Thursday, May 27, 2010

Mysteries of the Stock Market

From the Desk of Joe Rollins

Watching the pre-market news yesterday morning, I couldn’t help but be shocked by the losses recorded around the world. I was even taken aback by the stock market futures, which had forecasted a loss on the Dow Industrial Average of over 300 points when the market opened yesterday morning. I know there are problems in the world – and I’m well aware of the issues in Europe – but, as I have pointed out many times before, stock prices are determined on profits and economic reality, not hype by the financial media or the guys on Wall Street.

By the time the market closed yesterday, the market had recovered close to 300 points. The Dow closed down only 25 points, the S&P 500 index wound up actually being up for the day. I suppose any day close to 300 points are recovered in one trading day is not such a bad day. This just goes to show that the Wall Street traders live by a different set of rules. They sell in the morning and buy in the afternoon, and if they’ve made half a point, then they’re happy. As long-term investors, we need to ignore those actions and count on firm economic results to generate profits.

I want to discuss some of the issues the world is facing today and the potential corresponding impact on stock market performance. First, it seems that North Korea has decided to no longer deal at all with South Korea. North Korea torpedoed and sunk one of South Korea’s patrol boats, but apparently it’s the only country in the world that doesn’t understand why South Korea would like to be reimbursed for the cost of the destroyed vessel. Confusingly, however, North Korea decided it would be better to take their football and go home rather than continue to cooperate with South Korea by pulling out of their existing non-aggression treaty.

So the question is how this will affect the stock market. It’s important to understand that North Korea is in economic isolation. It has almost no natural resources and it cannot even feed its population without the assistance of China or humanitarian efforts. North Korea’s budget is almost entirely allocated to its military programs. Wouldn’t it be more beneficial to the North Koreans if their government used its economic resources to feed the public rather than create additional military armaments? In the end, North Korea will do whatever China tells it to do. If China tells North Korea to make peace with South Korea, they will have no choice but to do so. But to believe that North Korea is a military risk to that part of the world borders on the absurd. For these actions to create a worldwide stock market sell-off is ridiculous.

Likewise, and as I have discussed in previous posts, there is a question as to whether the debt situation in Greece will endanger the global economy. While it’s true that this situation will create a significant hardship on the Greek population, the fear of that spreading to the United States has been minimized by the recent actions of the European Union (“EU”) to guarantee the debts of its member countries. The Greek labor costs should enlighten you as to their problems. The national collective labor agreement in Greece provides for annual salary increases from 5% to 7% per year since 2000. The average increase in productivity during the same time was only 2%. Therefore, since 2000, the Greek economy has become more and more inefficient.

In effect, the cost of labor has out-priced its ability to compete in international commerce, and therefore, the Greek economy has suffered immensely. These are the same workers who received large increases in salaries throughout this period without increasing their productivity and are now being required to take salary decreases. It should be evident that the same group of laborers that benefited during the last decade should take the losses until the country gets back on stable ground. This is just good common sense.

To give you a basis for comparison, the unit labor cost in Greece went up 33% during the last decade; Italy’s increased 30% and Spain’s increased 28%. Germany, a country very much dependent upon its exports, only increased 6% while the U.S.’s costs plummeted 27%. The U.S. decrease in costs is mainly due to better technology – using machines rather than people. It shouldn’t be too hard to see that Greece essentially has priced itself out of the international export market due to their unsustainable high labor costs. Any negative comparisons between the U.S. workers and the Greeks workers are just inaccurate.

Did you know that in 1971, 11.1% of Greeks were 65 or older? In 2001, 17% of their population was over 65, and by the end of 2009, the population of over 65-year olds had increased to 18.7%. It’s now estimated that by 2031, 25% of all Greeks will be 65 or older. What makes this even more remarkable is that the average Greek retires before the age of 55. Young, skilled workers are leaving the country. As you can see, there are fewer and fewer workers supporting practically 25% of the entire population. This economic time bomb needed to be addressed; now it has been.

So far, the month of May has been disastrous to the equity markets. The Dow is down 9.69% for the month, the NASDAQ is down 10.06%, and the S&P is down 9.53%. However, year-to-date, the Dow is only down 2.61%, the NASDAQ is down 1.22%, and the S&P is down 2.94%. We all hate to lose money, but a 10% correction in the markets could be expected at any time after almost a continuous run upward since March of 2009 of approximately 80% on the major market indices. In any event, I don’t think any of these losses should be exaggerated by investors who are looking for long-term yields and not short-term trades.

The economic outlook for the United States is virtually unchanged, even with all of this market volatility. Corporate earnings have been quite extraordinary through the first quarter of 2010 and there is nothing I see today that would change that outlook. Interest rates are unbelievably low, which stimulates the economy and makes purchasing of a house almost at its lowest level at any time in our financial history. Even though the situation regarding Greece will ultimately have some impact on the U.S. economy, it’s unlikely to have a large effect. Many financial experts are predicting the effect on GDP for 2011 due to the European financial mess at less than .25%. This is basically a rounding error. Since our exports to Greece are only 15% of our total exports, any reduction in trade with Europe will have little effect on our economy.

There have been other factors that have negatively affected trading during the month of May. Traders seemed to be focused on Congress’s debate concerning financial reform. In the end, Congress created a bill that does virtually nothing – except make government bigger and increase taxes (again). It does nothing to attack the real problem.

Congress these days seems to be like a hockey goalie, avoiding the puck at each shot. With this bill, they’ve only created another gigantic government bureaucracy that does nothing to prevent another financial collapse. Without a doubt, Freddie and Fannie were the start, middle and the end of the financial disaster of 2007 and 2008. Not a single provision of the current legislation does anything to deal with those issues. There are plenty of financial controls in place now; they just need to be enforced.

I also believe the issue regarding the tremendous budget deficits is heavy on many traders’ minds. Everyone concurs that the deficits are unsustainable – they’re simply a bad omen for the future of this country. However, realistically, we cannot deal with the budget deficits until we’re absolutely positive the economy is on solid ground. We should have that assurance before the end of 2010.

It will be impossible for Congress to raise taxes enough to balance the budget even though, unquestionably, they will try. Sooner or later, we must reduce the size of government in order to get government expenditures anywhere close to the revenue our government receives. Creating higher taxes to fund an inefficient and bloated government is wrong on every level.

Therefore, I think it can be easily said that while these losses have been painful, they are certainly not unexpected and are certainly not something we would suggest you trade around when you a long-term investor.

The combined total of our entire portfolio reflects a loss of about 2% for 2010 thus far. That loss can be overcome in one week’s trading. If the financial circumstances in the United States were to quickly change or deteriorate, I might reconsider my position. However, that hasn’t happened so far. Therefore, we believe the best course of action is to wait out this small correction and see which way the market trades when it’s over. We should certainly know within 30 days whether that is a further downward movement or one of recovery.

As always, the foregoing comments are my opinions, thoughts and personal biases. In all cases, I could be wrong.