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Caution, Not Panic

By Elliott H. Gue on September 28, 2012

When I took the reins of this publication in late 2008, investors were in outright panic mode and the global economy was in the midst of the worst downturn in nearly 80 years. It was a time of emotional extremes, with some pundits seriously talking about the potential for America’s largest and most respected companies to go bankrupt because of their inability to roll over credit lines.

To be fair to the sensationalists, for a time the global economy ground to a halt. Ships stopped moving goods because operators couldn’t obtain letters of credit, the media was filled with pictures of grim-faced people lined up in front of banks to withdraw their money for fear of financial Armageddon, and the S&P 500 collapsed from over 1,300 in August to well under 800 by late November. After a brief bounce at year-end, the market continued its slide in early 2009, touching a low of 666.79 in March, one of the most vicious bear market cycles in financial history.

However, amid all the talk of crisis and the end of the world as we know it, this publication maintained a level head. Instead of mongering fear, we pinpointed a handful of economic indicators that have proven their worth over decades of real-world testing. Over the past few years, we have used these indicators to make accurate forecasts concerning the state of the markets and the economy. I am proud of our track record.

In particular, in early 2009 with many pundits still expecting the economy to remain mired in recession, we correctly identified the “green shoots” and predicted an end to recession by the second half of the year and significant upside for stocks.

A little over a year later in May 2010, markets were again in a panic thanks to a major oil spill in the Gulf of Mexico and growing turmoil in Greece and European credit markets. A “flash crash” that wiped out billions in stock market wealth in a matter of seconds further dented sentiment.

However, while many called for recession, we suggested the slowdown in the economy was simply a temporary soft patch and recommended investors buy the dip for a year-end rally. From its lows in July 2010 to its highs in May 2011, the S&P 500 rallied over 35 percent.

We made the same correct call again in the summer of 2011, in an August 5, 2011 column entitled “No Recession Looming: Buy Stocks into the Summer Shakeout.” Investors who followed that advice and simply bought the S&P 500 would have been up more than 13 percent just 6 months later. If you followed our advice to focus on high-yield groups such as the master limited partnerships (MLPs), you would have fared even better. The Alerian MLP Index soared more than 20 percent over the same period.

The New Normal

My view remains that the US economy is in the midst of its most anemic economic recovery of the post-war era. Prior to the 2007-09 recession and financial crisis, most investors considered the “normal” trend rate of economic growth for the US to be around 3 percent.

Of course, no trend is perfectly even and the economy was expected to experience periods of above-trend and below-trend growth. Nonetheless, over the long term, the average was expected to clock in at roughly 3 percent. In addition, investors’ concept of recession was skewed by the extremely mild downturns of 1990 to 1991, and March through November 2001. In both cases, the economy shrank for about 8 months before snapping back.

The trend has changed. While the US economy is still growing, the trend rate of growth is closer to 1 percent to 2 percent rather than 3 percent. This week’s release of the final estimate for US second-quarter gross domestic product (GDP) makes this “new normal” abundantly clear (see chart, below).

Source: Bloomberg

The headline rate of GDP growth was revised lower from 1.7 percent annualized to just 1.3 percent. That compared to 2.0 percent annualized growth in the first quarter of the year and 4.1 percent in the fourth quarter of 2011. A look inside the report shows that the downgrade stemmed from downside revisions in exports, personal consumption expenditures (consumer spending) and inventories.

Of course, GDP is a backward-looking indicator. The third quarter is nearly finished and the Bureau of Economic Analysis is just releasing its final estimate of second-quarter GDP. However, the durable goods report released this week also highlights reasons to be concerned about GDP growth in the back half of 2012 (see chart, below).

Source: Bloomberg

In August, durable goods orders plummeted 13.2 percent, far lower than the 5 percent drop the consensus expected. Durable goods represent a volatile data series but much of that volatility is due to big ticket items from the aircraft and defense sectors. Consequently, I tend to watch durable goods orders excluding transportation and the core number that excludes both transportation and defense.

As the durable goods chart shows, clear weakness exists in both of these series. Durable goods orders excluding transportation were off 1.6 percent compared to a 0.2 percent gain that was expected. And July data was revised sharply lower. Non-defense durable goods orders excluding aircraft were up 1.1 percent in August, better than the 0.7 percent gain expected. However, July data was revised sharply lower to -5.2 percent compared to the -3.4 percent previously reported.

Durable goods are defined as products that are designed to last more than one year. While it’s a volatile series, it’s important to watch because durable goods are typically big-ticket items and companies will tend to slow down their purchases of these products first when they’re worried about the state of the economy.

In addition to the weak economic data in the US, there remain several sources of uncertainty in the weeks ahead. First and foremost, US election cycles always produce plenty of emotion. This cycle is worse than most, with Congress and the president compelled to address the looming 2013 “fiscal cliff” soon after the election.

While my forecast remains for the US economy to muddle through the next few quarters with growth of around 1 percent to 2 percent, this outlook would change quickly if all of the fiscall cliff’s planned tax hikes and spending cuts were enacted. While I do expect a resolution, it will be an eleventh-hour deal and could cause plenty of volatility—just as the prolonged and messy resolution to the US debt ceiling debate generated extreme swings in stocks in the summer of 2011.

Europe: Still a Mess

Europe remains another headline risk. While the European Central Bank (ECB) has put forward a plan to buy bonds issued by Italy, Spain and other troubled EU countries, it will not actually start buying these bonds until these countries apply for assistance from Europe’s bailout fund and agree to a set of conditions. The Italian and Spanish governments have said they have no plans to apply for such assistance; don’t be surprised if borrowing costs for both countries begins to rise again, forcing their hands.

Pushing against weakness in the real economy are global central banks. The Federal Reserve’s announcement of “QE Infinity,” a third round of quantitative easing (QE) that’s unlimited in size and duration, seems aimed directly at pushing up inflation expectations and the stock market. With stocks at their highest levels since early 2008, the central bank has been at least partly successful. While the jury is out on whether this move will aid the economy, investors are historically reluctant to fight the Fed.

However, given weakness in the real economy, a squishy corporate earnings outlook and uncertainty surrounding the US election cycle, equity markets continue to look too complacent and are vulnerable to a significant correction. Ultimately I expect the US economy to muddle through the current slowdown but I continue to advise caution given the market’s recent run-up. Investors should favor large capitalization stocks and companies that offer significant dividend yields.

I recommend avoiding economically cyclical groups such as the industrials, a sector that has underperformed the broader market handily this year. Stocks levered to commodity markets including energy, gold and agriculture should benefit from the Fed’s efforts to push up inflation; I am looking for gold to top $2,000 per ounce by early 2013.

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