May 2011


May 2011 Monthly Thoughts and Comments
As we come into the summer, we expect a slowdown in the stock markets, as the old adage goes, “Sell in May and go away.” This year, there are several other items that are weighing on stocks as well, although we have yet to see how weak the stock markets get.
We have already started to significant sector rotation as traders rearrange their portfolios. In the past two months (and mostly in the past 30 days) a move towards more defensive stocks has rapidly been executed. Chart 1 shows the dramatic changes in sectors in the S&P 500 returns. The defensive stocks, Consumer Staples, Healthcare and Utilities all made huge jumps. Energy, the only sector to be up more than mid single digits in Q1 was down dramatically, although it has seen a bounce off the short-term bottom recently.
As of 5/31/11
YTD Gain/(Loss)
% Change vs. Q1 2011
Consumer Discretionary
Consumer Staples
Information Technology
Telecommunication Services
Chart 1: Data provided by Capital IQ
During this same time, commodity prices have dropped significantly as well. SLV (the iShares Silver Trust) lost 29% in five trading days and oil dropped 15% over the same time. Other commodities have dropped significantly as well: coffee is down 13%, corn is down almost 13%, rice is down 9%, sugar is down almost 20% and cotton is down almost 31%.
Part of the reason for the move in commodity prices was the significant increase in margin requirements, but that was only part. The other reason for the very rapid and painful (if you were on the wrong side) revaluation was, as I have said many times before, because traders, not investors are in the markets. Their view of “long term” is until momentum changes and given the leverage being used, the doorway is too narrow for most to exit in an orderly fashion.
There are several economic reasons for the rotation:
1) Greek Debt Crisis: Greece is in the middle of negotiating a “soft default” whereby they don’t technically default, they just restructure their debt. The EU will allow this restructuring because the banks cannot afford the losses. Portugal, Ireland, Spain, and now Italy are all not too far behind. Interesting to note, according to Reuters, a group of the largest stock picking hedge funds (the “Smart Money 30”) have all been selling bank stocks. I find it interesting how all this “smart money” is moving the exact same way at the same time – that seems to be more of a herd. However, the logic of selling banks given the European problem is logical.
2) China and U.S. Economies Weaken: China’s inflation rate is running close to 10%. They have significant debt problems – some estimates project that almost one third of bank debt are non-performing loans – that are being hidden by the government through off-balance sheet deals. They have been raising bank lending requirements, capital requirements and interest rates to try and slow lending. They have had two months now of slowing manufacturing numbers.
In the U.S. inflation rates have jumped in the past four months (to an annual rate of 9% for PPI and 5.4% for CPI). More companies are announcing that they are raising prices to pass along their increased costs. Housing prices have dropped into negative territory for the second time. Consumer spending is up only because of inflation. Manufacturing numbers, Consumer Sentiment, Capacity Utilization, Leading Indicators are all showing weakness in the past month. The latest manufacturing and inventory numbers suggest that there will be some additional weakness into the summer as inventories rose dramatically while new orders dropped equally dramatically.
                                           Chart 2:  Data provided by Bloomberg LP and Andrew Lees of UBS
3) QE2 ends June 30th: The Federal Reserve announced last September a second quantitative easing strategy which has come to be known as QE2. The purpose of this strategy was to inflate the prices of securities and thereby make people feel richer and more willing to spend. The concept was that such spending would help create jobs, lift the economy, and help the banks correct their balance sheets.
And it worked….sort of. Security prices did increase – rather dramatically - stocks rose by some 23% since the announcement of QE2. The problem was that it also led to speculation in commodities that has led to inflation – and in many parts of the world, ramped inflation. It was also a way to monetize this country’s debts by exporting a weak dollar. This has helped U.S. companies selling things abroad, but has increased the costs for imports and increased inflation around the world. Viet Nam, Brazil, and the Middle East – all are struggling to control inflation caused by rising commodity prices and rising currencies.
If one looks at M2 Money Supply less QE2, you find that money supply has actually been falling (see chart 2). The economic strength being reported in the past six months may seem to have been mostly due to QE2 and not because economies are really starting to strengthen.  Stock prices are up because of this liquidity, not because earnings growth is sustainable at the levels seen for the past two quarters.
So what will happen when QE2 ends? All that free money will have to come back, sucking it out of the markets. The question is, will the worldwide economy be able to stand on its own? The markets are not sure.
The stock markets peaked out at the end of April. The S&P 500 broke the 50-day moving average, but has held up at the 100 day moving average. Traders watch these averages as a sign of which way the markets are moving. A break below the 50-day always worries traders. A break below 200 day moving averages is a major sell signal. As can be seen in Chart 3, the upward momentum has been broken, at least for the time being.
So what should long-term investors do in the face of all of this inconsistent/negative information? We believe that zigging while others zag continues to be the best tactic.
We sold our gold and silver near the highs because we saw too much speculation with too little logic. When professionals say to buy silver because, “it is the poor man’s gold”, then it is time to leave. Remember the old joke – which weighs more a pound of cotton or a pound of lead? This is the financial equivalent.
                                          Chart 3 – Information provided by Bloomberg LP
We have also sold our Brazilian holdings because they are raising interest rates and restricting foreign investment to control inflation. While we applaud this in the long run, it suggests that stocks are going to weaken in Brazil as their economy cools off.
At the same time, we have found some very interesting companies that were cheap. Teva Pharmaceuticals, the world’s largest generic pharmaceutical company dropped from the high 50s to 45 because they may get some competition for some of their big drugs. However, the experts all agree that they have an exciting pipeline and have also announce a major joint venture with Proctor and Gamble.   At 12 times earnings with projected growth of 15% over the next three to five years, the stock was cheap, and so we bought it. We believe that the negatives are in the stock and that over time, this company is worth a high teens multiple.
We have also started buying Neo Materials, a Canadian processor or rare earth and magnetic metals. Their products are essential for batteries, cell phones, computers, televisions and semiconductors among other minor items. The company has been growing at 40% rates, has substantial margins and is in a business with significant barriers to entry. It just announced 40% earnings growth for Q1 and then promptly sold off some 20%. At a 14 multiple, this is a very attractive investment.
We expect that gold will sell off some more this summer, which would be normal. This will be exacerbated if the economy continues to slow. We will add to our positions as it drops because the inflation issues around the world due to excessive leverage have yet to be addressed.
In addition, we expect that industrials, chemicals and energy will continue to weaken if the markets sell off and we are ready to buy into several of these as well.
Finally, we would not be surprised to find the Fed comes up with a QE3. It will likely take a different form, but when they do, I expect stocks will rally again as will commodities.
The Bottom Line:
We expect a choppy summer at best. The volatility of the stock markets will provide entry and exit points for investors, and where in the past we have had months to take positions, now we often just get days. We have raised cash in the past month and expect to put it to work in the next few months.
Alan E. Rosenfield
Managing Director

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