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Mid-Week Market Evaluation

(January 12, 2006)

Dear Subscribers and Readers,

I hope all our subscribers have had the chance to "digest" our latest weekend commentary - which aims to identify the most likely economic risks for 2006 and for the foreseeable future.   In our opinion, the most important economic "risk" for U.S. stock market investors in 2006 is the direction of the Federal Reserve under the future guidance of the new Chairman, Ben Bernanke.  Readers should keep in mind that in 1987, the bond market - assuming Greenspan was going to be "soft" on inflation (the Volcker "inflation-fighting legacy" would be hard to top for anyone) - had pushed the 30-year yields from 7.25% to nearly 9% by the time Greenspan was appointed to office in early August.  In return, Greenspan attempted to send a clear message to the bond markets - by raising the Fed Funds rate 100 basis points in a mere two months - and did not slash the Fed Funds rate until after the October 19, 1987 stock market crash.  By mid 1988 again, however, the Fed Funds rate was back at the pre-crash level, and would go on to top at nearly 10% in early 1989.  With the gold price currently at $550 an ounce and with oil at $65 a barrel, would Dr. Bernanke attempt the same feat?  Historically, Central Bankers have always reacted harshly to a rising gold price (and the rate rising "campaign" of late 1987 to early 1989 was no different, as the gold price topped at $500 an ounce in late 1987), and Bernanke should be no different.  If so, then the last rate hike may not come until 5.00% or even 5.25%, as opposed to the 4.50% to 4.75% range that the Fed Funds futures are forecasting right now.

That being said, we are still more than three months away from the March 28th meeting (it is a given that the Fed will again raise rates on the January 31st meeting) - and in the timeframe of the financial markets, three months can be more than an eternity.  Should gold prices "calm down" and decline from now until March 28th, there is a very good chance the Fed will pause at that meeting - given the current slowdown in the housing markets and the decline in the growth of consumer borrowing.  In addition, readers should keep in mind that both the European Central Bank and the Bank of Japan are still relatively accommodative - and so there is also a chance that the U.S. Federal Reserve will pause for now and wait for the effects of the tightening policies of the European Central Bank (they are due to raise rates at least twice this year) and possibly Bank of Japan later in the year.  For now, we will just need to take it one day at a time.

Another potential economic "risk" that I had previously mentioned is the growing threat of a labor backlash - whether it is due to outsourcing, "offshoring," or from the threat of higher imports.  Any significant dissent among the "workers" will pose a threat to corporate profits.  All this is potentially worrying given the following quarterly chart showing the absolute level of corporate profits and corporate profits as a percentage of GDP from the first quarter of 1980 to the third quarter of 2005:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 3Q 2005) - Both corporate profits and corporate profits as a % of GDP rose to a new all-time high in the second quarter of 2005.  However, corporate profits took a dip in the third quarter of 2005.  Are corporate profits starting to roll over?  The former decreased from $1,150.3 billion  while the latter decreased from 9.3% to 8.5%.  Please note that the 9.3% level is on par with the 3rd Quarter 1997 high of 9.3% - and before that, a level not seen since the 2nd Quarter of 1969.  This rate of 9.3% and the subsequent decline to 8.5% is suggesting to me that the profit cycle is maturing - i.e. the easy money has definitely been made.

On reading the above chart, two important things should come to mind.  Firstly, corporate profits rose to a new all-time high while corporate profits as a percentage of GDP hit a level of 9.3% in the second quarter of 2005 - which equaled the previous high set during the third quarter of 1997.  Prior to 1997, however, you would have to go back to the second quarter of 1969 to match such a level in corporate profitability!  This much is clear: At the end of the second quarter of 2005, corporate profits as a percentage of the economy most probably got as high as it could get for the foreseeable future.  Secondly, corporate profits in the third quarter of 2005 actually declined - suggesting that corporate profits may be in the midst of rolling over.  While this occurred in 2004 as well, this latest decline is definitely more authoritative given that corporate profits are now declining from such a high level.

I now want to take this issue further and ask our readers a few questions.  At this point, the situation is very much in flux - but this is very important to keep in mind going forward.  Historically - even in a relatively capitalistic country like the United States - there has been a cycle between labor empowerment and labor disempowerment.  While the disempowerment of labor due to the "influx" of labor from China and India in recent years is most likely a structural change, it is crucial to keep in mind that this is by no means a "linear change."  That is - at various points - labor should fight back, whether it is through unions, government lobbying, or labor strikes or even violence.  Moreover, the most talented and educated of the U.S. labor force will always be in high demand, and once companies find out that offshoring may not necessarily solve all their cost problems (for example, replacing IBM's North American and European programmers with programmers from India), it will be time for U.S. labor to again be in control.  Let me now cut to the chase and ask a few questions:

  1. On the strength of outsourcing, offshoring, declining union power, automation, low borrowing costs, etc., corporate profits as a percentage of GDP are now (second quarter of 2005) at a 35-year high. Can this get any higher?

  2. Expanding on point number one above - all these are generally OK in a period of general economic prosperity. That is, it is OK for your neighbor to be laid off - but when it comes time for you to be laid off, it is not as OK - especially if one has to settle for a lower-paying job at Wal-Mart.  Reforms only work when unemployment is going down, and not up (that is why this author believes that reforms in Germany will ultimately not work).

  3. Given a period of rising stock prices or rising wages, which one will labor choose? Are we all capitalists now as many have stated in the last few years? Sure, rising home prices have made us feel good (and have provided many jobs since September 11th) but what happens if housing prices stop going up?  Given that 40% of all jobs created since 2001 is real estate related, it is also not difficult to envision a vicious cycle occurring in the United States (slowing housing market leading to higher unemployment which again leads to a weaker housing market, etc.).

  4. Are we going to see a labor backlash in 2006?  Will there be protectionist policies in some of our declining industries, such as in the form of more tariffs, quotas, or another call for a higher Chinese Yuan? For example, China became a net exporter of steel for the first time in 2005.  At the end of last year, the premium for "Hot Rolled Coil" in the United States was US$270 per tonne over the price in China (US$310 per tonne), and US$130 per tonne over the price in Korea.  Production in China is expected to increase 15% in 2006 - bringing the number to 390 million tonnes - a significant amount of which will be undoubtedly exported.  Given that total U.S. demand of steel is "only" 115 million tonnes, there is no doubt in mind that the premium will decline very swiftly during 2006 and beyond in the absence of government intervention.  Will the steel companies once again lobby for tariffs, as they have done again recently but without success?  Also, as I am writing this, two major Chinese auto companies are set to export their automobiles to the United States starting in 2007 and 2008, respectively, while another Chinese company is in talks to buy parts of Delphi.  Given that many men and women in Congress are already hotly debating the trade deficit issues, my guess is that unless the Chinese government intervenes in curbing overcapacity in both the steel and in the automobile sector, it is virtually a given that there will be some protectionist measures enacted sometime this year or 2007.  Ironically, GM or Ford going bankrupt may mark the "peak" of the power of the capitalists and shift power back to labor going forward possibly for the rest of this decade.

  5. And finally, what will happen to corporate profits if there is a labor backlash? Subsequently, what will happen to stock prices if there is a labor backlash?  As companies are discouraged to continue to offshore their operations, the more-educated segment of the U.S. labor force will again be able to demand a higher premium for their services.  Wages and benefits will generally rise after inflation and wage inequalities between executives and the technical workers will also decrease - for the first time in a long time.  Of course, all this will serve to decrease corporate profits.  At the same time, readers should keep in mind that nothing happens in a vacuum, and that if the United States does try to implement quotas or tariffs in either the steel or the auto industries, there will most likely be retaliatory actions - not just from China but from other Asian countries as well.  All this will serve to adversely impact international trade activity - and ultimately global economic growth.  Such a scenario will not be pretty for corporate profits going forward.

I now want to continue this commentary by referencing an email that a subscriber recently sent me.  In his email, he stated that one of the "risks" to the stock market this year may come in the form of a U.S. invasion on Iran - and that such a scenario will definitely not sit well with both U.S. and international investors.  Following was my response:

First of all, let me say that I am no expert on geopolitics, and certainly my "specialty" isn't the Middle Eastern areas.  My "guess," however, is that any potential attack will be the last resort - and only after more obvious and well-publicized efforts have failed to prevent Iran from trying to develop nuclear weapons.  Our President has already used up his political capital, and so I found it difficult to see the U.S. attacking Iran unilaterally without some kind of support from the major Western European countries.

Other things aside - unfortunately for stock market investors, the stock market is a discounting machine, and so unless we sit on the Joint Chiefs of Staff, it is very difficult to try to anticipate a geopolitical event such as this.  The indicator that should be watched going forward should not be gold, but oil, IMHO.  After all, many oil companies have ramped up their capital spending by 30% to 40%.  China is only importing 5% more oil than last year.  The increase in demand from India is negligible.  The growth in consumer credit is continuing to slow down - with the yield curve sure to invert by January 31st after the Fed meeting.

At the same time, the December 2006 crude oil contract is trading at $66.20 [note: this was written on Tuesday evening] - my guess is that crude may already be discounting some of the risks of the U.S. attacking Iraq.  Again, please keep in mind that I am not an expert in Middle Eastern politics by any means - and should the U.S. really attack Iran, my guess is that crude oil will be over $80 a barrel in a heartbeat.  I will continue to rely on our technical indicators to try to navigate these markets.

If this isn't going to convince our administration to seriously think about ways to strive for energy independence, I don't think what will.  My personal views aside, however, I don't doubt that this could be a serious development.  On the other hand, I continue to believe that an "invasion" won't occur overnight - and thus any ultimate adverse reaction on the part of U.S. and international investors would first be reflected in the readings of our technical indicators, as well as the overseas markets.  If most of the developed world reacts to the Iranian situation on a united basis, then the U.S. stock market should do well on a relative basis - although that does not mean it won't suffer some kind of general sell-off.

For now, the stock market still looks fine on a technical basis - although the major market indices are definitely overbought in the short-run.  As I am writing this, the ten-day moving average of the equity put/call ratio closed at 0.53 - down from the 0.56 reading last Friday and now on par with the highly overbought readings during December 2004 and July 2005.  At the same time, however, the ten-day moving average of the NYSE ARMS Index closed at a still relatively overbought level of 1.10 - down from 1.17 last Friday.  Again, this author will not be looking for a significant top in the stock market until the ten-day moving average of the NYSE ARMS Index has at least declined back to the 0.90 to 0.95 area.

Again, for readers who are looking to short the major market indices, we are definitely not there yet. - one of the best websites out there that specializes in sentiment indicators - is of the same opinion.  The following study done by puts into perspective on where we are, in terms of speculative activity that is currently occurring in the stock market:

Dollar Volume in OTC BB Stocks

One of their conjectures is that one of the best measures of speculative activity in the stock market has been the monthly amount of dollar volume traded in the OTC Bulletin Board stocks.  For comparison purposes, the OTC BB dollar volume during December 2005 only totaled $2.7 billion.  While this amount is not low on a relative basis, it is definitely not high enough to signal an impending top either - given that it only amounted to 10% of the February to March 2000 peak in OTC BB dollar volume.  A better comparison would be the January 2006 data, as retail investors and amateur traders come back from their vacations to find the stock market "sizzling" on the upside.  As an aside, Jim Cramer of the had recently been recommending his viewers to purchase stocks that are being traded on the pink sheets.  Is this a leading indicator of a significant, speculative top?  We will just have to see.

If one cares to see, there are definitely great companies out there selling for reasonable prices, such as KO, WMT, HDI, WFC, HD, and so forth.  Once in awhile, we will get a very good opportunity to buy them at bargain prices in a general stock market sell-off, such as in the last few months of 1974, 1982, mid 1984, and October 1990.  For 2006, I see a higher-than-usual amount of risks out there - which is further compounded by the fact that many investors still have no regard for risks, as exemplified by the record low spreads in emerging markets and by the huge inflows into international, domestic small cap and mid cap stocks.  That being said, this doesn't mean that we will need to sell all our stocks tomorrow - no matter how overbought the market gets in the meantime.  Like I said in our previous commentaries, this author is most probably going to hold a core portfolio of stocks this year (and revise this portfolio as time goes along) - with the intent to hedge this portfolio (using ETFS or stock index futures) once the stock market gets overbought on a general basis.  Any liquidation of stocks will be decided on an individual basis - such as fundamental or technical analysis of the individual stock or the industry that this company belongs to.  Going forward, I believe this route will be the best way to go - as it will surely help the "long only" investors out there sleep better at night, as well as to keep them from being too "trigger happy."

Remember: Ultimately, the biggest risk to being successful in long-term investing is you.  Subscribing to a newsletter such as ours will only go so far.  Alternatively, you can also invest your money with a great portfolio manager, but you will still not make money in the long-run if you take your money and run at the first sight of a losing year.  In his ground-breaking book "One Up on Wall Street," Peter Lynch emphasized that the individual investor needs to do a few certain things before he or she should start to invest in the markets, and if they do not, chances are that they will be a "potential victim."  I will end this commentary with the related quote from Peter Lynch.  Lynch's "One Up on Wall Street" is a definite must-read:

Before you think about buying stocks, you ought to have made some basic decisions about the market, about how much you trust corporate America, about whether you need to invest in stocks and what you expect to get out of them, about whether you are a short- or long-term investor, and about how you will react to sudden, unexpected, and severe drops in price.  It's best to define your objectives and clarify your attitudes (do I really think stocks are riskier than bonds?) beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss.  It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser.  Ultimately it is not the stock market nor even the companies themselves that determine an investor's fate.  It is the investor.

Signing off,

Henry K. To, CFA

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