This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Monday, August 31, 2009

Recovery in the making but danger still abounds

Each week goes by and the same question remains: How much higher can this market go? After rallying nearly 50% from its bottom in March, the stock market must be nearly out of steam.

Despite economic numbers beginning to show what looks like the beginning of a mild recovery, we simply can’t believe that this market can go much higher. Especially since there isn’t as much money supporting prices as there was at the old highs. Not after so much leverage was wiped out of the system during the collapse.

And yet, with each passing week, the market continues higher.

Looking at the current economic situation and the fundamentals driving this market, we firmly believe that there is a correction on the way. One that may not take the market back to lows set in March, but undoubtedly one that will cause investors sufficient alarm to throw up their hands and walk away, turning instead to “safer” bonds.

These folks, the unfortunate few who lack necessary preparation and lose their heads (and a good portion of their portfolio), will without question be stepping out of the frying pan and into the fire. This is because bonds, those old bastions of safety, are set to decimate investors in coming years, for two reasons.

First, with interest rates so low right now, there is really only one direction they can go. Of course, readers who have a grasp of basic tenets of finance – or remember the 1970s – will remember that rising interest rates decrease the value of existing bonds.

Second, even those bondholders who are willing to ride out it out through rising interest rates and hold their bonds until maturity will not fair much better. In a time of rising interest rates, inflation tends to run like crazy because consumers take out loans to make purchases sooner rather than later, since they know it will be more expensive later.

Inflation is that tax for which none of us get a bill, but all of us pay. To holders of long-term bonds, it means a crushing blow to purchasing power.

When it comes to the possible dangers of bonds, take the following example. In December of 2008 we made our predictions for 2009. One of which was that the 30-year Treasury bond would be among the worst investments for 2009. At the time the bond was yielding about 2.6%. Now that same bond is yielding about 4.24%.

Therefore, that “safe” bond has caused anyone who bought in around New Years to lose more than 36% of their principal. In other words, if they tried to sell that bond in today’s market, they couldn’t even get 64 cents on the dollar for it.

The bottom line is that in this market, despite the volatility, bonds simply aren’t the answer. In fact, right now the stock market is just nearing the end of a 10-year bear secular market in equities, based on inflation-adjusted returns.

After the correction that we see coming in the near term, stocks will likely trade sideways for another four years or so while stagflation runs its ugly course in the United States economy (stagflation indicates a period of inflation that coincides with economic stagnation, and last appeared during the 1970s). After that, look for the start of something big. After the market moves sideways for awhile, a big bull run is on way in stocks.

Even while the market trades sideways in coming years that hardly means that there won’t be any money to be made. Even sideways markets have very trade-able rallies.

The long-term bull market that we see coming down the line in stocks is deeply rooted in fundamentals and may well lead the United States back to prominence as THE global economic power. The major sector that we see leading the economy back to glory will be – try not to laugh – manufacturing.

It’s no secret that manufacturing has been shifting abroad for the past 15 years or longer. Now companies are finding themselves unable to control the productivity of employees or the quality of their products; and while cheap labor is nice, they simply can’t sacrifice quality.

With technology, resources and labor becoming cheaper here due to high unemployment and lack of demand for raw materials, what we see coming is a very gradual shift over the next several decades that will bring a significant amount of global manufacturing from Mexico and China back to the United States.

The following are several examples of this trend already developing.

  • Several months ago a Chinese industrial company made a bid to buy Hummer from GM, with the intention of leaving manufacturing in the United States, and even expanding production by opening other plans, all within the U.S.
  • Carlisle Tire & Wheel is closing down its production plant in China and bringing it back state-side, and consolidating that plant with others from Pennsylvania and Georgia all under one roof in Tennessee.
  • Hair iron producer Farouk Systems is consolidating all foreign production in Houston, Texas, according to an article in the Wall Street Journal on August 24th (Coming Home: Appliance Maker Drops China to Produce in Texas, Aeppel). According to the article, the company spends about $500,000 each month battling counterfeit versions of its products, most of which come out of China.

While this trend is obviously beginning to form, it unquestionably has hurdles to overcome. Policies in Washington need to encourage cheap manufacturing and provide incentives to businesses that relocate here, either through tax abatements or government grants.

The attitude that Americans have towards foreign firms also needs to change. No longer can Americans consider the Chinese or Japanese the enemy. Instead, they need to be seen as collaborative business partners. Americans cannot maintain the current “us versus them” mentality if they want to see see jobs move back here.

Recovery doesn’t always come from the usual sources. Right now consumer spending is still extremely tight because of high unemployment. Meanwhile, according to Federal Reserve Data cited in a Wall Street Journal article on August 26th, American nonfinancial companies are sitting on $14 trillion in liquid assets (Where Consumers Fail, Can Businesses Lead?, Gongloff). That’s equal to about a year’s worth of GDP. A simple loosening of their purse-strings to invest a fraction of those funds in future growth is more than enough to cause a serious economic recovery in this country.

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