I receive this analyst point of view from a patient of mine on a regular basis....has been helpful for me so I thought I would share....He's an insider at the Royal Bank of Canada
"The Musing: After four hectic days of nine branches and six separate client meetings of some size, I thought I would pass along some of the issues we discussed. The presentation I went with (at least the IA version) was designed to weigh the current situation and the look forward, rather than focus on what has already happened. Here were the highlights:
• There are four keys to a recovery: I see the solution to the near-term economic crisis in four pieces right now. The two obvious ones are monetary and fiscal stimulus, the two less obvious ones are housing and trust. The way I see it, monetary and fiscal stimulus are well aligned with an eventual recovery, while trust, in the form of falling credit spreads, is beginning to fall into place. However, I still believe that housing is far from aligning as of yet. Inventories remain around 10 months (normal is around four) and there are probably another couple of months of inventory that is foreclosed on, but not on the market as of yet (making the real inventory number around 12 months). Further, there are a huge number of prime and Alt-A (between prime and sub-prime) loans that will be resetting in the next 12 months (which could lead to another wave of defaults), so anyone who tells you we are near a bottom yet is probably trying to sell you real estate. Yes, the epicenter states – California, Florida and Arizona – are beginning to show signs of bottoming, as volumes are up big, but this is at prices 50-60% below peak, so everything is relative. Nationwide, prices are down 30% and will likely fall at least another 10-15% before they are done. The key is, it needs to be 10-15% and not worse, as we are prepared for the former, but not for the latter. Bottom line, I don’t buy into a sustainable turnaround until we get definitive signs of a housing bottom.
• That said, we will grow in Q409 through Q210: While I doubt a sustainable recovery without a housing turn, we will get positive economic growth beginning late this year. I premise this on the simple notion that Q408 and Q109 were so darn ugly that we almost have to grow off of these levels. How sustainable it is remains an open question, but at least positive growth will return for a little while.
• Deflation is the near-term concern: We are facing an unprecedented output gap, as unemployment will likely approach 10% (15%+ if you include disaffected workers) and capacity utilization will approach 65% (normal is 80%). This is highly deflationary and the Fed and the government are throwing everything at it to insure that deflation does not become entrenched. In the 1930’s and in 1990’s Japan, it was allowed to become entrenched, but in 2001-02, when Alan Greenspan faced a growing deflation risk brought on by the pricking of the tech bubble, he read page 14 of the book of economics (this is a mythical book that exists only in my mind, so you can’t buy it) and it outlined how to beat it (basically do the opposite of what they did in the 30’s and 90’s Japan, which was almost nothing for the first several years of the crises). Mr. Greenspan turned on the monetary taps and George Bush turned on the fiscal taps and entrenched deflation was averted.
• Inflation is the longer-term concern: Mr. Greenspan read page 14, but he failed to read page 15, which said, “okay, stop now.” He left monetary policy loose for far too long and there was also no shut-off for Bush’s fiscal policy. While we did not get inflation in the traditional sense, we got massive housing and debt-level inflation, which played a big hand in the catastrophic last 18 months. Now, Mr. Bernanke has clearly read page 14, as has Mr. Obama. But will they read page 15? I am guessing they won’t execute it properly for a couple of reasons:
1. Page 15 is hard, as raising rates and cutting spending is a delicate thing. If you do it too quickly, you risk sending the economy back into the soup and if you do it too slowly, you risk stoking inflation;
2. Delaying the decision has some benefits. The US is taking on an enormous amount of debt and the easiest way to reduce this debt burden is to inflate your way out of it. Allowing inflation to run rampant for a few years would drive strong nominal growth and thus reduce the yawing debt burden that the US faces. Bonds and equities
may not like it, but the government likely is not all that concerned about that right now. Thus, I think we face a real risk of inflation longer term.
• The next 25-years will be nothing like the last 25-years: From the early 80’s through mid-2007, we lived through an unprecedented period of calm. Growth was stable, recessions were few and minor, inflation was constantly dropping (so called disinflation), demographics were favorable (the echo generation) and the best investment strategy was buy and hold. I think the next 25-years set up nothing like the last. Growth was stable largely because we levered ourselves up and those days are over. Demographics turn against us in a big way, as the baby boomers retire (an issue that still barely gets discussed), while as I mentioned in the previous bullet, inflation may be far from tame. This is not an environment that sets up well for buy and hold, but rather for a more active investment style that focuses on the underlying economy and looks to capitalize when the economy is poised to grow, but also looks to get out of dodge in a big way when the underlying economy begins to sour. Asset allocation will need to be more dynamic and stocks will need to be bought and sold more frequently. For my two cents (and I readily admit there are people far smarter than I that can probably come up with better), I envision an investment strategy based on 40% stocks and 40% everything else, with a 20% “swing position” (note that these numbers are only for discussion sake and not etched in stone), When a certain set of indicators turn in a certain way, a committee of some regard may recommend a full 20% of the swing position be put into stocks, but when these indicators turn sour, the opposite may occur (PIM IA’s could add to or subtract from individual positions, whereas non-PIM IA’s might simply buy or sell index ETF’s). While this won’t prevent losses when the market turns down, it will mitigate them to some degree and that may be the best we can do at this point.
• A three-year view, rather than a one-year view: I find most analysts less useful right now, as they are rooted in the past 25 years. Making assumptions based on what prevailed in a long bull market may have very little use in a world where the economy could be far more cyclical than it was in the 80’s and 90’s. Further, most analysts look out 12-18 months, but quite frankly, I doubt anyone’s ability to tell me much about a timeframe such as this, as there is so much noise in the world right now in the form of government intervention and housing deflation that one might as well toss darts at a board. Short of looking at short-term technicals, which I think can be useful, I fade much of what analysts tell me these days. Rather, I take a three-year view, as I can safely say that in this timeframe, the housing crisis will be in the rearview mirror. If I can find stocks that can withstand a series of conservative assumptions and generate a decent return from current levels over this timeframe, then I am interested. Otherwise, I am not. The banks screened well back at the end of February, but the recent run has removed them from the list of names I’d buy right now. Examples of names that screen well for me right now include Transalta (TA), Rogers Communications (RCI.b), and Finning (FTT), but again, I am taking a three-year view.
• The current rally will likely run to the 200-day moving average, but then, I grow less enthusiastic: I believe in keeping the technicals simple and when I see a market breakthrough and hold its 50-day moving average, I believe at the very least it wants to test its 200-day before its done. Thus, the S&P looks to go to 950 or so before it is done and if I want to play this rally, I continue to ride for a while longer. At this point, I would use an index ETF rather than individual stocks, as I am unsure which stocks will be the drivers from here.
• I remain an unshaken long-term commodity bull: While it takes a bit of chutzpah to believe this, I think the last eight months have been just about the best thing possible for a long-term commodity thesis. I lay this on the premise that for much of the 80’s and 90’s commodity prices were in the tank. Management teams cut existing projects to the bone and most new projects were shelved. When this decade rolled around and Chinese demand emerged, the mining world was ill prepared and prices took off. But, management teams were reluctant to greenfield new projects, as they keenly remembered what took place in the 80’s and 90’s. To start a new project, one has to believe that prices will remain elevated for five to seven years, as new projects take about that long and few had this level of faith. But in mid-2007, this started to change, as we began to see the emergence of significant potential growth in 2012-2015, as management teams finally began to gain some long-term price faith. The last eight months have killed this faith. Huge supply has been shelved, while much of the longer term growth supply has been cancelled. While I think these guys can be fooled once, I doubt they will be fooled again and I see a huge reluctance to greenfield for the next decade. Right now, demand is not there, so this does not matter that much, but demand will come back at some point and I think we once again set up for a huge move in commodity prices down the road."
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