WEEKLY ECONOMIC ANALYSIS: June 26th, 2009

Provided by TEAM Financial Services

"The American polity is infected with a serious imbalance of power between elites and masses, a power which is the principal threat to our democracy."
- Paul Wellstone

Items for Discussion

As long time readers may remember, we like to step back from time to time in this weekly commentary and consider the long term macro environment. It is easy to get caught up in the day by day or week by week noise in the market place, so we will once again revisit some longer term factors we view as important.

With the major US stock market indexes like the Dow Jones Industrial Average and S&P 500 essentially flat over the past ten years and down so much over the past year, it would not be a terribly unusual deduction that stocks must be relatively “cheap”. Unfortunately, even with a “Lost Decade” for US stocks in general, the following chart provides one simple way to measure the value of the stock market versus the economy.



As the chart indicates, the ratio of stock market capitalization to GDP would have to fall by about 29% from the level at the end of May just to reach the long term average. It would have to fall by over 50% to reach levels approaching 40%, which was the minimal level from which prior long term bear markets ended in the 1930’s and early 1980’s. There are many other ways in which we gauge long term stock market value, and in total they point to a similar conclusion: stocks on average are no where near levels that have historically reflected long term lows.

What could the path to a long term low look like? The following chart provides one example of a major global stock market’s path:



The chart is of the Japanese Nikkei stock index and shows that the Japanese market peaked around 38,900 in 1989 and has been in a 20 year bear market ever since. A similar 20 year decline of 74% in the Dow Jones Industrial Average would result in the Dow trading around 3,700 versus its all time high around 14,200. This is by no means a forecast or prediction, but simply an example of one country’s stock market that has been in a bear market for 20 years.

We displayed a chart a couple of weeks ago showing the massive amount of debt in the US economy and explained our view that this imbalance is likely to be a major economic headwind for the foreseeable future. It has long been our premise that much of the economic growth in the US over the past 10+ years has been the result of excess debt/credit creation. We’ve also argued that once the major credit bubble finally popped, the horrendous mis-allocation of capital that resulted from the bubble could result in major dislocations in the economy and labor force. Where will all the mortgage brokers and real estate agents find jobs? Apparently the government is hiring….

As the chart above shows, the current recession has effectively wiped out almost all of the jobs growth in the economy over the past 10 years. The next chart provides still more insightful information as to why we are worried about the economy moving forward.

The private sector growth over the past 10 years has now been eclipsed by the growth in government jobs. Unfortunately, the news can be even worse. Inside the private sector, the leadership in job growth has been in the private industries that are either heavily influenced or subsidized by government, like healthcare and education.

Given this backdrop over the past 10 years, we are left to wonder where the jobs will come from now that the credit bubble has popped? The mis-allocation of capital to retail, home construction and financial services resulted in a massive amount of labor dedicated to those areas that is now obsolete. We believe it will take a long time for the economy to restructure and "replace" those lost jobs. The meddling of the government is likely to extend this problem and make it worse, in our opinion.

Market/Economic Climate

The internal health of the stock market continues to display warning signs that a correction of some significance is possible if not probable – at least in the 10%-15% from the recent high. Our model has shifted to a cautious posture on stocks, but also on many economically sensitive/industrial commodities like oil and copper. At the same time, our model has shifted to a positive posture on long term US treasuries and the US dollar. These shifts are based on short to intermediate time frames measured in weeks and maybe a couple of months. Until proven otherwise, we view these developments as counter trend.

When making allocation and investment decisions, our process in deciding whether to try to sidestep or hedge a counter trend move is based on the potential size of a “correction”. At present, our matrix of research and indicators suggest that the risks of a sizable correction are significant enough for us to have shifted our portfolio strategy to a more defensive stance.

We’ve moved progressively over the month of June to reduce portfolio risks and we continued that process this week. While we remain bullish on precious metals stocks over the long term, we decided to reduce our exposure to the industry over the past couple of weeks. Due to our sizable investment in the industry last fall and the significant appreciation since, these positions had grown to be a higher percentage of client portfolios than we are comfortable with given our concerns about a potential correction. By reducing exposure, we reduce risk and create enough room in portfolios to proactively re-buy exposure in the industry if a larger correction does emerge.

Along with the reduction in precious metals exposure, we also boosted our portfolio hedges again this week. With these latest moves, we believe client portfolios are well positioned to weather a potential correction of significance. Markets are likely to be choppy as we approach the end of the calendar quarter on Tuesday next week

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.