In the past three months, the rate of increase in unemployment has slowed, consumer durables and consumer discretionary spending has increased and banks are raising capital and talking of paying their way out of TARP. Perhaps most significant of all, however, is that according to a recent article on CNN/Money.com, the combined decrease in home prices and an $8,000 government tax credit for home buyers, has created a 6.7% increase pending home sales in May over April's figures, which was "far above the forecasts of experts." After rising 3.2% from March to April, the pending home sales figures suggests that the U.S. has finally reached a bottom in the housing market.
Consequently, the S&P 500 has increased roughly 26% in the past three months and the market continues to reach new year-to-date heights with each passing week. In fact, the S&P 500 now stands at a positive 3% return for the year.
According to a recent Wall Street Journal article, most analysts on Wall Street are expecting a fourth quarter recovery, meaning GDP is expected to grow during the final three months of the year. President Obama and Federal Reserve are also expecting positive growth by the end of the year. At last, it appears as though we have finally reached a bottom in the economic cycle.
So the recession is over and it's finally "safe" to move our money from the sidelines and back into the market, right?
Not so fast.
The Wall Street Journal article mentioned above, entitled "Land Mines Pockmark Road to Recovery," is named as such for a reason. While most people "in the know" are expecting the start of a recovery in 2009, there are many reasons to think otherwise. In fact, most well-known investors will state that the worst time to invest is when everyone is positive that everything is headed upward. I couldn't agree more and believe, wholeheartedly, that any person entering today's stock market is setting him/herself up for potentially very large losses.
Naturally, one cannot predict a market downturn by strictly charting the market's psychology. Well, some may claim that they can, but even investment sages need more concrete evidence than that!
Now, I'm not a sage by any stretch of the imagination, but I am a "thinker," and when I look at even the broadest of economic data, it is very difficult for me to see any significant green shoots in the coming months and years. When I couple my viewpoints with a market that has skyrocketed during the past three months, only one result seems plausible. Market losses are on their way.
What signs am I seeing that others are not?
None that aren't available to all. But like most things in life, when it comes to data, it's not what you know, but how you interpret it. And based on the data that I will list below, I just don't see how the U.S. economy will turn positive during the 4th quarter and beyond for some time to come, at least in a meaningful way-- the way that most seem to think that it will.
- As mentioned in my previous article on the Chinese Yuan, the U.S. total federal debt currently stands at over $11 trillion. This does not include an estimated $52 trillion in unfunded liabilities (Social Security & Medicare and Medicaid). The U.S. government only has one recourse to pay for its massive debt-- it has to issue more bonds.
- Also mentioned in my previous article, China, Brazil and other countries are bypassing the use of U.S. dollars in its business dealings with each other, opting, instead, to exchange each other's currencies directly. There is also evidence that China, for one, is starting to grow its commodity reserves, which also impacts the value of U.S. dollar.
- U.S. long-term treasury notes and bonds are dropping in value as new bonds flood the market place. Investors are also becoming more skeptical that the U.S. will be able to pay back its immense debt over the long-term. In turn, long-term bond yields are rising, which will create higher borrowing costs for any person or entity needing a loan.
- T-bill prices have remained strong; in fact, the spread between T-bills and long-term notes and bonds has been growing. This solidifies the point of view that treasury investors are convincingly confident only in the short-term U.S. currency market.
- The Federal Reserve is buying U.S. Treasuries and mortgage-backed securities in excess of $1 trillion. This policy is, literally, the equivalent of printing money out of thin air. It would be equivalent, on a household level, to loaning oneself money using his or her credit card--just at a much lower rate... for now.
It is essential to note that this policy has never worked successfully over the long-term in the history of civilization, and, as most of us know by now, breaking a credit card habit is difficult to do. One would think that the government would be aware of this by now.
Also of note is that, as of 2006, the U.S. treasury department, no longer makes its M3 figures public knowledge. It has claimed that the data is too costly to produce, yet skeptics argue that it is the government's attempt to cover up how much currency is actually in supply, out of fear that the public will be alarmed by the staggering supply growth during the past few years.
- The U.S. dollar has fallen against some major currencies by more than 20% since its March highs. Over the last three months, as of June 12th, the Japanese yen has remained flat against the dollar; the Euro has risen 8%; the Canadian dollar 15%; the British pound 16%; the Australian dollar 19%; the New Zealand dollar 21%.
- Since March, commodity prices have risen significantly due to the decline in the dollar's value, supply constraint beliefs due to the tightened credit market, and the viewpoint that a U.S. and world recovery is in the cards for later in the year. China is expected to grow more than 6% this year, lending more faith in a global turnaround.
- The U.S. government is coming under pressure from world leaders, such as Angela Merkel, to stop stimulating their economies and, recently, even Ben Bernanke has started to add pressure to the government to curb its record spending.
- According to the latest Bureau of Labor Statistics information, the official unemployment rate in the United States reached 9.4% in May, more than a 5% increase from April. Although the increase in the unemployment rate has been steady at close to 5% month-over-month, most economists who see "green shoots" point to the decrease in month-over-month seasonally-adjusted payroll figures and remind us that unemployment is a lagging indicator as to the prognosis of the economy.
However, a figure that is often excluded when unemployment is discussed is the percentage of people unemployed, underemployed, and marginally attached rate, which gives economists a much more accurate picture of unemployment statistics. According to the Bureau Labor Statistics (BLS) that rate stands at 16.4% as of May and, although the growth appears to be slowing in recent months, it is important to note that, by the BLS's own admission, the underemployed rate is very difficult to calculate. In fact, the unemployment figure, which is the media's traditional headline number, is only based on those persons who have actively looked for a job during the past four weeks.
- Robert Schiller's Irrational Exuberance, Second Edition web page, states that real home values have fallen more than 55% since 2006 and are still more than 20% higher than the historical median, based on real home price data from 1890 onward. This chart compiled by The New York Times' Bill Marsh shows just how exuberant the housing market was at its height when compared to historical prices.
- According to the MIT Center for Real Estate, the Moodys/Real Commercial Property Price Index (CPPI) is approximately 50% higher than its base point of January 2001. While the historical data points in the index are limited, it is conclusive that the real estate market started to increase exponentially around the start of this period. In fact, based on Case-Schiller information, the boom in real estate started in or around 1997, so, in fact, the CPPI base figure may be drastically overstated as a historical starting point, meaning that the CPPI index might have even more room to fall from its current level. This means that the commercial real estate bubble is only just starting to pop.
- Research from the St. Louis Federal Reserve states that the U.S. historical median personal savings rate from January 1, 1959 until April 2009 has been 7.8%. If one excludes the data from January 2005 onward, since savings during this period until mid-2008 ranged from -2.7% to around 1%, the historical personal savings rate stands at 8%. As of April 2009, the personal savings rate was 5.7%, a 26% increase from March.
In my opinion, it is safe to conclude that due to deteriorating employment conditions, households will continue to save and savings will exceed the historical rate by probably 2-3%, to a rate of 10% or more.
- Consumer spending accounts for approximately 70% of GDP.
While every person will interpret the above data differently, I believe the coming months and years will pan out this way for the U.S. economy:
President Obama is recently on record as saying that the U.S. record deficit spending is "unsustainable," stating that eventually foreign lenders, such as China, will grow tired of holding U.S. bonds and will cause interest rates to rise. However, Obama also continues to push high cost programs through Congress. His latest program is health care reform, which could cost more than $1 trillion over the next 10 years but, according to the president, could save taxpayers money over the long-term. More than $1 trillion worth, however? While the president is correct that health care, based solely on the Medicare and Medicaid programs, such statements are clearly double-speak.
While I do believe that the Obama administration will push some sort of health care "reform" through Congress, even though our balance sheet most certainly cannot afford it, I also believe that the President's admission that our current level of debt being "unsustainable" is very important. Our federal debt as a percentage of GDP, currently at close to 70%, is nearly twice as large as during the Great Depression. Our federal budget deficit as a percentage of GDP, currently projected to be about 13%, is more than twice as high as during the Great Depression. In fact, the U.S. budget deficit as a percentage of GDP has never been greater than 10% during a non-war period... until this year.
For informational purposes, the most current State of the Economy report from the non-partisan Congressional Budget Office can be found here.
It is expected that inventory rebuilding, after consumer spending returns later in the year, will be the growth engine for the U.S. economy. However, it is my opinion that the U.S. consumer will continue to revert to their historical savings mean of 8%. Therefore, I expect any positive GDP data to be very subdued. I believe that the effect of the U.S. consumer's increased savings rate, as a result of unemployment continuing to rise into 2010, alone will effect the stock market and GDP figures dramatically.
While debt remains the single largest problem facing the U.S. economy, I believe that the dollar will remain relatively strong over the short-term, as it will remain the world reserve currency for the foreseeable future, and also due to financial and economic issues that I contend much of the Europe, especially Germany, has yet to deal with. I also believe more and more each day that China's current growth rate is unsustainable without further government stimulus. (I will address the foreign economic issues in a later article.)
However, I do believe that the U.S. dollar will devalue dramatically if the government continues down its current path. Fortunately, I believe that U.S. citizens are increasingly becoming more aware of this issue on a daily basis, and I am confident that it, as well as international bond holders, will force the U.S. government to deal with its lack of fiscal responsibility more quickly than expected. While this argument would suggest that inflation could grow substantially in the mean time, I believe that worldwide deflation will keep inflation moderated during the short-to-mid term.
As unemployment and savings continue to grow, it is my feeling that residential real estate will continue to revert to its historical mean. Accordingly, commercial real estate will continue deflate as unemployment and consolidation within the private sector continue. It is my belief that both residential and commercial values will fall further than most expect, as most corrections tend to do.
Also, I believe that the deflation in real estate will cause massive stress to U.S. bank balance sheets, which will cause the government to face the decision of whether or not to bail the banking sector out yet again. However, this time, with the U.S. economy being much worse off than during the previous round of bailouts, coupled with the unforgiving attitude of the American public after yet another failure, there is a chance that the government will, this time, force the banks to deal with their own problems. I believe this attitude will be especially strong toward those banks that have paid back their TARP money and assured the government and taxpayers that they are strong enough to sustain the current environment. But, in the end, politics will most likely rise to the top and result in yet another round of bailouts for most institutions, which will put pressure on the U.S. dollar and force bond interest rates to rise.
Fortunately for the U.S., however, it is my belief that the world will also be dealing with its own economic issues and, therefore, keep the dollar relatively strong. However, higher interest rates will continue to dampen domestic economic growth and the continued world economic difficulty will most likely result in higher commodity prices than those currently, as farmers, especially, will grapple with funding issues while demand remains relatively strong.
It is my feeling that most prognosticators are setting up the U.S. for an inflationary environment in which gold and other commodities will outperform. While I do not disagree with this thesis, it seems to me that it could be much more beneficial to find opportunities where others are not looking.
Based on my thesis, it is my feeling that opportunities are now present in 2010/2011 severe out-of-the-money puts of U.S. consumer discretionary stocks, especially those with high debt-to-equity ratios and a large exposure to commodity prices.
Most of these stocks have risen dramatically during the past three months as liquidity and risk returned to the market. As such, it is my view that there is, at best, limited upside for many of these securities, while at worst, many could revert to their lows of March during the next year or so. In both cases, however, long-term out-of-the-money puts are trading at very cheap prices at the moment and if the market continues to make new highs, they could become even more inexpensive based on their risk-reward potential.
It is my opinion, based on my thesis, that in either of these cases, consumer discretionary stocks will fall dramatically from their current levels and, while they may not reach their strike prices, they should, most certainly, increase in value during their option dates. And where shorting a stock provides, at best, a potential 100% return on investment, options can provide an exponentially greater return with less risk, and, at the same time, protect oneself more so than shorting would, should the U.S. dollar react adversely to economic conditions.
The following are a few securities that, in my opinion, fall into the category in which I describe, and ones that I will be looking to potentially take put positions in, once I research each more thoroughly, during the coming time period.
Whole Foods Market, Inc. (WFMI) has risen more than 100% year-to-date, even though it is still dealing with the integration of Wild Oats, its former largest organic food competitor, which it acquired in late 2007, and its added debt to their balance sheet, as well as a deteriorating consumer base in a price sensitive market, increased competition from Albertsons and Safeway, who have been renovating stores to confront Whole Foods head-on and higher commodity prices. WFMI's reached an intraday low of $7.04 in November 2008 and was around the $12 range during the market's March 2009 low. It currently trades at close to $20 and its January 2011 options, while not trading as cheaply as some of the other companies I will mention, are worth consideration with its $5 puts trading at close to $0.30.
DineEquity, Inc (DIN) has risen more the 150% year-to-date, although the merger of Applebees and IHOP leaves this company with a debt-to-equity ratio of nearly 60 and negative operating margins in a very competitive, flooded casual dining market, at a time in which consumer savings, unemployment and commodity prices are increasing. DIN's 52-week low, reached in February 2009, is $5.24 and although long-term puts are not yet available, probably due to the chances that DineEquity could face the potential of bankruptcy, its December 2009 $10 puts at $0.75 might still be attractive, although I would probably feel more comfortable shorting the stock until 2010/2011 puts become available, as it currently trades at close to $30.
RadioShack Corp (RSH) actually has a very clean and attractive balance sheet; however, it trails market leader Best Buy by a very wide margin and is considered inferior in many respects to its big box competitors. With the government mandated switch to digital television now complete, I expect RadioShack's earnings to fall accordingly. RSH's 52-week low of $6.47 was reached in March of this year. Its January 2011 $5 put trades at close to $0.50; for more risk-reward, its January 2011 $2.50 puts trade at around $0.10. RSH currently trades near $14.
Macy's (M), the famous big box retailer with an equally infamous amount of debt is also worth a look with January 2011 $5 puts near $0.90 and $2.50 near $0.30. Its 52-week low is $5.07 and was reached in November 2008. Don't be surprised if it surpasses it by January 2011 with its shares currently exchanging hands at $12/share.
MGM Mirage, Inc (MGM) and Las Vegas Sands, Inc (LVS) have massive debt and both are struggling to maintain its debt covenants, at a time when consumers are more risk averse and interest rates and oil (air travel) are rising. Also of note are the facts that Las Vegas and Macao each have a glut of casinos, which will hamper margins for the foreseeable future, and MGM is currently building the most expensive casino complex in the world (City Center at $8.5 BB), which is due to be completed later this year and China has restricted the frequency of its citizens to Macao. January 2011 $2.50 puts stand at close to $0.60 for both firms. With 52-week lows for MGM at $1.81 and LVS at $1.38, both reached in March of this year, the risk appears to be worth the reward. MGM currently trades near $7/share and LVS at close to $9/share.
I believe that substantial downside potential also exists for Caribou Coffee Company (CBOU), especially with the emergence of McDonald's Corporation on the premium coffee scene and Ruth's Hospitality Group, Inc (RUTH), due to an increased focus on corporate expenditures and higher commodity costs. While not included in the consumer discretionary sector, I believe that Avid Technology, Inc (AVID), with the emergence of Apple as a dominant low-cost producer/provider of film editing software, is also worth a look.
*** The author does not hold positions in any of the stocks mentioned in this article.