If we look back at 2011, it began on a high note and had a rough middle, but finished on a more positive tone. GDP for the first three quarters came in at an annualized figure of 1.2%.¹ While the 3% fourth quarter estimate being widely predicted will help the year’s overall numbers, it will not be anywhere near the 3-3 1/2% economists widely forecast at the start of the year.

Due in part to the sluggish growth noted above and in part to worries over world events, the S&P 500 finished 2011 almost exactly where it began the year. The stock market moved positively during the first 4 months of the year, then reversed course. Strong tornados hit Alabama and Missouri. Japan was hit by a tsunami which significantly damaged a nuclear plant. The debt ceiling issue played out mid-year, after which Standard & Poor’s downgraded U.S. Treasury debt. Europe grappled with financial issues which impacted both their stock markets and ours. By mid-year, bearish news of a recession for the United States dominated the air waves. I would note that in the 26 years I have been in the investment business, I have noticed that bearish market calls appear to receive the heaviest press coverage. This year was no different.

I look at the investment environment like a scale – with positive items on one side and negative ones on the other. I do currently see more weight on the positive side than the negative. On the positive side, the U.S. is seeing a number of new oil and gas drilling techniques that have unlocked large amounts of natural gas. So much gas has hit the market that prices are now close to a 10-year low. The United States is now also a net exporter of oil-based fuels (gasoline, diesel, jet fuel, etc.)² – a change of which most Americans are still unaware. Other positives include new technologies like the internet cloud, tablet computers, and smart phones – all of which are increasing productivity and output. The Federal Reserve is very accommodative, meaning they are keeping interest rates low and allowing for easy access to lent capital. Federal spending is actually declining as a percentage of GDP.³ The housing decline that started in 2006 seems to be closer to its final stages. Lower real estate prices have increased affordability. As with much in life, these positives do not stand alone.

The increased affordability of housing has come at the cost of equity loss for many homeowners. While government spending in relation to GDP is slowing, it is still too high. While an easy Federal Reserve boosts growth, it will cause inflation down the line once the stimulus is pulled back. Most economists do not foresee a return of the high inflation levels of the late 70′s and early 80′s, but an increase of a more moderate level once we see upside pressure on wages and real estate – which would seem to be a few years out.

2012

I believe we will see 2012 come in with GDP growth in the 2 – 2 1/2% range, with gains in personal income and spending. I think stocks will move higher in 2012, based on an expectation of a durable U.S. economic expansion. It is being widely predicted that Europe will enter a recessionary phase. While this is likely, its impact on the U.S. economy is likely to be minimal. About 10% of the U.S. GDP is exports. Of our total exports, less than 20% go to Europe.⁴ Another way to look at this is that exports to Europe make up less than 2% of the U.S. economy. Some large banks do have exposure to European debt and have been reducing their exposure to European debt due to the changes seen over the past year. However, this debt exposure is concentrated to five giant bank/brokerage firms – Goldman Sachs, Citicorp, Bank of America, Morgan Stanley, and JP Morgan Chase. Exposure to European debt outside these companies is very limited within the U.S. banking sector.

The coming year is likely to look much like the previous – slow, but steady growth. While fears of a double dip recession have largely been forgotten and we are in a growth cycle, this is not robust growth. We are likely to see another year of positive, but incremental, change. Relatively high levels of stock market volatility are likely to remain as investors see slow growth and retain fears prompted by the recent recession. I expect to continue to focus on dividend-oriented businesses that do not rely on discretionary purchases as I search for appropriate investments for your portfolio. While 2012 is unlikely to be a banner year for the market, there are a number of underappreciated assets for the prudent investor to find.

1) We Were Too Optimistic, First Trust, 1/3/2012

2) http://www.forbes.com/sites/sap/2011/12/04/inside-americas-energy-export-boom-10-key-insights/

3) http://www.marketwatch.com/story/till-debt-do-us-apart-2012-01-17

4) http://www.ustr.gov/countries-regions/europe-middle-east/europe/european-union

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.

There has been a fair amount of press commentary speculating on the European debt situation pushing the U.S. economy into recession.  However, the actual numbers suggest a different perspective.  Exports to every other country on the globe only make up slightly more than 10% of the U.S. economy.¹  Exports to the European Union comprise less than 2%!²  Third quarter GDP growth was 2.5%.³   This means that even if all exports to Europe were to be stopped immediately (which is not going to happen), we would still see U.S. GDP rise by about 1/2% annually. 

 History shows that adverse conditions in the economy of a major trading partner do not necessarily impact U.S. corporations.  Japan’s economy has been ranked third or fourth largest in the world the past few decades (behind the U.S., Europe, and now China).  You may recall the severe Japanese downturn of the 1990′s.  It lasted the entire decade and affected all portions of the Japanese economy.  Although they were a major trading partner of the U.S. at the time, this downturn was not measurably felt by U.S. corporations during that decade of domestic prosperity. 

 Japan is also an excellent example of catastrophe failing to materialize.  I recall a number of pundits declaring the March earthquake and tsunami would drag the Japanese economy into recession and pull the U.S. economy along with it.  The reality has been far less dramatic.  The earthquake occurred in mid-March.  It did disrupt the Japanese economy and we saw second quarter post negative GDP.⁴  The third quarter has posted growth of 1.5%.⁴  That’s an annual rate of 6% GDP growth!  The earthquake’s impact on the U.S. economy seems to have been limited to delays in the supply chain for auto makers and dealers, computer companies, and the like.  These issues appear to have passed.

 I am not suggesting that the U.S. economy would be completely immune from a European downturn.  I am saying that U.S. exports to Europe are a very small part of the overall U.S. economy.  A European downturn is not likely to significantly alter U.S. exports  and, thus, significantly change or alter our economy as exports are a small portion of GDP.

 Changes in Europe

Europe does have a severe situation that needs to be addressed.  Both Italy and Greece have now seen changes in leadership.  The new ruling governments are expected to make significant changes in the fiscal picture of each nation.  Government spending must be reduced in both countries.  The only way to keep each country from spiraling into chaos is austerity measures.  It appears that the new faces of government in Italy and Greece are taking their responsibility seriously and will make the needed cuts. 

 Spain and Portugal are the other two countries with notably high debt levels in the Eurozone.  Spain saw flat GDP numbers for the third quarter.  Portugal has seen another quarter of contraction.  While not at dire levels, Portuguese third quarter GDP has come in at -1.6% annually.⁵  Further austerity measures are needed in each of these countries as well, but the situation is nowhere near as critical as for Greece and Italy.  Spain does have an important election coming up this weekend (November 20).  The party that is currently leading in the polls is promising to shake up government and make the changes needed to address Spain’s economic situation.

 All of the countries mentioned above have structural changes beyond government spending levels that need addressed.  Opening a business in much of Europe is a laborious process that requires substantial time, and often money.  While this system protects entrenched interests of varying types, it quashes innovation.  This is a well-known issue within economic circles.  It is hoped that the new governments will make changes in areas such as permitting & licensing, indemnity bonds, etc. that will allow new businesses to be created and contribute to their economies.

 There is some good news coming from Europe.  Ireland has contained its fiscal crisis and will not need further support from the EU.  Ireland’s fiscal troubles were mostly caused by state guarantees of national banks deeply involved in an Irish property bubble rather than conventional government overspending.  However, the government was still on the hook for bank losses and had to pass austerity measures in order to lower debt ratios and contain the damage.  Irish GDP is now growing.  In fact, the third quarter shows an annual GDP growth rate of 6.5% for Ireland, compared to just 0.8% annually for the Eurozone as a whole.¹ Due to this growth, Ireland has recently announced plans to exit the Eurozone bailout machinery. 

 Much of the European economic picture will depend on how quickly and thoroughly the Italian and Greek governments address their debt levels.  The change in leadership is an excellent sign of priorities shifting towards seriously confronting the fiscal issues within these countries.  It remains to be seen whether these countries will look to their changing reality as a push to creatively work smarter and better, or if riots will dominate the public response. 

 Summary

We have heard a number of pundits declare we are on the brink of financial ruin for the past 2 years.  You would think that being wrong so many times would be cause for pause and reflection.  That does not appear to have happened as many of these same loud voices are still searching for new ways to imagine the financial collapse of the nation.  Reality shows U.S. economy still improving. 

 It’s easy to get distracted by turmoil in Europe or noise from politically based domestic events, but the overall economic news for the country has not changed recently.  Unemployment numbers are consistently coming in better than expected and being revised downwards (meaning there are fewer unemployed workers than previously noted).  Retail sales figures for the third quarter have come in better than expected, but confidence remains low.⁶  The country is not roaring back to growth, but neither are we sinking into another recession.  Below is a list of a number of relevant data points:

  – Earnings growth for the S&P 500 in the 3rd quarter was 17%, with 12% expected for 2012.⁷

 - Retail sales increased by 1.1% in September, the highest rise in 7 months.⁸

 - Industrial production and factory output both saw increases, albeit at modest levels.⁹

 - Capacity utilization increased slightly.⁹  While still a bit below the long-term average over the past few decades, it is slowly working back up to the average.

- Housing starts rose 15% in September (from August), driven in large part to a multifamily construction increase of 51%.¹⁰

 - Weekly hours, aggregate hours, and weekly payrolls are all on a clearly defined upward trend.¹¹  The only soft employment sector is state and local government, where tax revenue declines have forced employment contraction. 

 I could list other metrics showing a similar story, but I imagine you get the picture – steady, but measured, growth.  Past recoveries have had more pronounced growth, but this is still a recovery nonetheless.

1)  http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS

2) First Trust Monday Morning Outlook, November 14, 2011

3)  http://www.reuters.com/article/2011/11/03/us-usa-fed-idUSTRE7A057A20111103

4)  http://www.tradingeconomics.com/japan/gdp-growth

5) http://www.marketwatch.com/story/germany-france-buoy-euro-zone-growth-2011-11-15?dist=beforebell

6) http://www.nationalpost.com/related/topics/retail+jumps+confidence+still+fragile/5554610/story.html

7)  Briefing.com, The Big Picture November 7, 2011

8) http://www.census.gov/retail/marts/www/marts_current.pdf

9)  http://www.federalreserve.gov/releases/g17/current/

10)  http://www.census.gov/const/newresconst.pdf

11) http://www.bls.gov/web/empsit/ceshighlights.pdf 

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different.  The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties.  Individuals are encouraged to seek advice from their own tax or legal counsel.  Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.  Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.

The market has bounced around this week over concerns regarding Greece and Italy.  By the end of the week both countries had announced new political leadership, which the market does like so far.  There is a general perception that the new leadership is likely to deal with economic issues in a more realistic fashion when compared to the previous leadership, which was highly entrenched in both countries.

The other news of note this week was a decline in jobless claims for the week ending November 5th.  New claims are at their lowest level since early April.¹

1)  http://www.nytimes.com/2011/11/11/business/economy/jobless-claims-fall-to-lowest-level-since-april.html

Q3/11

Positive Surprises:            227/323 =  70.3%

0% Surprises:                   32/323 =   9.9%

Negative Surprises:             64/323 =  19.8%

SOURCE:  Bloomberg

http://www.bloomberg.com/news/2011-10-28/third-quarter-of-11-s-p-500-earnings-snapshot-as-of-oct-28.html

Current market optimism is predicated not just on unexpectedly positive third quarter figures, but also on the expectation of future growth in earnings.  There are a number of areas of the economy one can look to when forecasting the future.  One key area is railroad freight volume.  Union Pacific, the largest railroad in the U.S., saw third quarter revenue rise by 16% over the previous year, with earnings rising by 19%.  Smaller national and regional railroads have also been in the news with increasing freight volume driving increasing earnings for the industry.  CSX, Rail America Inc, Norfolk Southern, Kansas City Southern, and CN Rail (Canada’s largest railroad) are just a few examples of railroads making recent news due to increased revenue and earnings.  Similar reports have been coming out of trucking companies, with Knight Transportation showing a year-over-year revenue increase of 18.7% for the third quarter.

A great deal of yesterday’s stock market move reflects optimism over the Euro debt plan that Germany has now agreed to.  European banks are the largest Greek bond holders and have been resistant to the idea of taking substantial losses on these holdings.  This has now changed.  Banks holding Greek debt have agreed to take significant write downs on their holdings – likely 50% – in exchange for European governments agreeing to back the banks in each of their countries.  The exact details are still being worked out, but the major points of the plan have been accepted by the key players involved.  While not a perfect solution, the market is judging this a workable plan that will allow Europeans to take the losses needed from Greek investment and move on.

These companies are just a few that have released third quarter figures, but show better than expected profits across a wide range of sectors.  As I have been mentioning for some time now, corporations are making money.  The volatility in the stock market we have seen this summer has been driven in part by emotional responses to European events that have little to do with the actual financial picture of most U.S. corporations.  The market drop we saw in the fall of 2008 took place in the context of lowered corporate earnings.  How significant of an earnings drop was to be seen was a large unknown at that time.  The current situation of rising corporate earnings clearly differs from the situation seen in 2008.  Most economists do not feel we are going to have a double dip in the U.S. economy and the upcoming earnings reports are likely to reinforce this view.  I would note that one of the more respected market technicians (a specialized market analyst) I subscribe to does think we have seen the lows of the current market.  I will give you additional information regarding further earnings releases as they come in over the next two weeks.

I would note that account values have fluctuated greatly from day-to-day during the past few weeks.  The monthly statement(s) you are receiving now were generated on September 30th and are dated.  Should these statements be generated today, you would likely see meaningfully higher account values given the market rise since the end of last month.

The news out of Europe continues to wag the tail of the U.S. stock market.  Much of the focus is on Germany and how the German government will react to the sovereign debt developments of weaker European nations.  Germany’s export market was around 20% of GDP prior to EU integration.  It is now around 40%, with most of the growth coming from EU partner nations.  Germany has benefited greatly from the European common currency and Euro zone agreements.  If the Euro were to unravel then Germany would get hit harder than many other European nations.  The German government understands the ramifications of Euro dissolution and is working to prevent any unraveling of the current system.  While the average German taxpayer does not appear to have much interest in helping economically weaker countries in the Euro zone, the government and much of the business community are working towards preservation of the current system.

It is looking more and more likely that Greece will default on its debt obligations sometime late this year or early in 2012.  Unnamed sources at the IMF have begun commenting on the likelihood of default before Spring 2012¹ and the Royal Bank of Scotland (RBS) expects to see default in December during Greece’s next IMF review.²  RBS has noted a lack of promised reform, unrealistic austerity targets, increasing difficulty in getting the Greek parliament to pass laws, and an increasing unwillingness of the IMF and European Union to compromise on their demands of Greece as the reasons default is likely this winter.  

Greek default will have a negative impact on European banks – most heavily upon German and French banks.  The German government is already preparing for this development and will help German banks hurt by a Greek default.³  Helping banks affected by default is seen as a much more sound long-term fiscal policy than continuing to help a government mired in mismanagement.  We are also likely to see Greece ejected from the EU as member nations tire of Greece’s inability to manage government finances.  German lawmakers in particular have been quite vocal in calling for Greece’s expulsion.⁴  

 Greece has never had a reputation for competent government management.  It became a nation in the modern era in 1829, but did not transition to a modern economy until war pushed it to do so in the era of WWI and its aftermath.  Greece has seen major economic crises play out  almost every decade since 1900.  While one would expect to see negative effects on European economies from WWI, the Depression, and WWII, Greece has also seen a civil war from 1944-1950, a coup d’état in 1967 that lead to dictatorial rule through the early 1970′s, inflation almost 20% (3 times the EU average) in the 1980′s⁵, and triple digit debt-to-GDP ratio in the 1990′s⁵.  While Greece was able to do much to improve finances and meet EU eligibility requirements for stability during the late 1990′s, that position has not been the norm in the economic history of Greece.  It cannot, therefore, be a shock that the country is having problems. 

 The effects of Greece, Italy, Spain, Portugal, and Ireland on the Euro has already been felt and priced into the value of the Euro.  I visited Italy in September of 2002.  I recall the Euro being worth slightly less than the dollar at that time.  Now we see a Euro worth about $1.40 U.S. as of September 9th.  Just a few months ago the Euro was even trading at about $1.50 to the U.S. dollar!⁶  As Greek default becomes more sure we are likely to see the Euro drop closer to parity with the dollar.  The consensus estimates from what I have been reading seems to be parity within 2-3 years as the sovereign debt situation in Europe plays out over the near future.

 The good news in this situation is that Greek default has been seen as a likely outcome within economic circles for quite some time now and is already mostly priced into the market.  While we have not seen reports regarding certain Greek default in the general media, this has been an issue widely noted and followed by economists and analysts for some time now.  A portion of the market volatility we have seen this summer has been directly linked to this issue and it being priced into the general markets.  Analysts of European banks have known for some time now that banks holding Greek bonds would not be getting back 100% of principal invested.  They have already priced in a default to their analyses, so a default will not be a shock to the system.  I would also note that default does not mean Greek debt holders receive nothing.  They are expected to see a partial repayment of debt.  What is unknown is the rate of repayment that can be expected.  That rate is likely to become more clear as we reach the December IMF review of Greek finances. 

 I would note that a Greek default is not without precedence.  Argentina saw  economic collapse (extreme currency devaluation and hyperinflation) in the late 1980′s and then outright default on debt in 2001.  It has recovered from these events and at $370 billion now has a GDP about 20% greater than Greece’s⁷.  There is no reason why Greece cannot similarly recover from default.

 A number of analysts see Greek default as a positive development.  It will allow for resolution to the situation for the Greek people, provide certainty (and calm) to the markets, and allow European banks and governments to regroup and move towards the future.  Knowing when to cut one’s losses and move on is part of a leader’s job.  EU countries like Germany and Finland have recently been quite vocal about their willingness to end the Greek crisis by allowing default.  I agree that it is time to make this call.

 U.S. Outlook

I don’t have much to add to my analysis of the U.S. economy in the August newsletter.  I have not seen much change in the U.S. situation over the past few weeks and the points I made then are still valid.  I did read an interesting article on CNBC this week that made a useful analogy.  It included commentary on the U.S. economy from Stephen Schwarzman, the CEO of the private equity firm Blackstone.⁸  Mr. Schwarzman compared the U.S. economy to the body of an out-of-shape athlete.  He noted that the U.S. government spending has historically been about 20% of GDP.  (This would be true since the early 1950′s.⁹)  That level has now risen to 25%.  I would elaborate on the analogy a bit.  Like an athlete that has allowed their waistline to grow and muscles to contract we have allowed spending to grow and infrastructure to shrink.  We need to see some combination spending reductions and tax increases on the part of government.  The Bush era tax cuts that may be allowed to expire are worth about $70 billion.  You may recall that S&P asked to see $4 trillion in deficit reduction when they downgraded U.S. debt.  So, while $70 billion would help the fiscal picture, government spending needs to be reduced. 

 In addition to discussions around spending cuts, we need to see a discussion about spending priorities from governmental leaders.  What is clear to me, and the business community members I interact with, is a need to focus more on the infrastructure spending.  We have water mains, bridges, air traffic control systems, a national electrical grid, and other such basic systems that are in great need of repair and/or updates.  Spending on these types of projects is really needed and the nature of the work would provide better paying jobs.  A reprioritization of spending with an eye towards the infrastructure needs of the country would seem to be more productive endeavor for the administration to focus on. 

 1)  http://www.businessinsider.com/senior-imf-economist-expects-hard-default-for-greece-soon-2011-9

2)  http://www.investmentweek.co.uk/investment-week/news/2106938/rbs-predicts-violent-greek-default-december

3)  http://www.bloomberg.com/news/2011-09-09/germany-said-to-prepare-plan-to-aid-country-s-banks-should-greece-default.html

4)  http://www.reuters.com/article/2011/09/08/germany-finmin-idUSL5E7K80CK20110908

5)   Elisabeth Oltheten, George Pinteras, and Theodore Sougiannis, “Greece in the European Union: policy lessons from two decades of membership”, The Quarterly Review of Economics and Finance Winter 2003

6)  http://www.x-rates.com/d/EUR/USD/graph120.html

7) http://en.wikipedia.org/wiki/Economy_of_Argentina

8)  http://www.cnbc.com/id/44437298

9)http://www.usgovernmentspending.com/downchart_gs.php?year=1903_2010&view=1&expand=&units=p&log=linear&fy=fy12&chart=F0-fed&bar=0&stack=1&size=m&title=&state=US&color=c&local=s

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different.  The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties.  Individuals are encouraged to seek advice from their own tax or legal counsel.  Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.  Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.

European Uncertainty
Turmoil in the markets has begun to seem the new normal this month.  As the economic picture for some of the southern European countries has darkened, many investors have become understandably nervous.  Germany and France are the main drivers of the euro zone economy.  As other weaker countries increasingly rely on Germany and France to shore up their finances, German and French taxpayers have become more disgruntled over the need to divert resources to other countries.  The uncertainty over how far taxpayers in more economically sound nations are willing to go in order to prop up other nations in the euro zone is at the heart of the current market instability.

A proposal has been put forth for the euro zone to create and release a Euro bond in order to meet the debt obligations of the region as a whole.  However, this would require German willingness to back the repayment of these bonds.  Since a number of countries in the euro zone may not be able to contribute their fair share to the repayment of such bonds, a disproportionate amount of repayment would likely land upon German shoulders.  So far they are unwilling to take on this type of obligation.  This situation has led to an increased likelihood of European recession.  A number of economists now put this figure at 50%, meaning there is an even chance Europe is facing a renewed recession.

How does this affect us in the United States?  European Union statistics show Europe accounting for about one-fifth of U.S export totals.¹  While this is clearly a minority stake; it is still a large portion of U.S. exports.  If Europe does enter a recessionary period, a large number of corporations here will see some effects on their business.

U.S. Outlook
U.S. corporations continue to show good profits.  In fact, they are earning record profits.  A July 29th article by Market Watch notes that profits are the highest they have been in 60 years.  Profits for 2008, 2009, and 2010 were actually $343 billion higher than previously estimated.²

Europe is not the only region that affects U.S. companies.  Japan has seen better than expected GDP figures as their economy has fared better than forecasted in the aftermath of the March earthquake.  Emerging markets are seeing average growth of about 6% annually.³  U.S. corporations are affected by the growth we see in these areas.

GDP forecasts are educated guesses that are constantly revised.  Most economists upwardly revised their 2011 growth forecasts at the beginning of this year.  They are now generally revising those numbers downward.  GDP estimates for the rest of the year are still in positive territory though.  Goldman Sachs recently revised their figures to 2% through early 2012, rising to 2.5% thereafter.⁴  The estimates do still show an expectation of further growth rather than contraction, albeit at most modest levels.  Morgan Stanley went on to note that although recession is quite possible for Europe, and even possibly for the U.S., over the next 6 to 12 months it would not be of the sort seen in 2008-2009 for either region.  If we do see recession in either economic zone it is likely to be shallow.

I would note that while the chance of U.S. recession has recently increased, most analysts still think recession is not the likely scenario.  A one in three chance of recession – the most widely agreed upon current figure – means that the quoted economist believes it more likely that we will not see recession. They believe we are twice as likely not to see another recession as to actually see one.  Additionally, this is the same chance given to the economy of entering into recession during 2010.^5,6  So, while the likelihood of U.S. recession has grown it is still not the expected path of the U.S. economy.  Slow growth is more likely than recession.

Debt Downgrade
The recent downgrade of U.S. debt by the S&P (but not Fitch or Moody’s) does deserve a mention.  This downgrade was expected.  S&P put the U.S. on Credit Watch negative by mid July.  On July 21st they said a downgrade would be likely unless budget cuts of $4 trillion were part of the debt ceiling deal.⁷  The cuts were not part of the deal, S&P followed through with their downgrade.  There was much media speculation this would lead to increased borrowing costs for consumers.  Such ideas have been proven wrong.  In fact, mortgage rates have fallen from about 4 1/2% to just over 4%.⁸  We have not seen credit card rates rise as some pundits had stated would occur.  Most significantly, the downgrade is likely to lower gas prices as it triggered lower crude oil futures prices.  This was yet another economic incident blown out of proportion by media hyperbole.

I recently read an interesting piece outlining the effects of the current low in interest rates.  Some companies with AAA credit ratings can issue debt for such low yields that they theoretically could use bond proceeds to buy their own stock back and net a profit from the difference between the interest they would pay on the bonds and the dividends they would receive from the stock!  In reality, all that has really risen with this downgrade by 1 of the 3 major ratings agencies is fear levels.

Summary
There are plenty of reasons to be pessimistic right now.  U.S. unemployment remains relatively high.  While the situation has improved, it is doing so at a very slow rate that is not likely to increase.  Bipartisan efforts to address the deficit over the next decade have largely failed.  Consumer uncertainty is negatively affecting retailers; although there are preliminary signs of a bottoming out here.³  Productivity gains are placing more pressure on workers who are not seeing pay growth.  Housing remains a weak area of the U.S. economy.  However, second quarter earnings for the S&P 500 are up 12% over the previous year.  Analysts have estimates of the third quarter showing an increase of 16% over the third quarter of 2010.³  Corporate profits are the prime motivator of stock market activity and they are up significantly.

It is quite understandable that investors would be nervous right now.  The decline in the market seen during the recent recession was of a scale not seen since the technology based bear market 10 years earlier.  For many investors this downturn was either the first they had seen or the first that significantly affected them.  An investor accustomed to seeing an ever increasing portfolio value is going to experience quite a shock when that balance begins to decline if they have never been through a previous down market.  Combine this with worries over unemployment, governmental gridlock at the federal level, and local government cutbacks and it’s enough to make anyone jumpy.  However, it is important not to allow emotion to override better judgment and keep focused on long-term strategies during such times.

The Price-Earnings (P/E) ratio of all stocks with earnings has fallen to 13.8 from 17.2 over the past 6 months.⁹  This decline has attractively priced a number of stocks and we have seen quite a bit of insider buying within the market over the past few weeks as a consequence.  The research firm TrimTabs calculated $861 million in insider buying from August 1st through August 12th alone.  To put this in perspective, this is the most insider buying in a single month since March 2009 (a month at the low point of the most recent major market decline).¹⁰  These insiders are not trading on information unavailable to the general public, but rather on the balance sheet figures they see rather than the fear they may feel.  Insiders can certainly be wrong, but this is a strong indicator that professionals familiar with many companies feel strongly enough that their company is currently undervalued that they are willing to invest heavily.

We are likely to see more negative news over the coming weeks as the governments of Greece, Spain, Portugal, Ireland, and other European nations continue to struggle to shore up their balance sheets.  Uncertainty over how far Germany and France will be willing to go to help these governments will likely continue to roil world markets.  Dysfunction within our own government is likely to continue to make U.S. investors nervous.  We are not on the brink of world economic collapse though.  In 10 years time it is likely August 2011 will be just another fluctuation on a long-term chart that no one remembers any better than they remember September 2001 or February 2003 today.

1)  http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113465.pdf, pg.4

2)  http://www.marketwatch.com/story/corporate-profits-share-of-pie-most-in-60-years-2011-07-29

3)  Barron’s, August 20, 2011 The Economy is Slowing, Not Stalling

4)  http://finance.fortune.cnn.com/2011/08/15/three-headwinds-to-corporate-profit-growth/

5)  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aluoqvsvAwO8

6)  http://money.cnn.com/2010/07/08/news/economy/double_dip_recession.fortune/index.htm

7)  http://www.bloomberg.com/news/2011-07-28/s-p-s-chambers-says-u-s-4-trillion-deficit-cut-is-good-down-payment-.html

8)  http://www.bloomberg.com/news/2011-08-18/u-s-mortgage-rates-fall-to-lowest-in-at-least-50-years-freddie-mac-says.html

9)  ValueLine Investment Survey August 19, 2011

10)  http://money.cnn.com/2011/08/11/markets/insider_trading_bulls/

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different.  The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties.  Individuals are encouraged to seek advice from their own tax or legal counsel.  Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.  Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.

Commodities and Inflation

As I mentioned last month, higher commodities prices create higher levels of inflation, creating a drag on economies.  Lower commodities prices are good for an economy as consumers then have more money for discretionary spending.  That is still the bottom line when it comes to commodities and their effect on an economy.  So what are the current trends in commodities prices?

The Dow Jones UBS Commodities Index has seen a 12% drop since the spring of this year.¹   While commodities prices are higher than they were a year ago, we are seeing an easing.  Oil prices driven high by political change in the Middle East have begun to pull back.  Some U.S. car prices increased slightly as supply problems originating in Japan decreased competition in the market.  These increases are expected to be rolled back as Japan’s recovery continues and competition in the sector returns to normal levels.  In addition, the Producer Price Index (PPI) shows the price producers receive for their products.  The PPI shows a decrease in food product prices for May.²  This will take some time to reach consumers, but will add to an easing in grocery prices for the average household.

The latest Consumer Price Index (CPI) release covers data through May.³  The release has a handy chart noting the figures for several major categories over the past 6 months.  Most categories show a peak in recent price increases in either February or March.  This would include food, energy (including gasoline and fuel oil), and all items in general.  Additionally, oil and gas prices began to decline in May.  An expected continued drop in oil prices will be felt throughout the economy as a whole as consumers pay less to commute, transportation companies see lower expenses for hauling goods, and vacations require less portions of family budgets.

Understanding this set of figures does get a bit tricky as the CPI measures inflation – the rate of increase in prices.  This does not mean the highest price was seen in March for any of these categories.  It means the greatest monthly increase was seen in March.  Prices continued to rise a bit in April, but at lower rate.  May saw either low levels of increasing prices or price declines for each category.  This means prices are still higher than they were a year ago in all major categories, but the increases have eased – and reversed in the case of oil and gas. 

Unemployment

Unemployment is still historically high.  The Bureau of Labor Statistics release of May numbers shows a rather stagnant jobs market.  There was a bit of hiring in May, but not enough to change the overall unemployment rate.  Analysts are predicting the creation of more jobs from an unexpected area – our recent natural disasters.  The tornadoes and floods that have devastated large sections of the country have created damage that needs to be cleaned up, homes and businesses that need to be rebuilt, and infrastructure that needs repaired.  The destruction that we have seen has been extensive enough that large numbers of people will need to be put to work in repairing the damage so many communities have sustained.  Much of this work will be in construction and other related sectors that have been so badly hit over the past few years.  While this is certainly not the way any of us would like to see the unemployment rate decrease, it is the reality of the situation we are in currently.  There is much repair work to be done and many unemployed with the skills to do so.

You may have heard of the Conference Board as their measure of consumer confidence is widely quoted upon release.  They also publish a lesser known survey of CEO confidence.  Their latest CEO Confidence report published in April is a bit dated, but is still of note.  It shows 85% of CEO’s stating business conditions are better than they were 6 months previously.⁵  Half of CEO’s predict increased hiring within their industry this year.  Both of these numbers are increases from the previous quarter.

Previous recessions have shown that it usually takes about a year and a half for the unemployment rate to decline to normal levels after the end of a recession.  We are lagging behind this metric.⁶  However, this was a major recession and a longer recovery time is to be expected.  Unemployment generally does not begin to climb until after a recession is well underway.  It also does not decrease until after a recovery is well underway.  Given that we have had a slow recovery it is not surprising to see a slow recovery in employment.

Housing

Housing is still a big drag on the recovery.  Many areas are still seeing high numbers of foreclosures as banks work through backlogs created by a lack of proper documentation.  We are starting to see a glimmer of positive news on this front though.  While the latest Case-Shiller Index does show prices down somewhat from a year ago, it also shows prices having increased over the previous month.⁷  One month does not make a trend.  It is too early to tell if this month-over-month increase is significant, or an anomaly.  Still, a report that shows only minor price declines from February to March followed by either increases in prices or very slight declines for the vast majority of the country for March to April is heartening news. 

Summary

2011 started well but began slowing in early spring.  Both large scale crop loss from freezing weather and a large swath of the country being hit by tornadoes have impacted 2011 so far.  Change always brings about the possibility of negative consequences.  Natural disasters are historically followed by rebuilding that has positive connotations to it.

The Bureau of Economic Analysis (BEA) revised first quarter GDP growth to 1.9% and finalized 2010 fourth quarter growth at 3.1%.⁸  The same release of figures noted corporate profits estimated to be $48.7 billion for the first quarter, as compared to $38.2 billion for the fourth quarter of 2010.  Bottom line, companies are making money.  Housing is still a weak spot and unemployment is still high.  However, we are seeing growth.  We have seen the unemployment rate ease over the past year.  The lowering of oil prices will help the economy.  The economy may not be recovering as quickly as most of us would like, but the facts and figures do show an economy that is slowly working its way back to pre-recession levels.

1)  http://www.morningstar.com/cover/videoCenter.aspx?id=382300 (Inflation Peaking video report, 6/23/2011)

2)  http://www.bls.gov/news.release/ppi.nr0.htm (July 14, 2011 Producer Price Index News Release)

3)  http://www.bls.gov/news.release/cpi.nr0.htm (July 15, 2011 Consumer Price Index Summary)

4)  http://www.bls.gov/news.release/empsit.nr0.htm (June 3, 2011 Employment Situation Summary)

5)  http://www.conference-board.org/data/ceoconfidence.cfm (April 7, 2011 CEO Confidence Survey)

6)  cnbc.com   CEO Blog: Why GDP Growth Has Not Provided Jobs Yet, 6/28/2011

7)  http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff–p-us—-  (April Seasonal Boost in Home Prices According to the S&P/Case-Shiller Home Price Indices 6/28/2011)

8)  http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different.  The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties.  Individuals are encouraged to seek advice from their own tax or legal counsel.  Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.  Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.

During the recession and recovery I have seen a number of programs or articles take an interesting data point that is worth mulling over and use that to speculate on the end of the U.S. economy as we know it. These same spokespeople and authors then treat the next day’s new data point with the same level of heightened emotion. Part of my job is to help you navigate this ever present media noise.

Commodities

I have recently read and seen some thoughts stating lower commodities prices are worrying as they signal a weakening U.S. economy. It is true that there are a number of speculators within the commodities markets who trade based on their expectations of overall economies in the near future. A pullback of these more speculative positions does not necessarily mean that these speculators see a weakening economy though. We have seen a rise in commodities decoupled from actual demand for the underlying materials. We are now seeing an unwinding of some of the more speculative commodities positions taken in recent months. This does not signal a weakening economy, but rather a return to commodities prices that reflect the actual cost of materials based on real world demand. This return will result in lower prices for some commodities, which will in turn help consumers and their spending power. That will help the general economy, not hurt it.

Higher commodities prices create higher levels of inflation, creating a drag on economies. Lower commodities prices are good for an economy as consumers then have more money for discretionary spending. That is still the bottom line when it comes to commodities and their effect on an economy.

Quantitative Easing

The Federal Reserve is purchasing government debt and increasing the money supply. Money supply growth has kept pace with moderate levels of economic growth and inflation. M2 refers to the total amount of money in circulation outside of bank vaults, savings and checking account balances, money market balances, and similar liquid assets. The May 26th release of the Federal Reserve’s H.6 statistical report¹ shows M2 growth of 4.9% over the past year. Even conservative analysts deem this acceptable for an economy whose GDP growth plus inflation are about the same level. Where is the U.S. in terms of GDP + inflation? The Bureau of Economic Analysis’ May report² notes 2010 4th quarter U.S. GDP at 3.1%, with 2011 1st quarter GDP an estimated 1.8%. The Bureau of Labor Statistics April report is their most recent. They note a year-over-year inflation increase of 3.2%.³ M2 growth is not exceeding the combination of GDP and inflation for the U.S. economy.

A quick look at exchange rates over the past 5 years shows the U.S. above the 5-year average against the Euro and the British Pound.⁴ We do not have excessive inflation or devaluation of the U.S. Dollar due to quantitative easing. Banks are still not lending at rates high enough to cover reasonable demand. The Federal Reserve’s policy of money supply growth is helping make up for these low lending levels, not fueling runaway inflation or currency devaluation.

Inflation

What will the inflation rate do? Will we see Zimbabwean effects on the U.S. Dollar, or more moderate runaway inflation such as Argentina saw several years ago? There is much fear in many hypothetical scenarios, but not often much in the way of fact. As noted above, inflation has increased to just over 3%. This is about average for the last decade.⁵ It has risen since 2009. However, this is due in part to a reversal of the deflationary pressure of the recession and the increase of commodities prices noted above. It is worth noting that the rise in inflation is just a rise to average levels.

Inflation increases due to demand based price pressure. The global economy is still too weak to exert much upward inflationary pressure. Nor is Federal Reserve policy causing inflationary pressure. Inflation will be an area to watch when the economy does revert to higher growth levels, but there is still too much drag on both the national and global economies to stimulate high levels of inflation.

Summary

The economic outlook is more of the same. Housing is a weak spot that is not likely to change soon. Unemployment levels are slowly decreasing. Credit is still tight. Companies are still earning profits. The economy is growing, but at a slow pace. It is hard to write an engaging article or retain viewers with headlines of “More of the Same” and “No Change Today”. While the media may have their reasons for speculative narratives surrounding the economy, much of what is said is just noise.

1) http://www.federalreserve.gov/releases/h6/Current/

2) http://www.bea.gov/scb/pdf/2011/05%20May/0511_gdpecon.pdf

3) http://www.bls.gov/news.release/cpi.nr0.htm

4) http://www.oanda.com/currency/historical-rates/

5) http://www.inflationdata.com/inflation/inflation_rate/historicalinflation.aspx

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.