2012 U.S. Economic Outlook

Of course a wise person will hedge his or her bets ...

In 2011 the U.S. economy took everything that nature and venal politicians could throw at it and still managed to grow overall. It could have been a banner year, but the tsunami in Japan, the politics of Washington, high oil prices due to Libya, the Euro crisis, and finally flooding in Thailand all took a toll.

I think the most likely scenario for the U.S. economy in 2012 is moderately strong growth. I don't think turmoil in Europe will hurt the profits of very many American companies; the worst effects will come from converting the Euro to dollars for multinationals, if they have substantial European sales and the dollar continues to strengthen. Keep in mind that the alarmist view of Europe may not pan out, in which case a rising Euro could have the opposite effect.

2011 was also the year in which almost every professional economist in the U.S. predicted a new recession, which did not happen, despite the best efforts of Congress. Where do they find these guys?

In fact, I would hazard that strong U.S. economic growth is now more likely than another recession, in 2012. Demand is out there: consumer demand for autos and housing, which are big economic drivers, is strong. Credit is a constraining factor, but there is still plenty of stimulus from the Fed and the deficit.

We are clearly in the virtuous cycle where demand leads to more employment and profits, which in turn creates more demand. It might even give bankers and other major capitalists enough confidence to invest in expansion. I'm not advocating going back to bubble days, but there is as much danger in being too cautious as there is in pretending there is no such thing as a risky investment or loan.

That should mean the stock market is heading up, but stocks are bought by by individuals, one decision at a time. Companies with the best track records for generating profits are already attracting investors. It is hard to find an overvalued stock today, although I could name a few. Undervalued stocks are plentiful, just pick a flavor, do thorough research, and avoid the wooden nickels.

Will the bond market fall? It should, but it won't as long as enough people are willing to accept almost no returns on their capital, as long as the capital is preserved and reasonably liquid. Once the bond market starts falling, if the economy is getting strong, watch out. Get out quick, while the getting is still good.

The gold bubble seems to have popped. I never liked gold as an asset (See The Gold Bubble [November 18, 2009]), but enough fools bidding on a Beanie Baby can make it seem valuable, until the auction fever dies. Gold has no intrinsic value. It just sits there, useless. Its price depends on the whims of jewelry consumers and irrational investors.

It would be helpful if the price of petroleum came down, but oil prices are geopolitical, for the most part set where the dictator of Saudi Arabia wants them set.

Inflation is dead in the U.S. for the moment, but high prices for agricultural commodities are giving some state economies a good boost. Wages will remain dead in the water until more unemployed workers are soaked up, so I don't intend to worry about inflation until 2013.

The main fly in the ointment is potential political suicide. Most investors know that the national deficit needs to be brought under control. The best way to do that is to freeze or even reduce federal expenditures, then allow for economic growth to increase tax revenues to the point the budget is balanced, and then start reducing the deficit. Counter-cyclical federal budgets were a major key to U.S. economic success ever since the Great Depression. Deficit spending during booms is as stupid as cutbacks during recessions. In no case does a train wreck in Washington help the situation.

Investors and the nation (and its government) need a long term outlook. It will take years to get to a balanced budget, and perhaps decades to significantly reduce the national debt. That takes planning and discipline. The Communist Party of China could accomplish that. Could we do it? Sure, we could. Will we? Only if long term, public-spirited investors insist on it.

Here's an outside opinion: the U.S. could become the driver of the global economy again in 2012, for the first time since 2006. We are still a big, rich, creative, and occasionally hard-working nation. Our natural direction is up.

ECB Good, Federal Reserve Bad

Today the European Central Bank (ECB) announced it was raising its interest rates from 1% to 1.25%. Given that the European economy, particularly the economies of Greece, Italy, Spain, Portugal, and Ireland, are supposed to be in poor shape, that may seem like a dramatic tightening of the screws. It is not. Interest rates are still very low in Europe. Any shortage of credit, or of takers, is not due to interest rates being too high. 1.25% should provide good support to further economic expansion.

In contrast in the United States of America the Federal Reserve Board (the Fed) recently left its benchmark interest rate at zero. That is right, 0%. I admit I would like to borrow some money at 0% interest, but the Fed alone lends to its member banks. The same people who charge you 15% to 35% interest on credit cards. This unprecedented low American interest rate did not make much sense even during the Panic of 2008. 0.25% or 0.5% would have been just as supportive to the economy and the banking system.

We are now in a pretty ordinary recession, except the prices of certain commodities have spiked due to global demand and limited supplies. The Fed's public argument is that the low rates are because a lot of Americans are out of work. One thing I know, the Fed does not care about the type of Americans who are out of work, unless they are banking CEOs. They are keeping interest rates low for the benefit of the banks, of the federal government (it keeps interest on the national debt low), and for large corporations that can currently borrow vast sums of money at huge rates. In my role as analyst I have not seen much corporate borrowing used for industrial or work force expansion. It is typically used to buy back stocks or mergers.

The dangers of these unprecedented low interest rates are so clear that even a few Fed board members have pointed them out. They can lead both to inflation and to more asset bubbles. We certainly already have a gold and silver bubble. Bubbles were the problem in the first place. New bubbles do not a sound economy make.

Meanwhile, ordinary savers are suffering from low interest rates. Retired people are having to eat their principle because they are getting almost no interest from CDs and bonds. The Fed says there is no inflation, but if your main discretionary expenses are gas and food, there is a lot of inflation. Other recessions were not met with such low rates.

Since 1952 the Fed had set interest rates below 2% for only a few brief periods, before 2008. [See Federal Reserve rate history] Given that the Fed should manage for the long term (not acting like Wall Street traders who can't see beyond the current quarter), the Fed's rate should already be at 2%.

Given that (at least in free market theory) private loan rates should be set by supply and demand, that should not budge rates for housing. Anyway, low interest rates have failed to provide an incentive for people to buy homes. Homes are seen as a bad investment; people want easy money, not assets that are taxed yearly (with real estate taxes) and need to be repaired regularly.

The Fed are cowards. They don't want to tick off Wall Street or Congress (Republicans want low rates for their business friends, Democrats because they don't understand economics). 2% is very supportive of economic expansion. If we had already gotten there gradually (or were near there like the ECB is now), then further gradual adjustments could be made, up or down, depending on the genuine need for credit for economic expansion, or on the danger of inflation.

If I were the President (fat chance) I'd fire the bums on the Federal Reserve and hire some people who can actually do the job.

Data: ECB interest rate press release April 7, 2011

Buying Stocks Low

According to people who aggregate such statistics, in 2010 investors small and large have been, on the whole, moving money out of stocks and into bonds and gold.

They are selling low and buying high. That is what I expect of them. If enough people do that, it allows some of us to buy low and sell high. Which is why I bother with stocks: if you can't generate a good return on an investment, you might as well let a bank or credit union give you almost nothing for your savings, while lending you money out at exorbitant interest rates.

There are really big, flashing neon signs saying that many if not most stocks have bargain basement prices right now. Take the semiconductor sector. Eliminate the loser companies. Look at, for example Microchip (MCHP) and Marvell (MRVL) which I own, or Intel (INTC), Analog Devices (ADI), Maxim (MXIM), etc. which I don't own. Almost all, at Friday's closing prices, have forward price to earnings ratios in the vicinity of 10. That means buying a share of stock is getting you 10% earnings per year. Even if the economy stays relatively flat. Many of these companies are growing profits so quickly you could get effectively 12 to 15% by 2012 if you invested Friday.

Need I say how that compares to investing in CD's, or bonds, or the housing market? Or gold, which earns nothing, and is in a bubble that will burst soon enough?

It is true that at any given time stocks are subject to auction marketing prices. What that means is that the price you get if you buy or sell may not recommend fundamental value. You may get a lot more or a lot less than fundamental value. There is no guarantee what an auction market will do any given day, month, year, or decade.

Which is why smart, long-term stock buyers pick stocks individually and try to do most of their buying when the stock market as a whole is low. When the stock market is high bond markets are (usually) low, meaning bonds carry high interest returns. So the classic cyclical smart thing to to is to sell your bonds (a portion of them, anyway) during recessions (that is selling high). Use the bond returns to buy stocks (buying low). When you get into an obvious bull market, you sell some of your stocks (selling high) and buy bonds again (with high interest rates, which means low cost).

But as simple as this is, and as easy as it is to do with portfolio balancing, most people can't do it. Institutional investors can't, individuals can't, rich can't, not so rich can't. We are human. We get excited by a rising stock market. We buy when we should be selling. We get frightened by a fallen market, and get sell when we should be buying. Brokers don't care, they take their commissions whether you sell or buy.

Keep in mind, for all of this, that individual companies vary greatly against the background of the overall stock market. A company that does well (growing revenues and profits) during a recession may not show off as an investment until the next bull market. But the real value is in the profits, not in the stock price.

Do your own research, including checking what other investors are saying. It is easy and free these days to look at the financial histories of companies, read SEC filings, find out what other investors thing, and even tune into analyst calls.

I like a low stock price when I am buying, and a high price when I am selling, same as anyone. But by focusing on value and keeping fundamental, well-known rules in mind, I keep out of trouble and get way better returns on stocks than I do on my CDs (which I keep, despite the low interest rates, to smooth out my personal finances, since my income varies greatly month to month, and they help with occasional large expenses).

Keep diversified!

Gilead Sciences better than Gold

Gilead Sciences reported Q4 results yesterday, and at last some investors took notice today of just how profitable this company is and will be. Meanwhile the gold bugs may be beginning to see the end of their bubble, as I predicted in The Gold Bubble on November 18, 2009.

Give me a company that has a plan to grow fast any day. In 2010 most of Gilead's revenue and earnings growth will come from the growth of the antiviral market and gaining market share for particular indications like HIV and Hepatitis B within the market. But Gilead has a deep pipeline of therapies that may come online this decade. As always, the number of therapies that are ultimately approved by the FDA are a small percentage of those that come out of preclinical trials. But Gilead has drugs at all phases of development, and they have shown an ability to pick a good percentage of winners in the past.

Revenues were $2.03 billion, up 13% sequentially from $1.80 billion and up 42% from $1.43 billion in the year-earlier quarter.

Net income (GAAP) was $802.2 million, up 19% sequentially from $673.0 million and up 43% from $560.0 million year-earlier.

Earnings per share (EPS) were $0.87, up 21% sequentially from $0.72 and up 47% from $0.59 year-earlier.

A bit of care should be taken in making projections because Gilead receives royalties on Tamiflu. Royalties have been way above their normal levels (reaching$228 million in the quarter) because of the recent flu scare. On the other hand, avoiding Gilead because its Tamiflu royalties fluctuate from quarter to quarter is overlooking the strength of the rest of the company. Product sales (excluding royalties) were up 30% y/y. That is phenomenal growth, and it comes with high profit margins.

While there are always risks and uncertainties, it is very likely Gilead's products will continue to gain market share in 2010. Even if Tamiflu revenues fell to zero, I would consider Gilead undervalued at today's closing price.

For more details, see my Gilead (GILD) Q4 2009 analyst conference summary.

I'll follow up, when I can, with a longer report on Gilead's product pipeline.

I own Gilead stock.

Keep Diversified!

The Gold Bubble

I correctly called bubbles in the stock market in the late 1990's, in the housing market, and in oil [See Oil Bubble to Burst, [March 11, 2008]. I believe there is a bubble in gold right now. I am not saying the bubble will pop soon, or at what price; seeing a bubble is a lot easier than saying when it will pop.

The magic of gold is purely psychological, and mainly a historic artifact. Gold is pretty and does not tarnish, so it makes nice jewelry. It is just uncommon enough that finding and mining it is usually not easy. Hence when money was invented, gold was adopted for use in coins.

Gold has more uses now. Of course it is used in dentistry. Its main use, besides jewelry, is in electronics. Gold is an excelent conductor of electricity, and does not corrode, so it is used to plate contacts on the best-quality electronic products. Because they are much cheaper, silver and copper are more widely used.

Gold investors often believe that gold is the ultimated measure of value. But its intrinsic value is negligible. If it were more common it might be regarded as a cheap anti-corrosion metal.

A lot of gold is being hoarded around the world. As in typical in auction markets, as long as the price is going up, people are given incentive to hold onto their gold stock, no matter how high it goes. That is how auction markets create bubbles.

But study history and you will find there have been many times and places where gold was not highly valued in comparison to other commodities. If something else is desirable enough, it is worth its weight in gold. Famously, salt was once traded in some places in Africa weight to weight with gold.

A new gold find can cause gold inflation. This happened when the Spanish stole the gold of Mexico and Peru in the 1500s. Europe at that time could not aborb that much gold, so the price of gold relative to other commodities swooned. Much of the gold migrated to China and India, which then had far more robust economies than the European nations.

The ratio of the price of gold to silver used to be a big, big deal back when money mostly meant metal coinage. It was the prominent issue in the U.S. Presidential campaign of 1896, in which the Democratic Party "declared for the unlimited coinage of silver at the ratio of sixteen ounces of silver to one of gold, though the market ratio was about thirty-two to one" as a means of getting more money into circulation [The American Pageant by Thomas Bailey, p. 599]. The Republican Candidate, William McKinley, won the Presidency after his campaign outspent his pro-silver rival sixteen to one.

Today, as I write, the quoted values of ounces of gold and silver are $1141.30 and $18.42. That gives a price ratio of about 62 to 1. Historically they have mainly fallen between 10 to 1 and 40 to 1. So if history is any indicator, either the price of silver has to skyrocket or the price of gold has to plunge to get us to equilibrium. It is possible that when the bubble bursts both will plunge in tandem.

One relatively sound source of gold's strength has been the weak dollar. The theory is that gold stays stationary in value. Therefore, if the dollar falls, the value of gold in dollars should rise. Of course normally financial brains would see right through that simple equation. The dollar should fall against any currency that rises against the dollar, if the theory were valid.

More fundamental is the usual fall in the value of goods versus currency when there is slack demand. In other words, deflation. There is concern that the astonishing amount of fictional money pumped into the American economy by the Federal Reserve starting in 2008 is going to cause the opposite, a great inflation. So the high price of gold, under that theory, is about looking ahead to the coming inflation. But the newly pumped money, so far, has not even replaced the money that dissappeared in the Great Panic of 2008. So it is a bit early to place heavy bets on inflation. If the Fed starts raising interest rates in 2010, and raises them fast enough, inflation should be held to its normal pace.

Like everything auctioned, the price of gold at any given time is highly dependent on the dynamics of the auction system. On an upswing people have every reason to delay selling in order to get higher prices at a later date. This in itself can create shortages that cycle into higher prices.

But there are always mini-cycles within the larger cycles. No one thinks much of a drop of a few pennies in the price of gold during the course of a trading day.

During a bubble at some point enough people will bail out to drive down the price of the asset enough for other holders to notice. If this trend become prolonged or deep, all the theories in the world won't support the price of the asset. Once gold starts falling consistently, people will realize it is not a magical store of value. They will trade their gold for something they can actually spend or invest more profitably.

Of course a gold bubble could also be popped by the discovery of a new gold field.

What confirms for me that we are in a gold bubble is that normally, during a severe recession, all asset classes are sold by investors. Gold should have come down subtantially in price in 2008 and 2009. Perhaps gold investors are more conservative by nature than those who invest in asset classes, so that they were not leveraged, and did not need to sell. I don't get that impression from the few big-time gold bugs I have met, but some times anecdotal evidence is misleading.

Remember, gold could go a lot higher before the bubble bursts. Shorting gold is no more a sure thing than going long on it.

Hedge your bets: keep diversified!

William P. Meyers