Investing – Time to Vote Republican

Here are the highlights of this month’s investing article:

In July, Europe and China calmed (though not resolved), but investors are now worried about US growth.

There’s not really foreseeable positive catalysts in the market until the November elections. If the Democrats win, markets will drop. If Republicans make headway, the market will rise.

For investors, it’s perfectly fine to stay on the sidelines in cash. But the next 4-6 months could also be a great buying opportunity, so it’s staying frosty.

Investing in July through Early August

Markets have been volatile for the last six weeks. When I wrote my last monthly article, entitled “Markets Break Down”, the S&P had broken the critical 1040 level. As of Tuesday, August 11th’s close, the S&P was at 1089.47. We’ve had a rally, but make no mistake, markets are still broken. If you’ve been following the business news at all, you will have noticed the following over the last month and a half:

Europe seems to have stabilized, at least for the moment. The EU conducted stress tests, and that seems to have relaxed markets. Strictly speaking, this doesn’t totally make sense, because the fundamentals haven’t really changed. You could say that the only difference is that we have more information. More than anything else, the markets seem to have temporarily “forgotten” about Europe, in my opinion. Some fears are likely to return, although perhaps not to the extent that were seen in May; those fears were likely an overreaction.

China seems to have stabilized, but markets remain nervous about the pace of slowdown in China. While the government seems to have pulled back from the aggressive slowdown policies that have marked the first half, it hasn’t forgotten about its slowdown objectives. Meanwhile, slower China growth numbers are contributing to worries about the US economy.

US markets, and the likelihood of a much weaker-than-expected second half, are the full focus of the market’s worries. Today, the rally back from 1040 was stopped, with very few positive catalysts likely in the next few months. Jobs are weak, production is slowing, demand remains absent and the Fed has decided to buy Treasuries – effectively keeping money in the system, instead of taking it out. The bigger issue: many are worried that the Fed has run out of tools to drive a recovery, and almost no one has faith that Washington will implement the policies needed to lift us out of another slump.

Before we discuss the US situation, let’s take a quick look at the last month. Here’s a chart of the S&P:

Sometimes a picture really does say a lot, which is why I use these charts so often. This chart is rather messy, but here’s what I’d suggest focusing on. You’ll notice that from May to June, the market moved in a downward channel, marked by a white line at the top and the bottom of the channel. At the beginning of July, the market found a short term bottom and reversed into another channel, this time moving upward. Marked again by the white lines above and below, this new channel is what is known as a “wedge” (because the two lines come together, like a wedge) or a flag. The flag is actually a bearish pattern. This may seem counterintuitive, since the flag’s direction is up. But the idea is this: the market’s major trend is downward, and the upward “wedge” or flag is simply a temporary reprieve before the downward pattern resumes. You’ll see that today, August 11, 2010, the market broke out of the wedge/flag to the downside, implying a resumption of the downward trend. If the market continues downward over the next few days, the bearish thesis will be confirmed.

A quick side note. We know in retrospect that the market had a short-term bottom in as July started (marked 38.2% retracement, 7/1/10), but we didn’t really know that until July 23rd or so, when the market broke out of its downward channel (marked “market breaks out, 7/23/10”). In fact, if you look at 7/16/10, you’ll see a massive down day. On that day, it seemed like we were headed back down, and the market reversed and went up the next day. This was a major head fake for many.
While the chart says a lot, too much chart reading, and at this level of detail, can easily cause headaches and a need for some Pepto Bismol. If you’re not into reading charts at this level of detail, let me summarize the major point – we’ve been in a downtrend since late April, and despite a rally in late July, the downward trend could easily resume going forward.

Strictly speaking, the technician would say you need further downside over the next few days to confirm the resumption of the downward trend. But for the record, I’m not really in the double dip camp (meaning we will revisit 666 on the S&P, about 400 points lower than where we are today). I’m in the sideways to possibly around ~ 950 camp.

If you’ve been reading my articles, then you know I always like to look at the macro and fundamentals before coming to a conclusion. So let’s do that.

Time To Vote Republican

Breaking Down GDP. So, I know I’m gonna get in trouble for this title. I usually try to refrain from political commentary, or only comment to the extent that politics affect investments. But I think we’re in a time where policy really matters. So try to hear me out, and I’ll try to make this short and straightforward.

I do have to note that I am a life long Democrat and that I voted for Obama. I’m also not against regulation, but I think we need more good regulation, not lots of bad regulation.
Let’s start by stepping back and looking at the bigger picture. In economics, they teach you that GDP = C + I + G + (X-M). Now don’t let your eyes roll over yet, because this is actually quite simple. All this formula says is that our output (GDP) equals the sum of

• what the consumer spends (C)
• what business invests (I)
• what the government spends (G)
• net exports (X-M, or exports – imports)

If you think about it, it makes lots of sense, because really, there’s nobody else involved.

If we break this down, we know that the consumer is still sitting on piles of debt, unemployment is high and further foreclosures are coming. Effectively, that means the consumer is out for the count.

Business has cash, but it’s not spending. We all know the story: businesses have cut expenses and increased profits. Then they re-stocked inventories. But now, there’s not much more they can do until somebody buys. And we know the consumer isn’t, so businesses aren’t hiring. So businesses have lots of cash, but it’s sitting in the bank.

As for exports, we know that Europe is slowing, and so is China. So in other words, the rest of the world isn’t buying.
Conclusion: there’s no one left that can do anything except the government. It’s now in the hands of the policy makers.
Fiscal vs. Monetary Policy. What the government can do falls into two categories: fiscal policy, or spending; and monetary, which is control of the money supply. The White House and Congress control fiscal policy, the Fed controls monetary policy. They do affect each other and coordinate, so it’s not really that neat, but it works for our purposes.

I would argue that much of what has been done to bring us out of the depths of March 2009 is really attributable to what the Fed has been doing: low interest rates and quantitative easing. I’m not convinced that the fiscal side, the stimulus package, has done that much. Some of the stimulus did work, such as the home buyer tax credits, and perhaps cash-for-clunkers. But a lot was hijacked by Congressional pet projects, a failed loan modification program, auto bailouts that won’t be repaid and the still unresolved Fannie Mae and Freddie Mac. I’m sure there’s more I missed, but the Fed deserves the credit for what’s been done so far, Obama and Congress do not.

The concern now is that the Fed can’t do much more. Interest rates are as low as they can get. In yesterday’s meeting, the Fed announced that it would take money from mortgages and roll it over to buy Treasuries. This keeps money in the system, keeps the money supply up at current levels. But the Fed may be close to the limits of what monetary policy can do. This is because the problem doesn’t lie in the money supply, but in whether banks will lend. Interest rates are as low as they can be. Banks have money, but their money is sitting at the Federal Reserve, deposited there and doing nothing. Banks aren’t lending because they’re afraid of further weakness in the economy, and because Washington wants them to be as conservative as possible. This is known as the classic Keynesian trap, where more money has no effect. This is what happened in Japan, and why so many are saying that we’ve become Japan.

Many argue (including me), that it’s now up to fiscal policy. That now, because the Fed can’t do much more, it’s up to Obama and Congress. They now have to get businesses to spend and hire, and consumers to buy. Now we’re at the crux of the matter.

Oh My, Obama-nomics. If you look at what Obama has done, there’s a pretty good argument for saying he’s done exactly the opposite of what is needed to get the economy, and jobs, going.
First, healthcare reform. Make no mistake, I really do think it’s great that insurance companies can’t refuse people because of their prior medical history, and that millions of people will now be covered by health insurance. This is really a big deal, a really big plus. But there is a flaw: no one’s worrying about the cost, and somebody’s gotta pay for it. If you’re gonna pass healthcare reform, you gotta spend some time worrying about how to cut costs in the system. Obama hasn’t done that, and I don’t see him doing that anytime soon. Instead, he’s gonna tax businesses and people. So business will have higher taxes, which means they’re gonna hire less, grow less. Then he’s gonna tax people, which means that people won’t spend, and the consumer is gonna hurt more. If you think about our little formula above, GDP = consumer + business investment + government + net exports, higher taxes will only make it worse for two key parties, the consumer and business.
Second, financial reform. Again, let me clear. I am all for proper financial reform. There are some good things in the current legislation. But there’s also lots of bad things, and lots is missing. Rather than get mired in the details, let me point to the more obvious things. We already know that part of the reason banks don’t want to lend is because no one understands the rules, and banks are afraid that actions they take now will allow regulatory agencies to come back and bite them later. Small businesses need to borrow, either from a bank or on a credit card, and we know that both are much harder now (keep in mind, it wasn’t small businesses that caused the credit crisis of 2008). And all those taxes or fees that the banks are paying? Well, the banks will pass those costs onto consumers. More strikes against a recovery.

Third, the moratorium on drilling in the Gulf. Yes, the BP spill is a terrible, terrible travesty. I don’t question that at all. I question Washington’s response regarding future drilling. What Obama should be doing is gathering the best oil company minds and coming up with a plan for future spills as fast as possible. Instead, he’s being political, waiting until the BP spill is capped, and until some government commission can come up with a plan. Waiting until the political heat subsides. In the meantime, tens of thousands of jobs are lost in the already devastated South. And guess what – cutting down our drilling will only mean higher gas prices later, which we will pay for later. And let’s not forget about removing the cap on liability. In the end, that cost will be passed on to the consumer in the price of gas. It’s like medical liability: okay, you can sue doctors and get massive payouts, but that only makes your medical bill higher in the end. And do lawsuits really improve the quality of care provided?

I realize that these are all contentious issues, and I have by no means provided “proof” of my arguments. So let me try to boil it down to a few straightforward questions: does anyone doubt that businesses would be hiring more if regulation in Washington weren’t so opaque? Does anyone doubt that Washington hasn’t spent enough time on the real key issue, jobs? And does anyone really think that Washington has made things better for small businesses and consumers going forward?
If the Democrats win in November, Obama will take it as an affirmation of everything he’s done so far. What’s worse, he may take it as license to continue along his path, which in my opinion is counter to recovery and jobs. While I find Obama’s goals admirable, he seems to think that there’s a lot of money sitting around, and all that we have to do is transfer it from one pocket to another. The reality is that all things come at a cost, and today, they come at the cost of the economy and jobs. Frankly, I can’t think of anything we need more. The perfect society can come later. Let’s get the country back to work.

Investing, Going Forward

So it may seem like I’ve gone off into op-ed land, but let me put things in the context of investing.

Going forward, there’s not much likelihood that the market will break upward. Think of it this way: where will the upside surprise come from?

Not the consumer, for sure, unless unemployment suddenly falls.
Probably not businesses, either. Earnings were good, but there are indications that orders have fallen off or been pushed back because of all the uncertainty in the markets. I think it’s very likely that all the market turmoil and questions about the economy going forward have caused companies to push back or delay delivery of goods. That means, despite good earnings in Q2, don’t expect much for Q3. We know that Europe will be implementing austerity and that China will engineering a slowdown.

With the US, Europe and China all slowing, don’t expect Latin America, Africa, Southeast Asia, Japan or Russia (i.e., the rest of the world) to make a dent in world demand.
Finally, will Fed action make a difference? We’ve already discussed how the Fed may have maxed out its tools.
That leaves fiscal policy. Here, I wouldn’t expect much until November. If the Democrats retain control, guaranteed the market will drop, perhaps even significantly, and your 401K won’t be happy. On the other hand, if the Republicans take some seats and counter the Democrats, markets will be happy, and so will your 401K.

Likely best case is that the market goes sideways. And there is a case where markets drift lower simply because there aren’t any significant catalysts coming up in the near future. Barring a big shock (hard landing in China, more fears of credit collapses in Europe), there is likely to be a floor under the market, and a point at which things look very cheap.

So what’s an investor to do?

If you’re a long-term investor, and you don’t like the volatility, it’s perfectly fine to sit it out in cash. Of course, I would look for things that might move markets – shocks to the system (as mentioned above), changes in policy dynamics, changes in unemployment, etc. So sitting in cash while watching for changes in direction is, I think a perfectly valid strategy.

If you like to be more active, it’s always good to remember that the next several months could also represent a great buying opportunity for the long-term. For example, if we get a more business friendly Congress in November, September – October might very well end up being the low for the next several years. Businesses are also more likely to do some gearing up for the December season, so that may be a positive catalyst into the end of the year.

If you’re willing to spend some time and do some trading, there will certainly be opportunities. In the short-term, valuations aren’t likely to mean much (they would longer term), and instead, technical trading will likely win the day.

Here’s some quick specifics:
Buying defensive, dividend paying stocks remains a pretty solid strategy. I continue to like Kraft, Clorox, PG, McDonald’s, Coke, Altria, Phillip Morris and the like. The trick here is to buy them when they drop a bit, because even though they’re defensive, they’ll still go down if the market does. They’re also more exposed than they have been in the past – P&G could weaken because consumers trade down; Kraft could be sensitive to rising food prices, caused by events such as the ban on wheat exports from Russia; and all are sensitive to international currency issues. But they will still hold up better than others in weak markets. I’ve advocated this approach all year, and continue to. I am long Kraft and PG for myself or my clients.

Personally, I’m not jumping into bonds or bond funds. You can, but you have to be watching to see when the market will turn. Remember, you’d be buying bonds at historic highs, and also at historically low yields right now. It’s not clear to me that the low yield is worth it; miss the turn and your low yield return could be wiped out quickly. I prefer defensive dividend paying stock strategy mentioned above.

Recent comments from analysts and from Cisco today has the market believing that tech will slow down in Q3. Very likely, as mentioned, that orders have been pushed. If nothing else, the market has certainly begun to believe it. Barring news that changes this picture, I would look to buy some tech in late September to October ahead of a possible ramp-up into December.

Anything consumer related is likely to be weak in Q3, so depending on how far consumer stocks fall, October might be a buy for December. Still, it’s too hard to say for certain now, best to revisit in the fall.

Expect financials to be weak going forward as well. Financials are very sensitive to market and consumer conditions. Also, you have to monitor the shape of the yield curve. If long rates rise while short-term rates stay low, financials will rally.

Industrials, which were enjoying quite a good run, will be subject to fears of a slowdown around the world. They will trade with the market’s assessment of a recovery.

For commodities, I find it hard to see a longer-term trend. Rather, commodities will be a trader’s market. Lower dollar created by easy monetary policy would argue for commodities, but signs of slowdown in China would push commodities down. Commodities are likely to bounce around quite a bit as economic reports give conflicting signals (because you know they always do!) The one area where commodities could see the beginning of a longer-term trend is in the agricultural sector – stocks such as Monsanto, Mosaic and Potash. Input costs are going up around the world, Russia’s fires have wiped out their wheat production, people have to eat and arable land is limited. But keep an eye on these – remember that they are momentum stocks, and “momo” stocks as they are called require attention. I am not long any of these stocks at the present time.

Gold is a likely winner, especially if fears of a weakened economy escalate. Here the thing is to try to buy it on enough of a pullback to lower the risk on the investment.

Currencies and interest rates. Yields are likely to remain low until we have some indication that the economy is growing appreciably. Usually this means a weaker dollar (people flee the dollar because there’s a higher return elsewhere), but at the moment, fear is driving people into the dollar, so the dollar is actually rising. I expect currencies to be volatile, and wouldn’t play currencies unless you have a good pulse on the market. If we think the market would rally into the end of the year, I’d look to short bonds or buy the TBT in late September / October.

Disclaimer. All material presented herein is believed to be accurate but we cannot attest to its accuracy. All trades, patterns, charts, systems, etc. discussed in this article are for illustrative purposes only and are not to be construed as specific advisory recommendations. All ideas and material presented are entirely those of the author and do not necessarily reflect those of the publisher. All readers are urged to consult with their investment counselors before making any investment decisions.

Ming Lo is an actor, director and investment advisor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.