September 2011

Monthly Thoughts and Comments

Q3 Review

Picture yourself floating in a balloon over a farm. It is dark outside. You hear squawking coming from below, but because of the pitch black, you can see nothing. Luckily for you, you have night-vision gear with you and you speak fluent chicken. On donning your night vision gear, the scene below you lights up, clear as can be.

Beneath you, thousands of chickens are running madly in the dark in all directions; crashing into each other, pecking and scratching at anything that comes close – sheer panic envelopes the yard.

They are all screeching that there are several wolves in the yard intending to eat them.  None can see the wolves, but they can smell them (unfortunately, there is just enough wind that the direction and distance of the wolves are impossible to tell).  Unfortunately for the chickens, they are not lemmings; they are not all running the same way, so that a contrarian chicken would know which way to go.  The yard, which defines the chickens’ world, is in total chaos.   The last thing you see as you drift away is that many chickens have gotten hurt just from being in the yard and having someone inadvertently run them over.  Those that actively were running hither and yon actually were hurt the worst; of course, a few were lucky and somehow got out of the yard with only a scratch (although maybe that is where the wolves are).  Those chickens that stayed relatively calm, and just hunkered down and watched and listened, on average got hurt the least.

Woof!  I think that fairly well summarizes the latest quarter.  The S&P 500 was down 10% for the year by the end of September.  Although the pain started in August, September, true to its history, proved to be an ugly month for the markets.

S&P 500 Sector YTD % Return (as of 9/30/11) Change from Q2 2011
Consumer Discretionary -9.20% -25.4
Consumer Staples 0.90% -17.8
Energy -17.30% -38.2
Financials -21.80% -22.8
Healthcare -0.30% -31.1
Industrials -16.40% -27.8
Information Technology -17.40% -18.8
Materials -21.30% -29.4
Telecommunication Services -17.10% -24.1
Utilities 7.00% -9.3
S&P 500 -10.00% -15

S&P 500 by Sector

Of the “defensive” areas of the stock market, only utilities actually were at all defensive.  All the other sectors have shown increased volatility.  At the same time, dollar-centric commodities like gold and silver and oil all showed confusing action as well.

Gold was up about 14% for the year, even though it is off just under 16% from its high in the past two months.  However, gold stocks (as measured by Market Vectors Gold Miners Trust) were flat for the quarter and down 10.2% for the year.  Silver dropped 30% for the quarter and is down over 4% for the year and oil is down just under 7% for the year, 30% since it’s peak in April and is down just over 20% since the second quarter.

There were a number of economic issues which held sway over the markets in the past quarter, all of which we have discussed in detail in prior letters, but will summarize here for clarity.

  1. The end of QE2. This repatriation of a huge amount of capital sucked the life out of much of the cheap money speculation that it had caused for the prior year.  This likely forced the unwinding of a number of speculative trades in the gold and oil areas, perhaps helping to explain those drops even while civil wars in the Middle East were causing production cuts.
  2. Greece is closer to default and Spain, Portugal, Italy, the U.K. and the U.S. are under greater financial stress.  But wait, this isn’t news at all – it has been going on for some time.
  3. China is showing signs of a slow down, as is much of Asia and Latin America.  All are being hit with a combination of inflation and significantly weaker exports, especially in the tech arena.  In addition, China’s banks debt may be as much as 80% uncollectible.  This certainly could have a negative impact on commodity prices (see the first point) and worldwide economies.
  4. Every country is trying to have a cheap currency so that they can win the export wars, which is leading to further signs of potential trade wars – which no one ever wins.
  5. The U.S. dollar has been getting strong recently due to the view that the U.S. dollar is still the safe haven in a storm.  This could have a negative impact on earnings for internationally focused companies.

None of these situations are new or terribly surprising, but many seem to be contradictory.  This has led to increased volatility in stock and bond markets and lower overall volume.

We have argued for a long time that much of the volatility comes from the fact that the markets are no longer leading indicators but coincident indicators.  This is because most of the volume occurring is from high frequency trading rather than long term investing, which changes the focus from long-term events and outcomes to current headlines such as the following:

  1. We attended a presentation by PIMCO in the past week.  They basically admitted they were confused and didn’t know what to do.  They complained that a financial analyst these days really had to be a political analyst.
  2. Warren Buffet, in a recent speech, said that most of his businesses were showing signs of improvement, except for those related to housing which still showed no signs of improvement at all.
  3. There is a greater fear that the U.S. is going into another recession.  This is the fear, but the information is inconclusive and quite mixed.
  4. Oil prices are down 30% from their peak in April (suggesting lack of demand) while much of the Middle East is in turmoil and production is down.  As production has started to increase again, prices have started rising again.  Also, note that world oil, even with the worries of lower demand is still averaging well over $100/barrel, up from the low $80 level in 2010.
  5. The Eurozone is in chaos; banks are holding credit of questionable quality, yet gold prices are down 16% during this same time.

What should an Investor do?

1) Stay focused and tune out the excessive noise coming from the media.

For the past three months, the S&P 500 has fluctuated a total of 655 points, or 54% of the current total index, which is at 1194.89 as of this writing.  Yet, if you look at chart 1, you see that the market is effective flat during this time period!

Chart 1:  August 8, 2011 – October 10, 2011 (circled): No net price movement and half the volume of the rest of the year.


2) Maintain a combination of stocks, bonds and commodities in your portfolio.

This kind of diversity still makes sense as a hedge against the various economic risks.  Fixed income, once again, has surprised most people in that it has provided better returns than stocks.  Corporate notes are relatively attractive, especially as spreads have risen, although absolute rates are still quite low; but then, earning 2% is better than losing 10%.

Many stocks pay dividends that are double the rate paid on ten-year treasuries.  This yield has typically, but not always provided tremendous protection from volatility.  As long as the companies are well capitalized and have low levels of debt, the dividends are likely to be safe and over time, provide attractive returns.  Pay special attention to the emphasis on “over time.”  If you are looking for guarantees over the next six to twelve or even twenty-four months, you shouldn’t be in stocks at all.

For those with longer time horizons, we continue to believe that industrial related businesses and agricultural related businesses provide good opportunities.

3) Gold should be a significant portion of your portfolio.

Gold continues to do well, year over year, though it has dropped almost 16% from its high in the past two months.   We believe that in this case, however, nothing has changed except the price.

Europe continues to fix debt problems with more debt, while ignoring the basic economic tenant that you cannot continually spend more than you make.  The U.S. government is more interested in getting reelected than solving economic problems and so nothing is being addressed here either.  Japan – too much debt; China – too much debt.  If the actions of the various parties have not changed, is there any reason to expect the outcome to change?

Several things have had a short-term impact on the price of gold.  First, the CME raised margin requirements, which led to the initial down draft.  Second, the price had risen too fast in a very short period of time and it would not be unusual to see a pullback from such a quick and dramatic rise; in fact, it is very healthy.  This was likely coupled with deleveraging as stocks around the world all fell together, leaving traders scrambling to sell positions to raise cash.

Because nothing fundamentally has changed, now seems to be a good entry point for those that do not have exposure or want to increase their exposure to gold.  While there is some risk to further downside in gold prices, we think the risk is limited; the long-term upward trend has not been broken on either a long or short-term basis (see charts #2 and #3).  Gold mining stocks are currently more undervalued relative to physical gold than they have been in years and we believe strongly that gold mining stocks offer some of the best investment opportunities on a risk/reward basis.

Chart 2:  5yr Gold vs S&P 500 Index



Chart 3:  2yr Gold vs S&P 500 Index


Alan E. Rosenfield
Managing Director

October 2011

Next Month:  Earnings Season is upon us, so next month we will review the results.

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