March

………..Thoughts and Comments

 

We have been proponents of long-term investing for many years, and harp on it frequently.  This month’s Thoughts and Comments help put that thinking into a clearer perspective.

 

Market Update

The indexes were all up nicely for the quarter, although they slowed in March and have stalled in April.  For the quarter, the S&P 500 was up 12.00% – a good year already.

 

Q1 2012:  Sector Analysis

  1. Financials: +18.99%
  2. Information Tech: +17.62%
  3. Consumer Discretionary: +16.50%
  4. Healthcare: +12.68%
  5. Materials: +11.55%
  6. Industrials: +10.48%
  7. Consumer Staples: +4.53%
  8. Energy: 3.39%
  9. Telecom: +1.26%
  10. 10.  Utilities: – 2.23%

A year earlier, the S&P 500 was up 5.42% for the first quarter, peaking at 8.43% at the end of April 2011.


Q1 2011:  Sector Analysis

  1. Financials: +4.11%
  2. Information Tech: +6.91%
  3. Consumer Discretionary: +5.62%
  4. Healthcare: +8.80%
  5. Materials: +5.88%
  6. Industrials: +7.48%
  7. Consumer Staples: +4.17%
  8. Energy: 18.34%
  9. Telecom: +2.44%
  10. 10.  Utilities: +3.27%

A year ago, energy was the leading sector; inflation was on everyone’s mind.  All the other sectors were reasonably close in growth, reflecting a slowly improving economy that still had investors nervous.

This year, the market and sectors seem to be much more bullish with financials and technology leading all other sectors, just like in the good old days.  The big change was in energy, which was one of the slowest areas and utilities, which were negative.

This seems to reflect the opinion that inflation is not a problem and growth is accelerating.  Interestingly, that conclusion does not seem to be supported by the facts.

Looking around the world, here is what we are actually seeing:

Greece:  Greece has already warned that it probably will have to restructure its latest restructuring.  While small relative to Italy or Spain, if Greece feels it can default, yet again, what will convince the other countries to accept their own financial pain?

Spain:  A new conservative government has been voted in and plans to lower Spain’s deficit from 8.5% of GDP to 5.3% this year.  The reaction has been swift.  The industrial and service sectors held a nationwide strike against the labor reforms (which include making it easier to lay off workers) and the two main labor unions called for walkouts, some of which became violent.  Also, the first bond auction since the government laid out its reform plans did poorly, in terms of both the amount raised (2.6 billion was raised but the target was between 2.5 billion and 3.5 billion) and the interest rate.

Italy:  After the new Prime Minister pushed for austerity as part of a deal with the EU, the unions have weakened these measures at every turn.  The Prime Minister, Mario Monti, is a well-respected economist and now he and his ministers are going to have to learn politics.

China: Growth in China has been slowing.  China is walking a fine line of trying to keep growth up and inflation down, which will be difficult at best, given the extremely low productivity of many of their assets.

In order to grow its economy, China will need to figure out how to increase consumption rather than relying on the state for spending.  A step in this direction was taken at the end of March when China announced a 13% increase to the minimum wage.

However, China also announced that margins in most industries dropped substantially at the end of March.

Michael Pettis, an extremely intelligent economist in China, published very good article explaining the economic issues in China today, and it is worth reading (Click here to go to his blog).

India: In mid-March, India, one of the largest exporters of cotton in the world, announced the closing of all shipments of cotton outside the country.

India did re-open their cotton exports within about two weeks because of the uproar internally and worldwide.  It seems that selling cotton abroad has much higher margins than in India, so locals were just as angry as everyone else.

At the same time, India has been lowering interest rates in order to try to stimulate the economy.

Malaysia:  In mid-March, Malaysia announced its first ever minimum wage.

Japan:  Japan has been trying to stimulate its economy by having the BoJ pump money into the system, just like everyone else.  The problem is that it is not working.  Factory output for February was down 1.2% (it was expected to be up 1.3%).  At the same time, Japan has decided to double the sales tax to 15% by 2015.  For the fiscal year starting in April, Japan is expected to run a deficit for the fourth year in a row.

Brazil:  Brazil extended the 6% tax on foreign loans to try to slow the strength of the Real.  At the same time, they have lowered interest rates, added tax incentives to induce consumers to make purchases, added government purchases and injected additional capital into the state development bank which provides loans to Brazilian companies.

U.S.:  Here at home, M2 money supply has slowed since July of 2011.  In the first half of 2011, the Fed expanded its balance sheet by USD600bn.  But as the Fed slowed, the ECB stepped in with its own easing.  From the end of June until the end of December, the ECB added EUR1.013bn.  Combined the US and the EU added almost USD 2 trillion of liquidity in 2011.  But this has been slowing in 2012, and the Fed said in a report in the past week that it does not foresee adding any additional liquidity at this time.

At the same time, spending has grown, although at a slower pace in Q1 of 2012 than Q4 of 2011, and faster than income — a trend that cannot be sustained.  If the economic expansion was due primarily to the easy money being printed by the Fed and the ECB, then it seems likely that reported growth in may well slow as well, although it may take until Q2 to start to see this.

Conclusion: The whole world continues along the same path:  everyone is trying to stimulate their economy, but most economies are over-extended.  Politicians are loathe to really make hard decisions and unions are adamant about not giving up anything

If the politicians bite the bullet, then economic growth will slow.  If they don’t, then debt will continue to rise until it collapses on taxpayers’ heads.

This does not suggest that stock markets should be as strong as they have been this quarter.  At the same time, while gold prices have been in a trading range of between ~$1625 and ~$1780 (USD/oz), the long term view suggests that when countries monetize their debt, their currencies decline in value and if everyone is trying to do it at the same time, protection against the devaluation of currencies will be sought.

 

High Frequency Trading – the Latest Game

In the past several weeks, there have been several major news articles about SEC investigations into high frequency trading and these traders’ relationships with stock exchanges.  What is becoming apparent is that high frequency traders, either independently or in conjunction with some of the exchanges, have gone from providers of liquidity to manipulators, bordering on illegal frontrunners.

The combination of the opaqueness of the markets, combined with a increased feeling that the “game is rigged,” is damaging the U.S. securities industry and exchanges.

The lack of trust has led to lower investor interest and will continue to do so.  At the same time, the U.S. is losing its reputation for fairness and transparency, which is driving business to other exchanges.  It has also led to increased volatility on the exchanges and a mindset that looks at headlines and day-to-day outcomes rather than longer term prospects.

For several years now, articles have abounded that question whether buy and hold strategies are dead and argue that “strategic investing” is now a more effective means of investing.  The problem with these discussions is that they have changed the definitions of these terms, which opens the door for confusion about the underlying issues.

A buy and hold strategy does not mean that you buy a security and go to sleep for 30 years; such a definition is an extreme over-simplification of the concept.  Buy and hold is basically a long-term investment process.  You buy a quality company and give management time to grow the company.  This takes years, not days.

However, it does not mean that you ignore fundamentals.  If the company is selling at multiples dramatically higher than its long-term growth rates, whether this is based on cash flows, revenues, earnings, debt levels or any other criteria, buy and hold does not dictate you ignore these facts and just go back to sleep.

By the same token, “strategic investing” has merely become a euphemism for trading frequently.

Conclusion : In times such as now when it seems like markets are manipulated, volatility is high, and investors seem to be getting whipsawed back an forth, it is the exact time to become an even firmer believer in long-term investing; effectively “zigging” while everyone else is “zagging”.

Having a focus on long-term value and prospects makes it easier to ride the waves of volatility without panicking.  It also keeps one throwing out all the opportunities because of the problems.

 

Future of the U.S. Dollar

Two weeks ago, Russia’s largest state development bank announced that Moscow and Delhi would switch to using domestic currencies for trade between the two in 3 years.

“With China it took us three years to [evolve] from initial conversations to trading in local currencies,” VEB chairman Vladimir Dmitriyev told reporters on the sidelines of the summit.

“I think we will meet similar terms with India,” he said.

Russian President Medvedev said that the BRICS must increase transactions in local currencies between them, and that the global financial system would have to adapt to reflecting the new role that the BRICs and South Africa are playing.

Two weeks earlier, it was reported in the Saudi Gazette that a number of countries in the Middle East are considering creating a combined currency like the Euro.  The target date for the currency is 2015 and it has yet to be decided whether the new currency will be linked to the U.S. dollar or a basket of currencies.

For some time China and Russia have been pushing for a basket of currencies to replace the U.S. Dollar.  While this is much easier said than done for a number of reasons, what we continue to see is a trend away from trading in U.S. Dollars and toward using local currencies.  This is both pragmatic and, as long as the U.S. maintains a policy of debasing its currency, logical.

So while it may be several years before we see the USD becoming less important in international trade, and while we do not anticipate its disappearance anytime soon, this certainly suggests that the USD will get weaker with time.

Even though we may see the USD strengthen over the next year or two, especially if Europe becomes weaker economically, and certainly if China has a hard landing or if Japan looks to become a potential debt hazard, what this will really bring into focus is the questionability of any fiat currency.

The following two charts compare gold prices to the U.S. Dollar index, which tracks the value of the U.S. Dollar to a basket of other major currencies.  These two charts explain why we still own gold even though it has been volatile and in a trading range for the past nine months.

Chart 1 – Gold (red) vs USD (black) – 1 Yr

 

Chart 2 – Gold (red) vs USD (black) – 10 Yrs

Conclusion : Using the same long-term investment thinking discussed in the prior two articles above, it becomes clearer why one should still own gold.

 

Alan E. Rosenfield                                                                                                                     Managing Director

April 2012

 

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