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