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Excelsia's Cliff Draughn Goes In Search Of Your Sleeping Point

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Perspectives from Cliff Draughn of Excelsia Investment Advisors

In Search of Your Sleeping Point

Whom the Gods
would destroy, they first make clueless.

  • Expectations – one’s beliefs central to forming a view of the future that creates the elements of surprise or disappointment.
  • Great Expectations – Charles Dickens story of Pip and his quest to become a man in the midst of cruelty, intimidation, and hard times.
  • Unrealistic Expectations – the current disconnect between stock analysts’ projected earnings growth of the S&P 500 and consensus economic outlook for GDP growth.

In my April newsletter, I spent considerable time
building the case that investors’ belief in the Bernanke Put, combined
with increasing risk appetites due to Zero Interest for savings, had
propelled stock prices past reasonable valuations. Well, the S&P
500 experienced an -11.43% decline in Q2 but that did nothing to temper
analyst enthusiasm for further earnings expansion.

According to Bloomberg, Wall Street analysts are “raising
earnings estimates for U.S. companies at the fastest rate since 2004
just as stocks post the biggest losses in 16 months.
” The
analysts’ expectations for S&P 500 EPS  project a 34% growth in
profits for 2010, which is up from the first-quarter consensus
projections of 27% growth in 2010 profits. These upward earnings
projections are coming in the face of higher unemployment, lower home
sales, continued deleveraging of balance sheets by consumers,
increasing government regulations, and higher taxes. 

As I stated in January and April letters, the next
shoe to drop on the economy is a second wave of delinquencies related
to the Alt-A and ARM mortgage resets that will last through 2011. The
US economic bubble/decline began with real estate, it will end with
real estate, and I fear we are in the sixth inning of real estate
foreclosures. I am in agreement with Meredith Whitney that we are headed
for a “double dip” in US housing. Therefore, if the average American’s
biggest asset is his home, then is it unreasonable to project
continued spending limitations and increasing savings as opposed to the
return of consumer consumption at the 2004-08 pace?

Take a look at the following graph from
S&P/Case-Shiller of the Quarterly Home Price Index:

Pricing data is from 2001 to the end of June,
2010. Does this look like home prices are recovering? Or are we simply
mean reverting?

A second indicator of consumer strength is the
Baltic Dry Index, which measures the level of freight being shipped
around the world. Again, does this indicator provide a level of comfort
that we have escaped the clutches of a potential double-dip recession?

Therefore, with home prices depressed and shipping
of goods nowhere near levels seen during the peaks of 2007 and 2008,
how can we agree with the analyst’s consensus for S&P 500 EPS
growth? As my teenage son sometimes comments: “Not!” which translates
into “We disagree.”

There is currently a huge gap between earnings
estimates of analysts following S&P 500 companies and GDP growth. I
take the following graph from WolfeTrahan’s research. Their conclusion
is that to simply meet consensus EPS estimates for 2011 and 2012 would
require a 6% GDP growth rate. The projections assume that efficiencies
in corporate operating margins remain constant. Of course there does
exist a possibility that profits could improve without revenue growth.
However, I contend that one reason we have high levels of unemployment
is that companies have wrung out all the “operating costs” they can,
and going forward increasing profits will require top-line sales
growth.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2009 Revenue $908.4

36.3%
Revenue Growth expected in 2010

2010 Revenue $1238.3

17.6%
Revenue Growth

2011 Revenue $1456.0

14.0%
Revenue Growth

2012 Revenue $1660.1

 

 

 

Implied GDP Growth  4.4%

 

Implied GDP Growth 6.3%

 

Implied GDP Growth 6.2%

 

EPS $59.70

 

EPS $81.38

 

EPS $99.69

 

EPS $109.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

82.7% cumulative growth in earnings expected through 2012

 

If the consensus economic outlook for GDP growth
in 2010 is currently 3.2%, then it falls short of the implied 4.4% GDP
growth needed to support the projected $81.38 EPS for 2010. And no one
is projecting the 6% or better GDP growth that is needed to support
current projections for 2011 and 2012 earnings. In the end, earnings
matter and valuations matter. In my opinion, the unrealistic earnings
growth projected by analysts is mandating a period of disappointment in
2011. Casey Stengel once said:

There are three things that can happen when
you play baseball. You can win. You can lose. Or, it can rain.

Continued high unemployment combined with
declining home prices will force the government to pass another
stimulus package. Obama, Bernanke, and Geithner are “all in” when it
comes to government spending, but in my opinion they cannot stop the
impending rain on their Keynesian parade.

Our themes for Q3 are as follows:

  • The GSEs the Fannie
    and Freddie Fix
  • Deflation and the Fed
  • Municipal Risks and Tax-Free Bonds
  • Lessons from Reinhart and Rogoff

The Government-Sponsored Entities

If you don’t know what you’re doing…
just stop!”
– My Dad

In 1938 the federal government legislated Fannie
Mae into existence for the purpose of creating liquidity for the US
housing market. In 1968 Fannie was converted into a private shareholder
corporation in order to remove its balance sheet from the federal
budget. Originally Fannie Mae (and her cousin Ginnie Mae) purchased
mortgages guaranteed by the Federal Housing Administration (FHA), as
well as the Veterans Administration (VA) and Farmers Home
Administration (FmHA), insuring mortgages with the full faith and
credit of the US government. In 1970, Congress approved Fannie to
purchase private mortgages in addition to agency-sponsored paper.
Congress also went one step further to create Freddie Mac, whose
purpose was to compete with Fannie Mae and supposedly provide a more
robust market for mortgage paper. Roll the financial ponzi forward to
September of 2008, when both Fannie and Freddie are placed into
“conservatorship” by the same government that is guaranteeing 56% of
the US’s $12-trillion mortgage market. The US taxpayer now owns 80% of
these institutions, having put in more than $145 billion to cover their
losses. From the SayAnything blog:

Fannie Mae and Freddie Mac took over a foreclosed home roughly every 90
seconds during the first three months of the year. They owned 163,828
houses at the end of March, a virtual city with more houses than
Seattle. The mortgage finance companies, created by Congress to help
Americans buy homes, have become two of the nation’s largest
landlords.…

For all the focus on the historic federal
rescue of the banking
industry, it is the government’s decision to seize Fannie Mae and
Freddie Mac in September 2008 that is likely to cost taxpayers the most
money. So far the tab stands at $145.9 billion, and it grows with every
foreclosure of a three-bedroom home with a two-car garage one hour
from Phoenix. The Congressional Budget Office has predicted that the
final bill could reach $389 billion.

According to the National Association of Realtors,
the median home price in the US has fallen 25% since July 2006. The
federal government is in a “no solution” mode in dealing with the
declining prices that create underwater households that lead to more
foreclosures. Congress simply keeps kicking the can down the road in
hopes that home prices will recover. The possible good news here is
that with mortgage rates at 50-year lows, cheap interest rates could
stabilize home prices… or at least stop the bleeding. The bad news is
that of the $5.5 trillion of mortgage loans owned by Fannie/Freddie,
$1.98 trillion are in the highest foreclosure states of California,
Florida, Arizona and Nevada. Recently both GSEs moved to “delist” their
stocks from the exchanges, and this makes sense from a cost
perspective (FNM was trading at 31 cents a share and FRE at 29 cents a
share). However, I caution that once these companies delist they will
no longer be required to report income or losses in a public forum;
this would allow Congress and the Treasury to create a black hole in
which to park the GSE train wreck of losses and taxpayer bailouts. I am
amazed that with these GSE entities at the root of our financial
crisis, there is not one word on how to fix or reform Fannie or Freddie
in the Dodd-Frank Financial Reform Bill. Frankly, the bill should be
called the Dodd-Frank Fiasco!!!

The Federal Reserve’s Deflation Battle –
The Super-Keynesian Era

We are in a secular credit contraction and as such
the dominant risk to the economy is deflation. Why do I say we are in a
contraction? Take a look at the following charts:

This graph illustrates the rate at which money
changes hands. Called the Velocity Index, it is created by dividing the
current GDP index by the M2 money supply. In this case we are looking
at the turnover of money from March of 1996 to March of 2010. For the
economy to expand, regardless of how much money the government shovels
to the fat-cat bankers, people must lend the money and move the money.
The Super-Keynesians, currently led by Paul Krugman, are encouraging
the Federal Reserve to add another round of government spending and put
Helicopter Ben Bernanke in the air to spread the money around. Krugman
calls it the “Kitchen Sink Strategy” that deploys ALL uses of fiscal
and monetary policy to prevent the economy from sliding back into
recession. However, as evidenced by the next chart, banks and consumers
are still deleveraging their balance sheets (saving money). The one
bright spot for the Fed is the amount of cash on corporate balance
sheets in the US. The hope is that the cash will be spent on new
opportunities and expansion, but the evidence coming from employment
numbers indicates corporate America is content to continue holding
cash.

Bull markets need liquidity and velocity of money;
a growing economy needs financing, risk taking and entrepreneurs. We
have neither right now.

"The budget should be balanced,
the Treasury should be refilled, public debt should be reduced, the
arrogance of officialdom should be tempered and controlled, and the
assistance to foreign lands should be curtailed lest Rome become
bankrupt. People must again learn to work, instead of living on public
assistance
."  Cicero, 55 BC

 

Regardless of the course the Fed
Reserve pursues, it will not defeat the double dip that is imminent in
the housing market and that will mark a new decade of consumer savings
and moderate spending. Savings is the death knell of Keynesian
economics. To stimulate spending as opposed to saving I foresee another
round of tax incentives, R&D credits, home buyer incentives, public
infrastructure spending, and alternative energy projects being enacted
immediately following the November elections. However, let’s hope that
the policies of past government spending (bank bailouts) can be
replaced with policies that benefit a broad base of Americans. I think
John Hussman has captured my opinion of the current Fed Chairman and
the Secretary of the Treasury:

 

“I continue to believe
that both Bernanke and Geithner's hands should be tied quickly. If we
have learned anything over the past 18 months, it is clear that these
bureaucrats can misallocate an enormous quantity of public resources
with mind-numbing speed. The diversion of public resources to the
bondholders of failing financials
to precisely the worst
stewards of capital in society
is not stimulative, but
ruthless. A second economic downturn should encourage the repudiation
of the policies that Bernanke and Geithner pursued during the first.”

Unfortunately, we should expect another round of
“Spend Baby Spend” policies from the Fed.

Municipal Risks and Tax-Free Bonds

 

Over the course of the past five years I
have focused our fixed-income efforts on the corporate bond arena, due
to (a) historically low tax rates, (b) superior financial information
and research tools to evaluate corporate debt, and (c) my distrust of
the credit rating agencies such as Moody’s and S&P, with regard to
how municipal bonds price.

 

However, the tax game is beginning to
change and our focus going forward for any new bond allocations for our
taxable clients will be toward the municipal market as opposed to
Treasury or corporate bonds. In my opinion, the recent budget troubles
of various states and cities are contributing to unrest in the
municipal bond arena. As I have often said, you buy what people want to
sell and sell what people want to buy. At this point in time, investors
are more comfortable buying a ten-year Treasury bond at 2.9% versus a
State of Georgia AAA at 2.8-3.2%, tax-free. The municipal market looks
like a smart bet for the high-net-worth individual.

 

Lessons from Reinhart and Rogoff

 

Last fall Carmen Reinhart, University
of Maryland, and Kenneth Rogoff, Harvard University, published This
Time is Different: Eight Centuries of Financial Folly.
Anyone who
seriously wants a panoramic view of financial crises throughout
history must read this book, as it exhaustively catalogs the economic
missteps of governments over time. The most recent events touched off
by the euro banking community bailout of potential defaults by the PIGS
(Portugal, Italy, Greece and Spain) are not unique among the
historical debasements and defaults studied by Reinhart and Rogoff.

 

When I read economists and financial analysts
comparing the current recession to recessions of the post-World War II
era, I am reminded that there is only one time period in the history of
the US that compares with the current credit strains and deleveraging
of balance sheets: the Great Depression of 1929-39. The economic events
we are currently experiencing are, in statistical terms, “out of
sample,” and therefore the work by Reinhart and Rogoff provides a
large, global data set that allows us to draw certain comparisons
between then and now. According to Reinhart and Rogoff, once an economy
experiences a systemic banking crisis, then you can expect:

  • Housing price declines
    average 6 more years from the onset of the crisis.
  • Stock prices decline on
    average for 3.4 years.
  • Unemployment typically
    rises for 5 years.
  • Tax revenues decline and,
    on average, government debt rises 86% during the 3 years following a
    bank crisis.
  • Commodity prices on a
    global basis typically decline.

 

While the US has yet to attain the critical levels of
debt-to-GDP that would forecast an impending inflationary spiral or
loss of dollar confidence, we should be aware that our crisis began in
the fall of 2008. That would suggest, on average, that housing remains
depressed until 2014, stocks sway back and forth with a negative tilt
through 2012, unemployment remains in the double-digit range (as
measured by U6), and that we should not be astonished by the explosion
in public debt. This thought brings me back to the title of this
epistle, “In Search of Your Sleeping Point.”

Summary

 

We cannot direct the wind, but we
can adjust the sails.
” Bertha Calloway

 

I have often said we can never
eliminate risk, only manage it based on what the market is telling us.
Our tactical asset allocation is directed towards the active management
of risk versus reward in defining how we approach the financial
markets. Our focus is to preserve wealth by controlling our exposure to
risk assets, based on a number of quantitative and qualitative data
points. In my opinion, a buy and hold allocation is a dead decision
during markets such as we have now. Asset allocation, in my opinion, is
an art involving quantitative analysis of financial markets combined
with common sense.

 

One critical factor in our process is
finding the “sleeping point,” which I define as that level of risk
exposure that allows you to sleep at night. Or, as one of my clients
stated recently, “Cliff, I do not want to go back to eating spam.” We
are here to make sure your investment process protects against the spam
effect.

 

We have had the worst May in stocks
since 1940. No credit still equals no jobs. China is destined for
turmoil as its real estate market unwinds. The Consumer Confidence
Index is down to 52.9 in June from 62.7 in May. Fair value on the
S&P for me is 950, which would indicate another 7% decline in stock
prices from here.

 

Find your sleeping point.

 

Cliff W. Draughn,
President and CIO

 

Late Night Thought

 

"I really worry about
China. In the end I am not sure they want any of us to win, or to be
successful
…”

"I look at my American colleagues; the hardest
thing to do in China is get a win-win relationship
."

Jeff Immelt, CEO,
General Electric

 

h/t Adam

 

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Wed, 07/14/2010 - 09:58 | 467968 vote_libertaria...
vote_libertarian_party's picture

So is there some reason why the peaks occured late June 2009, late December 2009, late June 2010?

Is this when leasing decisions need to be made so the suppliers jack up rates knowing when the buyers are caught in a crunch? 

Wed, 07/14/2010 - 10:12 | 468002 Cognitive Dissonance
Cognitive Dissonance's picture

I've nurtured a similar long standing theory that oil prices move the same way, up just before long term contracts are signed/renewed, back down afterward. There can be a "conspiracy" among producers without a single word being exchanged between any of them. Since they all work in the same field, attend the same conferences, the executives and other personel move between the various companies, it's not surprising they would act in concert without overt collusion.

Wed, 07/14/2010 - 10:00 | 467971 vote_libertaria...
vote_libertarian_party's picture

(I was speaking about BDIY)

Wed, 07/14/2010 - 10:18 | 468009 mephisto
mephisto's picture

Scary quote from Jeff Immelt at the end there.

http://www.ft.com/cms/s/0/ed654fac-8518-11df-adfa-00144feabdc0.html

Wed, 07/14/2010 - 10:32 | 468040 stickyfingers
stickyfingers's picture

"Fair value on the S&P for me is 950, which would indicate another 7% decline in stock prices from here."

Markets always over shoot the mark, on the upside as well as the downside.

Wed, 07/14/2010 - 10:36 | 468043 Mercury
Mercury's picture

Our focus is to preserve wealth by controlling our exposure to risk assets...

Great, bigger downside risk in this environment than upside.  No news to this choir. So what is your favorite store of value then? What asset isn't a risk asset these days?  $Cash is king I guess.

Another prominent plug for that Reinhart/Rogoff book I see.  Gonna have to check that out.  I like the sweeping historical analysis stuff.

Kind of funny - if you read this off the Excelsia site the B-berg screenshots are a bit bigger and you can see Dick Mayo (GMO founder) shooting him a message.

Wed, 07/14/2010 - 12:36 | 468377 jaiball
jaiball's picture

Or, as one of my clients stated recently, “Cliff, I do not want to go back to eating spam.” We are here to make sure your investment process protects against the spam effect.

Dude, whats so wrong with spam?

Sat, 07/17/2010 - 06:09 | 475162 Kobe Beef
Kobe Beef's picture

Dude, Spam is made of people meat! They started doing it first in the former Yugoslavia, then Somalia, Iraq. hahaha Just Joking, Dude

 

Excellent Article! Thanks, ZH!

Sat, 08/14/2010 - 10:40 | 521600 herry
herry's picture

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