Ripple Effect

The ripple effect from the successful ouster of a 30-year dictator Egypt is being felt all over the globe, as Libya, Bahrain, and maybe even Saudi Arabia take center stage and attempt their own versions of civil unrest.  Even in the United States, union protesters are battling various Governors over state budget deficits – right now Wisconsin is in focus, but soon it could be all around the country.  All of these issues are a systematic ripple effect from the financial crisis over 2 ½ years ago.

Now everyone is focused on oil, commodities, inflation, and what happens next in the Middle East.  However, the focus should really be concentrated on Asia as the ripple effect is being felt in many Asian nations.  Asia is very important to the United States.  Middle East countries tend to be poor and uneducated, repressed, and un-democratic. These countries are not the marginal buyer of copper, steel, cotton, or US treasuries.  Asia is the world’s power buyer. 

Now while there is not yet civil unrest in Asia, interesting events are happening which are being completely ignored by the mainstream media:  there has been a run on the banks in South Korea over the past week.  The eighth bank just closed yesterday because of insufficient capital and none of the banking officials are sure what to do to stem the flow of funds out of the banks.  No one is sure why it is happening. 

So what’s the issue? We should be sure we don’t let the latest news story in the Middle East distract us from the main attraction - Asia. China is beginning to face increasing social unrest. It is only one of many un-democratic regimes in the region, with a poor, uneducated class that is now facing rising food prices (actually all countries are facing rising food prices).  If China’s economic growth begins to slow due to social unrest, look for industrial commodities, such as copper, to fall sharply and a ripple effect to come out of China and impact the rest of the world.

Liquidity and QE2

With liquidity abound, QE2 has been a positive factor in igniting the current stock market rally.  As the Federal Reserve purchases bonds, the cash is being reinvested into the stock market via hedge funds, mutual funds, pension plans, and large institutions. 

However, QE2 has also precipitated both a rise in interest rates as well as a spike in commodity speculation (most commodities are priced in dollars), likely hurting many more than a stock rally helps. Also, as raw material input costs rise, companies must raise prices or cut costs to preserve margins as it is difficult to pass on these costs to consumers.  

So one of two things will likely happen:

1. businesses try to increase prices, they are not able to, and see their profit margins cut
2. businesses do raise prices, people buy less because of wage constraints, and revenue gets hit.

In both instances, companies will likely need to reduce costs to improve profit margins.  While this isn't an issue at the moment, it will be important to monitor moving forward as most commodities have seen prices rise dramatically in the past six months.  And it takes about 6 months or so for these price increases to work into the system.

See charts below:


 

 

Valentine's Day Humor

Happy Valentine's Day!  Below are some quotes about love and a couple of funny Valentine videos... 


"Valentine’s Day is when a lot of married men are reminded what a poor shot Cupid really is.” ~Unknown

"I wanted to make it really special on Valentine's Day, so I tied my boyfriend up. And for three solid hours I watched whatever I wanted on TV.” ~Tracy Smith

"If love is blind, why is lingerie so popular?" ~Unknown

"One should always be in love. That is the reason one should never marry." ~Oscar Wilde

"Gravitation can not be held responsible for people falling in love." ~Albert Einstein

“Sales ad at a store: ‘You are my one and only’ Valentine's cards, now on sale: 4 for $5.” ~Unknown

"Never go to bed mad -- stay up and fight." ~Phyllis Diller

"No matter how love sick a woman is, she shouldn't take the first pill that comes along." ~Joyce Brothers

"Love is like playing the piano. First you must learn to play by the rules, then you must forget the rules and play from your heart." ~Unknown

"If love is the answer, could you rephrase the question?" ~Lily Tomlin

"Behind every successful man is a woman, behind her is his wife." ~Groucho Marx

Global Markets Diverging

Below is a graph of the S&P 500 Index, along with a China Index, India Index, Brazil Index, and Emerging Market Index.  At the very top of the chart is the S&P 500 Index; the blue line represents emerging markets; the brown line represents Brazil; the orange line represents China; and the reddish line India.  The right scale is the percentage return over the past three months.

While markets don't always move in tandem, there is usually a general correlation with respect to global markets as global economies are very interconnected.  While some economies perform better than others and market returns will vary from one market to the next, it is interesting to observe the recent divergence over the past few months.  While the US markets are moving higher, the markets in the fastest growing global economies are moving lower.  The markets could be saying something or it could be nothing, but an interesting development none the less.   

Institutional Manager's Comments

For our current weekly update, we decided to share some of the insights we receive from the institutional managers we follow by paraphrasing their thoughts in short commentaries.  Collectively they represent many of the thoughts we have shared from time to time in our weekly updates, but we feel as we start the new year, it would be helpful to hear things "directly from the horse's mouth."

Specifically, these institutional managers judge security selection, valuation, and patience as key determinants for risk/reward decisions and long-term success, while the markets in general have become more herd oriented whose behavior swings wildly from "risk-on" to "risk-off" and back again - hence the volatility.  We believe this is mainly due to the increasing amount of capital controlled by people who are incentivized to take large risks with other people's money; this is caused by massive moral hazard (bailouts, free money), and not being held accountable (blame the markets or government policies). 

We point this out because we believe while we don't always get it right, we make real judgments about risk with respect to our clients' assets and understand we have a duty to intellectual integrity and prudent decision making - in a world where private and public money is largely controlled by those who have proven to be some of the most inefficient allocators of capital.  It is often difficult to go against the herd mentality, but history shows it has resulted in long term success.


Commentaries

#1
Despite hearing different prognosticators claim that equity investors now face no possibility of near-term losses, and that the coast is once again clear to ramp up risk, we remain unconvinced. Our skepticism is based in part on the Fed's poor track record over the course of our careers, particularly during the past decade-plus, during which short-term stimulative policy often proved short-sighted and resulted in severe unintended consequences later on. The LTCM bailout emboldened risk-takers and inflated the tech stock boom. The multi-year negative real rates implemented to counteract the ensuing bust caused a far greater and far more insidious problem, a housing bubble. One needs only to compare what percentage of Americans own houses to that which speculated meaningfully in stocks, or how housing is inextricably linked to credit, while tech investments were primarily equity-driven, to understand how much worse it was to trade one problem for the other.

Quantitative easing may feel good in the short-term, but the long-term risks seem substantial. A weaker dollar increases energy and other commodity costs for Americans -- essentially a highly regressive tax on the middle and lower classes, who are already grappling with sustained high unemployment and negative home equity. Also, it seems likely that a steadily depreciating dollar will provoke a meaningful response from both our trading partners and foreign holders of USD-denominated assets. These fears seem already to be reflected in the bond market, where long rates have risen quite sharply since late August (from 3.5% to 4.3%) -- not exactly the lower long-term interest rates the Fed claims quantitative easing will engender to stimulate the economy.

#2
Looking ahead, there is certainly room for optimism. Corporate earnings could rise to record levels. Valuations in some areas of the market remain attractive. The economy appears to be gaining strength. Business confidence coupled with healthy balance sheets could lead to increased merger and acquisition activity. An increase in investor sentiment could lead to further multiple expansions on corporate earnings, leading to further gains in the equity markets. The tax package will almost certainly stimulate further consumer spending. On the monetary side, the Federal Reserve continues its efforts to further ease credit markets with unconventional Treasury purchases, hoping that low interest rates spur more borrowing and force investors, perhaps unwillingly, into riskier assets to improve returns.

#3
On the other hand, going into 2011 we wonder just how much of this optimism has already been discounted. Three straight years of positive performance in the equity markets has only occurred twice since World War II.  In both cases, the third year saw average returns of just 1.7%.  Will 2011 follow suit?  We have no idea-the year 2010 was a difficult year in which to handicap the financial markets.  Despite what we see as an extremely disappointing economic recovery, the equity and fixed income markets performed extremely well. Looking forward to 2011, we do not know if the S&P 500's return to the level it held before Lehman Brothers collapsed is a confirmation of the market's strength or if the last marginal buyer has arrived and signals a temporary or perhaps longer term lasting market peak.

We have no desire to make any predictions for 2011 other than to expect a certain amount of the unexpected which will lead to at least some volatility in stock prices. At this moment, there are few desirable companies that can be bought with a decent margin of safety. This isn't to say that there aren't a lot of good companies whose stocks are worth continuing to own. But the unforeseen potholes that certainly lie ahead will once again give us opportunities to put fresh capital to work on more favorable terms."