The Permanent Income Hypothesis

By: Henry To | Wed, Jan 17, 2007
Print Email

Dear Subscribers,

It is said that the majority of New Year's Resolutions are not kept - which is not a surprise - as human nature tends to lack discipline and the patience/endurance to break out old, bad habits. I have been guilty of this all too often, especially when it comes to trading the stock and financial markets. That being said, I am going to commit myself this year to write commentaries that are more succinct (but which does not leave out any substance), as I know our subscribers are always pressed for time.

Many of you in the past have written asking us to devote more of our commentaries to individual stock picks or even manage a portfolio in real-time. I have partially responded to these requests by bringing in Rick Konrad from Value Discipline - a former institutional portfolio manager for over 25 years and a brilliant analyst on many things besides the financial markets. Along with our other regular guest commentator Bill Rempel, Rick has brought and will bring many more individual stock ideas for you to consider, along with a reasonable voice should this author ever get out of line! In addition, one of my friends and I will be starting up an investment management partnership later this year. It is mainly going to be an equity long-only fund - with various hedges in place should the general market or selective industries get too out of line. I will be mostly responsible for the qualitative analysis, while my partner will be responsible for the quantitative and the forensic accounting analysis (the comparative advantage law works best when you have more than one person running a company or an investment partnership!). Once our investment management business is fully in place, I will definitely have more individual stock ideas for you.

That being said, I do not intend to run a real-time investment portfolio on this website anytime soon. My "specialty" has always been macro analysis - and I do not want to take away a significant chunk of my time away from macro analysis in order to run an investment portfolio. I want our macro analysis to be one of the best out there - as many investors and traders have come to rely on us to time their stock market (and other financial instruments) purchases. Macro analysis and global money flows are also my first love. More importantly - and this may come as a surprise to some readers - I do not believe having a portfolio of stocks on our website will benefit our subscribers to any significant extent - as buying individual stocks only work if you have the knowledge, confidence, and patience for your purchases. Buying based on a mere recommendation (even from Warren Buffett or Peter Lynch) will not work - as you will not have the conviction to hold them for the long-term. And believe me, you will lose your conviction at the precise moment that you need them. According to Morningstar, the total annualized return for the Legg Mason Value Trust Fund (run by the great manager, Bill Miller) was 12.14% as of December 31, 2006. And yet, the investors return (what actual retail investors reaped from the fund) was a mere 9.30% annualized, as many investors timed themselves out of gains and chased performance. Having a portfolio of stocks on our site will only work as long as subscribers know about each individual stock as well as we do or better yet, do their own independent analysis. And while some subscribers will inevitably do that - based on past experience - most will not. However, we will continue to give you stock ideas on companies that we think deserve more research. From thereon, everything else will be up to you.

Before we continue with your commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,171.08 points.

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,051.08 points.

As of Sunday afternoon on January 14, 2007, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel, GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials. Moreover - judging by what we saw at the Consumer Electronics Show in Las Vegas last week, there is a good chance we are now seeing a revival of Sony as a great global corporation (barring a global economic recession, the rest of this and the next decade will be known as the age of the emerging market consumer). We also continued to be very bullish on good-quality and growth stocks in general.

In the short-run, the market is still vulnerable to some kind of correction - given that earnings season is going to ramp up this week. That said, expectations are relatively low this quarter, so corporations may continue to surprise on the upside. However, such a correction is definitely overdue, as bullish sentiment has turned higher in recent weeks (even though the market was in a consolidation phase) and as the market has not experienced a significant correction in over five months. Speaking of corrections, there is a good chance that both the correction in crude oil and natural gas has already ended late last week. Make no mistake, however, I still believe the pricing environment for energy and commodities in general will be tough this year - but for now, we have probably found a short-term bottom. Over the longer-run, however - as I have illustrated in last weekend's commentary - I still believe that U.S. equities in general will be one of the best performers in 2007. And even though I believe that both energy and commodity prices in general will struggle this year, I continue to be a secular energy bull - as long as there is no breakthrough in battery or solar energy in the next few years.

As many of you may know - Milton Friedman - who passed away last year at the age of 94 late last year, left behind many legacies. One of them is his theory of "permanent income hypothesis" - which essentially states that consumers based their future consumption patterns on long-term income expectations, as opposed to current income.

Why is this important? One of our premises for the continuation of the bull market in the United States and for the economy to reaccelerate early this year is our belief that the U.S. consumer is not close to being tapped out. The perma-bears would claim that much of the "mortgage equity withdrawal" over the last few years went directly into consumption - but as I have discussed many times before, a significant chunk of the MEW actually went towards paying off (higher-yielding) debt, not consumption. Another chunk of it went towards home improvements or starting businesses - both activities that could be classified as investments or capital spending (which is good for future economic growth).

The reduction in higher-yielding consumer debt is directly reflected in the consumer credit growth numbers over the last few years, as shown in the following chart:

Monthly Annualized Consumer Credit Growth (12-Month Smoothed)* (January 1989 to November 2006) - Both revolving and non-revolving consumer credit growth has been on a declining trend in the last four years - even as the U.S. emerged out of its latest recession in November 2001. In the latest month, the growth of the 12-month average of total consumer credit declined from 4.06% to 4.05% - the lowest growth since December 1993.

Look - the U.S. consumer is not that stupid. Quite often, they may not be looking at the right places, but if they turn on the TV or open the newspapers and see all this talk about the "U.S. housing bubble," then (according to Friedman's Theory of Permanent Income Hypothesis) they will appropriately plan their current spending patterns assuming the rise in home prices will not extend indefinitely into the future. In other words, all this talk about the U.S. housing bubble over the last 12 to 18 months (and how this would bring about a consumer-induced recession) actually helped prevent one - as many U.S. consumers had already planned (by cutting back their spending or paying down debt earlier in the process) for such a recession in advance.

So Henry, what happened in 2001? How did that recession come about?

The recession in 2001 was in fact preceded by a significant decline in capital spending - and in fact, the U.S. consumer never really retrenched (although they did suffer a significant slowdown). Many U.S. large caps had no cash - and many companies that did have cash had to suffer huge write-offs because their customers had no means to pay or had no cash or credit to buy any more equipment. In short, many U.S. companies stopped investing - not only because they did not have the means but also because there was such a huge overcapacity in the technology sector. Today, the situation has been reversed - as U.S. corporations are sitting on huge amount of cash and as businesses and consumers start to demand better wireless and fiber optics technology.

To a certain extent, the slowdown in consumer spending in 2001 was partly due to the mistaken belief that the rise in stock prices in the late 1990s was permanent. The March 2000 to September 2001 decline in stock prices shattered that belief - leaving a huge negative impact on U.S. consumer spending. Today, the bursting of the U.S. housing bubble had no similar effect, as many U.S. consumers never believed that the rise in housing prices were permanent - thus retrenching in advance. Milton Friedman saw this nearly 50 years ago. On the other hand, many economists today are still surprised by the resiliency of U.S. consumer spending. It is time to change your expectations, folks.

Based on my assertion that U.S. consumers are still not tapped out, and based on many of my commentaries over the last few months, I believe that 2007 will be a decent year for the U.S. stock market. Sure, margin debt is now at a high not seen since March 2000, but as we have discussed before, the amount of margin debt outstanding has historically tend to make new highs in each successive cyclical bull market - even during the secular bear market of 1966 to 1974. Moreover, as exemplified by the Barnes Index and the fact that S&P 500 earnings have been increasing at a quicker pace than the S&P 500, valuations are still relatively decent. And finally, the U.S. stock market is not even close to exhaustion, given that U.S. retail investors have been shunning domestic equities for the last 12 months - and given the following chart (this is the first time we are showing this) showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to December 2006) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio suggests that the market is not near exhaustion - indicating that the bull market is not over yet.

I got the idea of constructing the above chart from Ned Davis Research - who had constructed a similar chart for a Barron's article a few months ago (his assertion was that we are also not close to a significant top in the stock market). Make no mistake: The ratio between money market fund assets and the market cap of the S&P 500 is probably not a great timing indicator - but what it does show is the amount of "cushion" that we have in order to insure against a significant market decline. While this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet. Based on historical experience, this author will not be too concerned until this ratio hits a reading of 15% or below. Assuming that the amount of money market funds remains the same going forward, the market cap of the S&P 500 has to rise a further 13% before we see such a ratio. Based on the above study, we will remain 100% long in our DJIA Timing System.

More follows for subscribers...



Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

Copyright © 2005-2009

All Images, XHTML Renderings, and Source Code Copyright ©