Tuesday, July 14, 2015

Greek Tragedy 2015, Again?

There are many things in life that baffle me, but the one thing that baffles me the most about the stock market is why people react the way they do. As an example, in the last several weeks, why on earth were people getting up in the morning and thinking they must sell Microsoft, Apple, GE and other industrial stocks after reading that the Greeks cannot pay their bills?

None of those companies do significant business in Greece itself, but yes, we must sell them to feel comfortable. It is not an unusual thing that Greece cannot pay its bills; it has not paid its bills for almost 2,000 years. Certainly, that is not new news, and certainly has no significant long-term effect on the U.S. market. However, traders that only work on a short-term basis and only take positions for a day, a week, an hour or even less, make their living this way. Trading has nothing whatsoever to do with investing, and everything to do with speculation. Before I write my rant on Greece, China, and other worldly events, I need to summarize the first six months of the year for you.

The first six months of the year would have been very satisfactory indeed, if it had not been for a 2% selloff in all the markets the day preceding the end of the quarter. Even with that dramatic selloff, markets performed admirably. The Standard & Poor’s index of 500 stocks was up 1.2% for the six-month period and has a very satisfactory yield of 7.4% for the one-year period ending June 30th 2015. Interestingly, the 10-year annualized return on the S&P 500 has been 7.9%, even with the huge losses that this index suffered in 2008.

The NASDAQ Composite has a year-to-date total return of 5.9% and a one-year return of 14.4%. The Dow Jones industrial average returned a miniscule 0.1% for the first six months of the year and has a one-year return of 7.3%. As forecasted and written in these blogs numerous times over the last few years, bonds continue to struggle. The Barclays aggregate bond index ended the first six months at -0.1% and has returned 1.7% for the one-year period ended June 30, 2015.

As I have pointed out in numerous posts, bonds are facing a headwind of unprecedented difficulty. It is hard to make money in bonds when interest rates rise, which causes the principal value of bonds to decrease. In our view, it is fairly clear that stocks offer an advantage for long-term investors who are looking to grow their portfolio going forward.

Before I continue, here are some recent pictures of Ava:

Enjoying the summer

Practicing writing her first and last name

The whole issue with Greece is really a tempest in a teapot. You have to understand the scope of the Greek economy to understand how insignificant it really is. The entire GDP of Greece is about the equivalent as the GDP of the greater Miami area. The combined gross domestic product of Miami, Fort Lauderdale and West Palm Beach, had a combined GDP of $281 billion in 2013. The estimate for the Greek economy over the same time period is $282.6 billion. While certainly it would be tragic if the GDP in Miami were to fall, it certainly would not be catastrophic for the U.S. economy as a whole.

Greece represents only 2% of the gross domestic product of the European economies. Europe in its entirety actually constitutes a larger share of the world economy than the U.S. The effect of Greece falling into recession, or even a depression, on the European economy would have the same economic effect if metropolitan Miami failed in the United States. The effect of an isolated Greek failure would have a negligible impact on the European economy as a whole, mostly because it is not a significant force in the economy to begin with.

Greece is in a state of disarray at the current time by its own self-will. It has always desired to have a country like a Rolls-Royce, but in the economy of a VW beetle. Many times, it has been proven that socialism does not work, and the Greek economy is a prime example. You just cannot live in a welfare state when you only have borrowed money to support the economy.

There are numerous examples that represent this scenario, and I will not bore you with all of them. I did want to give you a few examples of how the Greek economy devolved into its current state. As of 2008, the Greeks had no fewer than 133 public pension funds. Each fund had its own little bureaucracy and the federal government in Greece had virtually no control over them. The 2010 version of the Greek tragedy included sanctions from the troika (European Commission, European Central Bank and the IMF), which mandated a total and complete reform of the federal pension laws in Greece. As of this date, NONE of those reforms have been implemented.

In Greece, 18% of the GDP is spent on public pensions. Compare that with Ireland, who only spends 7% and the U.S. who only spends 5%. Even those numbers are suspect though, given the complexity of the Greek pension plan and the poor reporting that goes along with it.

In 2010, the Greek government was required to privatize state-owned companies and assets to consequently bring in €50 billion from the sale of these properties. As of today, the Greek government has only sold off €2.5 billion of those government-controlled assets. The public sector wages in Greece are now 25% higher than in Germany, and virtually all food costs more in Greece than any other European country due to import restrictions.

Greece imports virtually all of its products, including pharmaceuticals and most of its food. Essentially, Greece is a country of takers, not givers. In the last two weeks, banks have essentially been closed down, only allowing Greek citizens to take €60 a day, thereby causing the economy to be completely shut down. It is now estimated by the Wall Street Journal that it would take a minimum of $25 billion just to prop up the Greek banks, so they can be open to the public and operate in a normal way again. Currently, the outstanding debt of Greece is 177% of GDP, which is falling on annual basis.

Greece has struggled with demographic challenges as an aging population, and a weak economy has complicated the Greek situation. There is virtually no amount of money that will save their economy until their economy picks up, yet the governments in Greece are not willing to take the necessary actions that will allow the economy to accelerate. Greece has roughly the same size economy as the state of Louisiana, yet they have 10 million residents while the state of Louisiana only has 5 million. I do not need to belabor this point; essentially, there are a lot of people in Greece not working and not contributing to the economy.

With all of that said, there is a very simple solution to Greece’s financial mess. Basically, an agreement will be reached where European countries will loan them enough money to repay the debts currently due to European economies, and Greece will agree to austerity and other economic sanctions. It is also very clear that they will not comply with those sanctions and we will be right back in this situation in a few months, years, or decades from now. It has been that way for 2000 years. Why would you expect anything different this time?

The effect on the U.S. economy of Greece’s misfortunes is practically zero. Back in 2008, the Greek banks constituted a real problem for U.S. banks, since many of those U.S. banks held Greek debt. Seven years later, that is not the case. It was interesting to see the U.S. banks selloff with the news of the Greek problems. However, U.S. banks own virtually no Greek debt. Almost all the debt of Greece is held by the governments of Europe or the international monetary fund. If Greece were to fail tomorrow, virtually no U.S. Bank would be impacted by that decline.

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There is also a fair amount of hand-wringing when it comes to the Chinese stock market selloff. When the market declined over 30%, the normal “doomsayers” in the U.S. proclaimed that the same would apply to the U.S. stock market. However, they failed to point out that the Chinese market has been up close to 100% over the last 12 months, and even after the dramatic selloff, the Chinese market for the year 2015 is up 19%. That would make it one of the best performing stock markets in the world, and therefore very successful. It went too high, it went too low, and now it is about right – Goldilocks stock market. Virtually, nothing that I have discussed so far has anything whatsoever to do with the U.S. and other developed countries’ economies.

There is one very important point about the Chinese stock market that uninformed readers need to realize. The stock market in China is basically a political organ of the government and not a barometer of economic reality. It is very clear that the stock market in China has no correlation to the economy in China. The government wanted the stock market to go higher by improving investor sentiment and creating wealth among the middle class. It is very simple to see that if the average Chinese person is able to increase his or her wealth through stock market performance, they will eventually cash out that wealth and spend it on consumer items, improving the economy. All of that is very difficult for U.S. investors to understand, given the foreign nature of a communist government controlling an otherwise free stock market exchange.

However, with all investments, eventually truth runs out and the Chinese stock market had to unwind from such lofty levels. With the government’s intervention into the market, it has now rallied again. However, a very important point lost in all this conversation is that the Chinese stock market, even after the selloff, is only selling at 20 times earnings of the underlying companies. That level of earnings is not significantly greater than the U.S. market, which is clearly not overvalued.

You need not be a brain surgeon to see that the U.S. economy is fine in most every respect. Even though GDP is not accelerating at a rapid rate, it continues to be soundly solid. The three components of investing (interest rates, earnings, and the economy) are all positive for upward movement in the stock market. It is estimated that the second-quarter earnings will be down 4% quarter to quarter. However, if you analyze these numbers, you will see that virtually the entire decline is centered in the energy sector. With oil prices one half of what they were last year, it is fairly clear that earnings in those companies cannot accelerate. However, the rest of the economy will report record earnings this quarter as they have for the last several years.

If you do not believe these numbers, just ask the people on the front end of economic expansion; ask an architect you know whether they are busy at this time; ask any engineer if they have projects in the works that have yet to be done. You will find that most are working at capacity or greater. If you look around Atlanta, there are construction cranes everywhere and projects being built. In fact, construction contracts, as reported by F.W. Dodge are up 41% year-over-year. Many of these contracts are in the development stage and construction has not even begun. Once construction starts on these projects, a lot of people will be put to work and each additional payroll creates GDP in the United States.

It has often been reported that housing is the real energizer of the U.S. economy. Just look around you and you will see houses under construction. New housing permits are up 25% year-over-year and growing. Even though we are not at the 2007 levels yet, there is a vast amount of work starting on housing. Although a permit is a long way from a housing start, it indicates you the intent to build houses in the future. As that housing boom starts to roll out, many people will start to work and GDP will improve.

A great deal of investing has a lot to do with consumer confidence rather than economics. Do people buy a new house or new car when times are bad? The answer, of course, is no, but when consumer confidence is high, people spend a great deal on vacations, cars, house additions, etc. Consumer confidence in June was 101.4% as compared to 86.4% one year preceding. Whether you realize it or not, consumer confidence unleashes pocket books which creates commerce.

There is absolutely a direct correlation between new cars and homes purchased and consumer confidence. When times are bad, people dig holes and do not come up for air. When times are good, people use their resources and consumer financing to purchase, spend, and develop. As we sit here today, all of those are extraordinarily positive signs for a higher GDP in the U.S.

It is just an important part of investing that you understand that things that happen at geopolitical events may or may not affect the U.S. economy. Some things clearly do, and others clearly do not. While Europe would be impacted by a failure in Greece, whether that country succeeds or fails has virtually nothing to do with the U.S. economy and virtually nothing to do with the U.S. stock market. Those of you reading this post that think that you need to be out of the market during these volatile times need to take a deep breath and just watch it happen.

While it is a very minor adjustment that has occurred in the market during June and July, it convinces me more than ever that a big rally is coming. At the current time, over one half of the stocks represented by the New York Stock Exchange are on a 52-week low. Every time I hear a commentator say that the U.S. stock market is trading at unrealistic levels, I hope they have reviewed that very important statistic. With interest rates low and likely to be low for another couple of years, and earnings that continue to be excellent and growing in an economy that is expanding even modestly, these are all positive indicators for higher stock prices in the future.

I am very much in the camp that the markets will continue to climb over the next 18 months to 2 years. It will not be a straight up move, but rather a gradual increase in the value of your portfolios. However, if you are not invested you cannot grow your portfolio.

We speak with people every day that have had their money in cash since 2008. Those people have lost the opportunity of a 200% gain in the market and are reluctant to reinvest until the next market crash. Based on the imperial evidence that basic economics brings us, they may have a long time to wait.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins