The Experts: Investing

       The first quarter was volatile but healthy

Column by Jim Flinchum, Inside Business - Hampton Roads, April 16, 2007

Original article here

If economics is the dry science of number-crunching, then investing is the subtle art of guessing how much the markets will overreact and to which headline. The past quarter was full of examples.

First, let’s look at the dry economics. GDP growth of 3.5 percent in the fourth quarter of last year was announced, but we can expect a downward revision to this. Exports in the fourth quarter were up 10 percent and imports were down 3.2 percent, which is great. This added 1.6 percent to the GDP in the fourth quarter. At the same time, the housing market had a 1.1 percent drag on GDP growth in that quarter. So, which of those two facts did you read about, the 1.6 percent boost or the 1.1 percent drag?

First-quarter GDP growth should be announced late this month and will probably be significantly lower, about 2 percent. In addition, durable goods orders were down a huge 7.8 percent, housing permits continue to fall rapidly, and new home sales have been revised downward for the last two months. As predicted, the economy is slowing, but that is not all bad.

It means the Fed will likely remain on hold, leaving rates unchanged during the second quarter. Although inflation at 2.4 percent is still above the Fed target, they also see the economy slowing and expect that will reduce the rate of inflation sufficiently. (Interestingly, the inflation is almost entirely in the services sector, with minimal inflation in manufactured goods.) The American people must also see the economy slowing, as consumer confidence dropped to 88.8, the lowest since November.

Normally, large company stocks fare best in a slowing economy. But it is important to note that for seven out of the last eight years, mid-size and small company stocks have outperformed large companies.

U.S. factories working hard

There was considerable good economic news that didn’t make the headlines. For example, industrial production was up 1 percent, considerably above expectations. And capacity utilization reached 82 percent, up from 81.4 percent in January. This is unusually high, showing U.S. factories are working as much as possible. This drove unemployment to a five-year low of 4.4 percent. Many economists see this low unemployment rate as inflationary, even though unit labor costs only rose 1.7 percent, which is below expectations.

Buried in the March job report announcement that 180,000 jobs were created in March, far above the expected 130,000, was the upward revision of the two preceding months of another 32,000 jobs. Almost all of these 32,000 were from small or mid-sized companies, which typically lag in their reporting.

This data signals a continued strength in the economy and helped increase total assets held by households to $4.9 trillion, while debt increased $1.1 trillion. That’s an increase in our household net worth of $3.8 trillion. It’s no wonder consumer spending continues to hold up so well. Both spending and incomes were up 0.6 percent in February alone, which is great.

The great moderation

There is an interesting discussion among economists about what Fed Chief Ben Bernanke calls “the great moderation,” and it is helpful in reading today’s economy and markets.

According to Chairman Bernanke, “One of the most striking features of the economic landscape over the past 20 years or so has been a substantial decline in macroeconomic volatility.” For instance, there is no prospect of unemployment spiking at 25 percent again, as it did 75 years ago. Clearly, volatility in the economy has decreased, but why? Bernanke believes it is due to better monetary management, and he is probably correct.

It’s important to remember that Bernanke refers to economic volatility, which is different from volatility in the stock markets and is usually measured by the Volatility Index or VIX. A low number is bullish and a high number is bearish. Since August 2002, it has been trending downward, while the S&P mirrored that trend upward.

If volatility is back, that is not all bad. It is good for hedge funds and day traders. Today, almost one-third of all trades are computer-generated, which exaggerates any normal reaction. For the brave investor, this is pure opportunity.

Greenspan still a player

One of the biggest “headline hits” of the first quarter was the statement in late February by former Fed Chief Alan Greenspan, who suggested there was a one in three chance of a recession this year, or a 67 percent probability of not having a recession. That set the stage.

Soon after, concerns focused on delinquencies in the subprime mortgage market, and the U.S. financial markets started to wobble. Then, the Shanghai stock market had a major correction. Quite naturally, our markets overreacted, with the Dow dropping an amazing 416 points or 3.3 percent in one day.

The problems in the subprime mortgage market are certainly real enough. Delinquencies have risen to a whopping 13.3 percent, compared to 0.54 percent for the market overall. But, as with all glaring headlines, it requires perspective. While the home mortgage business is hugely important, only 12 to 13 percent of it is subprime. Also, there is no discussion that all will become delinquent.

Remember, unemployment is only 4.4 percent. People are not losing their jobs. Factories are going full-blast. This “subprime crisis” should be called the “teaser rate crisis,” when unrealistically low introductory rates suddenly adjust to the prevailing interest rate. Those lenders who specialized in subprime mortgages are clearly suffering, especially if loaded with “teaser-rate” mortgages. But, the worst-case financial impact of all this is estimated at only $330 billion, which is far less than the damage from the savings and loan bailout in 1987-91.

When the Shanghai market lost a staggering 9 percent in one day, it helped trigger our overreaction. However, the Shanghai market has already recovered to a new high. We were remembering the Russian collapse or the Thai collapse and simply overreacted again. Remember this perspective: The total value of the Shanghai stock market was about $900 billion and lost 9 percent of that amount in one day. The value lost in our markets that day was $1.3 trillion. In other words, we lost more in our market than the total value of that market. That is certainly an overreaction!

When all was said and done, the stock markets ended the first quarter almost exactly where they started, but it was never boring for investors.

I continue to think 2007 will be a good year for investors, with the S&P ending the year about 1550. While the economy is clearly experiencing a healthy slowdown, it is still growing. It is not contracting. By the third quarter, I expect the economic recovery to resume. The stock markets are already recovering nicely. But, expect another “headline hit” and expect the market to overreact to it.

Jim Flinchum is the managing principal of Bay Capital Advisors in Virginia Beach and can be reached at (757) 963-5699 or jim@baycapitaladvice.com.