Ramblings of a Portfolio Manager

Sit on it or Rotate?

What the heck happened last week? “ What?” You Say? From most investors’ perspective it was a relative calm week. Though May didn’t start off with a big rise, as we have seen in prior months, a look at the indices shows that all, on the surface, was fairly calm. The Dow pulled back a modest 1.3% but the S&P 500 fell a more severe 2.1% and the Russell 2000 dropped 3.7%. Profit taking? “Sell in May and Go Away?” Some “de risking” ahead of the halt of the Fed liquidity stream? Europe again? Yes.

Actually, the raw index data belies the real underlying damage that was done to many sectors and their constituent stocks. Of the 10 S&P sectors, only one rose during the week, and that was Healthcare, up a modest 0.03%. Selected sectors, particularly ones that have done well this year, were taken to the woodshed with Energy down 7.3%, Materials down 4.5% and Industrials down 2.5%. Financials and Technology also took it on the chin, down 2% respectively. And these are the S&P sectors, composed of large cap stocks. The movements at the small-cap end of the spectrum were even more severe—almost double across the board. Is this the long awaited “major” pullback that strategists have been espousing for months now or something more subtle yet, in its own right, more severe? We think the latter.

The week/month actually started on a high note. Over the weekend we received news that our arch enemy, Osama Bin Laden, had been killed in Pakistan and much valuable Intel had been gleaned from his computers and records. That news alone sent the morning futures into triple digits. However, by the end of Monday, all major indices were in the red with the Russell 2000 taking the biggest hit, down over 1% on the day. The Dow, which held strong for most of the day, succumbed at the end and posted a modest loss. So was this “sell in May.” Well, there was selling for sure but there was also some buying—it depended upon what sector one looks at. With Energy, Materials and Industrials taking the brunt of the hit, one could point a finger squarely at the dollar. After all, the key to these sectors all year has been a weaker dollar. In fact, the dollar did rise for most of the week and the equity markets responded with their expected inverse relationship. The temptation would be to simply dismiss the action as investors’ attempt to get ahead of the Fed’s inevitable withdrawal of liquidity from the system slated, in Ben Bernanke’s words, for several months from now. We remind investors that a simple halt to QE2 does not mean an instant withdrawal of liquidity—we, like Japan, can sit for months, years, with low rates and lots of liquidity in the system. And in some ways, the actions of certain asset classes last week bore this theory out—bonds actually rose during the week, something most portfolio managers would expect to happen in reverse once the Fed stopped buying. So what was going on last week? Did simple patriotism cause a flight to the dollar and US bonds?

From our perspective last week was a sector rotation, plain and simple, but a strong one at that. Consumer growth companies and health care, the old fall backs in a weakening economy, far outperformed the cyclical sectors of energy and materials. The fact that we got some weak data during the week (weak GDP, ADP, Service Sector PMI) only reinforces this viewpoint. Fears of Fed tightening had little to do with this—in fact, the Fed factored in little except that Bernanke made it clear we would not have a QE3 and that, combined with weak economic data, scared many investors into thoughts that that the economy couldn’t stand on its own—i.e. that we would be headed toward a double dip once QE2 came to an end. That thinking explained much. Flight to the safe haven of Treasuries and the Dollar seem to be the rule when things look weak here (confirming that the Dollar remains the world’s reserve currency) and the rotation into less cyclical sectors confirmed the trend. By the end of the week, we saw somewhat of a reversal of trend but rumors of Greece pulling out of the EU stoked more headline risk and the rebound rally lost most of its steam.

So are we headed for a double dip or, at the least, a weakening economy? As we write Goldman Sachs is cutting its GDP forecast for the rest of the year by 0.50%. Not the stuff of a double dip but not heading in the right direction either. The worrisome part is that our foreign trading partners are still struggling to reign in their own economies, something that, if they are successful, will dampen foreign demand for our exports. Again, not something good for robust GDP at home. While we still believe that QE3 is not yet on the table, the Obama administration is up for reelection in 2010 and 9% unemployment just isn’t going to get him reelected. Then again, throwing us back into recession with squabbling over debt ceilings and Social Security cuts isn’t going to retain that republican majority either. So there is impetus on Capitol Hill to get things moving. In the end, we think the Fed will once again come to the rescue and hold off on any liquidity withdrawal until at least next year. And if the data continues to come through weak, then we may see loose monetary policy deep into 2012 or later. Maybe even QE3. Are we in Japan, you ask? It’s beginning to look like it.

Ramblings of a Portfolio Manager

Standard & Poors Just Issued a Warning on US Government Debt. What a Great Time to Buy US Government Debt!

Last Monday was a harrowing and confusing day in the US capital markets—a day that demonstrated the perverse, sometimes conflicting, nature of investing in financial assets: assets whose prices are determined not by any particular standardized underlying valuation metric but by the supply and demand dynamics of a wide range of investors, from the Ivory Tower PhD quants down to the trailer park chat-room day traders.

US investors awoke Monday to find the US equity market futures already deep in the red. Once again Europe’s debt woes (particularly Greece) had been thrust into the front of the headlines, with more rhetoric about default and further restructurings amid a tanking economy thanks to austerity measures. Like many, we assumed the day would play out as it had for the entire year—weaker hands would be shaken out of US stocks and into Treasuries in the morning, only for the reverse to happen later in the day when the “smart money” took advantage of what was essentially old news to do some bargain hunting. After all, “every” smart investor know that QE2 will be ending soon, producing an outflow from Treasuries, presumably into the next best alternative, US equities. It wasn’t to be. Late in the morning, before the US markets opened, the futures tanked even more and the news hit the wires that Standard & Poors, that Gold Standard, leading edge credit rating agency, which had given AAA rating status to most of the Credit Default Swaps and esoteric real-estate derivative products that almost sunk the world’s financial markets in 2008, had just put the entire outstanding balance of United States Treasuries (and future issuances) on a “negative” from “stable” outlook. For S&P, it was the first step in a 3 step process toward a full downgrade of US debt from its exalted AAA status, a distinction it has held for nearly 80 years, and signaled that years of profligate spending and mounting debt with nothing but political rhetoric and no solutions to the issue, had finally caught up with the world’s largest economy. The outcrop—if the US did not address its deficit and ballooning debt problem, S&P would most likely downgrade the country’s debt from its AAA status within 2 years.

Of course, the rational investor, trained in Friedman, Keynes, Malkiel and Samuelson, to name a few, expected that the bond market would tank that day and though money might not flow directly from Treasuries to stocks, at least the expectation was that the reaction in the equity markets would be “tame.” In fact, the rational investor, including us, was once again taken aback by the perverse nature of the capital markets of late. Financial instruments have never moved exactly as predicted by the text books and that relationship has broken down over time but seldom do we see a complete 180 turn from what would logically be expected. Last Monday, we saw that with the Dow trading down as much as 240 points on heavy volume, while the longer Treasury maturities, after a brief dip, beginning to climb. Huh? If the US were to lose its AAA status, would not it have to pay higher interest rates and, given the relationship between rates and bond prices, would not bonds sink? One would think so but, as we mentioned, the opposite happened, although stocks did recover some of their initial losses over the course of the day.

What happened? The brain trust of economists are still scratching their heads and fiddling with their models replete with Greek symbols, crunching them on Cray’s latest supercomputer. Meanwhile, the rest of us have cobbled together a more homespun explanation for what happened. First of all, some sort of action by the rating agencies was most likely expected by the bond market (heck if we know what the equity markets were expecting-remember influence of the trailer park day traders) and the one we got was the mildest of the moves S&P could make; in fact, it wasn’t even the step before a downgrade: we still have to go on “credit watch negative” before a downgrade is imminent. Secondly, S&P gave us a 33% chance of a downgrade in 2 years. That’s better than even money and extends beyond the next election when we hope (as we always do) that a more fiscally responsible group of politicians will take office. Thirdly and relatedly, the move was seen as indeed political, with S&P basing its decision more on the gridlock it sees in the current Congress than any deeper economic weakness of structural problem in the economy. Fourth, Moody’s ever the politician itself, quickly reassured the markets (and big brother) that it had no intention of following suit with a negative rating of its own. Finally, many in the markets saw the move as a call to action to the politicians—the proverbial straw that would break the camel’s back of gridlock and rhetoric and get those sound bite hogs in DC focused on the real matter at hand—cutting the deficit and reducing our outstanding debt load. It is interesting to note that the dollar fell on that day, as would initially be expected, but stayed low even as bonds rallied. Anyone think the Fed stepped in under QE2 to mitigate the fallout?

That’s a long-winded explanation of why bonds probably didn’t sell off, but why did the equity markets tank and why did bonds actually end up on the day? The answer here is probably more subtle and complex. Compared to what we said about bond market participants above, equity market players are less thoughtful, more reactive and just don’t do as much homework. To them, the reverse was true—S&P’s warning shot might cause Congress to overreact, following the UK and implementing austerity measures before the economy has fully recovered—maybe even canceling the QE3 through 15 that some expected. In addition, failing a resolution, a full downgrade of the US (2 years out at the least) would affect US corporations as well, raising the cost of their borrowings, which are now at an all time low. That would also serve to put the brakes on the fledgling recovery. Finally, the move was seen as changing Bernanke’s Wednesday Q&A on QE2, from something benign to something more hawkish. All of this would be bad for the economy and bad, ultimately, for corporate earnings and thus stocks. So why did US Treasuries rise on the day? Well, as we all know, when the US (or global) economy is seen as potentially having negative issues, investors “de risk” (someone please explain that term to us and how it is done in an hour on trillions of dollars) and flee to quality; the only perceived quality investment left (barring Switzerland and gold) is, you guessed it, US Treasuries. Gold was up on the day, as was Silver. This phenomenon has been seen many times in other countries—during a debt downgrade, it is equities that take the brunt of the downgrade. The funny thing is, following the news, a spate of strong US corporate earnings came out, pushing the yields (and prices) higher, signaling a stronger economy ahead and negating much of the flight to quality (but Gold and Silver still rose, this time on inflation fears—go figure).

Oh, and our 2 cents (less than 0.01 Swiss Franc now) is that Bernanke now comes out even more dovish than expected on April 27th. What simpler and politically more palatable way to avoid a debt crisis than to continue to deflate our currency, paying back our debt faster with worthless dollars, thus simultaneously stimulating our economy further and collecting more taxes at the same nominal rate and avoiding economic or political repercussions of a tax hike or austerity. Anyone see supply side economics in here anywhere? We think this would successfully avoid a downgrade (a growing economy, shrinking debt and higher taxes would keep the ratings fools at bay despite the devalued currency). QE3, we think, just got more probable so we would avoid the Dollar. We’re still not sure what to do about Treasuries, although we certainly wouldn’t hold them here. We just hope the Chinese don’t start voting with their feet (or Bloombergs to be precise). Welcome to the Bizarro Land of investing.

Ramblings of a Portfolio Manager

Which Asylum is Being Run by the Inmates?

Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.

One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?

There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.

The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.

Ramblings of a Portfolio Manager

Extra! Extra! Commodity Prices to Derail the Economy!

So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”

Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.

Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?

Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher

Ramblings of a Portfolio Manager

Bombs are Good for the Market?

“Sell on the trumpets, buy on the cannons” is an old Wall Street expression suggesting how to invest during armed conflict. It’s a reverse offshoot of the overly used “buy on the rumor, sell on the news” maxim and, despite its now trite status, the recommended behavioral anomaly seems to persist in the equity markets. It worked during Iraq’s invasion of Kuwait, during the US invasions of Afghanistan and Iraq, after Clinton used cruise missiles to kill a few camels and burn some Sudanese tents and an Aspirin factory and, given the status of market futures this morning, seems to be holding once again after allied missile strikes and bombing broke out in Libya over the weekend. The theory, as best we can define it, is that the reality of war is never so bad as the fear, fog and rumor leading up to it. In light of the above examples and Libya, that theory probably holds true especially given the asymmetrical powers of the opposing forces in all these recent cases.

Interesting, there is a lot more operating on the markets this morning than just hitting Libya with a few bombs. Japan seems to have stabilized their runaway reactors over the weekend, connecting power to drive water pumps and cool the core. That’s good news on the long road to resolving their ongoing post-quake reactor crisis and most likely is lightening some of the nuclear discount under which the markets have been trading of late. However, missed by the popular press was a statement issued by Japanese Prime Minister Kan, pledging to rebuild quickly and aiming to compile a relief and reconstruction package as soon as next month. Estimates for the cost of rebuilding effort run as high as $100 billion. That would also be good news not only for the Japanese people but for infrastructure companies both in Japan and abroad, a fact we pointed out last week. Not so well publicized was Saudi Arabia’s pledge to give out $36 billion (of our money) to its citizens to quell their thoughts of uprising. Also, not unlike the old joke about the reaction time of kicking a dinosaur in the tail, investors are also most likely coming to the realization that the Philly Fed Index released last week was very strong and that most banks passed the Fed’s Stress Test II on Friday and may now resume paying dividends. Both speak to the health and strength of our economy and its financial system. Putting it all together, the weekend navel contemplators have their buy orders in this morning. We wonder who makes money selling during panic and buying on euphoria.

In any case, the point of this week’s Ramblings is to look beyond the current world turmoil for signs of what it will all mean to the markets in the intermediate term, not just this morning, and opportunities presented therein. The last two weeks have seen oil and coal (and companies supplying both) rise on Mideast supply interruption fears and rumors of the early demise of Nuclear power. Stocks of Uranium producers have been decimated. Infrastructure plays only caught a bid on Friday after Larry Kudlow stated what we mentioned two days earlier—that the quake may benefit these companies. High-end retailers have gotten bombed as hard as Quadafi’s compound on fears of a pull-back in the Japanese tourist trade and, most perplexing of all, technology companies have been indiscriminately sold off on the belief that parts supply disruptions from Japan will crimp their earnings. How can one make money on these dislocations?

We like coal and oil, not so much for the temporary positives but for the long-term industrial and consumer need for these energy sources. Yes, US energy independence, solar, wind and other alternatives are wonderful dreams but, like Obama, Jimmy Carter had them too. We don’t know what to make of Uranium but 25 years ago we listened to a presentation by Alan Greenspan to the University Club in New York in which he predicted that the risks of Nuclear power may someday outweigh the risks of oil. We may be there now and that line of thinking will probably weigh on politicians for years to come. Plentiful and cheap coal will most likely slow the return to reactor building even in China. So Uranium is probably worth a miss for the not-so-stout-hearted. As for the other sectors hit by the turmoil, we believe that this is a great opportunity to pick from amid the market rubble. First of all, the indiscriminant selling of companies with supplies or sales wholly unconnected to Japan have given US investors an unprecedented gift. Secondly, even US companies somehow impacted by Japan have now been given a “bye,” meaning that whatever they report for the second and third quarters of this year, they will be able to blame it all on Japan, a one-time extraordinary event, rather than any kind of US economic weakness or company-specific issues. Any investors out there old enough to remember when El Niño was an excuse for missed estimates at everything from retailers to Caterpillar? It’s gonna happen again, trust us.

Some tech companies, like Alcatel Lucent and Texas Instruments, have already warned investors that supply disruptions will likely impact earnings for the upcoming quarters. For companies such as these, we suggest the buy on the rumor strategy, particularly for the tech companies. Yes, supplies will be interrupted in the short-term but demand (despite the trouble in Japan) will not. Prices will rise at the supplier end of the chain, giving those companies an earnings boost, and we should not underestimate their ability to quickly shift production to other locations (without publicly letting on), easing supply constraints but maintaining the higher prices. Beneficiaries of Japan’s ills are probably a good place to look but we caution that Japan’s insular, protectionist attitude has not been changed by this tragedy so they will look first to domestic companies before calling for help from the US and China. Still, let’s not forget that Libya will need some rebuilding and has no industry of its own—just ask the folks at Halliburton what Kuwait did for them. Indirect beneficiaries like commodity producers (steel, coking coal, aluminum, building supplies) are good places to look as Japan and Libya don’t have much in the way of their own raw material stocks and the Japanese producers, like steel plants, are currently off line due to power constraints and will be for some time. This list goes on. Interested investors should give us a call.

So, looking out into the next few quarters, we see many positives from US companies reporting earnings. Some will be directly benefited by recent world events; others will be negatively affected but given a free pass. Eventually oil should return to price levels commensurate with real demand, not war panic, giving the consumer a tax break and investors may finally start focusing on fundamentals, which are good, rather than headlines, which have been bad. All-in-all, then, we see the US equity markets rising from the recent ashes and would be buyers, although not on the euphoria of the moment. We have yet to return to pre-crises market levels and investors will be given another opportunity to get in before we do so. Remember, stocks take the stairs up but the elevator down—that gives prudent investors time to take advantage of the dislocations the recent negative headline events have produced.

Ramblings of a Portfolio Manager

Interim Ramblings -- Japan

10 basis points of World GDP growth. That’s it. One tenth of one percent of world GDP is expected to be affected by the terrible tragedy in Japan. And that is in the short term. No one has yet to quantify the longer-term benefits to manufacturers and exporters in the US and China from the strengthening Yen and the enormous needs for building materials and equipment soon to be hitting the order books during Japan’s reconstruction phase. It sounds perverse (and cruel) to say but it is very true that this tragedy has become Japan’s own Economic Recovery and Rebuilding Act—similar to our own except that the funds will doubtless be channeled into needed, productive projects rather than the many worthless make-work boondoggles the current Administration has squandered our funds upon here. And US exporters might just be the beneficiaries.

The US currently imports one half of what it did from Japan just 10 years ago and while our exports have increased, estimates are that only about 2% of the S&P 500 earnings are dependent on that trade. And it is unclear if exports from the US will even drop off. True, some industries like auto parts may suffer but food, medicine, building materials and energy (oil, coal) may actually increase to satisfy immediate needs and to replace lost productive capacity. For example, Japanese steel and aluminum plants are offline or damaged and much of both of those commodities will be needed for reconstruction. So far many tech companies have announced supply disruptions but they remind us that these disruptions will only be temporary and are the result of power outages rather than damages. Furthermore, for some segments of the Tech Sector, the damage to Japan’s infrastructure should be a good thing down the road: First, competitors are eliminated from the market temporarily. Secondly, some sectors, like optical components, were in a glut prior to the quake—the disruption will help them work down inventories, eventually raising prices. Finally, when the rebuilding occurs, the repairs will most certainly include the Country’s technology infrastructure and that will be good for US Tech manufacturers. Multiply these factors across many US industrial sectors and you will see where we’re going.

US equity markets are trading on sentiment—fear of nuclear fallout and of economic disaster in Japan, fear of the Middle East burning and fear of European debt defaults. Yet we have lost only about 6% from the top on all major US equity indices. That’s not bad considering the spike in the VIX and the huge drop in investor sentiment. For those of you who have hit the sell button, we suggest a long bike ride, maybe a cocktail and some re-runs of Two and a Half Men rather than shivering in front of CNN or CNBC, pondering more sales. The images coming across TV and the minute-by-minute conflicting headlines are only a recipe for angst and making an investment mistake. As Warren Buffet is fond of saying, be greedy when others are fearful, be fearful when others are greedy. Right now, it sure looks to us that others are panicking. It may sound mercenary and vulture-like but we’re investors so we are taking advantage of the situation. We suggest that you do too—but before the TV talking heads figure out that this tragedy, in the long run, may be just what both Japan and the US need to pull our respective economies out of their current malaise.

Happy St. Patrick’s Day.

Ramblings of a Portfolio Manager

Why isn’t Higher Oil the Straw in the Proverbial Camel’s Back of the Market?

After two weeks of turmoil in the Middle East and Africa, the major US equity averages have moved very little. Since riots in Egypt broke out at the end of January NYMEX crude has risen approximately $21/bbl, from roughly $85 to $106, a nearly 25% increase. Gasoline prices at the pump have risen a more modest 10%, yet despite the hike in real costs to consumers and the flood of negative press and television images, the Dow and S&P 500 have only declined by about 2% respectively from their highs. In fact, both indices are now trading exactly where they were at the end of January, when all this turmoil broke out in the first place. The spike in oil, naturally, has drawn pundits from out of the woodwork declaring potential economic Armageddon from higher oil, quoting such sensitivity numbers as a $2 per share impact in S&P earnings per every $20/bbl rise in oil. We don’t have the economic inputs for the model nor the Cray computer to run them to test this assertion so we’ll just take if for gospel (dangerous, we know). Based on current 2011 S&P earnings estimates of about $93 per share, that $2 would be roughly a 2.2% decline in corporate earnings for this year. Assuming no multiple contraction, that would equate to about 29 S&P or 270 Dow points, which would put us back just to where the markets were at the end of January, when all this began--that just so happens to be where we are right now!. Of course, with decline corporate earnings, one would expect some multiple compression resulting from the attendant dampening of investor sentiment. At the current multiple of the S&P 500, 14.2, a full multiple point of compression (pretty high historically) would equate to another 7% decline in the index. Combined with the prognosticated reduced corporate earnings power, that would give us the 10% decline that “everyone” is expecting as a pullback. A decline of that magnitude would just bring us back to about December 1st in the S&P 500.

But the tradeoff between oil prices, GDP and stock market levels is not rigidly formulaic. There are a number of variables that impact market levels in a rising energy market and make for a dynamic situation that, in reality, no economist or oil company executive (let alone a politician) can predict. For example, investor sentiment, which at the beginning of February was at a level that just about every talking head on TV who could emerge from under a rock proclaimed signaled a market pullback, has dropped significantly. According to AAII, the percentage of investors who are now bullish is nearly equal to those that are bearish at 36% vs. 32%. This is down from a level of nearly 52% bullishness at the beginning of February, just as the oil region turmoil began. The contrarian in us likes this move, especially in light of the relatively small decline in market averages.

Another factor that goes into the GDP vs. market level vs. energy price tradeoff is the impact at the consumer level, something the TV pundits like to take throw out continually. Here, simple math that even we can do throws this argument into doubt. According to the NHTSA, the average American drives 15,000 miles per year. According to the DOT, the average fuel consumption of all cars, light trucks and SUVs on the road today is 21.4 miles per gallon. Since the rioting began, gasoline at the pump is up, on average, about $0.33/ per gallon. Simple math tells us that the impact per average driver would be about $231 per year IF these higher gas prices persist for another year or more. Now, $231 may not seem like a lot to Wall Street types but it can be meaningful to the average American, at the margin. However, taking an adage from Wall Street, “nothing cures high oil prices like high oil prices.” That means, in basic economic terms, as gasoline prices climb, demand, being elastic, declines, thus reducing the per-family dollar impact and, eventually, bringing down the price of the commodity. The latest data we have on this phenomenon is from March 2008, when gas prices reached highs we are currently seeing at the pump. At that time, the number of miles driven dropped 4.3% in response, according to the Federal Highway Administration. Right now, even though oil has jumped 25%, stockpiles (you’ve heard all about Cushing and the spare oil sitting around in tankers in harbors around the world) have kept the pump price impact to half of that and will probably do so for several months. And that pump price needs to stay here for another 12 months before we see any significant impact to the average driver. At that point, miles driven will most likely decline, negating some of the impact. But we have a long time for stockpiles to be reduced (remember, ONLY 1.8% of the world’s supply has been cut and that has only seen a 50% reduction). In the meantime a situation such as we saw in 2007 and 2008, a significant move to more online shopping, will further negate the impact to consumers and consumer-related companies.

Of course, the GDP impact of higher oil isn’t just dependent upon consumers’ driving and spending habits. Energy is also used for home heating and transportation of goods, in addition to manufacturing (think plastics). On the first point, the Northern Hemisphere is now entering Spring/Summer. Heating demands will plummet, lessening both demand and the impact to consumer wallets. Transportation (trucking, rails, airlines, etc.) has gotten much more efficient over the last decade, further lessening the impact to the economy versus prior oil shocks. Our manufacturing economy has become both more efficient in energy use but has also transformed over the years. In fact, the dollar output of GDP per unit (BTU) of energy consumption has almost halved since 2000, according to the US Census Bureau. Simply put, our economy, despite all the hand wringing by opposing political parties, has indeed become less energy dependent as it has transformed from manufacturing to high-tech and financial services. Another 70’s style oil shock may well have a GDP impact but it can be expected to be much, much less in terms of reduction of domestic output.

The quoted $2/share S&P earnings impact per $20/bbl in oil presumes a permanent upward spike in oil to that higher level. So far, we have had only two weeks of rising oil and the new, higher price has not arrived all at once—it has been a steady incline. Except for airlines and other energy sensitive transportation industries, few US companies have yet felt the bit of higher oil. And, unless this new level of crude remains permanent or rises further, we believe few will. Right now a 25% rise in oil based on a 0.9% decline in supply says to us that there is a big “contagion premium” built into in oil prices right now. That premium probably assumes several Middle East countries undergo what Libya is now seeing, but probably not Saudi Arabia. A lot needs to go wrong in the Middle East for that scenario to develop—a fairly low probability, in our opinion. One thing we have to stress, though, is that all this turmoil represents a disruption, not destruction in supply. The length of this disruption is anybody’s guess but you can be sure that, as economies wholly dependent upon selling the black sticky stuff, the oil producing nations will ensure that it is as short as possible—or their troubles will only compound. That says to us that the price of oil has most likely over-reacted to current world events and that the equity markets have reacted rationally. Now that investor sentiment is low and oil is high, when we get a reversal of both (which we will and they will come together) the base will be set for much higher equity markets.