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

World events once again dominated the headlines last week:

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

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

S&P 500

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

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

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

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

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

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

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

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

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

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

Tim Phillips, CEO - Phillips and Company

The World Is Falling Apart Again

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

The markets were very extreme, especially in Japan.

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

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

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

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

In Search Of Meaning

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

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

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

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

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

Tim Phillips, CEO

Does it Really Matter?

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

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

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

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

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

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

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

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

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

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

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

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

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

Tim Phillips, CEO

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tim Phillips, CEO