Weekly Wrap-up: Some Risks for 2006
Last week in this space I wrote:
... in a world in which barriers to international trade and investment continue to fall, the flow of "wealth" from the US economy into less wealthy economies (in the form of our importing "tradables" and exporting money) will continue until such time as those less wealthy economies are no longer notably less wealthy.... And it may go on a lot longer than many think possible.
Ultimately...the net result will be the leveling of the global playing field in terms of the wealth of nations.
To elaborate on this theme further, the US TRADE DEFECIT may not so much be an expression of a DEVELOPING IMBALANCE (as Stephen Roach and a gathering cadre of skeptics would assert), but may well be THE PROCESS BY WHICH AN EXTANT IMBALANCE IS CORRECTING ITSELF.
Let's grossly oversimplify it.
Suppose that all of us in the US are in one bathtub...and many Asian nations are in adjacent bathtubs. Now suppose that the water in our bathtub (our accumulated wealth) is 3 feet high. And suppose that the water in their bathtubs is just 1 foot high. The removal of the barriers between and among the tubs (removal of barriers to trade and investment) creates an outpouring of water (wealth) from our tub into their tubs until a common level is achieved.
Now, if all you're looking at is the FLOW of water (money) it looks like there is a developing and unsustainable imbalance insofar as much more water (money) is running from our tub into their tub than is moving the other way (on balance we are exporting money via the trade deficit).
And of course, if what I've described above is the whole dynamic, then at some point, pretty soon, the water levels in the various tubs will be normalized at a level much lower than 3 feet.
But, what if in addition to the complex flow of liquid(ity) among the tubs we also must consider how liquid(ity) (value) is being added to the tubs from other sources? Then the computations become immeasurably more complicated. And this is where our discussion last week about the price of the median home relative to the price of gold is important-- and where our discussion of the DEflation of goods and services generally relative to assets (as well the deflation of currencies against assets) may be even more important.
In that context let's look at Household Sector Net Worth in the US.
At first glance we see that the trend in Household Assets (black) has continued to advance. And while Household Liabilities (red) have grown as well, the trend in Household Net Worth (green--the difference between the black and the red) is also still quite positive...in dollar terms.
That said, there is a troubling element in the relationships among these trends. While Household Assets have grown at a compound annual rate of 6.7% over the past 10 years, Household Debt has grown at an 8.5% rate over the same period Consequently the trend in Household Net Worth has advanced at a slower 6.3%.
But remember, this advance is denominated in dollars that are deflated relative to assets and commodities. So, while the Consumer's balance sheet looks good against a basket of goods and services, it would not look so impressive against a basket of hard assets and commodities.
And this fact could be of some concern down the road when foreign countries may decide that they their bathtubs and our bathtub are filled to relatively similar levels. At that point the wish to buy US Dollars and US Debt could wane and force a further downward adjustment in the dollar and a rise in interest rates. And that's where the structural change in the FLOW of LIQUIDITY could force some wrenching adjustments to the US standard of living.
Look at what's happening right now that could function as warning shots across the bow.
This chart shows the relationship between Household Liabilities and Household Assets. Those liabilities are now at a new high, above 18% of Assets.
"Yeah, but low interest rates make those liabilities more affordable" goes the apologists' argument.
Yes and no. That argument HAS made some difference. But less so more recently.
This chart is problematic. The Debt Service Burden as a Percentage of Personal Income has soared to a new high at 13.75%.
The Consumer's bathtub has endured heavy outflows as Consumption now outstrips income. However, the tub has been filled via asset (home-price) appreciation. But on balance the Consumer is now left with a large unpatched hole in his tub (Debt Service Burden).
As the US economy is now more dependent than ever on the dollar's (and Treasuries') appeal to foreign investors, the fate of our economy is now more dependent than ever upon its continuing to be an appealing place for foreign money to invest itself. In this context we have the goofy situation in which the US Economy is a "leveraged play" on ITSELF! Strength in the economy will beget further investing interest in it. And weakness in the economy will beget leveraged self-reinforcing DISinterest in it.
These kinds of leveraged plays can do well...but the risks are increased.
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WEEKLY ECONOMIC NEWS DIFFUSION INDEX (WENDI)
For those of you who are new to our Weekly Wrap-up our WENDI work involves reviewing the prior week's major economic reports. We assign each report a value anywhere between -1 and +1 in half-point increments. A very bearish report gets a -1, and a very bullish report gets a +1. And, say, a qualifiedly bullish report gets a +0.5.
We then sum the individual scores, divide by the total number of reports, and multiply that fraction by 100 to derive the Weekly WENDI (black line below), expressed as a percentage of anywhere between -100% and +100%. (The former is maximally bearish and the latter is maximally bullish.)
The Cumulative Weighted WENDI (red line below) is the running sum of the individual scores (raw trend). The 4-Wk Weighted WENDI (blue line below) is the sum of the past 4 weeks' individual scores divided by the total number of reports over the same period, and it tells us about the momentum in the flow of economic news.
Our Weekly WENDI dropped -7 points to +23% last week in a period that was light on news (11 reports, where the average is 13). The economic news was positive but just a bit less so than in the prior week. That pushed the Cumulative Weighted WENDI up a couple of points to +263, a bullish if modest rise that's very much in line with the northward-pointing, scalloped trend in the flow of economic news. The 4-Week Weighted WENDI, which identifies trends in momentum, is near the top of its 18-month range at +29%. So, it's decision time for the economy. Is it going to accelerate or will things turn south as the holiday shopping season draws to a close?
Our educated guess is that momentum will sustain for just a bit longer and then deteriorate as we head deeper into 1Q06 and normal seasonal deceleration.
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There isn't a whole lot of action on the earnings-revision front at this point in the season. Mid-quarter updates have been coming out but guidance is for the most part cautious.
The trends in our 3 earnings lines remain intact but are continuing to rise more as a function of the passage of time than of any changes in quarterly or annual estimates. The Quality of Earnings remains solid with Reported EPS (pink line) just 7.4% below Trailing Operating EPS (yellow line). And the prognosis for Operating EPS growth at 11.7% for the coming year.
The consensus for F52W EPS now stands 15.7% above where it stood a year ago.
That's down from the 20%+ highs seen in '04, but still well above the +10% level that has historically been an important cut-off point. Over the past 10 years the market has remained in bullish configurations unless/until the blue line has been either in a downward trend below +10% or else below 0%. Should CY06 EPS estimates remain where they are, anticipating growth in excess of 11%, the market is likely to avoid any really serious pitfalls. However, if the EPS estimates start falling off that +10% table, we'll be looking for more precipitous sell-downs.
The market remains cheap on a F52W PE basis.
While PE is not necessarily a great short-term timing device, here's an interesting statistic: over the last 20 years when the SPX has had a F52W PE of less than 17 it has never been lower 2 ½ years later.
Could that change? Sure it could. But the precipitate of that change would most likely be a significant increase in inflation....something which is not on any near-term horizon. (Of course we'll keep our eyes peeled for it.)
The Fed's Fair Value calculation yields a target of SPX 1875. (F52W EPS divided by the yield on the 10-Yr Treasury. That's $85.06/.04537= 1875.)
Our Risk Adjusted Fair Value (RAFV) calculation takes into account the added risk posted by the more dangerous post-9/11 world. The SPX has had a F52W Earnings Yield that has, on a median basis been 1.93% above the yield on the 10-Yr Treasury. So, we'll accept that the SPX "should" be as relatively cheap as it has been on a median basis since 9/11. Our calculation divides F52W EPS by the sum of the 10-Yr Treasury Yield and the median post-9/11 Risk Premium. $85.06/(.04537+.0193)=1316.
We continue to expect the SPX to kiss its RAFV price before this late-year rally is finished. Just as it did in late '03.
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On Tuesday the Fed will raise the Fed Funds rate to 4.25%. The spread between the 10-Yr Treasury Yield and the Fed Funds Rate will fall to about 27 basis points.
With the US Economy set up as a leveraged play on itself (as discussed above), an inverted yield curve (which historically has a tendency to slow economic growth) could pose some serious problems as the market heads toward a 4-Yr cycle low in October '06.
While we remain bullish for the rest of December, 2006 could be a tough year for the bullish case.
Best regards and have a great week.