9 stocks to gird against US contraction
MarketWatch.com has published an article written by Anton Kreil warning that the U.S. economy will continue to slow down and could be in trouble again by as soon as next year.
Given the impending risks in the second half of 2012 and 2013 to the U.S. economy, MarketWatch’s analyst at the Institute of Trading and Portfolio Management James Fournier has completed an intrinsic value study of U.S. “defensive” stocks:
The four sectors we have concentrated on are consumer staples, telecom services, health care and utilities. We applied a rule of only short listing stocks that are less than 20% away from their current Intrinsic value. The result is a watch list of defensive stocks that are very near or close to their intrinsic value.
We concentrated within the defensive sectors and applied our logic for the following reasons:
1. Buying cyclical stocks in periods of GDP contraction may cause large losses in a traders/investors portfolio. Predicting the quarter when slowdown or contraction ends is a dangerous game that we don’t like to play.
2. The vast majority of U.S. large cap defensive stocks within the sectors we have selected require a 50%-60% fall from current prices to hit their intrinsic values and become attractive longs from a “bottom up” valuation perspective. We believe this is unrealistic given the information we have at the present time on the U.S. economy.
3. Applying a 20% rule as a required drop in a stock from its current price before it hits intrinsic value (within defensive sectors only), presents long/short portfolio managers with an immediate watch list of longs that could potentially be bought on any dip in the market within a fairly well beta hedged portfolio.
This analysis is based on the notion that the current headwinds facing the United States have caused a significant probability shift in favor of a GDP downturn and possible contraction and recession in the U.S. in 2013.
The watch list assumes that the U.S. economy continues to slow and the S&P 500 falls anywhere between 10% and 20% from current levels.
Risks to the U.S. economy
1. The U.S. manufacturing sector is contracting.
First-quarter revisions to GDP came in lower at an annualized 1.9% and the U.S. manufacturing sector has now officially started contracting. The ISM manufacturing number came in at 49.7% in July for June, signaling contraction in the U.S. economy for the first time since July 2009. However, the last time the number went from a “rate of change” that was growing to “contracting” was June 2007. The S&P 500 then peaked in October 2007.
The ISM manufacturing number has broken 34 months of expansion and the momentum is to the downside. The New Orders index which is a leading indicator to the ISM itself fell 12.3% registering 47.3%. This has raised significant concerns over Q2 GDP estimates. Two to three readings below 50 signals a highly probably recession in the United States within 12 – 24 months.
2. The ‘Fiscal Drag’
The “Fiscal Drag” facing the U.S. is a massive risk. This isn’t likely to be sorted out until after the U.S. election. U.S. politicians can stop the reversal of the tax cuts however we believe they will be distracted by the election campaign. An extension of the tax cuts will have to go through congress and the most likely situation now is that congress will have six weeks to get this sorted out after the election. An extension of the tax cuts is supposed to occur on December 31 for 2013.
2013 U.S. Fiscal Drag in $billions
Payroll Tax Cuts Expiry: 125
Bush Tax Cuts (High Income) Expiry: 100
Bush Tax Cuts (All Other) Expiry: 150
AMT and Doc Files Expiry: 55
BAC Sequester: 85
Unemployment Benefits Expiry: 35
Other changes in revenue & spending: 200
Total Fiscal Drag: 750
Total Fiscal Drag in % GDP: 5%
3. No quantitative easing
The probability of QE now happening before the election has dropped significantly. The Fed has established its stance on this by implementing “Operation Twist 2” and Bernanke rhetorically stating, “It is too early to see the economic effect of the fiscal cliff uncertainty.”
Translated? It isn’t up to me to do anything about it, it is up to Congress. We know the numbers. So it isn’t “too early to see the effects.” It is a $750-billion withdrawal from the U.S. economy in 2013. That is 5% of projected GDP in 2013. That means certain recession!
We believe the Fed will now most likely not initiate QE3 in 2012. By doing so they will risk politicizing themselves. Republicans will simply use it as a tool to bash the Democrats on the economy.
The story in the U.S. has been slowly but surely unfolding. Taken together, the risk of severe GDP contraction and political risk in not fixing it now, increases the likelihood of a correction in the S&P500 by between 10% and 20% in the second half of 2012.
We now believe that the approach of simply holding cyclical sectors long in the U.S. vs. cyclical shorts in Europe for the reasons of “Least Dirtiest Shirt” and the “Bernanke Put” is a dangerous and stale trade. This is why we feel it is now necessary to seek out longs for a portfolio that present “bottom up” value in the United States, as the U.S. macroeconomic environment deteriorates relative to the rest of the world.