Has Spring Sprung?

Our lower cost I share is now available on Schwab and Pershing.  Also, our conservative international fund, the Discovery Fund (INTLX), is now available on Schwab, Fidelity and Pershing. 

The markets continued recovering in the second quarter and are now positive on the year.  We believe that we have avoided a depression but are still left with a difficult recession.  Many commentators are seeing “green shoots” in the economy.  We believe that on a relative basis, the economy has been leveling off, albeit at a lower level than a year ago, which is good news considering where we were a few months ago.

As expected, consumers have increased savings up to the 6-8% range (see first chart).  We believe that somewhere in this range, consumers will not have to cut back on spending to increase saving.  This causes consumption to level off from its more recent drops of around 10% this year (see second chart).

Factories have slowed down this cycle as the drop in consumption has reduced orders, especially for autos.  Factory Capacity Utilization is the lowest its been in over 40 years (see third chart).  Lower than the nasty recessions in the 70’s and 80’s.  Some of the reduced orders are due to an inventory correction.  Retailers do not need to restock shelves when consumption is down so they order less.  As the inventory correction ends, orders pick up to more normal levels and Capacity Utilization goes back up.

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So where do we go from here?

The question now is where do we go from here.  History would suggest that we get a “V” off of the bottom and the economy takes off.  This “V” is caused by two things.  First the inventory correction ends and orders increase.  Second, the Fed lowers interest rates and this spurs increased spending on durables, namely, houses and cars.  The increased spending causes more hiring, lowers unemployment and the newly employed start spending again.  Voila!  A “V” bottom. 

I think that it will be more difficult for history to repeat this time.  In past recessions, the Fed would raise interest rates to slow the economy.  It could then lower them and the economy would pick up again.  However, this recession was not caused by increased interest rates, but rather by falling home prices and a credit crisis (caused by falling home prices and its impact on Lehman, Fannie Mae and Freddie Mac).  Even as the Fed has lowered short term interest rates to zero, home prices have continued to fall.  As long as home prices continue to decline buyers wait on the sidelines instead of creating more housing demand.  Given the current mortgage default rates and foreclosure rates, home prices will be under pressure for some time. 

So one of the legs for a “V” bottom is missing.  What is more likely, in our view is a “U” bottom where the economy stops falling, but does not dramatically pick for a while.  Autos may pick up sooner than housing.  Financing has been the life blood of the auto industry and that may now be increasing, so sales could pick up.  Auto sales have been running at an annual rate of about 9 million while 12 million per year is closer to the replacement rate with no growth.

One thing that discourages me is the PPIP program that is supposed to buy toxic assets from the banks.  I thought that this program would really get at the root of the problem and help get lending going again.  However the program that was just announced calls for a puny amount to be spent on such assets, less than 10% of what was advertised.  Perhaps more money will be added later, but for now there is a program in name only.

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Employment has historically been a lagging indicator

Employment has historically been a lagging indicator.  That is because once the Fed lowers interest rates to get us out of a recession, durable spending picks up and employment in those areas increases.  However, currently there is around 10 months of inventory for new homes (and existing homes too).  This is about twice the normal level of 4-5 months.  It will take time to work off the excess inventory before new construction employment increases.

Continuing Unemployment Claims are running at the highest levels in 40 years (see fourth chart).  This too hurts consumption levels.  It may take longer for these people to get absorbed back into the work force.  It may even happen after their unemployment checks run out.

High homeowner debt levels plus a trigger event lead to mortgage defaults.  Unemployment is a huge event which triggers mortgage defaults.  If more unemployment leads to more mortgage defaults, unemployment could become a leading indicator instead of historically being a lagging indicator.

So far, the recent Recovery Plan has not stopped unemployment from increasing (see fifth chart).  There is currently talk about a new stimulus plan to deal with this, but the there is some doubt whether the administration backs this.

A few months ago people were using the “d” word (depression).  When looking at 9+% unemployment it may feel like a depression, but unemployment peaked out at about 25% back then.  Granted the old number included more categories of unemployed than the current number, but the Depression was much, much worse.

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Summary

In summary, we believe that the recession may be ending, that is, the economy may stop contracting.  However we are concerned about the rate of expansion after the recession.  We believe that earnings, while less than a year ago, will probably beat estimates.  We will be keeping a keen eye on forward guidance to gauge company’s expectations of a “V” bottom or “U” bottom.

Going forward we intend to find strong companies that are undervalued and have exceptional appreciation potential.  We will also keep one eye on controlling risk.  We expect continued market volatility and will position the fund accordingly.  We are grateful to have thrived so far in this environment and will continue to execute our strategy.

Best regards,

Thomas H. Forester

CIO and Portfolio Manager

For more complete information on the Forester Funds, including charges and expenses, obtain a prospectus by calling 1-800-388-0365 or visiting www.forestervalue.com. The prospectus should be read carefully before investing.

The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed herein are those of Thomas Forester and are not intended as investment advice.