The June 2009 UCLA Anderson Forecast
(June 21, 2009)
Dear Subscribers and Readers,
According to Ron Chernow in “The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance” (winner of the National Book Award), Wall Street had a very difficult time attracting students in the 1960s in the midst of the Vietnam War protests. Quoting “The House of Morgan”: When Frank A. Petito [former Chairman of Morgan Stanley] went to the Harvard Business School to try to recruit students, he ended up sitting alone in a classroom until a professor took pity on him and stopped by to chat.” Make no mistake: As we discussed in our previous commentaries, Wall Street is both a niche and a very cyclical industry. From a career and business standpoint, the supply (labor) side is as important as the demand (i.e. bull market vs. bear market) side. The majority of business school graduates who started in Wall Street in the 1960s made fortunes over the next 30 to 40 years. Despite the downsizing in the last couple of years, Wall Street still remains a bloated industry by historical standards. The time to get into Wall Street would be when the influx from business schools slow to a trickle – and this will be at least several years away.
Let us now continue our commentary by reviewing our 9 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 3,632.27 points as of Friday at the close.
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 3,323.27 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.
Last Tuesday morning, one of the most respected national and Californian economic forecasters – the UCLA Anderson Forecast – published their quarterly update. Aside from a discussion of the national and Californian economies, the breakfast (which I had the pleasure of attending) also provided an outlook of the commercial real estate market.
On the national level, the UCLA Anderson Forecast remains one of the more optimistic respected forecasters I track. The Forecast expects US real GDP to trough sometime this summer (equating to a 0% GDP growth rate in the third quarter), and for it to increase to 0.6% in both 4Q 2009 and 1Q 2010. Thereafter, real GDP growth is forecasted to be in the 2% to 3% range (a historically modest level judging by post WWII standards) for the next several years. In light of the recent recovery in the global financial markets and the recapitalization of global banks' balance sheets, many forecasters (including PIMCO) are also forecasting a trough in economic growth sometime this summer. The difference lies in the Anderson Forecast's projection of 2% to 3% real GDP growth from 2Q 2010 onwards (or in other words, “the shape of the recovery”). While that projection is below the post World War II trend of 3.0% to 3.5% growth, the Anderson Forecast is still relatively optimistic than many long-term forecasters. For example, PIMCO is forecasting a sub 2% growth not only for the next several years, but possibly for the next decade as a result of US balance sheet deleveraging and a structural rise in the US savings rate. Quoting the UCLA Anderson Forecast:
Recovery will be inhibited by the legacy of the financial excesses of 2003-07 in the form of millions of foreclosed homes and even more plagued with “underwater mortgages,” a nationalized domestic automobile industry and a partially nationalized banking system. This legacy is in sharp contrast to the roaring 1920s boom where the economy created such productivity-enhancing investments as the national electrical grid, a giant automotive industry, unit-drive motors in factories and witnessed the emergence of electronic technology in the form of radios. Similarly, the late-1990s bubble bequeathed to the economy the world-wide web and the flowering wireless communications.
The rise in savings is being caused by the need of consumers to replenish their tattered balance sheets ravaged by the bear market in housing and stocks and the new lending standards that will make it harder to borrow. For example, the quaint 20th century notion of consumers saving money to make down payments on houses will come back into vogue. To be sure the savings rate recently popped to 5%, but a good part of that is a result of the decline in automobile sales. Once automobile sales start to recover the saving rate will naturally drop.
Moreover, there will be downward pressure on consumer savings coming from the tax increases on high income individuals scheduled to take effect in the beginning of 2011. Nevertheless, by the end of 2011 we forecast that the saving rate will be running at a sustainable 3% rate and rising; a far cry from the zero rate experienced a few years ago. As a result real consumption spending will increase at a very low 1% rate in 2010 and 2011 compared to the historic 3% increases.
Although both monetary and fiscal policy put a floor under the economy, no mean feat, it is also likely that the policies now being put into place may put a ceiling on it as well. How so? First the Fed will likely take away a good part of the monetary stimulus injected into the economy. Failure to do so would run the risk of a substantial inflation a few years out. The removal of the monetary stimulus along with modest economy growth will work to return interest rates to more normal levels. In fact, this is the message of the recent run-up in 10 year U.S. Treasury yields from 3% to 3.9%
In terms of fiscal policy, the economy will be faced with trillion and near trillion dollar deficits for as far as the eye can see. With government spending (NIPA basis) estimated to peak out at a postwar record of 24.2% of GDP in 2010, the transfer of resources out of the private to the government sector will be hardly conducive to economic growth. Furthermore, a new regulatory regime with respect to finance, energy, environment and healthcare will hardly be a motivator for investment, at least, while the transition is taking place. Thus do not expect the recovery to look like those of 1991-99 and 2003-07. But then again living without bubble-induced growth will be a new experience.
In terms of the unemployment rate, a tepid economic recovery such as that predicted by the Anderson Forecast would lead to a continuing rise in the national unemployment rate into the spring and summer of 2010. The Anderson Forecast predicts unemployment to peak at 10.4%, and for it to remain near that level going into the end of 2011 (yes, 2011, no typo here). This structural rise in the unemployment rate has is as a result of the tepid recovery as well as the fundamental restructuring of several industries – including the auto, financial, and retail industries. As these industries restructure, many workers in these sectors will no longer have the necessary skill sets to find new jobs – thus resulting in a structural rise in the “natural unemployment rate.” Just like the Class of 2009, I expect college and MBA students who graduate next year to experience a tough recruiting season as well. But since college and business school hiring is determined at the margin (i.e. the first derivative), I expect the Class of 2011 to experience a much better recruiting season – as the unemployment rate is expected to peak in the summer of 2010 and to decline thereafter (which means companies would actually be hiring on a net basis).
The Anderson Forecast acknowledges that there are both upside and downside risks to this base case scenario (economists are notoriously good at hedging their bets). For example, since GDP growth since the Industrial Revolution has been mostly driven by productivity, we could experience “positive Black Swans” which could push real GDP growth to a higher trajectory. The Anderson Forecast did not specifically mention what, but in this author's opinion, such “positive Black Swans” could include a breakthrough in solar technology and battery storage (resulting in a phenomenon commonly named “grid parity”), nanomaterials (e.g. the commercialization of some derivative of carbon nanotubes to be used in construction materials, conductors, etc.), biotechnology (e.g. drug customization as a result of greater advances in genomics), and quantum computing (resulting in an exponential jump in raw supercomputing power). Unfortunately, I do not see any potential breakthroughs in any one of these four fields over the next three to five years. If anything, the risks are tilted more to the downside than the upside, as we covered in our commentaries over the last few weeks). In general, these are some of the main points I am tracking:
- Central bank liquidity creation. The Federal Reserve's balance sheet has stalled - but that is mainly due to the elimination of central bank liquidity swaps (which countries such as Korea don't need anymore) and support of money market funds. The Fed continues to buy Treasuries and agency debt/MBS. The Bank of England has been very aggressive - buying about 7 billion pounds of Gilts a week. That said, central bank liquidity creation remains a very big concern - the Fed needs to be more aggressive given the recent spike in yields and given the lack of cooperation from the ECB. I believe the lack of central bank liquidity creation will remain a headwind for the rest of the summer unless commodity prices decline 5% to 10% from current levels (which should in turn alleviate concerns about any monetary policy induced inflation);
- Systemic risks emerging from Central and Eastern Europe. There is no doubt that Latvia will devalue - if not next month, then later this year. The Latvian economy is in a significant downward spiral with its currency getting more expensive by the day. The sooner they devalue, the less painful the experience would be. Once Latvia devalues, Lithuania and Estonia should follow. Note that Swedish and Austrian banks are heavily exposed to the region. This could pose a systemic risk to the global financial system given the still "wobbly" nature of our system;
- Systemic risks emerging from the US commercial real estate sector. While the UCLA Anderson Forecast went through this at length last week, they (unfortunately) did not discuss the implications of the $1 trillion exposure in US CMBS and commercial real estate loans exposure on banks' balance sheets. This will be a continuing theme and headwind for years to come. The hope is that both the banks and the economy will be able to “inflate their way out” of this problem over the next three to five years. Even if this does not pose much systemic risk going forward, it will still put a damper on US lending for years to come (unless investment funds, through the PPIP, take these commercial real estate loans off banks' balance sheets).
Of course, not everything is “doom and gloom.” While US consumers have been spending their way into an abyss, many formerly “developing” countries have quietly gotten their houses in order over the last 10 years. Brazil and most of developed and emerging Asia are prime examples. These countries have also spent substantial sums investing in much-needed infrastructure and productivity-enhancing technologies. As a result, global GDP growth should remain decent for the foreseeable future. There is also a good chance that Brazil and most of Asia are already in structural bull markets - especially in domestic-oriented businesses such as retail, etc. Even a bust in US commercial real estate and a Eastern European devaluation may not affect this. On the contrary, such events may even be beneficial as both Asian currencies and the Asian consumer should reap great benefits from a US or a European devaluation. Stay tuned.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:
For the week ending June 19, 2009, the Dow Industrials declined 259.53 points while the Dow Transports declined 141.65 points. With the two Dow indices having risen by 30% and 50%, respectively, from their early March lows, and with systemic risks increasing substantially over the last few weeks, we decided to reduce our risk exposure by paring back our 125% long position to a 100% long position in our DJIA Timing System on the morning of June 8, 2009. We will continue to keep track of the amount of central bank liquidity creation and the systemic risks emanating from Eastern Europe, as feel that these two issues will pose the most downside risk to the U.S. stock market over the next few months.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators increased from a reading of 0.6% to 1.0% for the week ending June 19, 2009. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
While the 4-week MA is still relatively oversold on a historical basis, it has also increased very quickly since the early March lows – suggesting that we may be due for a short-term correction, especially given the recent lack of liquidity creation by the world's major central banks and the impending devaluation by Latvia. Moreover, the continuing increase in bullish sentiment in the midst of a weakening market is usually a cause for concern. While I believe the world's central banks are still committed to reflating the global financial system and economy, we still believe that paring back our 125% long position in our DJIA Timing System in order to control for risk was the right move. For now, we will remain 100% long in our DJIA Timing System, and will most likely not ever shift back to a 125% long position again unless the Dow Industrials break the 7,000 level and approach the early March lows.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
Except for the brief spike three weeks ago, the 20 DMA has been consolidating in the 127 to 137 range for the last three months. While this consolidation has allowed this indicator to work off its short-term overbought conditions, there are still some short-term but significant obstacles that the market needs to deal with. Moreover, while this indicator is still far from historically overbought levels, it is now bumping up against recent “resistance.” This suggests the market could continue to endure a correction in the short-run.
Conclusion: While the UCLA Anderson Forecast's latest views on the economy do sound relatively optimistic, keep in mind that this is their “base case” scenario. As “Black Swan” risks are tilted towards the downside, real GDP growth could disappoint going forward. Since many US industries are now undergoing fundamental restructuring, the national unemployment rate could continue to rise to the end of 2010 (to 11%) in such a scenario. In terms of the Californian economy, the Anderson Forecast is expecting a peak in the unemployment rate at 12% or slightly higher, given the younger demographics and the higher proportion of immigrants (both of which tend to result in higher unemployment levels) of the state.
In terms of the global equity markets, I expect the correction to run further in the short-run, as global central banks start to think about reining in their liquidity facilities and as the inevitable Latvia devaluation may usher in higher risk premiums in the Central and Eastern European countries. That said, I still expect the global equity markets to rise for the rest of this year. 2010 will be trickier, as consumers and corporations around the world will continue to rebuild their balance sheets. On a country-specific basis, I expect most of Asia and Brazil to continue to outperform (with a focus on domestic-orientated stocks). While this is still too early to say, I expect the next US bull market to be driven by technology and biotechnology stocks. Subscribers please stay tuned.
Henry To, CFA