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Into The Mist:
The Midyear 2009 Outlook
By Walter Frank
MONEYLETTER.com
Presenting a midyear outlook at this very moment is the equivalent of flying blind. Perhaps not quite, but close. Let's explain. Right now there are two main schools of though about the domestic economy's outlook. One school sees growth ahead as very sluggish, with the economy growing at about 1%-2% over our forecast horizon (nine months or so ahead). The other school sees growth doing better than that as this year moves on. In fact, it sees the economy building momentum for better-than-speed-limit growth as we move into next year.
Notice that both groups are talking about growth, and that is why we said, not quite. The discussion is no longer about whether the economy is turning around. In that sense we are no longer flying blind. There maybe dense fog as we look ahead, but we are almost certain that we are now headed up. But that is where the certainty ends.
Will consumers cooperate?
There are many, many factors that are being tossed around now in discussing the outlook: inflation, interest rates, export demand, house prices, etc. As we see it, though, the center of uncertainty is the consumer. Will the consumer spend? We are not talking about the big-time spender of the mid-2000s, with a zero savings rate. Forget that consumer, he was wept away by the housing and market crashes of 2007-2008. We are talking about a consumer with appositive savings rate of about 3%-4%. Or, will the consumer decide to save even more for a time building up the nest egg that vanished?
We just do not know. The latest data still depict a very distant consumer. No wonder. Think of house prices and the end of the rising-house-price borrowing binge. Thin of continuing large monthly job losses. The list could be long and depressing. The consequences has been a high savings rate recently, negating some of the intended effect of the stimulus.
On the other hand (yes, there is another hand) the market has rallied sharply. Some wealth has been regained and, with it, a rise in consumer sentiment. The green shoots have not turned brown, as some predicted.
Another element to consider is that the administration's stimulus package is only now hitting with force. Incomes will be growing. Then comes the question: What percent will be spent?
The answer is simply up in the air. Our own view is that we find it hard to ignore the majority opinion that the American consumer will be a brake on the growth outlook for the intermediate term. But that is where our agreement ends.
We see at least a partial offset to the consumer drag (if that is what will happen) over our forecast period. The offset will be coming from a substantial inventory swing; that will turn inventory investment from a strong negative to a strong positive.
American business has been running down inventory for months, and, with the economy improving, it is now only a matter of months until a turnaround occurs. When it does, it will be meaningful. We see perhaps a two-quarter period of improved growth over the year to next June, attributable to the thrust from an inventory turnaround and the stimulus it will provide.
The March-May rally turned a compellingly cheap market into a fairly or fully valued one, using forward-looking earnings estimates. The U.S. market has temporarily exhausted its near-term potential. Along these lines Goldman Sachs' Abby Joseph Cohen said in the Barrons 2009 Midyear Roundtable (June 15 issue), "Given lackluster profit expectations our six-to twelve month S&P outlook is 950 to 1050." The S&P is trading at the lower end of this range. There are some gains to be made, but they are not very exciting, if this range were to hold.
But read the statement closely. For us the operate words are "profit expectations." Earnings analysts are notoriously wrong at turning points and we believe that such is probably the case now. After last year's profit collapse, we expect that analysts are being extremely cautious in their profit outlooks. Who can blame them? We also expect that as the economy turns positive - even sluggishly - that we will see upgrade revisions. If the economy turns out to be running a little faster than now projected, the effect on profit revisions will be very noticeable. Profits magnify even small moves in the economy's growth rate.
Along these lines, Mrs. Cohen added an interesting commentary about the profit outlook. "There will be a major inflection point for earnings in the third or fourth quarter. Our analysts believe risk may be to the upside - that is, profits grow faster than previously forecast."
In considering the U.S. market outlook we think it prudent to stick with the current profit and price-earnings estimates. We think profit estimates are low and P/E ratios correspondingly high, but that is as far as we can go. We are also more optimistic than the apparent consensus when it comes to valuing those _earnings. Historic average valuation levels are being used when it comes to the market. That ignores the fact that if sluggish growth is the correct call then interest rates will remain low, and P/E ratios should be higher than normal.
Our conclusion is that the U.S. market still has intermediate-term upside potential, but the magnitude will depend on developments still unfolding.
This is an appropriate time to make a correction to our year-end outlook. Our opinion at year-end was that the U.S. and the U.S. market would be leading the way out of the deep recession, just as we led on the way down. In fact, that has not been the case. So far the leader has been China. When the Chinese stimulus package was presented there was much skepticism about its true size and effectiveness. No longer. Whatever the underlying causes, the estimates of China's growth this year have risen steadily, and China is now expected to reach its own growth target of 8%.
Investors have not been oblivious to the improved economic outlooks in Asia. China, of course, is the leading example but the smaller Asian countries such as Taiwan and South Korea have also seen their outlooks upgraded. Japan has chipped in as well.
A good deal of the impulse for this improvement has come from China as the Chinese continue to consume despite the earlier slowdown of their economy. Chinese imports from the rest of the region are playing a large role. Those imports, in turn, have encouraged consumption in the rest of the region, and Asian consumers have not increased their savings rate (already high) as has occurred here. For example, Chinese auto sales have been notably strong.
Once again in judging the outlook, we have to consider that a huge rally has occurred in the Asian stock markets. Fidelity China Region is up almost 33% this year, Matthews China 38% and Matthews Pacific Tiger also 38%. Even with these gains, we see these markets as reasonably valued. They are not bargains, but superior growth should keep investors interested.
As you may have noticed, we did not change our allocations (stocks/bond/cash) as the market rallied. We frequently used the word cautious when we presented our outlook. Even so, we were not ignoring the rally.
In fact, we embraced it, but we held our cash because we were looking for some signals from the economy that growth was beginning to occur. The signals have not yet reliably appeared. They are close and coming closer. We estimate the odds are very high that we will see growth before the next quarter is out. What has to be judged as the growth signals appear is whether the sluggish growth view is consistent with the data.
What we have done is to increase the risk level of the portfolios in our fund selections. For example, we introduced China funds into our portfolios. While we are always mindful of diversification, as small caps rallied, we brought more of them into the portfolios. We believe that risk will be rewarded over the intermediate-outlook.
That view informs our present decision to continue recommending as commodity fund position for the more risk oriented portfolios. The commodity markets recovered along with the equity markets. An important factor in their recovery has been - you guessed it - China. Whether Chinese demand for commodities will hold or soften is a key issue in the commodity markets nowadays. However that is resolved we see the global economic recovery as providing support for commodity prices over the intermediate-term.
Overall, our view is that the period ahead will prove more rewarding for investors than the cautious outlook hat now prevails. We are particularly encouraged by the growth prospects offered by China and a country we have not mentioned, India. With the U.S. not leading way, or expected to for some time, investors more than ever will have to take a global outlook for superior returns.
Editor's Note: Walter Frank is Chief Investment Officer of MONEYLETER.com, 479 Washington St., P.O. Box 6020, Holliston, MA 01746, 1 year, 24 issues, $180.
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