Ramblings of a Portfolio Manager

To Some, Economics is Just Crap

It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).

Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.

Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]

OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?

So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.

Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.

Ramblings of a Portfolio Manager

Changing Course

We’ve been criticized for being overly bullish on equities over the last few weeks, paradoxically by institutional brokers who only make money when stocks are going up and investors are willing to buy. But smart brokers use charts, knowing full-well that they can’t count on their own in-house research to even call the direction of the wind during a hurricane, and the charts always tell you to hate stocks when they are going down and to love them when they are going up. Stocks have been going down of late so who are we to fight the tape with such weak arguments as valuation, fundamentals, and economic growth? That being the case, we bow to the chartists, throw in the towel and present here 10 reasons why you should NOT own stocks.

1. Gold. It pays no dividend, costs you a great deal to hold, store and insure the physical asset (assuming you have a safe at home) and carries a 20%+ commission each way on trading it. But it’s going up and the chart guys say that means it’s going up. Sell stocks, buy gold. Someday you will be rich.
   
   
2. Obama. His administration is anti big banks, anti business, fond of high taxes, espouses non-growth producing social programs, and has produced no growth in jobs in his 17 months in office. This, of course, is all information that very few are aware of. All these qualities, naturally, are so popular with the voters that he and the incumbents in Congress are virtually assured of a massive sweep in the mid-term and 2012 presidential elections. We even hear talk of suspending term limits so we may have these excellent statesmen in office forever! Sell stocks.
   
   
3. BP. While the environmental impact is saddening, no one is sure if there will be a measurable economic impact from the spill in the gulf. BP isn’t in any US stock index so it can go to zero without affecting the indices here but we get to see that belching oil on TV every day and that has to be bad. Sell stocks.
   
   
4. Uninspiring retail sales. Yup, 70% of our economy is based on the consumer and the latest round of retail sales reports showed only modest growth. So we shall join in with the bears and proclaim the US consumer dead for the 9,378^th time in the last decade. Sell stocks.
   
   
5. Yields on the 10-Year US Treasuries are now a fat 3.28%. That’s almost a hefty 200 basis points above expected inflation according to the current 10-year TIPS. And, of course, we know that the price of gold isn’t saying ANYTHING about expected inflation (just the super-attractiveness of that asset class). Sell stocks, place a penny into Treasuries (not a bank, the Government tells us they are bad) and sit tight in anticipation of the 2020 Bentley (lighter fuse) you will be able to buy with all those guaranteed accrued interest earnings ten years hence.
   
   
6. Portugal. The rating agencies tell us things are bad there and those agencies employ some of the smartest, most forward thinking experts on Wall Street. And Portugal’s GDP is massive-- almost as big as Arizona’s! This is news. Sell stocks.
   
   
7. Italy. The rating agencies haven’t yet told us things are bad there so things are OK. But if they do downgrade Italy, Sell stocks.
   
   
8. Greece. The ratings agencies tell us things are bad there too. This is also news. Sell stocks.
   
   
9. Spain. Ditto
   
   
10. No-one wants to own stocks now. We all know the herd is always correct. Go with the herd. Sell stocks.

By the way, if you decoded our acronym, give us a call for this week’s picks.

Ramblings of a Portfolio Manager

How to Position Yourself Amid European Turmoil.

According to the databases, the S&P500 just experienced its worst May performance since 1962 while the Dow had its worst May since 1940 and we have Greece, Spain and the rest of the EU to thank for it. Savvy and nimble investors, of course, were able to avoid much of the pain by moving assets to markets less sensitive to the economies of those Sovereign entities, right? Think again. Here’s a little quiz: Now don’t glance at the chart below until you’ve finished reading! In which market would you rather have been invested during the recent ruckus over a potential European debt crisis? 1. The Shanghai Composite—China has the best balance sheet of the developed nations with plenty of reserves and no sovereign debt, however, the EU represents over 20% of Chinese exports. 2. The French CAC-40, which is comprised of companies deriving their earnings principally from the EU, including French banks that would have to write down their book values by over 40% in the event of a Greek and Spanish default. France also admitted at month-end that it would be a challenge to maintain its own AAA debt rating. 3. The S&P500, comprised of multinational corporations receiving only about 10% of their total earnings from the EU. 4. The NASDAQ Composite, made up of high-growth technology and biotech companies earning less than 5% from the EU in total. 5. The US Russell 2000 Index of small cap stocks, which are principally domestic-focused. 6, The German Xetra DAX—Germany is the EU country which will be shouldering most of the burden of pulling its fellow members out of the fire. 7. The Spanish IBEX—need we explain this one? 8. The UK FTSE 100—UK exports to the EU account for about 29% of GDP and the UK Pound has appreciated versus the Euro.

OK, now you can examine the chart below.

The answer, other than the obvious fact that you would have wanted to avoid the Spanish stock market, is that it almost didn’t matter in which developed, Eurozone-affected equity market you invested your money last month—you would have lost a similar amount of money in any of them. The conundrum, however, is that the equity market of one of the most vulnerable countries to a PIGS debacle, France, outperformed almost all of the equity markets in May while stocks in China, with the strongest economy, no debt and the reserves to stimulate, underperformed all but Spain. The FTSE, in a worse position than the US vis-à-vis currency and trade with the EU, outperformed the US. What’s going on? As we see it, there are several countervailing forces at work. First, US hedge fund managers, remembering the debacle of 2008, chose to shoot first and ask questions later—and they tend to be invested more heavily in mid-cap and technology stocks as found in the NASDAQ, the big domestic loser. Secondly, less trigger-happy investors began focusing on the markets where the weaker Euro would be a benefit—the European countries with the largest components of exports in their GDP—and where it would be a detriment—e.g. the US and Chinese multinationals. That’s the reason Germany, with over twice the exports of France, has seen the DAX dramatically outperform the CAC-40 this year and all US and Asian markets last month. Thirdly, the Chinese market is reacting not only to efforts to reign in the property bubble but to the strengthening of its currency versus the Euro, a double-whammy of anxiety. Finally, for the conspiracy-minded, there is the headline timing issue: for the latter part of the month, encouraging comments by politicians tended to come out during the trading day of European bourses (purposefully), allowing them to close higher, while the bad news was saved for “after market hours” (again purposefully) while the US equity markets were still open, sending them lower.. Do that a couple of days in a row (which occurred) and it certainly offers one explanation why the S&P 500 couldn’t put together two back-to-back positive days the entire month while the Euro bourses could. .Fitch’s Friday downgrade of Spanish debt just after the European markets closed but while the US markets were still trading, is a prime example of this.

What to make of this all? Of course this data is all backward-looking but it can give us a clue as to how some markets will perform for the rest of the year. First, we agree with the view that the export-minded EU countries are a buy right now. Several major investment banks have upgraded growth expectations for the stronger, export driven European economies over the past month as did the OECD last week. Secondly, we believe that the sell-off in smaller, US-focused countries is way overdone and that, going forward, they will outperform the large, US multinationals with significant European/currency exposure, especially if the Federal Reserve keeps a rate hike on extended hold, which we think will happen. The stronger dollar will continue to lure overseas investors to our markets and while some of that money will find its way into Treasuries is will also go into perceived “Euro-free” stocks, favoring small caps. Finally, though we have been dead wrong on the Chinese market this year, we have been correct on their economy and we believe that the Central Government will reverse their tightening course as soon as the measures appear to be working (which, as of this morning, they seem to be), especially in light of current world weakness, making Chinese stocks worth a serious look now, after a 20% slide year to date.