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

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.”



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