October 2011


Monthly Thoughts and Comments

Q3 Earnings – The Big Picture

Earnings are on track to outperform analyst expectations in 75% of all reports by S&P 500 companies.  Before you pop the cork on the champagne, we would like to note that this is the average over the past +5 years.  In other words, “no big whoop.”  Yes, this is another way of saying that if you just read the media headlines, you will not know what is really going on.

What is interesting is what we found as we actually dug into earnings (you know, doing actual research.)

Earnings were strong amongst most industry groups, with telecomm, parts of technology and parts of healthcare being the only exceptions.  Revenues were strong across the board.  However, margins, both at the operating and net income level were very mixed – with many more down than up.  The standouts were chemicals and utilities which were up strongly while telecom, parts of technology and healthcare were the most negative (see chart 1and 2 for details).

This suggests that higher prices were the chief driver for many companies, not increased demand.  This leads to the question, “will companies continue to be able to raise prices?”  If they can then earnings can increase.  If they can’t or don’t, then with flat volumes earnings are going to come to a screeching halt.

Furthermore, even though the Federal Reserve keeps repeating that there is no inflation, if most companies are raising their prices, then there is inflation and sooner or later it will show up in the government data. The government’s own manipulated reports (CPI and PPI) are already up 3.9% 5.0% through the end of September respectively.

Moreover, medical care was up 2.8%, apparel 3.5% and new vehicles 3.6% – but don’t worry – there is no inflation!  Guess what?  When everyone is raising prices, the CPI and the PPI are going to continue to rise and there is nothing the Fed can do except raise interest rates, which they cant do because they don’t want a recession and don’t want housing prices to fall.  The writing is on the wall.

The Slippery Slope

For the past year, Ireland, Portugal and Greece were the main worries.  What everyone really worried about, however, was Spain and Italy.  Then, about two weeks ago, it became evident that Greece was in trouble and Italy was too.  Interest rates in Greece rose to over 100% and in Italy to over 7% (the 10 year treasury in the U.S. is at about 2% by comparison).  Even though Greece and Italy have in the past week both replaced their governments with groups that everyone thinks will really start to address the problem, interest rates have not come down in those countries.  In fact, all that has happened, besides the stock market rally, is that now people are nervous about France.

Let’s be honest.  Greece is gone – it will default on its debt. The ECB (European Central Bank) is taking Mr. Geitner’s advice and is buying up Italian and Greek debt.  But of course, the ECB has no money of its own; they simply are printing money and requiring that all members of the EU be responsible for it.  Portugal came out last week and said everything can be solved if the ECB will just print enough money.

Albert Einstein once defined insanity as doing the same thing over and over again while expecting different results.  So why would politicians keep throwing more debt on a debt problem (picture your local fire department putting out a house fire by adding more wood and gasoline to the flames)?  The only rational reason is that they are trying to solve a different problem, one of politics rather than economics.

The same is happening in the U.S.  The “super committee” was supposed to do that which Congress could not: come up with a $1.2 trillion is savings.  But the committee is all politicians, so not surprisingly, the deadline is looming and nothing has been settled.  Most likely, both sides will blame the other and use the failure to position themselves for the upcoming 2012 elections.

The ECB printing more money, what we will henceforth call “QE2 or Quantitative Easing – Europe” (or should we call it “QE Too”?), is about to begin in earnest.  Japan is already pumping lots of money into the system to try and bring down the value of the Yen in order to stimulate their economy.  China, which announced that inflation rates dropped to 5.5% from 6.1% the month before and that housing prices fell 14%, is getting set to loosen up interest rates and bank lending requirements, in order to try and keep the economy from falling off a cliff.

So the whole problem of loose monetary policies worldwide, which has led to the debt situation is….continuing.  At some point (it is beginning to happen in Europe) investors will lose faith in government debt and the only choice governments will have is to depreciate their currencies and cut their excessive spending.  This will either happen because politicians will finally be convinced that voters know the “free” lunch is over and are willing to accept it, or when investors force voters to accept the reality.

If this happens, we expect governments will start to back their currency with gold again to provide some level of investor confidence.  China has been a large buyer of gold, and we would not be surprised if they used gold to make the Yuan a more important currency.  However, their current holdings are dramatically less as a percent of foreign reserves (1.7% vs. 75.5% for the US) and in total (1,054 tons vs. 8,133.5 tons respectively) than Europe’s or the U.S.’s holdings, and they will have to increase them first.

The Bottom Line

1)    The trends have not changed in some time; the new information merely confirms the trends we started discussing a year ago.  Inflation is building, which will help stocks as long as the economy does not collapse.  The market is headline/trader driven currently, which continues to create dramatic short-term volatility.  This will leads to stocks getting whipsawed and will provide investors with opportunities:  Apple is a current example at $383.

We still like the specialty chemical, agriculture, energy and technology areas.  Note that DuPont, Neo Materials, Apache Petroleum, Penn West, Trans Globe Energy, Cisco Systems and Apple all had terrific earnings reports.

2)    Gold seems to be the only hedge against currencies, even with the dollar playing the safe haven for short periods of time.  The gold stocks are still very cheap, and have provided excellent buying opportunities (In the past several weeks we bought more Goldcorp under $50 and Yamana under $14).

3)    Stay diversified: fixed income and cash are good defensive positions against market volatility.

4)    Be patient – investing requires time – especially when times are volatile.


Alan E. Rosenfield
Managing Director

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