Last year at this time sovereign debt issues in Greece became ever more disconcerting, and now Spain is joining them in the queue.  Greece’s GDP ranks 34^th overall as a country, but Spain’s ranks 12^th; therefore, Spain’s debt and unemployment problems will be far more deleterious to global markets.  Spanish banks are in trouble and are compounding the problem by continuing to accumulate their own government’s bonds.  Our indicators continue to show a high likelihood of a marked slowdown on a global scale ahead, as China, the European Union and emerging markets continue to demonstrate weakness.  Domestically we see problems ahead with fiscal concerns as Congress just can’t seem to pull it together and come up with a plan to try to deal with our deficit and tax issues.  Additionally, the Economic Counsel Research Institute is calling for another US recession later this year based on their indicators.  That being said, we will most likely make defensive moves in our clients’ portfolios into sectors like utilities which enjoy high dividend yields.

Domestic and Global GDP

The US Gross Domestic Product grew at 1.7 percent for 2011, and the Economic Cycle Research Institute (ECRI) has stuck to their guns predicting that we will enter into another recession later this year.  The charts below demonstrate their indicators of when a recession will occur.  The shadowed areas show when the last three recessions occurred.   Although this is just one of our research data points, you can clearly see there is some cause for concern going forward.

Although the fourth quarter GDP was up an annualized rate of 2.8 percent, nearly 2 percent of that increase was due to inventory rebuilding that has yet to be sold.  Housing numbers are still showing mostly bottom bouncing, and there still remains massive inventories in the form of bank owned properties that have not been put on the market. Global economic conditions are actually deteriorating faster than domestic, and we have now seen the fifth consecutive month of declines in the Chinese Purchasing Managers Index, as well as steeper declines in many European nations.  Massive debt problems in the European Union will continue to hobble any real growth due to necessary austerity measures.

The US government bureaucrats also like to tinker with how real GDP growth is measured by redefining inflation.  The way the Consumer Price Index is measured was changed in 1981 from defining our standard of living from a fixed basket of goods and services, to a complex variable basket that assumes when certain prices rise, like steak, people will move to chicken.  Using this model creates a CPI that measures our standard of survival as opposed to our standard of living.  Another research tool we use is looking at alternative measures of inflation.  John Williams, at Shadow Statistics produces a measure of the CPI that reflects how inflation would look today if we still used the original methodology.  Keep in mind that the former measures were used for over a century before it was changed due to the hyperinflationary pressures of the 1970’s.  The government understood that they needed to change the way Social Security was indexed or the system would have gone bankrupt much sooner than it already is at present.

Using the alternative data, real GDP has been negative since late in the year 2000.  Some may question these very radical looking numbers, however, upon doing more research, we have found since the beginning of 2000, a gallon of gas has risen 13.18 percent per year.  A pound of steak over the same time period is up 6.14 percent per year, and a typical basket of food and beverages has risen annually by 6.14 percent.  These are items we can’t really do without, except maybe for steak perhaps.  The official government annual inflation rate over the same time period is a mere 2.49 percent, but if measured the good old way that number is above 7 percent per year.  The graph below is very telling.  Note that I added long term trend lines for both series and in either case, US GDP growth has been on the decline for quite some time.

Weak Volume

The buy side volume has been extremely low ever since this most recent rally began in October.  Ironically, most retail investors have been selling out of equity mutual funds over the past month or so.  Where is the buying coming from?  Most of the buying has come from stock buybacks.  Public companies have been engaged in near record buybacks of their shares with the most recent announcements totaling over 75 billion dollars of stock.  The last time we saw these levels of share buybacks was in 2007, just before the market unraveled.

Public companies are buying 3 dollar’s worth of stock for every 1 dollar sold by investors.  Some pundits argue that companies are engaging in this strategy because they believe their shares are cheap, but a closer look shows a more disconcerting trend.  Many analysts, including me, consider buybacks to be the lazy way to boost the financial ratios of a given stock.  When a company retires shares, the earnings are then distributed among the fewer shares outstanding, thereby improving ratios such as the P/E, and the return on equity per share.  The truth is that the overall value of the company has not changed a bit, and cash that could have been directed to investments for growth is no longer available.

Another reason companies may do large buybacks is because their earnings forecast may be either leveling off, or perhaps peaking.  Reducing the number of shares outstanding is a way to boost earnings per share without doing anything productive.  There are now fewer equity shares available to buy than in 2006.  There is more evidence that officers of these public companies are scrambling to improve their ratios by observing the behavior of insiders.  Corporate insiders have been selling their shares at a pace of nearly 6 shares sold for every one share bought over the past 4 months, according to Argus Research.

Equity Valuations

Contrary to what many people are saying in the media, domestic stocks are not cheap.  Never before have we seen valuations this high if we were indeed at the end of a long term bear market cycle. Many believe the worst is now behind us, however we disagree.  Because of revisions and how often analysts are wrong regarding earnings forecasting, we only look at “as reported” trailing twelve month price to earnings ratios (P/E), for the S&P 500.  Looking at the fourth quarter for the S&P 500 as of March 15^th the current P/E ratio is 16.3.  This level is just a bit higher than the historical average of about 14.5 times earnings.  You can see by the graph below that equity valuations have been trending down over the past 12 years.   This graph shows an alternative method of measuring P/E ratios that smoothes out short term spikes and you can see that a normalized P/E of about 23 is far from inexpensive.  Robert Shiller is a widely respected economist and also the co-author of the Case/Shiller Housing Index.  We would also point out that the unprecedented P/E ratios we have seen may imply that we may actually bottom at P/E ratios of 5 to 6 as opposed to what has historically been between 7 to 10 times earnings.  Therefore, unless profits were to suddenly and surprisingly move sharply upward, we are looking at the likelihood of another significant sell off between 30 to 50 percent or possibly more.  Our forecast still sees a high probability that the market will retest the lows of 2009.

Employment

The employment picture is not as rosy as one might think, especially when we consider young people attempting to enter the work force, the growth of the adult population overall, and alternative measures of long-term unemployment.  According to the Bureau of Labor and Statistics (BLS), unemployment for young people between the ages of 16 to 24 is a staggering 54 percent, which is the highest since records began to be kept.  Also, the BLS has published numbers that show a downward trend over the past year for the self-employed.  Although nearly 2 million jobs were created over the past 12 months, the adult work force has increased by 3.5 million.  Looking at alternative measures for long term unemployment and underemployment we can see by the chart below that essentially no gains have been made. The graph demonstrates official U3, official U6, and the alternate U6 which reflects how that number was derived before it was changed in 1994.  Clinton signed off on massive welfare reform in 1994 and, as a result, revisions were made regarding how unemployment was calculated.  These revisions were disingenuously derived in order to understate long term underemployment.  You can see by Shadow Statistics alternate data that long-term employment problems are still trending up signifying that excess capacity is not being utilized.

Sometimes all the talk about whether or not unemployment is improving can be at the very least confusing, so I thought I would leave you with a link to what Abbott and Costello’s explanation might be, enjoy!   The Economics of Abbott and Costello.