Ramblings of a Portfolio Manager

To Some, Economics is Just Crap

It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).

Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.

Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]

OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?

So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.

Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.