As I’ve mentioned in previous communications, I’ve expected 2012 to be a solid year and indeed, it is off to a very strong start. The first quarter has shown signs of strength in both worldwide economies and financial markets. There comes a time, however, when we need to wonder how much good news is priced into the markets and build new expectations around proven new facts.
Now is one of those times.
An example of what I’m talking about came earlier this month in the form of McDonald’s earnings announcement. The report was good; earning met expectations and business in general seems to be just fine. But challenges in some important areas began to show up. They discussed a rise in commodity costs and slightly lower international sales as potential headwinds for future earnings growth. Are these leading indicators of the fundamental state of global profitability that need to be considered? Do they speak to a stuck-in-the mud future for McDonald’s and other multi-national companies?
In my opinion, keeping a close eye on how inflationary pressures mixed with consumer weakness in key parts of the world, most notably Europe, might creep into the overall earnings equation is smart. I think the market’s recent strength is justified. I also think these comments from McDonald’s are going to be more prevalent and become a cap on just how much farther we can expect earnings to rise for a while. So I’m still comfortable with earnings prospects and still believe the stock market shows some value; but the pace of the upside seems likely to slow a bit.
Shifting from golden arches to gold bars, a recent household survey conducted and published by CNBC last week is a bit concerning to me. In a very early edition of Worth Considering, on October 7th of last year, I wrote the following: “Please be mindful of the potential for a continued rise in the US Dollar and decline in the price of precious metals. I don’t believe the intermediate and long term trends in these assets are broken, however. Please don’t position yourself too aggressively to take advantage of the long term trends until the nearer term phases play out a bit more.” I need to echo this remark, especially about gold at this particular moment. Incidentally, since the time of my comments, precious metals like gold and silver are essentially unchanged as is the value of the US dollar against most major currencies. In that same period, the S&P 500 has risen more than 20%.
One of the major arguments of gold bulls is that gold is still under-appreciated and relatively under-owned. It is always a good sign for any asset if its fundamental value is misunderstood and the investment community and the general public alike are still unaware or even opposed to the situation. Beyond the obvious in-vogue inflationary and geopolitical cases for gold, one of the main theories bulls cite for why it has plenty of room to rise is that the public hadn’t yet gotten involved in the bull market. This recent survey by CNBC pokes a huge hole in that theory. Their findings were that “gold is seen by the American public as the best investment right now, chosen by 37 percent of respondents. Real estate is a distant second with 24% followed by stocks at 19%.” One of the pollsters, Jay Campbell of Hart Research added that “if not first, gold comes in as a very close second among investors.”
These aren’t survey results gold bulls would love. Bull markets are born and mature as very lonely creatures. They end when they reach unsustainable popularity – particularly among every day investors. It was true with technology stocks and houses and it’ll someday be true about every asset’s period in the sun, including gold. My message here isn’t to dislike and/or not own gold. I just want to keep expectations realistic and dispel the myth that no one beyond the perceived financial elite is talking about gold.
Beyond the golden arches and gold bullion, there are plenty of interesting things happening in the world. I’ll briefly touch on a few of them.
One obvious noteworthy topic is the price of gas. Yet again this spring we have the annual prediction of rising gasoline prices throughout the upcoming summer driving season. Along with this prediction also comes the call for the economy to suffer dramatically under unrelenting energy costs. By all means, if the price of gas rises substantially from here there would be an adverse impact economically. But as Brian Westbury, the Chief Economist at First Trust, pointed out: “what analysts are missing is that households’ financial obligations – recurring payments like mortgages, rent, car loans/leases, as well as other debt service – are now the smallest share of income since 1984. As a result, consumers can lift their spending faster than their income.” He uses observations like these to point to a continued economic recovery in a general sense, and the ability for gas to rise a bit higher without doing irreparable damage as one specific piece of the equation.
But what about another noteworthy topic – the upcoming election in France? This topic hasn’t gotten much air time in the news yet, but I suspect that it will. What if Sarkozy isn’t re-elected; what type of impact might this have on the relative calm throughout Europe at the moment? According to Harris Interactive, President Nicolas Sarkozy is now in the process of overcoming a 10 point deficit in the polls and currently has taken a 1 point lead roughly three weeks ahead of the elections on April 22nd. His closest challenger, Francois Hollande, is widely seen as someone who would wish to alter the current course of coordinated action between France and the rest of Europe. It is well known that having France, Germany, and many monetary authorities on the same page has been vital to keeping Europe from falling off the cliff. If France were to scale down or back away from their current understood posture, negative ramifications throughout Europe should be expected.
Spain is another European subject that will likely make a lot of headlines in coming months, regardless of the French election. Recent months have seen both Spain and Italy issue bonds at levels much better than feared; meaning it didn’t cost them as much as feared to borrow capital. However, the more recent trend sees those same borrowing costs pushing higher in Spain. Spanish borrowing costs are not at panic levels, but this most recent trend bears watching as a potential flash point.
And then, of course, there’s China. Two readings of Chinese manufacturing showed conflicting results. HSBC’s survey indicated output decelerated at the second-fastest rate in three years while the Li & Fung report showed a strong increase. This serves to underscore why I prefer to invest in the growth of China through indirect investments in companies that serve the growing Chinese middle and upper class consumer rather than making direct investments in Chinese companies themselves. It is nearly impossible to have a sense of confidence in most economic or earnings numbers that are put out; but the growth in their consumer spending can’t be fabricated. Suffice to say that if China’s growth rate were to truly slow at anything other than a modest pace, there would be negative effects felt worldwide.
Turning attention back home – have Treasury bonds begun to reverse their course permanently? The answer, of course, is that nobody knows. Many of the best bond investors of our time are at odds on this topic. What I think is important to do is differentiate between government and corporate bonds when reviewing a portfolio. The first quarter of the year saw Treasury prices suffer quite a bit while corporate bonds surged. Corporate balance sheets for the most part look terrific; not quite the case with Uncle Sam. The best course of action in the bond markets nowadays, in my opinion, is to not venture too far out in time. Default risk in corporate America is pretty low. And while I don’t predict the default of US government bonds, I also don’t want to own them very heavily in today’s interest rate environment. Short and intermediate term corporate bonds of most ratings, however, shouldn’t face much complication even if rates rise on the government side. Keep in mind, however, that long dated bonds of even the greatest company on the planet will lose value in a steadily increasing interest rate environment. That is simply a function of math and not credit quality.
As for recent commentary on stocks here at home, it made big news recently when Goldman Sachs stated that stocks are presenting a once-in-a-generation buying opportunity. They are not the only group making some lofty claims and raising projected levels for the indexes. We’ve recently seen some outspoken bears adopt bullish stances as well. It’s nice to hear positive commentary, but along the lines of my comments earlier about gold, it is also a little worrisome when things like this happen.
I’ll end with some thoughts on the monetary policy comments and actions of Ben Bernanke and some updated numbers on the US economy.
With respect to the economy, we just got another positive indicator this week in the ISM manufacturing index announcement. Manufacturing came in better than expected in March and remains at levels that signal continued expansion in the factory sector. This index has now been in an expansionary reading for 32 straight months. Last week we saw some important data regarding inflation. Government data showed that overall consumption prices are up 2.3% in the past year, above the Fed’s supposed target of 2%. “Core” prices are up 1.9% from a year ago and have risen at a 2% rate in the past three months. Given healthy spending patterns and inflation already at their target, the Fed seems to have no justification for another round of quantitative easing. Yet, Ben Bernanke left that option on the center of the table in a speech last week. The Chairman plainly sees that we are in the midst of a modest but unspectacular expansion. His fear is that some type of language he uses might appear to be too optimistic about the economy and not overly concerned about downside risks. If that becomes his perceived public stance there might be a strong uptick in bond yields and that would, in turn, hurt the fragile economy. There are downside risks to our recovery, and Bernanke isn’t out of line for expressing concerns, but at a minimum he is doing his best to talk bond yields down and nurture the expansion. At worst he is really mulling another form of QE that could feel good in the short term, but potentially painful when the effects wear off. I believe his stance about keeping rates on the floor until late-2014 is more than enough. He very well might not be able to keep that promise if the economy continues to meander to a healthier place.
The takeaway:
- As was cited in the example of the Golden Arches, there are some yellow caution signals flashing on the horizon. They don’t point to a dire scenario, in my opinion. They are yellow lights, not red. But they do make the case for maintaining a balanced portfolio rather than betting on a full speed global recovery just yet. After all, the continued economic recovery in the US is real even if it isn’t strong and its underpinnings aren’t ideal. Just don’t over-do it.
- Many analysts that have been bearish have recently turned bullish. Lookout when this happens.
- As for bonds, corporate bonds of reasonable length are still attractive; but government bonds are too risky for my taste at current real yield levels.
- When it comes to precious metals, be aware that the period of obscurity is over. Moms and Pops around the country are aware of and involved in the bull market. This fact alone certainly doesn’t kill the bull market, but should still temper enthusiasm in the near term. Own gold and silver as an important part of a comprehensive portfolio, but don’t make them a “make it or break it” asset for you. Don’t do that with any asset for that matter…..ever.
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