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A Top Economist Weighs In

September 18, 2011 Leave a comment

This post is taken from an interview conducted by NPR.  The economist who is featured here is one of the most trusted voices I listen to in my efforts to ‘take the temperature’ of the current economic conditions.  While he is not calling for an outright recession, his tone and demeanor in the interview clearly indicated, at least to me, that he is very concerned about the near-term future of the fragile global recovery.

Last year economist Lakshman Achuthan said he thought the United States had emerged from the depths of a recession, but today the picture looks a bit more grim. Unemployment is hovering above 9 percent and there were no new jobs created in August. On top of that, consumer confidence is at its second-lowest level of the year.

Lakshman Achuthan is managing director of the Economic Cycle Research Institute.

“We are skating on very thin ice,” Achuthan tells Guy Raz, host of weekends on All Things Considered.

Achuthan says the jury is still out on whether the U.S. will go into another recession, but he suspects that it will be clear one way or the other by the end of November.

Caution: Economy Slowing Ahead

Achuthan, co-founder and chief operations officer of the Economic Cycle Research Institute, says all of his economic indicators point to more sputtering ahead.

“The risk of a new recession is quite high,” he says.

If we do have a double-dip recession, Achuthan says, the people who are already having trouble finding work and paying bills are already in a depression and that they “are going to suffer more.”

“It poses massive problems for policymakers because a new recession automatically increases all of these expenditures out of the public sector, while at the same time dramatically decreasing all their revenue,” he says. “So there’s even less ability to help the people who are hurting the most.”

This Time Is Different

Some economists argue that right now we are just in a period of slow growth, not unlike that of the early 1980s. They say there are signs of a turnaround in the near future. Achuthan argues there is no evidence to support that point of view.

“This is very different than the early 1980s. The issues that ail the U.S. economy and the jobs market today are not things that result from nearby events. What we’re living through and dealing with now has been building for decades,” he says. “If you look at the data, you see that the pace of expansion has been stair-stepping down ever since the 1970s, on all counts — on production, how much can we produce, how many jobs can we create, how much money do we make, how much do we sell. These are all trending down.”

So, Achuthan says, “those who were expecting we should have a vigorous recovery had no right to do so.”

In fact, he says, it is likely that the U.S. will see more frequent recessions than it’s used to for the next five or 10 years.

“The best news I can give you is that cycles do turn, but there is going to be a lot of pain in between,” he says.

So what should an investor do in light of this downbeat assessment for the economy?  Remain vigilant, reduce risk where possible, but stay invested for the time being.  At ZenInvestor.org we recently made changes to our model portfolios which reflect the weakness of the economy.  We reduced equity exposure across the board, but we did not recommend wholesale liquidation to our subscribers.

For a detailed breakdown of our current thinking, visit http://www.zeninvestor.org and check out our model portfolios.

The Stock Market, The Business Cycle, and Earnings

September 2, 2011 Leave a comment

The stock market isn’t a random set of numbers that goes up and down for no reason – although it seems like that’s often true.  No, the stock market is tied to company earnings, and earnings are in turn tied to the business cycle.  The connection is a loose one, with plenty of play both on the upside and the downside.  But the link is real and permanent.  The stock market will always return to fair value after straying too far afield, and fair value is determined by current and future earnings.

One of the best sources of information for all things related to earnings is Zacks Investment Research.  Below is an article from Zacks.com which I think does a very good job of highlighting the link between earnings and the market.  The author is Kevin Cook, who has written extensively on the market and earnings.

“While you enjoy your Labor Day weekend, and think about White House plans to give more people labor afterwards, you will have something else to look forward to when you get back to work and investing next week: earnings estimate revisions.

But many of these will not be of the happy kind. They will be downward revisions.

Below is how I summed it up on August 3 in “Look Out Below!” when the S&P 500 had punctured the June lows at 1,260 and I said “Next Downside Target: 1,200.”

“The next target will be somewhere in the 1,200 to 1,175 area. This is a highly likely scenario because the focus has shifted from exceptional earnings to questions about where the growth will come from to sustain them.

What you don’t see yet in the earnings picture is the downward revisions and warnings that will likely come after Labor Day in preparation for third quarter earnings season. Remember, equity portfolio managers have to look out at least two quarters to model their risk/reward.

PM’s listen to equity analysts because analysts have their ears to the ground on companies and industries. But analysts haven’t yet begun to lower their future earnings estimates.

In their line of work, they have the luxury of time on their side because it is far better to have lots of confirming data from the economy and from the companies themselves before lowering estimates than it is to be early and wrong.

So some PM’s will shift their asset allocations and, if in doubt about earnings and estimates, they will lighten their holdings of higher-beta growth names. Then when the lower estimates do roll in, the selling will really heat up.

Whether or not the economy actually logs another dip into recession territory, equities will be part of a self-reinforcing feedback loop that prices in much slower growth.

Why? Because Emerging Markets cannot get much hotter right now. And there is nothing in the data to suggest that domestic demand is going to pick up from here, especially as unemployment trends stagnant to higher.”

GDP vs. Corporate Earnings Disconnect

It was a big deal for me to get so bearish so quickly in early August. Why? Because even though I had grown cautious in May and went to over 50% cash in my personal portfolio, I was still bullish on global growth, especially from the double-digit engines we call Emerging Markets (EM).

It was wonderful to enjoy the unfolding record-breaking success story of the S&P 500 on its way to earning nearly $100 per share in 2011 and over $105 in 2012. But those July 29 GDP revisions which took first half growth down to 0.85% made me question all my assumptions.

Here’s what I said on August 2 in “Jobs, Growth, and Stocks: Perilous Company”…

“But, now that I think the catalysts — primarily sovereign debt crises vs. EM growth — are becoming less balanced, my view is shifting even more towards the “lower” part of the equation (based on my May 31 call for a ‘sideways-to-lower’ summer stock market).

Why? Because of the ‘structural economic internals.’ What I mean by that mouthful is that if EM is slowing down and GDP and jobs are weak, the economy cannot support the stock market at these levels. The earnings won’t be there in the next quarters.

On August 3, I’ll look at the chart of the S&P 500 and why a break of the 200-day moving average could finally take us down to 1,200, and probably much lower. I will also look at the dollar as a ‘scorecard and symptom’ of risk appetite that could confirm lower equity prices.”

So now that we have priced-in a mild potential recession, is it still possible that global growth from Emerging Markets could save the US economy from a worse contraction? Yes, it’s possible.

But the probability is pretty close to a coin flip when you look at the combination of weak US cyclical data and the engineered slowdowns occurring in “engines” like China.

And remember, the trend and momentum of the business cycle are a “big ship” that turns slowly. Corporate profits are inextricably tied to that cycle. Yes, many companies will still do well even in a slow-growth, 1%-GDP, muddle-through environment.

But, the negative feedback loop in an economic contraction is a falling tide that takes most stocks down with it.

As of August 31, the Standard and Poor’s website has the next four quarters of earnings estimates totaling $105. At an index level of 1,200, that’s a forward P/E multiple of 11.4. At S&P 1,100, it’s 10.5. Those are very cheap market valuations — as long as estimates and growth aren’t headed lower.

Even if I don’t and can’t know how bad things could get, as I said in my “Gray Skies” article earlier this week, I will be buying stocks at S&P 1,100 and lower when we go back down there.

See my “Recession Watch” articles linked below for bearish scenarios and possible government action to thwart them.

A Moving Puzzle

Markets are both a puzzle and a moving target. I have learned over the years to focus on “why the big money moves” into or out of stocks to help tell me what the next trend is.

Years ago, my knowledge was a hodgepodge of ideas about the economic cycle and “institutional money flow.” Last year, I reformulated that into clearer ideas about how the “outperformance” mandate of portfolio managers created certain rules for the game that made them “have to buy” stocks.

I wrote a series for The Options News Network in January 2010 titled “5 Secrets of Wall Street: Profiting from How Stuff Works.” Two of the “secrets” were “They Have to Buy Stocks” and “They Don’t Have to Sell.” (I will share more about these ideas in a future piece.)

Then when I discovered the Zacks model only early this year, I further refined my approach to focus more specifically on earnings momentum and analyst earnings estimate revisions (EER).

Needless to say, 2009 through 2011 has been my best stretch for market timing. But I don’t always tell the story that well when given my opportunity in a 30-second “elevator speech.” Like yesterday when I was on FOX Business in the closing hour with Cheryl Casone and two other guests.

One of them said that stocks would stay up and go higher into year end because of the need to “outperform benchmarks.” I shook my head in disagreement and the anchor came back to me. I explained that this was a minor factor now because of the probable recession and global structural issues greatly impacting the economic cycle.

Then I shared my prediction from August 5 that the market would trade between S&P 1,150 and 1,250 in a “wait and see” mode until we knew more about the probable recession.

(See my “Gray Skies” article and video below about how I’ve traded the short-term bottom at S&P 1,120 and profited from the relief rally with strong stocks and bullish 3X leveraged ETFs like UPRO and TNA. I took profits on those Wednesday and went short the market Thursday with SPXU and TZA, the inverse 3X bearish versions.)

As soon as I said it and my time was up, I kicked myself (figuratively, of course) for simply bragging about a prediction that had come true when I could have given them one from August 3 that has yet to be proven.

And that prediction, about the downward EER likely to come, may prove to be as powerful — in an unhappy way — as any positive jobs stimulus we get from Obama next week.”