Ivan lo Equedia says...

Every day, it seems we're heading back closer to 2008.
 
A quick recap of last week will tell you the tale. Bear with me.
 
Crude oil capped the largest quarterly drop since the 2008 financial crisis by tumbling to a one-year low. Despite the rally on Tuesday, stocks eventually fell and the MSCI All- Country World Index took its biggest quarterly loss since 2008.
 
Big banks across the board also dropped - with Morgan Stanley down 10 percent, Goldman Sachs Group Inc. down 5.4 percent and Deutsche Bank AG down 4.9 percent.
 
Last week, the four-day rout erased $1 trillion from U.S. equities - this left the S&P 500 trading at 12.4 times earnings in the past 12 months. According to Bloomberg data, this is 4.4 percent below its average valuation at the lowest point during the last nine bear markets.
 
Even gold, silver, and other commodities took a major tumble. On Monday, gold plunged to its biggest 3-day loss in 28 years. Silver traded below $30 for the first time since February.
 
A few weeks ago, I wrote in a past letter (see Mark Your Calendar) that if Bernanke didn't announce or make a hint of QE3 at the September 20-21 FOMC meeting, the markets will crumble. Since then, the market has taken a nose dive. No surprise here.  
 
The world economies are obviously at risk. In terms of growth, there is more downside than upside in the near future as the world works to solve its fiscal issues. Europe is on the verge of some major changes and China is looking more like a bubble every day.
 
On Sept. 13, the Census Bureau released their annual report on income, poverty, and health insurance in the United States. The report said that the number of people below the official poverty line rose from 14.3% in 2009 to 15.1% in 2010. This meant that 2.6 million more people fell into poverty last year, and the total of 46.2 million poor was the largest number in more than 50 years of records.
 
At the same time, corporate profits after taxes soared to a record high in 2010. Corporate profits grew 36.8% in 2010, the biggest gain since 1950. Total business profits totalled almost $3.5 trillion, or about one-quarter of the entire economy.
 
So why is it that even with continued high unemployment levels and more people falling into poverty, US corporate profits are at record levels?
 
The Secret Behind Corporate Profits  
 
While profits are high, that doesn't mean business is strong.  
 
Corporate profits are now being generated through a bunch of economic anomalies that are not the normal course or factors that generate profits.
 
Since 2008, we have had record low interest rates, less borrowing by companies and a surge in productivity that has allowed companies to do more with the same number of workers or fewer. Corporations have been getting away with paying less and expecting more. Either take the job, or don't - because with the employment crisis, someone else will . Furthermore, there has been a big push by these corporations to cut their bottom line costs.
 
There is a huge difference between corporate profitability based on top line revenue growth and bottom line cost cutting. Even with declining revenues in certain quarters, profit margins continue to rise - leading to stronger corporate earnings.
 
That is how US corporations have been able to generate record profits on very, very low volume and very weak economic growth.
 
But there's a problem with this scenario.
 
The Hidden Tale 
 
Profit margins have surged over the last few years due to massive cost cutting, layoffs and benefit reductions - that means profitability came at the bottom line of the income statement. In a normal environment, this would spell short term success for corporations. However, in no way does that signal a bright outlook for the US economy.
 
Corporations will hire instead of cut workers if they expect a bright and growing future. When economic conditions worsen, corporations will cut back - they'll work to trim the excess fat.  
 
Shareholders are looking for profit margins and with dismal growth and a bleak economic outlook, that is how corporations give shareholders what they want. Cut costs and trim the fat.
 
There is nothing wrong with this in the short term. As a matter of fact, that is exactly what a corporation should be doing in times of uncertainty. As such, stocks should rise to catch up with earnings if the European mess is contained.  
 
However, this method of profit growth cannot be sustained in the long term because many of these corporations have already taken their diet pills through layoffs and benefit reductions.
 
Even with record earnings, analysts continue to slash earnings growth as year-over-year profit growth of companies is on the verge of going negative. That means asset prices will have to adjust to meet the decline in profitability.
 
Since companies have already trimmed the fat by cutting workers, inventories, and reduced borrowing - it will be exceptionally difficult in the future to cover up declining profits with further cost cutting. In other words, when profit margins can no longer grow through cost cutting, corporations will have to rely on top line growth - which, given the economic outlook, doesn't appear to be very optimistic.
 
With an already weak economy, it is only a matter of time before the markets begin to adjust for lower profit growth.

So while the short term outlook for stocks may be strong, don't expect extreme growth for overall equities in the next few years. Unless you can buy stocks now and put them away for five years, as Warren Buffett does, don't expect any miracles in the short term.   
  
The Exception  
 
Go into Gold. Go into Silver. Go into related stocks.   
 
We've seen the S&P rise 2%, while gold rose 4%. This is the type of correlation that signals gold is in a league of its own - it's the type of signal that shows gold's prowess in the market despite what happens to the dollar. I have mentioned this before (see The Big Signal).
 
While the selloff in gold and silver has investors nervous, don't be. The selloff was due to many factors such as profit taking and margin requirements. When people lose money on stocks, they sell their strongest investments that have been making money to cover their loses. Gold was merely an innocent bystander.   
 
With the recent pullback in precious metals, the buying opportunity looks strong. While it may not be the exact bottom, gold and silver at these levels look very promising. Within a year's time, I fully expect gold to hit $2500 and would not be surprised to see it hit $2000 by the end of this year.      
 
In an article published by Bloomberg a few weeks ago, Dylan Grice of Société Générale calculated the "fair value" for gold based on the price at which each dollar in the U.S. monetary base would have been if backed by an ounce of the precious metal.  As of June, this price would have exceeded $10,000/oz.   
 
While gold and silver sit at these levels, investors will have the opportunity to pick up these precious metal and related stocks at rock bottom prices.  
 
That's because sooner or later, certain events will make these precious metals climb higher and faster than they have before...  
  
The Next Leg Up 
 
The U.S. and Europe face about a 40 percent likelihood of a prolonged period of economic stagnation should policy makers fail to restore confidence, according to analyst Jose Ursua of Goldman Sachs: 
 
"The prospect of a long period of stagnant growth is a plausible risk and a legitimate concern for the major developed economies. Whether these countries manage to avoid a 'Great Stagnation' by a pick-up in the recovery is likely to depend on policy being able to restore confidence and putting in place reforms that can decisively jolt growth."
 
After analyzing 93 episodes of the conditions in the past 150 years, Ursa concluded that the U.S. and Europe are already exhibiting signs that would be typical of stagnations, characterized by "high and sticky" unemployment, an average 0.5 percent growth rate in per capita gross domestic product and stock markets that underperform historical averages.  
 
When this happens, policy makers must begin new rounds of stimulus to stimulate the economy - they know that the damage wrought by prolonged stagnation will be much worse than printing more dollars.  
 
Most Bank of England policy makers have already said it's "increasingly probable" more asset purchases will be needed to support growth, while European Central Bank officials are likely to debate restarting their covered-bond purchases and further measures to ease monetary conditions.
 
Fed Chairman Ben S. Bernanke said this week the U.S. is facing "a national crisis" with the jobless rate at around 9 percent since April 2009:     
 
"We've had close to 10% unemployment now for a number of years, and of the people who are unemployed, about 45% have been unemployed for six months or more. This is unheard of." - Bernanke, September 28, 2011
 
With the economy and markets shattered and prices of commodities coming down, it now means that the threat of inflation is becoming subdued. Without the short term threat of inflation, the Fed will soon have the firepower to implement (you guessed it) QE3:   
   
 "If inflation falls too low or inflation expectations fall too low, that would be something we have to respond to because we do not want deflation" - Bernanke, September 28, 2011
 
St. Louis Federal Reserve President James Bullard said the Fed is prepared to ease policy should the U.S. economy weaken, while keeping an eye on inflation risks:
 
"The Fed has potent tools at its disposal and is not now, or ever, out of ammunition. Should further weakness develop, monetary policy will need to respond appropriately." - Bullard 
 
While no one is talking about QE3 anymore, the lagging economy and poor stock market performance gives way to a new round of talks in the near future.  
 
Regardless, gold and silver will rise over time but will shoot even higher if QE3 becomes a reality - which I still believe it will.    
   
That is my prediction. Of course, this prediction involves politics based on fundamentals, so take it with a grain of salt.  
 
Here's what I am looking to do:
 
I continue to hold cash but will be buying gold and silver on dips. I will also be looking at both the Market Vectors Gold Miners ETF (NYSE: GDX) and Market Vectors Junior Gold Miners ETF (NYSE: GDXJ), as well as other individual gold and silver explorers and miners -  including the more speculative plays. The GDXJ has a basket of gold stocks that are very well positioned and should be able to take advantage of the run up in gold prices as more investors move into gold stocks.
  
I will also be looking at the extremely beat up energy sector - especially if politics show any bigger signs of QE3. I will be looking to buy through individual large cap stocks, as well as ETF`s such as the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) and the Claymore Oil Sands ETF (TSX: CLO).
   
There are lots of bargains out there if you can stomach the volatility. Happy hunting.  
 
   
 
Until next week,
 
Ivan Lo
Equedia Weekly