The Good News: Things
Aren't Getting Worse At An Increasing Rate
by Guy Baker
As we measure the state of the economy, there is little we can call good news. Maybe we can say, things aren’t getting worse at an increasing rate. But other than that, there is not much reason to think things are on the upswing. At least not yet.
Here are some indicators:
- Industrial production fell -1.1% in May, notice this is a slower rate of decline
- Capacity utilization declined to 65.0%. This is the lowest rate since they began measuring it in 1948
- Good news - the Conference Board's index of leading indicators rose a little +1.2%
- Also up was new residential construction (+17.2%), mostly attributed to multifamily construction
- The U. S. trade deficit – declined by 34.5%, but it is still $101.5 billion
So what conclusions can you draw from these numbers? One good thing is that inflation has remained calm. We are still in a "one step forward, two steps back" mode. But if nothing bad happens (big if), most economists predict things will pick up towards the end of this year, but it could be mid 2010 before we see any consistency. Regardless, there is nothing indicating the growth rate will pick up and match what we saw in the first half of this century.
THE MARKETS
Even the markets did the stock two step. Major indicators declined, giving back some of their recent gains. The Dow Jones Industrials [-2.95%; -2.69%], the S & P 500 [-2.64%; +2.02%], and the NASDAQ Composite [-1.69%; +15.88%] all went in reverse, with the Dow slipping back to a loss for the year. Remember markets typically price in anticipated changes. So the pull back indicates something new is going on they don’t like. What could it be? Maybe it is the proposed regulatory rules for financial institutions. Or perhaps it is the cap on pharmaceutical prices for Medicare patients. Maybe the markets are getting worried about the Alt-A loans that are getting ready to reset. Or the large increase in the number of foreclosures. Whatever it is, it spooked the pros and the market retreated.
We are almost at the end of 2Q, so earnings reports will be coming out soon. It is likely they will not be robust. Reading the news, it does not seem like any companies are touting their results currently. So it is likely, they will be flat or slightly up, if at all.
Reported mortgage rates declined and long-term T-Bills slipped. This is reflective of the prospective low rate of inflation short term. The flood of bailout monies and stimulus payments may eventually result in higher prices, but not in the near term since none of the money has actually reached the economy yet. Most reports say this is likely two to five years from now.
Since Congress raced to pass the bill, what is causing the delay? In all probability, whatever government borrowing and spending is happening is offsetting the decline in consumer purchases. So it is a wash. When consumers return to the marketplace, then inflation is going to gain a head of steam and prices will jump dramatically. This will be the classic definition of inflation, "too much money chasing too few goods and services."
If the government modulates spending and reduces outlays once consumers return to the marketplace, inflation could be avoided. But when has government ever done that? There are some built in “have tos.” For example, Medicare will begin to soar as the babyboomers reach age 65. Not to mention social security payments will begin to rise dramatically. All these are ingredients the Government knows about and has been tracking.
Oil and gasoline prices continued their steady upward climb. It has been slow and steady so no one really has screamed. But gasoline prices are up by more than 65% for the year. Crude oil has gone from low $40s to above $70 per barrel and is holding. Probably not going to see energy costs declining anytime soon.
PERSONAL FINANCIAL PLANNING – Lower Market Returns?
As the reality of the market decline begins to sink in, investors are starting to acclimate to the impact. But some are still clinging to the hope, the markets will rebound quickly and this nightmare will have been just a bad dream. Unfortunately, there is not much out there to make anyone think this is reality.
The historical market returns of the 20th century (10%+) may be something we read about in the history books. The new reality is that the current administration is doing everything it can to dampen the financial sector’s ability to make money. And when that happens, the incentive to drive the market ever higher is removed. Warren Buffet predicted this months ago, so it should not be news.
Two events have caused commentators to trim their expectations. I mentioned both earlier. The administration issued their "White Paper" and recommended significant changes to how banks, investment banks, and securities markets should be regulated. These proposals are very far-reaching and are reminiscent of the depression mindset and reaction in the 1930s.
Whatever happens it is likely economy's financial sector will be significantly impacted and the net result will be lower earnings. There will likely be higher capital requirements, increased legislative oversight, and increased restrictions on leverage. Since the financial sector makes up the largest component of the S & P 500 it is reasonable to expect there will be a huge impact on the index return.
Some of these changes are probably prudent and needed. We saw the wholesale collapse in share prices almost overnight. Much of the risk would be regulated away with these proposals. The result of a stabile financial services industry is likely to be mediocrity and this translates to lower market returns.
You may have missed the most recent agreement between the government and the major drug companies. This agreement called for those pharmaceutical companies to lower their medication costs under certain circumstances for Medicare drug recipients. The expected cost to the drug companies is going to approach $80 billion dollars over the next ten years. Guess who pays for that?
Is this a good thing? You all be the judge. But regardless, that $80 billion has got to come from somewhere and as proposed it will come right out of the pockets of shareholders. So what is going to happen to their stock? This is another major sector of the S&P, which will impact total returns. Will there be any benefits? We can hope so. Maybe when we look in the rear view mirror, analysts will say it was worth the cost. And if the result is a more stable financial system with fewer bubbles, as well as some controls on the entitlement programs, it may have been a shrewd move.
However, it is probable the returns in the market will be dramatically hurt by these two important sectors being dramatically impacted. If we're going to be living in a "five-percent return world" instead of 10%, the loss can only be made up in one of two ways – more investment or more risk. Both may be impossibilities.
FINANCIAL FACT OF THE MONTH
Healthcare is expected to increase by 9% in 2010 according to a study produced by PricewaterhouseCoopers. Health insurance premiums for employees have increased four times faster than wages over the last 5 years. The result is that employers are charging more and more of the cost to the employees. On average, workers pay roughly 25% of their insurance premium instead of receiving it as a 100% paid benefit as in years past.