5 ½ years during 1967-1973 as a Vietnamese POW.  From 1977-1981, he served as Navy liaison to the US Senate, was elected to Congress in 1982, and elected to the Senate in 1986.  He admits to little or no understanding of economic issues and appears to have a hazy grasp of the history and differences of Shia versus Sunni Muslims, which would seem to be a prerequisite for understanding current world affairs.

The Democratic nominee, Senator Barack Obama, has stellar academic credentials (Columbia University, Harvard Law School including presidency of the Law Review) but a modest resume by presidential standards (Chicago community activist, associate attorney, constitutional law professor at University of Chicago, Illinois State Senator from 1996-2004, elected to the US Senate in 2004.)

Policy differences boil down to:  McCain would keep troops in Iraq "for a hundred years if necessary" while Obama would withdraw troops from Iraq promptly and "begin a dialogue with Iran."  Given that the US maintains troops in Germany, Japan and Korea decades after those conflicts ended, we think McCain's prescription is more realistic.

McCain is generally pro free-trade, Obama is generally opposed.

McCain would make the Bush tax cuts permanent, keep the capital gains rate at 15%, apply a 15% tax rate to estates with a $10 million exemption, and cut the corporate income tax rate from 35% to 25%.  He hasn't explained how this would prevent the deficit from ballooning.

Obama would raise the income tax rate on income over $250K by 10%, remove the Social Security cap (SS tax is currently 15% paid 50/50 by employer/employees on the first $97,500 of income), apply a 45% estate tax rate with a $7 million exemption, and almost double the capital gains rate from 15% to 28%. 

Like other "soak the rich" policies such as the Alternative Minimum Tax, this policy would backfire on the middle class.  $250K/year annual income sounds like a lot in, say Kansas.  In urban New York, California, Texas, Illinois, Connecticut, and Massachusetts, that's not much income at all.  For families struggling to keep up with their mortgages, get their kids through college, save for retirement, keep up with out-of-pocket medical expenses while already supporting a combined US, State, City, Social Security, real estate and sales tax burden of 50%, the proposed 10% tax increase amounts to a 20% reduction in income.  We could well look back at the current slowdown with nostalgia if that tax package came to pass.

Other policies regarding healthcare, energy policy, solving the housing crisis and dealing with global warming are still in the "gelatinous, amorphous" stage.  Both candidates pledge to crack down on "earmark" spending (relatively frivolous projects of individual congressman and senators.)  In 2007, defense spending totaled 24.5% of the budget, transfer payments such as Social Security and Medicare totaled 57.7% and interest on the national debt totaled 9.4%.  Discretionary spending at 18% was slightly higher than the on-budget (not including the Social Security surplus) deficit of 16.8%. The total deficit was 8.6% of revenues.

We can't yet project who the winner of the election will be.  The Democratic candidate has the advantage of the popular vote (52% of registered voters are Democratic, 37% Republican, 11% independent or other), a 28 to 22 advantage among state governors, Democratic majorities in both houses of Congress, potentially a 2:1 fund raising advantage, a large, organized and enthusiastic campaign organization, movie star good looks and stage presence, and the advantage of not being from the same party as George Bush, whose administration turned everything it touched to lead.

Despite those advantages, the final results all boil down to electoral college math.  In the last two elections the Presidency swung on control of a single state; Ohio in 2004 and Florida in 2000 (actually, if Gore had won either Tennessee or Arkansas in 2000, Florida wouldn't have mattered.)  At the national level (data summarized by RealClearPolitics.com,) Obama has a 1.8% lead in opinion polls with 8.2% undecided.  Among the top "battleground" states sorted in ascending order by closeness of polls:

In the 2004 election, the Republican candidate received 286 electoral votes; the Democratic challenger received 252.  If the election was held tomorrow, based on these polls McCain would beat Obama 273 to 265.  However, as the percentage of undecided dramatically exceeds the percentage of leadership among many of these states, we cannot offer a final projection based on these projections.

More than most contests, this one may hinge on the selection of the Vice-President.  Hillary Clinton clearly wants to be offered the Vice-President's slot.  However, there's no doubt that the Democrats will win New York.  She could make the argument that she carries a lot of weight in states like Ohio, Pennsylvania and Florida.  Obama may decide, however, that he doesn't want a co-president per se and instead op directly for a VP candidate from Ohio or Pennsylvania.  McCain, meanwhile, may focus on a running mate from Florida or Virginia, or might even reach out to Mitt Romney, who can bring some cash to the table as well.

5 months to go!

Strategy

We believe that the US slowdown will be short lived, and it will be interesting to see whether the National Bureau of Economic Research officially concludes that we are at present in recession.  We are not waiting to position our portfolios for the next expansion, however.  Already we're seeing economically sensitive technology stocks move up sharply.  We're also taking advantage of the market's decline over the last 6 months to add high yielding utility, energy pass through and financial services stocks.  Given that we expect US stocks to appreciate only 8-10%/year over the next 5 years, obtaining dividend yields in the 5-13% range gets us the equivalent return with less risk.