It is time again to worry about earnings and warnings. This is the beginning of the earnings reporting season for fourth quarter 2010 periods. The beauty of this time of year and the problem is that 2010 doesn’t matter anymore. We are in 2011 already and that means that the forecasts of management for the future take on extra meaning. That is problematic as most managements have a distinct bias toward under-promising so they can later over-deliver on their guesses. This conservatism can be mistaken for a downbeat outlook. Just remember Cisco’s outlook in October that crushed that stock, just because they weren’t forecasting a stronger future than either their suppliers or competitors, good but not good enough. That could be one factor that keeps visiting negative surprises on this market.
We wouldn’t worry about this so much if investor sentiment hadn’t gotten too darned bullish lately. In the American Association of Individual Investors survey, which we monitor because it is free and because it is weekly as opposed to monthly, bullishness has recently been above 50%, even above 60% one week. That is darned bullish. As recently as late August the percentage of bulls was barely 20%. If we had a bunch of caution out in investor-land, we wouldn’t worry too much about bad news because most everybody else was already worried. But, not that almost no one is all that worried, we are worried. If that sounds a little paranoid, welcome to the world of the contrarian.
Investor sentiment is one of the better short-term market timing tools around so long as you use it as a contrary indicator. The more bullish people are, the less likely it is that they will be successful. The fewer bullish people there are, the more likely they will be successful. Get it? We know that it can be difficult to use contrarian analysis because it is so well contrarian. Looking at hardship as a good thing is tough. But, you are reading the rantings of a guy who when the Berlin Wall came down in 1989 proclaimed that this looked like a top. What more could go right?
Most investors look at good news as good news. The contrarian has to look through the news to how people react to it. When investors treat good news with skepticism, which is a healthy sign. Since the bear market began in very late 2007, people were treating good news as good news, embracing it and largely discounting bad news. Even we were subject to this trend at the time. But, since the market collapsed in September 2008 until recently, nearly every bit of good news on the economy, the markets, anything, was treated with skepticism. That was music to our ears.
We said that sentiment was a good short-term tool. Short-term is still going to be months to years, not days to weeks. Sentiment can get worse or better beyond all reason at times. But, there are some reasonable rules to follow. Each sentiment survey is somewhat different, but with a few simple statistics you can learn to read them. Most surveys have a history that you can learn from. Looking back to periods when sentiment was extreme, like 1999-2000 or 2009 in the opposite direction. At the bottom of the last bear market in March of 2009 only 19% of the AAII survey sample was bullish and 70% were bearish. At the other extreme, on January 6, 2000 the AAII survey was 75% bullish and only 13% bearish. You can’t just sit around and wait for these types of extremes to use this kind of data, but it is important to be aware of what extreme bullishness or bearishness looks like, so you can recognize it later. Only a few weeks ago, the week before Christmas, the AAII survey got as high as 63% bulls. That is a yellow flag.
One of the many troubles with the late 2007 market highs was that sentiment never did reach an extreme. This was a sort of an unemotional market top, but the demise of that market came not from within, but from without. The financial panic and breakdown dragged on the market. It was not a market that got extremely overvalued and over-believed.
As market technicians like to say, the market bottoms when everyone who is going to sell has sold. It tops when everyone who is going to buy has bought. Extreme sentiment confirms those two ideas.
Issue of the Week
Is the US a junk credit? Probably not yet, but both Moody’s Investor Service and Standard and Poor’s warned that without improvement on the path of recovery and slowing of the growth of outstanding debt, the US could face a downgrade. This is significant mainly as the US benefits from the unquestioned (well only slightly questioned) strength of Treasury bonds and the role played by the dollar in international financial and trade circles.
The US Treasury debt has grown from a little more than $8 trillion to $14 trillion in a few short years (beginning under Bush and accelerating under Obama). Much of that change was due to the emergency spending surrounding the financial panic in 2008 and 2009 and special stimulus to counteract the recession, regular counter cyclical spending for income support plus reduced tax revenues by the lower level of GDP. However, even with a stronger US economy now than then, we still have deficits that are outsized. At the worst, the deficit was roughly 10% of US GDP, now it is down to ‘only’ 8%. That won’t work in the long-run. With recovery, much of the stimulus spending can come to an end. The larger issue becomes how to pay for the enormous welfare state that we have erected for ourselves without determining who is going to pay for it.
The comments were in the context of a conference on sovereign debt. What Moody’s actually said was that if nothing changes shortly, their outlook for the USA’s credit rating could go from stable to negative in the next two years. Today, the US has an Aaa rating from Moody’s with a stable outlook. Aaa with a negative outlook would be the smallest change possible. Then, after another period of time, the rating would go to Aa with a stable outlook.
Standard and Poor’s was much harsher in their critique. They argued that were it not for the benefit the US gains from what is called the ‘exorbitant privilege’ of having the world’s reserve currency, we would already be on negative outlook. This exorbitant privilege comes from the desire or need of other governments, corporations and individuals to use dollars and hold dollars for everyday business transactions. Governments use dollars as reserves for their own currencies. Many governments sell their debt in dollar denominated securities, rather than in their own currency. All this demand for dollars and US Treasury obligations ‘artificially’ raises the value of both the dollar and Treasury bonds, benefiting the issuer. It also keeps our interest rates lower than otherwise would likely be the case.
The US, UK, Germany and France are all pretty much in the same boat with a growing commitment to spending with no clear path to raising the requisite revenue. It is far more the trajectory of the deficits and the debt that worries the credit rating agencies, rather than the current levels. These are cautionary comments about a dark future without an AAA/Aaa US Treasury.
Both agencies point to the ever expanding commitments to support Social Security and Medicare without the visible means to pay for it as the single largest risk to the AAA/Aaa rating. Both have suggestions, including eliminating many deductions taxpayers enjoy or raising taxes, on gasoline or income generally. Moody’s pointed to the National Commission on Fiscal Responsibility and Reform as having several meaningful recommendations that are not going to be implemented due to insufficient support in Congress.
We aren’t a banana republic just yet, and we may not go that way, but if something isn’t done fairly soon, that destination will look a lot more likely than your pundit thinks it should be.
Economic News
The US Federal Deficit was a measly $79.9 billion in December, an improvement from $91.4 billion the year before. Revenues were 8% higher at $236.8 billion but expenditures were also higher, at $316.8 billion. We will not likely exceed the total deficit of 2009, which was a record $1.42 Trillion but we will see a deficit of $1.29 trillion. Oh well.
While the budget gap grew, the trade gap narrowed. The US Trade Deficit was a mere $38.3 billion in November versus $38.4 billion in October. This is the fourth straight month where our trade gap showed improvement.
Producer prices rose 1.1% in December according to the Bureau of Labor Statistics. Energy prices gained 3.7% to drive the change. The core index, excluding food and energy prices, rose 0.2%. For 2010, the headline inflation rate was 4.0% (does that surprise anyone?) while the core number was 1.3%.
The Consumer price index rose 0.5%, the largest increase since June 2009. The culprit behind the rise was energy prices, as with PPI above. The core CPI, which excludes food and energy prices, rose only 0.1%. For the entire year 2010 CPI rose 1.5% and the core version a mere 0.8%.
Retail sales rose 0.6%, but excluding auto sales the gain was just 0.5%. This marks the sixth straight month with gains in retail sales. Many economists had expected even better sales after the better than expected Christmas selling season for many retailers. However, bad weather likely reduced much routine purchasing on the Eastern Seaboard and the upper Midwest.
Industrial production rose 0.8% in December.
The Bank of England and the European Central Bank both left their overnight lending rates unchanged.
Consumer sentiment surprisingly fell in early January in the University of Michigan survey. The index slipped from 75.2 to 72.7 while all sorts of other economic indicators are screaming improvement. Are we really that dumb? Probably.
Weekly Stuff
For what seemed like a do-nothing week, we had some pretty darned good performance from the equity markets. Frankly, we were surprised to see some of the numbers when we created the Weekly Review companion piece to accompany this missive. Sure the Dow gained less than 1%, but Merck had some bad news and this is yet another reason why the Dow is a horrible index for the broad market. When one out of thirty stocks gets clobbered, it gives a mistaken view of what happened in the broad market. Most stocks advanced, many advanced nicely.
It seemed like all the old bogey men came back last week and yet we faced them all down (and now, this isn’t some So You Think You Can Dance reference). The European debt ‘crisis’ was again apparent with the fear of a failed Portuguese bond auction, but the European Central Bank came in and bought most of it, so it was okay. There was the Chinese stealth fighter that seemed to even surprise Chinese Premier Hu. There was all the brouhaha over comments in the media about conservative compliance in the Tucson shootings that caused even the President in his remarks at the memorial service to reject such speech.
It is a new year and we need new fears to stop this market. The inflation reports gave us some ammunition for renewed fear from that quarter. The employment numbers didn’t support the idea of a brisker pace of recovery there. Yet, the market went up and up nicely.
All the major US indexes were well into positive territory. Foreign stocks joined in as well. The sigh of relief in Europe made the developed markets pop. Chinese monetary actions and Indian stock weakness held back the emerging markets.
Bonds around the world were mixed. The US Treasury market was hurt by the inflation news and sheer supply. Foreign markets were a mix of relief in Europe to demand in emerging markets. Australia’s bonds were higher based on the weakness in their economy expected from the flooding in Queensland in the past week. Australia could use some cooling off, but this is not what is meant by that phrase.
Real estate securities markets followed the equity markets higher. While commodities mixed but generally higher. The precious metals were the most obvious weak part of the commodities complex. Energy was the strongest.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.
480-895-0611