There has been a lot of talk about a slowdown in the Chinese economy.  A slowdown which could have possible broad based implications as China is the third largest global economy (behind the European Union and United States). 

Although, before we get deeper into what those implications might be, let’s look at some recent data from January on China:

• Exports and imports fell for the first time in two years.
• New lending was the lowest for that month in five years.
• Money supply grew the least in more than a decade.

Even with this data, China’s GDP is still projected to grow at 8.50% this year. That number is staggering compared to the United States’ expected GDP growth rate of merely 2.20%.  In fact, if both China and the United States continue to grow at their expected rates and maintain that as a constant growth rate over the next several years, China will surpass the U.S. in GDP by 2024.

Here’s the, “Ripley’s Believe It or Not” part: some Chinese economists have expressed that if China’s economy does grow by less than 8%, it would be consider a recession by the Chinese! They believe China needs to maintain an 8% growth rate to stay on course with current social pressures created by new entrants coming into the workforce and people migrating towards more urban areas for jobs.

Economists also suggest there could be dire consequences if China does experience an actual recession. Yesterday, in response to the soft economic data from January the Peoples Bank of China (PBoC) cut their banks’ reserve requirement ratio (RRR) by 50 basis points. The PBoC hopes this cut will spur additional borrowing and growth. The Central Bank first cut the RRR at the end of November and utilized additional open market operations in January to provide short-term cash for banks.

Xi Jinpeng, China’s soon to be leader, suggested there would be no hard landing for China. Based on recent actions, it seems China is taking a page from the American playbook on loose monetary policy.

Going forward, if you believe the “American style” monetary policy will cause the Chinese consumer to borrow, then China might still be a good bet and could continue to rally. Although, if you think China is a society in structural change and the Chinese will not consume, then it would be wise to underweight China in your holdings. Also, if you do believe the latter then you might want to take it a step further and hedge against possible global deflationary concerns too.

The good news is the American consumer seems poised to pick up some of the slack (keyword: “some”). With the American consumer continuing to deleverage, it is unsure how much slack in consumption we could actually pick up. Let's just hope the Chinese are more responsive to the “American style” monetary policy than we’ve been.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

Markets have been on a rip roaring rally these last few weeks.  The S&P 500 was up 4.48% in January and is up 6.98% YTD.  Under normal circumstances coming off a year like last year where returns seemed non-existent, one would expect a strong start.

After a solid jobs report in January and stronger than expected improvements in consumer credit, it can be easy for one to conclude we’re currently in the throes of an improving economy.

In fact, this is one of the few times individual investors and professionals are normally optimistic about the markets. However, if you looked at analyst expectations of future corporate earnings you would see an entirely different picture.

Wall Street analysts have been reducing earnings expectations in droves. The following is a chart by Bespoke showing the daily net change in analyst’s upgrades (downgrades). As you can see, there has yet to be a single day this year where there were more upgrades than downgrades.

Numbers did improve throughout this earnings season as we suspected. However, during this earnings season companies continue to still lower guidance and expectations.  

While this might suggest we’re about to face some headwinds in our rally (which wouldn’t surprise me given the YTD performance numbers), calling market tops and bottoms is nearly impossible. Credit Suisse has also taken noticed of the interesting contrast between analyst opinions and the YTD performance numbers. This anomaly can be seen in a research study they did which compared the changes in earnings estimates with actual stock market performance.  Below is a chart that summarizes their findings.

From this chart, it appears when earnings estimates are lower than they were at the start of the year, the equity markets tended to finish higher roughly 2 out of 3 times. This underlines one of our core investment philosophies: it’s not about timing the market; it’s about time in the market.  Markets can be “irrational” longer than a logical investor’s patients. 

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Adam Gulledge, Associate – Phillips & Company

Hatip: Bespoke Investment Group for Sentiment Chart, Analyst Upgrades/downgrades and Guidance data. 

Tim Phillips, CEO – Phillips and Company

Is Facebook worth it?  Without a doubt, this will be the biggest question we get asked as advisors over the coming weeks. So, could investing in Facebook once it becomes publically traded be the path to fortune or could it be another version of “accidental investing” like the recent commercials suggest? 

When Facebook does have its IPO, it is expected to be valued between $75 and $100 billion. On their S-1 filings with the SEC, Facebook had reported revenues of $3.7 billion and earned $1 billion in profit last year. Based on these numbers, Facebook would have a price-to-earnings ratio (P/E) of 75 to 100 and a price-to-sales ratio (P/S) of 20 to 27!

In comparison to other tech titans, Facebook’s valuation might be considered rich:

The difference between Facebook and the other tech titans is their growth rate. Facebook’s revenue grew by 88% in 2011, while Apple, Google, and General Electric’s revenue grew by 68%, 29%, and -1.5% respectively.

Facebook boasts that 1/8^th of the world population are currently active users. However, this may mean Facebook’s user growth could start slowing simply because everybody who might join Facebook has already done so. Looking at the ad revenue growth numbers in 2011, we see growth of 18% in Q4, 3% in Q3, 22% in Q2, and -3% in Q1!

So what's Facebook actually worth? I’ll let the market decide the final number. Personally, I think a $60 billion valuation would be more attractive. If I succumb to “accidental investing” I might gravitate towards the $75 billion valuation. If I do, then I’ll certainly be much more cautious as I over pay.

Jobs, but not Steve.

Just to keep with our Facebook theme, I took a look at how many people our comparative company’s employ:

• Google has approximately 32,000
• Apple has approximately 63,000
• Facebook has approximately 3,200
• GE has approximately 287,000

From this fragment of data, the new economy appears to make more value and less employment.

With that piece of antidotal evidence in mind, we did have a great job's report last Friday. Job growth was widespread with large gains in professional and business services, leisure and hospitality, and manufacturing.

• Professional services added 70,000 jobs.
• Manufacturers added 50,000
• Leisure/hospitality payrolls increased by 44,000.
• Retailers added 11,000

There is no other way to put this jobs number other than a possible sign of a stronger consumer. The only downside is the employment participation rate dropped to 63.7%, the lowest rate since the early 80’s.

If Facebook represents the next generation of companies, then new companies look more like wealth creators than job creators. With Facebook being valued at near levels with the likes of Boeing, Caterpillar, McDonalds, and Cisco, yet only creating a few thousand jobs; the real winner will be the wealth effect not the employment effect.

Perhaps it's time to put more inflation hedges into the portfolio and add more risk into your holdings.  Just don't be caught “accidentally investing.”

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

A few things happened this week that give significant clarity around the winners and losers in our economy this coming year.

Event 1: As expected, the Federal Reserve announced no change in interest rates. However, they did unexpectedly change their specific language for when rates could increase from “mid-2013” to “late-2014.” The Fed cited two specific reasons for the change: continued weakness  in our labor markets and a global slowdown (i.e. Europe). Clearly, they see more need for accommodative rates to support the fragile growth we have in our economy. 

Event 2:  US GDP Estimates were released for Q4 2011.  They showed the economy growing at an annual rate of 2.8% in Q4 of last year. Growth is always welcomed; however, when you look behind the headline numbers you see two interesting facts.  First, business’s rebuilt inventories to the tune of 1.9 percentage points of the 2.8% (that's BIG).  Second, the US Consumer grew spending by 2 percentage points (There were several categories that subtracted GDP therefore these two numbers won't add up).  Our conclusion, inventory rebuild cannot be depended upon to add to GDP in the coming quarters as businesses don’t just build blindly. Especially, as consumers still appear very cautious about spending.

% Change in Personal Consumption Expenditures

Change in Private Inventories

Event 3:  The President focused his State of the Union Address on rebuilding the United States’ manufacturing base.  We view this as a good thing because much of what we manufacture is exported and exports generally benefit from a weak dollar. Because of the Feds unexpected actions (event #1), we should continue to see a weaker dollar. The manufacturing sector can be a large employer and an improvement in this sector can help improve the labor markets.

Without revisiting our yearly forecasts the storyline of these three events is pretty clear: Continued slow growth ahead for the next year or so.

Given these events, as an investor I might consider a few things:

• Pushing fixed income maturities out a bit (from 3-5 years to 5-7 years)
• Look beyond dividend paying stocks and perhaps select some energy and agency issues that can enhance income.  Be careful as these can be tricky investments.
• Inflation is a customary risk with all this cheap money floating around and certain commodities are going to be attractive.  I don't necessarily believe inflation is a threat in the short run.  Most of this cheap money is still being used to repair balance sheets for business and consumers.  Without money chasing goods and services, employment dropping; inflation might be a delayed effect.

One thing seems certain; we could be in store for another average year.  As an investor and advisor, I would strongly look past just one years’ worth of numbers as they really are irrelevant.  I was recently reminded of that by economist Robert Shiller when he quipped, “I don’t know why people keep using one year earnings. That is the time it takes the earth to go around the sun. I don’t see any other significance.”

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

For just once I would like a piece of economic data without strings attached.  I long for the olden days of the 1990's when everything just pointed up and you hardly had to think as an investor. Just steer the car in the right direction and it would go where good returns were a commodity and all the data was great.

Oh how I wish.......

Today, everything seems to have a cautionary note attached.  Take for example our recent jobs report.

The Bureau of Labor Statistics (BLS) reported the unemployment rate dropped to 8.5% in December, down from 8.7%.  This is the lowest reading in almost 3 years.  Subsequently, we saw an addition of over 212,000 jobs in the private sector.  

The cautionary tale is that within this data, there were roughly 42,000 jobs added in the courier and messenger industry which was most likely due to the seasonal upswing of the holidays.  When you normalize this out, you get closer to the 150,000 jobs number which is more in line with expectations. 

On the side of bad news, we saw many retailers post weaker than expected numbers. Companies like Target, Wal-Mart and J.C. Penny’s reported to either have missed or reduced earnings forecasts. However, certain retailers such as Macy’s and Zumiez (a specialty retailer) reflected some pretty strong numbers. Some attribute the weaker numbers as a result of mis-timing promotions and under stocking inventories.

Finally, we have two confusing messages on Leading Economic Indicators.  

The two charts above compares the Economic Cycle Research Institute (ECRI) Weekly Leading Index (WLI) to the Conference Board’s (CB) Leading Economic Indicators (LEI) over the span of many decades. From the data you can see that for most of the WLI and LEI’s history there is a reasonable degree of correlation. However, beginning in the spring of 2010 (only 6 months after the last recession) we see a major unexplained deviation between the two. 

Perhaps all the divergence in this data is due to a schizophrenic economy or possibly it’s a sign we might be at a pivot point from a macro perspective. Or maybe, this is just the "new normal" and if that’s the case, we'd better get used to it always being something.

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

Tim Phillips, CEO – Phillips and Company

The start of the year has me preparing for meetings with endowment and foundation committees as well as strategic planning meetings for our firm. In general, I take a macro view on key themes that could impact investment outcomes and build those into my meeting preparations and strategic plans. Last week, I shared my wild guess as to the outcome for the S&P 500 by year end 2012.

The base case for economic forecasting is as follows (provided by Bloomberg):

• 2.10% Real US GDP Growth
• 8.70% US Unemployment
• 2.10% US Inflation
• 2.28% Real Global GDP Growth

Using that as my starting point, here are my key themes for this year’s base case:

US Economics

As you can see, the consensus estimates are a bit muted. My guess is there’s a 25% chance of an upside surprise driven by two main factors, foreclosures and consumer spending. First, foreclosures should begin to help clear the system and housing prices could stabilize this year. Secondly, the consumer could feel confident enough to spend down savings a bit more despite the lackluster wage growth.

US Politics

You can hardly mention consumer confidence without commenting on the state of politics in America. Contrary to popular opinion, I don't see public policy playing as large a role in 2012 as it did in 2011. In my opinion, there are only two big events that will play out this year in public policy:

• An extension of the payroll tax cuts beyond 2 months
• The Supreme Court’s ruling on ObamaCare.

The payroll tax is likely going to get extended without much of a fight as Republicans basically conceded that ground in December. The President will also make a public affairs debate over two key provisions in ObamaCare that are wildly popular: child health care and health care for people with pre-existing conditions.

Any other major debates will probably wait until after the election. The President wants to paint Congress (read Republicans) as a “do nothing congress” so it may be in his best interest to propose nothing. On the other hand, many in Congress want to paint the President as ineffective at getting things done, so it may be in their interest to propose nothing as well. We'll have to see who wins this stalemate in the coming November. As for markets, a year without big policy considerations might be helpful.

Europe

European Union countries may likely slip into a recession if they are not in one already. This on its own is already baked into the base case scenario and would certainly be a drag on Global GDP growth as the European Union is the largest economy in the world. Underweighting Europe has always been our mantra for years. However, there could be a low probability of an upside surprise if the recession is mild and the EU finds more ways to stabilize their currency and banks. Although, if a series of defaults occur outside of Greece, we could see a large drop in global equity markets.

What's a bit more troubling than the impact on our GDP is the impact on emerging markets.

Emerging Markets

While there is plenty of opportunity in emerging markets this coming year, one significant drag on that possibility is Europe. What most people don't realize is that the EU banks have been very large lenders to emerging market countries.

Since EU banks don't seem to want to issue new stock at cheap prices, they will most likely pull back on lending both at home and abroad. This is potentially bad as the EU banks are large players in both US and emerging market lending. I'm cautiously optimistic the emerging markets will provide positive returns this year.

US Markets

While my base case calls for the S&P 500 to close at $1,339, I do see a few areas of potential upside. One may be to continue concentrating on high dividend paying stocks, although this is hardly a fresh perspective. I continue to focus on high yield and distressed corporate bonds for those that can appreciate the risks. Additionally, I favor mid-cap stocks over small cap stocks this year. Large corporations have record levels of free cash flow and net income that I believe could be used to acquire smaller companies in the mid-cap sector.

To summarize, many global risks have been built into the base case outlook and there certainly could be some great upside surprises this coming year making the base case look very conservative. On the downside, a European Union breakup and defaults would crush Europe, damage Emerging Markets and have a strong negative impact on our markets. No portfolio would be exempt from this shock, but I consider this scenario highly unlikely.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

It's that time of year when everyone in my business tries, in earnest, to predict the markets for next year. I've spoken to some of these professionals and my takeaway is that they (still) tend to believe in their prognosticating skills.

In my profession, I’ve come to observe that the more “precise” you are, the more people are apt to find comfort in believing you. People seem to believe if you make very precise statements it must mean you are very confident and therefore it has to be accurate. Unfortunately, in my profession the opposite tends to be true when it comes to forecasting. The more precise the forecast, the more inaccurate the forecast tends to be.

The best example of this in 2011 was Meredith Whitney’s very bold, very precise, and very inaccurate prediction for the municipal bond market made last December 19th, on an episode of 60 Minutes where she said:

“There’s not a doubt in my mind that you will see a spate of municipal bond defaults... You could see 50 sizeable defaults, 50 to 100 sizeable defaults, more. This will amount to hundreds of billions of dollars worth of defaults”

Then later in the same interview in regards to rating agencies and their relationship to the municipal market:

“When individual investors look to people that are supposed to know better, they’re told – they’re patted on the head and told it’s not something you need to worry, about when it will be something to worry about within the next 12 months”

This prediction was heard around the world. She made the cover of magazines, and multiple TV appearances. It appears being precise is better for business than being accurate.

Since her prediction on Dec 19^th, 2010 the municipal market has returned 10.5% as of Dec 16^th according the Merrill Lynch Municipal Master Index. That beats U.S. Treasuries, stocks, corporate bonds and commodities. The municipal bond market was arguably the best performing asset class of 2011.

In keeping with the parlor trick theme, I will make my stab at outcomes for 2012.  Here it goes:

For 2012, I predict the S&P 500 earnings will be $103/share with an earnings multiple of 13. This would make a year-end target of $1,339.00 on the S&P 500, an increase from $1,265.33 which was seen at the close this past Friday, December 23^rd.

I see a very nice move in the equity markets in early Q1 driven by continued rebuilding of inventory.  Q2 will be a bit tougher as we have continued slack in housing and the peak of foreclosures take hold.  The second half of 2012 will be election driven and perhaps a choppy but rising market.

Europe will be the market to watch and certainly those that overweight their portfolio now could be richly rewarded, but I will not be one of them. Even if they solve their currency and debt problems, they still have a culture of leisure that I predict will keep them in recession or near a recession for a longer period of time.

Of course, a European disaster would spell an extreme event of perhaps 25%+ downside.  The actual GDP impact would most likely be small, however, I believe the equity markets would react swiftly and forcefully.

Asia (China) growth will slow slightly but much of that appears to have been discounted in 2011 as the Hang Seng Index and the Shanghai composite are down -19.13% and -22.86% year to date respectively. While many might run from Asia, I believe they have taken the brunt of the slowdown.

Ok, those are my best guesses.  I like parlor tricks so I played along; however, in the long run I tend to depend on solid allocations with specific tilts to take advantage of opportunities. The predicting is fun and if I'm right I'll be sure to let you know.  If I'm wrong and there is a high probability of that, then I will hope you are too busy to notice.  After all, this is a core concept for those in the parlor trick business.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Have a happy and safe New Years.

Tim Phillips, CEO – Phillips & Company

While Europe has been grabbing all the headlines winning our "Grim Reaper" award, there has been one country quietly accumulating some momentum, the United States. The U.S. has been posting some fairly positive numbers so far for the month of December. As you can see from the chart, we’re about evenly split between indicators that have beaten expectations and those that have not.

Most important are the weekly claims numbers that may suggest we are seeing a slight improvement in job growth. The data above shows that initial jobless claims have been significantly better than expectations for the past two weeks in a row.

Even with retail sales missing estimates, a breakdown of the 13 components show an interesting trend; consumer cyclical sectors all beat estimates while staples generally underperformed.

The Market may already be taking notice of our situation and acting accordingly. The U.S. dollar has recently strengthened against other currencies (especially the Euro) and coincidentally we’re seeing gold continuing to sell off. There has also been a lot of talk about gold breaking below its 200 day moving average of around $1,690 which is a bearish technical pattern. On Friday, the spot price of gold closed at $1,599/oz, down 15.89% from its high of $1,900/oz on September 5^th of this year.

With a 2011-2012 federal budget signed into law, we can move that debate off the table. Up next, we have payroll tax cuts and unemployment insurance and a two month extension would be counterproductive.  Who is going to run out and spend their two months of benefits if they think it will be their last? We believe a good resolution to this debate could support another 1% of GDP growth next year.

Finally, with the holiday fast approaching I want to thank all of you on behalf of everyone at Phillips and Company for your trust and confidence.  This has indeed been a volatile year that has been taxing for individuals and institutions.  We hope this holiday provides you with some time with family, friends and some moments of joy and happiness.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Happy Holidays and Merry Christmas!

Tim Phillips, CEO – Phillips & Company

Hat tip to Bespoke Investment Group for the Economic Data

Last week, we touched on a report from the Economic Cycle Research Institute (ECRI) that calls for the United States to enter a recession in 2012. This deserves further examination for two reasons. First, it’s a significant outlier from other 2012 GDP forecasts. Second, they’ve correctly called three recessions without any false alarms in-between.

The ECRI’s call is based on a number of leading indices which a key piece is their view on the United States Gross Domestic Income (GDI). GDI is similar to GDP conceptually in that it adds up a set of economic components. GDI is different from GDP in that it adds up economic components from the other side of the equation. In other words, GDP gauges the economy from the expenditure side, while GDI gauges the economy from the income side. In theory, the two should be equal but are usually not because in practice they are calculated in different ways. Where GDP is the sum of consumption, investments, government spending and net exports; GDI is calculated based on employee wages, corporate profits, and tax revenues. Looking at our economy based on income is fairly intuitive as income drives consumption and 70% of our economy is driven by consumption.

According to the ECRI the last reading on GDI was 0.30%. This is much lower than GDP which came in at 2.0% down from the initial reading of 2.5%. The ECRI goes on to explain that when you have a two quarter annualized GDI growth rate of 2% or lower, you reach a recessionary stall speed. The last reading was 0.28% and has been trending down steadily.

Looking past the troubling GDI data there are still a couple of interesting data points on what consumers are doing with their income.

First, according to the Bureau of Economic Analysis, income increased faster than spending and the savings rate increased slightly:

Personal saving --  (disposable personal income) DPI less personal outlays -- was $400.2 billion in October, compared with $376.9 billion in September. Personal saving as a percentage of disposable personal income was 3.5 percent in October, compared with 3.3 percent in September.

The savings rate ticked up in October, however, the trend still appears to be going lower. Consumers appear to be feeling more confident because they are more willing to spend down savings in order to consume.

Second, consumers have been using more revolving and non-revolving credit in the last couple of months to increase consumption.

As for companies, they are sitting on $2.11 trillion in cash. When you put this in terms of the total assets on their balance sheet – cash on the sidelines – it’s at a 30 year high. After all, many non-financial companies were frozen out of the debt and overnight lending markets by banks which almost collapsed their businesses.  However, there will come a point when they deploy this cash for higher returns.

Last but not least, corporations have had another banner quarter of record earnings which we did discuss last week.

So while the GDI data suggests gross income for our country is down, the consumer is still finding ways to consume.  Maybe it's just in our behavior to consume and we can't help ourselves.  Perhaps our consumption is unsustainable and we will fall back into a recession.  No one really knows what next year holds and the best bet is to tailor your investment strategy based upon shaping risk with time and allocating accordingly.

I for one wouldn’t want to bet against the consumer demonstrating unsustainable habits because history has shown how resilient the US consumer can be to spending at an unsustainable rate

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Hat tip to Calculated Risk for the savings graph, and Ritholitz and Arbor Research for the “cash on the sidelines” graph

Over the last two weeks we've looked at the European Debt Crisis and the potential impact on US exports if Europe falls into a recession (What’s All the Fuss?). We also covered the challenges many European countries face on budget agreements as a consequence of each country’s relatively unique social programs (The Cost of Leisure Part 2). It seems to me there is a lot of emotional noise; perhaps it’s time to step back and look at issues a little closer to home.

The official start of the 2012 presidential election campaign season is just 30 days away with the Iowa caucus on January 3, 2012. That means the political class has just one more chance to get something done and as a result, it appears we’ll have an extension of the employee payroll tax cut and unemployment benefits. These extensions will likely be funded with “kick the can down the road” funding mechanisms which will lead to cutting expenses sometime in the future.

Economic data was pretty mixed last week. Probably the biggest headline surprise was the drop in the unemployment rate to 8.6% down from 9.0%. Unfortunately, it was largely due to the decline in the Labor Force Participation Rate which fell well below the 66% to 67% rate that has been the norm over the last 20 years. On the positive side, October and September hiring numbers were revised up to 100,000 from 80,000 and 210,000 from 158,000 respectively.

Overall, our economy is still at a very fragile point and we’ve pointed out how a simple quarter of a percentage point can be the difference between expansion and contraction for our economy today. The Economic Cycle Research Institute (ECRI) still expects the US economy to tip into a new recession in 2012 despite what our policy makers do (you can read a summary and the full report here). The bottom line is, ECRI is basically saying, “If you think this is a bad economy, you haven’t seen anything yet.”

Companies continue to beat earnings expectations at pre-recessionary rates however we saw a big drop in the revenue beat rate. At the end of the US corporate earnings are near record highs thanks to improving margins.

Abroad, European Union Leaders meet for their next big summit in Brussels this Friday. We expect the leaders to continue to agree on being more connected through budget agreements and determined to save the EU and the Euro. However, anything can happen and the markets are growing impatient. On the other side of the Americas, we saw China unexpectedly cut required reserves by 50 bps.

Looking across the board, I think in the near term the upsurge and downsides are a toss-up and we need to continue to dig deeper to find the right allocation path. Remember without the uncertainty, the opportunities to generate returns would prove to be difficult and underline how critical it is to shape the risk by using time well.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

As we discussed earlier this month, a recession seems almost inevitable and the impact on US GDP growth is negligible. In fact, this morning the Organization for Economic Cooperation and Development warned that Europe risks a severe recession if they can’t halt the sell-off in the Eurozone sovereign debt market. What we did not discuss last week was a potential full blown collapse of the Euro.

What would happen if the 27 country European Union dissolved over a failure to come to terms with member country debt? After extensive searching, I’ve realized I cannot find a single paper written by the International Monetary Fund (IMF) or the European Union (EU) outlining a contingency plan to dissolve the EU and the Euro. Likely, any plan could be catastrophic if leaked and probably not worth the risk of writing. Perhaps this indicates a failure of the EU is not conceivable by the parties.

Before we can address what would happen if the EU fails we should review what's holding the countries back from agreeing on a solution.  In simple terms, Germans don't want to pay for Italian leisure at the expense of their own and each country has their own social programs (some much more generous than others).

Countries with these generous social programs need their economy and GDP to grow fast enough to cover the costs. When their economy doesn’t grow fast enough, they must borrow to keep their promises. Currently, it appears to be seen as political suicide for a Leader of an EU member country to decide to cover the debts of a “lazier” EU member country. So what are some possible solutions?

Eurobonds are still out of the question because it puts the burden of generous social programs onto the stronger economies. Hypothetically speaking, if Eurobonds are issued at 4.5% then any member country that was paying more than 4.5% would benefit and any member country that was paying less than 4.5% would be disadvantaged. Germany doesn’t want to backstop Italian summer vacations.

Reworking the EU treaty to stipulate more fiscal controls would certainly be a good place to start if everyone was going to share pain.  However, convincing sovereign nations to give up fiscal control is not an overnight process. Getting the 27 members to agree on specific changes to the EU treaty would take more time than they have.

The International Monetary Fund (IMF) could provide a rescue package or credit line to troubled EU members. This option would keep the EU together and buy additional time to revise the EU Treaty. The catch is who funds the IMF. Approximately 17% of the IMF’s funds come from the United States. Instead of Germany paying for Italian summer vacations it will be you and me.

There is also a possibility it may be too late for any solution. What if it all failed? The truth is the largest economy in the world would spend several years trying to figure out how to re-trench and grow again.  The geo-political consequences would be significant and we would all face a really ugly "new normal".

We are working diligently to continue to rebalance away from Europe without giving up opportunities to profit. With markets moving so quickly in both directions it’s a non-stop effort to determine the "best" next moves. While Europe slides into a recession and perhaps a depression we will continue to work hard, just like you. I sure hope Europe enjoys their leisure now, because one day the cost might be too much to bear. That's how conflict really starts.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

As of this writing on Sunday, the Joint Select Committee on Deficit Reduction, i.e. the Supercommittee, is poised to admit defeat.  Once again, Washington is gridlocked and if the markets react like they did during the summer’s debt extension debate there’s potential for another round of market volatility.

Even though “across the board cuts” won’t start until 2013, I have concerns today with how our macro-economy and GDP will be affected if our debt problems balloon to an impasse like those of Europe and Greece. 

For example, if our GDP grows at an annualized rate of 2% each year from 2011, then the first round of cuts in 2013 would amount to 0.44% of GDP.

These year-over-year spending cuts would have a significant impact on GDP particularly since we are already experiencing anemic growth.  To make matters worse, if you include the 0.25% hit to GPD from our import/export relationship with the European Union, then our economy could face close to a 0.75% hit to GDP in 2013.

The markets care about this a great deal. Right now, there seems to be a tremendous focus on companies that receive substantial government funding like healthcare and defense spending. Looking at healthcare and more specifically the home healthcare and assisted living sectors, anticipated cuts to Medicare appear to have already been priced as seen in the YTD performance of the following healthcare companies:

Smaller defense and aerospace companies whose revenue relies greatly on significant government contracts could also come under pressure if these “across the board” cuts actually happen. While the S&P 500 is only down 4.80% since August 2nd (when Obama signed the Budget Control Act of 2011), there is potential for more negative markets.

With all this doom and gloom, let’s look at the bright side for a moment.  It is likely many market participants have already discounted what they always knew: that partisan politicians can never get anything done and provide us a tremendous buying opportunity in light of expected GDP growth.

Let's see who shows up for the big announcement and who really cares. We certainly do.

Have a happy and joyous Thanks giving!

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

By now, I think it’s safe to say investors have been sufficiently tortured by what’s happening in the European economy.  The moment Greece moved off the headlines, Italy took center stage. Once the media gets tired of Italy and the markets adjust, they will probably move on to the next victim country.

What’s not talked about is how this may directly impact the US economy and our GDP.

First, the European Union is the largest Economy in the world. The European Union combined with the United States represents almost 50% of the entire World’s GDP. 

Clearly Europe matters, the question is, how much does Europe matter? Over the last 12 months we have exported approximately $324 billion dollars to the European Union in goods and services. We also import more from Europe than we export; therefore we have a negative trade balance which subtracts from our total GDP. This negative gap could grow significantly if we continue to import goods from Europe and we are not able to increase our export goods. 

As a quick rule of thumb, every $140 billion in economic activity is 1% of our GDP (1% of $14 trillion is $140 billion).  With that in mind, a 10% drop in exports to the European Union would be a decline of $32.4 billion in US GDP (about ¼ of 1% of our GDP). Under normal economic conditions that wouldn’t mean much.  However, under current circumstances 1/4 of 1% means something. 

Last week, we highlighted the Federal Reserve’s economic forecast where they slashed their 2011 United States GDP growth from a range of 3.3%-3.7% down to 2%-2.5%. Under current circumstances, a 0.25% drop in GDP would be 10% of our growth. 

The International Monetary Fund has trimmed its European growth forecasts to 1.4% and I believe the markets are expecting a European Recession. It's not hard to imagine their economy slipping into negative growth if there are no bold policy considerations for bailing out irresponsible, socialistic member countries of the European Union.  As I have said several times in presentations, this is the price for leisure.

I believe most of the bad news is already built into our markets, which is good news to me. Looking at export numbers year to year, exports to Europe peaked in 2008, fell steeply in 2009 and rebounded in 2010. Year to Date, 2011 looks to be better than 2010, but not quite as good as 2008 leaving more upside for US exports to the European Union in 2012.

When we get all the nasty headlines about Europe try to look past the emotion and perhaps we won't lose export ground as much as some pundits believe.  If this is indeed the case we could see a nice upside surprise to our markets.  Now that would be something to fuss over!

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Last week, we discussed the details of the Bureau of Economic Analysis’ (BEA) advance estimate of US real GDP for the third quarter. Sticking with the GDP theme, later that week the Federal Reserve came out with their fourth and final GDP and unemployment projections for the year.

GDP and unemployment projections have moved in the wrong directions since the beginning of the year. The November projection for 2011 GDP is expected to be 1.6% to 1.7%. This is much lower compared to their projection of 3.4% to 3.9% at the beginning of the year. Based on these new projections the Fed does not expect a 3.0% or greater change of real GDP until 2013!

As for the unemployment projections, the Fed still expects 9.0% to 9.1% for 2011 and does not expect to see unemployment under 8% until sometime in 2013.

According to an analysis by Bill McBride, author of the economics blog Calculated Risk: 

If we continue to see sluggish growth with 125,000 payroll jobs added per month (the pace this year), it will take an additional 52 months just to get back to the pre-recession level of payroll employment.

If job growth picks up a little - say to 200,000 payroll jobs per month - it will take an additional 33 months to get back to the pre-recession level.

Based on those numbers, unemployment won’t return to the pre-recession level until somewhere between July 2014 (blue line) and February 2016 (red line). McBride also notes that these projections do not include population growth and new entrants into the workforce.

While these numbers might be slightly depressing, it’s important to realize they are moving in the right direction, albeit slowly. GDP numbers continue to stay positive and we continue to have positive net jobs added per month. For now it looks like the US will avoid a “double dip” recession and continue its slow growth trend. In fact, Merrill Lynch and Goldman Sachs raised their Q4 GDP forecasts on the heels of the BEA numbers last week citing the same reasons we did previously, improved domestic demand and increased consumer spending.

It’s important to protect your portfolio from downside fluctuations, but it’s equally as important to not get caught flatfooted and miss a potential year-end rally. Historically, November and December are two of the best months of the year for US equities. 

Between the European Debt Crisis and our own fiscal problems there are plenty of downside catalysts, but if the consumer decides to spend more than expected this holiday season we could continue to see positive surprises in consumption and GDP.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

“Average Monthly % Change for the Dow Jones Industrial Average” provided by Bespoke Investment Group

You hear a lot about “risk on” and “risk off” by the media to describe the day-to-day short term volatility. For example, in the third quarter the S&P 500 fell 13.87%, clearly a “risk off” quarter. Then in October, as of Friday the 28^th the S&P had increased by 13.74%, clearly a “risk on” month. At the end of all this, the S&P was actually up by 3.87% so far for the year.

The last four months have been a roller coaster ride but it’s important to maintain an intermediate and long term perspective in order to invest in the right areas. With that in mind, we took a deeper look at the advanced real GDP numbers. According to the BEA and based on the advanced estimate numbers, the US Economy increased by 2.5% in the third quarter. This number was in line with consensus and better than the first two quarters of the year.

Looking deeper into the GDP numbers, you can see that third quarter was clearly a “consumption on” quarter when compared to second quarter:

I would say this is better than another “inventory rebuild” quarter, but we are still not out of the woods until we see wage inflation. “Consumption on” is much better than “consumption off”, but we need to make sure it’s sustainable consumption.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Hat tip to the Dismal Scientist for the spending graph

We have now entered the final quarter of the year and Alcoa kicked off the final earnings season after the bell on October 11^th. As we hit the home stretch we wanted to look back and compare the S&P 500 forecast from the beginning of the year, to current S&P 500 forecasts. Back in January, the average forecast for the S&P 500 2011 year end was 1384. As of October 17^th the average forecast is approximately 100 points lower at 1282. What happened?

To understand what happened, first we need to understand how they come up with year-end forecasts for the S&P 500. It’s basically two things: forecasted Earnings Per Share (EPS) and a forecasted multiple.  The EPS is based on the aggregated forecasted EPS from all the companies that make up the S&P 500 index. The forecasted multiple is based on the estimated level of certainty and predictability of those earnings. When there appears to be more certainty, multiples go up and when there appears to be less, multiples go down.

Earnings have been fairly good for the year and this earnings season appears to be shaping up similarly to the last two quarters; possibly a little better. The percentage of companies that have beaten earnings estimates so far is higher than the last two quarters (this is based on the companies that have reported as of October 21^st). 

Taking a look at the first variable EPS, the average 2011 EPS forecast for the S&P 500 was $92.75 at the beginning of the year. As of October 17^th the average 2011 EPS forecast for the S&P 500 is actually up $3.60 to $96.35. This underscores the fact that companies are continuing to meet and beat earnings estimates throughout the year. Clearly, this part of the formula is not bringing down the forecasts for the S&P 500.

The other variable in the S&P 500 year-end forecast is the multiple. The mean year-end forecast at the beginning of the year implied a year-end S&P 500 multiple of 14.9. The most recent year-end forecast now implies a year-end S&P 500 multiple of 13.3.

This contraction in the multiple is highly likely due to the increase in global uncertainty. In the United States, you still have the fiscal uncertainty and political silliness surrounding the “Super Committee.” The Committee’s deadline is November 23^rd to come up with a proposal and congress is supposed to vote on the Committee’s budget proposal on December 23^rd. In Europe, you have a grocery list of monetary and fiscal issues that are creating uncertainty in the Eurozone and the future of the Euro. German Chancellor Angela Merkel and French President Nicolas Sarkozy are supposed to make a big announcement on Wednesday regarding “a broad agreement” regarding these uncertainties. Lastly, in China you have talks about slowing GDP growth, and a real estate market bubble that could lead to a “hard landing.”

The bottom line is corporations are driving good earnings with a back drop of global political uncertainty. It used to be you could count on the corporations and the CEOs to do something that would create a circus. For example, Koslowsky at Tyco buying $6,000 shower curtains paid for by shareholders.  Now it seems like the politicians are the clowns under the tent.

This circus show might be hard to watch right now, but my guess is corporate earnings and opportunities through innovation will win out over rhetorical fights, political gridlock and self-interest. In my opinion, the best way to take advantage of this current environment is to continue to invest prudently, be patient, and align investments with time horizons.

To leave you on a hypothetical high note; if we were to take todays projected S&P year-end EPS ($96.35) and multiply it by the first quarter’s year-end multiple (14.9). You would get a year-end target of 1435 for the S&P 500 and a 14.5% rally between today and the end of the year.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Lately everyone I talk to from small business owners to “the men on the street” are words of doom and gloom. They all express significant doubts about the global economy and think a recession is all but guaranteed at this point.

• Consumer confidence is near a 30 year low, last seen during the “Great Recession.”
• Congress’ approval rating is at an all-time low – 13%
• Presidential approval rating remains at term-low – 41%

Overall, the mood of the country is awful and the people are targeting Wall St. and K St. for their general malaise.

Despite all of the negativity in the air, the US economy is still posting some signs of growth. To be clear, the signs suggest very slow growth, but growth none-the-less. If you look at the last few weeks of economic indicators most of them have been above expectations. For example, retail sales in September rose 1.1% from last month and 7.9% from the same month last year. Retail sales are now 4.5% above the pre-recession peak.

There seems to clearly be a divergence between the mood of our country and its economic indicators. This phenomenon can happen for a couple of reasons.

The first is that indicators have not caught up to our mood. This is usually the case when only lagging indicators are above expectations. However, we have seen some leading, lagging and coinciding indicators come in above expectations over the last few weeks.

The second is a straight forward but less obvious psychological explanation. Over the course of my 25 year career in money management I’ve made a few observations about human behavior. One observation is people tend to weigh recent events more than prior events.

I believe this is the reason for the divergence between our mood and our economic indicators. We just went through a very traumatic financial crisis that most people have yet to fully recover from. Now, we have a similar situation potentially developing in Europe and those feelings from our own financial crisis might be bubbling up again.

You might be a bit skeptical of my behavioral observation and dismiss it as anecdotal; however, this is actually a well-known cognitive memory bias. It’s called the Peak-End Rule and it’s related to the Recency Effect. This bias was discovered by Daniel Kahneman, an Israeli-American psychologist and Nobel laureate.

Despite the “okay news” from the economic indicators, we are still projecting our fears forward judging our past experiences almost entirely on how they were at their peak and that wasn’t pretty. This is not to say that we aren’t in or heading towards another recession, but I’m suggesting we should be mindful of our human biases and avoid letting them lead us to bad decisions.

A few weeks ago we talked about getting paid for volatility and we continue to look for good investment opportunities that can pay the rent. Including high yield corporate bonds, high dividend US large cap equities and preferred equities.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

The equity markets performed well last week after a historic late day rally on Tuesday. However the prevailing mood of business and consumers are of significant caution and concern. 

At the end of the day 70% of our economy is based on consumption. If people aren’t buying, then businesses can’t be hiring. If business aren’t hiring, then people can’t be buying. So which needs to come first in this “chicken or the egg” dilemma? We believe the consumer needs to come first and then businesses will follow. Keynes described this predicament in 1936 as spontaneous optimism.

In a recession, government spending can help spur spontaneous optimism.  However, it appears to have had little effect on our economy over the last three years. Outside of government spending Keynes would probably advocate for two additional solutions: a stable tax policy and a regulatory environment that allows businesses and consumers to make longer term plans. With the house and the senate controlled by different parties and a political polarization above 90% this doesn’t look likely.

M&A and IPO activity can be indicators of spontaneous optimism for businesses. Both of these events can inject more liquidity into our economy and suggest optimism from buyers. M&A activity has been fairly stagnant over the last few quarters and ventured-back IPO activity is at the lowest level in seven quarters according to Thomson Reuters and the National Venture Capital Association (NVCA). 

For consumers, an expansion of credit and willingness to borrow can be early signs of spontaneous optimism. Unfortunately, according to the Federal Reserve, consumer credit decreased at an annual rate of 4.5% in August. This was first decrease in in consumer credit in nine months.

None of these look very optimistic. However, as W. Somerset Maugham (the best paid author of the 1930’s) said, “When things are at their worst, I find something always happens.” He probably knew a thing or two about spontaneous optimism.

If you have additional feedback we encourage you to get in touch with us via  Twitter, Facebook, or Email me directly.

Last month, European physicists announced that they may have put a serious dent in Albert Einstein’s theory of relativity when they suggested it might be possible for something to travel faster than the speed of light. With relativity on the mind and a trove of economic data released last week, we decided to look at the actual numbers relative to what people were expecting. Surprisingly, most indicators actually beat expectations.

Overall 14 out of 18 reports were better than expectations. This included new home sales, durable goods, GDP, jobless claims and personal consumption.

This doesn’t have the same ground breaking implications that the European physicists’ findings do about relativity and it doesn’t mean we are not slipping into or not already in a recession. It does imply though, that there may be some pretty negative expectations already built in.

After the sizeable decline in July the market was relatively directionless and range bound for the remainder of the third quarter. Emotions seem to be ruling the day and a directionless market can still churn stomachs. The average daily change in the index for the last 40 days of the quarter was +/- 1.9%!

Continuing with the theme of relativity, we looked at how the market performs on average during different quarters of the year. 

The third quarter is historically the worst quarter of the year (this year being no exception so far) and the fourth quarter is historically the best quarter of the year. Relative to the other quarters of the year, the best quarter is still yet to come.

If we have already built in negative economic expectations and people are fearful due to the volatility, then a few economic surprises and little consistency this quarter could go a long way in providing a nice return backdrop for the fourth quarter, relatively speaking of course.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Hat tip to the Bespoke Investment Group for the charts and tables. 

Investor and consumer sentiment are near all-time lows and the instinctive thing to do is to follow the crowd and run for the exit. 

Behaviorally speaking I call this, “risk as emotion versus risk as fact”.  Humans tend to view risk through an emotional lens.  When we see things that may be threatening to us we have a fight-or-flight response.  This is a good response for staying alive in a hostile world, but usually not a good response when it comes to investing. When things get bad (sentiment and prices are low) we sell and conversely when things are great (sentiment and prices are high) we buy.  Therefore you get the paradigm of buying high and selling low with the typical individual investor.

The good news is we can use sentiment as a contrarian indicator. When things get bad (sentiment and prices are low) and the individual investor is so dour, generally it can be a good time to buy. The real question in my mind is, “what is it time to buy?”

Right now global economic issues are driving the major moves in the markets. The prevailing global economic issues are Europe’s capital flow concerns and the United States’ fiscal policy concerns. Both issues are not likely to be resolved anytime soon.

According to the International Monetary Fund, The European Union is the largest economy in the world. It will take a coordinated effort by all the Eurozone members, led by Germany and France, to get the capital flowing in the region. These efforts will also take time to work their way through the Eurozone financial system and the global financial system.

As for the United States, the political class doesn’t want to solve our fiscal problem overnight even if stable fiscal policy is what’s wanted and needed. Both sides seem to want to kick the can down the road until elections because fiscal (tax and spending) policies are big ballot items.

If there is going to be continued uncertainty in the world’s two largest economies, then volatility should continue as well. My strong belief is investors should be paid for taking risks. Simply buying stocks and holding during volatile times doesn’t mean you’ll get paid. Based on my belief I’d like propose a tweak to that approach. Look at investments that pay you to hold on during volatile times.  If companies can "pay the rent" (dividends or interest) to be in your portfolio, then it can be easier to look past the volatility in price and easier to resist your fight-or-flight instinct of buying high and selling low.  Below is a table of asset classes which have been “paying the rent:”

Once we see some certainty in fiscal policy for our country and capital flows for Europe we can make a tilt toward growth.  In the interim, let's get paid for dealing with the volatility.

Once again, if you haven’t had a chance to fill out our survey we encourage you to do so. The outcome will lead us to developing a better experience for you and perhaps better outcomes for your wealth. If you have additional feedback we also encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Tim Phillips, CEO – Phillips & Company

tphillips@phillipsandco.com

Research provided by:

Adam Gulledge, Associate – Phillips & Company

Focusing on one side of the balance sheet for consumers and corporations from a big picture standpoint you have: debt (liabilities) and net worth (equity). Adding up government, business and consumer debt, we are sitting at a nominal record of $36.5 trillion in debt. Looking specifically at the consumer debt numbers, we are in slightly better shape than we were in 2009 but still significantly above our historical average debt level relative to GDP:

• Current Total Household Debt (6/30/11): 66% of GDP
• Total Household Debt in early 2009: 76% of GDP
• Historical Average Total Household Debt: 37% of GDP

According to the Federal Reserve’s Flow of Funds data, total US consumer debt is down from the $13.93 trillion peak at the end of second quarter of 2008 to $13.30 trillion at the end of the second quarter of 2011. That’s a decrease of only $630 billion over three years, or only 210 billion a year.

So far this is not a pretty picture; let’s look at the other part.

On the other side of the balance sheet picture is net worth.US consumer’s net worth is down from the $65.9 trillion peak in 2007 to $58.5 trillion at the end of the second quarter this year. That’s a decrease of $7.4 trillion dollars. If consumers are only paying off $210 billion a year in debt (assuming everything else is equal) it would take roughly 35 years for household net worth to reach the 2007 peak of $65.9 trillion dollars.

The consumer balance sheet is not a pretty picture. Even though it appears to be heading in the right direction, it has a long way to go. The consumer needs to continue to repair their balance sheet and this means the consumer will have less of a desire to speculate, consume, and invest.

Based on this scenario it would be nearly impossible to get the net worth of the consumer back to the 2007 peak without somehow putting more dollars in the consumers’ pockets. This is one thing I think Washington DC understands which is why we are seeing so many discussions around fiscal policy. However, Washington also understands adding to our government debt is not a widely acceptable solution and leaves us in a consumption paradox.

Until we get to earnings season we will unfortunately only have a few economic data points and a public fist fight on policy. You can be certain the coming weeks will continue to be very volatile in our equity markets as the policy debates rage on in Washington. None of this will ease concerns in the markets.

However, if you can look past this short term phase of political silliness and focus on maximizing returns it might be wise to capture some attractive yields in the market. We’re focusing on high quality dividend growth and high dividend paying companies on the equities side, and bonds just below investment grade that still have an attractive higher yield. Frankly, as long as we select companies that can continue to pay the rent (dividends or interest payments) price fluctuations are less meaningful in the short run.

Once again, if you haven’t had a chance to fill out our survey we encourage you to do so. The outcome will lead us to developing a better experience for you and perhaps better outcomes for your wealth. If you have additional feedback we also encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

I'm from the Government and I'm here to help.

Tim Phillips, CEO – Phillips & Company

We heard that message loud and clear last week.  Bernanke gave a speech to reiterate the FED still has plenty of tools at their disposal and Obama gave a speech to a joint session of Congress discussing his plans to create more jobs in our country.

The day after their speeches the markets fell 2+%.  Either the market doesn’t believe these guys anymore or the market believes the problems in Europe outweigh any government help at home.

If we strip away the emotional reaction to the speeches and look at the facts, here is my assessment.

People elected to office are there to govern, make public policy and do things that try to improve our "lot" in life.  Unfortunately, sometimes they can do more harm than good.  My point is politicians –Democrat and Republicans– don't like to sit and do nothing even if doing nothing might be the right thing to do.  So I suspect congress will take action.

If they act on the Obama plan- this will pump about 450 billion dollars into our economy over the next year and some economists suggest (Mark Zandi – Chief Economist of Moody’s Analytics) we will add 1.9 million jobs. According to Zandi the net impact of all this could be a 2% bump to next year.

If investors begin to believe the old saying, “We’re from the government and we’re here to help” and the political class will actually get something done, then we might see some kind of lift in equity markets.

This week we have retail sales numbers coming out and consensus is for 0.2% M/M increase. Based on the consumer data I highlighted in last week’s commentary, I expect this number to come out above consensus. We are also coming to the close of the third quarter and I suspect earnings will be slightly better than expected. Until then, it should be an interesting next few weeks.

Last week, we started collecting some additional feedback to gain a deeper appreciation for the values you look for in a firm and its employees. If you haven’t gotten a chance to fill it out, we encourage you to do so. The outcome should lead us to developing a better experience for you and perhaps better outcomes for your wealth.

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We would like to honor those who lost their lives and loved ones on September 11, 2001. I was visiting the World Trade Center just one month before September 11^th and I will never forget the faces of those I met and spent the smallest sliver of time with.

Tim Phillips, CEO – Phillips & Company

@PHCO Advisors

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Research provided by:

Adam Gulledge, Associate – Phillips & Company

Risk vs. Return in Low Growth Economy

Tim Phillips, CEO – Phillips & Company

There is plenty of economic data to look at every week, but between Ben Bernanke’s speech in Jackson Hole and the September FOMC meeting there are three major economic data points:

• August employment (9-2-11)
• Retail sales (9-14-11)
• CPI (9-15-11)

Last week we had the first of the three come out and it suggests the recovery has hit a significant soft patch.

Looking at some of the other economic data consumers actually spent more than expected and saved less despite this recent soft patch.

According to a paper by Reinhardt & Rogoff titled, The Aftermath of Financial Crises, the average unemployment rises for almost 5 years with an increase in the unemployment rate of about 7 percentage points. If we use the date the National Bureau of Economic Research says the recession began, which is December of 2007 then that means we could have elevated levels of unemployment until December of 2012 (15 months away).

If we still have 15 months of elevated unemployment and a deleveraging consumer it could be hard to generate historical returns without assuming more risk. For example lower risk 10 year treasuries used to yield 3-4% and higher risk emerging market equities (based on the MSCI Emerging Market Index) used to return in the mid-teens.

In today’s slow growth and lower interest rate environment 10 year treasuries are now yielding less than 2% and emerging markets equity returns are flat to negative. We are being forced to accept either more risk or live with less return.

This is where blending asset classes to compose the right risk and return profile comes into play.

As you can see from the graphic above, based on historical data when you increase your diversification you can generate a higher return and lower standard deviation over time. Maximizing the power of diversification can be an easy way to increase your return and lower your standard deviation in this current environment with more risk and less return.

We are approaching the one year mark for our weekly market commentary and we have received plenty of feedback along the way. We wanted to take that feedback to the next level to try a gain a deeper appreciation for the values you look for in a firm and its employees. Below is a link to a quick online survey, the outcome of this work should lead to us developing a better experience for you and perhaps better outcomes for your wealth.

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Tim Phillips, CEO – Phillips & Company

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Research provided by:

Adam Gulledge, Associate – Phillips & Company

Uncle Ben is Not Afraid Why Should We Be?

Tim Phillips, CEO – Phillips & Company 

Last week everyone was focused on Ben Bernanke’s speech in Jackson Hole, where last year he outlined QE2. As we expected earlier this summer, he didn’t announce or outline “QE3.” He did however make some very key statements:

Ben confirmed that the Federal Reserve still has options:

“The Federal Reserve has a range of tools that could be used to provide additional monetary stimulus.”

“[The Committee] is prepared to employ its tools as appropriate to promote a stronger economic recovery…”

The economy is not in a deflationary (read recessionary) trap:

“Temporary factors… were part of the reason for the weak performance of the economy in the first half of 2011; accordingly, growth in the second half looks likely to improve as their influence recedes…”

Although we are not out of the woods yet:

“Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if--and I stress if--our country takes the necessary steps to secure that outcome.”

A fitting speech given that only 90 minutes before his speech, the Commerce Department lowered its estimate for the second quarter GDP growth down to 1.0 % compared to the initial estimate of 1.3%.

Value Opportunity or Value Trap?

Value Opportunity:

This morning Bloomberg noted that based on Friday’s close the S&P 500 is trading at 10.8x analysts’ forecast for profits in the next 12 months of $109.12 a share and that the five-decade average P/E of the S&P 500 is 16.4x. If companies meet analysts’ expectations ($109.12) and we see a revision back to the mean in the P/E ratio (16.4) then that would mean the S&P 500 would be at 1789.57. That is over 600 points higher on the S&P 500 than the close on Friday!

That may be wildly opportunistic given the current economic environment, but it definitely shows a margin of safety for value investors.

As of this morning the S&P 500 had a slightly higher yield than the 10 year Treasury bond. The last time this happened was in the fall of 2008.

Value Trap:

This potential opportunity could turn into a trap if consumer confidence continues to fade. We have been living in a skittish and frightened state for 3 years now with a “sell first and ask questions later” mentality.

Gallup’s Economic Confidence Index and the University of Michigan Consumer Sentiment Index (released the day of Bernanke’s speech) both fell to levels that were last seen early in 2009. Constantly living in a “sell first and ask questions later” mentality has made equity investing very challenging, but the opportunities tend to lie within the fear. If Ben does not see a deflationary (read recessionary) trap yet, perhaps, and that's a big perhaps, it's just the same fear we've been feeling in our economy for the last 3 years.

If you have questions or comments please let us know, we appreciate all of your responses every week!

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

Facebook.com/phillipsandco

Research Provided by:

Adam Gulledge, Associate – Phillips & Company

Cold Hard Facts

Tim Phillips, CEO – Phillips & Company

Last month I mentioned we might “face some pretty gut wrenching days ahead with tremendous market volatility.” That might have been an understatement with everything that has happened.

• Dysfunction in DC
• Weak economic data
• European bank problems
• Downward revision on economic forecasts

The real question is on many investor’s minds is, now what?

If we could all retire comfortably with our cash on hand and live off of near 0% returns, then that would be fantastic.  Unfortunately, individual investors, pension plans, endowments, and foundations need better returns in order to meet their future obligations. That necessity for returns is why we invest in riskier assets like stocks and bonds.

Since investing is a necessity and market timing is a parlor trick, let’s look past the Wall of Worry and look at some of the cold hard facts (charts are courtesy of the Bespoke Investment Group)

1) Companies reported better earnings and revenue last quarter.  They also raised guidance going forward.

2) Wall Street strategists are still holding onto their return expectations according to Bloomberg. In general, I don’t hold out much faith in this cohort; however they do look at data more analytically and rationally than most.

3) This year is looking a lot like last year. Both peaked at the end of April and saw a very weak summer where the S&P 500 went negative for the year. Last year that weak summer was followed by a monster rally that started just after the Jackson Hole Fed Meeting. That same meeting is set to take place this week.

Last year the Jackson Hole Meeting was on August 27^th. Between August 27^th and the end of the year the market rallied 18.94%.

Not to sound too wildly optimistic, there is a real chance the consumer loses confidence in this recovery and in the policy makers. Durable goods numbers come out this week which might give us a good indication. While I’m not a pessimist by any measure we could see more downside if consumption data shows significant weakness. Lastly, when markets drop this much they tend to overcorrect to the upside before building a base.

Here are some simple tips to make sure you are prepared for either situation:

• Review statements to make sure you don't have any unknown risks.
• Continue to reflect on your time horizon for the use of your investments.  If you have time (3 to 5 years) equity markets can be reasonable places to invest.
• Build in hedges for deflation.  If a slowdown in global growth occurs, there will be a mad rush for higher fixed income returns. This is something we focused on with our clients.
• Stop, challenge and choose your path based upon cold hard facts.  Emotions are always tempting to follow unfortunately more often than not they lead to poor outcomes.

We appreciate all the feedback we get every week I look forward to your responses throughout the week

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

www.facebook.com/phillipsandco

Primary research done by

Adam Gulledge, Associate – Phillips & Company

"After a wild week on Wall Street the world is different"

Tim Phillips, CEO – Phillips & Company

This was the cover of Time Magazine just after the crash of 1987.  I remember being very new in the business and thinking, "Had the world fallen apart?" At the time, I also thought a “crash" was a once in a lifetime event.  It looks like I was wrong on both accounts.

People think things are different because today we have High Frequency Traders, algorithms and hedge funds, but I would argue similar schemes and large investors existed in 1987 as well. Despite our 2011 “wild week on wall street,” the S&P 500 closed down only 1.64%.

In my opinion this wild week was due to the increased probability of another recession and uncertainty in the European Banking System (note uncertainty not failure).  At the same time, retail sales data came out that seems to suggest the consumer is not in too bad of shape (as we suspected). Sales continued to grow for the 4^th month in a row including increased sales for electronics and appliances.

We believe if another recession happened it wouldn’t be a repeat of the Great Recession of 2008.  Cyclical industries like automotive and homebuilders are not coming off revenue bubbles and are still bouncing along the bottom.

We also know that investor confidence and consumer confidence can be a threat to push the consumer back into a cave.  This is one we’ll need to watch closely.

I see two possible scenarios:

• If the consumer does not nose dive then this market reaction is overdone and opportunities lie ahead
• If the consumer does nose dive then the market was right and market prices have already taken that into account.

In other words, possible good upside opportunity with limited downside

The interesting thing about allocating cash into your portfolio at this time is the potential outstanding return opportunities:

The downside to reacting to emotions is the poor returns you can achieve when you try to time the market too much (I am a firm believer in opportunistic cash at the risk of being wrong many times):

Besides the yield on the S&P 500 is currently better than that of treasuries:

After weeks like this it’s a good time to review your investment time horizon relative to your needs. For individuals, this means thinking about your retirement time frame and determining how much time and ability you have to ride out “wild weeks.” For foundations and endowments this means focusing on the big picture; thinking multi-generational and not in terms of “wild weeks.”

Over the last 25+ years I’ve been in the industry, the world has definitely changed. However, over the last 2000 years, our emotions have not. Humans have always been “fight or flight” animals and unfortunately it’s not a good quantitative analysis tool.

If you have questions or comments please let us know, and we always appreciate all your feedback

Tim Phillips, CEO – Phillips & Company

Research Provided:
Scott Edwards, Vice President of Wealth Strategies – Phillips & Company

Adam Gulledge, Associate – Phillips & Company

Find us on Twitter and Facebook:

@PHCOAdvisors

Facebook.com/phillipsandco

More Questions Than Answers

Tim Phillips, CEO – Phillips & Company

As

I discussed in our blog post last week about Deficits, Defaults, and Downgrades, we believed a downgrade was inevitable, but thought it would come to fruition much further down the road. At this point, there are plenty more questions than answers, but here is my insight into this unprecedented downgrade.  Please remember there has never been a downgrade in United States History, so much of what I have to say should be taken in that context.

The likely short-run impact on US debt will be limited and muted. I suspect we will see effects to the magnitude of 25bp-50bp. Going from AAA to AA+ doesn’t mean much in terms of the government’s ability to pay. However, the negative outlook, if not removed and if other rating agencies follow suit, we may soon see much higher interest rates.

This situation is really more about prodding the political class to resolve the problems we all know exist in our country: entitlement spending, our debt, the deficit and tax policy.

There could be a significant impact on municipal debt with many downgrades to come. Any debt attached to federal spending or with US agency backing would likely see some deterioration.

Banking Sector

This sector was predominately sparred from the Fed, suggesting holding AA+ debt is the same as holding AAA debt. We shouldn’t see bankers running for the exits. Where would they run to anyway? France? Bermuda? New Zealand?

Corporate Sector

Insurance companies may have a tougher challenge to overcome based upon their charters, prospectuses and covenants. We’ll have to watch this sector closely. Companies in general might need to make some investment policy changes or dump their treasuries if they don’t have rating flexibility. This could pose a problem.

The Fed

As I have been suggesting, the Fed will likely enact some kind of easing policy to push banks into lending and stimulate the economy. This might become more challenging if the Fed attempts to buy the debt from the banks and issues new debt with a lower rating at the same old price. My guess is the banks are going to want better returns at some point in exchange for buying slightly worse debt. That in turn may cause banks to hold the debt with higher yields and not lend. So much for quantitative easing. Let’s see if the Fed can successfully navigate this situation.

Political Class

The real benefit is our politicians just got a cow prod up their you know what’s to resolve systemic problems with government spending habits. As they do this with the Budget Control Act which passed last week, we might actually see much more stability brought back to our markets once the committee makes its big cuts. This is to be done before Thanksgiving.

The Consumer

Assuming rates don’t jump through the roof, which I don’t expect to see in the near future, the consumer is not in too bad of shape.

• RevPar, the average price a consumer pays for a hotel room, is rising. This only occurs when rooms are being rented, suggesting a very good sign for consumer consumption and confidence.
• Furthermore, same store sales growth are rising 3-5%+.

My suggestion is to prepare for volatility and review debt holding in detail with your financial advisor. Also, if you have the time horizon to do so, make strategic investments in the coming months.

If the consumer is in as good of shape as the data suggests and this debt debacle is really about political posturing, then as Washington resolves these issues this could mark a historic buying opportunity.

This is speculation on my part and there are many more questions than answers at this point. Stay tuned to see how this all unfolds and what it might mean for you.

If you have any other questions about the downgrade feel free to contact me.

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

http://www.facebook.com/phillipsandco

Primary Research done by:

Adam Gulledge, Associate – Phillips & Company

There is Only One Way

Tim Phillips, CEO – Phillips & Company

As we expected, it looks like the political class will get something done. As anticipated, The Debt Limit Deal also looks like it's heavily back loaded (much ado about nothing).  In fact, all the real cuts to spending will likely come under a different congress and perhaps a different President. Now that the "fiscal conservatism" charades are behind us, we can look at the one and only way to really cut deficits and our debt – GDP growth.

In the middle of the debt debate we received a pretty ugly report card on our economic activity.  According to the BEA, real GDP in Q2 grew only 1.3% compared to a consensus estimate of 1.9% and Q1 GDP was revised downward to a mere .40%. While the top line number looks weak some of the component parts look pretty good.

• Real nonresidential fixed investment increased by 6.3% in the second quarter, compared with an increase of 2.1% in the first.
• Real residential fixed investment increased 3.8%, in contrast to a decrease of 2.4%.
• Real exports increased by 6%.
• The change in real private inventories added 0.18 percentage points to the second quarter change in real GDP.

The one area of concern, and it's the biggest, is consumption (70+% of GDP).  This area had very anemic growth.  However, much of the drag came from autos and I attribute much of that to the events in Japan.

It looks like the automotive industry is ramping up for better supply and demand from the consumer, which should bode well for the strong second half of 2011.

As long as we can get our "sausage making" debate about the debt behind us soon and create stability for business, I believe they will begin to hire and continue to spend.  This should boost confidence with the consumer and allow them to free up their pocketbooks a bit.  With savings rates at 5.0% and corporations sitting on a mountain of cash there is plenty of fuel in the tank.

Once we get some stability from the political class, American businesses and consumers can do what they do best – innovate, create, invent, invest with the outcome being spending.

Remember, investing is anticipatory and requires us to look at past data and make intelligent guesses about the future.  I see a pivot, not a growth surge mind you, but a resumption of growth and employment and I'm a buyer (assuming our political class get its act together).

Thank you for your thoughts and comments, please keep them coming.

Tim Phillips, CEO - Phillips and Company

Twitter: @PHCOAdvisors

http://www.facebook.com/phillipsandco

Primary research done by Adam Gulledge, Associate – Phillips and Company

Deficits, Defaults, and Downgrades

Tim Phillips, CEO – Phillips & Company

There are so many interesting things going on right now in the world, but if I wrote on anything other than the debt debate it would be like talking about baseball during football season.

I still stand by my forecast that we will have a debt deal although I too am getting very worried as the decision comes down to the wire.  Although a debt deal may be reached, one unanticipated consequence of this debate will likely be an eventual downgrade of our debt rating.  (Note the use of the word eventual as it might be years)

For years, we have been racking up annual budget deficit that make up our $14.3 trillion dollar debt.

In 2007, the deficit was a mere $500 billion and now we are talking about over $1.6 trillion.

The credit rating agencies have come out and said: 

“We may lower the long-term rating on the U.S. by one or more notches into the 'AA' category in the next three months, if we conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future.” - Standard & Poor’s

“Moody's considers the probability of a default on interest payments to be low but no longer to be de minimis. An actual default, regardless of duration, would fundamentally alter Moody's assessment of the timeliness of future payments, and an Aaa rating would likely no longer be appropriate”. - Moodys

By the way, these are the same jokers that placed Triple-A ratings on junk mortgages just a few years ago. 

The interesting thing about the debate and the reaction from the credit rating agencies is they’re not talking about our ability to pay back the debt (the $14.3 trillion). Instead, they’re talking about our ability to shrink the amount of borrowing we take on each year and our ability to refinance that debt continuously.  At the end of the day the "full faith and credit" of the United States Government is meaning a little less right now in the opinion of the credit rating mafia.  This is a sad state of affairs.

Whether we talk about paying down the debt, shrinking the deficit, refinancing our existing debt or a debt rating downgrade, we’re facing one simple fact – higher interest rates.  That's why I'm spending considerable time working on what works in a continuously rising rate environment.  You saw some of that in last week’s blog.

As we face some pretty gut wrenching days ahead with tremendous market volatility, keep your eye on the horizon which is your investable time frame.  If you have enough time, and that's relative for each of us, the volatility can be looked passed.  What can't be overlooked is the reality that we are facing the proposition of much higher interest rates under almost every scenario and we need to prepare ourselves for that.

The one scenario where rates can stay low is if the Fed steps in with more open market activity.  Remember the Fed can still buy and sell US Government debt.  They simply can't sell new issued debt as that comes from the Treasury at the authority of Congress (the debt ceiling thing).

We appreciate all the feedback we get every week and I look forward to response throughout the week.

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

tphillips@phillipsandco.com

Primary Research done by:
Adam Gulledge, Associate – Phillips & Company

Much Ado About Nothing - A Shakespearian Comedy That Exists today

Weekly Market Commentary 7-18-11

Tim Phillips, CEO – Phillips & Company

We’re into the weeds on the debt ceiling debate there’s no doubt about it. Like the Shakespearian couples in his classic comedy, there is a lot of talk yet no real outcome. I continue to stand by my prediction that much of this is political silly pre-season posturing and a debt deal is going to be finalized. What I'm trying to determine is the impact on growth and where to invest.

Let's review some current numbers:

• We have a $14.6 trillion dollar annual economy (GDP)
• We have a Federal budget of $3.7 trillion (26% of GDP)
• We have Federal income of $2.2 trillion (tax revenue)
• We have to borrow $1.5 trillion to make up the gap (deficit)

For every $140 billion dollars in cuts to federal spending we theoretically cut 1% out of GDP. These are big percentage cuts especially when the economy is only growing by 1.9% so far this year.

The so-called "political leaders" are bouncing around $1 trillion to $4 trillion dollars in cuts over 10 years or $100 billion to $400 billion a year. Given the big cuts to GDP and growth, I would be willing to bet almost all of these cuts will occur in the theoretical outlying years (years 6-10) of the plan. No one is really willing to make significant cuts to the budget and GDP while the economy is bouncing along the bottom.

Frankly, even in the outlying years $400 billion in cuts on a $1.4 trillion dollar deficit is a nice start, but doesn't begin to solve our problems.

Short of fiscal policy solutions, the monetary solutions are fairly straight forward - keep the US Dollar cheap relative to other currencies and inflate your way out of debt.

So what happens to asset classes when inflation is low and rising over many years?

We know one of the Fed's mandates is to keep inflation low, so we can anticipate much higher interest rates.  Here's a look at what asset classes do in rising rate environments.

Let's brace ourselves for lots of hot air and much ado about nothing.

As always we appreciate all of your feedback. Please email your thoughts and comments to me directly.

Tim Phillips, CEO – Phillips & Company

tphillips@phillipsandco.com

@PHCOAdvisors

Primary Research done by:

Adam Gulledge, Associate – Phillips & Company

Special thanks as well to:

Scott Edwards, Vice President of Wealth Strategies – Phillips & Company

Setting Up for Something Big

Tim Phillips, CEO – Phillips and Company

Last Friday, The U.S. Bureau of Labor Statistics released the June Employment Report. The numbers were dismal, and well below consensus.

• Only 18,000 total nonfarm payroll jobs added (consensus was 80,000)
• Revised down April and May payrolls numbers
• The unemployment rate increased from 9.1% to 9.2% (consensus was 9.1%)
• The participation rate declined to 64.1%
• The average workweek declined to 34.3 hours (consensus was 34.4)

Despite the dismal report, The Dow Jones Industrial Average closed down a little over 60 points (.48%) on Friday and was still up 722 points (6.16%) for the last two weeks. The numbers may have been below the consensus but the market wasn’t surprised.

In fact, if you look at the unemployment forecasts from the beginning of the year you can see we are still within the forecasted range.

If the market begins to expect slower than normal growth and the economic data is going to be range bound, then the market should be surprised if we see normal or even higher than normal growth. So the question is where is there an opportunity to surprise the market with better growth numbers? We believe the answer is 2^nd quarter earnings season, which Alcoa Inc. (NYSE:AA) will kick off today after the close.

We had a lot of one-time events last quarter:

• Flooding throughout the Midwest of the United States
• A massive earthquake in Japan followed by tsunamis and a nuclear meltdown
• Politics playing brinkmanship with United States budget and debt ceiling
• Threats of default across Europe
• The end of Quantitative Easing 2

It’s no wonder why analysts have been lowering forecasts. According to Bespoke Investment Group, “This is now the tenth week in a row that this reading has declined, representing the longest streak since at least late 2007.”

Investor sentiment looks to still be low and there is plenty to be worried about, but right now we’re trying to focus on where the high probability surprises will be.

As always we appreciate all of your feedback. Please Email your thoughts and comments to me directly.

Tim Phillips, CEO – Phillips & Company

tphillips@phillipsandco.com

@PHCOAdvisors

Primary Research done by:
Adam Gulledge, Associate – Phillips & Company

Effective Cash Management

Weekly Market Commentary 7-5-11

Tim Phillips, CEO – Phillips and Company

The Fourth of July celebration came early for the stock market. The S&P 500 closed up 5.61% and the Dow Jones Industrial Average closed up 648 points last week. We did suspect a bit of window dressing by fund managers because June 30^th was the end of the quarter but I don’t think anyone expected a week like that.

Figure

1 Chart of last week’s S&P 500 performance

I often get asked:

Why do professional money managers not use cash more as a tactical asset class?

My answer:

Weeks like that. Before last week the S&P 500 total for the year was 1.80%. After last week, the S&P 500 total return for the year was 7.57%. If you missed last week, you missed out on over 75% of the S&P 500 total return for the year.  We believe that timing the market is an exercise in futility. Investors should be more concerned about time in the market rather than timing the market.

Below is a table showing what happens to your portfolio return if you missed the best days between 1-1-91 and 12-31-10 based on the S&P 500

Figure 2 Data taken from Standard & Poor's chart which graphed how a $10,000 investment would have been affected by missing the market's top-performing days over the 20-year period from January 1, 1991, to December 31, 2010

If you missed only the 40 best days over a 20 year period (approximately 7300 days) your annualized return goes from positive to negative. 40 out of 7300 is not a lot of room for error when trying to time the market. If you’re paying 1% in fees and inflation is at 2% your real return can go from positive to negative after missing just the best 20 days. Investors can’t afford to miss weeks like last week.

Now that doesn’t mean cash can’t be used prudently. Cash can be an important asset class when it comes to having a proper asset allocation. It can provide a short term income to meet upcoming liabilities and liquidity needs and be used as a simple hedge against deflation.

It’s important to use cash the right way in order to maximize your return through asset allocation (which determines over 91.50% of your portfolio’s return) and not a market timing tool which accounts for less than 2% of your portfolio’s return.

With all this being said, in my experience having cash on hand to be able to buy things at the right time has usually been a pretty good investment strategy too.

If you have any questions or would like to discuss ways to more effectively manage your cash more in-depth please contact myself or your Registered Investment Advisor here at Phillips & Company.

Tim Phillips, CEO – Phillips and Company

Email: tphillips@phillipsandco.com

Twitter: @PHCOAdvisors

Primary research done by Adam Gulledge, Associate – Phillips and Company

Ben Bernanke's “Investor Insurance for Investors”

Weekly Market Commentary 6-27-11

Tim Phillips, CEO – Phillips & Company 

This week Ben Bernanke, Chairman of the Federal Reserve, gave a press conference following the release of the FOMC statement.

While the market reacted poorly to the Fed's downward revisions to GDP it might have missed a critical point.

¹ Projections of change in real GDP and in inflation are from the fourth quarter of the previous year to the fourth quarter of the year indicated. 

After Bernanke read his prepared remarks, he opened the floor up for questions. During that Q&A session he made an interesting statement when asked why the Fed wouldn’t consider taking more actions to stimulate growth if the Fed believes the recent uptick in inflation is transitory:

“We'll continue to look at the outlook and act, you know, as appropriately as the news comes in and the projections change. We do have a number of ways of acting… We could, for example, do more securities purchases and structure them in different ways.  We could cut the interest on excess reserves that we pay to banks…. But we'd be prepared to take additional action, obviously, if conditions warranted.”

I interpreted this statement as a possible blanket “insurance policy for investors” issued by Bernanke and the Fed. The question is no longer if the Fed will step in if needed, but instead what would need to happen for the Fed to step in. There are two games of brinksmanship going on and consequently, it could cause the Fed to take additional action.

At home the Democrats and Republicans are playing brinksmanship with the US Debt Ceiling while internationally, Greece and the ECB are doing the same thing with the European Union’s next round of funding for Greece.

I believe the most probable outcome concerning the US Debt Ceiling is it gets lifted at the 11^th hour. Everyone agrees on spending cuts, the fundamental public disagreement is on tax increases. In the end, the democrats won’t need to fight too hard because the current tax cuts expire at the end of 2012. Republicans would perhaps like to have tax policy as a major issue in the next presidential campaign. Much of this is all public posturing in my opinion.  This political theater should provide improved ratings for the 24/7 news channels and provide investors with good buying opportunities leading up to August 2nd.

Looking across the Atlantic at the Greece situation, I agree with Bernanke. A disorderly default would no doubt roil financial markets globally; I don’t believe that is the most probable outcome. The European Central Bank (ECB) and the International Monetary Fund (IMF) have too much at stake to let Greece simply default. I think the more probable outcome will be continued talks among the ECB, the IMF, the Greek Parliament, and other countries to enable members of the European Union (EU) to save face and gracefully exit the EU before an actual default. I also believe this will provide investors with a good buying opportunity at some point.

In the long run, I don’t think the Fed will have to pay out on its “insurance policy for investors,” but because it’s there I’m using these brinkmanship events at home and abroad as buying opportunities.

Thank you for your thoughts and comments, please keep them coming. Send them to: tphillips@phillipsandco.com

Tim Phillips, CEO - Phillips and Company

Twitter: @PHCOAdvisors

Primary research done by Adam Gulledge, Associate – Phillips and Company

Nothing is Exactly as it Appears

Weekly Market Commentary 6-20-11

Tim Phillips, CEO – Phillips and Company

According to the advance monthly sales for retail and food services released last week by the US Census Bureau, retail sales declined 0.2% in May (seasonal adjusted). While the headline suggests slowing sales, some things may not be exactly as they appear.

First, looking passed the headline number and on to a breakdown of the number calculation, it’s clear 16.83% of the adjusted total is derived from motor vehicle & parts dealers. This represents the biggest component of the monthly sales number.

Secondly, on the third page of the press release the percentage change is broken down for each section of the total retail sales headline number. The section with the highest percentage drop from April to May was motor vehicle & parts dealers at -2.9%, followed by electronics & appliances stores at -1.3%.

This means May’s biggest drop in month over month sales came in the biggest section of the headline number. When excluding motor vehicle & parts dealers sales numbers, the headline retail number goes from -0.24% to 0.32%, a difference of 56 bps. Is this divergence between “motor vehicle & parts dealers” and “total retail sales excluding motor vehicle & parts dealers” an early indicator of a decline in consumption?

One way to measure demand for big ticket items (like automobiles) is to look at the change in non-revolving credit, also known as installment credit. According to the Federal Reserve’s most recent consumer credit report released June 7, 2011, non-revolving credit increased at an annual rate of 5.25% in April and 6.0% in the first quarter of 2011. Based on this data, consumers are buying and banks are lending and it doesn’t appear to be an issue with demand.

What about the other side of the economic coin? Supply

Since the March 11 earthquake and tsunami hit Japan, Japanese auto makers have taken a big hit and investors are just now beginning to see the effect. For the month of April: Nissan, Honda, and Toyota sales fell by 9.1%, 22.5% and 33.4%, respectively. While the earthquake and tsunami happened in mid-March, it seems apparent that the supply chain for automobile manufacturing and exporting in Japan will take a few months to fully recover.

Nothing is exactly as it appears. A headline number first appearing to indicate a potential slowdown in consumption and demand, turns out could actually be a result from a temporary supply chain disruption. This also supports the potential future outcome #2 discussed at the beginning of the month.

As always, we appreciate all the feedback we get. Please send your thoughts and comments tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips and Company

Primary research done by Adam Gulledge, Associate – Phillips and Company

Twitter: @PHCOAdvisors

Weekly Market Commentary 6-13-11

Our Emotions or Their Stupidity

Tim Phillips, CEO – Phillips and Company 

The S&P 500 is down 6.8% since the end of April and is currently on a six-week losing streak. According to Bespoke Investment Group:

Going back to 1928, this is only the 17th time the S&P 500 has had a six-week losing streak. The last time this occurred was back in July of 2008 during the midst of the Financial Crisis… there have only been three weekly losing streaks of seven or more for the index.

Despite this six week losing streak, earnings forecasts are still fairly loft:

• We’re almost half way through the year and the mean 2011 EPS forecast for the S&P 500 is $95.61. That represents an increase of 8.88% between now and the end of 2011.
• The mean forecast for the 2011 close of the S&P 500 is 1400. That represents an increase of 10.15% between the close on June 10^th and the end of the year.
• This weekend JP Morgan came out and said it expected earnings to climb an average of 10% a year through 2013.

Something has to give. Either the analysts’ forecasts are wrong and we will see a lot of downward revisions in the coming weeks, or pessimism is the emotion of the day and the market is exacerbating any negative information.

Personally I think the latter and here’s why. Below is a chart of the S&P 500 (the white line) overlaid on top of the American Associate of Individual Investors (AAII) Bullish Sentiment Survey (the orange line). As you can see from recent data, very low bullish sentiment has historically been a good time to buy.

That said, I'm not saying the analysts’ forecasts are 100% right either. They may be precise but that doesn’t mean they are always accurate. In fact, a friend of mine who is a highly respected fund manager told me he believes sell side analysts (brokerage firm analysts) tend to miss earnings by +/- 22% due to forecasting errors in their models.

Just keep in mind that since this six-week losing streak began in May the S&P 500 is down 6.8% and that big of a move over a short time frame might be enough of a discount to compensate for analysts errors.

Going Forward

With the end of the quarter a few weeks away, we are coming into “window dressing” season where managers sell their biggest losers and buy more of their high performers. With this recent dip it might provide a good opportunity for these managers to accumulate more of their favorite high-flying stocks.

Secondly, earning season is around the corner with Alcoa set to kick things off on July 11^th after the close of the market. Looking at EPS forecasts for this quarter and next we are currently discounting some pretty tough comparative earnings for the S&P 500. Below is a chart showing Q2 and Q3 estimates and the forecasted YOY change.

I'm going to continue to seek good entry points that represent value over the long term regardless of the analysts’ forecasts for the next few quarters or our emotions today.

As always, we appreciate all the feedback we get. Please send your thoughts and comments to: tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips & Company

Primary research done by Adam Gulledge

 Weekly Market Commentary 6-6-11

Tim Phillips, CEO – Phillips and Co.

The Probability of Being 

When it comes to investing it’s about trying to predict future outcomes. These predictions about future outcomes have a range of probabilities and likelihoods of happening. Last week’s avalanche of gloomy economic data, believe it or not, helped me clarify the probabilities of what might lie ahead of us.

Potential Future Outcome #1: QE3

Based on the poor economic data below coming in the last few weeks, the Fed orchestrates another round of quantitative easing.

• Falling house prices
• Weak auto sales
• Lower manufacturing numbers
• Weak labor report

At first, this once again seems intuitive because this is what the Fed has done in the past, however, I don’t see a high probability of this outcome in the near term. I believe the main purpose of past rounds of quantitative easing have been to primarily fight deflationary pressures and not to stimulate the economy.

Bloomberg - The University of Michigan’s Inflation Expectation Survey of Consumers historical 12 month expectations

The University of Michigan’s Inflation Expectation Survey of Consumers shows that the median expected price change for the next 12 months is 4.1%. Therefore, I don’t see a high probability of deflation in the near term, so at this point I rank the probability of this outcome as low. Now if we do see signs of continued slow growth in the economy and an increase in the probability of deflation then I believe the likelihood of QE3 goes up very quickly.

Potential Future Outcome #2: Resumption of Consumption

The economic data we have seen for the past two months could be in part due to a series of major natural disasters (tsunamis, floods, and tornados) across the world and their effect on consumer psychology and the global supply chain. Once consumer confidence returns and the breaks in the supply chain are fixed we should see a resumption of consumption.

 Bloomberg – Graph of graph of consumer confidence

Looking at the consumer confidence numbers, these tragic events appear to me to be a contributor to malaise. We may not see the consumption resume as fast as it fell, but I would rank the probability of this outcome higher than the first one.

Potential Future Outcome #3: Political Normalcy

The political silly season is now upon us and we have already seen politicians point out economic problems that, “they and only they can fix as President,” such as:

• Our national debt
• Tax policies
• Entitlement spending

And anything else that shows America is on an “unsustainable path.” Since we are currently in between earnings seasons the market has nothing else to focus on except this daily attack on our economic foundation by politicians who make a living by pointing out these problems.

In the end, the political process works its magic: compromises are made on our national debt, tax and spending policies are reformed, and then we return to normalcy. We talked about this effect of political uncertainty on consumption earlier this year. Based on my insights from when I ran for US Congress, these are textbook politics at work.

There are, of course, an infinite number of possible outcomes, but out of the three broad outcomes discussed, I rank this one with the highest probability. Based on that, I’m using market pull backs as buying opportunities. While we aren’t believers in being able to time the market, we do like to layer in cash at times like these that appear to be opportunistic.

Please send me your thoughts, comments and feedback at tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips & Company

Primary research done by Adam Gulledge

Sector Rotation

Tim Phillips, CEO – Phillips and Company

“An elegant solution for keeping track of reality” – Inception

Right now, there seems to be a healthy debate over GDP growth for the US. Q1 real GDP growth remained unrevised at 1.8% compared to a forecasted upward revision to 2.1%.  Other economic data was soft as well:

• Manufacturing numbers were light for the week in Chicago, Kansas City, and Richmond
• Initial unemployment claims still are over 400K
• Consumer data was mixed at best.

This has people asking: Is this the beginning of a soft patch for the US economy or is this data just “statistical noise” in an economy that is still trending up?

The good news is that we might not have to answer that question because as we pointed out last week, investor returns do not correlate very well to GDP growth. Along with softer economic data last week we also saw some of the defensive sectors (consumer staples and utilities) underperform the broader index and cyclical sectors (basic materials and energy) outperform the broader index. Now, this seems counterintuitive so we decided to dig a little deeper.

Let’s take a step back. According to Bloomberg, there are only 612 large cap (market cap > $5 billion) US based companies and over 6000 mutual funds focused on US large cap. Couple this data point with advances in technology and continual regulatory reform efforts to make the US markets more efficient and you get a lot of fishermen in a very small, crystal clear pond that continues to get clearer. This makes for a pretty fair and level playing field; however, it also makes it incredibly difficult for those 6000 managers to consistently outperform their benchmark.

One way we can attempt to gain a slight advantage (legally) over all these money managers (chasing so few companies) is through sector rotation.  Broadly speaking, sector rotation is when money managers shift investments from one sector (or asset class) to another.  If we can identify sectors that might be coming into favor early on we can take advantage of this information and rotate in before all 6000 mutual fund managers do.

Moving forward, perhaps this helps explain what at first seemed counterintuitive when we focused on just the broad economic data. Looking back at the last three months, utilities and consumer staples outperformed the S&P 500 compared to materials which were about even, and energy which had underperformed.

This raises the question: Could last week be the beginning of a sector rotation from defensive sectors to cyclical sectors?

Thoughts and comments are always welcome. Please Email me directly at tphillips@phillipsandco.com

You can also find me on twitter: @PHCOAdvisors

Tim Phillips – CEO, Phillips and Company

Primary research done by Adam Gulledge

Weekly Market Commentary 5-23-11

Inflationary head fake?

Tim Phillips, CEO – Phillips and Company

Recently when I’ve been out learning how to see, there has been a lot of discussion on rapid inflation in the near future. Frankly, I agree with their concerns. However, the bond market doesn’t seem to agree. Bond prices continue to rise and continue to push yields lower. The bond market appears to be pricing in the exact opposite: low inflation in the near future.

Instead of arguing in the affirmative for higher and rapid inflation, I want to play devil’s advocate and see if I can build a case for low inflation.

Wage Growth?

Currently, wage growth is around 2% annually. Looking at the wage growth data from the last recession it could still be headed lower before it bottoms out. Unemployment is off the recessionary highs but still has a long way to go to get to pre-recessionary levels.

Housing Market?

The housing market appeared to be stabilizing however, recent data from Case-Shiller and CoreLogic show potentially more downside. If housing is approximately 40% of the CPI then it could prove to be difficult to have runaway inflation with flat or lower housing numbers...

Commodities?

For the year, commodities have done well but recently we have seen a pullback in commodities across the board.

Low Inflation Means What?

If this devil’s advocate scenario of low inflation in the near future is playing out then we should see lower GDP growth. Wait a minute! We have already seen GDP forecasted for the year revised lower. If lower CPI leads to lower GDP growth, does that mean lower stock prices too? At first it makes good logical sense, but the data seems to suggest otherwise.

In 2004, Jay Ritter did an exhausting study entitled, “Economic Growth and Equity Returns” and concluded that there is no stable relationship between growth and equity returns. Goldman Sachs ran their own analysis (“Staying the Course” 01/2011) and found similar results: there is no statistical significance in the relationship between equity returns and pace of economic growth. Lastly, Vanguard also produced similar results when they did their own study (“Investing in Emerging Markets: …”) last year stating that, “Since 1900, the correlation between long-run economic growth and long-run stock returns across 16 major markets has been effectively zero.”

If other people are making the “logical assumption” that cooling GDP numbers means lower stock market returns, we could see some emotional selling and a rocky summer that could prove to be a nice buying opportunity for investors that actually looked at the historical correlation. This could be a good summer to look back and evaluate whether or not your investment managers are actually adding any value and beating benchmarks or if they fall for a potential head fake.

As always, we appreciate all the feedback we get. Please send your thoughts and comments to: tphillips@phillipsandco.com.

You can also find us on twitter: @PHCOAdvisors

Tim Phillips – CEO, Phillips and Company

Learning How to See Part II

Tim Phillips – CEO, Phillips and Company

Weekly Market Commentary 5-16-11 

While many professionals in my industry spend hours analyzing data points looking for trends and searching online for industry reports, I prefer an additional tool: hitting the road and meeting with investment decision makers.

I don’t believe you can quite replace a personal relationship and insight with a spreadsheet alone.

Last week I promised to give you a couple of insights into where I am seeing investment dollars flow.

First would be the CIVETS. Not the animal, but a sub segment of the emerging markets. CIVETS is an acronym for: Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa. The grouping was introduced by the Economist and the main investment thesis is that while these countries are geographically dispersed, they have important similarities:

• Sizeable, young populations
• Diversified economies not excessively reliant on commodities
• Reasonably sophisticated financial systems

Here’s how they look by the numbers:

While Robert Ward (Global Financing Director for The Economist Intelligence Unit) coined the term in late 2009, Standard and Poor’s just developed an index to track this particular group last month. In my opinion and based on my meetings with investment decision makers, Standard & Poor’s new benchmark is a strong indication that institutions wanted a good benchmark to measure performance against.

The second major area I’m seeing investment dollars flow into is global infrastructure:

Above is a chart from the 2011 Preqin Global Infrastructure Report (ISBN: 978-1-907012-36-5) showing a 225% increase on aggregate capital raised from 2009 to 2010, and just 22% less than what was raised in 2008. Preqin also noted that in January this year, a record 122 unlisted infrastructure funds were on the road targeting $85.5 billion in investor commitments.

In the long run, the Canadian Imperial Bank of Commerce (CIBC) World Market estimates that $35 trillion dollars will be spent on infrastructure in the next 20 years. Below is a table that highlights some of the projected infrastructure spending for 2009 through 2015 broken down by country:

Like everything in my business nothing is certain and much of what we do is based upon a blend of analytics and probabilities. That's why Leonardo Da Vinci was correct when he said "Sapre Vedere” – know how to see.

Please send all comments or questions to tphillips@phillipsandco.com

Tim Phillips – CEO, Phillips and Company

Learning How to See – Part I

Tim Phillips – CEO, Phillips and Company

Last quarter we mentioned that 67.4% of companies beat earnings estimates. We also pointed out that the historical beat rate is 63%. As of this morning, over 80% of the S&P 500 companies have posted earnings for the first quarter and 72.2% of them beat their earnings estimates this quarter.

Alcoa kicked off earnings season after the bell on April 11^th. Since then the S&P 500 has returned 1.39%.  Now that earnings season is coming to an end, we expect market participants will likely shift their focus towards broader economic trends when making investment decisions.

Looking at the broader economic trends we currently have several cross currents:

On the negative side we have:

• Fiscal concerns with the debt ceiling
• Monetary uncertainty surrounding the end of QE2
• Increased likelihood of default in Greece moving the EU and Euro to a more unstable position

On the positive side we have:

• Strong jobs numbers
• Improving consumer credit markets
• Retail sales are now above the pre-recession peak

We added 244,000 jobs in April, March was revised up from 216,000 to 221,000 and February was revised up from 194,000 jobs to 235,000 jobs. That makes three straight months with 200,000+ new jobs.

This morning the NY Fed released its Quarterly Report on Household Debt and Credit, which continues to show improvements:

• Continued decline of new foreclosures and new bankruptcies, down 17.7% and 13.3% respectively in the last quarter
• 15% decline of total delinquent balances, compared to a year ago

So the question for investors is: which trends win, the trends that suggest a stronger economy or the trends that question the economic recovery?

Either way, most institutional money managers are forced to stay fully invested so it’s unlikely we will see a mass exodus from the market or see it move straight up. There will probably still be large swings in both directions in the near future, but overall it still looks constructive for portfolios that have a heavy allocation to equities.

For our retail investors it's always important to point out this heavy equity bias in institutional portfolios.  Pension plans, insurance companies, and college and university endowments, tend to keep portfolios in the 80% plus equity exposure.  The math is simple:

Some may need up to 9.5% to 10% in annual returns depending upon their specific payout rate and fees.

The only way institutions get this type of return is with a heavy bias to equity.  Be comforted but not too much.  I continue to see rotation in and out of asset classes and regular portfolio rebalancing including large allocations of cash (20%+) at times. This type of rotation and rebalancing by large institutions can cause some interim pain for all of us as they adjust their allocations

Next week I will give you some insights into what some of the larger institutions are looking at as sectors and segments; this week I am on the road "learning how to see.”

If you have anything specific you would like some insights on or questions to ask some of these larger institutions please email them to me at:  tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips and Company

The Prediction Business

Tim Phillips – CEO, Phillips & Company

Weekly Market Commentary 5-2-11

The week was interesting enough for capital markets.  In spite of all the concerning headlines (gas prices, debt ceilings, birth certificates, Fed press conferences) the equity markets trudged higher. I suspect it was mostly driven by higher than expected earnings reports. According to a Reuters news release on Sunday (May 1^st, 2011):

“So far, 324 of the S&P 500 companies have reported earnings, of which 73 percent were above analysts' expectations, according to Thomson Reuter’s data. In a typical quarter, 62 percent of companies beat estimates.” - (“Sell in May and go away? Not so fast” by Angela Moon)

Not bad.

Unfortunately, a rear view mirror commentary isn’t worth very much when you’re in the prediction business.  Make no mistake about it, when you invest in the stock market you are in the prediction business. 

So the forward looking question in my mind continues to be what happens when the Fed stops their purchase of government bonds?  Back in November, I discussed the actual Fed mechanism that details the basics about the Fed program.  In short, the Fed is pushing the yield curve down forcing banks and others that hold Treasuries to swap short term, low yield, low risk Treasuries for longer term, higher yield, higher risk lending and speculating.

This has appeared to have happened. Since the beginning of October, the S&P 500 is up 17.2% and consumer credit is up $12.1 billion.  The Wealth Effect has certainly been given a chance.

The ultimate question is whether the consumer is in better shape now to sustain economic activity than they were when the Fed ended their stimulus programs in April of 2010.

Recall, the Federal Government had many stimulus programs in place which include:

• Term Asset- Backed Securities Loan Facility - TALF
• Troubled Asset Relief Program – TARP
• Public- Private Investment Program – PPIP
• Unemployment Benefit Extension
• American Recovery and Reinvestment Act
• Car Allowance Rebate System – “Cash for Clunkers”
• FHA Housing Rescue – First Time Homebuyers Credit

The list goes on and on. You can go to CNN Money for a full list of bailout programs. 

Is the consumer better off?  Let's take a look at a few consumer indicators:

• Personal income is up 5.3% YOY
• Consumption is up 4.6% YOY
• Personal Savings rate is 5.5% (which leaves plenty of "dry powder" for consumers to absorb higher gas prices and keep on spending)
• Consumer Credit is up 3.8% YOY
• Revolving Credit is down only 4.0% YOY
• Unemployment is down to 8.8%
• Bank lending on durable or non-revolving assets are up 8.0% YOY

With the cuts made to payroll taxes, accelerated depreciation and other federal tax breaks the consumer might be able to sustain spending at a reasonable pace without another federal stimulus program. The markets will certainly pivot on this issue as more clarity is provided. This is indeed a great time for the prediction business to make intelligent tactical asset allocation bets on whether or not you believe the consumer is juiced up enough to sustain these current trends.

My prediction is they are, but to the tune of 3% GDP, not quite 4 or 4.5% GDP. Just remember, when it comes to the predicting business, the more precise, the more likely it is to be inaccurate.

Thank you for your thoughts and comments, please keep them coming. Send them to: tphillips@phillipsandco.com

Tim Phillips, CEO - Phillips and Company

Higher Gas Prices-Who's the loser?

Tim Phillips – CEO, Phillips & Company

A few weeks ago we mentioned how we had already seen some GDP forecasts revised down to 2.97% from highs in February of 3.20%

Either all of these guys aren’t very good at accurately forecasting the size of the world’s largest economy 12 months in advance or there’s a fly in the 2011 economic ointment they were depending on.  My guess is that we are all lousy at forecasting the outcomes of a $14.7 trillion economy 12 months in advance. However, to humor these professionals I wanted to see if one of the flies in the ointment is higher gas prices.

According the Energy Information Administration (EIA), US Regular Conventional Retail Gasoline Prices have risen by 33.90% in the last 12 months.

As seen with current data, politicians generally take a hit in their approval rating for rising gas prices.  Even when the economy has been improving Obama’s approval ratings have dropped lately with the spike in gas prices.

Recent research has shown that marginally higher gas prices don't have a large impact on gas consumption, so the real questions are:

• Do rising gas prices have an impact on consumer spending?
• If so, how big is that impact?

To put it another way, how much does a rise in gas prices take from discretionary income? Experts have called this the “Discretionary Income Effect”.

Opinions vary, but according to the US Department of Energy, in 2007 the average percentage of household income spent on gasoline was 4.80%.

If the average income per household is $49,777 (as recorded in 2009) and gas prices are up 33.90% then the lost dollars to other consumables is $810 per year or $67.50 per month.  That’s a fairly insignificant amount to those that drive most of the consumption (which are earners above the median income).

While there are other casual implications like:

• Does the uncertainty of rising gas prices drive consumers to save more vs. spend on other items?
• What’s the impact of consumption of durables and specifically items that consume energy? 

The bottom line is fairly straightforward, the politicians have much more to lose than our consumption driven economy. 

Please send me your thoughts, comments and feedback to tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips & Company

Painful Start or Painful Taxes

Tim Phillips, CEO – Phillips and Company

Last quarter, when we were in the thick of earnings season we noted how well the numbers were looking at the top line and bottom line. When all was said and done, Bloomberg’s numbers showed that 72% of the S&P 500 beat earnings estimates. Unfortunately, this quarter’s earnings season isn’t looking so optimistic.

Bespoke Investment Group noted that a number of analysts have come in and revised their earnings estimates downwards over the last few weeks.

Although we are just at the start of earnings season, so far in general, it hasn’t mattered if you beat or missed the numbers you traded lower.

Not listing as a recommendation, but for an example last week Alcoa officially kicked off the earnings season after the close on Monday (4/11); they beat their earnings per share number but missed their sales number. Tuesday the stock opened down 4.84% and closed down 6.02%.

Tax Day Vs. Good Friday

We have two interesting things going on this week: Tax Day (pushed back from Friday due to Emancipation Day) and Good Friday.

Last week’s rough start to earnings season might have been exaggerated due to the Federal Tax Deadline. According to Bespoke, historically over the last 30 years the average performance of the week before the tax deadline has been muted. Last week was no exception, the S&P closed down 0.70%.

Looking ahead though, historically the week after tax day has been much stronger. Over the same time period the S&P 500 has risen on average by 1.10%. We also have Good Friday at the end of the week. Going all the way back to 1928 the S&P 500 has averaged a gain of 0.53% during the 4 day work week leading up to Good Friday. It will be important to focus on companies that report earnings this week to see how they do with these historical tail winds.

A few major earnings reports this week:

• Citigroup (4/18)
• Intel (4/19)
• EMC (4/20)
• Apple (4/20)
• McDonalds (4/21)
• Honeywell (4/21)

This should help determine if this painful start is a sign of what to expect throughout earnings season or if was just the painful effects of taxes.

As always, we appreciate all the feedback we get. Please send your thoughts and comments to: tphillips@phillipsandco.com

Political Drama – Enter Stage Left & Right

Tim Phillips, CEO – Phillips and Company

In, The General Theory of Employment, Interest and Money, John Maynard Keynes laid out six objective factors that influence the propensity to consume. I would like to take a moment to focus on two of them that are pretty straight forward:

 1.  A change in the difference between income and net income: The amount of consumption depends on net income rather than on income, since it is, by definition, his net income that a man has primarily in mind when he is deciding his scale of consumption. (emphasis added)

 2.  Changes in fiscal policy:  In so far as the inducement to the individual to save depends on the future return which he expects, it clearly depends not only on the rate of interest but on the fiscal policy of the Government. Income taxes, especially when they discriminate against “unearned” income, taxes on capital-profits, death-duties and the like are as relevant as the rate of interest (emphasis added). 

People consume net income and not their gross since their net income is dependent on expectations for interest rates and fiscal policy.

Since fiscal policy directly impacts our consumption (which is approximately 70% of our GDP), it’s rather interesting that despite the fact we went into the weekend with no clear agreement on the government budget and a real possibility of a government shutdown, the S&P 500 was only down about 4 points (-.32%).

Since that debate has been decided, I suspect that the markets will turn their attention back to fundamentals with earnings season set to kick off today after the close. However, the fiscal drama is far from over for the year as the political theater turns their eyes to the debt ceiling and the 2012 Budget for their next act.

If we learned anything from last week’s political theater, it’s that both sides benefitted from brinksmanship (the practice of pushing dangerous events to the verge of disaster in order to achieve the most advantageous outcome) and it will most likely be utilized by both sides again in the next act with the debt limit debate and 2012 budget set to debut over the next several months.

While this may be beneficial to the two political parties, it unfortunately could be detrimental as increased uncertainty in fiscal policy (i.e. Medicare and social security) and our net income (i.e. personal and corporate tax rates, and personal deductions) could cause a decrease in our propensity to consume and significantly threaten corporate earnings and our GDP.

In fact we have already seen some GDP forecasts revised lower over the last month. The mean GDP forecast for the US is now 2.97%, which is down from the highs in February of 3.20% (per Bloomberg).

My most likely scenarios (based upon a healthy dose of skepticism and lack of trust for the political class) are:

• If the 2012 budget is to truly address entitlement spending then it could rage on throughout fall and could in fact continue on through the 2012 political season.
• The 2012 budget will likely drop any entitlement spending reform and that debate will be delayed for the following act, The 2012 Elections.
• The debt limit will be raised and those practicing brinksmanship (playing chicken) will find some way to save face.

Overall, market reaction will probably be muted (similar to last week) as most of the investor class has grown weary of the political drama. However, we could see increased volatility as the two political parties play chicken. This volatility could provide additional dips and buying opportunities for the investors who prefer to take a dynamic approach to investing as we go through economic cycles.

Below is a chart of the S&P 500 with the dates of the last three times we raised the debt limit circled in green:

Thoughts and comments are always welcome and I look forward to them throughout the week. Please send them to:

tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips and Company

Jobs – Now What?

According to the BLS data for March employment increased by 216,000 and the unemployment rate dropped to a 2 year low of 8.8%. They also revised up the January and February employment numbers. So for the first three months of the year the economy has added 188,000 private payroll jobs per month. Based on this trailing indicator the economy is clearly improving.

Now What?

With the US economy now improving, the next questions to ask are:

• How good will it get?
• How soon will it take to get there?

When the recession began we used this simple graph below to illustrate the question at that time. It seems to me we can dust off the graph and use it again.

We now know how far the economy fell and we are coming close to knowing how long it will take to recover.

It's my guess (emphasize on guess) that if we continue to get 3.3%+ GDP growth then we could see continued job growth around 225k/month and possibly 300k/month by the end of the year.

As discussed last week, we still have a “Wall of Worry” at center stage that we have to work through, and that’s going to generate some bumps and bruises for those that lose perspective.

To keep the right perspective, remember that the markets are forward looking. So at the same time, we have to start thinking about how good can the future get because our markets are fairly efficient at discounting news and can do so far into the future

Because asset allocation matters most, per the illustration below, it is critical to contemplate the next adjustments to our portfolios. Much more on this in future comments.

Determinants of Portfolio Performance:

Source: Financial Analysts Journal, May-June, 1991, “Determinants of Portfolio Performance II: an Update” by B.G.P. Brinson, B.D. Singer and G.L. Beebower. Results are based on the 10-year performance record of 91 pension funds.

As for now, it's on to earnings season to see if the lagging jobs numbers match the earnings capabilities of companies.

The “Now What?” always comes quicker than we realize.

Please send me your thoughts, comments and feedback to tphillips@phillipsandco.com

Tim Phillips, CEO – Phillips and Company

Climbing the “Wall of Worry” – What Is That?

World events once again dominated the headlines last week:

• Japanese nuclear issues
• Unrest in the Middle East and Northern Africa (MENA), specifically Libya and Syria
• The European Debt Crisis, specifically Portugal, Ireland and Greece

Certainly, the equity markets overcame some serious headlines this week to post a nice gain. 

S&P 500

The "Mad Dog", Muammar Qaddafi, has continued threating his citizenry which may lead up to a massive exodus into Egypt and Tunisia and further destabilization in the entire region. Other regions to continue to watch are Syria and Jordan as the 2010-2011 Middle East and North Africa Protests continue to unfold

The simple fact is that, according to the CIA World Factbook, the combined GDP of Libya, Jordan, Egypt, Tunisia and Syria amount to less than 1% of global GDP.

From this perspective the wall doesn’t look so high, however, if you look at it from the perspective of a global disruption in oil supply it becomes an entirely different “wall of worry” to climb.

Adding to this wall, Japan now has over 300 billion in damages and counting as radiation leaks into the sea. This could have a material impact on global shipping and supply chain management because ships that become radiated will no longer be allowed into any foreign ports. Imagine owning a 200 million dollar ship that becomes radiated. You can almost feel the desperation and worry.

On top of all that is the European Debt Crisis. It’s clear from past research on countries that the pattern seems to be once a defaulter always a defaulter. Portugal is one such nation; it has defaulted 6 times since its independence in 1139. Add to this Germany's upcoming election and lack of desire to back a new €80 billion bailout fund for the Eurozone. The implications of a non-unified European Union are certainly big concerns. 

So what is driving equity investors to push the markets higher?

The answer is actually something quite rational: The world’s largest economy, military and best educated enterprising population is improving.

The United States Real GDP was revised up to 3.1% from 2.8% in the fourth quarter of last year. Corporate profits increased 29.2% in 2010, which is in contrast to the 0.4% decrease in 2009. That’s a huge swing in profitability.

So it seems investors have looked rationally at the United States’ economic growth and determined that these future cash flows matter more than the contaminated ships, food supply bottlenecks, crazy dictators, and completely insolvent countries when valuing an asset. Let’s hope these future cash flows continue to be strong enough to withstand the stresses around the world. In reality there is always a “wall of worry”, it just happens to be center stage right now.

Thank you for your thoughts and comments, please keep them coming. Send them to: tphillips@phillipsandco.com

Tim Phillips, CEO - Phillips and Company

The World Is Falling Apart Again

Last week’s blog made a fairly easy prediction for rough market conditions and extreme volatility.  As usual, the human predictive ability is limited, and that applies to me.  Who could foretell a nuclear disaster on top of a brutal dictator dominating our headlines?

The markets were very extreme, especially in Japan.

The S&P 500 dropped as much as 3.14% before closing the week down 1.92%.

The Nikkei 225 fell as much as 19.7% closing the week down 10.22%.

All the while, Muammar Gaddafi a crazy madman was taking advantage of a distracted world and began to brutalize his citizenry. 

Personally, it was almost hard for me to stay objective and be an observer.  As the week wore on, I reflected on cash.  How comforting it is to have it and utilize it to reduce volatility in portfolios.  The unfortunate part of cash, as I have said in the past, is it won't help you live very well in the future.  While it will help you sleep well today, inflation will deteriorate its purchasing power and leave you wondering what happened.  This is a paradox I regularly deal with when allocating assets.

In Search Of Meaning

I struggled to find my footing in all the turmoil.  I allocated some cash into the markets and held more cash out of the markets.  I might be wrong, but over time it probably won't impact returns too much in either direction. 

I didn't really wrap my head around the big picture until I was watching Meet the Press on NBC.  Mostly it's good background noise but they displayed a few photos that hit me between the eyes.

What's amazing about these Time magazine covers is that they were not from the last few weeks; they were from over 25 years ago.

I was beginning my professional career in investments one year earlier and it looks like The World is Falling Apart Again.

This chart taken from Bloomberg represents the market cycles I've worked through.  Shocking after 25 years it takes a Sunday talk show for me to get a little perspective and realize this time it's not different.  While I can doubt markets at times as I'm sure you do, if you have time then risk can be shaped to your advantage. 

Tim Phillips, CEO

Does it Really Matter?

How do you write about Japan and its economy when the death toll from the earthquake and tsunami is expected to exceed 10,000?  After all, nothing really matters like life, liberty and family. My thoughts and prayers are with the people of Japan.

Given my profession though, I cannot simply dodge the question:

When the fifth largest earthquake on record hits the third largest country by GDP, how does that impact the United States Economy and the markets?

Japan is the world’s fourth largest exporter and fifth largest importer. Main exports include cars, electronic devices, and computers and their largest export partners as of 2009 are China, the United States, South Korea, Taiwan, and Hong Kong.  On the import side, Japan imports mostly fossil fuels, foodstuffs, textiles, and wood. Their largest import partners as of 2009 are China, the United States, Australia, Saudi Arabia, United Arab Emirates and South Korea.

Clearly, Japan plays a major role in the United States economy and the world economy.  Anyone that suggests otherwise is simply wrong. 

From an investment perspective, when people think of “investing in Asia” they think of high risk emerging market funds.  However, Japan is one of the few countries in Asia that is considered a developed economy. As an investor, there is a concern about investments in international developed funds. Here at Phillips and Company we have been reducing our exposure to international developed markets for the last two quarters due to their increasing debt burden and aging populations. Japan is certainly no exception to either of those two. The Japanese Health Ministry estimates the nation’s total population will decrease by 25% from 2005 to 2050 and their public debt is over 200% of their GDP just behind Zimbabwe.

Unfortunately for Japan, from 1980 to 2010 their average quarterly GDP growth has been a dismal 0.55% and last quarter it shrunk by 0.30%. We do not believe this level of economic growth is significant enough to easily absorb a major shock to their economy. The Bank of Japan has been quick to provide stability and liquidity by pumping cash as needed after unleashing 15 trillion yen in one-day operations yesterday.

The last time a major earthquake hit Japan the Nikkei had a knee jerk reaction down but just as quickly recovered.  Clearly some very difficult market activity may be in store for Japan.

While the whole world will rightfully mourn this tragedy, there will be some economies and industries that benefit.

• Without Japan’s fully-functioning nuclear capabilities and 36% of their oil refining capacities shut down energy producing countries and companies may experience increased demand.
• Wood products might also see a boost as Japan begins to recover and rebuild.
• US auto manufacturers could also fill the void as Toyota may lose output of at least 40,000 vehicles, Nissan suspended operations at four plants until the 16^th and Honda will halt output through March 20^th.
• Only 15% of Japan’s land is suitable for cultivation and as noted above it imports most of its foodstuff which means food exports to Japan might pick up any supply lost in the earthquake and tsunami.

However, it might not be that straightforward because there are so many moving parts when it comes to our world economy. We will likely see increased volatility in world markets as new information continues to be released. The volatility will be dictated by the efficiency of the flow of information and the market participant’s ability to absorb and adjust portfolios.

In the final analysis, Japan’s suffering is awful; losing loved ones, as we all have, is life altering and rebuilding is exhausting and painful.  Not one economic analysis, not one dollar made or lost, not one more blog will take anything away from the difficult journey many will have to endure in the years ahead for Japan.

When I watch the videos of this disaster, sometimes it seems like what we do doesn't really matter in the grand scheme of things.  You depend on us to think through things and while it seems trivial at times - you matter and that's why we do it.

Tim Phillips, CEO

Please send me your comments or thoughts to tphillips@phillipsandco.com.

Inductive reasoning is one of the many thought processes we use today to make decisions and has helped us survive throughout our history.  It's our ability to make judgments (or should I say “educated guesses”) based upon past experiences.  

For example: We might believe that snakes are scary and dangerous. This belief can be formed without having specific or deep experience with snakes because we can call upon our past teachings, readings and life lessons to draw this conclusion. In most cases, this type of inductive logic can keep us safe.

Now we know that not all snakes are dangerous.  However, probability suggests that we should stay away or approach with caution, as some snakes can be deadly.  We let the past influence our current actions based upon our ability to quickly draw on probabilities and outcomes.

Unfortunately, this inductive reasoning can lead investors far astray.  By simply looking at the past performance of asset classes and drawing broad conclusions about the future can be probabilistically accurate and also be wrong.  Whatever the odds are, if they turn against you, wrong is wrong.

That's why I always ask myself 6 questions before I invest in an asset class.  I learned this several years earlier from Ben Inker at GMO, a well-respected Institutional Asset Manager.  He reiterated these in “Back to Basics: Six Questions to Consider Before Investing” a white paper published in October 2010 and I thought I would share them with you:

1)    Would a rational investor buy this asset class if it did not offer returns above cash?

2)    Where do the returns from this asset come from, and who funds them?

3)    Why would the funder of returns for this asset be willing to offer a return greater than cash in the long run?

4)    Have the historical returns been consistent with the risk premium we expected?

5)    Have the sources of the returns been consistent with the returns achieved?

6)    Has something important changed to make us doubt the relevance of the historical returns?

While these questions aren't exhaustive they do help me from falling into the trap of only looking at past returns and not reflecting on the probabilities of being wrong.  Unfortunately, unlike in life, jumping to broad judgments when investing doesn't always keep you from getting bitten.

I always appreciate any direct comments or feedback.  Please send it to my email at: tphillips@phillipsandco.com

Tim Phillips, CEO

Sesame Street takes on the Federal Budget

It has finally gotten to me.  I have seen and heard so much about budget cutting and deficits and I suspect you have too.  What's the big deal about all of this and what is the possible impact on our markets and investments?

The proposals to cut the budget are pretty straight forward.  Democrats want to trim $40 billion dollars from the 2009-2010 budget and the Republicans want to trim $100 billion dollars.  If they don't reach some kind of agreement by the end of this week, the Government will shut down as a consequence. Unfortunately, in the grand scheme of things either proposal seems trivial and meaningless in my opinion.

Let’s start by taking a look at the current Federal Budget with some simple math and The Count

Here’s the math for 2010: (According to the CBO)

  2.162 trillion in Taxes (Revenues)

- 3.456 trillion in Federal Spending (Expenses)

- 1.294 trillion to Finance

Here's the projected math for 2011: (According to the CBO)

  2.2 trillion in Taxes (Revenues)

- 3.7 trillion in Federal Spending (Expenses)

- 1.5 trillion to Finance (2010-11 Deficit)

Simpler Math: How much do we add to the Federal Debt ?

  13.8 trillion is our current approximate Federal Debt

+  1.5 trillion in 2010-2011financing (2010-11 Deficit)

  15.3 trillion is our forecasted Federal Debt

Since a trillion (a million millions) is a fairly abstract number to most people, let’s compare it to something people are more familiar with, the GDP of the United States. If we divided our forecasted Federal Debt ($15.3 trillion) by our forecasted 2011 GDP ($15.3 trillion), then our forecasted Federal Debt would be approximately 100% of our forecasted 2011 GDP.

Meaningless Arguments

When you compare the 2008 Federal Budget to the CBO’s forecasted 2011 Federal Budget we plan on spending approximately $700 billion dollars more in 2011 than we did in 2008 (That’s a 24% increase over three years). This $700 billion dollar increase was spent to temporarily stimulate the US Economy and the US Consumer. Going forward this temporary stimulus appears to be becoming permanent spending embedding into our Federal Budget for the foreseeable future. 

 Going back to the two budget proposals, the difference between $40 billion dollars and $100 billion dollars is really just a 1% difference in trimming the total federal spending for 2011.

Looking at it this way the argument appears to be important symbolically, but meaningless in its impact on the Federal Deficit for 2011 and removing the temporary stimulus.

The Consequences

From a fiscal perspective, the consequences can be grave for several segments of the economy in the long run.

From a market perspective we’re just not seeing any end in sight to the amount of temporary stimulus being pumped into the economy that's rapidly embedding itself into permanent spending.  We have essentially just fed the Cookie Monster, and now he can’t get enough.

My assessment is there is nothing in all the political noise to disrupt the unsustainable gravy train from pushing this economy forward.  I have said it before and I'll repeat myself one more time: The Great American Ponzi Scheme needs something to keep it going until we trick ourselves into spending and consuming more which will lead to more jobs and better wages.

Until then we will continue to feed the Cookie Monster.

 TIm Phillips, CEO

While scrolling through the hundreds of tweets I receive on a daily basis; I found a nice chart that truly keeps things in perspective for me and I hope you as well.

The stock market is up 100% and that's amazing (Reference 1).  The Fed has done it's self described job of inflating the only asset class they can - Equities.  While their mandate is generally described as keeping inflation well-managed and attempting to support full employment, the Fed has also managed to finagle their way into asset bubble creation and destruction.

So, let's not get too carried away with the 100% thing.

(Reference 1)

As seen in the chart over a three year period we are still down and over a longer term period the markets are at the same level as they were in 1999.  This does not bode well for long-term wealth creation.

However, the past is what it is and there really is no point in spending too much time being miserable about the last 11 years and 10 months.  Probably more important for us to look at are the likely scenarios for the short and intermediate future.

Here's what we believe based on the Bespoke Economic Indicators in reference 2.  The business environment is improving.  What once started off as a very slow recovery (the last 1 1/2 years) is looking to turn into one with more departure speed.  Our friends at Bespoke Investment Group do a nice job of summarizing the changes to economic indicators.  Green is good, Red is bad.

             (Reference 2)

As little as 6 months ago we saw lots of declining indicators.  Of course this is a 10,000 ft level view of the macro picture; however, the point is things seem to be improving even if they are still negative in some areas like housing.

Much of this can be attributed to the Fed’s use of quantitative easing as a policy tool.  See my earlier blog on how easing works.

When the Fed ends the second round of quantitative easing in June, we will once again try and rely on the US economy and the US consumer to leave the gravitational pull of earth for the self-sustaining euphoria of no gravity

Will we reach departure speed?

Corporate earnings and revenue can be a guide to how much fuel is in the economy.  With earnings season wrapping up on Tuesday, we have seen 67.4% of companies beat earnings estimates about 2 percentage points higher than last quarter.

 Revenues have also improved with 70% of companies reporting better revenue and if the quarter ends this way, it will be the best quarter for revenue since Q4 2009. 

On a going forward basis, 8.7% of companies have revised earnings guidance upward with 6.6% revising downward.

Overall, the short run earnings are strong supported by revenue and expectations for decent earnings in the future.

So while it feels very frothy in the equity markets relative to the last year or so, there is some reason to believe we may see an overall positive year in equity returns for 2011.  I won't attempt to tell you the exact path we'll take.  Likely it will be bumpy, frustrating and at times sleep deprived.  However, if we as investors and advisors can manage our time horizons correctly we may be able to improve our odds of success.

Tim Phillips, CEO Phillips and Company

 "Either we change the way we live or change the way they live"- Don Rumsfeld

With all that is going on in the Middle East I can’t help but reflect on an asset class that has been out of favor the last few years: energy.

Looking at the chart below, out of all US Equity sectors, energy has had the best performance over the last 20 years with a mean annual return of 12%. Looking just at the last three years though, energy has had an annualized return of -3.26%.

It’s important to consider the alternative though. The energy sector may be on a long downward mean reversion process and could underperform for years to come. It’s too early to come to any defined conclusions but you shouldn’t be surprised when the energy sector, and more specifically oil, continues to experience interesting price activity.

Here are some facts based on numbers from the EIA:

• United States’ oil consumption is a smaller percentage of world consumption. In 1980 the US was the largest consumer of petroleum and was 27% of world consumption. As of 2009 we were still the number one consumer, but our consumption represented only 22% of the total. I would be stunned if this trend didn’t continue.
  • Looking at the supply side, Saudi Arabia is a smaller part of the world supply. Also, Saudi Arabia’s proven reserves are a smaller percentage of the world’s proven reserves. In 1980 Saudi Arabia represented 16% of the world supply of petroleum; in 2009 it was only 12%. In that same time frame Saudi Arabia’s proven reserves as a percentage of the world’s proven reserves fell from 26% to 20%.

• Petroleum consumption should continue to increase mainly due to China and India. China and India alone went from 4% of the world’s consumption in 1980 to 14% in 2009.

All of these macro-trends have been in place for many years and have been discounted by some degree to reflect the current market price. However, I believe the long-term changes occurring in the Middle East and its effect on the supply side of petroleum going forward have not been fully priced in.

Using a loose definition of “democracy”, there are at best three “democracies” currently in the Middle-East. According to the Economist Intelligence Unit, Israel is a “Flawed Democracy” while Turkey and Iraq are considered to be “Hybrid Regimes.” My perspective: the best we can hope for are “Hybrid Regimes” in Egypt and Tunisia, bringing it to five “democracies” in the Middle East.

An Oops Moment

What makes this type of democratic tidal wave so unpredictable is that many countries in the region are dominated by religious ideology. These different perspectives become the fault lines for political parties in the Middle East. In Egypt, these ideological fault lines are split between two prominent parties: the “Muslim Brotherhood” and the “Wise Men Council.” I don’t pretend to be an expert on either group or their beliefs, but I don’t think either has fully grasped what has just happened.

The Google Guy

Wael Ghonim is the Head of Marketing at Google for the Middle East & North Africa. To make a long story short, he got upset this summer over an atrocity that occurred in his home country of Egypt. After posting several videos and some timely usage of social networking, he became a leader of this Egyptian Revolution almost by default. I don’t think this guy gives much credence to a group calling themselves the “Council of Wise Men.”

History has seen many revolutions, and we can look to recent examples in Russia, the Balkans, and in Eastern Europe. Despite their differences they all have one thing in common; it is never simple to figure out the winners and losers. Finding out who's elected and what values they will bring to the table will take time, all while the world waits for the oil it deeply depends on.

The last time there was a democratic election in the region was in Palestine, and they elected Hamas. For those unfamiliar, Hamas is an acronym for a phrase that roughly translates into “Islamic Resistance Movement.” They have been classified as a terrorist organization by the United States, Israel, the European Union, Canada and Japan. Democracy doesn’t always make a region more stable. What is even more concerning is that Hamas was founded as an offshoot of the Egyptian Muslim Brotherhood in 1987 during the First Intifada. This makes it even harder to believe in the prospect of lower oil prices.

Unfortunately, if we don’t change the way we consume, we are going to change the way they are going to live. It’s not entirely clear what the consequences in the short run will be on the geopolitical landscape. However, with the instability in the Middle East there is a high probability that both oil prices and the energy sector will continue to be in favor.

TIm Phillips, CEO

Some things in life really count and should be counted,

some things in life really count and can't be counted

There are two sets of data that I want to bring to your attention in this very brief blog (as it is Super Bowl Sunday). I have a Super Bowl diet allocation of 3,500 calories that I'm about to consume, and as I’ll explain, this is a number that doesn't count.

Data Point 1

Unemployment dropped to a mind altering 9% this week. Most Wall Street economists, including myself, were not expecting this type of drop. 

Of Course, we need to place a lot of value in the unemployment rate. With 70% of our nearly 15 trillion dollar GDP driven by consumption; jobs and wages matter. 

Unfortunately, for a Government that we allow to spend over 3.5 trillion dollars of our hard earned money a year, they can’t' seem to count when it really counts. If this 9% unemployment rate were accurate it would mean that we added 1,765,000 jobs in the last 15 months from its peak of 10.1% in October. That is 117,666 jobs per month 

We know the numbers simply don’t add up. What has actually happened is an increase number of willing (I use this term loosely) and able American workers are simply giving up and running out of benefits. According to Bill McBride, author of Calculated Risk, “The Labor Force Participation Rate declined to 64.2% in January. This is the lowest level since the early '80s. (This is the percentage of the working age population in the labor force. The participation rate is well below the 66% to 67% rate that was normal over the last 20 years.)”

Let's not take the headline number too seriously until we can get a key performance indicator that actually counts. And by the way, if I couldn't accurately count the most critical number in my business, I would run a serious risk of becoming a statistic also.

Data Point 2

The 1.9 Trillion dollars worth of cash recorded on the balance sheets of many U.S. companies at the end of Q3, 2010 is what really counts.

What corporate CEO's and Boards will do with the cash really matters, but can't necessarily be counted on. It seems a natural conclusion for many companies will be to use a part of this cash to buy more growth in the form of M&A activity. In fact, we are seeing a lift in activity with an estimated $124 Billion in global deals already being announced this year. This is the greatest number to date since 2000. While corporate balance sheets are sitting on 7.3 trillion dollars of debt or over 52% of their total financial assets, the dollars may be used to pay down debt. These are some of the highest debt levels reported since 1998 with an exception in 2008.  (The Deal)

The difference between buying companies and paying down debt speaks volumes about what corporate CEO's are thinking about the economic future. One implies optimism and a willingness to risk for growth, while the other suggests a continued feeling of concern and reluctance to live with a balance sheet that can implode with another economic hiccup. 

Hope and Fear can't really be counted but perhaps by watching what happens to all of this cash it can help us count the uncountable.

Political Jab

With an incalculable amount of this cash sitting overseas from foreign profits, we predict companies won't bring this back "onshore" to pay the current 39% corporate tax rate.  Why onshore it when they can count it as earnings, pay off debt with it in any country they like, and deploy it for cheaper labor and manufacturing?

Let's hope our partners in business (the U.S. Government) can start to learn how to count what can be counted and how to appreciate what can’t always be counted.

Tim Phillips, CEO

Two Sides of the Same Coin

This week the news was dominated by the turmoil enveloping Egypt, the geopolitical center of the Middle East. What is occurring shares many of the same characteristics of the popular revolt in Iran during the 70's. In that instance, extremists hijacked the moderate populous and moved the country to the absolute fringe extreme. Let's hope that doesn't happen here. How does this impact us? The United States has a positive trade balance of approximately 4 billion dollars with Egypt (http://bit.ly/ePkehi) and we shouldn’t forget the 1.5 billion dollars we send them annually to buy their support on a host of issues. Maintaining this trade surplus (exporting more to them than we import) is always worth considering. Yet relative to our 14.9 trillion dollar GDP, it's not on the radar; notwithstanding the significant negative consequences that would occur if the country fell into the hands of the angry "Arab Street".

What has been lost in all the news surrounding the chaos in Egypt was our own GDP data. For the 4th quarter of 2010, real GDP grew by 3.2% in real terms and 3.4% in nominal terms, which was slightly below estimates. Consumption increased by 3% while inventories shrunk by -3.7%.  If you took consumer and business consumption, and added back the draw down on inventories (assuming business will replenish that inventory) you can get an aggregate demand of 7.1%. This would be the largest quarterly gain since 1984 according to Moody's (http://bit.ly/aDecXC).

Test this against one of my favorite consumption indicators, the U.S. savings rate, and you can almost say the consumer is back. In May of 2009, the apex of financial fear, the US savings rate was 6.9% vs. a near 0% rate just years earlier. It is now down to 5.3%. This isn’t at the levels we saw that drove frenzied consumption but it is a strong signal the consumers are becoming more confident (http://bit.ly/hurAxF) (http://bit.ly/dIwiii).

We know our equity markets are structured around the anticipation of growth. In the current scenario this type of consumption plus the possibility of a GDP lift from replenishing inventories could bode well for the next quarter or two. Some of the "Wall Street Mafia" forecasts for the markets just might come true.

 The Other Side of the Coin

I know I should wrap up here and leave on a high note. However, I get paid to demonstrate some balanced judgment. So let me throw some cold water on these growth flames.

 Across the Atlantic, the GDP of the UK shrank 0.5%. Not a positive indicator. While pundits blame much of this on weather related issues, I would respectfully suggest that they are overplaying this convenient truth. Perhaps the "inconvenient truth" is that the austerity measures put in place by the current British Administration are having an impact on their GDP (http://reut.rs/girUs1). 

• Increase in the Value-Add Tax (VAT)
• Bank Balance Sheet Levy
• Payroll taxes rise for employees by one percentage point in April 2011
• The Treasury plans to raise four billion pounds a year by cutting tax relief on pensions for about 100,000 higher earners.

While this fiscal responsibility is necessary, and our country should eventually consider a similar approach to curb runaway spending and ballooning deficits, this GDP play out can come to our shores as well. If the American consumer cannot get a strong lift before significant cuts are made....watch out.

With a 14.8 trillion dollar economy (http://bit.ly/eRJ0yb), a 3.5 trillion dollar Federal Budget (http://bit.ly/b7LpSH) and the 1.5 Trillion we still have to borrow (http://yhoo.it/hfbBMf) it's hard to see how a few hundred billion dollars cut here and there would tip our economic world over. Additionally, the track record of US Presidents and Congress delivering on real austerity is abysmal at best. I wouldn't bet on any earth shattering GDP shifting events from our home team. 

I hope I'm wrong and that we do the right things for the long term. That being said, I believe that we will see both advances and pull backs in our market in the next few quarters. Ultimately, the balance should be in favor of the consumer and positive equity markets.

My equity themes continue to focus on the following:

• Consumer discretionary, specifically high end retailers
• Gas and Oil
• Business processing technology
• Media (Print that is adapting to on-line)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Segmentation of emerging markets rather than broad based emerging markets exposure, specifically Brazil Energy and Telecom
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters

Tim Phillips, CEO

Objects in the Rear View Mirror

Are they closer than they appear? 

Retail sales rose 7.9% on a year over year basis for 2010. Retail sales are up 13.5% from the bottom and up 0.2% above the pre-recession peak in November 2007. The consumer is back!

Here is a recent quote from the San Francisco Fed:

"The economic expansion appears to be building steam. After increasing 2.8% in 2010, we expect real GDP to grow nearly 4% this year and for growth to pick up to about 4½% in 2012. Pent-up demand for durable goods and eventually housing, and improving confidence are contributing to a steady improvement in the economy." (http://bit.ly/iekylK)

Job creation is still slow and pent up demand could help drive an inventory driven job growth spurt.

While it's hard to imagine increases in consumption with 14.5 million Americans out of work and another 8.9 million underemployed (http://bit.ly/4zoS3A); it appears that those working are spending and also those not working are still consuming. If many are not paying their mortgages and still receiving unemployment benefits, consumption may increase from the potential of free cash flow.

Whether this consumption leads to employment will be one of the key tests for our economy and equity markets in the months to come. My friends at Bespoke did a terrific job with a 2010 year end summary. Instead of having you read all 128 pages, I want to highlight a few key themes.

1)    On average, analyst forecast a modest gain in the S&P 500 from 2010 to 2011 of 9.02%.

 2)    The trailing P/E on the S&P 500 was 15.92 compared to a historical average of 15.37 marked over an 80 year period. While we are roughly at fair value, we are anticipating significant earnings growth this year and perhaps an expansion in the multiple. Remember, things tend to move above and below the mean, and I expect the same with the 2011 trailing P/E ratio.

3)    As seen from the data compiled by Bespoke, historically if the first two years of a president’s term saw strong market performance, the third year also showed higher than average returns. While I don't place a lot of merit on this type of data points, I hope to see this as a repeatable pattern.

While there may not be anything earth shattering in this week's write up, it's precisely the ordinary that most investors overlook and overcomplicate. Sometimes objects in the rear view mirror are exactly as they appear.

I continue to focus on several themes:

• Consumer discretionary, specifically high end retailers
• Gas and Oil
• Business processing technology
• Media (Print that is adapting to on-line)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Segmentation of emerging markets rather than broad based emerging markets exposure, specifically Brazil Energy and Telecom
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters

I am removing Germany from my top of mind theme list as there has been a significant run in its economy and with its neighbors introducing austerity measures it will be tougher for them to export their way to the same growth rates. We all need our neighbors and at this point Germany’s are not strong enough.

Tim Phillips, CEO

Investor Class vs. Working Class 

The economy is expected to possibly grow at a rate of 3.5% in 2011. By comparison, to achieve stable employment, a GDP of 2.7% would probably be necessary. Clearly the estimates being put forward suggest a significant improvement in the employment picture.

As we enter earnings season this week we should see a flurry of strong earnings reports. There is no question that business profits are up. According to economists at Goldman Sachs, we could potentially see corporate profit gains of 20% - 25% this year and 15% - 20% in 2012 (http://t.co/0kZbuwb).  We can also assume that corporate hiring will see consistent improvement with the increases in corporate profits. 

We are also seeing a significant boost in both overtime hours and temporary help. These are two key precursors to firms adding permanent hires (http://bit.ly/gEd7bm).

So it seems that in a “not too distant future” we should begin to see real -not just mathematical- improvements in the U.S. employment situation. What I mean by ‘real’ is this: actual people getting back to work, not just shifting numbers in how we count the unemployed.

What About US (United States)

However a careful review of the profit situation may reveal a different type of recovery. When you break down the geographic sources of U.S. corporate profits from S&P 500 companies a simple truth is revealed. Approximately 40% of those profits are coming from foreign operations (http://wapo.st/elNMzy).

It’s not hard to imagine that U.S. corporations are finding large profits through foreign operations with:

• India having a population of 1.1 billion people
• China having a population of 1.3 billion people
• The United States only having a population of 307 million people

If that's the case than perhaps domestic hiring will take a bit longer.  Why hire people here in the United States if you are manufacturing goods overseas and selling them overseas? We could have great profit recovery and foreign employment growth at the same time.

It doesn't take a rocket scientist to figure out that the investor class will run up stock prices based upon profits, indifferent to where those profits come from. What we could be left with is a profit recovery, stock market recovery and a long slow job recovery. This is good news for the investor class, good news for the emerging middle class in foreign markets but perhaps some pretty bad news for the working middle class here in the United States.

Make no mistake; the United States needs a vibrant, employed middle class. No one else will drive the consumption our economy needs to grow over the medium term (3-5 years). 

While political and intellectual leaders struggle with this puzzle, we will continue to find segments and sectors that can benefit from this interesting trend.

My Current Investment Themes

• Consumer discretionary, specifically high end retailers
• Gas and Oil
• Business processing technology
• Media (Print that is adapting to on-line)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Segmentation of emerging markets rather than broad based emerging markets exposure, specifically Brazil Energy and Telecom
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters
• Germany

Tim Phillips, CEO

New Year's Resolutions 

Our focus for the New Year.  Call it a recommitment, an affirmation, or simply stating the obvious.

It's clear to me that in order for Phillips and Company to thrive and grow we need to make a couple of New Year's Resolutions. It's not to eat healthier, drink less, speak kinder, lose weight, make it home in time for dinner with the kids, be more respectful or walk the dog. While these are extremely important resolutions ours should be a little different.

Our Achievement or Your Achievement

The securities, asset management and financial services industry was founded on and thrived on a simple concept: Personal Achievement.  People come into this industry to make lots of money, beat the "house", figure out how to beat the market, own a big home, vacation home, jet, fancy cars and all the other American trappings.

These are necessary motivations in America.  Achievement - it's what drives growth, which pays for lots of our habits like Medicare....you name it. I, like other business owners, have had many of the same desires. However, there is a small problem with Achievement: when personal achievement comes ahead of client achievement.

Unfortunately, that is exactly what has happened and dominates the financial services industry.  Again, it's not that personal achievement is a bad thing.  When aligned properly with client achievement, personal achievement can be a wonderful elixir for positive outcomes.

Things like assets under management, how much money you have, who else they manage money for, who they know, fancy brochures, what they drive, how much they have are all distracters to the main issue at hand.  Simply put, do they care enough about you to put their full dedication into your achievement as a priority over their own achievement? In one word: TRUST.

This year, while the financial industry focuses on their recovery (you’re going to hear a lot about the banks and financial institutions brag about record growth) we’re going to dig even deeper into your achievement.  This is our resolution!!!

We’re going to focus on your values, what you want and need, being better communicators, keeping you well ahead of us in the achievement ranking category.  We’re going to measure things differently also, things that you want for your success not just things we count for our success.

I know this might sound a bit Pollyanna-ish but for 25 years I have been a professional in this industry and a realignment is desperately needed and it doesn't look like it's going to be lead by the big names.  They, in my opinion, will return to their new normal- quarterly earnings results, cute slogans, and behavioral devices to get you to invest.

Hendrik Coetzee-"The Great White Explorer"

I hate the obituaries; I guess I am still young enough to want to avoid staring at mortality especially my own.  The only obituary I will read is in the Economist.  They usually have one each week and it's somebody noteworthy. 

This week they featured 35 year old Hendrik Coetzee the great whitewater explorer.  He died being eaten by a crocodile while exploring some of the world’s most dangerous white water in Africa on December 8th. 

Just prior to his death November 28th he wrote a very eloquent blog (http://bit.ly/hKtHbW) that struck me right in the eyes.  While he wrote poetically about white water, rivers and African landscapes, he really wrote about risk.

Our second resolution should be to double down on our focus on risk.  We always talk about risk budgeting, manager risk and measuring risk and this year will be no different. 

However, this year, when it looks like everyone is calling for a big up year in the markets and perhaps greed becomes the predominant investment filter we want to continue to describe risks to you:  timing, liquidity, selection, sector, and holding period risks just to name a few.

It's not that we are here to eliminate risk, we can't do that.  If you need returns we need to give you risk.  It's really a question of what type of risks, how much to get you your desired outcomes and the time frame you give us.

We should always keep the following chart front and center in our minds. The chart covers the period of 1871 to August 2010.

I think Hendrik Coetzee said it best just prior to his death

"It is hard to know the difference between irrational fear and instinct, but fortunate is he who can. Often there is no clear right or wrong option, only the safest one. And if safe was all I wanted, I would have stayed home in Jinja. Too often when trying something no one has ever done, there are only 3 likely outcomes: Success, quitting, or serious injury and beyond. The difference in the three, are often forces outside of your control. But this is the nature of the beast: Risk.

Anyone who is good at what they do, be it marketing, sports or hairdressing will tell you they trust their instincts. There are rational explanations for people making the right choices based on information they could not have known beforehand but only because we live in a rational world. If you chose this option and believe that all that all there is to know is already known, then that is your boring truth, keep me out of it. Whatever the real reason, I think we all agree that people who can go successfully beyond facts are the ones who excel in any, and all fields."

"Risk is the nature of the beast" While we can't promise to tame the beast we can work very hard to shape it to your advantage as best we can.

Happy New Year!

Now What

The $800 billion Clinton-Bush-Obama Tax Plan is in the books. The $600 billion Fed bond purchase program is underway and the stock market is moving higher as a result.

United States GDP estimates for 2011 are inching up with some very notable experts, including Alan Greenspan, suggesting we could possibly see 3.5% growth in 2011.

The U.S. economy is picking up speed and may grow by 3 percent to 3.5 percent next year - Alan Greenspan (http://bit.ly/hwsl3M) 

Instead of another year expanding at no more than the U.S. economy’s potential growth rate—with job gains of 1.2 million and unemployment hovering near 10%—real GDP growth will accelerate to 4%, job gains will pick up to 2.8 million, and the unemployment rate will decline to around 8.5% by year’s end.- Mark Zandi (http://bit.ly/hRT7RN)

Pacific Investment Management Co., manager of the world's largest bond fund, raised its growth forecast for the U.S. economy to between 3% and 3.5% for 2011 from an earlier estimate of 2% to 2.5% - Mohamed El-Erian (http://aol.it/g7sx8u)

The economy will expand about 3 percent next year,- Bob Doll (http://bit.ly/e5rxkU)

In addition, optimism among U.S. chief executives in the fourth quarter rose to the highest level since the start of 2006. Business leaders projected increased sales, investment and hiring according to a Business Roundtable survey. (http://bit.ly/f78rkG)

Experts: Guessing Early and Guessing Often

Next up will be an assortment of investment experts giving us their very precise and inaccurate predictions for 2011.  One thing I have grown to despise but appreciate is the general public desire for precise predictions.  Unfortunately, the more precise a prediction is, the more inaccurate it becomes.  Forecasts will be calling for upgraded GDP growth in the 3% range for all of 2011 and some of this "parlor trick" prognostication may move the markets. Further, I expect most experts will be calling for the S&P 500 to advance 11%-17%.

I like all of this. It sounds wonderful. But I’m not sold just yet. I know how unpredictable these prognostications can be when we still have 9.8% unemployment, 9 million underemployed, and housing starts and housing prices at record lows.

So I'm going to continue to watch and see if people return to work, consumption patterns broaden across all Americans, wages increase, savings rates drop, revolving credit expands and business start making more investments.  Essentially, see that everyone other than the US Government is demonstrating confidence and betting on growth.

With all of that said, we should also be investing because if investors miss just a few critical days of stock market gains they lose out on critical returns. Burton Malkiel summarizes this nicely in his Wall Street Journal article, 'Buy and Hold' Is Still a Winner:

Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009. But if they had missed the 30 best days in the market over that period, their return would have been negative.

So What Now?

If 2011 is indeed another expansion year you should be doing the following:

• Re-examine your asset allocation to ensure you are properly allocated across the right asset classes, sectors and segments.
• Evaluate the risks you took out of your portfolios and make intelligent choices about the risks you want to add back into your portfolios to capture appropriate opportunities.
• Aggregate all the various accounts you might hold and look at your allocation from a macro perspective.  I'll bet you will find some interesting flaws and misconceptions once you look at everything in totality.
• Make a commitment to review your current assets and determine your future liabilities and claims on those assets to ensure your managing those assets properly. More succinctly, budget your risks based upon realistic growth requirements.

While many aspects of next year are uncertain, I do know that we are going to be stronger partners with all of those that turn to us for advice and counsel. That's what’s next.

On behalf of everyone here at Phillips and Company we wish you a very peaceful holiday season, and a happy, healthy and prosperous New Year.

The CBO: Congressional Budget Office Clinton, Bush, and Obama Stimulus Program

Politics Makes Strange Bedfellows Indeed

Weekly Market Commentary 12-13-10

At the end of the week just as everyone was heading out to enjoy the weekend, I took a quick glimpse at the future, or should I say the past.  On TV was former President Clinton standing in front of a Presidential banner backdrop in the White House Press Briefing Room.  This must be a replay from the 90’s I reasoned.  Yet he was talking about the current tax cut proposal in front of Congress.  Maybe it was the stress of the week, or perhaps the delayed impact of the couple of glasses of wine I had the night before.  I felt I was in some kind of time machine malfunction; a past Democrat President pitching a past Republican President’s tax plan that will help the future on behalf of the current Democrat President.

In any case, I shook off the shock and awe and began to analyze the implications on politics and the economy.

The economy first and foremost

 
The tax plan calls for somewhere unto $900 billion in spending, tax breaks, give backs and other items.  (http://bit.ly/ht4qQA) (http://nyti.ms/gSkDIK)

Now if we go back to an earlier blog and review the components of our 14 Trillion GDP economy we can make some logical inferences. 

So what does the additional $900 Billion do for GDP? What sectors will be impacted the most?  These seem to be the main questions investors need to answer. 

Most analysts prior to the details of the tax plan estimated GDP growth for 2011 to be around 2.5%. (http://bit.ly/byj8fJ)   It's no surprise we are now seeing quick estimates for 2011 GDP coming in around 3.5% to 4% by Q4 of 2011.

3.5% GDP in the form of good consumption could be enough to get the “Great American Consumption Machine” flowing at a self sustaining pace.  It's simple, and I have said it many times before:

Consumption and Investments = Jobs, Wages, Profits = More Consumption and Investments

3.5% to 4% GDP is enough to create net new jobs including new entrants to the labor force in my estimation.  This is good for everyone.

In fact, the benchmark gauge for American equities (the S&P 500 Index) is predicted to rise 11 percent to 1,379 in 2011, bringing the possible increase since 2008 to 53 percent, the best return since 1997 to 2000, according to the average of 11 strategists in a Bloomberg News survey. (http://bit.ly/dVIgjU)

The New CBO and Politics

The CBO (Clinton, Bush, Obama) tax plan is stimulating in the short run, if the consumer is willing to consume.  Obama is betting his election on an improvement to GDP before 2012.  He must have concluded he was not going to be re-elected no matter what he did if the economy is not better by 2012.  If he now focuses in on mid and long run deficit reduction, he might hit a home run compared to the rest of the world as they face austerity and we continue to borrow from tomorrow and spend today.

My Investment Themes

So my investment themes continue to be centered on targeted improvements in the economy.  Only now, I am adding a large focus on consumer discretionary (assuming the tax plan actually passes).  While we have had a focus on the high end consumer, I believe the CBO stimulus will reach down to most American consumers.  While I don’t personally support huge deficit programs it’s clear that short run spending might be the best chance we have to keep the US economy from becoming Japan’s economy.

• Luxury Goods with growing emerging market exposure
• Weak dollar opportunities - exporters
• Select technology - specifically business processing
• Media (Print that is adapting to on-line)
• Rare Earths (again see our Tweets on this)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Segmentation of emerging markets rather than broad based emerging markets exposure, specifically Brazil Energy and Telecom
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters
• Healthcare Assisted Living
• Germany
• Financial Asset Managers/Hedge Funds
• High end retail

Tim Phillips, CEO

At the confluence of the mighty Columbia River and the Pacific Ocean is Buoy 10, a great spot for Salmon Fishing and getting sea sick.  The absolute chop, current and waves caused by these two massive bodies of water cause quite a stir.  In fact, it’s often people lose their lives trying to cross this bar or fish in the currents.

This is a little what it’s like navigating the treacherous capital markets these days.   While it’s true the best opportunities to generate positive returns is to invest in somewhat uncertain times (please take note of the word “somewhat”).  The chop is what you need to make returns but it doesn’t mean you won’t get sick.

That’s what it was like this last week.  On one hand you had Goldman Sachs (the self proclaimed gold standard of investing) calling for 2.7% GDP growth and a 22% return for the S&P 500 in 2011.  In fact, they called for massive opportunity in many asset classes and countries next year.  Of special note Goldman became very bullish of financial stocks for the first time since 2008.  These guys are really feeling the economic love.  Below you can see a few of their predictions (http://read.bi/fzCk9J).

Japan

Current:  875   2011 End:  1000    Change:  +14%

Asian Markets Ex Japan

Current:  449   2011 End:  580    Change:  +29%

 STXE 600

Current:  262    2011 End:  330     Change:  +26%

S&P 500

Current:  1188   2011 End: 1450    Change:  +22%

On the other hand you had a Friday jobs report that fell well short of expectations, adding only 39K jobs for November vs. an expected 100K jobs bumping the unemployment rate from 9.6% to 9.8%. What was particularly disturbing was the zero growth in wages (http://bit.ly/48PjbR).

While there is lots of conflicting data that creates these choppy seas, these two converse data points highlight the fact that we are in the middle of some very choppy seas.  Buoy 10 never felt so good in comparison.

The critical point to keep in mind is the fact that markets trade on expectations for the future.  Goldman’s analysis is clearly an expectation for the future.  While the jobs data is a clear and ugly look at the very recent past.  For Goldman’s analysis to see any hope of implementation we will need to see the end of 2011 and much of 2012 GDP growing in the 3%-plus range.  My personal opinion is that is entirely possible. 

A slight lift in our economy can create a significant lift in our markets as they have built in so much permanent negative information.  Hopefully some smooth sailing ahead.

Unfortunately, we will have to work through some choppy waters as the churn from forward expectations and the reality of backward looking economic ugliness collide.

My Investment Themes:

• Luxury Goods with growing emerging market exposure
• Weak dollar opportunities - exporters
• Select technology - specifically business processing
• Media (Print that is adapting to on-line)
• Rare Earths (again see our Tweets on this)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Segmentation of emerging markets rather than broad based emerging markets exposure
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters
• Healthcare Assisted Living
• Germany
• Brazil Energy
• Brazil Telecom
• Financial Asset Managers/Hedge Funds
• High end retail

Tim Phillips, CEO

Weekly Market Commentary 11-29-10  

With official earnings season concluded, market participants are clearly re-focusing their attention back on to macro economic data.  GDP, Income, Savings, European Financial Crisis, and Jobs; all were part of headlines that moved the markets.

The data noise can almost be mind numbing particularly when everyone is trying to find a direction to our economy.

Let's start with two simple facts, GDP and Personal Consumption are very muted in the current "Economic Recovery" we are currently being tortured with.

Naturally, the real data I am continuing to look for is a resurrection of the consumer.  Consumption being 70%+ of our GDP (http://bit.ly/eLCMaO) it’s the ball we need to keep our eye on.

                                                                                                                                               Source: St. Louis Fed

This last week was going to be a strong indication of what lies ahead for consumption and therefore GDP growth.   While it's hard to compare data from a year ago due to so many variables here's the early take.

On-line shoppers gave merchants a 16% boost to revenues according to Coremetrics an on-line tracking firm.  Not bad so far unfortunately, on-line shopping is still a small but growing part of the retail landscape.

According to ShopperTrak, "Black Friday sales rose only slightly from a year ago even though more shoppers visited stores, retail traffic monitor ShopperTrak said Saturday, setting the stage for another uncertain holiday season for retailers. Sales increased 0.3% to $10.7 billion". 

So like most things about investing it's never a clear cut picture and will continue to require good judgment when it comes to selection and timing of investments.

My personal sense of what's next on the macro investing environment will be the pending tax cuts.  I know Europe is falling apart and much of that is being discounted into our markets. I'm talking about what's beyond that crisis.  The Tax Cut Showdown - we really need to keep our eye on this ball. 

To set the stage for this epic battle of policy, economics, stability and future growth allow me to summarize a very nice analysis by the folks at Moody's Analytic's.

• If Congress were to allow the tax cuts to expire by year end for everyone the budget deficit would drop to $732 billion from the current $1.3 trillion in 2010.  GOOD

• Again according to Moody's (don't shoot the messenger) GDP growth would tail off to 0.9% and unemployment would average 10.7%.  BAD

• If Congress were to extend the tax cuts permanently to everyone other than top earners (over $250K) then according to Moody's the economy would grow 2.6% because low and middle income earners spend more of their take home pay than the highest earners do.  GOOD

• Unfortunately, those that create the jobs will be less likely to hire more people and unemployment will likely average 10% in 2011 from 9.7% currently.  BAD

• The budget deficit will likely gravitate around $900 billion in 2011.  BETTER than $1.3 trillion in 2010.  Again this according to Moody's

• If Congress was to simply extend the tax cuts for one or two years for high earners and permanently for everyone else, the economy would grow 2.95 percent next year, unemployment would average 9.9 percent next year. OK

• Even though no one's taxes would rise in 2011, the budget deficit would drop to $943 billion from $1.3 trillion this year. GOOD

• The other scenario to keep our eye on is to make the tax cuts permanent for everyone. By Moody's calculations, the impact on unemployment, growth and the deficit in 2011 would be the same as if Congress extended tax cuts permanently to everyone other than top earners.  GOOD 

However, extending the tax cuts across the board would swell the debt over the next decade by nearly $4 trillion, according to the Congressional Budget Office.   Not that the CBO can be trusted either. 

So the battle is starting to take shape.  Compromises are being discussed and negotiations are pursued.  Certainly political posturing is being considered in every move.  How to pin the blame for more economic failure is the undertone.  

The outcome of this debate matters terribly.  However, what matters most in my mind is a set of rules that businesses can rely upon to make decisions.  Keynes often said it was important to have consistent tax policy to create economic stability.  One thing we have not had in the last three years is stability. 

I'll keep my eyes on this ball and hope policy makers do the same. 

My investment themes continue to be: 

• Luxury Goods with growing emerging market exposure
• Weak dollar opportunities - exporters
• Select technology - specifically business processing
• Media (Print that is adapting to on-line)
• Rare Earths (again see our Tweets on this)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters.

Tim Phillips, CEO

Weekly Market Commentary 11-22-10

I rarely write about local issues here in Oregon as this blog is received by thousands of people throughout the United States.  Generally, Oregon issues aren't that relevant to the macro picture in the economy.

However, something very interesting took place in Oregon this week that did not pick up very much attention here or throughout the rest of the US. 

Market Clearing Activity

I have always maintained in my past posts that one of the biggest challenges for the US economy is the lack of market clearing activities.  This is the ability for assets (houses, hotels, office buildings, businesses) to be re-priced at levels that allow those assets to be purchased by new buyers that can then operate and utilize those assets appropriately and with more productivity.

In the past, such strong government intervention into clearing forces:  modified mortgages, stress tests on banks, credit standards modification, higher capital ratios, TARP, TALF and many other programs I can't recall, delays the ability of the free market to adjust quickly.  While the economy was saved from catastrophe by these actions the unintended consequences was a delay in asset movement and a prolonged, slow and sluggish recovery.

Back to Bend, Oregon.

What those of us in Oregon know is Bend, Oregon was the hottest real estate market in the country. According to MONEY Magazine, prices rose 130% from 2000 to early 2007.  Since then prices have dropped 34% (http://bit.ly/9TcrE9)

Banks didn't write down assets quickly that they had loans against, jobs disappeared (especially construction), the service industry collapsed, golf courses closed or modified their exclusive membership programs and the list of devastation goes on and on.  The local banks that needed to clear the assets off their books failed or at minimum their stock prices collapsed. Likely, you have heard or experienced similar circumstances in your community. Below is a 10 year stock price chart for Cascade Bancorp (CACB) which is the largest full service community bank in the Bend area.

Last Week In Bend Oregon

This last week in Bend two events took place that struck me as very exciting.  Cascade Bancorp (Bank of the Cascades) received a major cash infusion with some new owners.  They received 177 million dollars in exchange for 87% of the bank (http://bit.ly/cUZrtD).  Good.  What's even more fascinating is who made the buy.  It was none other than noted bottom feeder, billionaire Wilbur Ross along with his pals at Leonard Green Partners. Wilbur Ross shorted the housing market at the peak and both firms are the best at finding bottoms in markets and taking advantage of them.  In my mind, they have reprised the bank and will likely allow the bank to now clear their books of overpriced real estate.  This is a much needed market clearing activity to get the Bend economy going again. 

The second event was a direct market clearing activity.  One of Oregon's most respected private companies, Jeld-Wen, the global leader in windows and doors just sold massive amounts of resort real estate in Oregon (http://bit.ly/d1ZC3Q). Knowing the players at Jeld-Wen like I do they are very smart managers and likely sold to allow them to focus on their core business. To me, this is another sign of market clearing activity in the worst real estate market in the country.

Could this be the bottom for:

• Real estate in Bend?
• In Oregon?
• Perhaps the Country

A stretch, but perhaps. The tea leaves look good to me: 

• a terrible collapse in prices
• an awful follow on economy
• smart money Jeld-Wen selling assets
• a bank getting needed capital infusions based upon likely significant losses in its real estate book
• really smart buyers with billions of dollars to invest breaching the void and making a bet.

If there is such a thing as a "canary in a coal mine" then this could be one.  Since, there are no coal mines I know of in Bend we should call it a "Canary in the Lava Tube" as we have lots of those here in the Cascade Mountains.

A quick hit on the market:

This week ended official earnings season on Tuesday.  While the markets fell apart during this earnings season as it drew to a close the markets regained some of its strength.  Below is chart of the S&P 500 since October 7^th when Alcoa kicked off Q3 earnings season:

The relatively good news (according to Bespoke Investment Group) is 64.6% of companies beat their earnings estimates and 62.1% beat their revenue estimates.  It could be worse.

What's even more promising is companies continue to guide higher in the coming quarter.  See another Bespoke chart below.

My investment themes continue to be:

• Luxury Goods with growing emerging market exposure
• Weak dollar opportunities - exporters
• Select technology - specifically business processing
• Media (Print that is adapting to on-line)
• Rare Earths (again see our Tweets on this)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment  environments
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters

Thanks

Wishing you a very Happy Thanksgiving

I gave a brief explanation last week to a group of employees here at Phillips and Company on why the recently announced Quantitative Easing policy by the Fed is not inflationary in its primary essence.

I think it's worth discussing here, as I believe alignment around outlook is critical if we want to improve our return capabilities for our clients.  I'm going to skip some non-essential details for simplicity sake, so here it goes.

You hear it all the time, "the Fed is printing money".  Not really....  If it were, then inflation would be a concern.  When the Fed buys back treasury securities (Quantitative Easing) from commercial banks and primary dealers (those authorized to conduct business directly with the Fed) they don't really put more cash into the economy directly.

The Fed operation goes something like this:

The Fed buys back treasury securities from dealers and banks that have set maturities and specific yields.  In return the banks basically buy new treasury securities at new rates and maturities.  Basically, all that's changing at the bank level is the rate and maturity duration of the treasury securities they own.  The concept of a bank holding cash is bogus.  They buy something with the money and it's usually a treasury security.

So instead of printing money, the Fed is swapping rate and duration.  This is why Bernanke insists his QE2 is not inflationary in and of itself (see his Washington Post Op Ed piece for more http://wapo.st/bpBThf). On Friday, November 5^th Ben Bernanke gave a speech at Jacksonville University where he stated:

 “What the purchases do… is… if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed. Now the question is what happens as the economy starts to grow quickly and it’s time to pull back the monetary policy accommodation. There are several tools that we have”

(video: http://www.c-spanvideo.org/program/296446-1)

(http://pragcap.com/ben-bernanke-explains-fed-qe)  

What is the Federal Reserve looking to accomplish?  If the Fed buys back higher yielding treasury issues and issues lower yielding treasury issues then perhaps banks and primary dealers might choose to lend out more money or buy riskier assets in hopes of better returns.  Basically, they are trying to induce investors of treasuries to move up the risk curve into things like business loans, personal loans, real estate loans and stock market purchases.  They hope that banks will want a better return than what the Fed can offer, and as a result banks will start to speculate.  I emphasize hope.

Here's why: If investors start investing into the economy, especially the stock market, the Fed may be able to stimulate the “Wealth Effect.” According to Karen Dynan and Dean Maki in their study Does Stock Market Wealth matter for Consumption in May 2001, they estimated that an additional dollar of wealth leads households with moderate securities holdings to increase consumption between 5 cents and 15 cents, with the most likely gain in the lower part of this range. (http://bit.ly/ctinqz)

Although speculative, I think the Wealth Effect trade is on and if we see several months of positive returns then we could see a self sustaining cycle of consumption that drives production and investment. This in turn will drive consumption, jobs and income.  Shazaam! You now have GDP growth and the Great American Ponzi Scheme is back on.

However there is a problem with this Wealth Effect trade that the Fed is banking on.  There is no demand for money, debt, or speculation by the largest segment of job creators, small businesses. Small firms accounted for 65% of the 15 million net new jobs created between 1993 and 2009 (http://bit.ly/5s9XD). Animal Spirits are at the foundation of the Fed Trade and no one really knows if cheap money will drive speculative animal spirits.

On this we will have to wait, watch closely and see.

Some side notes on what else I'm seeing from the Fed Wealth Effect Trade:

Those misinterpreting the inflationary impact of this trade are bidding up many commodities.  I don't include gold in this as I think there are other factors that are pushing gold higher beyond the inflation speculation.  While QE2 can lead to inflation, the treasury buyback will only directly impact inflation if the demand for higher returns trumps safety.

The real losers of the wealth effect trade are those that live off of interest income of have "cash" in the bank.  Let's face it, these rates are going to get worse…if that's possible.

The emerging markets might be the biggest recipient of the speculative trade.  If I'm an investor (and I am) I'm buying countries with a growing middle class and less litigation, regulation and taxation.  That's not the United States!  Unfortunately, if the money inflates the emerging markets for just a few investors then the Wealth Effect is a non-effect.

I hope this clarifies some things for you and explains why Ben Bernanke insists QE2 is not inflationary... It's not, but let's hope it leads to at least a little inflation in the coming year.

My investment themes continue to be:

• Luxury Goods with growing emerging market exposure
• Weak dollar opportunities - exporters
• Select technology - specifically business processing
• Media (Print that is adapting to on-line)
• Rare Earths (again see our Tweets on this)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment  environments
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters.

 Tim Phillips, CEO

Sleep Well Money

Money that helps me to sleep well tonight is probably not going to help me live well tomorrow. The 5% return many have received in the last ten years of investing is not going to be enough for the next twenty years (Trailing Returns, as of 3Q 2010, for an investment portfolio that is 70% S&P 500, and 30% Barclays Capital US Bond Aggregate Index are shown below via Morningstar Analytics)

However, However this last week lifted my thoughts on a very slow future. Consumer credit balances increased for the first time in eight months, rising at an annualized rate of 1.1%. What's still troubling about this data is the difference between the revolving credit data and the non-revolving data. Revolving credit (often stuff bought with credit cards) is still down 11.4% on an annualized basis. However, non-revolving credit (auto financing for example) is up 8.2% on an annualized basis for September 2010.

My take on it is this: while there is still pent up demand on large items being financed at very low and favorable terms, the expensive financing for credit cards is driving down usage. In addition, there are still processing impediments associated with credit card issuance. This is holding down consumption (http://bit.ly/ciGL8D )

While organized credit is still constraining consumption in some parts of the US, overall the grey market for credit is flowing freely. In a recent article I read, one analyst put the amount of extra cash being generated in our economy from those not paying mortgages at $2.6 Billion per month. $2.6 BILLION PER MONTH. (http://ow.ly/32Wx5). I want to know what happens when banks finally stop the giveaway at the expense of others. Will consumption shrink? Will those paying their mortgages revolt and take their turn at building savings and consuming on someone else's dime? Let's watch this trend carefully.

What a week. In addition to the credit data, we had over 150,000 jobs added by the private sector and the Fed announced that they will pump $600 Billion into the economy over the next several months. What's even more amazing is that this week we saw historic political change and a shift in rhetoric regarding tax cuts. Now it appears that the current administration might just flex on an extension of tax cuts which will help the equity markets. What does all of this mean for our markets and the short run view of our economy?

Here's how I see it:

We have an inflated stock market that feeds into the wealth effect of the consumer. This will drive consumption up in the short run and perhaps even provide a slight lift to real estate assets. This is the hope of the Fed and I don't like to fight the Fed especially in short bursts.

If consumption lifts we could see a ‘follow-on’ effect with employment continuing at 100,000 + improvements. Remember, there are about 125,000 new entrants into the work force each month and 17+ million unemployed or underemployed.

Here is how Jeremy Grantham from GMO sees it:

Jeremy Grantham is a well respected institutional asset manager for the largest organizations in the country. He manages over 100 billion in assets and always has very interesting and perhaps acerbic comments that cut through all the noise and get to the point. Here are a few few focus points from his most recent letter, titled “Night of the Living Fed:”

•   Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates.

November 1^st 2010

The GDP numbers that were reported this week were not as bad as most think.  Sure, at 2% GDP growth for Q3 (initial) we are not going to quickly put more people back to work.  However, on a rolling 12 month basis the 2% added to the prior 3 quarters puts us at around 3.1% growth for the last 12 months.

Looking further into these GDP numbers we see a nice increase in consumption.  Consumer spending added 1.8 percentage points to GDP this quarter, an improvement over last quarter. (http://bit.ly/aDecXC)

In fact, when you look at the last 3 recessions and recoveries, GDP growth coming out of this recession is similar to GDP growth coming out of the last three recessions.  (Via University of Michigan Economist Mark J. Perry at http://mjperry.blogspot.com/)

All of these wonderful statistics aside, GDP is a clear look in the rear view mirror, while investing is about the future.  As a wise investor once said (although I can’t remember his name), "you can't eat past performance."

So how does the future look from my perspective?

I see structural deflation continuing to put pressure on GDP growth. 

When I can walk into a toy store and buy a G.I. Joe with the Kung Fu Grip at a 40% discount, and through efficient supply chain management another one will appear tomorrow on the shelf at the same or lower discount; you have a supply chain driven deflationary holding pattern.

When a business person walks away from his hotel he owns because of too much debt and the new buyer gets the property cheaper with less debt; they can lower prices and hope to increase demand. This is another structural deflationary challenge.

It’s everywhere, as it’s been built into our free market system. This structural deflation is not just a demand problem either; it's also a supply problem.  Things are still too expensive and consumers are still too cheap.  The consumer will win this battle at the expense of GDP growth and perhaps income growth, employment growth and real estate appreciation.

By the way, we have been living with this battle for over 10 years so it's not the recession it's the reality.

Structural deflation aside I also see tremendous gridlock in Washington DC. Unfortunately, I follow politics very carefully.  My view is there will be little political compromise on tax policy and perhaps everyone will get stuck paying higher taxes with the expiration of the Bush Tax Cuts.

I do see some type of Equipment and Capital Purchases Tax Credit making its way through the political silly season.  Encouraging more planned investment by business is another way to fix the GDP model.

I also see congress going along with a ‘roads and rails’ infrastructure allocation.  It’s an easy example of how even though we hear all about the moralizations of no federal spending, congressmen are always looking to be reelected. To do this, they have to deliver something to their district. And as distasteful as this is, every politician is playing the game of "political chicken" and it's not hard to imagine our leaders going for more pork early in spite of what they say to our faces.

The Fed is going to jump in this week with their solution to the obvious policy gaps that are about to occur.  They will offer up more asset purchase programs to attempt to ease the pain of the consumer and force more cash off the sidelines into riskier assets (BBB corporate bonds, equities and emerging markets).  This will have a temporary and limited impact from my perspective.  It's not really the supply of money, there is plenty of that.  As I said earlier, it's the supply of goods and services and the demand from the consumer that is distorted.

However, I do see this distortion being corrected in Q4 and improving throughout next year.  In fact, I can see GDP growth bettering the 2% we experienced in Q3, driven up by more consumption, better trade balances with a weaker dollar and depletion on corporate budgets for capital purchases. We might even reach 2.5% to 3% GDP growth if we get a quick win on the capital purchases tax credit.

While all of this occurs in the real economy there is plenty of opportunity in the capital markets economy.

My investment themes continue to be:

• Weak dollar opportunities-exporters
• Select technology - specifically business processing
• Media (Print that is adapting to on-line)
• Rare Earths (again see our Tweets on this)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment  environments
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters.

It may be a bit early but another theme would be around the roads and rails infrastructure opportunity.

Finally, my team spent some time at a meeting with noted investor billionaire Wilbur Ross.  I have attached my staff's notes from that meeting (http://bit.ly/coDjT6).  They are indeed interesting and not too far off from what I see.

Again follow us on Twitter as you will see me post my favorite research sources, comments from meetings with opinion leaders and other self declared interesting things.

@PHCOAdvisors

Macro Economic Outlook:

• No double-dip, but no “W”, or “V-shape” recovery either. “It won’t look like any letter in the alphabet, it will look more like punctuation marks (e.g. ! ? - : )”
• There are still more opportunities in the distressed debt market.
• The American consumer (70% of GDP) lost 11 trillion in net worth due to the collapse in the real estate market
• While headline unemployment is 9.7%, realistic unemployment (under employed, no longer looking) is probably double that. Unemployment is no longer cyclical and is becoming structural.
• Large corporations are in great shape from a balance sheet perspective which is why we are seeing small increases at the top line leading to big bottom line increases. Corporations are doing more with less and creating bigger profits with fewer workers.

The following is Mr. Ross’s current investment themes for distressed investments:

Banks

• Buying small local and community banks to create larger regional banks then selling off the large regional bank as a whole.
• Outside of the US, Ireland and German banks look favorable too

Healthcare

• Healthcare represents 16% of the US economy
• The recent healthcare reform has created the biggest opportunity since the Clinton Administration passed the Medicare reform

Shale Gas and Natural Gas

• Specifically looking in the Exploration and Production area.
• The increase in natural gas due to shale gas production in TX, WY, and PA has caused a glut in natural gas cause the price of natural gas to fall substantially.
• Natural Gas is much cheaper and much clearer than other fossil fuels
• At $4mcf natural gas companies are just breaking even, but going forward he sees prices increase to $7-$8mcf which will make the industry much more profitable

Real Estate Services

• Specifically in RE brokerage, property management, CRE special services
• The firm (Invesco Inc. which is the parent company for WL Ross & Co) is also one of eight Public-Private Investment Program (PPIP) members.

India & China

• The Firm has recently opened up offices in Mumbai, India and Beijing, China.  They are specifically looking at the housing market in India as well.
• Continued flow of opportunities in India and Beijing

Bonus: Long Term outlook for America:

America is producing 1/7 the engineers as China and India combined. This will lead to a lack of talent and innovation in America. One of the reasons this is happening is due to the complexities and problems with getting visas.

All written content on this site is for informational purposes only. Nothing in this blog should be construed as investment advice in any way, shape or form. Comments, as well as, content on other sites linked to or from this one do not necessarily represent the opinion of the owner of this site. Material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual advisor prior to implementation.

 Investment advisory services are offered by Phillips and Company, a registered Investment Advisor/Broker Dealer. The presence of this blog on the internet shall in no direct or indirect way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any state other than states we are licensed in or where otherwise legally permitted. We are legally empowered to provide investment advisory services to residents of states we are licensed in and certain other states.

Consistent downgrades from Wall Street analysts have set us up for a very smooth start to the earnings season.

"Of the 132 companies in the S&P 500 that reported results since Oct. 7, more than 85 percent have topped analysts’ per- share earnings estimates, according to data compiled by Bloomberg. Analysts surveyed by Bloomberg predict 26 percent growth in third-quarter profit from a year earlier for S&P 500 companies, the fourth straight quarterly increase." (Bloomberg)

The chart I have displayed below from the Bespoke Investment Group, LLC. (B.I.G) shows earnings per share beat rate (the % of companies that beat estimates) has crushed the long-term historical average of 63%.  

A bit more concerning is the top line growth of companies.  After all, it's one thing to make a profit from cutting expenses (jobs, technology, health care etc.) and an entirely different picture to have revenue growth due to increased demand by the consumer.

 If you look again at the B.I.G. data, revenues have gotten off to a relatively weak start. Only 58% of companies that have reported beat top line estimates so far. 

An obvious absence of top line growth from the broad based market does not mean we can't get a lift in GDP growth.  After all, it's hard to fall off the floor.  Analysts are anticipating Q3 GDP growth to come in around 2% vs. the 1.7% for Q2.  Much of this marginal increase will be driven by an increase in consumer spending.  It looks like consumer spending was up 2% for the 3rd quarter.

If you scroll back through some of my earlier posts you'll see a common formula:

Jobs, Wages, Profits = Consumption and Investments = Jobs, Wages, Profits 

Here's the good news, companies are making profits albeit at the expense of jobs, but profits none the less.  These profits should be circulated back into our economy through planned investments, dividends and perhaps a few jobs here and there. 

The story goes that if enough profits are created, enough jobs might follow and then reckless consumption can start all over again (Happy days will be here again).  This is what I believe is being discounted in our current equities markets.  Of course, I did leave a few key factors out of the equation:  Savings and Consumer Credit.  While savings is on the rise, consumer revolving credit is still being shrunk.  Both of these have a draw down impact on consumption.  Let's see how these play out in the coming months reports.  I'll keep you posted.

For now, it's an investing environment with lowered expectations, muted consumption and better profits.

My themes continue to be:

• Weak dollar opportunities-exporters
• Select technology-specifically in business processing
• Media (Print that is adapting to online) see some tweets on this @PHCOadvisors.
• Rare Earths (again see our Tweets on this)

I'm also anticipating some kind of equipment tax credits that could be passed during a lame duck session.  There seems to be some common ground on this element of tax cuts so equipment manufacturers could benefit.  More on this in coming tweets and postings.

This weekend in the Northeast corner of the United States a very interesting conference took place. It was titled ‘Revisiting Monetary Policy in a Low Inflation Environment: Remarks at the Federal Reserve Bank of Boston’s 55th Economic Conference,’ and the speaker was Eric S. Rosengren, President & Chief Executive Officer of the Boston Federal Reserve Bank (http://bit.ly/biJDTo)

If you’re too busy to read the entire speech, the bottom line is this: even with tax, fiscal and social policies, once you enter a true deflationary period you will run the risk of deflation persisting.  The data he draws upon is from the last 20 years in Japan and it's clear that a deflationary spiral is nothing to fool with.

Coincidentally, the NY Times ran a very interesting article this Sunday showcasing some snippets of life in Japan.  It was troubling to see this article show the human sides of deflation on the spirit and drive of the Japanese people and its impact on the culture.  Low interest rates and government stimulus can't begin to solve the motivational and incentive problems in Japan. You can access the article from my Twitter (@PHCOAdvisors) or directly from here: http://nyti.ms/cHXolC

The Kitchen Sink

Before I get to the kitchen sink, I probably should back up and give a quick primer on GDP in the simplest terms.  In fact, I think this will explain what's going on with our politicians right now once we agree on some basics.

Is there really a new roadmap to GDP growth?

First, GDP is a simple formula that is quite easy to explain.  There are only a few ways to move the needle on GDP growth.  We can consume a whole lot more, have our government spend more, we can invest more in plant, equipment and technology as businesses, or we can export more of what we make and import less of what "they” make. Everything else you read about, listen to and watch, when it comes to economic policy feeds into those basic facts.

Dr. Mohamed Abdulla El-Erian a wise man from PIMCO coined the term "New Normal" when it comes to this investing environment.  What he doesn’t go onto suggest is a ‘new normal’ for the one component of GDP that matters most… (drum roll please) CONSUMPTION.

As you can see by the slide it's over 70% of our GDP formula.

I asked my team to run some "What If's" if the "New Normal" meant less consumption by all of us.   What would have to go up if we dropped consumption by 10% in the GDP formula?  By the way, during the Great Depression consumption dropped by 41% so a 10% drop is not unimaginable.

You can see that all things being equal:

Investment would have to go up by:

Government Spending would have to go up by:

 
Imports vs. Exports would have to balance out by:

Or you can run a combination of all four to make it less severe on each component:

Let's connect the dots, formula to reality:

• Investments by private business are strained by not having a clear picture of demand from the end consumer.  However, we hear about accelerated depreciation ideas and R&D tax credits. These are all incentives to move the needle on planned investments by the private sector.

• Government Spending is something that we’ve all heard a lot about in the last 18 months. We all know the spending spree the government is on and now we know why.  It's controllable by them, it can have a major impact on the GDP formula and the government can almost manufacture any amount of GDP growth for a period of time (for as long as they are willing to borrow or until it all breaks down). Ideas like stimulus and road projects are a few examples of this component.

• Imports vs. Exports, or in other words, our Trade Balance. We know the current administration has said several times that we need to import less and export more.  It’s not rocket science as to why.  Ideas like bailing out poorly operated auto manufacturers, support for unions, trade wars, and our weak dollar all support this policy.  One of the problems in playing with this part of the equation is that this is how real wars start. This is a topic that deserves its own article at a later date.

The bottom line, as the slides suggest, is that without Consumption restored the entire formula has limited chances of functioning well over the long term. There is no “New Road Map.”

Now here's the kitchen sink part. It’s clear that:

• Any opinion leader, politician or policy maker is coming to grips with the reality that there are only temporary and likely unsustainable solutions without the consumer.

• Without demand from the consumer, prices of everything will drop until they find a new equilibrium level (deflation).

• If deflation is persistent, and we have probably been in a deflationary environment for 10 years (as evident by housing prices, stock market values, real wages and income, higher rates of poverty, unemployment, under employment, low overall demand), then we are not far from falling into the “Japanification” of our people.

 Remember, this is also a behavioral phenomena and not just an economic one.

 No one, and I mean no one, wants to see the lost decades of Japan come to our shores.  So you can expect the Fed to react in the extreme with more quantitative easing, all while the government tries every policy trick in the book. Even the educational academy will get involved by encouraging all kinds of ideas to fix the formula or change the mix of the formula.  They will throw everything at this problem, including your kids and grandkids futures, as well as the kitchen sink.

Conclusion:

• The real economy will likely limp along until "they", and I'm not exactly sure who "they" is, find the right combination.
• The stock market and financial economy will likely benefit from all the attempts to re-inflate the economy in the short run.
• The human spirit of investment, speculation and desire for more will be muted until "they" realize we need stability in all areas before we can consume massively again.

There is no “New Road Map”, just attempts at fixing the road we have always traveled on.

My investment themes continue to be:

• Yield, Yield, Yield - deflationary hedge
• Media (Both print and on-line)
• Germany for a weak euro as the 2nd largest exporter in the world
• Technology-especially business processing
• US Mega Capitalized Companies with large cash balances paying dividends

On Institutional Allocations:

Hold steady, but be prepared to have discussions about a very choppy sea ahead and gain alignment with your board on multiyear return expectations. Alignment is more important right now than investment policy tweaks.  Rough seas can mean bad decisions especially when it comes to liquidity constraints.

I was having a recent conversation with a well respected lawyer and very intelligent investor in my community (his specialty is timber- which is in a bit of a recession itself). After some pretty good discussion on a range of topics he asked me the obvious question- why is the stock market up?

I gave him the obligatory answers someone in my position is expected to give and off we went onto the next topic.  However, this time that question stuck with me.  Why was the stock market rallying?

Was it all the jobs being created in the economy…. nope.

Was it the slew of clearly positive data during this week’s economic reporting calendar let’s see:

• Factory Orders shrank by -.5%
• Chain Store Sales shrank by -.8%
• The ISM Non-Manufacturing showed some strength.
• Revolving Credit balances shrank which is good for balance sheets but not good for consumption, while Non-Revolving credit balances grew demonstrating that lower interest rates are having a positive impact of larger purchases like vehicles.
• The work force shrank again losing another 95,000 jobs but the private sector added 65,000 yet the Unemployment rate held steady at 9.6%.
• Bookings for non-military capital goods excluding planes increased 5.1 percent, the biggest gain since March.
• The number of contracts to buy previously owned houses rose 4.3 percent, topping the median forecast of economists surveyed by Bloomberg News, data from the National Association of Realtors showed.

Well it looks like a mixed bag of data so that can't be driving the markets

Was it Warren Buffett's comments this week?  He announced this week that his Berkshire companies are "coming back" and when asked about his outlook on equity markets he said investors buying bonds after yields fell this year "are making a mistake."  He went on to say, “It’s quite clear that stocks are cheaper than bonds, I can’t imagine anyone having bonds in their portfolio when they can own equities.”….Perhaps?

How about Goldman Sachs, the pillar of social justice and their outlook for our economy?

They lowered their outlook for next year's GDP growth to 1.5% to 2% saying the economy could be "fairly bad to very bad" for the next six to nine months… That can't be why the markets are rallying.

Could it be investors looking at the third year effect that I posted on twitter that moved the markets?  Since I only have 43 followers I don't think so but the data is outstanding and you can find it on Twitter @PHCOAdvisors (Article: http://yhoo.it/cSwojJ). The article simply suggests that markets rally a lot when there is gridlock in the 3rd year of a Presidential Cycle, something to the tune of 16% to 21%.

So what is it?  My conclusion is twofold:

Major market participants have already discounted a pretty tough start to next year.  They have also discounted a pretty difficult earnings season we are entering into.  My belief is that the season will have more surprises to the upside due to the fact so many analysts guiding down over the last few weeks.

Second is all this talk of QE2.  QE2 is not a ship.  What all the noise this last week was about is Quantitative Easing being considered by the fed.  Simply put the Fed will resume buying treasuries and other interest rate instruments.  The thinking goes something like this:  when the Fed buys these financial vehicles it will put liquidity into debt markets and support business and consumer credit.

The hope is consumption and investment = Jobs, wages and profits which equals more consumption and more investment

Here's a slight wrinkle in the Fed's thinking.  They might be assuming it's the supply of money (lending) that's the problem.  What if it's the demand for money?  My thinking suggests it might be that most business (small and mid size) are not saying their business is bigger than the debt they can take on or at least the debt service they would take on.

So the capital markets are rallying and that's a good thing.  Anything can happen in the equity markets and it usually does.

The labor markets are still shrinking and that's bad.

Someone or some company will need to breach the supply for money and demand for money void and make a move to grow.  Animal Spirits (Keynes) will need to kick in and the profit motive will move some smart CEO or Company to make a move to grow.

While all of this goes on I continue to find relevant themes to invest.

• I'm still focused on yield, yield, yield. Select corporate bonds that can provide the appropriate yield with the right controlled risks.
• I especially like the Mega Cap US based export driven companies with a continuing weak dollar theme.
• Of course the iPad that I'm writing this post on right now, and other tablet PCs, promise to provide a nice segment of companies to invest in.  This is also another theme I would consider.
• Don't forget Media (both print and on-line)
• With all the trade war talk between China and Japan the Rare Earth space also seems to be heating up.

In the mean time, the capital market can continue to rally and labor market can continue to suffer but at some point one has to support the other. 

Tim Phillips, CEO

References:

http://www.goldmansucs.com/2010/09/28/goldman-releases-most-bearish-2011-outlook-presentation-yet-sees-sp-in-725-800-range-in-qe2-case/

Some people say the craziest things to grab headlines. Jeff Hirsch the Editor of the Stock Almanac made such a prediction calling for Dow 38,000 by 2025.

What's interesting about the prediction isn't the prediction itself.

It's the reaction it received. It was met worldwide with skepticism, disbelief and contempt. This is the mental state of affairs investors have about investing.

As unbelievable as the number seems on face value it's really quite possible.  To have a Dow at 38,000 by 2025 we would need an 8.8% annual return. It wasn't that long ago when we all talked about the equity markets generating 10% per year as a rule of thumb.  By the way, that would put the Dow at 45,000 in 2025.

In another intriguing analysis by Bespoke, they spotted a very interesting trend with yield curves.  I'll paraphrase some of their analysis.

Since April 2010, the slope of the yield curve on Treasuries has gone from more than a 1.5 standard deviation above its long-term average to less than one standard deviation above its long-term average. Since 1962, there have only been ten other periods where the yield curve has seen this swift a decline from such high levels.

"In those ten periods, the S&P 500 has averaged a gain of 3.99% during the initial six-month decline in the yield curve.  Over the following three months, the S&P 500 has averaged a gain of 5.21% with no occurrences of negative returns. Six months later, the S&P 500 averages a gain of 8.65% with positive returns in eight out of ten periods. Finally, over the next year the S&P 500 has seen an average gain of 17.97% with gains 80% of the time."

With bond yields so low it's not hard to believe investors choose stocks over bonds in hopes of higher returns.

On to Don Robinson's comments on Friday which were not all that uplifting and positive for the next few years.  You can find my summary on Twitter under PHCOAdvisors.  His forecast calls for very muted returns in stocks with sub-par growth in GDP over the next few years.  While I agree with many of his thoughts, particularly around the absence of inflation, a slight bias toward deflation and persistent unemployment, I do think we will find positive growth periods in equities driven by a few trends.

            Technology will drive innovation and in this environment drive efficiencies and productivity.  Technology will fill the gap that the consumer can’t.  If the consumer can't drive profits for companies, innovation, efficiency and optimization will.

            Health Care and Longer Living- with a global baby boomer generation entering retirement there should be plenty of opportunities to profit from the most highly educated, wealthiest and largest population cluster in the history of the world.

            Higher Standards of Living- regardless of what may be said to the media; the world wants our living standards, from quality of food to construction, media and entertainment.  We will continue to set the benchmark and those in emerging markets will aspire to attain our level of abundance.

My point is human instinct and animal spirits (Keynes) will drive the profit motive and help fuel equities forward.  As I have suggested several times in the past equity returns will be very uneven across sectors and segments.  Rising tides will not lift all boats and selection matters most in this type of market.

In the very near term my themes continue to be:

German Exporters-with a weak Euro they will benefit Technology especially export driven Media (both print and television.) Emerging Markets Yield, Yield, Yield (preferred's, very selective bonds.)

I also like the directional approach Lockwood suggested - long/short and market neutral.

The new generation of Phillips Advisors has convinced me to take this step and it proves to be a fascinating and great way to share relevant information. You can see some of my favorite articles and current ideas on Twitter by following us at PHCOAdvisors.