2Q10 THEME - APRIL FLOWERS/MAY SHOWERS - MACRO SUSTAINABILITY?

The central principal of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.”

  ~Warren Buffet

Our 2Q10 theme, APRIL FLOWERS/MAY SHOWERS, suggested that the S&P 500 could sees a 4-7% correction in 2Q10.  We did not think it would happen in a matter of days.  While Buffet took some heat over the weekend for talking up his book, he is still the ORACLE OF OMAHA.  As he suggests in the quote above, the persuasive bullishness of late is just to “dear” to the masses.   

Last week, the government reported that real GDP increased 3.2% annualized in the first quarter.  This print was slightly below consensus +3.3% and vs. prior +5.6%.  Personal consumption expenditures (PCE) were +3.6%; higher than consensus +3.3% and prior +1.6%.  PCE accounted for 2.5% of the reported gain and business investment accounted for 1.6% points, of which 1.5% was due to a continuing relative buildup in inventories.  The big concern with the Q1 GDP report is whether or not the trends in PCE are SUSTAINABLE.

As I wrote the other day, SUSTAINABLE growth in PCE requires continued growth in real disposable income.  Without growth in income consumption can only be borrowed from the future quarters through borrowing more and/or the consumer spending his/her savings.  In the current environment, neither of those sources is real or sustainable.  In 1Q10, the quarter-to-quarter trend in real disposable income was contracting.  Real consumer credit, which has been reported only for January and February, was also contracting in the first-quarter versus the fourth-quarter.  

If the U.S. banking system were able to function normally, it would be lending more money, not contributing to a slow downward spiral in consumer and business credit outstanding.  Needless to say, these trends show no basis for SUSTAINABLE growth in the economy or PCE.

The US market bulls expect the market to continue to move higher on stronger earnings.  A Bloomberg survey suggests expectations for total profit from Standard & Poor’s 500 Index companies of $88 to $90 a share this year, and close to $100 a share in 2011.

It seems unlikely that these strikingly bullish estimates incorporate proactive slowing of the free money trail in a number of regions around the world in 2H10 and 2011.  With the Chinese market down 13% year-to-date, worries about a slowdown in China are increasing.  The Government is proactively saying things are too hot.  The number of countries that are “proactively slowing” growth is increasing every week; it’s becoming the norm not the exception (Australia joined in last night and India has a real inflation problem to address).  Just to name a few….

With this trend solidly in place, and critical component to overall earnings growth, we would argue that over the next four quarters the risk/reward points to the downside in emerging economies; thereby placing much more pressure on the developed world recovery to meet the S&P 500 earnings growth numbers.  Such a recovery is not a likely event! 

We have been very vocal about the mounting sovereign solvency issues in Europe.  In many ways, the European crisis echoes the way the U.S. banking crisis brought the global banking system to its knees.  At that time, the global monetary policy-makers allocated trillions to prevent systemic collapse.  In total, the sovereign debt crisis in Europe could also threaten systemic collapse.  As with the U.S. banking crisis, I expect that everything possible will be done to prevent that type of massive melt down. 

As a result, U.S. fiscal stability is the key to keeping global systemic risk in check.  Unfortunately, our balance sheet issues are very much the same as those facing the PIIGS.

April Flowers/May Showers

Howard Penney
Managing Director