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!