Parable of the Broken Window

Neil Dutta, Head of U.S. Economics, Renaissance Macro Research

In thinking about the devastation caused by Hurricane Sandy, I’m reminded of the Parable of the Broken Window.  In the 19th century, French classical liberal economist Frederic Bastiat tells a story to draw the distinction between what is and what could have been. We can see how the money is spent to repair a broken window, however, we do not see how the money would have been spent otherwise.

The dilemma that is faced in Bastiat’s parable is one to ponder as we assess the economic fallout of Hurricane Sandy.

We do not believe that billions of dollars in property damage is a good thing. Still, damage to roads and bridges does not shave GDP while rebuilding activity helps boost GDP and employment. Dramatic weather events act as a temporary shock, weighing on growth in the immediate term then boosting growth over subsequent quarters. Economic activity is delayed or shifted. Taking a two quarter view, the entire event is essentially a wash.

A few quick points:

  • Recall the fallout from Hurricane Katrina. Growth moderated in Q4 2005 and then rebounded sharply in Q1 2006. Hurricane Sandy hit the most populated area of the United States during the workweek. The flooding the Hurricane has left in its wake suggest a more persistent drag on activity. A 0.5ppt hit to Q4 GDP growth would not surprise us though we would expect the activity to be made up in subsequent quarters. It may well be possible that the recovery is faster, spanning months, limiting the impact to quarterly GDP. Time will tell.
  • Some retailers will see sales decline while others will see sales improve. When a tree is blocking you from leaving your neighborhood, it is relatively safe to say that you will prioritize buying things you need immediately over things you don’t. Auto dealers, apparel retailers, and restaurant sales will likely weaken while spending on grocery stores and home renovation stores pick-up. The broader story is that consumers have already drawn down their savings quite a bit over the last three months, raising the risk to discretionary spending beyond the immediate aftermath of the Hurricane.
  • Residential construction and utilities production will likely moderate in the Northeast. There are a number of reports that refineries in this part of the country have been idled, and that means higher gasoline prices at the pump.

It is all about your time horizon. The near-term effect of the storm will be to make a weak economy that much weaker. Thereafter, we would expect the data to look strong relative to the underlying trend in the economy.

Weaker Earnings Outlook Weighs on Stocks

Amy Magnotta, CFA, Brinker Capital

I wrote last week about the shaky start to the earnings season. That trend has continued this week and it is weighing on equity prices. Companies are beating on the earnings side (over 60% have beat earnings estimates), but revenue growth has been disappointing. As of October 19, only 42% of companies were beating sales estimates, the lowest percentage since the first quarter of 2009 (Source: FactSet).

Source: FactSet

In addition, forward guidance has been abysmal. Large companies, such as Caterpillar, DuPont and United Technologies, have been cautious on growth looking forward, both in the U.S. and abroad.* The number of companies delivering negative guidance is multiples of those offering positive guidance. Coming into 2012 companies had relied on margin expansion to grow earnings, but with margins at peak levels, revenue growth must follow in order to meet consensus growth expectations. This will be difficult to accomplish in this sluggish growth environment.

Source: Strategas Research Partners

While the Fed has tried to boost liquidity and asset prices with more quantitative easing, investors seem to now be focusing on the fundamentals. The uncertain macro environment, including risks surrounding the U.S. fiscal cliff, Europe, and a slowdown in China, is beginning to flow through and impact company earnings. We expect growth estimates for 2013 to be downgraded in response.

*Individual securities listed are shown for illustrative purposes only.

Feed the Validation Impulse

Sue BerginSue Bergin

There was a time when you could provide clients with a prospectus along with your recommendation, and that would be enough.  Your clients would go home, read it, and get back to you with a yay or nay.

Just as your recommendation is one slice of data the client considers when making an investment decision, the prospectus is another.  There could potentially be many other data slices that you don’t know about.

Clients are increasingly relying upon online sources to validate the recommendations made by advisors. 

According to a recent LIMRA study, the number of people who researched individual insurance or annuity products online increased from 38% in 2006 to 61% now.   Reasons clients flock to their keypads:  research companies and product offerings, seek product information, and compare prices.

The good news from LIMRA’s study is that sixty-nine (69%) of survey participants view their advisor as the most valuable and influential source for information.

The dangerous aspect of the online validation trend for advisors is that there is no way of knowing where clients go for more about the investments or strategies you recommend.  They could Google-step right into the lair of your biggest competitor.  They may discover that certain sites make investments sound so easy that they begin to think they don’t need an advisor after all.

The best way to deal with the validation impulse is to feed it.  When you recommend a strategy or product, give your client online resources that you’ve confirmed support your recommendation.  Sure, you can hand out pamphlets and brochures, but do something that will settle the twitchy fingers.  Provide links to online articles or websites that have credible information.

The best-case scenario is to link resources to your own website. For example, your website could have a knowledge center or research room.  You don’t have to draft all of the content, but rather link to credible sources.  That way you become both the primary and secondary source of information.  You provide the path to validation and guided the decision-making process.

Divergence in Crude Oil Prices

Amy Magnotta, Brinker Capital

An interesting observation from 13D Research last week:

“U.S. gasoline prices appear to be more closely correlated with the global crude oil benchmark (Brent) than West Texas Intermediate (WTI). Consider the following: When WTI first crossed $92 per barrel in October 2007, the average gasoline price approximated $2.90 per gallon. Now, with WTI near the same $92 level as five years ago, the average gasoline price is 34% higher. Not surprisingly, Brent crude also gained 33% during that five-year span.”

The chart below shows how the prices of WTI and Brent crude oil have diverged since 2011:

Getting Into the Mind of Today’s Affluent

Matt Oechsli

“Not coming from an affluent background, my mother was a teacher and my father worked construction. I’ve never been part of the country club scene,” explained Harry, then asked “How do the affluent think?  Shouldn’t you have money to advise people with money?”

Harry was hitting on an issue that has troubled advisors for years; the proverbial white elephant in the room.   Many advisors are uncomfortable in affluent spheres of influence, especially when it comes to marketing their services.  Why?  Because, like Harry, most advisors come from middle class backgrounds.  Thus many advisors suffer from some form of social self-consciousness, which left unchecked will interfere with their potential growth as an advisor.

As I explained to Harry, once you have a basic understanding of today’s affluent, it’s much easier to advise them on their family’s finances.  When done well, it becomes much easier to acquire more affluent clients.  The following are three affluent truths that will help you get into the mind of today’s affluent.

It appeared that Harry had a lot going for him.  He was a true professional; he was knowledgeable and looked the part.  His challenge was giving himself permission to ply his services in affluent circles.

Increase Sex Appeal: Add Data Scientist Elements to Capabilities

Sue BerginSue Bergin

Recently the Harvard Business Law Review declared data scientist the sexiest job of the 21st Century.

The profession is described as part analyst, part artist; part digital trendspotter and part storyteller weaving various pieces of information together. Its meteoric rise in popularity is due to the sheer amount of data that exists in the world today.  Companies employ scientists just to make sense out of it all.  Today alone there are 836 data scientist jobs posted on CareerBuilder.com.

While data scientist might be newly minted as a sexy profession, the art of culling through data to identify creative strategies is nothing new.   It is, after all, the skill that makes advisors successful in helping clients achieve their life goals.

Data is the hottest commodity in the business world, and it is also a critical component of our client relationships.

Market your ability to take over the management of the mountain of data associated with your client’s financial world.  Tell the world how your firm can stitch together the various pieces of their financial puzzle.  Admittedly, you probably can’t hold yourself out as a data scientist, but you do know how to analyze numbers, spot trends, uncover hidden insights and identify investment and tax savings opportunities.

Can Strong Earnings Growth Continue?

Amy Magnotta, CFA, Brinker Capital

Third quarter earnings season has begun with 70 of the S&P 500 companies reporting so far. Overall earnings and sales have surprised on the upside, with the largest surprise in the financials sector.  Third quarter estimates may have been brought down enough to create positive earnings surprises.  For those 70 companies reporting, year over year sales growth has been +1.5%, with earnings growth of +2.7% (Source: Bloomberg).

Source: Strategas Research Partners, LLC

Strategas analysts expect a 12% increase in operating earnings for 2013, which seems a bit aggressive in the face of a 4% nominal growth rate and declining margins.  With margins rolling over, companies need to generate stronger top line growth which will be more difficult as global growth slows further.

Companies remain cautious.  In his commentary earlier this week, Joe Preisser mentioned a downgrade in global growth expectations from two large industrial companies.  The fiscal cliff and regulatory policy uncertainty are also playing a role in holding back hiring and capex spending.  CEO confidence is at low levels.

While it looks like we are on our way to another quarter of profit growth, growth in coming quarters may be more difficult to achieve.  However, with stronger balance sheets, companies are in a better position to withstand a downturn.  The resolution of fiscal and regulatory issues could boost confidence, leading to increased hiring and spending, and as a result, stronger economic growth.

Find Out What Clients Want to Avoid

Sue BerginSue Bergin

Sometimes the risk tolerance question is difficult for clients because it involves using terminology that is not part of their daily vocabulary.  Next time you ask a client about their tolerance for investment risk, try a different track.   Find out the conditions they want to avoid.

Ask the client what routing preference they use when mapping out a trip.  Do they always choose the fastest route, the shortest distance, most fuel-efficient route, or do they try to avoid highways?

Route selection is based on a number of things. The client might have a strong personal preference that outweighs other factors like current traffic conditions, or whether they are in a rush.  Clients are also willing to accept a certain level of risk if they think that their selection will meet some of their criteria, for example, to save on gas.

Most often, however, the choice is driven by the desire to avoid certain conditions or risks inherent with those paths e.g., traffic, Sunday drivers, scenery, etc.

Routing preferences are one of the key differentiators among global positioning systems on the market today.  Consumers want to customize their maps according to their preferences and the conditions they seek to avoid.

By the same token, investors want to have control over the route that they will take in their financial journey.  They want to make a choice that allows them to avoid certain conditions.

“The fastest routes,” or “shortest distance” route might be too bumpy for their liking.  Similarly, clients might want to avoid the rough terrain that goes along with stock investments.  Instead, they might enjoy a “smoother ride” option, one that is marked by steady progress instead of wild fluctuations in speed.  These are the types of investors who could be most interested in absolute return fund strategies.  Clients interested in a “fuel efficient” option might do so because they want to avoid doing more damage to the environment than necessary. If so, these clients might also be interested in socially responsible investment alternatives.

Avoidance is a powerful motivator in determining what route a client will chose, whether it is on the road to Grandma’s, or the path to financial security.

Housing Recovery Will Be Slow-going

Amy Magnotta, CFA, Brinker Capital

There has been much talk about a recovery in the housing market.  Sales have been decent, albeit volatile.  Prices have inched higher.  Inventories are down.  Homebuilder confidence has improved.  The Fed is certainly trying to boost the housing market with their latest mortgage-backed security purchase program.  Affordability is at record levels as the 30-year mortgage rate has fallen to 3.4% (bankrate.com).  Refinance activity has surged in response but purchase activity hasn’t yet followed.

While there are undoubtedly positive signs in the housing market, the chart below from David Rosenberg at Gluskin Sheff puts the recent increase in housing starts into perspective.  While starts have increased meaningfully over the last two years, they remain very depressed when you look at historical levels.

The demand for housing should slowly improve as employment picks up and the pace of household formation increase.  However, despite the recent decline in inventories, the supply side will pick up as well.  Potential sellers may be sitting on the sidelines waiting for firmer prices.  There are also a significant number of delinquent and foreclosed properties – so-called shadow inventory – in the pipeline.

We don’t expect a sharp turnaround in housing starts or sales, but any improvement will be an incremental positive to growth after acting as a detractor from growth for some time.  Stabilization in housing prices will also serve as a boost to consumer confidence. For this reason we recently added the improvement in the housing market as one of our positive tailwinds for the U.S. economy, acknowledging this is a long-term view and will likely be played out over many quarters, not months.

Combat the Fear of Missing Out

Sue BerginSue Bergin

The fear of missing out has always been a strong motivator, but its power is increasing.  Social networking exposes us to what more people are thinking and doing.  This is causing many clients to question their choices, and at times make rash decisions.

According to marketing and communications agency JWT, fear of missing out (FOMO) is the uneasy and sometimes all-consuming feeling of missing out — that peers are doing, in the know about, or in possession of more or something better than you.

The role FOMO plays in motivating clients to action should not be underestimated.  It may be behind the Monday morning call from a client inquiring about absolute return investment strategies.  The call may leave you somewhat confounded, particularly if he rejected your previous overtures towards absolute return strategies.  The client’s change of heart can probably be attributed to a cocktail party discussion.  He may remember some of the buzz phrases and maybe even some fund names, but what sticks with him the most is that “they” are in and he is not.  He doesn’t want to be left behind, perceived as out-of-touch, or miss out on a great opportunity.  The opportunity is not immediately valued on its merits, but by whether the client wants to be part of the “in” group.

Social media adds fuel to the fear of missing out fire.  As you poke around on Facebook, LinkedIn or Twitter or media message boards it is easy to get influenced by the perceived masses.

In the example above, your client may have been perfectly comfortable with his decision to ignore your recommendations for incorporating absolute return strategies when presented in March.  Now that he has heard that his friends all have a certain percentage of their portfolios in absolute return strategies, he suddenly wants to follow suit

Investments aren’t the only ways that FOMO can affect your practice.  Clients are also going to hear talk or be exposed to social networking chatter about the level of service, accessibility and transparency offered by their advisor.  If everyone else in their social circle or aspirational social circle is working with advisors who provide online access to an aggregated and consolidated view of their portfolios, your relationship is vulnerable unless you can match or beat that service.

The best way to ensure that FOMO doesn’t lead clients astray from their financial plans or their relationships with you is to stay ahead of the curve.  Keep the lines of communication open, and offer your thoughts on a wide range of investment strategies.  This way, clients will remember where they heard about investment strategies first.   From you.  They’ll remember that you had an opinion, and they simply have to reach out to you for your opinion as to whether it is in their best interests.