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The Mid-Year Scorecard

By: Beese Fulmer
Thursday, July 12, 2012

The Mid-Year Scorecard

Despite a somewhat weak second quarter, stocks ended June with the lion’s share of their first-quarter gains. As you can see, the S&P 500 Stock Index declined by 2.75% in the three months ending June, but we enter July with a very healthy 9.48% total return. For the Dow Jones Industrials, the loss of 1.84% leaves the 30-stock benchmark with a 6.82% first-half return. The Nasdaq Composite, which rose so dramatically in the first quarter, gave back 5.06% in the second and finished June with a 12.66% year-to-date return. (At this time last year, the numbers for these indices were 6.01, 8.57, and 11.25%, respectively: the S&P ended the year with a gain of just 2%, while the Nasdaq Composite went negative by the end of 2011.)

If you are wondering how stocks will fare the rest of this year, we believe it will depend on the health of our economy (we’re in another “soft patch” now), the depth of the European and Chinese slowdowns, and the outcome of our national election. You can also throw in any and every “out-of-the-blue” crisis you’ve considered possible. Here are a few other issues people in our industry are discussing.

Nine Hours

The stock market is open for trading most days from 9:30 a.m. to 4 p.m., or six and a half hours. Virtually the entire price gain for stocks in June was realized in the last nine hours of trading on the 28th and 29th of the month. Thank goodness for that, because stock prices had retreated during May and much of June in response to bad news from the euro zone and an emerging mixed picture for our economy’s health. By mid-day on June 28, the market was really taking it on the chin. It seemed as though the euro zone-powers would leave their summit unable to craft a plan to bail out the next falling domino in the mess over there. Even worse, the Supreme Court ruled that the ObamaCare plan was valid for reasons only a lawyer could love. Analysts quickly calculated that the plan would add $2 per hour to the business cost of hiring every new employee in this country. Not good. By noon, the Dow was down 185 points in decidedly “risk-off” trading. Around lunch time, however, news leaked out that Germany’s leader had “blinked” and would go along with a proposal that could save Spain, and hence Italy and France, and stocks reversed course and headed higher. By the end of the day, the Dow was down less than 30 points. On Friday morning, as more details emerged about a deal in Europe, stocks went nuts in a totally “risk-on” frenzy. Perhaps our exporting companies would have someone in Europe to sell to after all! Maybe the whole world wasn’t broke! It didn’t escape anyone’s notice that it was also the last trading day of the quarter, or that speculators had piled into trades that would benefit were the Europeans to fail to agree on “plan E.” One commentator said it was the greatest short covering squeeze in years, and stocks advanced by more than 2.5% in one trading day. Although stocks still finished down for the second quarter, this nine-hour rally over one and a half days of trading added 4% of market gains.

Cliff Notes

The tax hikes and spending cuts Americans are facing at year end have come to be known as the “Fiscal Cliff.” Barclays figures “the cliff” represents about $650 billion, equal to 4% of GDP, of expiring tax cuts and automatic spending cuts (the result of last summer’s debt ceiling deal). The tax cuts set to expire are the Bush cuts (yep, he did it), and if allowed to vanish, means current income-tax rates will revert to pre-2001 levels. The lowest rate will rise from 10% to 15%, and the highest will jump from the current top of 35% to 39.6%. (Taxpayers then get to add on state and local taxes.) There’s more bad news: Taxes on dividends and capital gains will jump from 15% to the pre-2001 level of a taxpayer’s income tax rate—which will mean that nasty rich folks could be paying a 39.6% tax on dividends and capital gains. And don’t forget the little surprise in the recently-anointed ObamaCare plan: there is an additional 3.8% tax on this kind of income, meaning those earning “way too much anyway” will be paying a 43.4% rate on gains and dividends come January 2013--versus a rate of 15% now. If these increases take place, the U.S. will have dividend taxes that are higher than all of the other 33 countries in the developed world.

If you believe these increases will affect only the 1%, you are sadly mistaken. Businesses and investors ALWAYS adjust their behavior when tax laws change. Already this year, the big-cap dividend stocks that investors have flocked to are underperforming the non-paying “growthy” names; and there will be some serious capital gains harvesting before year end. Companies will certainly rethink their dividend policies, since they may determine there are other ways to use their cash, and stock buybacks don’t deliver the income that investors are looking for. Since 75% of dividend payments goes to Americans over age 55, a change in this dynamic will not be welcome. Mr. Bernanke has spent the last 3 years imposing low interest rates on older Americans in order to force them into the stock market. (Remember his logic: Higher stock prices equal a feeling of wealth equals more consumer spending equals more business hiring equals him keeping his job.) It hasn’t worked so far because he’s running smack into a demographic headwind that can’t be defeated. Baby boomers won’t commit to a stock market that is so volatile. In the period through May, investors have withdrawn money on a net basis from stock funds in 12 of the last 13 months.

That being said, investors have dipped their toes into the market by buying high-yielding (relative to the 1.6% yield on 10-year Treasuries) big-cap stocks. And now, after they’ve been lured into this area of the market, another branch of government could double or triple the tax on these “safe-haven” stocks. What’s more, the job market, already gasping for breath, could be facing a big retreat in government spending on equipment and services. The combination of hikes and cuts is so onerous that most analysts assume it will never happen. But if our politicians can’t agree on a way to cut our debt levels, the credit worthiness of the country will be called into question again. Will the financial markets and rating agencies allow us to “kick the can” on this issue for another year? It’s serious stuff.


Allow us to explain what we don’t like about ObamaCare. We are quite sympathetic to the financial burdens that health care places on the average middle class American family, as unexpected large deductibles and co-payments can crush any family budget. The central problem of both ObamaCare and Medicare is the third-party payment system that eliminates the normal cost/benefit analysis that takes place with other consumer purchases. This leads to less pricing and spending discipline and creates an unaffordable and unsustainable system. It is interesting that the health-care industry is testing different business models--such as Medicare Advantage plans and other integrated health-care plans--that have proven to be effective at reducing costs and keeping patients satisfied. We’d much rather see the 50 individual states allow development of new ideas rather than have one plan developed by the so called experts in Washington D.C. We believe that The Patient Protection and Affordable Care Act, aka ObamaCare, will stifle new ideas and discourage us from finding the best business model to lead us to a sustainable health care system. Furthermore, the plan was stitched together by lobbyists, no one understands it, it will lead to a further expansion of government control, and it includes 21 new taxes, including 7 that hit Americans making less than $250,000.

Inner Voices

There were two monumental screw ups made by CEOs during the quarter, and we believe there is a subtle but profound similarity in the mistakes they made. While those around them were telling one story, their inner voices took flight—and brought both of them real headaches.

The first faux pas award goes to Mark Zuckerberg, CEO of Facebook. In the days leading up to his company’s initial public offering, his hired stock peddlers were out telling interested parties that Facebook was one lollapalooza of a growth stock. Mr. Z chose to attend only two of the seven the road-show soirees, choosing instead to spend most of his time in California with his minions. (He did go to the road-show kick off in New York, and wore blue jeans and his trademark hoodie.) As the offering drew nearer, it emerged that Facebook’s revenues and earnings for the first quarter 2011 had declined relative to fourth quarter 2012 levels. No matter, as the frenzy to get shares was in full swing—and the insiders were more than happy to sell far more stock than originally anticipated. On the day of the offering, May 18, Mr. Z decided to ring the opening bell on the floor of the Nasdaq exchange—from California! Mark spoke to his acolytes and took the opportunity to explain his thinking about Facebook going forward. And he made it very clear that he is not at all concerned about quarterly earnings numbers going in only one direction. In fact, for him, the company is not a corporation in the traditional sense of the word: “Our mission isn’t to be a public company. Our mission is to make the world more open and connected.” Mark, who has never had to answer to anyone when it comes to Facebook, let the hucksters market the deal, went on his honeymoon while Nasdaq officials tried to cope with the trading disaster they had created, and has said next to nothing else about the whole IPO mess. And why should he? He raised the money he needed to finance his cause, or his mission, or whatever Facebook will become, and will now run the enterprise the way he sees fit. Don’t be surprised if investors discover on their ride through Farmville that they’ve been “hoodie winked!”

The second egregious gaffe of the quarter was the one committed by the CEO of our country, President Obama. The antithesis of Mr. Zuckerberg when it comes to speaking publically, Mr. Obama can barely contain himself when it comes to opining on just about any topic. Since he has not suffered any consequences from the whoppers he has told over the last three and a half years, Mr. Obama has gradually weaned himself off the teleprompter. On June 8, commenting about the state of the economy, Mr. Obama lamented that the public sector was where the woes were, but that the “private sector is doing just fine.” Unfortunately for Mr. Obama, Jay Carney was hiding in the men’s room, so the President was forced to walk back his comments a few hours later. But his original remarks revealed where his heart resides. He has never worked in the private sector, doesn’t trust it, and won the election after telling Joe the Plumber he wanted “to spread the wealth around.” Your wealth. And the facts on the economy don’t support him: Unemployment in this country is 8.2%, and it’s 4.2% for government workers. Federal employment has grown by almost 12% since the end of 2007. Public-sector wages and benefits are much higher than in the private sector. Meanwhile: Adjusted for inflation, median household income was lower in 2010 than in 2001. Median household net worth was decimated by the housing bubble in the 2007-2010 period, and it is now back to 1992 levels. Student-loan debt has grown from $200 billion to nearly a trillion dollars since 2000, and 54% of young college grads are unemployed or underemployed, while those who do get a job are receiving a starting wage that has declined by 8%. Forty-nine percent of Americans don’t have enough cash saved to cover three months of emergency expenses, while 28% don’t have any savings at all. Forty-six million Americans are on food stamps, and the annual cost to the taxpayer is nearly $80 billion. (And the federal government is urging state officials to run ads and have local parties to let people know how easy it is to qualify for benefits.) Yep, the private sector is doing just fine.

Mr. Zuckerberg and Mr. Obama have something in common. When their inner voices take flight, we get a true picture of where their hearts are. Investors gobbled up the IPO shares based on hard-sell marketing, and in the realm of politics, voters buy into a carefully-crafted script meant to sell us what we want to hear. But both CEOs have told us what they really believe.

Speaking Truth to Power

There is an interesting video making the rounds that features Dr. Michael Burry addressing the UCLA Economics Department’s graduating class of 2012. If you’ve read The Big Short by Michael Lewis, you’ll remember Dr. Burry as one of the investors who figured out the housing bubble would burst and profited handsomely by doing so in the collapse of 2005-2008. Burry’s background is fascinating: His feeling of being an “outsider” started when he lost an eye to cancer as a child and caused him to be a contrarian by nature. His ability to concentrate for long hours while reading pages of financial minutiae was due, in part, to having a mild case of Asperger’s syndrome.

While attending business school at UCLA, Burry also completed the courses required to gain admission to medical school. He did so, at Vanderbilt, and graduated, even though his interest in business never left him. In fact, while in med school, he put up a website about investing, and while he was a resident physician, he accepted a job writing a financial blog for Microsoft’s MSN Money Internet site.

He founded Scion Capital based on his belief in value investing, and attracted other investors who had followed his writings on the Internet. His contrary nature led him to question everything. This habit enabled him to figure out that the housing bubble would burst for very fundamental reasons. Although his strategy didn’t work at first (many investors left him and many more were irritated with him because he didn’t like to talk to them), he was proven correct and, as he says in his Commencement address, he became part of the 1% of wealthiest Americans. He then closed his fund to the public, deciding he wanted to invest for himself without the need to communicate or hassle with other investors. His June speech to the graduates is sobering. Dr. Burry believes the prospects for the Class of 2012 are much dimmer because of the “willful ignorance” of people in positions of financial and political power; he’s certain the standard of living for all Americans will be lower than it could be (since it already is); and he’s sure we will face more financial crises. But those predictions are not the most troubling parts of his speech.

After the housing bubble burst and the damage had been done, the “powers that be” in Washington and New York tried to float the meme that no one could have seen the bubble coming. Chairman Bernanke continues to read from the same script today. In 2010, after watching former Fed Chairman Greenspan tell an interviewer that Burry’s success was based on luck and not financial acumen, Dr. Burry wrote an op-ed in the New York Times reputing this notion. If it could not have been predicted, then how did he and others do it? He sets out the conditions he analyzed to come to his conclusions. It’s obvious he’s no fan of Mr. Greenspan, who helped inflate the bubble whenever necessary. At any rate, remember that Greenspan was out of power by the time Burry penned his op-ed. In his address to the graduates, Burry mentions the op-ed and says that he hoped by writing it, he would hear from people in Washington who might want ideas on how to prevent another such occurrence. He heard from Washington all right but not in the way he anticipated. Within two weeks of writing his op-ed, his six closed funds were targeted by the IRS for audits. A Congressional Committee demanded all of his e-mails and a list of the people he had spoken to about his strategy going back to 2003. And, “a little later, the FBI showed up.” By the time the Feds were done wringing him out, he had spent thousands of hours and a million dollars on legal and accounting costs. And they found nothing. All because he wrote an op-ed that challenged the story the government wanted to run with. He summarizes his experience in this way: “Sadly, at the highest levels of economic thought in government, questions are not tolerated. It is as if we are dealing with a binary judgment of a fundamentalist religion.” It’s a chilling revelation…and all too familiar. Dr. Burry concludes his address by offering some hopeful advice on how individuals can deal with what he sees coming. Google Dr. Burry and watch the video; it is well worth your time no matter when you graduated.  (Written 7/3/2012)

Sources for this Outlook include, but are not limited to:

Barclays Research: “The only certainty is uncertainty” June 13, 2012

Merrill Matthews/IBD: “Triple tax hike just might be in your future” June 20, 2012

The Washington Times: “21 Tax Hikes” June 29, 2012

Breitbart.com: “ObamaCare: Seven new taxes on citizens earning less than $250,000” June 29, 2012

Brian Deacon/IBD: “Facebook founder’s management mettle faces critical test” June 11, 2012

WSJ: “Facebook launch sputters” May19-20, 2012

IBD Editorial: “Another ‘Fine’ Obama Mess” June 11, 2012

Jeff Kearns/Bloomberg: “Fed says U.S. wealth fell 38.8% in 2007-2010 on Housing” June 12, 2012

Blake Ellis/CNNMoney: “28% of Americans have no emergency savings” June 25, 2012

Michael Burry/NYTimes: I saw the crisis coming. Why didn’t the Fed?” April 3, 2010

ZeroHedge/ http://www.zerohedge.com/news/dr-michael-big-short-burrys-brutal-hangove...


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