Q3 2010 Notes on the Quarter

Q3 2010 Notes on the Quarter

Download (PDF)

Overview of the Quarter:

  1. Q2 Results: S&P 500: (11.39%), Dow: (9.32%), NASDAQ: (11.81%), Europe: (5.80%), Asia: (9.29%)
    6/30–8/17 Results: S&P500: (6.99%), Dow: (4.14%), NASDAQ: (8.68%), Europe: (0.84%), Asia: (4.68%)
    YTD Results: S&P 500: (1.97%), Dow: 0.47%, NASDAQ: (3.28%), Europe: 3.35%, Asia (0.34%)

    That is a lot of movement to get nowhere.

  2. Fixed income, on the other hand, continued to make attractive gains.
    Q2 results: 5yr Treas: 4.7%, 10yr Treas: 9.1%, 30yr Treas: 16.3%, ave 5yr Corp: 3.7%
    6/30–8/17 Results: 5yr Treas: 6.9%, 10yr Treas: 12.6%, 30yr Treas: 19.5%, ave 5yr Corp: 6.6%
    YTD Results: 5yr Treas: 8.8%, 10yr Treas: 14.5%, 30yr Treas: 19.3%, ave 5yr Corp: 9.6%
  3. “The market giveth and the market taketh away…” We questioned last quarter whether the Q1 economic reports for GDP and employment were bumps due to inventory restocking and we have gotten our answer – yes. While Q2 earnings have been good, we have found margins were generally down, and as Cisco and a few others have mentioned, corporate consumption is cautious.
  4. Everyone seems to have forgotten about Greece and the economic worries of much of the Eurozone…perhaps the calm before the storm? Spain and Portugal have seen their ratings cut. Such calm often precedes a default. At least they are talking about increasing the retirement age and reducing public pensions in Europe. Most state governments in the U.S. (as well as the federal government) are refusing to admit they have the same issues.
  5. Taxes will be going up over the next several years. The top effective rate will be about 55% (including state and local but not including the cost of increased regulation) unless something changes. This, combined with the excessive government spending, is a huge headwind for companies and a huge tailwind for inflation.

Portfolio Specifics:

  1. Earnings this quarter were pretty good compared to a year ago – no surprise there. But margins were lower and backlogs were down. This smells a lot like inventory rebuilding, not a strong economy.

    We note that industrials and techs followed this pattern, and several CEOs, even with excellent results, warned that what they saw looking ahead was far less positive. Retailers’ sales have been weak. Even Wal-Mart, which had been benefitting from shopper’s downscaling, is showing negative same store sales results and aggressive discounting strategies did not provide the additional sales hoped for.

  2. Commodities as a whole continued to be flat. Oil is in upper part of its range, but has been falling quickly the past few days as more economic weakness is being reported by the Fed. With both China and Brazil showing some signs of slowing we don’t expect commodities to get much stronger soon.
  3. We took advantage of the pullback between May and July and added Apple and some fixed income. On the recent market rise in the past two weeks, we have sold off some positions to increase our portfolio focus and reduce exposure to the overall equity market. For the quarter we are very pleased by how much we outperformed. However, the most important point to understand is that we kept our volatility down. The rise and fall will continue to whip back and forth, so we don’t want to crow about a return that changes every two weeks. But by keeping our risks down, we will keep more of what we earn rather than give it all back.

Looking Ahead:

The financial markets have breathed a sigh of relief. Greece is fixing its problems and so is everyone else. Now if only we could get things growing again, all would be well. Well, that is the way the papers have effectively portrayed things. But let’s try and be a little bit longer term oriented. Let’s actually use the part of the brain that uses long-term memory (more than two weeks) and add to that a little bit of research and see what kind of shocking results we can achieve.

Much of Europe still has dramatic public debt and weak economies. This hasn’t disappeared, just disappeared from the newspapers. Yes, Germany reported a strong quarter: thanks to a very weak Euro. But the growth was entirely export-related and as we have noted before, everyone can’t be an exporter; someone has to be a consumer and no one, including the Germans, are consuming.

Furthermore, remember one trillion dollars was thrown at the Greece problem. Now maybe no one over there considers one trillion dollars to be enough to worry about, in which case I am moving* (*notice: no bags have been packed so I must be using sarcasm), but we expect this will keep the lid on growth for a while.

However, there are positive signs that bear watching: several countries have 1) proposed increasing the retirement age to more reasonable ages and reducing public benefits; and 2) actually decided to spend less and let their economies work their way through the debt levels without more government spending. This will inflict some pain, but if they really follow through, they will actually recover much faster.

The U.S., on the other hand, continues to run down the “let’s spend more money to solve the problem” route. The Fed just announced that they are now taking the return of capital from the mortgages they bought to buy long term treasuries. HUD now wants to offer 0% loans for people who are being foreclosed on; Congress is trying to push another stimulus bill through and just passed a $26 billion dollar package to bail out states that refuse to cut their spending (this bill also included tax hikes on companies doing business abroad). In addition, a number of tax hikes are on the way over the next two years. Welcome to Congress’s version of new math: 1+1 = whatever I want it to be.

This is, of course, producing the following results: 1) Companies are being very cautious about hiring people. Yes they are hiring, but only tentatively – no one is making aggressive bets on growth. 2) Wages are not rising much; in fact, with the new healthcare costs, wages will actually go down. In addition, people are working longer hours. 3) With many people out of work, and others concerned about their jobs, savings will continue to rise. Not all of these results are bad, but for a while it means weak demand, which means weak revenues and earnings.

Meanwhile, interest rates continue to drop. As of this writing, the 10 year U.S. Treasury is yielding 2.62% and the 30 year is at 3.73%. Corporate and high yield spreads continue to tighten.

IBM issued a 3 year note at 1%. Johnson & Johnson issued 10 year bonds at 2.95% and 30 year bonds at 4.5% – all three record low yields according to the Wall Street Journal and Moody’s.

With all of the government leverage, why are rates dropping so much and why are rates so low? Certainly there is not huge demand for loans from consumers these days. At the same time, banks are reticent to lend to small and mid-sized businesses. Large businesses are raising plenty of money in the debt markets and using it to fund acquisitions in part, so there is some demand there.

Worries about deflation are cropping up and have some validity. Deflation would certainly make buying long term debt logical except that during deflationary times corporate balance sheets can get really ugly, so you wouldn’t want to be buying long term corporate debt on any but the strongest of issuers.

So deflationary worries could be one of the drivers, but we think there is more to it than that because while deflation is a risk, it is far from assured at this juncture. Instead, we believe that much of motivation for investors has been fear and frustration.

Consider again, the volatility we have seen in the past two and a half years. Even in the last seven and a half months, the markets have gyrated so wildly it is hard to imagine anyone who is not feeling confused. We have discussed why we think there are such extreme gyrations before so we will not do it again now, but we believe many retail investors are 1) scared and 2) frustrated; and there is fundamental evidence which supports this conclusion.

First, there is mounting evidence of inflationary pressures building, even if it is several years before it becomes evident. The fact is that all levels of our government, as we have noted multiple times, are spending like drunken sailors (our sincere apology for insulting sailors worldwide). This debt will have to be repaid, and research suggests that the likeliest outcome is the devaluation of the currency via considerable inflation (for detailed research on this, read This Time is Different, by C. Reinhart and K. Rogoff, Princeton University Press, 2009).

Second, fixed income prices are getting irrational. Even with the moderate inflation we currently have of 1.2% (if you accept the governments figures), 2.95% yields on the 10 year JNJ paper actually net an investor less than 0.5%. If rates go back to where they were just one month ago, then the 10 year JNJ bond would be losing money (almost 5%). There is little upside and lots of downside to this investment, which hints at irrationality.

Third, while we believe that growth will be quite moderate for some time, stocks do offer some attractive fundamental advantages over fixed income. One example is dividend yields. While the current dividend yield on the S&P 500 is only 2%, a number of high quality stocks have higher yields, and we have started to see some dividends being raised. In addition, dividend yields on many foreign stocks are even higher.

Also, price to free cash flow (P/FCF) on the S&P 500, a measure of investors’ willingness to pay for the available cash on a company’s balance sheet, is lower than I have seen in over 12 years. This is another suggestion that stocks are cheap.

The combination of these factors makes us feel that debt is less attractive than it has been in some time. Investors must always balance the risks they are taking with the expected and potential rewards. We find it difficult to balance the risks given the current low interest rate environment. Thus, while we are not selling most of our fixed income assets, we are inclined to look elsewhere for opportunities.

The Bottom Line…

Top-down analysis says that earnings growth is going to be difficult in many parts of the world. Deflation is a possibility as countries try and export their way back to growth, and yet, inflation is a long term risk.

Bottom-up analysis says that the S&P 500 is reasonably priced, not a screaming buy, not a screaming sell. Corporate balance sheets are in good shape, but that margins and earnings could be negatively impacted by taxes and new regulations, adding stress to those very same balance sheets.

Market action says that traders are controlling most of the day-to-day movement and investors are cautious at best.

All of this tells us that asset class diversification continues to be critical: some fixed income to protect against possible deflation, some stocks and commodities to protect against inflation. Stock picking is going to be important and patience vital. We will get opportunities to grab stocks that get cheap because of hysteria (exactly what happened with Apple), but in the mean time patience should be the watchword.

We continue to focus our work on the following themes:

  1. Inflation
  2. The Internet as a driver impacting how people and companies communicate and manage their everyday lives
  3. Regulation will cost many companies but provides a growth drivers for others

Alan E. Rosenfield
August 2010

Comments are closed.