Congress Having Difficulty Cutting Spending In Debt Ceiling Debate

The debate over raising the debt ceiling is now focusing on an important issue the rating agencies have highlighted, i.e., the deficit itself and the level of the governments debt. The difficulty some members of Congress are having has to deal with the apparent lack of cuts in the early years of both Reid and Boehner's agreement. As an example, in the Boehner plan, the cuts are very little in 2012 and is very much back end loaded. The Reid plan is no better in reducing the deficit as well.

(click for larger image)

From The Blog of HORAN Capital Advisors

Paraphrasing from a recent article on Zero Hedge's website, the CBO’s scoring of the Boehner budget proposal comes to a deficit reduction of $851 billion from 2012-2021. However, this plan is heavily back end loaded and, on a net present value basis the reduction is only $50 billion. The current federal deficit is about $1.4 trillion this year and growing; hence, some members interest in Congress to focus on expenses. Every year that passes without addressing entitlements, the more painful the medicine might be.

It is becoming increasing likely the August 2nd deadline is not met. If that is the case, what is the impact on cash levels at the Treasury? It appears the Treasury has enough cash until 8/12 and could probably get to 8/15, an interest payment date. This is highlighted in a Reuters article this morning. The table assumes that the Treasury will be able to at least roll over maturing debt on August 4, 11 and 15. See below chart from Stone & McCarthy research.

From The Blog of HORAN Capital Advisors

Both plans are highly likely to lead to a lowering of the government's credit rating given the reduced focus on the deficit and debt level.


h/t: Zero Hedge

Foreign Holders Of U.S. Government Debt

Which countries are impacted the most in a debt default, assuming it does occur. Below is detail on the foreign holders of U.S. government debt. The trend in the debt holdings is available from the U.S. Treasury site.

From The Blog of HORAN Capital Advisors

Graphic Source/Link: Reuters

Debt Ceiling Alone Is Not The Only Issue

Raising the debt ceiling itself is not the issue facing Congress and the U.S. government. As the below chart shows, Washington seems to do a good job issuing new debt up to the maximum limit each time the debt ceiling is increased.

From The Blog of HORAN Capital Advisors

The result of Congress' propensity to spend is the government's budgeted expenses now far outpace incoming revenues. In fact, the government now borrows 40 cents of every dollar it spends as noted in the below chart.

From The Blog of HORAN Capital Advisors

The stickiness of the unemployment rate is contributing to this gap in expenses versus revenue. The below chart shows the "income security" spending component of the government's budget has nearly doubled to $603 billion from $374 billion since the beginning of 2008. This increase in the "income security" portion of the budget is highly correlated with the unemployment rate. The "income security category" includes unemployment compensation, housing and food assistance.

From The Blog of HORAN Capital Advisors

Not many CEOs have commented on the impact Washington's policies are having on business decisions, primarily the desire by businesses to increase employment. However, during a recent Wynn Resorts investor meeting, Steve Wynn, CEO of Wynn Resorts (WYNN), noted the difficulty businesses are having navigating the new policies and regulations coming out of Washington. The audio of a portion of that meeting can be heard at this link: Wynn Investor Meeting audio.

From The Blog of HORAN Capital Advisors

If politicians in Washington would simply develop a credible plan that reduced spending and created an environment that was conducive to growing revenue over some reasonable time frame, say ten years, the business environment in the U.S. would likely improve.

Economy After The Debt Ceiling Debate Concludes

It is nearly impossible to turn to any business or news program where the lead story is anything but commentary on the debt ceiling debate going on in Congress. As we noted in our 2nd Quarter Investor Letter published on Monday, the real issue is not simply raising the debt ceiling, rather the growth in the debt itself.

As the below chart shows, Congress has the unique ability to increase the Federal debt (spend beyond its means) every time the ceiling is raised. The more significant issue facing the government is developing a plan that reduces the government's overall debt.

From The Blog of HORAN Capital Advisors

At HORAN Capital Advisors we do believe the debt ceiling will be increased and if it occurs after the August 2nd deadline, the delay will not have a negative long term impact on the economy. A key will be whether spending reductions are incorporated into any debt ceiling increase that passes Congress.

From an economic perspective, we noted in our recent newsletter that the steepness of the yield curve and bank lending are suggesting a better economic environment ahead. As the below charts detail, the 13-week rate of change in loans and leases at commercial banks has turned positive, i.e., above zero, for the first time since January 2009.

From The Blog of HORAN Capital Advisors

Additionally, the below chart shows the steepness of the yield curve (fed funds versus 10 year treasury). This spread is near a record high and historically recessions have been 3+ years into the future; hence, a double dip recession does not seem to be just around the corner.

From The Blog of HORAN Capital Advisors

Chart source: Charles Schwab

Lastly, recent earnings announcements have been coming in on the strong side as 75%+ of companies that have reported have exceeded expectations.

Second Quarter 2011 Investor Letter

The debt ceiling debate is top of mind for investors and the market and our our recently released 2nd Quarter Investor Letter includes commentary on this issue. We hope you find the content of our letter insightful as we look to the balance of 2011.

HORAN Capital Advisors' complete Investor Letter can be accessed at the following link: 2nd Quarter Investor Letter.

The Real Issue With The Debt Ceiling

Much of the media attention surrounding the debate going on in Washington is about the issue of increasing the debt ceiling. If one reads Standard & Poor's recent report that placed U.S. government debt on "Negative Credit Watch", the primary issue cited in S&P's report was not simply an increase in the debt ceiling. A bigger issue cited in the report was Washington's lack of any credible plan on reducing the actual level of debt. In Standard & Poor’s Negative Credit Watch report S&P concluded,

“Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden [emphasis added] and are not likely to achieve one in the foreseeable future.”

The below video provides a clear summary of the current debate.

Lastly, Karl Denninger of The Market Ticker, provides a detailed summary of the debt issues facing the U.S. in a post titled, The Truth About Budgets, For Both Left and Right. It is an article that should be read in order to better understand the debt issue debate.

Estimated Earnings Growth Through 2012

By clicking the below graphic, readers can access estimated earnings growth rates for the S&P and its sectors through 2012. Beginning in Q4 2011, financials are expected to show the strongest growth in earnings. Only time will tell.

From The Blog of HORAN Capital Advisors

Slowing Emerging Market Economic Growth

Emerging market economies are at risk of overheating; however, many emerging countries are working to stem growth in an effort to prevent a hard landing of their economic growth. The countries at highest risk of overheating are detailed in the below table.

From The Blog of HORAN Capital Advisors

The factors that make up the overheating index are displayed in the below interactive table.

Source:

American Exceptionalism
The Economist
By: R.A.
July 1, 2011
http://www.economist.com/blogs/freeexchange/2011/07/global-growth

Dividends, Stock Buybacks And Cash Balances All Higher In First Quarter

Stock buybacks and dividend increases for companies in the S&P 500 Index have certainly been on the mend since the end of the financial crisis in 2009. For the first quarter, and on a year over year basis, dividends are 13.7% higher, buybacks are 62.7% higher and buybacks plus dividends are higher by 39.6%.

From The Blog of HORAN Capital Advisors

Data Source: S&P (PDF)

In addition to the improvement in buyback and dividend payments, company cash balances now exceed a record $1 trillion, a 14.6% increase versus Q1 2010. It would certainly be positive if companies had the confidence to commit some of this cash to larger dividend increases.

From The Blog of HORAN Capital Advisors

Source: Standard & Poor's

Below is a table containing the top 10 S&P 500 companies ranked by per share cash balances.

From The Blog of HORAN Capital Advisors

Source: Standard & Poor's

Lastly, investors are encouraged to examine company 10-Qs and 10-Ks to assess the quality of corporate cash balances. An article by professors at Villinova University and Pennsylvania State University title, What's Up With Cash Balances, notes the recent poor quality of cash balances reported in financial reports. For example, in a recent 10-K for Pep Boys (PBY), the company states:

All credit and debit card transactions that settle in less than seven days are also classified as cash and cash equivalents.

Instead of showing as cash, these transactions should be classified as receivables. The article notes other liberties taken by companies with the classification of cash assets. Certainly, corporate cash balances are higher; however, actual cash may note be as high as it seems.

Significant Decline In Put/Call Ratio And Market Rallies

In our post in mid June titled, Market Adjusting To Slower Growth Economic Environment, we noted the put/call ratio had climbed to 1.1 and was at a level last reached at the market's low in March 2009. At the time of our post, the S&P 500 Index was trading at 1,271. Since that time the put/call ratio has declined to .56 and the S&P has rallied to 1,339, an advance of 5.3%.

From The Blog of HORAN Capital Advisors

The ability of the market to move higher in the coming week's may hinge on the market's view on a number of economic reports next week: durable goods report on Tuesday, jobless claims on Thursday, private payrolls, unemployment rate and wholesale inventories on Friday.

Michael Mauboussin Interview: Challenging Investors' Behaviors

Consulo Mack interviews Michael Mauboussin in this week's WealthTrack video. Mauboussin is Chief Investment Strategist at Legg Mason Capital. In this interview, Mauboussin discusses why investors tend to buy high and sell low and why higher trading activity often leads to lower returns. Mauboussin is one of the leading experts on the behavioral tendencies that impact investor returns. Mauboussin believes the economy is in the earlier stages of a recovery and favors large cap equities at this point in the economic cycle. This is a must view interview for investors.

Mid Cap Relative Valuations At Historically High Levels

Since January 1, 2000 small cap and mid cap stocks have significantly outperformed large cap U.S. equities.

From The Blog of HORAN Capital Advisors

From a valuation perspective, since the beginning of 1992, mid cap equities are trading at historically high valuations compared to large cap stocks on a relative basis. Absolute valuations of mid cap stocks still look reasonable; however, if there is a reversion to the mean, large cap equities are likely to gain the upper hand on performance as one looks forward. Maintaining some exposure to mid caps will likely be beneficial though as merger activity often times targets the mid cap companies.

From The Blog of HORAN Capital Advisors

Source: T. Rowe Price (PDF)

Market Adjusting To Slower Growth Economic Environment

Market volatility of late seems to be the norm due to concerns over European debt defaults, budget deficits and slow worldwide growth expectations. These issues are being somewhat offset by the large amount of liquidity that resides on corporate and individual balance sheets. This liquidity is seeking a home that offers better returns than U.S. Treasuries. The 5-year Treasury is yielding around 1.53% and the 10-year treasury is under 3%, trading at a yield of around 2.95%.

Our positioning of our client portfolios maintains an overweight in health care (more defensive sector) and technology (generating strong earnings growth). We continue to maintain an underweight in the financial sector, more specifically in banks, due to our concern about their earnings growth ability in the near term given the large amount of regulation coming out of Washington D.C. Our portfolio structure continues to focus on reducing the volatility in our client investment accounts.

We do believe the economy is still growing, although at a slow pace. Some of the factors inhibiting growth are the result of supply chain disruptions caused by the tsunami in Japan and floods in the Midwest. We believe the recent market pullback is an adjustment to a slower growth global economic environment.

It is likely money flow into equities and out of bonds could pickup in the second half of this year coincident with better clarity on economic growth. The financial condition of most large companies is strong as they hold record levels of cash on their balance sheet and continue to deliver strong earnings results, although earnings comparisons become more difficult in the second quarter. These financially strong companies should provide better returns than the low rates available on treasuries. The recent market pullback seems to be providing investors underweight in equities with an opportunity to add to equity allocations and/or equity positions.

The equity put/call ratio at 1.1 is higher than the level reached at the market low in July 2010 and higher than the level at the market's low in March of 2009.

From HORAN Capital Advisors

Additionally, individual investor bullish sentiment as reported by the American Association of Individual Investors remains at low levels. Last week's reading was reported at 29.0%. Although this represents an increase of 4.58% from the prior week's reading, the 8-period moving average continues in a downtrend and came in at a lower 30%. This contrary indicator tends to be most accurate at the extremes.

From HORAN Capital Advisors

The excessive investor pessimism, a potential resolution to the Greek debt crisis before the end of the weekend or early next week, even if only a short term one and decent equity fundamentals could see the market recover from oversold conditions in the near term.

Bullish Investor Sentiment In Continued Downtrend

This morning the American Association of Individual Investors reported a decline in individual investor bullish sentiment 24.42% versus last week's reading of 30.18%. The bearish sentiment level jumped over 14% to 47.67% versus last week's bearishness level of 33.43%. This resulted in a bull/bear spread of -23.3% versus last week's -3.3%. Lastly, the 8-period moving average of the bullish sentiment reading is approaching levels reached in March 2009, a market turning point.

From The Blog of HORAN Capital Advisors

Market Is Looking Oversold

The S&P 500 Index has generated a negative return in each of the last five weeks and has started the sixth week on a down note. From a technical perspective the market appears oversold.

The percentage of stocks selling above their 50 day moving average has fallen to levels last seen during the March lows earlier this year. After the close today only 24% of S&P 500 stocks are trading above their 50 day moving average compared to 27% in March. Additionally, the percentage of stocks trading above their 150 day moving average is at a level last seen in the third quarter of 2010.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

The Dow Struggles In The Month Of June

Chart of the Day recently provided information on the historical monthly performance of the Dow. Below is what they had to say along with their graphic.

"[The] chart illustrates the Dow's average performance for each calendar month since 1950 (blue columns) and the average monthly performance of the Dow from 1950 to the present (gray line). [The] chart illustrates that the Dow has tended to perform best during the last several months and first several months of a calendar year. During the middle of a calendar year, the Dow has tended to struggle (with the exception of July). It is worth noting that there have been only two calendar months during which the Dow has declined on average -- June and September."

From The Blog of HORAN Capital Advisors

Source: Chart of the Day

A Slow Growth Market Environment

Before May and now the first day of June, it seems the S&P 500 Index desires to do anything but move higher. The S&P 500 Index had advanced over 9% through the first four months of the year. It is not reasonable to think the market can move higher by 9% every four months. So in May, the S&P declined 1.13% and June is starting off on a weak note by declining 2.28%. After the markets decline today, the S&P 500 Index is still up 5.38% on a year to date basis.

The next support level for the S&P is 1,305; however, it is difficult to guess market bottoms. From a fundamental perspective though, valuations for large cap U.S. equities continue to look more and more attractive. The forward four quarter P/E ratio for the S&P 500 Index is 12.8 times based on projected earnings of $103.57 for the S&P 500.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

The sell off today was triggered by the weaker than expected ADP payroll report. Unfortunately, we believe this type of weaker, or less than robust, economic data will be the norm over the course of the next 6-12 months. The unemployment rate will likely remain stubbornly high as we noted on page 3 of our first quarter investor letter.

The small down tick in the U.S. Leading Economic Index is not unusual when the economy is entering the mid-cycle of a recovery.

From The Blog of HORAN Capital Advisors

Additionally, companies have reduced inventory levels relative to sales to the point that a slight improvement in demand will likely result in the need to increase manufacturing to replenish stocks.

From The Blog of HORAN Capital Advisors

And finally, as Liz Ann Sonders notes in a recent strategy article, Chief Investment Strategist at Charles Schwab & Co. (SCHW),

"The...massive flow disruptions in Japan are already beginning to turn. Commodity prices have come off the boil. Finally, both monetary and fiscal policy remains stimulative; even considering the finale of QE2 in a few weeks. The Fed has no intention of draining its balance sheet any time soon, nor raising rates.

Corporate America has rarely been healthier, and the cash firepower available to companies is massive. Debt-to-equity for US companies is at its lowest in over 20 years and they hold nearly $2 trillion in cash on their balance sheets.

With leverage so low, if it simply returned to the average of the past decade, companies would have an extra $2.7 trillion to spend, according to the Financial Times. Deal-making is back.

In sum, growth has certainly slowed, but many of the contributing factors are temporary in nature. Assuming US GDP growth can rebound back above 2%, historically this isn't a bad backdrop for stocks. Looking at all years when US GDP growth was between 2% and 3%, the average return for the S&P 500 was nearly 14%, with only two down years out of 11 total. Not bad (emphasis added)."

Disclosure: Long SCHW

Food Inflation Versus CPI

Much has been made lately regarding food inflation and the lack of impact on the Consumer Price Index. In large part, the reason for this is due to the fact, in the U.S., the food component in CPI is a much smaller weighting than in developing countries around the globe.

From HORAN Capital Advisors

Source: Fidelity (page 20)

Below is a chart of the CRB Spot Foodstuffs Index and the U.S. Consumer Price Index. As the 20-year chart shows, although the Foodstuffs Index is up over 40% on a YOY basis and CPI is up 3.1%, the two indexes are tracking closely. Several of the component's of the Foodstuffs Index are butter, cocoa, corn and hogs. And, although we are seeing food price inflation, it represents a smaller weighting within the CPI, for example, butter is only .067% of the consumer price index.

From HORAN Capital Advisors

Small Cap Valuations Getting Extended

On a relative basis, small cap stock stocks are trading at near record levels from a valuation perspective since 1990.

From HORAN Capital Advisors

Source: Fidelity, pg. 29 (PDF)

A part of the valuation difference is a result of the strong performance achieved by small cap stocks versus large cap stocks. As the below chart details, the 10-year return of the Russel 2000 small cap index has far outpaced the return of the S&P 500 index, 70.8% versus 6.7%, respectively.

From The Blog of HORAN Capital Advisors

Bullish Investor Sentiment Continues Its Decline

In this week's sentiment survey by the American Association of Individual Investors, it was reported that bullish sentiment fell to 26.69%. This is the lowest level for bullish investor sentiment since August of last year, which was near the low point for the market in 2010. The bull/bear spread was reported at -14.6%. It is important to note the sentiment indicator is a contrarian one and tends to be most accurate at its extremes. As the below chart outlines, the bullish indicator is entering extreme territory.

From HORAN Capital Advisors

Source: AAII