Markets Unplugged VI

Transcript for November 9, 2011 Conference Call

Welcome again to our 6th Conference Call, or what is unofficially titled as “Market’s Unplugged – VI”. On behalf of our group, it’s a pleasure to be sharing time with you this evening.

In tonight’s call we will briefly re-visit where price has taken us over the course of the last year. We discuss price and volatility relative to the longer term, we’ll cite what we got right and what we got wrong since our last Call. We’ll discuss the Federal Reserve’s current role in the markets, review the current relationships between the U.S. and global markets, we will review which sectors look attractive for investment, discuss seasonality from an historical perspective and what we expect over the next six months. So let’s get started.

As we prepare for our bi-annual calls, I always go back and reference past price levels on the SP500 stock market benchmark to see where we were then and where we are now. Making comparisons over time provides perspective. Perspective is a key ingredient for successful investing. Since last year’s November’s Conference Call, the change in the SP500, through the close of business last Friday, the market is +5.25%, but only +1.3% year-to-date including dividends. Not much of a change over the course of a year, which might surprise some of you given the recent price volatility we’ve experienced over the shorter term. In fact, what many investors don’t realize is that markets are trendless about ¾’s of the time when taking a long-term view.

A good example of the market’s overall “trendlessness” or sideways price action occurred between 2000-2010. Stock market returns with dividends averaged less than +1.4% per year over that 10 year period. On a cumulative basis, that is less than +14% total return in 10 years. We discussed “secular bear” markets at length in our last Conference Call, citing periods that average 15-20 years where the market over the longer term is trendless. It happens frequently. These periods occurred between 1901-1920, 1929-1947 and 1966-1981. Presently, we are in a similar phase since 2000. Conversely, we experience bull markets, as well, the last starting in 1982, while giving us healthy returns for 18 years, up until 2000. Charles Dow, whom the Dow Jones Industrial Average is named after, likened these up and down moves to the tides in the ocean. Price movements in the markets, like the tides in the ocean, he said, come in and go out with some regularity. In between the primary tides, you will experience intermediate tides, like riptides, and in the shorter term, one will witness smaller waves, all the way down to ripples. I rather like the analogy Charles Dow created, comparing the stock market averages to tides.

While the tide is out, patience is needed while we wait for the tide to come back in. Duration and valuation are the two factors that decide the beginning and end of bull and bear markets. Presently, we need to see reasonable valuations before we head higher in the markets averages. The good news is American businesses have been increasing their earnings for the past 10 years. Even though prices have fallen into a narrow range, as earnings increase, the price/earnings ratio is decreasing. Bull markets begin with low price/earnings ratios. Since the start of the bear market in 2000, we have seen the P/E multiple of 44 cut in half over the past 11 years. In fact, we are down into the mid to high-teens. Bull markets start right around P/E multiples of 10. Valuations are telling us we are getting closer to the levels we need before we start the next leg of a bull market.

We’re moving in the right direction.

Even though shorter term moves exhibit wild gyrations, over the longer term, prices are less volatile than you may realize. Know thy time frames. Like the winning turtle in the Aesop Fable, the race goes to those who are not high-strung, anxious or impatient, but rather to those who are cool, calm, collective and focused on knowing this race, the “stock market race,” is a marathon, not a sprint. Patience over time, wins the race. Think like a turtle. Slow and steady wins the race.

What did we get right and what did we miss regarding last May’s Conference Call? Last May, when the SP500 was near a 52 week high at 1342, we took a contrarian view while looking ahead for the coming six months; citing poor economic fundamentals and poor seasonality as “head-winds” for price declines in the coming months. Our quote was, “we will be less aggressive in the coming months in terms of purchases, unless we see some real values.” We got that right. It wasn’t a popular call at the time since our forecast was not “upbeat.” The news media, on the other hand, was calling for new highs. Specifically, we cited the historical precedent that since 1950, the May through October period had produced the majority of the declines in the equity markets. We were just starting the month of May on our last Conference Call, and from this past May to the September low, one month ago, the SP500 lost over 17%; most of the losses coming in Q3, supporting this historical precedent. On our last Conference Call, we cited the continuation of poor economic fundamentals as a reason to put us on the defensive; declining GDP, the Euro-Zone debt problems, the end of the QE2 stimulus program and a weak employment outlook. Another primary contributor to our “bearish view,” was discussed in our weekly research meetings. We observed prior to the May Call that the SP500 had increased in price by + 25% from September 1, 2010 to our Conference Call date of May 12, 2011. A +25% gain in only 8 months! Remember what I said about perspective? Can anyone guess the last time the markets moved +25% in that short a period of time? If you said, “during the dot.com bubble” you’re correct. We learned back then that trees don’t grow to the sky. History was repeating itself relative to price appreciation when we met last May. We were able to learn from the past. What we did not anticipate was Congress’ inability to raise debt limits, nor were we able to forecast the downgrade of U.S. debt by the Standard and Poor’s rating agency. What we did get right was correctly analyzing seasonality, economic fundamentals and past price action to anticipate the weak market since our last call.

That was then. Now what? Where do we go from here? What, if anything will move the markets forward? Let’s explore these questions.

Currently, the Federal Reserve System is trying to help our beleaguered economy. It might seem like a long time ago, but it’s been just a little over 3 years since the start of the realization that the “American Dream” of home ownership was handled badly. The “American Dream” of homeownership has become an on-going nightmare for individuals, government and business. We are still working through this problem. Not everyone deserved a new or a bigger home. Most purchasers of homes who were not qualified are either “upside down” on their existing mortgages, have left their homes vacant or are in foreclosure. Our Federal Reserve Board is trying to mitigate the stress the housing market has put on individuals, banks and the economy.

The Fed realizes that real estate, in large part, got us into our current financial mess and it’s the Fed’s hope that real estate will lead us out. Their current solution is to assist real estate owners through their stimulus program, called Operation Twist. Twist will focus its efforts in assisting those individuals who purchased Adjustable Rate Mortgages (called ARMS) falling due after 7 years of home purchase. The Fed’s plan is to keep interest rates low on 7-10 year bonds in an effort to assist mortgage holders to keep their property. The 7-10 year bond duration is most closely tied to these adjustable rate mortgages. A few months ago, the Fed issued a statement calling for a 2 year period where they have pledged to keep rates low on this end of the yield curve. We see this as a step in the right direction as our country works itself out of our “indebtedness.” Low interest rates should continue to help indebted entities; whether they are individuals, businesses or government agencies. Conversely, lower interest rates in bonds are positive for investors securing healthy dividends in the equity markets.

Let’s move on to the relationship between the U.S. equity markets and the global markets. While the U.S. markets were moving higher last fall and through the late spring, global markets were beginning severe bear markets, marking losses between 20-30% through the third quarter. Large countries like India and China have been global growth engines for a number of years. The downside to growth is it often leads to inflation as economies expand. China and India’s Central Banks decided early this year to stop their inflationary spiral. We believe this is fiscally responsible on their part. Since late last year, these countries have instigated “tight money” policies. Tight money means making it more difficult for their consumers and businesses to borrow and spend. They have implemented higher reserve requirements and interest rates for banks and consumers. The good news is that these strategies should keep long term growth on an even keel. But in the short run, as we have seen through most of 2011, these sound fiscal policies have dampened their economic growth and consumption. In turn, when their growth engine slows down, so does the rest of the world. That’s where we are now. Lack of spending and consumption by the Asian economies will continue to put downward pressure on all markets around the globe, in particular, the sectors relating to energy, basic materials and industrials.

But since our race is a marathon and not a sprint, it makes sense that pauses and “slowdowns” will occur in the U.S. and global markets after periods of rising price action. Remember, trees don’t grow to the sky. The oil and energy sector appreciated in price by +55% from last September to this past May. Basic Materials, inputs for global infrastructure, appreciated over +20%, while the Industrial sector saw price appreciation of over +40% since last summer. In other words, your portfolios appreciated in price during these time frames had you held energies, materials and industrials.

Therefore, it makes sense for these issues to pause after a large run-up in price. As global economies continue to expand, we believe the longer; macro trend will continue to favor energy, basic materials, industrial applications, as well as consumer staples, healthcare, technology and services. Our global population of 7 billion people will need the goods and services of those companies that meet these needs. Each of your portfolios contains some or all these sectors, either through mutual funds, ETF’s or equities. One of the primary benefits of investing in U.S. based multinationals and foreign companies are these companies return value to shareholders through dividends. While the Federal Reserve and global central banks strive to keep interest rates low, where is an investor going to find present and future income? Dividend paying companies are an ideal place to generate portfolio income. Dividend paying issues, coupled with price appreciation in companies that cater to a growing world, offer significant investment opportunities abroad for long-term investors.

Up until this past spring, our sector and Intermarket work showed us coming out of an “early expansion” phase in the U.S. business cycle. We had seen an up tick in the transportation and technology sectors and strong moves in the industrial sector. This type of sector rotation was beneficial as we were climbing out of the 2008 recession.

But, with the Asian economies announcing their need to curb inflation in January, it was inevitable that we could expect a slowdown in their economies. A double-whammy has occurred, with the uncertainty in the European Union regarding their on-going debt problems. Both these factors, the slowdown in Asia and the European problems with Greece, Italy and Portugal, have temporarily stalled the positive rotation in our business cycle. But, to the positive, not only has the last month brought us an almost 11% gain in the benchmarks, but energy, basic materials and industrials were again the leading sectors. It just might be good news that Asia has been leading the way down since last November. These countries are likely to turn up before the U.S. markets. And similar to 2009, these growing infrastructure and commodity related economies should drive equity markets higher around the world. We expect this theme to reassert itself once Asia steadies itself against inflation.

In the meantime, we will be exploring alternative opportunities for investments as they relate to a stronger U.S. dollar. Relative to all currencies, as money seeks a safe haven in times of uncertainty, especially given the uncertainty in Europe, the U.S. dollar takes the spot light. Also, gold continues to be a standard for investment in uncertain economic times. In the equity space over the past year, and especially since last spring, the top performers have been consumer staples, utilities and healthcare. These issues perform well in volatile and uncertain times. They reflect safety and most pay dividends.

Historically, the next six months provide investors with an opportunity to take advantage of positive seasonality. This phenomenon’s history is updated in a yearly publication entitled the Stock Market Almanac, authored by Jeffery and Yale Hirsh and published by Wiley & Sons. Through 2010, the November through April time frame has shown positive stock market returns, on average, 3 out of every 4 years since 1950; that’s 75% of the time. This kind of knowledge is beneficial since it puts percentages on our side in understanding how seasonal time frames correlate to price in the equity markets. Academics would have you believe that market movement is random and you would be better off thrown darts at a list of financial choices. We respectfully disagree. 75% of the time in the markets is not “random;” rather, 75% of the time is statistically significant and should not be ignored. This is positive, but not a guarantee. Financials, Consumer Cyclicals, Technology, Pharmaceuticals & Healthcare, transportation and energy historically benefit in the next six months.

2011 is the third year of the Presidential cycle. In this pre-presidential election year, the markets have not witnessed a down year since 1939 when the DJIA was off 2.9%. The only severe loss in a pre-presidential election year going back 100 years occurred in 1931 during the Great Depression. The Presidential cycle is positive until the end of the year. The fourth year of the presidential cycle, 2012, is typically the second best performing year in the four year cycle.

We’ve covered a number 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

November 9, 2011