INVESTMENT IMPLICATIONS OF REFORM, From David Kelly, chief market strategist, JPMorgan
After almost a year of heated debate, the president has achieved his goal of a major reform to the health care system. So what does this mean for investors?
Taxes: The most obvious quantifiable impact of the bill is an increase in taxes for upper income Americans, particularly on investment income. Starting in 2013, the Medicare tax rate on households with income over $250,000 will be increased from 1.45% to 2.35%. In addition, a new 3.8% Medicare tax will be introduced for the same group on investment income. Currently, the tax rate on dividends and long-term capital gains is 15%. In 2011, those rates are expected to rise to 20% for households earning over $250,000 and with the new Medicare tax, these rates will rise to 23.8% for the same group. Under current tax law, investors get to keep 85% of the income stream from taxable stock market investments. Under this new law this will be cut by 8.8% to 76.2%, reducing the value of the income stream by 10.4% (that is 8.8% of 85%). This is obviously a significant number. However, it is worth noting three things about this:
For the Federal Deficit: According to the Congressional Budget Office, the passage of this legislation would reduce federal deficits by a cumulative $143 billion between 2010 and 2019 and by greater amounts in the following decade. However, these estimates should be taken with more than a grain of salt. It is obviously very hard to estimate what total federal health care spending will be over the next decade. However, whatever else is said about this bill there is nothing in it to suggest a reduction in either the quantity or prices of health care services consumed.
In fact, for the most part this bill moves away from, rather than towards, the principles of market economics. In 2007, the U.S. devoted 16% of its GDP to health care spending compared to 11% in the country with the second highest spending which was France. Despite this it ranks 38th in the world in life expectancy at birth. Sadly, this bill isn’t likely to change either of these numbers for the better.
For the economy: Despite dire predictions, it’s not clear that health care reform will really slow economic growth that much. Most of the tax provisions don’t kick in until 2013 and the mandates on businesses and individuals don’t kick in in a big way until 2016. Between now and then, the economy is quite capable of staging a full cyclical recovery. It may be that businesses will, in the end, be forced to pay more for the health care of their workers—however, overall, American business is quite capable of limiting wage increases to add to benefit costs. It should be noted, however, that to the extent that the government incurs more debt to pay for higher health care costs, it probably does mean higher long-term interest rates.
ALL EYES ON EMPLOYMENT, From Bob Doll, vice chairman and chief equity strategist at BlackRock
Last week marked the third consecutive up week for stocks, with the Dow Jones Industrial Average climbing 1.1% to 10,742, the S&P 500 Index advancing 0.9% to 1,160 and the Nasdaq Composite rising 0.3% to 2,374.
The Federal Reserve held its regularly scheduled meeting last week and, as anticipated,
did not change any of its key policy language. Looking ahead, we anticipate that the central bank will need to see more clear evidence of a sustained recovery (chiefly positive employment growth) before it will consider changing course. This is particularly true given that inflation pressures have remained muted. Given the amount of excess capacity in the economy, we expect inflation to remain tame.
As we have been discussing for some time, the key economic variable that most are watching is the employment picture. From our perspective, we believe the jobsshedding phase appears to have ended, although new jobs are still not being created. We are optimistic that this scenario will change in March. Decreases in unemployment claims, one of the strongest leading indicators of payrolls, have accelerated in recent weeks. We have also seen increases in temporary employment levels and many companies have been discussing plans for increasing permanent employment as well. We are forecasting that payrolls may increase in the six-figure range for the current month. Factoring in the hiring of census workers, we would not be surprised to see that number top the 200,000 mark. Once jobs growth does commence in earnest, we also expect to see corporate earnings estimates increase for next year and investor uncertainty levels diminish. As such, we believe employment growth will be the key factor in terms of driving the next phase of the current cyclical bull market in equities.
Equity markets do continue to face some risks. In addition to the prevailing economic uncertainty, investors are concerned about the prospects of premature policy tightening in markets around the world, including China. Meanwhile, credit-related problems such as those surrounding Greece’s debt remind us that deflationary pressures have not vanished. Many are also concerned about the Fed’s strategy for exiting its current accommodative stance, although we think that even when the Fed does begin to raise rates, it will take quite some time before short-term rates move into restrictive territory. Additionally, state and local governments remain under pressure and concerns about the effects of protectionist trade policies present some risks. Finally, in the short term, the recent run-up in stock prices has caused sentiment and some technical factors to become stretched.
On balance, however, we continue to believe that the positive factors outweigh the negatives. Credit conditions are improving, we expect employment to increase, the Fed remains accommodative, inflation threats are absent and corporations are ramping up merger and acquisition activity. In all, we expect a prevailing equityfriendly environment will help stock prices continue to rise over the long term.
CATCHING PIGS, From Jeffrey D. Saut, chief investment strategist, Raymond James
Currently, the U.S. equity markets don’t “see” the potential for a lower structural growth rate, and lower P/E ratio, as the Dow Theory “buy signal” of last year was reconfirmed last Wednesday. Indeed, the DJIA finally confirmed the DJTA by registering a new reaction high. That upside action also left the DJIA above the 50% level, meaning the Dow has recaptured more than 50% of the points lost in the October 2007 to March 2009 decline. At the same time, last Wednesday there were 601 new 52-week highs on the NYSE, a new high total, and well above the 523 new highs of Jan. 11, 2010. All of this caused one Wall Street wag to exclaim, “Is this a breakout, or a fake out?”
Clearly it is a breakout, but it comes pretty late in the rally that commenced from the “hammer lows” of Feb. 4 and 5, and, has a lot of “hair” on it. For example, approximately 89% of the S&P 500 ([SPX]/1159.90) stocks are above their respective 200-day moving averages (DMAs) and consequently overbought. Likewise, about 86% of the SPX’s stocks are above their 50-DMAs, leaving the SPX, in the aggregate, roughly two standard deviations above its 50-DMA. Maybe that’s why the NYSE Overbought Indicator tagged a rare 90+ reading about a week ago, or why the S&P 500 relative strength index is above 90, both signaling that stocks are overbought. Now maybe this week’s end of quarter window dressing will keep institutional types engaged on the buy side, but with mutual fund cash positions at a paltry 3.6%, much of their firepower has already been used. Perhaps that realization, or Friday’s quadruple witch-twitch, is what finally rendered a “red candlestick” downside-day in the charts after the somewhat historic 14-day upside skein without any such “red candlesticks.”
Still the overbought condition, as of yet, has been outweighed by the upside momentum. When the “momentum mash” wanes is anyone’s guess, but as stated—I am not a very good momentum investor. Accordingly, in the short-term I remain cautious thinking the best strategy is to continue to pare some positions and/or raise stop-loss points. Longer-term, I maintain this is not the “new normal,” but rather the typical economic cycle. That is, corporate profits surge, which drives an inventory rebuild. Currently, profits have indeed surged with the largest ramp in corporate cash (y/y) since 1983. Combined with the increased activity at seaports, and the rise in shipping prices, it suggests inventory restocking has begun. Following an inventory rebuild comes a capital expenditure cycle and then companies begin to hire people. Then, and only then, comes a noticeable increase in consumption. It is important to note that hiring and consumption come on the back end of the cycle, not the front-end. To be sure, the stock market believes this is the way it is going to evolve given that the Consumer Discretionary sector is the third best performing sector year-to-date (+8.34%), behind Industrials (+10.97%) and Financials (+8.98%).
All considered, while cautious in the short-term, we are moored in the belief that the current backdrop will allow the SPX to fill the downside vacuum created in the charts by the Lehman bankruptcy over the next few months. That yields an upside target between 1200 and 1250. We continue to like the strategy of accumulating favorably rated names, preferably with dividends, in the investment account. Some names for your consideration include: CenturyTel ([CTL]/$34.86/Outperform), Leggett & Platt ([LEG]/$21.47/Outperform), and Brinker ([EAT]/$19.74/Outperform).
THE POSITIVES OF PASSIVE INVESTING, From John West, director, Research Affiliate
If the past 10 years is representative, institutional investors face prospective coin-toss odds for active large company management versus passive management. In order to win, they must believe that they can overcome three successively higher hurdles:
• Markets are inefficient, therefore there are ways to beat the market, even though the inefficiencies are presumably constantly changing, with some arbitraged away, only to be replaced by new inefficiencies.
• Some managers have the skill to identify these constantly changing inefficiencies in advance, even though their successes must be funded by failing managers’ mistakes.
• The ability to identify these superior managers, in advance, even though successes must be funded by failing investors’ underperforming manager choices.
We must surmount all three hurdles to win. It may sound like we believe the active management game is a fool’s sport. Far from it. But, we do believe it’s a very tough game, which most investors cannot win.
The average individual investor should be so lucky. Without scale to negotiate directly with managers, mutual fund fees are twice as high. In fact, studies of mutual fund peer groups—which are reported net of all costs—tell a completely different story for the S&P 500 during the 2000s from the story of institutional managed accounts. Even without adjusting for survivorship bias, the S&P 500 ranks in the 60th percentile in the Lipper peer group and in the 50th percentile for the Morningstar peer group. This is 30–40 percentile ranks better than the gross-of-fees institutional peer group! Adjusting for survivorship bias in the mutual fund peer groups would place the S&P 500 squarely better than the average active fund for the 2000s. And, because many individual accounts are taxable, the results would only get worse after we take into account after-tax returns due to active management’s propensity for higher turnover (Arnott, Berkin, and Ye, 2000).
AMERICANS PAY DOWN DEBT, From Alan Levenson, chief economist, T. Rowe Price
Households’ mortgage and nonmortgage consumer debt outstanding fell by $58 billion over the final three months of last year, and by $277 billion over the course of 2009 (-2.1%), reducing the ratio of debt to disposable income to 115.3% from 120.6% a year earlier.1
It seems likely that debt will fall at least that much in 2010, primarily because loan losses are set to accelerate. The mounting wave of mortgage loan foreclosures through 2009, reflected in steeply climbing charge-off rates at banks, points to a pickup in the pace of mortgage write-downs over the course of this year. A June, 2009 peak in bank delinquency rates for nonmortgage consumer suggests that write-downs in this segment may moderate, but this would provide only a partial offset to the quickening deterioration of mortgage portfolios, which account for almost 70% of household borrowing. A $280 billion decline in households’ mortgage and nonmortgage consumer debt over the course of this year, combined with a forecast 3% rise in disposable income would reduce the debt-to-income ratio to 109.5% at year-end 2009. If the sum of household mortgage and consumer debt matched last year’s $277 billion decline and the effective rate on outstanding debt were unchanged, we estimate that debt service would decline to 11.9% at the end of this year, substantially completing the correction to its long-term sustainable rate.
SOME NAGGING CONCERNS, From David Rosenberg, chief economist and strategist, Gluskin Sheff
It would seem that investors are taking comfort in the view that the U.S. labour market and home prices are stabilizing. The problem with the former is that if it only stabilizes and does not improve, then a persistent 10% unemployment rate will, over time, lead to a deflationary environment, which is never good for equities unless driven by the kind of tech-led productivity gains we saw in the 1990s. This deflation is caused by excess capacity and insufficient aggregate demand—it’s not the same. Jobless claims have to fall below 400k, not merely stabilize around 460-470k, before employment growth can resume.
A big impediment for the employment outlook is the fact that the State and local government sector employs 20 million people or 15% of the workforce (versus less than three million in the federal government) and is in major downsizing mode. More than 25% of Detroit’s public schools are closing their doors in June to stem budgetary red ink of $219mln. Also see the WSJ for how the lower levels of government are doing all they can to bolster their depleted revenue base (“States Pressure E-Tailers to Collect Sales Tax,” on 3/17).
As for home prices, we have a total of over 20 months’ supply of total housing inventory overhanging the residential real estate market when all the shadow inventory is accounted for; therefore, it is hard to believe that we have hit bottom in the home price deflation cycle. And, the demand for homes, as we can see in the continued negative year-over-year readings in mortgage applications for new purchases and the receding new traffic index in the NAHB survey, is dormant at best.
Meanwhile, a wave of new supply is coming from strategic defaults, which now account for 35% of all defaults according to research published by the University of Chicago. To be sure, the Case-Shiller index has emerged as the nonfarm equivalent to home price measures, and it has yet to roll over. But it has slowed, and being a three-month average, it may take time to show deflation again. The LoanPerformance home price index is down for four months running. Freddie Mac’s conventional home price index fell 0.7% in Q4. RadarLogic’s 25-city house price index is down for two months in a row and in four of the past five.
And, the FHFA index, which used to be the market-mover in years past, posted a 1.6% home price slide in December, which was the steepest decline since November 2008 — at the peak of the mania of the mid-1990s, this index began to show cracks about four months before the Case-Shiller did. Stay tuned.
REPORTS CALENDAR
Monday, March 22: Treasury Secretary Tim Geithner speaks at the American Enterprise Institute on financial regulatory reform
Tuesday, March 23: February Existing Home Sales; January Federal Housing Finance Agency (FHFA) House Price Index
Wednesday, March 24: Mortgage Applications (weekly); February Durable Goods Orders; February New Home Sales
Thursday, March 25: Jobless Claims (weekly)
Friday, March 26: Fourth quarter ’09 GDP (final numbers); fourth quarter ’09 Corporate Profits; March Consumer Sentiment
