Sesame Street takes on the Federal Budget

It has finally gotten to me.  I have seen and heard so much about budget cutting and deficits and I suspect you have too.  What's the big deal about all of this and what is the possible impact on our markets and investments?

The proposals to cut the budget are pretty straight forward.  Democrats want to trim $40 billion dollars from the 2009-2010 budget and the Republicans want to trim $100 billion dollars.  If they don't reach some kind of agreement by the end of this week, the Government will shut down as a consequence. Unfortunately, in the grand scheme of things either proposal seems trivial and meaningless in my opinion.

Let’s start by taking a look at the current Federal Budget with some simple math and The Count

Here’s the math for 2010: (According to the CBO)

  2.162 trillion in Taxes (Revenues)

- 3.456 trillion in Federal Spending (Expenses)

- 1.294 trillion to Finance

Here's the projected math for 2011: (According to the CBO)

  2.2 trillion in Taxes (Revenues)

- 3.7 trillion in Federal Spending (Expenses)

- 1.5 trillion to Finance (2010-11 Deficit)

Simpler Math: How much do we add to the Federal Debt ?

  13.8 trillion is our current approximate Federal Debt

+  1.5 trillion in 2010-2011financing (2010-11 Deficit)

  15.3 trillion is our forecasted Federal Debt

Since a trillion (a million millions) is a fairly abstract number to most people, let’s compare it to something people are more familiar with, the GDP of the United States. If we divided our forecasted Federal Debt ($15.3 trillion) by our forecasted 2011 GDP ($15.3 trillion), then our forecasted Federal Debt would be approximately 100% of our forecasted 2011 GDP.

Meaningless Arguments

When you compare the 2008 Federal Budget to the CBO’s forecasted 2011 Federal Budget we plan on spending approximately $700 billion dollars more in 2011 than we did in 2008 (That’s a 24% increase over three years). This $700 billion dollar increase was spent to temporarily stimulate the US Economy and the US Consumer. Going forward this temporary stimulus appears to be becoming permanent spending embedding into our Federal Budget for the foreseeable future. 

 Going back to the two budget proposals, the difference between $40 billion dollars and $100 billion dollars is really just a 1% difference in trimming the total federal spending for 2011.

Looking at it this way the argument appears to be important symbolically, but meaningless in its impact on the Federal Deficit for 2011 and removing the temporary stimulus.

The Consequences

From a fiscal perspective, the consequences can be grave for several segments of the economy in the long run.

From a market perspective we’re just not seeing any end in sight to the amount of temporary stimulus being pumped into the economy that's rapidly embedding itself into permanent spending.  We have essentially just fed the Cookie Monster, and now he can’t get enough.

My assessment is there is nothing in all the political noise to disrupt the unsustainable gravy train from pushing this economy forward.  I have said it before and I'll repeat myself one more time: The Great American Ponzi Scheme needs something to keep it going until we trick ourselves into spending and consuming more which will lead to more jobs and better wages.

Until then we will continue to feed the Cookie Monster.

 TIm Phillips, CEO

While scrolling through the hundreds of tweets I receive on a daily basis; I found a nice chart that truly keeps things in perspective for me and I hope you as well.

The stock market is up 100% and that's amazing (Reference 1).  The Fed has done it's self described job of inflating the only asset class they can - Equities.  While their mandate is generally described as keeping inflation well-managed and attempting to support full employment, the Fed has also managed to finagle their way into asset bubble creation and destruction.

So, let's not get too carried away with the 100% thing.

(Reference 1)

As seen in the chart over a three year period we are still down and over a longer term period the markets are at the same level as they were in 1999.  This does not bode well for long-term wealth creation.

However, the past is what it is and there really is no point in spending too much time being miserable about the last 11 years and 10 months.  Probably more important for us to look at are the likely scenarios for the short and intermediate future.

Here's what we believe based on the Bespoke Economic Indicators in reference 2.  The business environment is improving.  What once started off as a very slow recovery (the last 1 1/2 years) is looking to turn into one with more departure speed.  Our friends at Bespoke Investment Group do a nice job of summarizing the changes to economic indicators.  Green is good, Red is bad.

             (Reference 2)

As little as 6 months ago we saw lots of declining indicators.  Of course this is a 10,000 ft level view of the macro picture; however, the point is things seem to be improving even if they are still negative in some areas like housing.

Much of this can be attributed to the Fed’s use of quantitative easing as a policy tool.  See my earlier blog on how easing works.

When the Fed ends the second round of quantitative easing in June, we will once again try and rely on the US economy and the US consumer to leave the gravitational pull of earth for the self-sustaining euphoria of no gravity

Will we reach departure speed?

Corporate earnings and revenue can be a guide to how much fuel is in the economy.  With earnings season wrapping up on Tuesday, we have seen 67.4% of companies beat earnings estimates about 2 percentage points higher than last quarter.

 Revenues have also improved with 70% of companies reporting better revenue and if the quarter ends this way, it will be the best quarter for revenue since Q4 2009. 

On a going forward basis, 8.7% of companies have revised earnings guidance upward with 6.6% revising downward.

Overall, the short run earnings are strong supported by revenue and expectations for decent earnings in the future.

So while it feels very frothy in the equity markets relative to the last year or so, there is some reason to believe we may see an overall positive year in equity returns for 2011.  I won't attempt to tell you the exact path we'll take.  Likely it will be bumpy, frustrating and at times sleep deprived.  However, if we as investors and advisors can manage our time horizons correctly we may be able to improve our odds of success.

Tim Phillips, CEO Phillips and Company

 "Either we change the way we live or change the way they live"- Don Rumsfeld

With all that is going on in the Middle East I can’t help but reflect on an asset class that has been out of favor the last few years: energy.

Looking at the chart below, out of all US Equity sectors, energy has had the best performance over the last 20 years with a mean annual return of 12%. Looking just at the last three years though, energy has had an annualized return of -3.26%.

It’s important to consider the alternative though. The energy sector may be on a long downward mean reversion process and could underperform for years to come. It’s too early to come to any defined conclusions but you shouldn’t be surprised when the energy sector, and more specifically oil, continues to experience interesting price activity.

Here are some facts based on numbers from the EIA:

• United States’ oil consumption is a smaller percentage of world consumption. In 1980 the US was the largest consumer of petroleum and was 27% of world consumption. As of 2009 we were still the number one consumer, but our consumption represented only 22% of the total. I would be stunned if this trend didn’t continue.
  • Looking at the supply side, Saudi Arabia is a smaller part of the world supply. Also, Saudi Arabia’s proven reserves are a smaller percentage of the world’s proven reserves. In 1980 Saudi Arabia represented 16% of the world supply of petroleum; in 2009 it was only 12%. In that same time frame Saudi Arabia’s proven reserves as a percentage of the world’s proven reserves fell from 26% to 20%.

• Petroleum consumption should continue to increase mainly due to China and India. China and India alone went from 4% of the world’s consumption in 1980 to 14% in 2009.

All of these macro-trends have been in place for many years and have been discounted by some degree to reflect the current market price. However, I believe the long-term changes occurring in the Middle East and its effect on the supply side of petroleum going forward have not been fully priced in.

Using a loose definition of “democracy”, there are at best three “democracies” currently in the Middle-East. According to the Economist Intelligence Unit, Israel is a “Flawed Democracy” while Turkey and Iraq are considered to be “Hybrid Regimes.” My perspective: the best we can hope for are “Hybrid Regimes” in Egypt and Tunisia, bringing it to five “democracies” in the Middle East.

An Oops Moment

What makes this type of democratic tidal wave so unpredictable is that many countries in the region are dominated by religious ideology. These different perspectives become the fault lines for political parties in the Middle East. In Egypt, these ideological fault lines are split between two prominent parties: the “Muslim Brotherhood” and the “Wise Men Council.” I don’t pretend to be an expert on either group or their beliefs, but I don’t think either has fully grasped what has just happened.

The Google Guy

Wael Ghonim is the Head of Marketing at Google for the Middle East & North Africa. To make a long story short, he got upset this summer over an atrocity that occurred in his home country of Egypt. After posting several videos and some timely usage of social networking, he became a leader of this Egyptian Revolution almost by default. I don’t think this guy gives much credence to a group calling themselves the “Council of Wise Men.”

History has seen many revolutions, and we can look to recent examples in Russia, the Balkans, and in Eastern Europe. Despite their differences they all have one thing in common; it is never simple to figure out the winners and losers. Finding out who's elected and what values they will bring to the table will take time, all while the world waits for the oil it deeply depends on.

The last time there was a democratic election in the region was in Palestine, and they elected Hamas. For those unfamiliar, Hamas is an acronym for a phrase that roughly translates into “Islamic Resistance Movement.” They have been classified as a terrorist organization by the United States, Israel, the European Union, Canada and Japan. Democracy doesn’t always make a region more stable. What is even more concerning is that Hamas was founded as an offshoot of the Egyptian Muslim Brotherhood in 1987 during the First Intifada. This makes it even harder to believe in the prospect of lower oil prices.

Unfortunately, if we don’t change the way we consume, we are going to change the way they are going to live. It’s not entirely clear what the consequences in the short run will be on the geopolitical landscape. However, with the instability in the Middle East there is a high probability that both oil prices and the energy sector will continue to be in favor.

TIm Phillips, CEO

Some things in life really count and should be counted,

some things in life really count and can't be counted

There are two sets of data that I want to bring to your attention in this very brief blog (as it is Super Bowl Sunday). I have a Super Bowl diet allocation of 3,500 calories that I'm about to consume, and as I’ll explain, this is a number that doesn't count.

Data Point 1

Unemployment dropped to a mind altering 9% this week. Most Wall Street economists, including myself, were not expecting this type of drop. 

Of Course, we need to place a lot of value in the unemployment rate. With 70% of our nearly 15 trillion dollar GDP driven by consumption; jobs and wages matter. 

Unfortunately, for a Government that we allow to spend over 3.5 trillion dollars of our hard earned money a year, they can’t' seem to count when it really counts. If this 9% unemployment rate were accurate it would mean that we added 1,765,000 jobs in the last 15 months from its peak of 10.1% in October. That is 117,666 jobs per month 

We know the numbers simply don’t add up. What has actually happened is an increase number of willing (I use this term loosely) and able American workers are simply giving up and running out of benefits. According to Bill McBride, author of Calculated Risk, “The Labor Force Participation Rate declined to 64.2% in January. This is the lowest level since the early '80s. (This is the percentage of the working age population in the labor force. The participation rate is well below the 66% to 67% rate that was normal over the last 20 years.)”

Let's not take the headline number too seriously until we can get a key performance indicator that actually counts. And by the way, if I couldn't accurately count the most critical number in my business, I would run a serious risk of becoming a statistic also.

Data Point 2

The 1.9 Trillion dollars worth of cash recorded on the balance sheets of many U.S. companies at the end of Q3, 2010 is what really counts.

What corporate CEO's and Boards will do with the cash really matters, but can't necessarily be counted on. It seems a natural conclusion for many companies will be to use a part of this cash to buy more growth in the form of M&A activity. In fact, we are seeing a lift in activity with an estimated $124 Billion in global deals already being announced this year. This is the greatest number to date since 2000. While corporate balance sheets are sitting on 7.3 trillion dollars of debt or over 52% of their total financial assets, the dollars may be used to pay down debt. These are some of the highest debt levels reported since 1998 with an exception in 2008.  (The Deal)

The difference between buying companies and paying down debt speaks volumes about what corporate CEO's are thinking about the economic future. One implies optimism and a willingness to risk for growth, while the other suggests a continued feeling of concern and reluctance to live with a balance sheet that can implode with another economic hiccup. 

Hope and Fear can't really be counted but perhaps by watching what happens to all of this cash it can help us count the uncountable.

Political Jab

With an incalculable amount of this cash sitting overseas from foreign profits, we predict companies won't bring this back "onshore" to pay the current 39% corporate tax rate.  Why onshore it when they can count it as earnings, pay off debt with it in any country they like, and deploy it for cheaper labor and manufacturing?

Let's hope our partners in business (the U.S. Government) can start to learn how to count what can be counted and how to appreciate what can’t always be counted.

Tim Phillips, CEO