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Jeff Saut Presents: Mid-Term, Mid-Cycle and Other Random Thoughts


The tightness of the labor market, combined with a concurrent rise in unit labor costs, is not an unimportant point because it suggests the risk of a profit margin squeeze for corporate America.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

While my firm focuses on our departure to the Dominican Republic (DR) for a week of relaxation, Wall Street is likely focusing on tomorrow's mid-term elections. With the Republicans in control of Congress (Senate/House) since 1994, the election stakes are high. Indeed, there is a distinct possibility that the Democrats will seize control of the House and potentially the Senate. Currently, Republicans control 232 seats in the House and 55 in the Senate. All 435 of the House's seats are up for grabs, while participants are vying for 33 of the Senate's 100 seats. To gain control of the House the Dems will need to win 15 seats, yet only need six to capture the Senate. The last time we checked, "" put the odds of a Democratic-controlled House at roughly 80% and the odds they win the Senate at 30%.

Given the media's attention, a split Congress has probably been discounted by the various markets. However, if the Democrats take control of the entire Congress, I don't think it would be particularly stock market friendly. While a split Congress would likely lead to gridlock, Democrat control of Congress would probably push politics in an anti-business direction (raise taxes, raise minimum wage, public spending, protectionism, anti-insurance/banking/oil/healthcare, etc.). Of course, if President Bush could "find" his veto power, gridlock could still prevail. My firm's main worries following tomorrow's elections center on trade protectionism and the budget deficit. Recall that the government keeps two sets of books. The book that everybody refers to, which does not contain unfunded liabilities (Social Security, Medicare, etc.) shows a rather dramatic improvement in the country's fiscal condition. The other book contains such "off balance sheet" items and continues to track toward a $1 trillion deficit.

As for the commonly shared view that we are currently experiencing the fabled mid-economic cycle slowdown, my firm is not so sure. Clearly, the silent crash in gasoline prices has offset the demise in the housing market, at least for the near-term, and engendered the sense that an undersaved/overspent consumer has been reenergized. And, reenergized may not be particularly pleasing to the Federal Reserve. For months my firm has stated that one of the few governmental statistics we have confidence in is reported tax receipts since people don't pay taxes if they are not earning money. Ladies and gentlemen, tax receipts continue to track above a 10% ramp-rate, which just does not "foot" with the recent 1.6% GDP report. Further, last Friday's employment numbers were shockingly strong. While the headline figure of a 92,000 increase in job claims was shy of expectations, the 139,000 upward revision for the previous two months was plainly a surprise. Meanwhile, the Household jobs survey rose to a VERY robust 437,000 after gains of 271,000 in September and 250,000 in August (as a sidebar the government recently "found" another 810,000 jobs they had not previously counted).

Adding to the strong employment numbers was a decline to 4.4% (the lowest since 2001) for the much watched unemployment rate, a 3.9% year/year rise in average hourly earnings and an employment/population ratio (@63.3) that is the highest since September 2001. The tightness of the labor market, combined with a concurrent rise in unit labor costs, is not an unimportant point because it suggests the risk of a profit margin squeeze for corporate America. It also implies that the Fed will NOT be lowering interest rates anytime soon and may actually raise them. And don't look now, but China raised reserve requirements last week to restrain growth while India and Australia also tightened.

As for the various markets, the bond market took a massive one-day downside "hit" (read: higher interest rates) on last Friday's employment report, which also caused a breakdown in the Bank Index (BKX) below its 10/30/50-day exponential weighted moving averages accompanied by an attendant upside breakout in gold (GLD), on which my firm remains steadfastly bullish. Yet we remain mystified by the lack of growth in this country's monetary base (read: money supply). Also troubling is the recent Bullish Consensus figures, which show that EVERYONE is currently bullish. That is everyone except the prescient hedge fund manager Julian Robertson, who is counseling for caution. To wit, as reprised by John Browne:

"Julian Robertson has over $9 billion under management. He has given his investors an average yearly return, net of fees, of some 25% a year over the past 20 years. When he says he is cautious, we should all pay attention. Interviewed on CNBC's Street Signs, Robertson was asked what made him so cautious. He replied, 'there are a number of things now overhanging the market that could come to break and hurt us badly for a long time.' Asked for details, Robertson cited housing as a serious concern. He then said that, if interest rates turn up, in combination with an oversupply of housing, things could look very bad."

Obviously my firm agrees, yet our cautious stock market stance did not shield us from last week's surprising revelations from Canada on the tax status of their royalty trusts. Verily, they don't call 'em surprises because you expect 'em... and we were clearly blindsided by last week's proposed changes in the treatment of the Canadian Royalty Trusts. Indeed, following the minority government's decision regarding taxing said trusts, after vehemently denying they would make any changes, my firm was surprised by the flip-flop of Canada's Finance Minister, Jim Flaherty, and his proposed changes for corporate trusts, which would no longer enjoy their tax exempt status.

According to Brown Brothers Harriman's Marc Harriman:

"In addition to the fact that these trusts will still enjoy their favorable tax status until 2011, there is another consideration that is likely to support prices and the Canadian dollar over the intermediate term. Under the current rules, if non-Canadians acquire a majority of shares in a trust, the trust loses its tax exemption. This has discouraged foreign acquisition of trusts. This seems especially true in the energy space. The trusts themselves have been gobbling up energy producing assets. One industry report calculated that trusts accounted for 60% of the C$22.7 bln energy producing assets purchased this year, which is nearly twice last year's pace.

For their part, foreign companies already are responsible for half of Canada's oil and gas output, according to the Canadian Associated of Petroleum Producers. Trusts control account for about 14% of Canada's oil and gas production. If trusts lose their tax exemption, the risk is that they become take-over targets for foreign companies. Such bids could help support share prices and the Canadian dollar, on a medium term view.

There is another current that dovetails with this one. There is a large country that is awash with capital and has a nearly insatiable appetite for raw materials, commodities, and especially energy. China. China's State Council, the country's top governing body launched a new initiative at the end of October to encourage domestic companies to invest and expand more overseas. This past April, China began relaxing the restrictions on foreign exchange outflows and created the QDII-Qualified Domestic Institutional Investors. Thus far the government has approved about $11.6 bln of outflows for investment purposes. The goal is to boost this to about $60 bln a year by 2010. Chinese outward bound investment rose by 26% in 2005 to $6.9 bln. This includes equity investment as well as the reinvestment of earnings from those investments. The investments have been concentrated in four industries, mining, manufacturing, telecoms and transportation. Chinese investors would seem to have the desire and the means to consider investing in Canada's energy belt. While foreign purchases of Canadian dollars to buy trust assets may help support prices, it would seem to reduce the amount of tax revenue that Flaherty seems to think can be made up by eliminating the tax advantage for trusts.

While we have been caught "wrong-footed" in 12%-yielding Trinidad Drilling Trust (TDGNF), fortunately we rebalanced (read: sold partial long positions) ALL of my firm's "stuff stocks" during their respective parabolic upside blow-offs between January and May of this year, making "Trinidad's Tumble" more palatable since we need the tax loss. And other than that, we are off to the Dominican Republic.

The call for this week: It's been said that, "In this business vacation never comes"... while that's true in the developed world, in the third world, where our phone doesn't work, and email doesn't exist, that old stock market axiom does not apply!

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