2012Feb13 Will it last?

As the relentless march of time embraces 2012, there are a couple important issues to address.  Investors are beginning to recoup some of the confidence that was lost during the turbulent year that was 2011. Europe showed signs of stabilizing in January. Since then, the showdown between Germany which has money and Greece which needs it has stalemated, again.

Is the renewed confidence justified?  Or is this a classic case of investors hearing what they want to hear and believing what they want to believe?

The ongoing European sovereign debt crisis is the single most important issue facing the world economy.  Europe did take several important steps with its new fiscal treaty.  At the end of January, every European Union country, except the UK and the Czech Republic, approved a German-sponsored treaty that would force Euro zone members to balance their budgets or face sanctions—essentially outlawing Keynesian economics.

The treaty should thrill fiscal conservatives. It has helped to restore confidence in the bond market.  Combined with fairly aggressive lending by the European Central Bank, Europe has sidestepped what could have quickly turned into another 2008 meltdown scenario.  This is the good news.

Now, for the bad news.  We expect the next GDP data in Europe to indicate the region is already in recession. Cutting government spending to stay within treaty terms when the private sector is shrinking and banks aren’t lending will only make the recession worse.  The deeper the recession gets, the harder it will be for Europe’s governments to raise tax revenues and service its existing debts.  This is a vicious cycle. We are just in the early stages of it.

Meanwhile, both Greece and Portugal may still be heading for default, and no one knows what affect this will have on the world’s stock and bond markets.  Should things spiral out of control—which is still a very real possibility—we could indeed see a repeat of the volatility 2008.  We’ll know soon. Greece will probably default by the end of March if no progress is made in its negotiations with creditors.

The U.S. economic picture is, also, mixed.  GDP grew by 2.8 percent in the fourth quarter of 2011, but 2.0 percent of this growth was due to inventory restocking of companies.  Elsewhere, growth remains tepid at best. Official unemployment numbers have shown improvement. The IRS payroll tax data, however, shows a loss of more than 1.5 million jobs in December and January.

The housing sector, which was the root of all of the turbulence of the past five years, also remains a mixed story.  Nineteen of the twenty metropolitan areas tracked by the Case-Shiller Home Price Index fell in November, the last month for which we have data. This is the third consecutive month that the index has declined, falling 1.3 percent from October to November and 3.7 percent from November of the prior year.  The enormous inventory of properties in foreclosure continues to act as brake to any recovery in prices.

Even so, we do see some welcome developments.  Inventories of unsold homes continue to fall, and the price-to-rent ratio has fallen to its lowest level since the year 2000.  In other words, homes are the most affordable they have been in 12 years versus renting. However, many banks have begun paying delinquent borrowers to leave their homes. It is done when the “bribe” is less expensive than the foreclosure process. Many real estate analysts expect prices to bottom out in another five years.

All of this, in Europe, America, and beyond, can be summarized as uncertainty.  We have a lot of uncertainty out there, and this requires vigilance and patience. The recent rally has occurred without significant volume. Our updated data shows international markets attracting investor dollars. That is a positive sign that investors are becoming more risk tolerant, perhaps recognizing the bond market bubble that has been created by central banks. 

While short-term trading indicators have been positive for a few months, the prospect of a whip-saw has remained high. Our long-term indicators are shifting towards a sustainable trend. When that occurs, we will reduce our cash position.