It's that time of year when everyone in my business tries, in earnest, to predict the markets for next year. I've spoken to some of these professionals and my takeaway is that they (still) tend to believe in their prognosticating skills.

In my profession, I’ve come to observe that the more “precise” you are, the more people are apt to find comfort in believing you. People seem to believe if you make very precise statements it must mean you are very confident and therefore it has to be accurate. Unfortunately, in my profession the opposite tends to be true when it comes to forecasting. The more precise the forecast, the more inaccurate the forecast tends to be.

The best example of this in 2011 was Meredith Whitney’s very bold, very precise, and very inaccurate prediction for the municipal bond market made last December 19th, on an episode of 60 Minutes where she said:

“There’s not a doubt in my mind that you will see a spate of municipal bond defaults... You could see 50 sizeable defaults, 50 to 100 sizeable defaults, more. This will amount to hundreds of billions of dollars worth of defaults”

Then later in the same interview in regards to rating agencies and their relationship to the municipal market:

“When individual investors look to people that are supposed to know better, they’re told – they’re patted on the head and told it’s not something you need to worry, about when it will be something to worry about within the next 12 months”

This prediction was heard around the world. She made the cover of magazines, and multiple TV appearances. It appears being precise is better for business than being accurate.

Since her prediction on Dec 19^th, 2010 the municipal market has returned 10.5% as of Dec 16^th according the Merrill Lynch Municipal Master Index. That beats U.S. Treasuries, stocks, corporate bonds and commodities. The municipal bond market was arguably the best performing asset class of 2011.

In keeping with the parlor trick theme, I will make my stab at outcomes for 2012.  Here it goes:

For 2012, I predict the S&P 500 earnings will be $103/share with an earnings multiple of 13. This would make a year-end target of $1,339.00 on the S&P 500, an increase from $1,265.33 which was seen at the close this past Friday, December 23^rd.

I see a very nice move in the equity markets in early Q1 driven by continued rebuilding of inventory.  Q2 will be a bit tougher as we have continued slack in housing and the peak of foreclosures take hold.  The second half of 2012 will be election driven and perhaps a choppy but rising market.

Europe will be the market to watch and certainly those that overweight their portfolio now could be richly rewarded, but I will not be one of them. Even if they solve their currency and debt problems, they still have a culture of leisure that I predict will keep them in recession or near a recession for a longer period of time.

Of course, a European disaster would spell an extreme event of perhaps 25%+ downside.  The actual GDP impact would most likely be small, however, I believe the equity markets would react swiftly and forcefully.

Asia (China) growth will slow slightly but much of that appears to have been discounted in 2011 as the Hang Seng Index and the Shanghai composite are down -19.13% and -22.86% year to date respectively. While many might run from Asia, I believe they have taken the brunt of the slowdown.

Ok, those are my best guesses.  I like parlor tricks so I played along; however, in the long run I tend to depend on solid allocations with specific tilts to take advantage of opportunities. The predicting is fun and if I'm right I'll be sure to let you know.  If I'm wrong and there is a high probability of that, then I will hope you are too busy to notice.  After all, this is a core concept for those in the parlor trick business.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Have a happy and safe New Years.

Tim Phillips, CEO – Phillips & Company

While Europe has been grabbing all the headlines winning our "Grim Reaper" award, there has been one country quietly accumulating some momentum, the United States. The U.S. has been posting some fairly positive numbers so far for the month of December. As you can see from the chart, we’re about evenly split between indicators that have beaten expectations and those that have not.

Most important are the weekly claims numbers that may suggest we are seeing a slight improvement in job growth. The data above shows that initial jobless claims have been significantly better than expectations for the past two weeks in a row.

Even with retail sales missing estimates, a breakdown of the 13 components show an interesting trend; consumer cyclical sectors all beat estimates while staples generally underperformed.

The Market may already be taking notice of our situation and acting accordingly. The U.S. dollar has recently strengthened against other currencies (especially the Euro) and coincidentally we’re seeing gold continuing to sell off. There has also been a lot of talk about gold breaking below its 200 day moving average of around $1,690 which is a bearish technical pattern. On Friday, the spot price of gold closed at $1,599/oz, down 15.89% from its high of $1,900/oz on September 5^th of this year.

With a 2011-2012 federal budget signed into law, we can move that debate off the table. Up next, we have payroll tax cuts and unemployment insurance and a two month extension would be counterproductive.  Who is going to run out and spend their two months of benefits if they think it will be their last? We believe a good resolution to this debate could support another 1% of GDP growth next year.

Finally, with the holiday fast approaching I want to thank all of you on behalf of everyone at Phillips and Company for your trust and confidence.  This has indeed been a volatile year that has been taxing for individuals and institutions.  We hope this holiday provides you with some time with family, friends and some moments of joy and happiness.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Happy Holidays and Merry Christmas!

Tim Phillips, CEO – Phillips & Company

Hat tip to Bespoke Investment Group for the Economic Data

Last week, we touched on a report from the Economic Cycle Research Institute (ECRI) that calls for the United States to enter a recession in 2012. This deserves further examination for two reasons. First, it’s a significant outlier from other 2012 GDP forecasts. Second, they’ve correctly called three recessions without any false alarms in-between.

The ECRI’s call is based on a number of leading indices which a key piece is their view on the United States Gross Domestic Income (GDI). GDI is similar to GDP conceptually in that it adds up a set of economic components. GDI is different from GDP in that it adds up economic components from the other side of the equation. In other words, GDP gauges the economy from the expenditure side, while GDI gauges the economy from the income side. In theory, the two should be equal but are usually not because in practice they are calculated in different ways. Where GDP is the sum of consumption, investments, government spending and net exports; GDI is calculated based on employee wages, corporate profits, and tax revenues. Looking at our economy based on income is fairly intuitive as income drives consumption and 70% of our economy is driven by consumption.

According to the ECRI the last reading on GDI was 0.30%. This is much lower than GDP which came in at 2.0% down from the initial reading of 2.5%. The ECRI goes on to explain that when you have a two quarter annualized GDI growth rate of 2% or lower, you reach a recessionary stall speed. The last reading was 0.28% and has been trending down steadily.

Looking past the troubling GDI data there are still a couple of interesting data points on what consumers are doing with their income.

First, according to the Bureau of Economic Analysis, income increased faster than spending and the savings rate increased slightly:

Personal saving --  (disposable personal income) DPI less personal outlays -- was $400.2 billion in October, compared with $376.9 billion in September. Personal saving as a percentage of disposable personal income was 3.5 percent in October, compared with 3.3 percent in September.

The savings rate ticked up in October, however, the trend still appears to be going lower. Consumers appear to be feeling more confident because they are more willing to spend down savings in order to consume.

Second, consumers have been using more revolving and non-revolving credit in the last couple of months to increase consumption.

As for companies, they are sitting on $2.11 trillion in cash. When you put this in terms of the total assets on their balance sheet – cash on the sidelines – it’s at a 30 year high. After all, many non-financial companies were frozen out of the debt and overnight lending markets by banks which almost collapsed their businesses.  However, there will come a point when they deploy this cash for higher returns.

Last but not least, corporations have had another banner quarter of record earnings which we did discuss last week.

So while the GDI data suggests gross income for our country is down, the consumer is still finding ways to consume.  Maybe it's just in our behavior to consume and we can't help ourselves.  Perhaps our consumption is unsustainable and we will fall back into a recession.  No one really knows what next year holds and the best bet is to tailor your investment strategy based upon shaping risk with time and allocating accordingly.

I for one wouldn’t want to bet against the consumer demonstrating unsustainable habits because history has shown how resilient the US consumer can be to spending at an unsustainable rate

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Hat tip to Calculated Risk for the savings graph, and Ritholitz and Arbor Research for the “cash on the sidelines” graph

Over the last two weeks we've looked at the European Debt Crisis and the potential impact on US exports if Europe falls into a recession (What’s All the Fuss?). We also covered the challenges many European countries face on budget agreements as a consequence of each country’s relatively unique social programs (The Cost of Leisure Part 2). It seems to me there is a lot of emotional noise; perhaps it’s time to step back and look at issues a little closer to home.

The official start of the 2012 presidential election campaign season is just 30 days away with the Iowa caucus on January 3, 2012. That means the political class has just one more chance to get something done and as a result, it appears we’ll have an extension of the employee payroll tax cut and unemployment benefits. These extensions will likely be funded with “kick the can down the road” funding mechanisms which will lead to cutting expenses sometime in the future.

Economic data was pretty mixed last week. Probably the biggest headline surprise was the drop in the unemployment rate to 8.6% down from 9.0%. Unfortunately, it was largely due to the decline in the Labor Force Participation Rate which fell well below the 66% to 67% rate that has been the norm over the last 20 years. On the positive side, October and September hiring numbers were revised up to 100,000 from 80,000 and 210,000 from 158,000 respectively.

Overall, our economy is still at a very fragile point and we’ve pointed out how a simple quarter of a percentage point can be the difference between expansion and contraction for our economy today. The Economic Cycle Research Institute (ECRI) still expects the US economy to tip into a new recession in 2012 despite what our policy makers do (you can read a summary and the full report here). The bottom line is, ECRI is basically saying, “If you think this is a bad economy, you haven’t seen anything yet.”

Companies continue to beat earnings expectations at pre-recessionary rates however we saw a big drop in the revenue beat rate. At the end of the US corporate earnings are near record highs thanks to improving margins.

Abroad, European Union Leaders meet for their next big summit in Brussels this Friday. We expect the leaders to continue to agree on being more connected through budget agreements and determined to save the EU and the Euro. However, anything can happen and the markets are growing impatient. On the other side of the Americas, we saw China unexpectedly cut required reserves by 50 bps.

Looking across the board, I think in the near term the upsurge and downsides are a toss-up and we need to continue to dig deeper to find the right allocation path. Remember without the uncertainty, the opportunities to generate returns would prove to be difficult and underline how critical it is to shape the risk by using time well.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

As we discussed earlier this month, a recession seems almost inevitable and the impact on US GDP growth is negligible. In fact, this morning the Organization for Economic Cooperation and Development warned that Europe risks a severe recession if they can’t halt the sell-off in the Eurozone sovereign debt market. What we did not discuss last week was a potential full blown collapse of the Euro.

What would happen if the 27 country European Union dissolved over a failure to come to terms with member country debt? After extensive searching, I’ve realized I cannot find a single paper written by the International Monetary Fund (IMF) or the European Union (EU) outlining a contingency plan to dissolve the EU and the Euro. Likely, any plan could be catastrophic if leaked and probably not worth the risk of writing. Perhaps this indicates a failure of the EU is not conceivable by the parties.

Before we can address what would happen if the EU fails we should review what's holding the countries back from agreeing on a solution.  In simple terms, Germans don't want to pay for Italian leisure at the expense of their own and each country has their own social programs (some much more generous than others).

Countries with these generous social programs need their economy and GDP to grow fast enough to cover the costs. When their economy doesn’t grow fast enough, they must borrow to keep their promises. Currently, it appears to be seen as political suicide for a Leader of an EU member country to decide to cover the debts of a “lazier” EU member country. So what are some possible solutions?

Eurobonds are still out of the question because it puts the burden of generous social programs onto the stronger economies. Hypothetically speaking, if Eurobonds are issued at 4.5% then any member country that was paying more than 4.5% would benefit and any member country that was paying less than 4.5% would be disadvantaged. Germany doesn’t want to backstop Italian summer vacations.

Reworking the EU treaty to stipulate more fiscal controls would certainly be a good place to start if everyone was going to share pain.  However, convincing sovereign nations to give up fiscal control is not an overnight process. Getting the 27 members to agree on specific changes to the EU treaty would take more time than they have.

The International Monetary Fund (IMF) could provide a rescue package or credit line to troubled EU members. This option would keep the EU together and buy additional time to revise the EU Treaty. The catch is who funds the IMF. Approximately 17% of the IMF’s funds come from the United States. Instead of Germany paying for Italian summer vacations it will be you and me.

There is also a possibility it may be too late for any solution. What if it all failed? The truth is the largest economy in the world would spend several years trying to figure out how to re-trench and grow again.  The geo-political consequences would be significant and we would all face a really ugly "new normal".

We are working diligently to continue to rebalance away from Europe without giving up opportunities to profit. With markets moving so quickly in both directions it’s a non-stop effort to determine the "best" next moves. While Europe slides into a recession and perhaps a depression we will continue to work hard, just like you. I sure hope Europe enjoys their leisure now, because one day the cost might be too much to bear. That's how conflict really starts.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

As of this writing on Sunday, the Joint Select Committee on Deficit Reduction, i.e. the Supercommittee, is poised to admit defeat.  Once again, Washington is gridlocked and if the markets react like they did during the summer’s debt extension debate there’s potential for another round of market volatility.

Even though “across the board cuts” won’t start until 2013, I have concerns today with how our macro-economy and GDP will be affected if our debt problems balloon to an impasse like those of Europe and Greece. 

For example, if our GDP grows at an annualized rate of 2% each year from 2011, then the first round of cuts in 2013 would amount to 0.44% of GDP.

These year-over-year spending cuts would have a significant impact on GDP particularly since we are already experiencing anemic growth.  To make matters worse, if you include the 0.25% hit to GPD from our import/export relationship with the European Union, then our economy could face close to a 0.75% hit to GDP in 2013.

The markets care about this a great deal. Right now, there seems to be a tremendous focus on companies that receive substantial government funding like healthcare and defense spending. Looking at healthcare and more specifically the home healthcare and assisted living sectors, anticipated cuts to Medicare appear to have already been priced as seen in the YTD performance of the following healthcare companies:

Smaller defense and aerospace companies whose revenue relies greatly on significant government contracts could also come under pressure if these “across the board” cuts actually happen. While the S&P 500 is only down 4.80% since August 2nd (when Obama signed the Budget Control Act of 2011), there is potential for more negative markets.

With all this doom and gloom, let’s look at the bright side for a moment.  It is likely many market participants have already discounted what they always knew: that partisan politicians can never get anything done and provide us a tremendous buying opportunity in light of expected GDP growth.

Let's see who shows up for the big announcement and who really cares. We certainly do.

Have a happy and joyous Thanks giving!

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

By now, I think it’s safe to say investors have been sufficiently tortured by what’s happening in the European economy.  The moment Greece moved off the headlines, Italy took center stage. Once the media gets tired of Italy and the markets adjust, they will probably move on to the next victim country.

What’s not talked about is how this may directly impact the US economy and our GDP.

First, the European Union is the largest Economy in the world. The European Union combined with the United States represents almost 50% of the entire World’s GDP. 

Clearly Europe matters, the question is, how much does Europe matter? Over the last 12 months we have exported approximately $324 billion dollars to the European Union in goods and services. We also import more from Europe than we export; therefore we have a negative trade balance which subtracts from our total GDP. This negative gap could grow significantly if we continue to import goods from Europe and we are not able to increase our export goods. 

As a quick rule of thumb, every $140 billion in economic activity is 1% of our GDP (1% of $14 trillion is $140 billion).  With that in mind, a 10% drop in exports to the European Union would be a decline of $32.4 billion in US GDP (about ¼ of 1% of our GDP). Under normal economic conditions that wouldn’t mean much.  However, under current circumstances 1/4 of 1% means something. 

Last week, we highlighted the Federal Reserve’s economic forecast where they slashed their 2011 United States GDP growth from a range of 3.3%-3.7% down to 2%-2.5%. Under current circumstances, a 0.25% drop in GDP would be 10% of our growth. 

The International Monetary Fund has trimmed its European growth forecasts to 1.4% and I believe the markets are expecting a European Recession. It's not hard to imagine their economy slipping into negative growth if there are no bold policy considerations for bailing out irresponsible, socialistic member countries of the European Union.  As I have said several times in presentations, this is the price for leisure.

I believe most of the bad news is already built into our markets, which is good news to me. Looking at export numbers year to year, exports to Europe peaked in 2008, fell steeply in 2009 and rebounded in 2010. Year to Date, 2011 looks to be better than 2010, but not quite as good as 2008 leaving more upside for US exports to the European Union in 2012.

When we get all the nasty headlines about Europe try to look past the emotion and perhaps we won't lose export ground as much as some pundits believe.  If this is indeed the case we could see a nice upside surprise to our markets.  Now that would be something to fuss over!

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Last week, we discussed the details of the Bureau of Economic Analysis’ (BEA) advance estimate of US real GDP for the third quarter. Sticking with the GDP theme, later that week the Federal Reserve came out with their fourth and final GDP and unemployment projections for the year.

GDP and unemployment projections have moved in the wrong directions since the beginning of the year. The November projection for 2011 GDP is expected to be 1.6% to 1.7%. This is much lower compared to their projection of 3.4% to 3.9% at the beginning of the year. Based on these new projections the Fed does not expect a 3.0% or greater change of real GDP until 2013!

As for the unemployment projections, the Fed still expects 9.0% to 9.1% for 2011 and does not expect to see unemployment under 8% until sometime in 2013.

According to an analysis by Bill McBride, author of the economics blog Calculated Risk: 

If we continue to see sluggish growth with 125,000 payroll jobs added per month (the pace this year), it will take an additional 52 months just to get back to the pre-recession level of payroll employment.

If job growth picks up a little - say to 200,000 payroll jobs per month - it will take an additional 33 months to get back to the pre-recession level.

Based on those numbers, unemployment won’t return to the pre-recession level until somewhere between July 2014 (blue line) and February 2016 (red line). McBride also notes that these projections do not include population growth and new entrants into the workforce.

While these numbers might be slightly depressing, it’s important to realize they are moving in the right direction, albeit slowly. GDP numbers continue to stay positive and we continue to have positive net jobs added per month. For now it looks like the US will avoid a “double dip” recession and continue its slow growth trend. In fact, Merrill Lynch and Goldman Sachs raised their Q4 GDP forecasts on the heels of the BEA numbers last week citing the same reasons we did previously, improved domestic demand and increased consumer spending.

It’s important to protect your portfolio from downside fluctuations, but it’s equally as important to not get caught flatfooted and miss a potential year-end rally. Historically, November and December are two of the best months of the year for US equities. 

Between the European Debt Crisis and our own fiscal problems there are plenty of downside catalysts, but if the consumer decides to spend more than expected this holiday season we could continue to see positive surprises in consumption and GDP.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

“Average Monthly % Change for the Dow Jones Industrial Average” provided by Bespoke Investment Group

You hear a lot about “risk on” and “risk off” by the media to describe the day-to-day short term volatility. For example, in the third quarter the S&P 500 fell 13.87%, clearly a “risk off” quarter. Then in October, as of Friday the 28^th the S&P had increased by 13.74%, clearly a “risk on” month. At the end of all this, the S&P was actually up by 3.87% so far for the year.

The last four months have been a roller coaster ride but it’s important to maintain an intermediate and long term perspective in order to invest in the right areas. With that in mind, we took a deeper look at the advanced real GDP numbers. According to the BEA and based on the advanced estimate numbers, the US Economy increased by 2.5% in the third quarter. This number was in line with consensus and better than the first two quarters of the year.

Looking deeper into the GDP numbers, you can see that third quarter was clearly a “consumption on” quarter when compared to second quarter:

I would say this is better than another “inventory rebuild” quarter, but we are still not out of the woods until we see wage inflation. “Consumption on” is much better than “consumption off”, but we need to make sure it’s sustainable consumption.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Hat tip to the Dismal Scientist for the spending graph

We have now entered the final quarter of the year and Alcoa kicked off the final earnings season after the bell on October 11^th. As we hit the home stretch we wanted to look back and compare the S&P 500 forecast from the beginning of the year, to current S&P 500 forecasts. Back in January, the average forecast for the S&P 500 2011 year end was 1384. As of October 17^th the average forecast is approximately 100 points lower at 1282. What happened?

To understand what happened, first we need to understand how they come up with year-end forecasts for the S&P 500. It’s basically two things: forecasted Earnings Per Share (EPS) and a forecasted multiple.  The EPS is based on the aggregated forecasted EPS from all the companies that make up the S&P 500 index. The forecasted multiple is based on the estimated level of certainty and predictability of those earnings. When there appears to be more certainty, multiples go up and when there appears to be less, multiples go down.

Earnings have been fairly good for the year and this earnings season appears to be shaping up similarly to the last two quarters; possibly a little better. The percentage of companies that have beaten earnings estimates so far is higher than the last two quarters (this is based on the companies that have reported as of October 21^st). 

Taking a look at the first variable EPS, the average 2011 EPS forecast for the S&P 500 was $92.75 at the beginning of the year. As of October 17^th the average 2011 EPS forecast for the S&P 500 is actually up $3.60 to $96.35. This underscores the fact that companies are continuing to meet and beat earnings estimates throughout the year. Clearly, this part of the formula is not bringing down the forecasts for the S&P 500.

The other variable in the S&P 500 year-end forecast is the multiple. The mean year-end forecast at the beginning of the year implied a year-end S&P 500 multiple of 14.9. The most recent year-end forecast now implies a year-end S&P 500 multiple of 13.3.

This contraction in the multiple is highly likely due to the increase in global uncertainty. In the United States, you still have the fiscal uncertainty and political silliness surrounding the “Super Committee.” The Committee’s deadline is November 23^rd to come up with a proposal and congress is supposed to vote on the Committee’s budget proposal on December 23^rd. In Europe, you have a grocery list of monetary and fiscal issues that are creating uncertainty in the Eurozone and the future of the Euro. German Chancellor Angela Merkel and French President Nicolas Sarkozy are supposed to make a big announcement on Wednesday regarding “a broad agreement” regarding these uncertainties. Lastly, in China you have talks about slowing GDP growth, and a real estate market bubble that could lead to a “hard landing.”

The bottom line is corporations are driving good earnings with a back drop of global political uncertainty. It used to be you could count on the corporations and the CEOs to do something that would create a circus. For example, Koslowsky at Tyco buying $6,000 shower curtains paid for by shareholders.  Now it seems like the politicians are the clowns under the tent.

This circus show might be hard to watch right now, but my guess is corporate earnings and opportunities through innovation will win out over rhetorical fights, political gridlock and self-interest. In my opinion, the best way to take advantage of this current environment is to continue to invest prudently, be patient, and align investments with time horizons.

To leave you on a hypothetical high note; if we were to take todays projected S&P year-end EPS ($96.35) and multiply it by the first quarter’s year-end multiple (14.9). You would get a year-end target of 1435 for the S&P 500 and a 14.5% rally between today and the end of the year.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.