The Markets – Unplugged V

Transcript for May 11, 2011 Conference Call

Welcome again to our 5th Conference Call. On behalf of our group, it’s a pleasure to be sharing time with you this evening.

Let’s go back a year ago, to last April’s Conference Call on April 28th, 2010. We reached a new high at the time in the SP500 benchmark. The month of April normally marks new highs for the first half of each year. Last April was no exception. On the call last April we noted that the May – October time frame portends weakness, historically, May-October being the worst 6 consecutive month period in the equity markets. Sure enough, April 26 last year was the high point for last year’s first half. Then the market fell almost 14% through the late summer last year. The media cited the European Debt Crisis coupled with the BP Oil spill in the Gulf of Mexico as causes. But as the summer wore on and various government stimulus packages expired; “Cash for Clunkers,” as well as, “Cash for New Home Purchases,” it became obvious the economy missed the government stimulus money. Economic measures, formerly indicating strength, were faltering.

The SP500 benchmark fell from + 8.7% at the end of April last year, down to -6.1% by the end of August 2010. Then, the Federal Reserve came in with another stimulus package coined Quantitative Easing 2 or “QE2.” Its purpose was to create new money, via the Federal Reserve printing press, keep interest rates low and kept credit “easy” for cash strapped Americans, especially those caught up in the mortgage crisis.

The Federal Reserve’s hope was to revive the sagging economy. There were some intended and unintended consequences as a result of their aid through QE2. An intended consequence was to help Americans re-finance their mortgages at very low rates. In fact, our last bit of advice from our last Conference Call in November was “…if you are able, get your re-financing done soon; before the inevitable rise in interest rates occur.” A few of our clients did re-finance on that advice and we congratulate you, because those   mortgage rates last November were the lowest since the Eisenhower Administration. Arguably, perhaps an unintended consequence of QE2 was to entice investors out of low yielding financial instruments like bonds and into the stock market. This is the reason we have seen such a dramatic rise in the stock market since last August; money is always looking for higher returns. Consequently, money which had been flowing into bonds for 30 straight months exited into stocks.  By offering another stimulus program, the QE2, Wall Street and Main Street felt safe. They felt, much like they did back in the days of Alan Greenspan’s Fed Administration, that whenever the economy starts to struggle, the Federal Reserve will come to the rescue. Right now, this is the perception.

Therefore, the pattern in the stock market’s price action over the past year, really the past two years, has been the market following the Federal Reserve stimulus packages. The first stimulus package of $1.75 trillion dollars of printed money bought between early 2009 and early 2010 in its first round of QE helped the market up. When the first program ended in late spring last year, the market went down. When the second program, QE2 came on line, the market went up again. The second round of easing is set to end this June.
That brings us up to date on the market action. I wanted to rekindle your memory so you can see that there is a discernable pattern in the Federal Reserves actions, reasons for them doing what they did and why they did it, and market consequences and reactions as a result of their stimulus programs.

Before we move on to review what’s happening around the world and here in the United States I want to discuss a practical matter that does not get enough news, because this kind of news does not sell. But we would be remiss not to communicate it; so, here’s some market perspective. I’ll just blurt it out: currently, we are in a secular bear market, and have been since 2000. That may come as a surprise to some of you, considering the market has been rising since 2009. But, as of December 31, 2010 the market as measured by the SP500 without dividends was negative, on average, every year for the past 10 years.  “Secular” means long-term. Secular bull and bear markets last between 15-20 years. Yes, there are secular bull markets, as well; the last being from 1982-2000. This was an easy time to invest in the markets. The long-term trend was up, on average, each year. The last secular bear market was from 1966-1981. The secular bull market before that was from 1947-1965. So, if you can picture it in your mind, the market moves up; thrusts, pauses, moves up again, pauses, moves up…you get the picture. So, the truism,
“The market always goes up” is correct, if you have enough time on your side.
But there are long periods of time, called secular bears, when the market is range-bound with large swings, up and down, as much as 25-50% within a defined range.

We’ve experienced two such swings since 2000; the internet crash from 2000-2003, the ensuing up move and then the credit bubble and crash from late 2007 to early 2009, and now the ensuing up move. These smaller moves within the longer term are called “cyclical” moves. Right now we are in a “cyclical bull” or up move, within a longer term “secular bear.” During the last secular bear market from 1966-1981, we had four cyclical bulls and four cyclical bear moves. Each bull move averaged about 50% from the low; just like the cyclical bull we are in now. So, even though the longer term trend is bearish, money can be made; and money has been made the past two years. The point I am trying to make is this; until the secular bear is over, we are bound to experience large price moves, both up and down within a defined range. The range we find ourselves in right now on the SP500 is roughly between 750 on the low end and 1550 on the high end. Right now we sit at 1342. Therefore, when your advisor seems concerned, or has you in conservative instruments, or even cash, it’s for the reasons I have outlined above. It makes more sense to be prudent at this time than to be very aggressive. That does not mean its time to “run for the hills,” it’s not. There are reasons to be positive until the next election, at least, and we will speak to those areas of optimism shortly. In secular bear markets, our primary concern for your accounts is capital preservation. It not what you make that matters, it’s what you lose that counts.

Let’s get on with what’s happening here in the United States and around the world. While the U.S. stock market has been rising dramatically since last fall, the major averages for other developing nations; China, India and Brazil have been falling between 10-15%. This disconnect is not unusual and we have continued to experience this phenomena since late 2009.

Currently, while the U.S. is in an early Middle Expansion stage in our domestic business cycle, a large part of the developing world is trying to reign in their growth.
Both India and China are trying to fight inflation; rising food prices, rising housing prices and rising energy prices. These countries have been the engine of growth since the turn of the 21st century. You can read more about these developing economies in our past “Markets Unplugged” transcripts. Rising consumer economies, newer rising middle classes and growing global consumption benefits businesses world-wide and has been positive for your portfolios. This macro theme should continue.

There was a fear many years ago that when the “baby boomers” retired, they would sell all their stocks for retirement income and the market would crash because there would be too many sellers and not enough new buyers, forcing stock prices lower. What we’ve come to find out is that there are and will be plenty of buyers. They will be purchasers from other countries. It’s not just an American market or an American economy now. It’s a world economy and a global financial marketplace. China is opening a bond market. Can you imagine that? Communists are opening a bond market?
Financial issues are being sold on 244 exchanges around the world. Foreign exchanges are purchasing or merging with U.S. exchanges. There is even talk of inventing new currencies. It’s a dynamic and exciting time to be an investor and the opportunities are becoming more plentiful each year. It’s a matter of being in the right places.
Our team finds the right places through our company wide weekly economic meetings, in our investment committee meetings and through our fundamental and technical research.
We determine where global and U.S. trends are going and then try to make reasonable purchases within these trends. For domestic issues, we incorporate our monthly sub-industry group review and overlay it onto our Business Cycle Road Map, to find areas of opportunity for you.

So where are these opportunities now? Where are we in the business cycle? Prices lead the news and the economy. The headlines are the hind lines; that’s why you often hear that you can’t trade on the news. Therefore, each month, we examine the price action and the fundamentals of 213 sub-industry groups that make up the SP500. We evaluate and rank these groups relative to one another and to the overall market, trying to find pockets of strength. These pockets of strength are ultimately validated by the economic numbers produced by our government. Market prices can lead the news by as much as 6 to 9 months. This is the reason why markets often lead the business cycle. In the past few weeks, a strong durables good number validated the rising prices we have seen in the past 12 months in the industrial services group.  This means that corporations are finally investing their money and that’s good for the economy and the unemployed.
This presents opportunities for industry sub-groups involved in the manufacturing & distribution of capital/industrial goods, firms involved directly or indirectly in the production and transportation of basic materials and in the manufacturing, supply and distribution of energy and energy related goods and services.
In layman’s terms, these are represented in your portfolios through industrial companies and conglomerates, railroads and other transportation companies, oil and natural gas, industrial and precious metals and mining companies.

Here in the states, we believe, we are in an early Middle Expansionary phase that should extend for 12-18 months. But, with an expanding U.S. economy and the rising tide in business comes the rising cost of money. We’ve already seen rising prices at the gas pump and the food store.  A stronger economy is a double-edged sword. No one wants rising prices. On the other hand, no one wants a stagnant economy. This is the balancing act our Federal Reserve deals with each day.

Let’s address the U.S. dollar. By keeping rates low through quantitative easing, in an effort to revive our economy, another consequence has been a weak U.S. dollar. Let’s address this for a moment. The Federal Reserve is aware of what they are doing and aware that quantitative easing causes our dollar to depreciate. A weak U.S. dollar is not necessarily bad for the country.

In fact, a weak U.S. dollar is good for U.S. exports, as it entices foreign countries to purchase our goods and services. This is a positive for U.S. manufacturers and their employees. A weak U.S. dollar benefits your portfolios. The stock prices of large multinational companies rise when the dollar is week. Examples of multinational companies are Johnson & Johnson, Proctor & Gamble, Coca-Cola, McDonalds, DuPont, Dow Chemical and General Electric, just to name a few.
Why is a weak dollar good for multinationals? When these U.S. companies sell their goods and services to other countries that pay in that country’s stronger currency, currencies stronger than the dollar, the balance sheets of these multinationals show a higher profit. This is called “dollar translation” and it’s good for those of you who hold multinational companies.

If you hold commodity related issues like major integrated oil stocks, or agricultural issues, a weak dollar is good for you, also. Since oil is traded in dollars, a weak dollar means it takes more dollars to purchase oil. More dollars means more profit to companies that deal in these commodities. Therefore, if you hold oil, for example, you profit. When the dollar weakens the precious metal gold, which backs the dollar rises. For those of you who have exposure to gold, precious metals or mining companies, you profit. Also, a weak dollar is great for U.S. tourism. These are examples to support the advantage of a weak U.S. dollar. Your portfolios are configured to take advantage of Federal Reserve policies that purposely promote a weak dollar.

Currently, we are in the third year of the Presidential Cycle. After next year our country votes for our current Administration or a new one. The normal outcome for the third year in a presidential cycle is for stock prices to end the year higher than they started. But, even though we want our money working for us in the market during this third year, we need to recognize that two headwinds are blowing against us right now; the May-October weak market period and QE2 ending next month.

As we mentioned earlier, when QE1 ended last summer, the economy became weaker and stock prices fell. Therefore, we will be less aggressive in the coming months in terms of purchases, unless we see some real values.

We’ve covered a multitude of areas this evening and I hope you’ve found this material informative. I’m sure a few of you, as you usually do, have some questions. So, at this time, I’d like to thank you for calling in and turn the microphone back over to our moderator.

Carl Perthel
May 11, 2011