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Today's Commentary: 12.13.05
A Look Back:
A Financial Cul-de-Sac: Our 2005 Outlook
Editor's Note:Before I offer you our annual view of the next year, I thought it would be in all of our interests to review how well we did at prognosticating. The piece, titled "A Financial Cul-de-Sac: Our 2005 Outlook" began this way:
Soon, 2004's problems will be shifted to 2005. The first and certainly not the least of these problems was the investor climate that pushed the end of year rally in the stock market. "Wait", you say, "how can a positive year in equities be perceived as anything but cheer-worthy"? Up is up and that end of year rally did pull the markets into positive territory. That, unfortunately, is the only carryover that will greet 2005 and it will be short-lived.
I was wrong about the short-lived part. Rallies continued throughout the year with indexes pushing through to new highs only to see the life sucked out of them by higher energy costs, weather events that we were wholly unprepared for, and the continued growth of deficits in Washington and among the general populace.
The equity market at this writing is up for the year across the board with the Dow Transports leading the major U.S. indices in spectacular fashion. If you listen to the chorus from Wall Street, this is the surest indication that the economy is in full and vibrant recovery. Wouldn't it be great if that thinking were in fact true. And I use the word fact loosely because it is a theory based on history, which we all must admit has never seen economic conditions quite like this. There are similarities and sifting through the records might find comparisons but as a stand alone moment in time, the economic landscape we are currently in and heading for is largely uncharted.
This of course proved to be true. The comparisons that provide so much in the way of comfort for the average investor are simply nowhere to be found. 2005 made us witness to the beginning of a changed economy. Interest rates began to rise thanks in part to the Federal Reserve Board's measured answer to strength. What wasn't expected was the lack of long term faith in the economy pointed out so eloquently with Greenspan's reference to his conundrum.
The problem with the Transport index is capacity. Even at current shipping levels, any uptick in manufacturing would prove disastrous for all ends of the supply chain. Trucks and trains are still crammed full of products from foreign lands entering into U.S. markets. Should the homeland industries decide to add to the mix, something would need to give and that give would almost certainly be in pricing. This will be good for investors in the short term but a decidedly worrisome problem should it become reality.
Industry never did add to the capacity in any significant way. Fuel prices rose and that was the event that changed how well the Transports did. Companies, flush with cash from their continued efforts at squeezing additional productivity from the same labor force and bolstered by tax cuts and the repatriation of overseas profits, were able to absorb the higher costs of getting goods to market.
The rest of the stock market benefited from a surge in the single minded belief that if everyone jumps in, there must be good reason. And for many story stocks, it was a very good year. For some Dow members although, it was not.
There is still plenty of time for the Dow to break even or slightly better. Buoyed by the incredible year in energy stocks, both the Dow and the S&P 500 look as if they had an okay kind of a year. Take out those companies and the indexes look quite bad indeed.
Before the confetti has settled in Times Square, the giant pharmaceuticals are now being hailed as the next best thing for '05. Mostly this enthusiasm comes via the health sector as a whole, whose burdensome litigation - the pleading for torte reform continues to amuse me - did not even come close to matching its yearly performance as a sector against the S&P 500. The spread between these two groups topped 400%.
Health services was an easy target and too easy of a pick for market strength. The costs associated with insuring the health of this nation's citizens has not been adequately addressed. It also looks to be troublesome for all of us in the years to come. As an investment, health care seems to be a long term winner as the first of the baby boomers begins to retire adding additional pressures on an understaffed system.
Pharmaceuticals were hit this past year and hit hard by litigation that has proven that there might be something amiss in the FDA approval system. Two major players in the Dow, Pfizer and Merck are down almost 25% and 9% for the year respectively.
The belief that the abatement in oil prices should be hailed as a sure sign that the new year will be less stressful for the commodity dependent industries of the world. But forty dollars a barrel, even with the terrorist premium of $15 supposedly built in at this level, it is still too expensive to grant the supply chain of goods and services the necessary leeway when it comes to pricing.
Oil at $60 a barrel has been dutifully absorbed by both business and consumers. The average American will pay a premium to heat their homes this winter which will not have much of an effect on 2005. As states begin to subsidize their less fortunate citizens with heat credits, newly replenished tax revenue coffers will be quickly depleted if the weather across the country settles in for a long winter's freeze.
The one thing that has kept the economy rolling is going to make those higher fuel costs more of a concern for economy watchers. As housing prices level off in many areas and fall in others, consumers will not have that endless stream of cash from their home's equity to pay both the energy bills and keep the economy growing.
( I'm getting ahead of myself. 2006's predictions won't be out until the first of the year. Is there any doubt that energy prices will dominate the outlook?)
What has come under stress is not the inventory levels which remain low but the inability of the new age theorem of "just in time" supply to meet demand. This revolutionary way of manufacturing a product over the last twenty years or so was based almost solely on the belief that commodities would be priced at ever decreasing levels. This would allow for pricing to meet demand and in the end controlling it. What was not predicted was the opposite.
To fill you in on how this past problem came to be next year's problem is based on two things. The first test of the widely accepted practice was the undermining of the endless supply of cheap commodities because of a global demand the likes of which modern manufacturing has never seen. This had the unsavory effect of exposing holes in a shortened supply chain. The second was increase in prices that naturally followed those raw materials.
The knee-jerk reaction here at home will be an increase in inventories in almost every industry as they try to offset further shortages which have the predictable effect of diminishing profits. One pleasant side effect will be a temporary pop in employment as business try to play catch-up but other factors will undermine any long term change in the workplace.
I did okay with that prediction but failed to mention the increase in not only the Producer's Price Index but the consumer's cost for those goods. China and India were blamed incessantly throughout the year as their economies grew in near double digit fashion. Growth like that puts serious pressure on those raw materials and that trickled down to the price of goods.
The United States reaction was to sling mud at the valuation of Yuan, China's currency. To their credit, the Chinese did make a currency move by indexing themselves to a basket of currencies. This seemed to appease Washington who should have spent their efforts at controlling of piracy rather than protection of the dollar.
As we see the new year break, we will also see compressed operating margins in far too many industries as a result of this inevitable shift in thinking. Let's face it, the fourth quarter enthusiasm which led the markets into the positive - barely - from what looked to be a dismal year will not be there beyond the first quarter of the next year. Much of this enthusiasm will be taken down by comparisons, deflation and the dollar.
That's right, deflation will be add to the great undermining of the markets. The confidence reported at the end of the year is rife with indicators that point to problems even as the Conference Board results for December showed an increase.
Deflation never really materialized. What kept it from happening was indefatigable consumer who now has a savings rate of -1.5%. Higher interest rates be damned, the consumer will spend until the bill comes due - in 2006.
The indicators that pushed the results higher were from stock prices, real money supply, average weekly initial claims for unemployment insurance (inverted), index of consumer expectations, manufacturersą new orders for nondefense capital goods, and manufacturersą new orders for consumer goods and materials. Unable to offset those somewhat misleading indices were the indicators that will continue to decline in the new year: vendor performance, average weekly manufacturing hours, building permits, and the interest rate spread.
Those indicators did continue to push surveyed confidence reports higher - and the lower - and then as prices at the pump ebbed - higher again. Look back over the last year and our confidence has been on a roller coaster ride of emotional ups and downs. Not exactly the hallmark of a good solid recovery.
The declines I predicted were perhaps a bit premature for 2005. Indications are showing a year-end decline which will carryover into the new year.
Deflation is the inability of those confident consumers to buy anything that isn't a bargain. Any change in the ability for prices to rise will have a ripple effect across the economic landscape both here and abroad. Without the cost push or demand pull pressures that result in inflation, the only thing that can happen is deeper discounts to consumers who may or may not be willing to part with the fewer and less valuable dollars they own.
And bargain hunt we did. The dollar however...
Which brings us to the ever-declining dollar, something that has steadily occurred throughout 2004 and looks to continue to decline in the near future. Our strong dollar policy is not working and the results will show up first in productivity. Despite the reassurances that a declining dollar will make our trade gap adjust itself to more manageable levels, that will not be the case. Our exports have been increasing for the last five quarters but our consumption of products produced on foreign shores has risen right along with it keeping the gap wide. The biggest fear would be an abrupt fall of the dollar. This would bless our dire scenario with the duel complications of higher interest rates and significantly decreased purchasing power.
The later would dismantle this fragile foundation of consumer support. With a retreat of this powerful force, much of this recovery will reverse itself.
The dollar got stronger but not for reasons that imply we as a nation got stronger. The strength of the dollar seems to be propped up by poor European policies. Without a safer haven available, foreign investors continued their buying dollars. The only noticeable shift was which investors were doing the purchasing. The largest amount of Treasuries were bought not by China during 2005 but by other individual investors overseas. Once again it boiled down to lack of choice rather than faith.
I hesitate to blame the deficits just yet. Some optimistic part of me wants to believe that this administration will stop spending as it has for the last four years. Some part of me wants to believe that Mr. Bush might have an economic trick up his sleeve to stop what looks to be the inevitable damage of "twin deficits" in trade and budgets. But as he pursues the costly domestic agenda of reforming Social Security, my hopes for some economic leadership from Washington is dashed.
There are no economic tricks up the President's sleeve. The deficits will play a major role in this economy for years to come and we can all be thankful that Social Security reform never got much further than it did. Let's just hope as the year ends, Congress shows some mercy on those spending programs that cut the basic services of this country as they increase the deficits with unneeded tax cuts.
The next year will see the fruition of missteps in '04. The payment will be harsh and hard to swallow. But if we look on the bright side, it will make us a nation of savers again just as the world economy needs us to spend.
2005 did not turn us into a nation of savers. What it did though was give us a glimpse of the future, one riddled with debt and no real way to declare bankruptcy.
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