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.