Q2 2010 Notes on the Quarter

Q2 2010 Notes on the Quarter

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Overview of the Quarter:

  1. Q1 Results: S&P 500: 4.9%, Dow: 4.1%, Nasdaq: 5.7%, Europe: 3.6%, Asia: 3.9%
    3/31–5/14 Results: S&P 500:(3.4%), Dow:(2.5%), Nasdaq:(2.8%) Europe:(2.5%) Asia: (3.2%)
    Net Results: S&P500: 1.4%, Dow: 1.5%, Nasdaq: 2.7%, Europe: 1.0%, Asia: 0.5%
  2. Economic numbers all were positive in the first quarter and the government’s inflation indicators were quite low, although such numbers are misleading at best (“downright lies” might be more accurate). Is the first quarter strength due to inventory restocking and very limited new employment? It is possible, so we shall wait for Q2 information.
  3. The most critical economic development has been the economic chaos in Greece. Europe is worried about the problems spreading to the rest of the Eurozone. Greece and Portuguese debt has been downgraded. At first, the European Union and IMF agreed to provide 110 million Euros, but few believed it would be enough, or that the Greeks would actually follow through with their promises of fiscal restraint. When the markets fell further, they announced a ~$1 trillion package—remember, when you want to fight a fire, it doesn’t matter what you throw on it, as long as you throw something!

Portfolio Specifics:

  1. Earnings this quarter were pretty good. A large majority of companies surprised to the upside—not surprising in the early stages of an economic rebound. The question of course, is whether this an economic rebound or a one quarter inventory correction?
  2. Positions: Dynamic Materials reported Q1 results in line. Margins were down a little and they are starting to see signs of strengthening, but it is early. Searchlight Minerals: on track although the stock has been acting terribly. They should been running end-to-end within the week. They have added two new board members and the search for a C level manager is on track. GoldCorp and Newmont Mining announced increased production and earnings and we have added Newmont Mining to portfolios. Intel had blowout earnings and margins were higher. Cisco reported great results (up 49% yoy) and is seeing positive growth in all areas. The best industry performers were industrials and technology.
  3. Gold broke down during the first quarter, but with the worries about currencies, gold has turned and has hit new highs. While the oil trade held up for most of the time, it has finally started to break down and is currently trading at $71.50/barrel (down from about $87/barrel).
  4. We did not keep up with the broad markets this past quarter as we continue to be more defensively positioned. In comparison, in the past month since the market has dropped, we have significantly outperformed. While we have added positions during these pullbacks, they have been intentionally small as we await a stronger and longer pullback of at least 10%.

Looking Ahead:

Ok, it is times like this that I always have to fight off just reprinting the prior quarter discussion and going home early. We have already said how big a problem Greece is. We have already complained that the markets are over-priced, too optimistic, and that traders as a group all suck (ok, we really didn’t say that, but sometimes it’s how we feel). However, I will fight the urge and discuss some of these issues in a different light so that our strategies are clear.


The Greek debt crisis is more than just a Greek crisis; they are simply the unfortunate symbol of a Western Europe (and United States) issue. Europe has for many decades espoused an “everyone should get everything they want” mentality. The public sector is the basis of much of the employment, and that which is not controlled by the public sector (i.e., the government) is regulated by it. In Greece (and many other places including the U.S.) there are 14 monthly paychecks—a month bonus at Christmas and Easter. The retirement age in Greece is 53 years old. The average vacation in Europe is well over one month. Healthcare has price controls. It is a wonderful life—except for the fact that someone has to pay for it. The problem is finally coming home to roost in Greece, and the Greeks are angry about it. They don’t want to pay more taxes and they don’t want to have to work harder, longer, or for less. I have a seven year old who explained in all earnest earlier this week that she has tantrums simply because she wants to get her way. Funny, the two situations sound the same, so please, someone tell me: is my daughter European or are Europeans seven year olds?

Europe’s answer to the problem was to borrow another trillion dollars to provide aid. This is like putting fuel on a fire—you can’t solve a debt problem by borrowing more money! It may stabilize markets short term, but sooner or later you have to pay back the debt or default. In the mean time, some European countries are raising taxes (which will result in lower tax collections) so costs will rise while governments are piling on debt.

United Nations, World Population Prospects: the 2002 Revision (2003)

Europe is already having trouble supporting its population, as can be seen by the current financial crisis.

Typically it takes a ratio of ~3 working people to 1 retiree to maintain a country’s standard of living. The current pyramid—highlighted in green—is not broad enough to support Europe, but as the red portion shows, in the next 30 years, as people born in the 1960s and later retire, it will get substantially worse.

Japan’s population is even older, as are most of the other Asian countries. The U.S. is behind Europe by about twenty years. The only growing populations are in the emerging and frontier markets.

The problem is that the U.S. is in the same situation, only a few years behind. And worse yet, we seem to be running toward the European model as fast as we can. The healthcare bill was the perfect example. Various Congressional offices have already come out and admitted that the cost of the bill will be dramatically higher than originally forecast. States are in serious trouble and the healthcare bill will increase their costs. Taxpayers are going to have to pay for all of this because the government can’t, and the only taxpayers that are going to be able to pay are those that would have put that capital into savings.

This of course leads us to gold. Gold is $1,228/oz—an all time high. The reason for the rise is that investors/traders are looking to gold as a hedge against all currencies. The U.S. Dollar (“USD”) has been rising at the same time—which is a new phenomenon. Typically, the USD moves inversely to gold, however now speculators are moving out of the Euro and running to the Yen and the USD as the safe havens.


China has created and continues to feed a very similar credit problem. They are in the midst of a real estate speculative boom just like what Europe and the U.S. have experienced. It is being financed by cheap government debt and the government’s desire to have GDP growth, which are contrary desires. For a better understanding of the issue, I recommend reading Michael Pettis’s blog—a very bright individual living in China (http://mpettis.com). Michael explains the issues, and I have quoted him below for simplicity and clarity.

“What really matters if we want to stop the speculative (real estate) frenzy is to find ways of raising interest rates and removing domestic liquidity. But both of these are tough to do. Raising lending rates, if it is done enough to suppress real estate speculation, will put unbearable pressure on Chinese borrowers—many of who can only manage the debt because it is virtually free—and will make it impossible to revalue the currency in any serious way. The fact that it would prevent currency revaluation shouldn’t matter because, as I have pointed out many times, low interest rates may have as much or more to do with China’s trade surplus as the undervalued RMB, but unfortunately the RMB has become so politicized that a failure to move will simply fan foreign anger at China and lead to increasing trade tensions—and China is terribly vulnerable to trade war.

“But putting pressure on borrowers is a real problem. After so many years of being able to invest with almost no concern for the return on investment, raising funding costs will force real financial distress onto borrowers. Either they ignore it, and government debt levels rise serenely ever higher (and remember, as I discussed in a previous post, government debt must be paid for by reducing future household consumption), or they respond by cutting borrowing. Less borrowing means that investment slows dramatically, and in an economy so dependent on increased investment for its growth, anything that slows investment slows growth.

“It is even tougher to contract domestic liquidity. As long as China maintains the currency regime it is hard to control the domestic money supply, and the one powerful tool Beijing does have—too powerful to be wielded smoothly—is the lending quota. The problem here of course, to repeat, is that Chinese growth is so heavily dependent on additional investment, which is itself heavily dependent on new lending, that Beijing can’t really force down loan growth without seeing GDP growth drop sharply.”

So if everything is so hopeless, why even bother? Well, as gloomy as these issues are and as scary as these issues are, out of chaos come opportunity. The key, we believe, will be to keep focused on the long term rather than the wild swings we will experience along the way.

The Bottom Line:

Before the markets can truly enter a new bull phase such as what we experienced between 1982 and 1999, values must get rebalanced. This means that stocks prices relative to earnings and debt must be lower. It also means that public debt and spending must be moderated. This cannot be accomplished quickly, it will require time and some pain.

At the same there will be individual companies that are very successful even with this backdrop. This is because many companies have reduced their debts and their payrolls significantly. Thus, while many margins will be lower over time, profits could be quite strong. Therefore, our strategy, which we have been implementing for some time now, is a blend of: 1) multiple asset classes to balance the economic crosswinds we have discussed with 2) mostly individual securities with a few ETFs, as it will be more of a stock pickers market as the markets will likely trend flat to downward for another five to ten years (just like the last decade).

Here are some of the pieces:

  1. Protection from inflation: gold, and at times, other commodities. We like food long term because people still have to eat. Energy will be necessary and as emerging markets grow over time, will be in shorter supply.
  2. Protection from deflation and recession: High quality corporate notes. High quality—as in low debt/asset levels and high interest coverage ratios (in other words—companies that can pay their debt back even if their business slows down).
  3. Protection from wars: gold and oil and defense stocks. As world economies become more and more stressed, the potential for armed conflicts rises.
  4. Increased regulation: the government—all governments—will always blame their financial problems on the private sector (for example, the financial crisis was all Wall Street’s fault). We expect government regulation and intervention in people’s lives will increase. Increased regulation requires someone to enforce and deal with said regulation, which means business opportunities. Alternative energy sources, clean water and clean air related companies will benefit. Banks, financial institutions, energy companies and health care companies will be hit with smaller profit margins. However, certain medical fields will still grow as demand for cures for cancer, arthritis and obesity related diseases will increase as populations ages. Energy related companies will grow based on supply and demand as emerging and frontier markets develop and increase their standards of livings.

Alan E. Rosenfield
May 2010

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