Download “An era of optimism dies in the crisis, but in dying, it gives birth to an

“An era of optimism dies in the crisis, but in dying, it gives birth to an error of
pessimism. This new error is born not an infant, but a giant.” Arthur C. Pigou
When Liz Ann Sonders first read this quote, she noticed the play on words “error” for “era”.
After reflecting on that play as it relates to the financial crisis, she sees how pessimism became
an error of judgment, causing many investors to miss the market’s monumental rebound since
the March 2009 lows. Remaining anchored in the error of pessimism, many continue to miss the
bright spots of unfolding positive economic stories. Below is a summary of the stories Liz Ann
told at Barron’s Top 100 Independent Financial Advisors Summit held in Orlando March 6-8, 2013.
Recent GDP Numbers
One quarter’s GDP numbers are not all that exciting to Liz Ann because they are always
adjusted. She noted the latest quarterly numbers are likely outliers:
GDP growth
3Q 2012
3.1%
4Q 2012
-.1%
She does not believe in conspiracies as some do, but rather attributes the dramatic change to
unique moves in federal government spending and inventory adjustments that caused Q3 to be
overstated and Q4 to be understated. For example, during the 2012 4Q, federal government
spending fell 15% from Q3 after rising 9.5% during Q3 from Q2. Reality that will be captured in
future GDP revisions is likely in the middle of 3.1% and -.1%.
The big story in the last half of 2012 GDP numbers is the trend in residential housing.
Residential construction increased 13.5% in Q3 and 15.3% in Q4. This could add a point to
future GDP growth.
Long-term GDP Trends-“It’s hard to get hurt falling out of a basement.”
Swings in GDP have become less dramatic with more mid-cycle pauses. A chart of real GDP
growth since WWII shows that from 1948 to 1978, declines in GDP led to dramatic rebounds.
Think of a stretched rubber band snapping back. Debt has dampened upswings since 1978
causing muted snapbacks from recessions.
Further, we have experienced three consecutive mid-year slowdowns in GDP and may
experience another this year. If so, expect the double-dippers (an error of pessimism) to
pronounce they were right about a looming double-dip recession. Liz Ann declared that the
statute of limitation for a double-dip recession is over with the Great Recession now five years
behind us. She will be looking at economic diffusion index charts exhibiting economic strength
minus weakness for clues of a mid-year slowdown.
Financial Conditions are much healthier and have recently moved into the best zone for
stock market returns. The National Financial Conditions Index (NFCI), which measures weekly
monetary conditions in the traditional and shadow banking systems, shows that we have pulled
out of the recession with steadily improving financial conditions. Since 1973, the S&P 500 Index
returned 10.4% annualized when the NFCI was in the current zone.
Fiscal Cliff and Sequester
After all the media hype, the cliff turned out to be a fiscal slope, likely to put a 1% drag on GDP.
This “new” drag from tax hikes replaces the “old” drag from waning 2009 fiscal stimulus enacted
in 2009.
Businesses are hoarding cash at levels not seen since WWII. Reflecting heightened
uncertainty, businesses have become their own bankers. This has caused pent up demand for
investment and capital expenditures.
Federal Reserve Policy
Liz Ann believes the recent market upswing has been driven by the better economy, not solely
QE from the Fed. She views easing of fed market operations as a good thing. While normalizing
monetary policy will be positive, it will add to market volatility.
Central Bank Policy from 2002-2013
Inflation forced some central bankers to lighten up on stimulus from the 2008 easing cycle, but
now all central banks are easing. This is why global equity markets and economies are better.
Size and rate of increase in Fed’s balance sheet causes some to worry, “Is inflation an accident
waiting to happen?” Yet velocity of money remains depressed. Without a pickup in the velocity
of money, inflation will not occur. The big questions are, “When will velocity pick up?” and,
“What will the slope look like?” Liz Ann showed a chart illustrating the growing gap between
U.S. bank deposits and U.S. bank loans, something to keep an eye on to anticipate future
inflation trends.
Debt & Public Sector Deleveraging
“There are two ways to conquer and enslave a nation. One is by the sword and the other is by
debt.” John Adams
Debt deleveraging causes anemic recoveries, the conclusion of extensive research by Reinhart
and Rogoff. From 1790 to 2009 advanced economies, average GDP growth was cut in half to
1.7% when debt-to-GDP was 90% or above. U.S. federal debt is currently 102% of GDP.
But, while we are not yet on the path to stabilized debt-to-GDP, there is some good news. The
deficit is improving. Federal outlays as a percent of GDP is trending down from peak Great
Recession levels while federal receipts as a percent of GDP are trending up from Great
Recession lows.
Liz Ann expects decent economic growth even if fiscal drag continues. Lessons from recent
past fiscal contractions in Finland, Sweden, UK and Norway show that even with fiscal drags
ranging from 1.1% to 1.6% of GDP, their economies grew at rates ranging from 2.7% to 3.8%.
Furthermore, private sector deleveraging has come a long way. Household debt as a
percentage of household debt, which had ballooned to 130% at the height of the housing
bubble, is no longer a danger. Current private debt servicing levels are so low that if the private
sector were its own economy, based on levels observed since 1980, we would likely see 3.3%
real GDP growth and 2% payroll growth. With both housing and stocks moving higher, Q1 2013
wealth effect may add 7% to 9% growth in consumption. The wealth effect is now firing on both
cylinders, both stocks and house prices.
Liz Ann’s Consumer Stress Index, which is the Carter-era Misery Index on steroids, shows
that consumers’ stresses have eased significantly. Higher home prices and lower inflation and
debt have helped ease household financial stress, bringing it to a low zone.
Bright Spots & Untold Stories
U.S. Manufacturing Renaissance and Energy Independence Story
A renaissance in U.S. manufacturing and energy production could become bright spots for not
only the next several years, but for decades. Key advantages enjoyed in the U.S. contributing to
the renaissance include: restrained U.S. labor costs in contrast to big emerging markets wage
increases, abundant energy and low natural gas prices, low dollar, digitization, labor market
stability, rule of law, economic and accounting transparency, favorable demographics, deep and
liquid capital markets, well-developed infrastructure and superior inventory control, a contrast to
energy problems in Japan and Eurozone uncertainty.
With U.S. energy production trending up during the last few years and imports trending down
since the Great Recession, U.S. energy independence is no longer a pipe dream. Indeed, the
International Energy Agency predicts the U.S. will be energy independent by 2025.
Liz Ann first got wind of this renaissance five years ago while in China. Several Americans came
up to her after she spoke to a crowd and told her they were seeing a shift in the cost of Chinese
wages and housing and warned her to keep an eye on the trend for goods to be made in
America again.
This trend can be seen in GDP numbers. Manufacturing has risen to 13% of GDP. (Consumer
spending still accounts for 70% of GDP, so we have a long way to go before rising to levels
seen in the 60s and early 70s.) We’ve started making things and exporting again. Key reason—
no upward pressure on costs in the U.S. Energy independence will drive significant future
economic growth.
Liz Ann showed a chart of the multiplier effect on jobs from different industries, which bodes well
for future GDP growth. For example, an Economic Policy Institute study shows that 100 jobs in
petroleum produce 1,190 other jobs, 100 jobs in chemicals produce 495 related jobs, 100 jobs
in automobiles create 464 related jobs, 100 manufacturing jobs produce 291 jobs and 100 jobs
in construction produce an additional 190 jobs. The U.S. renaissance will be biased toward
energy and autos.
After plummeting during the Great Recession, manufacturing capacity has begun to recover.
Equipment and manufacturing plants are the oldest on record. Liz Ann sees capacity ramping
up with a large replacement cycle likely.
The Housing Story
A key housing market index, the National Association of Home Builders (NAHB)/Wells Fargo
Housing Market Index or HMI has surged in percentage terms to unprecedented levels. Yet, the
HNI has stalled in the last two months and is worth watching to see if sales trends continue.
The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to
take the pulse of the single-family housing market. The survey asks respondents to rate market
conditions for the sale of new homes at the present time and in the next 6 months as well as the
traffic of prospective buyers of new homes.
[A sharp decline in this index in 2006, caused Liz Ann to predict a recession, long before Mr.
Market moved from euphoria to despair. We were there and heard her words of caution many
months before the housing market plummeted. So, when Liz Ann notes significant changes in
this index, we take heed.]
With seven quarters of positive contribution to GDP after six years of drag, the housing sector is
becoming a bigger contributor to GDP.
Having recently touched a record relative to income, the housing affordability index is great
even with the recent run up in housing prices. As a percentage of disposable personal income,
home prices are at record lows. Meanwhile, inventories are at record lows, explaining the recent
weakness in sales. Sales are weak due to lack of inventory, not demand.
Furthermore, household formation has doubled from historic lows hit in 2010 and the
supply/demand gap--measured by net household formations versus housing completions--has
opened up. Household formations now exceed home completion.
According to Liz Ann, real mortgage rates remain key to housing demand and home price
trends. Real mortgage rates are more important than nominal mortgage rates in driving
demand. She defines real mortgage rates as:
Real mortgage rate = nominal mortgage rates – real inflation/decline in housing prices
At the housing peak, the real mortgage rate was -10.8% with the nominal mortgage rate of 6.1%
mortgage interest rate minus 16.9% appreciation. With the real mortgage rate at a negative
10.8%, no wonder there was a housing bubble.
In contrast, at the bottom of the housing market, real mortgage rates were +21.8% with nominal
mortgage rates of 5.1% minus the negative 16.7% depreciation in housing process. At real rates
of 21.8%, caused mainly by the decline in housing prices, no wonder demand for housing dried
up. Even with very low nominal mortgage rates, demand stalled. The decline in housing prices
had to stop before demand could pick up, regardless of how low nominal mortgage rates were.
With nominal mortgage rates currently at 3.5% minus 12.6% appreciation in housing prices, real
mortgage rates are now -9.9%. No wonder we’re seeing a pick up in demand.
Housing is closely tied to unemployment. With the pick up in demand, economists estimate that
700,000 housing-related jobs will be created in 2013, another reason for optimism.
Unemployment, Recessions, Recoveries and the S&P 500 Index Annualized Returns.
Economists have long contended that the unemployment rate is a lagging indicator. Indeed, the
unemployment rate lags the economic cycle big time. Liz Ann showed a chart demonstrating
that unemployment rates peak as recoveries begin and are at their lowest as recessions begin.
High unemployment cause investors to be pessimistic at market bottoms and low
unemployment causes investors to feel optimistic at market peaks. The best time to buy stocks
in when unemployment has peaked. Indeed, since 1948, when the unemployment rate has
exceeded 6%, the S&P 500 Index returned a 13.4% annualized gain. In contrast, when the
unemployment rate is less than 4.3%, the S&P 500 Index returned 1.7% annualized.
Stock & Bond Market Valuation and Sentiment
Stocks lead the economy. The market anticipates economic inflection points. It does not react to
them.
This may be the most hated bull market ever. Many investors aren’t even aware of the bull
market or its strength. In a investor sentiment survey conducted by Franklin Templeton,
respondents were asked whether the stock market was up or down during the previous year.
For 2009, 66% of respondents said the market was down. The S&P 500 Index was actually up
26.5% from 12/31/2008. For 2010, 49% of respondents said the market was down. The S&P
500 Index was actually up 15.1%. For 2011, 70% of respondents said the market was down.
The S&P 500 Index was actually up 2.1%. The open questions is, “How many will say that the
market was down in 2012 when it was actually up 16%?” With the market recently hitting new
highs, the results will be interesting. Stay tuned.
After a lengthy post financial period where stocks were banished in favor of bonds, January saw
huge equity inflows. Another question that looms large is, “Has the tide turned?” Data show it
has not. Money continues flowing into bond funds. Funds flowing into stocks during January
appear to be coming from cash and money market funds.
Pension plans have de-risked from 60% invested in equities in 2005 to less than 40% as of
12/31/2011. Endowment funds’ equity exposure is way down to 33%, with alternative strategies
now comprising 53% of total endowment assets.
Yields are rising from historic lows and fed manipulation and deleveraging is expected to keep
them down…for now. Fed’s stated threshold of unemployment dropping to 6.5% before easing
will end puts monthly payroll numbers into the spotlight.
[Liz Ann’s charts indicate that should payroll additions continue at the above 230,000 pace
reported for February, one could expect unemployment rate to hit 6.5% in March 2014. The Fed
would then take their foot off the accelerator with the rate on the 10 year Treasury Note likely
reaching 3.9%.] Stock and bond prices are positively correlated. Therefore, higher stock market
prices may accompany higher bond yields.
On forward earnings, stocks appear undervalued. The current forward P/E of 14.5 is below the
median since 1990 of 16.6. This gives the market a little breathing room in face of waning
earning growth.
A note of caution for the near term, investor sentiment is rising with the rally with the Ned Davis
Research Crowd Sentiment Poll above 66%. Since 1995, this level of bullish sentiment has
been followed by a 9.2% annualized decline in the S&P 500 Index. So, Liz Ann wouldn’t be
surprised to see a near-term market pull back.
Mr. Market’s Emotional Roller Coaster
Liz Ann concluded her remarks with a chart capturing Mr. Market’s emotional roller coaster
through a market cycle. Bear markets end at the point of maximum despair and bull markets
end at the point of maximum euphoria. Mr. Market moves from despair at market bottoms to
hope to relief and then he crosses the line into optimism. Feeling good, Mr. Market then moves
to enthusiasm to exhilaration and on to euphoria. She believes Mr. Market has just barely
crossed the line into optimism, causing her to believe the ride has just begun.