Mutual Fund Research Newsletter
Copyright 2011 Tom Madell, PhD, Publisher
Sept/Oct 2011

The Upsides of the Downside

by Steve Shefler

Amid all the doom and gloom about the economy, it is important to maintain a balanced perspective. Currently, most news articles are emphasizing the downsides in the economy. Along with those downsides come some countervailing upsides.

Gas prices: Gasoline prices jumped from about $3.10 per gallon in early February to over $3.50 per gallon in early March as oil prices increased from about $84 per barrel to over $100 per barrel. Since oil prices have declined back to the early February levels gasoline prices will probably decline too. The collapse in oil prices means that motorists should see pump prices drop as much as 50 cents a gallon over the next several weeks, if the historical relationship between the price of crude oil and gas holds. Lower gas prices put more money in the hands of the Walmart shopper and exurban resident with a long commute. Economists estimate that a $10 drop in oil prices translates to an increase of a few tenths of a percent in gross-domestic product growth.

Lower interest rates: A combination of action by the Federal Reserve and a flight to the safety of bonds has driven interest rates to new lows. The benchmark 10 year treasury rate recently fell to its lowest level since 1951 and now is in the 2% range. Mortgage rates on fixed rate loans are at their lowest level since Freddie Mac first started collecting data in 1971. Thirty year fixed rate loans were at 4.15% in the most recent report, and 15 year loans were at 3.36%. The upshot is that homeowners are refinancing their loans and lowering their monthly payments, thereby making more money available to them for other consumer purchases. Lower interest rates also make home purchasing more affordable and provide a tailwind to the depressed housing market.

Countercyclicals: As pointed out in previous columns, a depressed economy results in pent up demand. In the decade prior to the 2008 recession, annual auto sales averaged 17.1 million per year and never dropped below the 16 million. In 2009, they plummeted to 10.4 million and then in 2010 came in at 11.5 million. This year auto sales are projected to come in at about 12.5 to 12.8 million. The major auto analysts (Edwards, J.D. Powers, IHS Automotive) report that there is a high level of pent up demand for replacement vehicles. During the first two weeks of August auto sales held steady notwithstanding the turmoil in the stock market.

Apartment construction is another area that is climbing due to pent up demand for housing as individuals rent rather than buy. Over the past few months, the Department of Commerce has reported a steady increase in permits for multi-unit housing construction. Multi-family permits have been steadily running at an approximately 15% increase year over year.

The impact of these countercyclical factors is a key basis of Warren Buffett’s muted optimism about the economy.

Governmental action: The increased predictions of economic distress and disappointing economic data make supportive governmental action more likely. President Obama will announce a new jobs program in early September along with other initiatives to bolster economic growth. He has already indicated that he wants both the payroll tax holiday and long term unemployment benefits extended. Bad economic data may bring some Republican support.

On housing, Diana Olick of CNBC summed up the possibilities as follows:

As the housing numbers turn ever more negative, the rumbles of action in Washington grow louder. Refinance and rent-to-own proposals, principal forgiveness plans, big bank settlement payoffs...they're all out there and they've been out there, but suddenly they're getting more traction. President Obama is expected to make some kind of housing announcement in his post-Labor Day speech on the economy, but all ideas are still on the table, each with its own barrier to entry.

The deeper the economic crisis becomes, the more likely that the administration will be willing to take unilateral action. In addition, Federal Reserve Chairman Bernanke has made clear his determination “to do whatever it takes to turn around the economy.” The prospect remains that the Federal Reserve will purchase more long term debt in an effort to lower such rates even further.

Contrarians and Bargain Hunters: As the stock market declines, contrarians and bargain hunters are likely to counteract the fall. Jeremy Siegel of Stocks for Long Run fame wrote the following in a recent Wall Street Journal editorial:

The dividend yield on the S&P 500 Index exceeds 2%, and these dividends represent less than 30% of profits these firms earn. This gives management a huge cushion to maintain dividends if indeed the U.S. economy experiences a double-dip recession. Today the aggregate dividends paid by the nonfinancial sectors are about 20% higher than they were at the 2007 peak. Finally, dividend growth in the last two years has averaged over 10% per year, more than twice the long-term dividend growth rate, as firms rightly begin to return their record cash balances to shareholders.

Siegel, like numerous others, points out that the dividend yield on high level stocks, together with the potential of dividend growth, makes them more favorable than treasuries. The buildup of corporate cash reserves as corporations are reluctant to invest and hire provides a safety net for future dividends. Even well-known market pessimists such as John Hussman and Marc Faber are suggesting that the stock market is currently oversold. Stabilization and even modest recovery in the market would support the overall economy.

Good market judgment depends on the ability to maintain balance and perspective. Markets and commentators tend to rotate between excess optimism and excess pessimism. Last April, it was hard to find a commentator with a bearish view of the economy and market. In times like these, it is useful for investors to focus some attention on the upsides of the downside.


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