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7.31.2007 2007 2nd Quarter Client Newsletter
Economic Update: All Quiet on the Western Front
The US economy continues to grow with real GDP up 0.7% in 1Q2007 compared to 2.5% in 4Q2006. The media continues to say the consumer is worn out and the recession is coming. It is hard to believe the economy slowed its rate of growth 1.8% in just three months with no world turmoil. I conclude the fourth quarter 2006 is overstated or the first quarter 2007 is understated. Here is the US government’s reported real GDP during the last economic slow down.
| Quarter | Real GDP | Rate of Change | | 2000q2 | 6.4 | | | 2000q3 | -0.5 | -6.9% | | 2000q4 | 2.1 | 2.6% | | 2001q1 | -0.5 | -2.6% | | 2001q2 | 1.2 | 1.7% | | 2001q3 | -1.4 | -2.6% | | 2001q4 | 1.6 | 3.0% |
How does the economy slow down 6.9% from one quarter to the next, and then grow 2.6% the next quarter? The rates of change are greater than the actual growth rates! These figures don’t even factor in inflation.
In any case, the economy continues to grow. Based on income tax withholdings data from the Daily Treasury Statement, the wages of all U.S. workers on payrolls jumped 7.2% year-over-year during the recent six months.
Market Update: Cash is King!
Buy-out mania and corporate stock buy-backs continue to shrink the number of shares outstanding and give shareholders cash to reinvest. Each of the past 36 months, corporate buying has exceeded corporate selling. More corporations are buying their own stock, or other corporations’ stock, than are selling their stock to the public. During this 3-year period, the S&P500 is up 30%. As long-term investors, we can’t deny someone else’s insatiable desire to buy our shares. We shouldn’t fight the trend that should continue.
The buy-out mania is being fueled by leveraged buy-out firms using leverage (debt) to purchase publicly traded companies. Leverage is risk. If you borrow money with a mortgage, credit card, auto loan, or margin debt, you are spending money you don’t have. If you can’t make the interest payments on the borrowed funds, you risk bankruptcy. The same holds for companies buying other companies using leverage. This all works as long as the debtor makes its interest payments on the debt.
Although the economy experienced one of the mildest recessions on record earlier this decade, S&P 500 profits fell by nearly one-half. During the next recession, companies with mountains of debt will suffer significantly more than companies without as much debt as corporate profits will fall even faster with the debt to service. The use of debt is risky. I will expand on this in the coming quarters.
Portfolio Update: Large Caps Poised to Outperform
The market continues to quietly reward risk taking as it sets new highs. The stock market’s volatility over the last four years is one-half of its normal volatility. This leads the average investor to believe the market will continue to deliver excess returns for less risk. This will change once more investors are lulled back into the market.
International large companies and US large growth companies are the cheapest stocks in the world. This is relative to other asset classes, because every other asset class is expensive. In 2007, two-thirds (67%) of every dollar invested in the US is being invested in international equities. This is down from ninety (90%) in 2006. I expect this trend to continue as the US market continues to move higher.
We will continue to favor US and international large companies in anticipation of this market continuing to move higher over the next 18 to 30 months when we anticipate the storms to hit.
Thank you for your continued trust and support.
Trevor K. Holsinger, CFP
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