Ramblings of a Portfolio Manager

Is the Bear Case Really That Fragile or is Everyone Just Short?

Friday brought us a very nice rally across the US equity markets with the Dow, S&P500, NASDAQ and Russell 2000 indices all up nearly 2% or more. The rally capped off an odd week—after a strong rally on Monday, fostered by better than expected news from the Basel III bank capital accord over the weekend, where regulators gave firms more time than analysts expected to comply with stiffer capital requirements aimed at preventing future financial crises, the markets slowly began to give back the gains on the back of mixed financial data coming out of the US and Europe. Mixed data on housing starts in the US, a weaker than expected PMI out of Germany (which, of course, caused all the analysts to proclaim “the bloom is off the European rose) and the FOMC refusing to rule out further Quantitative Easing, all conspired to cause investors to start questioning the recent run up in stocks. Even Treasury yields started to head back downward again and the dollar weakened throughout the week. Then came Friday.

What happened on Friday? Thursday’s close saw the markets go from holding in positive territory all day to a strong late-day sell off. Considering that the economic data expected to be released on Friday (Durable Goods Orders and New Home Sales) was of fairly low import on the broad spectrum of impactful data, the market reaction was as odd as it was unexpected. Yet the futures opened strongly Friday morning with the one decent piece of global economic news having been released that morning being the German IFO, their version of our Business Sentiment Index, which came out stronger than expected. So what was with the rally? It may sound laughable and weak peg on which to hang one’s hat, but we truly believe that Friday’s rally was based nearly in whole on the guests who appeared on CNBC. The morning started with Jack Welch, former Chairman of GE and no fan of Obama. His strong opinions on the fate of the Obama machine and the Bush tax cuts come this election period added to the strength of the futures throughout the morning even as he declared “slow growth” in his ex-firm’s business lines. Following Jack came good old Doug Kass, the man who proclaimed the generational market bottom (and was right) on March 6th, 2009. His fairly bullish commentary on the value of stocks and own opinion on the upcoming elections added even more steam to the pre-market futures. You could almost see the shorts playing at home getting nervous as they sat at their laptops, in their boxer shorts, coffee in hand, trading on E-Trade. His final punch, however, was his call that shorting Treasuries would be the trade of the next century. Of course, outlining the reasons for this call gave him the opportunity to present some fairly bullish economic commentary, which certainly did not hurt the gathering strength.

The knock-out punch, however, was the appearance of David Tepper of Appaloosa Management, a legendary hedge fund manager who has been more right than wrong over the years and who made a killing on financial stocks last year when no one wanted them. Tepper rarely gives interviews, certainly not several hour-long appearances on financial TV, so his appearance was closely watched. Tepper didn’t disappoint. According to him, we are in a virtuous cycle (not his words) given the Fed’s stance on QE. Appaloosa typically allocates about 30% of capital to stocks and 70% to bonds and Tepper disclosed that he is still about 10% in stocks but moving more into them as he finds them cheap, particularly amid the current interest rate/Federal Reserve backdrop. To Tepper, if the economy strengthens stocks will do well. Conversely, in that scenario he thinks bonds and gold will not. On the other hand, he believes the Federal Reserve is acting as a put option for his strategy because if the economy worsens, the Fed will step in with quantitative easing, lowering long rates further and then all asset classes (except the dollar) would do well. It was his version of a win-win scenario and one could just watch the futures jump as he built his case.

All this CNBC commentary certainly added fuel to a fire that had started smoldering after the German IFO but the gasoline came at 8:30am when Durable Goods orders came in slightly better than expected, flying in the face of several back-to-back bad Philly Fed reports. Then, at 10am, New Home Sales came out mixed but overall stronger than expected and the fire was lit. Markets jumped and never came back. The funny thing about Friday’s market action was that, after the Dow hit it’s high of around +200, it sat there all day long, barely budging. No trader we questioned is quite sure why the daily stability but so much for 3pm being the most important hour of the day.

Did the favorable market opinions on TV Friday really drive the strong market reaction? And if it did, would wheeling out Nouriel Roubini and a few other bears bring it right back down? We suppose no-one will ever know the true answer but the commentary given certainly was rational, well thought out and made a helluva lot more sense to those schooled in economics (including us) than the knee-jerk “we’re the next Japan” headline grabbers that have been populating the airwaves lately. So, to answer last week’s question, are the elections already baked into market prices, we would have to say not yet. If a week’s worth of hand wringing over the margin by which Republicans will win in November managed to rock the markets back and forth only to be erased by some positive commentary from a couple of smart guys, then we think there is a lot more “kicker” left from certainty creeping into the eventual outcome of the elections and the events beyond. And to answer this week’s question, it sure seems to us like there’s a lot of non-believers out there—whether they are short or just plain underinvested, the case for being so is starting to look a little thin.

Ramblings of a Portfolio Manager

Running Scared, Running Right

R&D tax credits for small business. $50bn to build and improve our transportation infrastructure (none of which would be spent on signs touting such!). Extension of capital gains and income tax cuts. A $30bn fund to invest in banks to lend to small business. $17bn in tax breaks to business to hire unemployed workers. Tax credits? Tax cuts? Sounds like George Bush in year 5 of his administration. Oddly enough, in the Bizzarroland that is Washington D.C. these days, these are all proposals that have come out of the Obama administration in the last month alone! Odder still are the Republicans who are breaking rank with their party to jump on the President’s bandwagon for these plans at the same time a fair number of Democrats are jumping the ship of Obama like rats. Yup, the mid-term congressional elections are coming up and with the economy wallowing in the doldrums of no-growth, the politicians up for re-election are starting to fear for their cushy jobs. Now you understand why they call this the “silly season.” Desperate times call for desperate measures and, it seems, even the starry-eyed ideologue in the White House seems to be getting the message. We had postulated that that lone intractable zealot would wait for the election outcome to head in the right (double entendre intended) direction but it seems that he actually, albeit slowly, may be taking some cues from history. Specifically we refer to the Clinton years and it sure seems from our perspective that Obama is already taking baby steps toward the middle of the political spectrum. In the 90’s this move worked for Clinton, it worked for our economy and, ultimately, it worked spectacularly for our stock market. Now, Mr. O may not care about any of these three items but he certainly has a big concern for retaining sufficient power to push through his agendas and, well, if he has to bend a little to retain that power, maybe that’s a good idea. If any of this sounds like a 180 degree turn in the administration’s thinking, it is; and for the equity markets it has been recently, and will continue to be, a good thing.

Will it last? Since the President began his (begrudgingly) pro-business stumping, the S&P 500 has risen over 60 points and the Dow is up close to 500 points. Is the market discounting a kinder, friendlier Administration post-November? Or is it looking forward to all the congressional bums being thrown out? Or is it starting to read the tea leaves that have been showing the World economy (including the US) was and is not as bad as believed in May through August? Did interest rates get just too low? Or was the market just oversold on light summer volume? Yes. The answer, in our humble opinion, is probably a combination of all these factors. Taken with the extraordinary build up of negativity in the markets since April--which we have been discussing over the last month--all these factors conspired to take what was a very over-sold US equity market and give it a lift. But, we ask again, will it last? And if so how long? Sentiment has definitely improved, the extension of the Bush tax cuts is seen as all but a given (the only debate is how far up the income ladder to extend them), Vegas is long a Republican victory in November, Obama is obviously on some pro-business narcotic (where can we buy more?) and even Warren Buffett is out saying “no way will we have a double dip.” Is all the good news already in the market? Will the markets sell off post-election day? The trader in us says “probably.” The long-term investor in us, however, says “ we still have some way to go and if the market does sell off, buy, buy, buy.” Over the last two weeks, taking advantage of historically low rates, corporate America has been drastically improving its balance sheet. Equity issues, sub 1% debt issues, 100 year bond issues, you name it, if healthy corporations could exploit the dislocations we have in interest rates and stock prices, they did it. And that bodes well for the future—for earnings and growth.

We’re buyers into mid-October when we will get a better read on the political polls. Investors will probably take whatever those polls say as an opportunity to take profits. Late October and early November may be rocky but that’s when you buy—economic data and the political landscape will be better then than they are now, earnings estimates will be higher and the market will start focusing on 2011 earnings, which are sill around $90 for the S&P500, an all time high. Remember, stock prices are a function of the multiple (Price/Earnings, for example) and that which the multiple is measuring. Right now we have a good number to measure (S&P earnings) but sentiment is keeping the multiple down. We expect late November and December will bring us a lot to be optimistic about and with both multiples and earnings estimates high, we could see a very, very nice Santa Clause rally.

Ramblings of a Portfolio Manager

The Culture of Pessimism

The markets just closed out their worst August since 2001. After a strong July, based on good corporate earnings reports and guidance, the markets looked to be poised to continue the rally. Unfortunately, that rally lasted exactly one day into the month and then fizzled. A string of mixed economic data during the month trumped what were some fairly impressive numbers from Corporate America and investors, having been once burned in 2008, chose to shoot first and question later. The August Federal Reserve meeting, which was intended to calm the markets instead caused fear and renewed discussions of deflation and a double-dip recession. By the way, a strict definition of a double-dip assumes we have already emerged from the prior slowdown to the pre-recession GDP—we haven’t so yet just keep that in mind when the CNBC talking heads get going on their “double dip” talk.

In terms of Q2 earnings reports we had over 75% earnings beats with similar results in raised guidance. While these statistics are near an all time high and contributed to a strong July, the market’s mood turned sour in August on some of the macro economic data, particularly the Philly Fed Index, and good earnings reports, rather than being rewarded, in fact, turned into an opportunity to SELL.

The equity markets are now in a culture of pessimism. Time Magazine just ran an article questioning whether Americans should own homes. A poll of Hedge Fund managers showed the highest degree of pessimism regarding the equity markets since 2008 (47%) . The AAII index of investor bullishness is at 20%, a 5 year low. Yet another poll put investor sentiment at the lowest point since March of 2009, the “Generational Low” we hit after the financial crisis. Outflows from equity funds and into Treasury Bond funds is at the level of late 2008. Gold and US Treasuries have become cult investments with gold just off its all time high and the 10 year bond yield near its all time low. Wall Street Analysts, usually a lagging indicator, have for the first time in more than a decade, rated the percentage of stocks as Buy below 29%, down from 75% in 1997, according to Bloomberg. Paradoxically, analysts aren't telling investors to sell either, with Sell ratings remaining near a low 5%. Instead, Hold ratings have ballooned to a record 66%. All along these analysts are raising their earnings estimates for companies while dropping their target prices for their stocks. Finally, the London FT just ran an article that it has become fashionable to be negative both in the financial and popular press. Typically, all this pessimism would signal that we are nearing a low in the equity markets. But one has to have a strong stomach and a good dose of contrarianism too hold ones nose and jump into the equity markets. We have both.

We think this is an excellent time to build a portfolio in equities. Why? First of all, we were on almost every earnings conference call and spoke with management during earnings season. The tone and the guidance we heard was almost universally positive. And, nowadays, when Managements lie they do so to the downside so they can sandbag the upcoming quarter. This means the rest of the year is probably going to be better than to what they are guiding. The problem is, no one believes it. That’s why there is so much cash sitting on the sidelines and in bonds. One little hiccup in bonds and there will be a panic move into stocks, small cap stocks in particular. What will cause the hiccup? Getting those idiots out of Congress for one, better economic data (as we have seen in the last few weeks) is another. We’ve had 13 months of improving manufacturing data. At some point even the dense guys sitting in cash will get it.

We believe that the markets are discounting an economic scenario that is much worse than what exists. In addition, we have several catalysts ahead of us to further bolster equity returns. Republicans now have a 10 pt lead in the polls versus the Democrats going into the mid-term elections, the largest in 68 years. This signals political gridlock at the least, usually good for the markets, or a Republican sweep, which would ensure that the Bush Tax cuts will be extended for all income classes. Additional tax cuts may also follow a Republican regain of control. One little tidbit: the six months following a mid-term election have shown strong positive equity gains every year since 1950.

Last week we got a little taste of what a rally based on “not as bad as feared” data might look like. It was strong with many of the indicies erasing nearly all of their August losses in just three days. Will it last? That depends upon the data we continue to get but imagine the rally that would ensue if the data actually turned positive and beat consensus, if we get regime change and Obama chooses Clinton’s wise course when he lost his majority in the mid-terms and moved to the center . World equity markets have been moving up strongly for a few weeks now on strong economic data. We have not. The ‘decoupling” adherents are starting to come out of the woodwork. Their record had been very consistent—100% wrong. So if the Worlds’ economy is humming along better than expected, perhaps so is ours.

Ramblings of a Portfolio Manager

“Dude, you’ll need a different board to catch a phat ride without a rad curve!”


It’s been nearly two weeks since the Federal Reserve last met and made the historic pronouncement of their intent to start purchasing long-dated treasuries with the runoff from their maturing MBS portfolio. Since that decision the Dow and S&P500 have fallen roughly 5% each. Harder hit, however, have been the bank stocks, which have fallen 8% as expressed by the Keefe Bruyette Bank Index, and small cap stocks with the financial-heavy Russell 2000 Index also down 8%. Thanks guys!

We opined last week on the reasons for the market’s ill take on the Fed’s decision so we won’t repeat it. Rather, we question whether the market is “getting it” in its negative view on bank stocks in particular and by extension, equities in general. The conventional wisdom of the portfolio manager is that the flattening of the treasury yield curve from the Fed’s actions will crimp bank earnings—particularly in the current environment in which most banks have been “surfing the curve” by using their near zero cost of funding (from Fed Funds, negative real rates on time deposits after fees and pitiful CD rates) to reinvest in long-dated, risk-free treasuries. We don’t disagree--with a steep yield curve, the banks were literally printing money with little risk given the Fed’s promise to hold short-term rates low for a very, very long time. Now, however, that little game seems to be over and with the other arm of the Government rushing to “help” with the Financial Reform bill, estimates are that earnings of banks and other financial institutions will fall significantly (25% or more by some estimates). Where we disagree is with the extension of the conventional wisdom to encompass the belief that this will dampen the incentive to lend, thus weakening the economy. We lost count of how many PMs appeared on TV over the last two weeks with a statement to the effect of “the market cannot recover without the banks leading the way.”

It’s been too short a time to analyze bank balance sheets to determine whether the Fed’s decision has made any substantial change in Management behavior and it could take up to a quarter or so for the information to work its way into financial statements. In the short-term, however, we can see the immediate effect on consumer behavior and at the end of the day, that’s what we all care about anyhow. Last week, mortgage refinancings were up 16%--an immediate reaction attributable to the rapid drop in long term rates. That little blip alone should put substantially more money in the pocket of the beleaguered consumer, more than whatever new fees the banks might extract thanks to Fin Reg. That’s a net positive to the economy. But what about those banks? Will a flat curve hurt them? We believe the Fed’s actions were designed to do just the opposite. By flattening the yield curve, the Fed did two things, both of which were intentional: First, it brought down mortgage rates, a shot in the arm to the ailing housing market. Secondly, it sent a message to the banks that the risk-free surfing is over and that’s a good thing. If bank Management wants to stay employed and appease shareholders, they’re going to have to find new sources of revenue. One, as we mentioned, will be to raise fees to depositors, but we feel the lower long-rate environment will more than make up for that in consumer wallets. The other is to boost net interest margin by reaching for yield—that is, by taking some risks like making loans or even buying MBSs themselves. In the latter case, the banks would be taking over the Fed’s recent job (the market didn’t like the Fed’s decision to stop MBS purchases), driving mortgage rates even lower, and in the former they would actually be spurring on economic growth. Either action would be good for the housing market, the overall economy and, ultimately, for the equity markets. We just need the Obama Administration to get out of the way and let the banks do what they do best.

Ramblings of a Portfolio Manager

Bullard vs. Buffett


The Federal Reserve held its monthly meeting last week and since then the equity markets have churned lower daily. By the end of the week all the major equity indices were down following the decision with the S&P 500 and Dow dropping 4% respectively and the Russell 2000 index of small cap stocks plunging 8%, all within three trading days. The reaction was as dramatic as it was unexpected and left all major US equity indices back in the red for the year. The Ten Year Treasury Bond yield, meanwhile, hit a 16 year low and is now below the dividend yield on the S&P 500, something that almost never happens. The pundits ascribed the market’s response to the Fed’s downgrade of expected GDP growth-- which is interesting as that was something that was widely expected--and its decision to maintain its balance sheet at current levels, essentially halting its earlier ongoing withdrawal of liquidity from the markets. The Fed also reiterated its intent to keep rates at the same level for an extended period (also expected) and to reinvest the proceeds of maturing Mortgage Backed Securities into Long Maturity Treasuries.

Forget the pundits, why did we get such a dramatic negative reaction? Typically, continued easy money policy would be seen as a positive. The simple answer is based on the Fed’s signaling. Historically, a good portion of the efficacy of the Federal Reserve has been not so much its actions as its pronouncements—that is, simple declarations of intent to proceed in one direction or another have been sufficient to achieve the desired economic results, rather than actual direct monetary intervention. Of course, the Fed tries very hard to send signals that guide the markets and economic participants to the desired behavior…and such was the case this time around. The problem is, like any type of guidance, the outcome depends upon the expectations of those that are guided. In the case of the equity markets, a recent round of strong economic data got many participants (us included) into the belief that the economy is stronger that the economic data suggest and that the Fed was of the same belief. Their downgrade of economic growth, though expected, paired with additional quantitative easing, quashed that belief for many. Had they done nothing, the markets would doubtless be much higher today.

The second issue we see with the Fed’s actions is the decision to allow short term MBS securities to roll off and to use the proceeds to buy long-dated US Treasuries. We believe the market had hoped for more open market purchases of MBS securities thereby bolstering the housing market, a weak link in our current economic recovery, with continued low mortgage rates. The current plan would simply flatten the yield curve, which for many is seen as a net negative. We disagree. First of all, mortgages are priced off the 10-30 year Treasuries so with the Fed driving down the yield on these instruments mortgage rates will fall any how. Secondly, we believe that flattening the yield curve is going to get some of the big banks off their collective conservative butts to stop “surfing” the Treasury yield curve. That is, borrowing short term at essentially zero and plowing it into risk free Treasuries at a 4% yield, free money so long as the yield curve doesn’t invert. Now, with 30 year Treasuries heading toward the 3% range, many banks will face the prospect of below historical net interest margins. How to boost them? Make loans, of course. That is what the economy really needs (other than certainty out of Washington but that’s tantamount to expecting a $1mm check from the tooth fairy) and we believe that is what the Fed had in mind with its strategy. Obviously, the market does not see it our way.

The other outcome of the Fed’s move was renewed talk of deflation. St. Louis Federal Reserve Member James Bullard has been doing the speaking circuit with his prediction that the US is heading toward a Japanese-style deflationary economy based on the Fed’s continuing zero-interest rate policy, which he believes is putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years. Now, when a Fed governor speaks, the Markets listen and the current weakening expansion certainly lends credence to his beliefs. The interesting tidbit to consider is that his predictions fly in the face of the predictions of a very famous market participant, Warren Buffett. Reports have Buffett , link to report, shortening the duration of his bond holdings after warning that deficit spending could force inflation higher. Twenty-one percent of his holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter. As Buffett was quoted as saying “The United States is spewing a potentially damaging substance into our economy -- greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.” Clearly, his opinion of the outcome of the Fed’s monetary policy is 180 degrees from Bullard’s.

So who to believe? We tend to follow the guys with the real world experience rather than the academics. Furthermore, based on the earnings conference calls we have sat in on we continue to hear that companies are bumping up against the limits of their productivity growth or capacity utilization. At some point, like flood water behind a dam, that has to push through in a great rush of additional hiring and plant expansion. That, we believe, will give us the growth and employment this economy needs and, ultimately inflation rather than deflation.

Ramblings of a Portfolio Manager

Mr. Peabody’s Apples

The dog days of summer are upon us so we’ll spare you a lengthy treatise on some arcane aspect of finance. Instead we’d like to talk about a little children’s story, written by Madonna of all people, that we used to read to our kids. It’s based on an old Eastern European folk tale of a woman who spread a false rumor and the village wise man who challenged her to shred a feather pillow into the wind and then try to recapture all the loose down, the moral being that once out false rumors and gossip are almost impossible to recall. Sound like the internet? Sounds a lot like CNBC to us as well.

OK, confession: what we really want to do is give you a quick report card on the current earnings season to date. So far approximately 1/3rd of S&P 500--and by extension all US--companies have reported their second quarter earnings. Going into this reporting season the general consensus among the Wall Street sell side and financial media was that the second quarter reports would be good, but not great, and that management guidance would be terrible, given the turmoil in Europe and engineered slowdown in Asia. How did that consensus belief come into being? Cynically, we suspect that it originated from a Wall Street sell side analyst who was unable to update his Q3 and 2011 earnings models because the managements of companies he followed refused to spoon feed him the correct numbers. In any case, however it began, the financial media picked up the story and repeated it ad naseum, without any attempt at corroboration or even sanity test, until it became an accepted fact—it all just made so much sense (to them, anyhow).

Fast forward a month and where are we? Well, by our calculations, 78% of the companies reporting so far have beaten Wall Street earnings estimates with EPS up 42% year-over-year versus initial expectations of 27%--i.e. 15% better than forecasts. That’s almost 10% higher than the average “beat” rate since 1998. As for guidance, at least 10% of companies that have reported so far have raised guidance, 2% have lowered it with the rest maintaining their outlook for the rest of the year and into 2011. Doing the tough math, that’s 98% of reporting companies NOT seeing the future in the same way as the sell side or financial media. By the way, according to Bespoke Investment Group (whose numbers differ very slightly from ours), that’s the highest percentage spread of up vs. down guidance since 2001 and the fifth consecutive quarter where positive guidance has outnumbered lower, the longest streak since 2001. And how are the analysts and media reacting to this reality? Well, some of the feathers are back in the pillow, but the perception remains and the talking heads still manage an ominous “What will management say about the future?” at least once a day when mentioning companies due to report. In addition, beaten but not out, financial reporters, who obviously haven’t read the Mr. Peabody parable (do they even read?) have started yet another rumor: this one goes something like “While the earnings have come in better than expected and guidance has been strong, most companies have missed or not beaten on the top line.” This amounts to an admission of “Well, we may have been wrong about the first rumor but, surely, two pillows will need not be restuffed…?”

So with all the hand-wringing about the top line, what does the data say? Stuff it Baby! According to our data and others, revenues have largely followed earnings with 73% of reporting companies beating top line expectations to date, a number also well above the historical average. In fact Reuters just last week raised its year-over-year revenue growth expectations from 9% to 9.5%. While the percentage “beat” has not been as great on the top as the bottom line (5% vs 15% for EPS), the data is still in direct conflict with what we hear daily in the media. Yup, the financial media’s reaction to this fact has been to throw out the pillow entirely--to simply ignore facts and continue with the mantra of “Revenues just aren’t living up to expectations.” We suppose it makes for better headlines than “We Was Wrong!” So, in answer to our question above, no, financial reporters don’t read…or at the least they can’t read earnings reports. It’s a good thing your first grade teacher wasn’t also a financial reporter—with their ability to analyze report cards, you’d still be repeating that grade.

This morning the brains on CNBC are reporting that 1/3rd of S&P 500 companies are left to report. It appears that retailers, on a one-month lagged fiscal year, no longer count in Medialand. We wonder if any attempt will be made to return these feathers. Doubtful. As we tell our kids while they watch cartoons, “don’t believe everything you see on TV…except, for course for Spongebob.”

On next week’s installment of Misconception Becomes Mantra : How 50.6% of the stimulus package having been spent so far amounts to “almost all of it” when it hits the airwaves.

Ramblings of a Portfolio Manager

What More Does the Market Want?

We just ended a second consecutive week during which an enormous amount of potentially positive market moving data was released. Two weeks ago we got strong earnings and forward guidance from the likes of Alcoa, CSX, GE and Intel, heard of a Goldman Sachs settlement with the SEC and learned that BP may have successfully capped its leaking well in the Gulf. Last week we saw continuing positive news: the Financial Regulation Bill was passed by the Senate and signed into law by the President, relieving much of the uncertainty surrounding the bill especially when in the final analysis the rules may take up to a decade to be implemented by which time affected firms will have adapted to or circumvented them; the results of the European bank stress tests were released, results that were much, much better than expected both in terms of the number of firms that passed and capital that needed to be raised; housing start data was in line with expectations but new permits were better than expected; weekly jobless claims came in more or less in line and the Senate approved an extension of unemployment insurance, restoring benefits to 2.5 million people; Fed Chairman Bernanke testified on Capitol Hill that the Fed does not see a double dip and maintains its 3%+ GDP growth forecast but is in no rush to hike rates and is ready to implement “QE2” should growth slow; General Electric hiked its dividend earlier than expected, a sign that they see strength in their business going forward and, finally, the string of strong corporate earnings and raised forward guidance continued with the who’s who of the Fortune 500 reporting including IBM, Microsoft, American Express, Coca Cola, Apple, UPS and Ford. The markets responded positively to this data with the Dow and S&P 500 both rallying about 2.3% over the last two weeks. This rally, however, was very choppy (markets initially dropped over 1.5% on Bernanke’s testimony) and still leaves us negative for the year with the Dow down 1% and the S&P 500 just below the flat line.

With all the positive news and dissipation of uncertainty during the last two weeks, the major market indexes still sit in the red for the year. What will it take for investors to feel comfortable enough to get back into the market and move us higher? Last week we opined on the dichotomy between the economic data and company reports. A more accurate depiction, it now appears, is reality vs. the forecasts of economists—i.e. the view from the trenches vs. that from the Ivory Tower. We reiterate our belief that the best prognosticators of the Country’s economic future are its CEOs and not politically (or otherwise) motivated egg heads, most of whom have never held a real job. Still, with all the positive chatter coming out of Corporate America, the markets languish. What more do they want?

We believe that there is one remaining piece to the puzzle, or conundrum in Alan Greenspan speak, and that is jobs. Though companies have painted a rosy outlook for their future profits, most have done so with the assumption of no new hiring. Clearly, for the markets to advance, unemployment must come down, which means these companies must incorporate additional staffing into their forecasts. Two factors are going to cause them to do this: first, their businesses must improve to the point where they cannot possibly grow Earnings Per Share fast enough to meet Wall Street expectations without brining in new workers—i.e. capacity utilization must increase to the point where productivity gains alone (i.e. using more technology or working existing employees harder) will not suffice to drive earnings higher. We believe that many companies are getting to that point right now. Just this morning Federal Express hiked its guidance, saying that they expect volumes to grow 20% this year. Given that their planes are already nearly full, they will have to add new planes, and people to fill and fly them, to meet this growth. We’ve heard similar reports from other industries, who are also beginning to ramp their capacity utilization.

The second factor that will spur hiring feeds into the first, and it involves the reduction of uncertainty regarding Government policy—both on taxes and regulation. Companies will hire when business improves but only if they are confident in estimating the marginal cost of those hires. Right now, given the uncertainty over the cost of health care reform, new taxes in 2011 and any other fiat of regulation that Congress decides to ram through between now and November, that marginal cost of hiring is almost impossible to estimate. For the future to be sufficiently clear to give CEOs the green light to hire, we are going to need a radical change in policy/behavior on Capitol Hill and the only way to achieve that is to get some good old fashioned gridlock, or better yet complete regime change, in Congress. Poll any CEO and it is highly probable that you will hear the belief that we currently have the most anti-business Government in this nation’s history occupying our seats on Capitol Hill. This isn’t necessarily our opinion—it’s a message we have consistently heard from virtually every earnings conference call we have attended—and it is a line of thinking that doesn’t encourage Managements to hire. Fortunately, the mid-term elections are only a little more than three months away and we will be getting early data from the political polls very soon. Given that markets are discounting mechanisms, this means that if the polling data shows CEOs will be getting their wish this election, then we can see continued equity gains through the fall. Let’s just hope that the “dead men walking” on Capitol Hill don’t pull the same tricks as the Corzine administration did to New Jersey just before it was ejected on its ear last fall—that is, ramming through more tax and spend policies at the 11th hour. Hopefully, those soon-to-be lame ducks will start thinking about their futures in the private sector and exercise some spending restraint for a change.