A recent economic report from Merrill Lynch included an interesting phrase – “The Four Horsemen and the Consumer.” The present day “Four Horsemen” according to the report are Energy, Housing, Employment and Credit. Based on the way the market has been trading so far this year perhaps Grantland Rice’s version is more apropos…
“Outlined against a blue-gray October sky the Four Horsemen rode again. In dramatic lore they are known as famine, pestilence, destruction and death. These are only aliases. Their real names are: Stuhldreher, Miller, Crowley and Layden. They formed the crest of the South Bend cyclone before which another fighting Army team was swept over the precipice at the Polo Grounds this afternoon as 55,000 spectators peered down upon the bewildering panorama spread out upon the green plain below.” Grantland Rice - New York Herald Tribune on October 18, 1924
That might be a stretch, but how about if we combine the two. If the legendary Grantland Rice were writing about the economy today he might pen, “…In dramatic lore they are known as famine, pestilence, destruction and death. These are only aliases. Their real names are Energy, Housing, Employment and Credit. Together they form a powerful headwind pushing the economy ever closer to a dreadful recession despite endless political promises and billions in write downs as a swath of bewildered voters, consumers and investors search for answers.” OK, Grantland Rice, I’m not. However, I do believe energy, housing, employment and credit are, in fact, critical issues for the economy and therefore the markets. These are our thoughts on each one.
Pummeled at the Pump… Oil prices doubled in 2007 and the current price of a barrel of oil is setting just below $100/barrel. There is no disputing that gasoline approaching $4 per gallon is taking a bite out of consumer’s pocket book. In the near-term, a slower economy might drive energy prices lower. Unfortunately, longer-term, the trend is still for higher prices. Alternative fuel technologies, while interesting to read about, remain too far off to have a meaningful impact over the next few years.
Housing deflation… Home prices are down close to 10% over the last year. With the supply of homes for sale at a twenty-year high housing deflation is likely to continue. Moreover, the peak in adjustable rate mortgage resets will not occur until early in the third quarter of this year, which means the impact from increasing foreclosures and untimely sales will be felt over the next several months.
Employment… The latest employment statistics have been weak. Given the slowdown in consumer spending and the ongoing troubles in the financial sector, my sense is the employment situation is unlikely to improve in the near term.
Credit… The problems in the credit markets continue to fester. There has already been about $100 Billion in write-downs on Collateralized Debt Obligations (CDOs) and subprime paper. The projections for future write-downs range from alarming to down right scary. Banks are struggling to value debt on their books and as a result, interbank lending has ground to a halt. It will likely take most of this year for the various financial institutions (banks, insurance companies, brokers, and hedge funds) to work through these challenges. In the meantime, I’m not sure what to make of all the foreign entities who are riding to the rescue with billions of capital for beleaguered companies like Citigroup and Merrill Lynch. To date investors from Japan, Korea, Singapore, Saudi Arabia, and Kuwait have pledged $19 Billion in capital to these two struggling financial titans. One thing I do know is that foreign investment will become a bigger political issue.
In summary, all four factors are negative and arguably getting worse. On the bright side, there are some interesting under currents.
For instance, a serious shortage of clean water, a growing need to improve infrastructure, and worsening environmental and energy concerns are critical issues for most of the developing world. US multinational industrial companies, bolstered by the weak US dollar are poised to benefit from these secular opportunities. Generally speaking, in contrast to leveraged US households, corporations are in very strong financial condition and seem to have the cash flow and strategic commitment to invest globally whenever opportunities are discovered. And even the beleaguered consumer will eventually return to the malls. Few forces are more powerful than pent-up consumer demand.
Having said all that, the catalyst for a market turnaround will be valuation. Quality Stocks will simply get too cheap at some point. Companies that can achieve earnings targets on a consistent basis will likely be the first to bottom. That is where fundamental analysis comes in.
While we remain defensively positioned, we are searching for bargains. Speaking of cheap and getting cheaper, financials and consumer discretionary stocks will rally at some point later this year, but may continue to struggle in the near term. As current Notre Dame football fans understand all too well, patience, at times, is critical.