Tuesday, December 28, 2010

Making Sense of Projections

   As 2011 approaches, it's important to look back at the year passing. Entering 2010, analysts and experts were largely bullish on the economy and stocks. Many prognosticators expected U.S. GDP growth above 3.5%, unemployment to fall towards 9%, 10-year Treasury yields to rise above 4% and the S&P 500 to climb above 1250. Oddly enough, while the consensus was nearly dead on regarding the stock market, most other expectations for the economy proved off target. Given this divergence, considering which expectations are or aren't important for maintaining predictions on the stock market would appear to be valuable insight.
   Determining the pace of economic growth for future years intuitively seems like an important factor in estimating earnings growth. (S&P 500 earnings used as metric) This intuition happens to be very misleading looking back over the past 50 years. Amazingly, since 1960 there have only been 5 years during which real GDP growth was negative over the entire year. However, during the same period, there have been 12 different years in which S&P 500 earnings declined. Of those 5 years that real GDP declined, 2008 marked only the third in which both real GDP and earnings dropped together. Also surprising, real GDP actually grew above 4% in three separate years that earnings declined. Glancing at the other 75% of the years when earnings actually grew, the level of GDP expansion shows very little correlation. GDP growth expectations may be rising toward 4%, but whether higher earnings will follow remains unclear.
   With new tax cuts recently enacted and further rounds of quantitative easing (both opposites of last year's expectations), an expanding GDP is believed to start bringing down unemployment in 2011. Although pundits have predicted monthly job growth topping 250,000 since the fourth quarter of 2009 to no avail, those predictions remain widespread for 2011. As 2010 comes to a close, unemployment remains elevated near 10%. Making matters worse (in real terms, better by numbers), nearly 8 million Americans have dropped out of the workforce in the past 3 years. By comparison, when unemployment last topped 10% between 1981 and 1982, the peak to trough loss in total workforce was only 2 million. This period also began a string of negative earnings growth in 4 out of 5 years. So far, heightened unemployment has created far less damage to corporate earnings this time around. Whether this new trend holds will be interesting to watch since workforce growth alone makes hopes for 5 % unemployment daunting. 
   A strengthening economy was believed to generate confidence in the recovery and push investors into riskier assets in 2010. As a byproduct, Treasury yields were expected to rise with the Federal Reserve beginning to raise interest rates in the fourth quarter of the year. 10-year Treasury yields began the year above 3.8% and after briefly topping 4%, plunged below 2.35% before finishing the year around 3.4%. Rather than gaining confidence in the recovery, the Fed has actually cut economic forecasts throughout the year and embarked on a second round of quantitative easing. Although rising rates are a negative for equity valuations, yields are once again expected to rise in 2011. Yields have primarily been falling for 30 years, accompanying massive growth in earnings and stocks. If the trend reverses in coming years, this correlation may prove troublesome for bond and stock investors alike.
   Heading into 2010, S&P 500 earnings were expected to increase nearly 30% to approximately $83. Despite weaker GDP growth and higher unemployment, 2010 earnings are now likely to top expectations, totaling more than $85. With that year end total, 2010 will mark the second largest increase in earnings since 1960 (when earnings were only $3.11). 2011 is thought to be another banner year for earnings, growing 14% to a new all-time high over $97. Alongside rising earnings, the S&P 500 is widely projected to increase between 10-20% next year. It's worthwhile to consider that only once since 1960 has the S&P 500 experienced double digit gains in 3 or more consecutive years (five straight from '95-'99). This amazing string was followed by the only 3 year period of recurring losses since 1960 (each year was down double digits). While the current outlook seems extremely bright, past precedent argues for caution in becoming too bullish.
  As analysts, investors, economists and others share their outlooks for 2011, I urge investors to apply a couple lessons from history. First and foremost, predictions are frequently incorrect and which projections prove true is anybodies guess. Second, economic growth and unemployment may be less associated with corporate earnings or stock market performance than previously thought. Therefore, variations in economic projections or failure to accurately predict economic growth may not imply incorrect market expectations. Third, be conscious of historical trends, which may not help forecast the future but offer insight for judging projections.  
   For the past 6 years, strategists have predicted the S&P 500 would end the years with gains (shown above). Their predictions have proved correct 83% of the time. Unfortunately, the one year projections were wrong, the index lost nearly 40%. The S&P 500 closed 2004 at 1211.92 and today rests a few percent higher at 1257. Even more frustrating to investors, the S&P 500 closed 1998 at 1229.23. Despite rising in 10 out of 12 years, the stock market has barely moved. Predicting the stock market to rise is clearly a matter of odds. Earning returns over the long-run may prove a bit more difficult. 
   With only a few days left in 2010, here's to hoping the optimistic outlook for 2011 proves true.   

Friday, December 24, 2010

The Bubble that Wasn't

   An economic bubble is often described as "trade in high volumes at prices that are considerably at variance with intrinsic values (Wikipedia).
   Some analysts claim that the commodities market is in the middle of another bubble, as the prices of crude oil, copper, wheat and coffee reach multi-decade highs while these products attract record financial investments. Tobias Levkovich, Citigroup’s chief US strategist, holds this view. He says in a recent report that commodities, particularly gold, are looking like a “bubble prospect” as “easy money and speculative juices combine to drive prices unsustainably higher”. But whether commodities have truly become the third and last bubble of the past decade is open to debate. Kevin Norrish, at Barclays Capital, disagrees with the view of a bubble. “The price rise is fundamentally driven,” he says, pointing to robust demand, lagging supply in spite of record prices for key raw materials, and jumping production costs. John Kemp, an economist at Sempra Metals, a London-based commodities brokerage, says a bubble has probably emerged as investors pile into raw materials on the expectation that prices will continue to rise. “It will be a mistake to assume that commodities prices will rise further without doing damage to the economy and triggering a response from central banks worried about inflation,” Mr Kemp says.
   The above passage actually comes from an article by Javier Blas in the Financial Times on March 10, 2008 titled Analysts differ about commodity bubble. In reality, the only thing mentioned above that has really changed in the last two and half years is that few analysts currently believe commodities represent a bubble. For most individuals, aside from changes in the price of crude oil which are overly apparent in the rapid price changes of gasoline, the price of most commodities probably goes unnoticed. Therefore one could be forgiven for not recognizing the remarkable price swings that have taken place over the past several years. In order to paint a clearer picture of the true magnitude of these fluctuations, let's look back at the price of several commodities over the previous decades.
   For a general representation of commodities, I've selected those mentioned in the above article (crude oil, copper, wheat, coffee) while adding silver and sugar to round out the group. Prices of various commodities are generally represented by futures contracts with the front month (nearest to current date trading) establishing the spot price for trading. The time series in consideration looks at the front month futures' closing price at the end of each month starting in January 1980 (except crude oil which begins in March 1983 and copper in December 1988). The graphs (courtesy of Bloomberg) shown below depict weekly closing prices of these front month contracts for the past 10 years.

Crude Oil
   In the early 1980's crude oil spiked due to foreign tensions and threats of cutting off supply. However, by 1983 the tensions had subsided and crude oil sat at $29.29 a barrel. Despite substantial economic growth during the rest of the 1980's, the price of crude oil actually fell to $21.82 by the end of the decade. The 1990's followed, marking one of the strongest decades of economic growth for the U.S. Yet for most of the decade crude oil prices held steady, until a 25% increase in the final 6 months pushed crude up to $25.6. As the new millennium began, the dot com bubble was well under way and the general consensus was that the Internet would dramatically expand worldwide economic growth. In 2000 the price of crude oil rose to nearly $34 before the first bubble of the decade popped and the ensuing recession sent prices back down under $20 by the start of 2002. It wasn't until early 2004 that crude oil topped $34 again and although it wasn't clear then, a massive run-up had begun. In the next 9 months, the price of crude would rise over 50% to nearly $52 a barrel. Another 10 months passed and the price reached almost $69. The price then staggered over the following two years, closing the first half of 2007 just above $70. This period later proved to be the calm before the storm as crude oil prices erupted in the following year, reaching a peak near $150 a barrel in July 2008. Crude oil prices peaked just as the subprime mortgage crisis was taking hold and most of the world was entering or already in a recession. Even more remarkable than the over 700% rise in 5 years was the dramatic decline that would follow. Within 5 months after reaching its peak, crude oil prices would fall to a low of $32 a barrel in December 2008. At the time, many economists and analysts considered the astonishing rise to have been a bubble, unsupported by fundamental demand/supply constraints and subject to significant speculation. While that premise seemed obvious at the time, 2009 brought about another rapid rise in prices to nearly $80 a barrel by year end. Although the upward momentum has slowed during 2010, crude oil seems poised to close above $90 a barrel this year. Looking ahead, most analysts expect a continuing trend with price predictions ranging between $100 and $120 a barrel for 2011. 

   Back in 1988, copper swapped hands for $1.56 per pound. By 1990, copper prices had fallen by over 50% to just below $1. The 1990's were not much better for copper as prices dropped another 15% to $0.85. After closing below $0.70 per pound at the end of 2002, China's rapid expansion sparked massive real and perceived growth in demand. Over the next 3 1/2 years, prices rose more than five fold to above $4 per pound by early 2006. The following two years witnessed some volatility with the price falling below $2.50 before topping out slightly above $4 again in early 2008. The ensuing decline rivaled the fall in crude oil as copper prices plunged below $1.25 per pound by the end of 2008. Although the drop failed to match similar extremes, the recent rise has actually exceeded that of crude oil. In 2009 copper nearly tripled, ending the year above $3.30 per pound. Helped by a greater than 10% rise in the past month, copper prices reached a new all-time high this week above $4.28 per pound.    

   Wheat began the 1980's trading around $4.70 per bushel but fell to just over $4 by the end of the decade. The 1990's proved even worse for wheat with prices falling nearly 40% below $2.50 per bushel. Unlike oil and copper, wheat actually rose early in the new millennium climbing to $3.25 by the end of 2002. However, by 2006 little had changed with wheat trading just below $3.40per pound. Wheat joined the general commodity trend of astonishing growth a bit late but made up for it quickly. In slightly over 2 years wheat prices nearly quadrupled, eclipsing $13.30 per pound on the last day of February 2008. This massive rise was equally short-lived as prices declined below $5 per pound before year's end. Comparatively, the 50% increase in wheat over the past two years appears slim, but recent shortages suggest wheat may play catch-up in the near future.   
    Similar to several other commodities, the 1980's were negative for coffee prices. During the decade, coffee fell more than 50% from over $1.60 per pound to just below $0.80 by the start of the 1990's. The 90's was a particularly volatile decade for the coffee market as prices fell near $0.50 towards the end of 1992, rallied above $2 late in 1994, fell back below $1 in 1995, spiked above $2.75 briefly in 1997 and ultimately settled around $1.25 per pound entering the new millennium. The new decade began similarly to the previous one as prices fell dramatically to just above $0.40 per pound near the end of 2001. Volatility would decrease and prices began rising steadily, peaking above $1.60 per pound in early 2008.  Differing from many other commodities, coffee prices were not as deeply affected by the credit crisis with prices remaining above $1 throughout the recession. As the world economy regained its footing and began expanding more rapidly, coffee regained its upward momentum. Over the past 6 months, coffee prices shot upwards from $1.35 to over $2.35 per pound and are quickly approaching new all-time highs. 
   Silver prices began the 1980's in a much different place than other commodities, near all-time highs above $35 per ounce. This peak was short-lived as the price plunged to $12 in two short months. Although silver rose above $20 per ounce again later that year, it quickly reversed course and that price level would not be seen again for decades. By mid-1981, as Paul Volcker began his quest to break the back of inflation, silver had fallen below $10 per ounce. Silver remained in steady decline for a majority of the decade, closing at just above $5. Contrary to many other commodities, silver prices experienced minimal volatility during the 1990's and ended the decade practically where it had begun. The early part of the new century brought little change for silver prices as well. In 2004 the U.S. economy was back on track and interests rates remained very low, helping spur demand for commodities. Breaking out of a nearly 15-year range, silver's slow rise became more dramatic entering 2008 when prices rose above $20 per ounce for the first time since 1980. Then the credit crisis struck and a period of deflation began, sending silver back below $10 per ounce in 6 months. As silver hit a trough, interest rates were being lowered dramatically around the world and fear sparked demand for precious metals. A combination of fear, economic growth, negative real interest rates and money printing have greatly increased demand for silver since. After nearly doubling in 2009, the price of silver has risen nearly another $10 in the past 4 months and currently rests near $30 per ounce.     
   Sugar's price movements over the pat 30 years resemble that of silver. In 1980 alone, the price of sugar nearly doubled from $0.22 per pound before ending the year slightly above $0.30. Only 16 months later, the price would fall below $0.10 and by mid-1985 the price rested barely above $0.02 per pound. Sugar would rally back in the second half of the decade, finishing the 80's around $0.13 per pound. Prices fluctuated minimally most of the 1990's before a rapid decline in 1998-1999 dropped the price to $0.06 per pound to end the century. Once again, sugar prices bounced along the bottom until beginning a steep incline in mid-2005. By early 2006 the price nearly touched $0.20 per pound before falling back towards $0.10 later the same year. Sugar prices briefly peaked again in early 2008, though only near $0.15 per pound. The ensuing decline was equally minimal compared to other commodities. Joining the trend again, in late 2008 sugar prices began an astonishing rise from $0.12 to $0.30 per pound in just over 12 months. What has happened since is even more surprising as prices fell below $0.15 at the end of May 2010 before rising back above $0.34 this week. 

   The story of these commodity prices represents the remarkable volatility over the past few decades and especially the past several years. Although inflation is unaccounted for in these prices, actual core inflation in the U.S. (as measured by the Fed) during the past decade could only explain a minuscule portion of the rising prices. Back in 2007-2008, the main story on the street was that ever increasing demand for commodities by China and other emerging markets would outstrip supply offering a sure bet on higher future prices. Yet somehow as fear of an impending second depression spread, demand appeared to nearly evaporate. Suddenly oversupply ruled market sentiment sending prices sharply lower and spurring talks of a bursting commodity bubble. Two short years later, economic growth has picked up, governments are printing more money, interest rates in developed countries remain between 0 and 1% and global demand has picked up. Once again, the widely accepted view holds that demand will vastly exceed supply in coming years. Attempting to front run expectations, prices of many commodities have already jumped back above previous peaks with several approaching or hitting all-time highs. 

   All of this begs the question, were commodity prices in 2007-2008 a bubble? When demand appeared nonexistent in late 2008, early 2009 the answer would have seemed an overwhelming affirmative. Considering prices today, a strong argument can be made against this idea. For those considering investing in commodities today, whether through futures, ETFs or stocks, pondering this question in incredibly important. As recent experience has shown, global demand for raw materials can be far more volatile than most believed. Speculation on future prices can not be ruled out either and investor sentiment has proved even more volatile than demand. Ultimately the answer to the question may reside somewhere in the middle. Given a long investment horizon (10+ years), global demand is very likely to increase and out-pace supply. However, since that view is nearly universal, current prices may already reflect a substantial portion of the expected growth story. Either way, caution is advised, as the past 30 years have demonstrated investors may be in for a very bumpy ride!

Wednesday, December 8, 2010

Take That, Fiscal Commission!

   On February 18th, 2010, President Obama signed an executive order creating the bipartisan National Commission on Fiscal Responsibility and Reform. The group of 18 was allotted eight months to derive a plan for reigning in budget deficits and restoring America to a sound fiscal path for the future. Last week, the Commission's final report was published and is well worth reading. With every option on the table, the final report details a number of politically challenging, thoughtful and creative ideas. Although many members were unable to agree on specifics within the plan, the basic conclusion was unanimous and well depicted by the following excerpt from the preamble. "As members of the National Commission on Fiscal Responsibility and Reform, we spent the past eight months studying the same cold, hard facts. Together, we have reached these unavoidable conclusions: The problem is real. The solution will be painful. There is no easy way out. Everything must be on the table. And Washington must lead."

   Only a week after the report's release, President Obama and the rest of Congress are sending a loud and clear message back..."who cares!" This week President Obama announced a compromise with the Republican Party on the extension of tax cuts otherwise ending in a few weeks. Not only does this compromise extend the entirety of Bush and Obama tax cuts for two years, but the plan adds new tax cuts such as reduction of the payroll tax. Social Security was previously expected to deplete all funds in 2037, but new revenue cuts are likely to be pull that end date forward. A few extra tax cuts alone would not have undermined the fiscal commission, but the compromise does not stop there. On top of tax cuts, extended unemployment insurance will be continued for another 13 months. In direct opposition to the fiscal commission's report, the forthcoming tax bill will reduce revenues and raise expenditures without any plan for future deficit reduction. On the whole, the tax compromise is likely to add upwards of $1 trillion to the deficit over the next two years.

   With tax rate questions now practically answered (the bill could fail, inflicting serious negative consequences), the likely economic effects can be analyzed. Looking at the positive aspects, lower taxes should boost short-term GDP growth and extending unemployment insurance will prevent millions of Americans from falling short on bill and mortgage payments. It's also conceivable that increased spending spurs further spending, resulting in rapid economic growth and shrinking unemployment. Although possible, the Bush tax cuts of 2001 and 2003 fail to offer much substantive truth behind this notion. Make no mistake, letting the tax cuts expire for 98 percent of Americans would have likely have had terrible consequences for the economy and equity markets. Despite this view, numerous questions remain regarding the efficacy and effects of the tax compromise.
   Let's start with the basics, expectations for GDP growth. Many economists and equity market strategists have been quick to raise 2011 GDP growth expectations in light of lower tax rates. Most have added between 0.5% and 1% to expectations, however a Citigroup report now projects 4.5-5% growth for the coming year. However, the extension of tax cuts should not be mistaken for actual tax cuts. Unless the majority of Americans had truly expected their tax rates to rise at the end of this year (despite Congressional agreement on maintaining tax cuts for the bottom 98%), expectations will not be changed by this bill and therefore action is unlikely to alter greatly either. Further, current tax rates are only guaranteed through 2012 which still leaves businesses with tax uncertainty for large capital projects. Although failing to maintain current rates for most Americans may have thrown the economy back into recession, it remains unclear how much extra growth will be generated by holding them constant.

   Next we'll consider the further extension of unemployment benefits. These benefits will almost certainly be used for consumption and therefore provide added stimulus to the economy. However, quietly ignored by this compromise was any extension of benefits for 99ers, those Americans who already exhausted current weekly maximums for unemployment benefits. A couple million Americans currently hold this designation and the President's Council of Economic Advisors recently calculated another 4 million may stop receiving benefits next year. Having several million people out of work without any benefits is likely to be a drag on the economy.

   Finally, tax rates benefiting the wealthy were seemingly the biggest compromise made by President Obama. The main benefits to highest income groups include holding tax rates at current levels for income, capital gains and dividends, as well as setting the estate tax at 35% with a $5 million individual exemption. In his speech, President Obama made his disapproval of these measures extremely clear. What's been most intriguing in the argument to raise taxes on the wealthy, is how directly its premise opposes Federal Reserve Chairman Ben Bernanke's premise behind QEII. President Obama and Democrats (correctly) argue that providing extra income to the wealthiest few percent of the population leads to a minimal increase in spending and more saving. To the contrary, Chairman Bernanke has suggested that quantitative easing will support asset prices and resulting capital gains will drive increased spending. With nearly 85% of stocks being held by the top 15% of the population, its clear the burden of rising expenditures falls on the wealthy. Extensive research has been done on the wealth effect and much of it supports only a minimal impact on consumption. Unfortunately President Obama has been forced to the opposing side, for which the likely outcome is continuation of widening disparities in the general population.

   So what's the take away from this news with regards to investing? In response to the tax compromise, bonds have sold off sharply reflecting some combination of perceived higher GDP growth, inflation, deficits and debt. Treasury maturities between five and ten years have witnessed yields rise nearly 1% in the past six weeks, breaking significant technical strength. On November 4th, in Fighting the Fed, I recommended shorting Treasuries through use of a couple ETFs, PST and TBT. Since then, each security is up over 11% and further upside seems limited. At this point I'd recommend selling out of those positions and have done so personally, reducing my position by approximately 90%. Rising yields have already impacted other markets as yields now offer a more reasonable alternative to stocks and rising mortgage rates are pressuring an already weak housing market. If Treasury yields rise further, to 5% on 30-year maturities, it may become prudent to reverse course and go long bonds.

   As yields and the dollar rose recently the stock market has managed to hold onto yearly gains. Previous columns have outlined the extreme optimism that currently persists within the market. Several headwinds linger  preventing a sustainable economic recovery from taking hold and limiting corporate earnings growth going forward. Expectations for S&P 500 earnings growth have already come down significantly for next year to about 10%. Based on these views, the stock market remains slightly overvalued at this juncture. My recommendation is therefore to raise some cash and wait for a better opportunity to enter select stocks, ideally with strong dividends.

Disclosure: Long Proshares Ultrashort 7-10 year Treasury (PST) and Proshares Ultrashort 20+ year Treasury (TBT).