Why Residential Building Won’t Recover Quickly

Before I get to the graphs, let me first cover the credit bubble and how it related to home prices rising:

1. Low interest rates, lax lending standards, and credit market innovations helped fuel a boom in credit growth and subsequently home prices.
2. Speculators got more and more involved, further pushing up prices to unsustainable levels by buying more houses. 
3. Builders started building more and more houses because when prices are high so are revenues.
4. At these unsustainable levels, individuals and companies took out more and more loans that were exotic, probably unaffordable, and maybe dependent on homes increasing in value.
5. Given home prices were unsustainable, as soon as credit was removed from  the system market prices started to crash.

So now we have a situation where people who bought homes at a high price can no longer afford or want to pay their mortgage (not to mention high unemployment):

This results in increased foreclosures.  Foreclosures prices are usually pretty low as the bank wants to unload those houses off their balance sheet.  Thus, you have a situation where there is a large supply of existing homes on the market at depressed prices, which new homes can’t compete with:

In short, until forecloses come down more and the overhang of existing housing is cleared, we probably won’t see too many new homes built. 

Go to Calculated Risk for good graphs like the ones above. 

Are Dividend Paying Stocks Bond Substitutes? Yes and No.

I have commented before on how I like dividend paying stocks; however, I like them more for the type of company you tend to get.  Others I presume may like them more for the income stream.

There is nothing wrong with that, especially in this low interest rate environment where investors are looking for yield.  Investors just need to know that just because a stock pays a healthy dividend doesn’t mean it’s high quality. 

Similarly, while the income from stocks might be higher than bonds currently, the volatility of dividend paying stocks is also higher.  In short, if you are using bonds to help lower the volatility of your portfolio then dividend paying stocks are no substitute. 

Vanguard recently wrote an article that shows while bonds yielded less than dividend paying stocks from 1998 through the end of October 2011, they also were less volatile and had a higher return.

None of this is to say that dividend paying stocks aren’t a good place to invest going forward; however, if you are using them as a bond substitute, just be prepared for a bumpier ride.

The Employment Problem

Recently I was alerted to two interesting bits of information:

1. As Italian yields moved higher, so did equities.  The opposite of what you would expect.
2. Despite the rash of headlines on the Eurozone, there appears to be a decent correlation between jobless claims and equities.

Does this mean that markets are being moved` solely by unemployment and are unaffected by Europe?  I have no idea.  I would guess no, but who knows what moves markets, these days? 

What the above links do demonstrate, in my opinion, is how important it is to create jobs for the economy (obviously) and the market.  Take a look at this graph via Calculated Risk:  

Two things standout:  

1. The job loss from the last recession is much larger than any at other time since WWII.
2. The recovery from the lost jobs will no doubt be much longer than any at other time since WWII.

As I have mentioned before, I think it will take time to go through the deleveraging cycle.   This jobs chart is an example of the sluggish growth that we have experienced and probably will experience for the next few years. 

That said, if we can figure out a way to create jobs the great likelihood would be not only a nice economic lift, but also a corresponding bounce in the stock market.

Barron’s Likes Brazil

On last week’s cover of Baron’s is an article highlighting the long-term outlook for Brazil’s economy.

The article lists four big themes that should help the world’s 7^th largest economy: 

1. Growing Middle Class – social mobility gives rise to domestic demand; positive trend in terms population that makes up middle and upper classes; young and growing population
2. Healthy Banking System – high real interest rates curb malinvestment
3. Stable Government – addressing a crumbling infrastructure (6% of roads paved) while preparing for the 2014 FIFA World Cup; large gap between interest rates and inflation rates allows room for rate cutting if need be
4. Globally Focused Companies – a large amount of natural resources that are being exported to other countries (e.g. China)

While the stock market has struggled this year, GDP growth is expected to average 4% over the next three years.  Further, a depressed stock market makes for more compelling valuations.  It should also be noted that Foreign Investment ($60Bb) is 3x the amount 10 years ago.

I do think the article is compelling; however, there are still a few items of which I am wary:

• How dependent on China is Brazil’s economy?  If China has a hard landing, what will the impact be?  Note:  32% of the stock market, but just 3% of the economy is commodity based.
• There are still slums (I recall hearing some of the worst in the world) and a high poverty rate, begs a risk of social unrest?
• Highest corporate taxes in emerging markets (34%).
• An unraveling in Europe could derail the growth story.
• Currency is still volatile.  The Real depreciated 60% versus USD in 2008.  If risk returns to credit markets you could see a large drop as investors flock to the dollar. 

Ultimately I think the risk/reward here makes a compelling reason to like Brazil.  Perhaps the biggest reason for optimism was the quote by Alan Vinson at the end of the article: “The average Brazilian is very optimistic”.  Optimism amongst its citizens provides fuel and lends credence to the abovementioned positive trends.

Europe Summarized

As the Euro crisis deepens and the leaders of Italy and Greece resign, I figured it would be a good time to summarize what is going on.  Luckily, I found this great SNL video that does so nicely (via Big Picture):

Aside from being funny, I think you would be hard pressed to find another three minute video that better captures what is going on overseas:

• It’s hard to convince the masses to cut government spending and lower their standard of living.
• Why were countries like Germany and France lending lots and lots of money to countries like Greece and Italy when the former should have known paying off all that debt would be difficult, if not impossible?
• As such, creditors need to work with debtors to figure out a solution.  The burden isn’t only on the debtor. 
• Leadership from France and Germany has been weak.
• Given the cultural, social, and language barriers, pulling the Eurozone together was an uphill battle from the start.  In times of crisis this will probably prove to be more difficult.  Plus they have been fighting each other since Europe was inhabited and were at it as recently as 60 or so years ago. 

Even the Best are Struggling

Many successful bond managers have had an off year in 2011, the most prominent being   Bill Gross, who recently issued a “Mea Culpa” for his poor performance. 

The same can be said for some equity managers, who have until this year had very good long-term results, for instance John Paulson and Bruce Berkowitz. 

As I already commented, picking a manager based solely on past returns can really get you burned.  It is more important to look at the process, whether or not it’s sustainable, and recognizing AND acting when it’s time to make a change.  (Note:  I am NOT recommending selling any of the above managers, just pointing out their poor returns as of late)

However, the lackluster performance by some of the industy’s best managers who had previously shattered their respective benchmarks points to how hard it has been to invest in the current market environment, due in part to the following:

• Continued consumer deleveraging
• Massive monetary and fiscal stimulus and then the removal of the stimulus
• Credit markets collapsing, then repairing, and now skittish again
• Emerging markets increasing importance and then the subsequent possibility of overheating
• Eurozone struggles  

So if the best are struggling, how can the average investor help weather the storm?  Here are some tips:

• Don’t make big bets , and don’t rely too much on one manager – avoid concentration risk by diversifying
• Develop escape routes before investing
• Take risk off the table when you get queasy
• Avoid drastic moves - if you make moves one way or the other, keep it small
• Hedge when and where it’s appropriate
• Don’t get emotional

“Positive Earnings” are Good, but You Need to Look Deeper

So as of October 21^st about 64% of companies beat Q3 earnings estimates!  On the surface, that seems great; however, take a look at the attached graph.  As you can see, earnings beat rates are always around 64%. 

As Bespoke notes, the earnings beat rates are higher than the last two quarters but still slightly below the average of the current bull market.  Bianco Research, LLC research reaches the same conclusion. 

In short, there appears to be nothing spectacular about 64% of companies beating earnings estimates.  Having said that, the revenue beat rates appear to look a tad better.  Why is that important?

• The first is that corporate margins are at all-time highs or close to that.  Eventually there should be some mean regression and margins will compress.  At that point the only way earnings can continue to impress is if revenue grows.
• Revenue growth is more of an indication of economic health than earnings, especially in this environment.  As the consumer delevers top-line growth would be affected (more savings = less consumption).  If revenue growth strengthens, it would be more of an indication the deleveraging process is becoming manageable and orderly.

So to conclude, just because S&P earnings are “killing” the estimates doesn’t necessarily equate to strong corporate earnings – earnings always kill estimates.  Take a look at historical beat rates and make sure to look at top-line growth estimates too.  

A Good Watch – Ray Dalio on Charlie Rose

Ray Dalio is the founder of Bridgewater Associates, which is ranked as the largest and best- performing hedge fund in the world.  The fund is a global macro hedge fund so it assesses what the world economy is like how various asset classes will change. 

In this video he is being interviewed by Charlie Rose. Given the insight and knowledge base Ray Dalio has, I thought it would be best to provide excerpts on what I thought were the key points, as opposed to commenting on the interview (see Zero Hedge for the transcript):

• “We have to understand the big picture is -- there`s a deleveraging. Three big themes: first there’s a deleveraging; secondly we have a problem with monetary and fiscal policies are running out of ammunition; and thirdly we have an issue in terms of people most importantly who are at each other`s throats politically and globally in terms of having a problem resolving those.”
• “[Deleveraging will] take place over ten years. The key is to spread it out as much as you can. Make sure that it`s not disorderly.”
• On the kicking the can down the road and the deficit:  “I want to say that I`m very concerned not just of that. I do not believe that we will find a political solution. I think that that would not be -- I`m pessimistic about that… We can`t solve the problem easily because we still have too much debt. But we can move forward in being able to make the best of it. We can spread it out, we can keep orderly we have a situation now in which we have a very severe situation, not only because we have a deleveraging going on, but we have a situation in which monetary policy cannot work the way it worked in the past, that fiscal policy will not be simulative.”
• “Yes, so number one is we have a deleveraging. Now that deleveraging means we`re going to have more debt problems. You`re going to see -- no matter what is solved in Europe you will have a deleveraging. Banks will lend less and lending less will mean a contraction. That`s -- that is what I believe is the case, we should talk about whether or not that is the case. Thoughtful people should discuss that.”
• “We have a debt problem in Europe. You can either transfer the money from one rich country to a poor country [or] you can print the money… Or you can write them down. Those are the choices.  Hair cut.”
• “The number one principle at our place is that if something doesn`t make sense to you, you have the right to explore it, to see if it makes sense.”
• “When looking at China, China because they can`t raise interest rates because of their existing monetary policy, is that they can`t control credit growth in the normal ways that we control credit growth. So there`s a credit bubble emerging there and as -- in other words there`s a quality of lending and it`s bypassing the credit system.”
• “We don`t have the ability to have the same effect of monetary policy as we did before because a central bank -- it can buy a bond. It can -- therefore buy the bond. It gives that money to somebody who sold the bond and they were going to buy something like a bond. They`re -- the -- the getting it in the hands of somebody who spends it on cars and houses who really owes probably too much in debt is not an easy thing to do for monetary policy. So monetary policy is not as effective and then we have this social tension.”
• “We should be able to grow at a rate that`s comparable to our income growth if we are -- if we keep orderly and we -- and we work this through and everything is orderly. That means something between like 1.5 percent or 2 percent… The problem with the 2 percent vicinity is that the employment rate remains the same or can trend higher. That produces social pressures, that produces tension which itself means that you can have a situation analogous to that which is existing in Greece and more social pressure you create the more tension that is existing and emerging in various ways, not just a Wall Street piece. But it`s existing in Spain… If we have disruption… and we can`t have fiscal stimulation and you have a problem of what do you do -- you can`t recapitalize the banks. I mean if you should happen to need to recapitalize the banks you can`t have a TARP program again…  Politically not feasible.”
• On being optimistic or pessimistic:  I suppose I`m -- if I was -- I`m concerned. I think it`s a test of us. It`s a test of us in our society. It`s a test of us.