Throughout this Storm Series, I have identified potential storm fronts that will soon engulf the financial markets. The front edge of the storm has already arrived. It can be seen in the collapse of the technology bubble, the rapid slowdown of the economy, the acceleration of job layoffs, the deterioration in corporate profits and the currency upheaval in Turkey, in Argentina, and now the dollar. The politicians, the analysts and the news anchors are telling us this is just a brief mid-summer squall. I believe it to be otherwise. No one is infallible in his or her predictions. I certainly make no such claims. Nevertheless, there is a storm brewing. The direction, the path and the severity of this approaching storm have yet to be determined. Time will give us that answer.
Follow the Wind
When I'm out sailing, I constantly watch the tell-tails along the edges of my sails. If I am in perfect trim, these strips flow parallel to the water with the direction of the wind. I use them to determine if I am sailing true to my course. The wind never flows steadily in one direction for very long. If I don't pay attention, and keep my sails in perfect trim, the tell-tails begin to droop. This tells me I am moving off-course and I need to make an adjustment. If I don't, the boat will eventually lose speed and become less balanced. If I want to keep the boat optimally powered, those tell-tails must flow in the same direction as the wind. The wind can decrease or increase in force as well as change its direction. Sailors call these changes "puffs", which are short gusts of wind. These short gusts are either headers or lifts. A lift is a short burst of wind, which helps to accelerate the boat in the direction that is desired. A header does just the opposite. Headers shift the boat away from the desired direction that the boat is headed. A good sailor will always fine-tune his sails to maximize the speed of the boat by anticipating and responding to headers and lifts.
In order to anticipate these puffs, you must follow the wind. Wind cannot be seen. But its effect can be seen on the water by dark patches or ripples in the waves. A trained eye can spot them with ease. For investors, it is the same. Like the tell-tails on a sail, the economy and the financial markets are constantly giving us feedback. They tell us about the force and the direction that both are headed. In the case of the current storm, the financial tell-tails are drooping, signaling a course change, and an adjustment at the wheel.
Financial Tell-Tails
The Economy
The fist tell-tail to keep your eye on is the economy. Right now the economy is slowing down, but it is still not in recession. Real estate and consumer spending are holding it up. Watch these two indicators for a sudden shift. Be on the lookout for a drop in consumer spending and a pullback in borrowing. We are already seeing the early signs of slowing. The government has reported that borrowing by consumers has already begun to slowdown. Watch the composition of the retail sales numbers. Right now they are flat, but already a sudden shift is taking place. The sales of department stores have fallen dramatically. Discounters like Costco and Wal-Mart are still doing well, but the shift of sales to discounters is telling me that consumers are becoming more cautious. However, even Wal-Mart has warned analysts that the next two quarters may be on the low end of their estimates. When Wal-Mart and Costco sales start falling, the retrenchment will be in full swing. Inventories and the production of cardboard will also be another sign. When inventories continue to build and the production of cardboard drops it will signal the retrenchment in consumer spending is gathering strength. Even today, August 16th, this trend continues. Gap and Nordstrom reported 2nd quarter profits. Gap's earnings fell 51% and Nordstrom's net income was down 15%. Even so, Kohl's which attracted shoppers with low prices on clothing and housewares, reported net income jumped 35%.
Real Estate
Housing will be another sector to keep your eyes on. At the moment it is still running strong because of low mortgage rates. However, the upper-end on housing is already starting to soften. When the wealthy stop buying, the little guy will follow. Watch for a drop in permits, housing starts, and a fall off in existing home sales. You should also begin to see housing prices start to soften. Watch the paper for adds on price reductions. Following Home Depot sales will provide further confirmation on whether the housing market is softening. When Home Depot sales figures start to drop, they should confirm the drop in permits, housing starts and new home sales. The consumer and housing markets are the last two sectors to remain standing. When they go, we will be in a true recession.
Corporate Profits
The other indicator to keep an eye on is corporate profits. Wall Street is counting on a pick up in capital spending to take over from the consumer. However, profits drive capital spending by business. When profits disappear or when losses appear, companies will start to conserve their cash. Without an increase in profits, there will be no money to fund capital expenditures. We will see Corporate America begin to hunker down and conserve cash to help weather the downturn. This strategy accounts for the massive amount of layoffs. Financial analysts are counting on capital spending to be the first sign that a recovery is taking place. Watch profits first. They'll give you the answer on whether a capital spending recovery now widely forecasted will end up being fact or fiction.
On the day I published this installment, Dell and Hewlett-Packard reported their latest quarterly earnings. Dell lost $101 million versus a profit of $462 million during the same period last year. HP reported that its earnings fell 89%, while sales dropped 14%. Dell reported that its profit margins declined from 21.3% to 17.5%. Furthermore, the PC industry reported its first sales decline in the second quarter for the first time in 15 years as consumers and businesses spent less. The industry is in the midst of a vicious price war. These are additional signs that a deflationary storm front is hitting the U. S. economy. From techs to retailing, prices are dropping.
Estimating the Storm's Intensity
Once you have a handle on the direction of the economy and the approaching recession, you will need to discern the severity of the storm. Will it be a nor'easter, a hurricane, or just a passing squall? The main direction this storm is likely to take is either a low-pressure cold front, which could be deflationary, or a high-pressure hurricane, which would be inflationary. The key will be the dollar and whether it holds. If the dollar falls and doesn't recoup, then we're headed for very rough weather. There is too much hot money in our financial markets right now. Our record trade deficits have put an enormous amount of money into the hands of foreigners. Right now, they are selling us goods and investing the dollars we pay them in exchange, back into our financial markets in bonds, stocks, cash, and real estate. As long as there is confidence in the dollar, the economic and financial storms will be less severe. I have listed several indicators in Storm Tactics, which identify whether the storm will end up being inflationary or deflationary. Just remember, the dollar will be the key. Faith in the dollar is based on faith in the strength of America's economy and the strength of America's military. A loss in either would deal a mortal wound to our currency.
Preparing for the Storm
Reduce Personal Debt
If I've emphasized anything at all over this last year, it's get out of debt. If you have credit cards, pay them off. If you are contributing to a 401(k) plan, and you have large amounts of credit card debt or installment debt, stop contributing. Instead direct the money towards riding yourself of your debt burdens. It is doubtful that your mutual funds are going to give you the same return when compared to the interest banks are charging you on your Visa or MasterCard.
Mortgage Debt
If your mortgage payments are too high, consider refinancing. Interest rates are still low. If your house payment keeps you up at night, it is too high. Think of downsizing now while the housing market is still strong. Ask yourself how secure is your job or that of your spouse? What would happen if one spouse lost his or her job? Could you still afford the payment? I'm not suggesting that everyone should get out of real estate. If your payment is comfortable and your job is secure, you have no need to worry. It is those who are heavily mortgaged or those whose jobs are in jeopardy that I'm concerned about.
Cash Reserves
Finally, if you don't have debt problems, build up your cash reserves. This will allow you to take advantage of investment bargains or provide a safety cushion if your employment situation changes. Having cash reserves is important. It is like having a life preserver on board ship. Economic downturns can either be feared or they can provide opportunity. It all depends on your perspective. Having cash when prices drop puts you in a better position to take advantage when an opportunity presents itself.
Personal Investments
As far as investments are concerned, don't be invested in anything you don't understand. If you're not sure about what it is you own, you better find out now. If you don't understand it, don't own it. If you don't want to do this alone, then find someone you can trust that holds similar convictions. The other alternative is to keep your money in cash. I would recommend T-bills if you have more than $10,000 or if less, a government money market fund. If you have sufficient investment knowledge, keep your eye on natural resources. I believe they will provide the best opportunity to make money in this storm.
Remember my analogy about weather. When it is winter in one part of the globe, it is summer in the other part of the world. It all boils down to keeping a clear head and watching the tell-tails. I strongly believe the natural resource boom is the next "Big Thing". Very few people see it, yet all of the signs are there. Study the Century Chart. I think it speaks volumes about the trend ahead.
Finally, no matter the outcome of the financial storms heading towards the US economy, I wish you fair winds, clear skies, and safe passage. May God speed you in these uncharted waters of The Perfect Financial Storm.
