Research + Forecast USA Corporate Profits, Dow Jones Index

AUGUST 30, 2009 RECOMMENDATION: STAY IN

We recommend to stay invested in the Dow Jones Industrial Average Index (DJIA) until the next quarterly update at the end of November 2009.

+160% Profit Resulted from “Strong Buy” Signal Issued in March 2009

The Business Cycle Investor – Global Macro Fund (blue line) returned +160% in the recent months. The performance is independently verified by TimerTrac chart:

The investment strategy involved picking or timing US Dow Jones and S&P500 Indexes and main Sectors (Emerging, International, Financial, Technology, Large Cap, Real Estate, Energy and Bonds) using leveraged ETFs. The performance does not include returns from recent two financial Special Situation Stocks Picking Signals that each produced an extra 50% ungeared gain.

Latest Results

The Second Quarter’s 2009 US NIPA Corporate Profits announced in August 2009 by the USA Government rose by +5.7% on previous quarter (blue line on the Performance chart), due to a strong 16.7% growth in the Financial Sector’s Corporate Profits. The Non-Financial component of Profits also recovered rising +4.5% on the previous quarter.

Latest Results

Note Corporate Profits (blue line) recovery in the last two quarters Q1-09 and Q2-09 following “Strong Buy” Recommendation in March 09 when Dow Jones was trading at 7,776 level.

The Profits first attempted a recovery in Q2/Q3-08 following “Buy” Recommendation in March 2008. The bounce coincided with positive recovery in GDP but was abruptly reversed in Q4-08 by Lehman Brothers bankruptcy mid September 2008 that led to a Great Recession and stock market crash.

The US Government revised in July 2009 historical economic data and time-series including Corporate Profits. The above historical performance charts have been updated.

The Next Quarter’s Outlook

The updated value of the proprietary Business Cycle Index (green line on the above charts) is firmly above its historical average pointing to a very favorable environment ahead for the broad USA stock market and US Corporate Profits.

We expect the upward trend in the Corporate Profits (blue line) to strengthen and extend into the next quarter.

The Dow Jones is currently trading close to its historical average Price Earnings Ratio. It does not seem to be overvalued despite gaining 50% over the last six months assuming the earnings will grow as expected.

The easiest money in this cycle has already been made. The next few months may be more bumpy trending upwards.

The broad market should continue to grow and in particular Real Estate Sector and associated with it parts of the Financial Services Sector look relatively more attractive.

The “In Periods” identified by our proprietary methodology have been historically characterized by solid and consistent returns underpinned by favorable macroeconomic fundamentals leading to stronger Corporate Profits growth. The “In Periods” delivered annualized 20% ungeared return over 60 years history including the last 5 years of actual results (refer to Performance record).

The Charts above illustrate recent performance until August 30, 2009. Next quarterly update is planned for the end of November 2009.

Risks

This general recommendation is subject to inherent predictable and unpredictable risks always requiring appropriate risk management – see legal statement at the end.

In times of glory, it would be wise to remember that investing always involves risk and nothing is 100% certain. Our methodology does not always work – it did not avoid the painful Lehman Brothers collapse in September 2008. An unpredictable event such as 9/11 or a devastating earthquake in a highly populated developed part of the world or political turmoil in one of the hot-spots can turn the game on its head in a split second. It is a good practice to set Stop Losses on all holdings for that reason.

It is easy, being in a positive frame of mind, to convince oneself to make another aggressive decision too quickly forgetting that “trend is not always your friend” after the market made large gains.

Having qualified the optimistic outlook, we do not expect major surprises on the macroeconomic front.

Monetary Policy should be stable for time being while Mr Ben Bernanke’s nomination for the next 4-year term at the Fed is being scrutinized by the Congress.

Fiscal Policy decisions are less predictable but negative surprises are unlikely before we start seeing signs of stability and improvement in the job market. Politicians are positioning for the 2010 mid-term elections and will be anxious to please the voters with good news about the improving economy.

However, as we said on many occasions, Ben Bernanke’s belief in inflation targeting is always a cause for concern as it requires of Central Bank more aggressive use of the monetary policy and other available tools to influence the economy in both directions.

During the Global Financial Crisis, Bernanke’s quick and aggressive response probably saved the financial system and put a floor under the assets values.

Such aggressiveness in times when economy is growing again can end the stocks rally much too early. A premature and bald rise of interest rates, invariably explained by a need to control threat of inflation, may depress asset values including the stock market before they reach full potential. However, in the early stages of the recovery as we are now, we do not expect Fed to be overly concerned about inflation.

The focus of the Central Bank and the Government in the foreseeable future is likely to be on restoring asset values as they are holding directly or indirectly a massive portfolio of extremely stressed assets acquired during rescue of the financial system. The debt has been distributed around the world including foreign governments and major trading partners, notably China, which makes it also a political issue.

The critics of ever growing Government’s debt have not quite appreciated how much debt in addition to its official balance sheet the Government really has. For example, the 80% controlling ownership of Freddie Mac, Fannie Mae and AIG makes the Government effectively responsible for their multi-trillion-dollar toxic debt. While the debt is technically sitting on the companies books, it represents Government’s “off-balance sheet” debt. Fed is in a similar situation having purchased hundreds of billions of toxic debt and issued trillions of dollars of various guarantees.

One of the ways out for the Government and Fed is through the recovery in value of the toxic assets that underpin their extraordinary obligations. The motivation aligns Government’s and Fed’s interests with those of the stock market investors. The Government, Fed and Taxpayers that they represent are the biggest investors in the market and all participants would benefit from asset values recovery.

New Bull Market

The US stocks have been in a new bull market since March 2009 anticipating the economic recovery in mid 2009. Dow Jones and S&P500 gained around 50% since March lows in one of the strongest and sharpest recoveries on record. US GDP is now clearly turning in a sharp V-shape and a feared by some double-dip W-style recession or 1930s style depression is rather unlikely… in this cycle that is. The Business Cycle lives on and the downturn will eventually return but not in the immediate future in our opinion.

The relevant question at this stage is how strong will be the GDP recovery and if the Stock Market has much more upside potential after the recent 50% gains.

The Great Recession is Over

Let’s first look at the evidence of the V-shape economic recovery on the ISM Index chart. Historically, the recession was over every time the coinciding with the economic cycle ISM manufacturing activity index bounced back to such magnitude as recently:

Research by Fed also points to a sharp V-shape recovery (blue dashed line) on the recent GDP chart:

Actual Q2-2009 GDP, while slightly negative, improved decisively on the previous two deeply recessional quarters and now consensus forecast is for above 2% growth in Q3-2009 followed by a series of positive quarters. Even if we assume the lowest value of the Q3-09 forecast, the GDP recovery will be a sharp V-shape. The upward slope of the ”V” is much steeper than the frightening fall that we’ve just experienced.

The worst since 1930s US Great Recession has already ended in our opinion. The view is apparently shared by the consensus forecast used by the Fed.

It is purely an academic exercise, best left to the NBER Business Cycle Dating Committee, to call the exact date when the recession ended. The conservative Committee usually takes time, often 3 to 12 months, to observe if the new uptrend holds before retrospectively calling the official end of the recession.

Economic Forecast Tend to Be Behind the Curve

Economic outlooks tend to be influenced by what’s in the rear-view mirror. It is hard to be suddenly very optimistic when economy has been falling apart. This human tendency to extrapolate current state into the future was confirmed in an elegant research by David Altig, Research Director of Atlanta Fed in July 2009.

It is probable the current GDP forecast is underestimating the strength of the recovery. According to Altig’s research of past recessions, the deeper a recession the strongest was the following it recovery. The graph below shows the strong positive relation between the depth of a recession on the horizontal axis and strength of the recovery in the first year on the vertical axis. Past recessions are circled in red.

Current GDP forecast circled in blue is in the right bottom corner of the chart and should be in the top right corner if history was to repeat itself in this cycle; the forecast recovery should be much stronger. Time will tell if the consensus pessimism was justified.

Stock Market Is Very Bullish

S&P500 Historical Average Returns in Past 15 USA Recessions

Investors gave much more positive verdict about the future economic growth driving the stocks by 50% in six months since March lows. Historically, the gain was more than twice the average according to another interesting analysis by Financial Times. The chart below is based on Shiller, Bloomberg and Capital Economics Research in Aug 2009 and shows stock market returns around the recessional bottoms.

The most lucrative for stock market times were before and six months after the end of recession. The average returns split into three stages were as follows (approximately):

1.       19% return from through to end of recession,
2.       16% return in first 6 months of Recovery, and
3.       2% return in the second 6 months of Recovery.

Assuming we have just come out of the recession i.e. Stage 1 has ended, the market still has another Stage 2 to go.

Current Stage 1 returned impressive 50% - more than double the average 19%. The high gains may give a cause for concern that Stage 2 in this cycle may be weaker presuming that most of the recovery is already priced-in. On the other hand, given the current recession was extremely deep, the recovery may be expected to be unusually strong – perhaps twice as strong.

History teaches us to be careful in Stage 3 as the second six months of the recovery were much weaker.

The above statistics is the evidence that stock market was well ahead of the GDP turning points. It was important to pick the end of the GDP recessions in advance to catch the first stage of the stock market gains. In this cycle, the time to go into the market was in March 2009 few months before the end of recession.

Critical Housing Sector is Beginning Recovery

A staggering 27% of US mortgages are currently “under water” - the houses are priced below the loans taken to buy them. Many unfortunate mortgagees have been opting to foreclose on the non-recourse mortgages even if they could afford paying interest. It makes economical sense, after allowing for transaction costs, to walk away from the deeply “out of the money” situation and start afresh with a new property in buyers market at the rock bottom prices.

Hence, foreclosure statistics paint too dark a picture. Looking at the upward Foreclosures trend on the graph below, one could be forgiven to think there is no end to the misery but the situation is not that bad after allowing for the “tactical” foreclosures.

Stock market is more optimistic as the iShares Dow Jones US Home Construction ETF Index Fund (ITB) graph shows: The sector has been in a bumpy uptrend since March that has intensified in July and August 2009 ahead of the “green shoots” economic data for the Real Estate sector.

Here are some coinciding indicators that give grounds for the positive outlook:

US Median Home Prices continue upward trend:

The recovery from the Feb-May W-double bottom is critical for the whole economy. If the prices did not stabilize, the financial crisis would have been worse.

Second, the home prices fell so much that they are flirting with the replacement costs – a clear sign that further falls would be an overreaction while the inventory is returning to equilibrium levels.

William Wheaton, Professor of Economics at MIT, argues with the view that US is due for a protracted decline in housing prices. In his opinion “fundamentals on the supply side of the housing market imply that US housing prices are about to bottom out. They should resume rising soon.”

The view has a good chance of being right.

In July 2009 Professor Wheaton wrote:

“In a New York Times column last month, Robert Shiller painted a scenario in which home prices might fall for years (and even decades) to come. However, this view ignores some critical differences between real estate and other more purely “financial” assets. This oversight often leads to an exclusive focus on demand fundamentals, expectations, and other factors that both create asset price bubbles and their collapse. What is missing from this analysis is the supply side of the market. Real estate is a physical asset and not just a claim on a hypothetical income flow.

As housing is a physical asset, its price must eventually equal or exceed the full cost building or rebuilding it – that is, as long as the market requires the construction of additional housing. So the real questions in the current crisis are a) when and how much future housing will the US need to construct, and b) are prices today so much higher than the cost of construction that they could still fall significantly and have development remain economically viable?

During the last decade, net new household formation averaged approximately 1.4 million per year. Last year, the Census reported that the US added only 544,000 new households – during severe contractions the young stay at home, singles “double up”, and household formation (normally) slows. Even with declining demographics, however, most analysts foresee new household growth resuming to a level of at least 1 million by 2010 and beyond. If we conservatively add 200,000 demolitions per year, the US economy will “need” at least 1.25 million new units yearly in the near future. With today’s currently depressed construction, this generates a yearly deficit of 750,000 units. At that rate, the current excess inventory of units for sale or rent will be back below normal by 2011. Prices historically have a strong relationship with sales “duration” – the ratio of inventory-to-sales. Hence under reasonable conditions, in two years we will have to increase construction considerably and prices will have to justify the cost of that construction.

Even without physical growth, income growth can also help provide a floor on housing prices. With rising prosperity, most nations demand “bigger and better” housing units – even if not more of them. This generates significant residential re-development as well as “alterations and additions”. These investments in turn require incremental increases in value to justify the expenditure. Once again, replacement cost can set a floor on prices.”

Builders are also sensing better times ahead and their Confidence has been rising since April:

There are first reports of land prices recovering and builders buying land after years of offloading excess inventory – click here.

Supply of Houses for Sale (months required to sell the inventory) is declining; current Inventory would take 9.5 months to clear. Normal level is around 5-6 months:

30 years Fixed Mortgage Rates are steady at low levels below 5.5% and are closely watched and held at low levels by Fed:

While Consumer Confidence has been firming up. The graph below does not show the latest reported value of 54.1:

Professional Investors have finally come out of the “Depression Trenches”. More than 58% are now bullish as reflected in the Bloomberg Global Confidence Index (its latest value 58.12 is not on the graph). What a turnaround from only 5% of optimists in April 2009!

Given the improved sentiment, cash is being moved from the sidelines presumably to equities after paying interest on mortgages, as shown in Money Market Funds chart. We are getting close to the pre-Lehman September 2008 levels of cash on the sidelines:

Chart Links are at: http://www.businesscycleinvestor.com/resources.htm

More analysis and commentary can be found at http://www.businesscycleinvestor.com/news.htm

Business Cycle Investor
Aug 30, 2009

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More information about the research methodology can be found at www.businesscycleinvestor.com/methodology.htm

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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USA Corporate Profits & Dow Jones Forecast

Business Cycle Investor