Archive for March, 2011

Energy Dominates First Quarter Returns

Thursday, March 31st, 2011

Relative Performance to S&P 500

Arthur Hill, a respected technical analyst put this chart together and I really like it. You can see very clearly that the return of the S&P 500 was dominated by energy companies. Industrials were the only other sector that showed outperformance to the broad index.

I’m a worrier – most of my friends know it. As I look at the coming quarter, I worry that we will see a correction much like we saw in the second quarter last year. Why? The end of QE2 scheduled for June will begin to be discounted by the market. Confusion will reign the day as we have never been through this before, and equity investors hate uncertainty. This leads me to think we need to raise cash, maybe 10% of portfolio allocations, in case we see a pullback.

On the flip side, though, is the fact that earnings season is upon us and we will likely see strong earnings. Growing earnings generally increase stock prices EXCEPT when we see shrinking P/E ratios – aka valuations. Certain things make investors less willing to pay for earnings, even growing earnings, things like potentially rising interest rates or slowing economic activity.

With the end of QE2, we could have both of these things. The Fed has been buying 70% of the treasury bonds issued to fund our deficits as part of QE2. If they stop, then interest rates will intuitively have to rise to entice others to buy the bonds. Also, if the monetary stimulus ends, the potential exists for the economy to slow down.

But the emerging economies are still growing and much of industrial America has transformed itself into a supply chain for Asia and South America. A slowing US economy quite possibly could have only a marginal impact on overall corporate earnings as long as the developing world continues to move forward. Reports are that China is satisfied with its results in slowing its economy and is preparing to resume imports – and Brazil is thought to have a handle on its inflation issues and will complete its cycle of interest rate increases this year, pushing its stock market higher.

The spike up in oil prices today is also worrying me – at some point we will see demand destruction and impacts on economic activity from higher oil prices that will send oil stocks and other economically sensitive stocks down. We aren’t there yet, but I’m keeping a watchful eye this issue to see if we will side step a pull back.

So, I am in a holding pattern at the moment from a fundamental standpoint waiting to see how the stock market reacts to some of this stuff. I can tell you that from a technical standpoint, one fairly reliable indicator is saying that we are likely moving higher – at least in the near-term. As you can see on the following chart, the 10-day moving average of the S&P 500 Index has crossed over to the upside of the 50-day moving average. If you look at the chart, you can see that situation is generally good for several percentage points of positive return for the broader market.

S&P 500 Index with 10-day and 50-day Moving Averages

So, at the end of the first quarter, Energy and Industrials were the big winners with other sectors underperforming. The second quarter has the potential for a pullback, but the reliable cross-over indicator above says that we could still have some room to run.

As I tell everyone, invest what you see not what you believe. I see the technicals telling me that we have some upside left, so I’ll go with that for the present. However, as we near the end of earnings season and the end of the QE2, we’ll see what the market tells us about whether we need to raise some cash.

Click here for video on YouTube


Play Offense Not Defense

Tuesday, March 29th, 2011

Keppel Corp Vs. S&P 500 Vs. Proctor & Gamble

I get a lot of questions from people asking why I don’t invest in companies like Proctor & Gamble or Colgate Palmolive. Companies like that are defensive in nature, according to investment theory, and should provide shareholder returns no matter what happens to the economy or the financial markets – everyone needs toothpaste and laundry detergent the theory goes, so they are better investments if you want to own stocks.

In the chart above, I’ve put a performance comparison of Keppel Corp, the S&P 500 Index, and Proctor & Gamble. Keppel has far outperformed the other two, and the S&P 500 Index has clearly outperformed Proctor & Gamble. Keppel is the sort of company I really like to have money in. It is located in Singapore with access to the fastest growing economies and the globe’s best demographics. It focuses on some of my favorite investment ideas: water desalination, environmental engineering, shipping, off shore oil rig construction, efficient power generation, and more. It has strong earnings growth because if focuses on businesses that are positioned for the future. It is definitely not a defensive company.

As a foreign mid-cap, there are other risks that have to be managed – we manage them through small position sizes (not risking too much capital on any one company), geographic, thematic and industry diversification, and application of technical analysis to help us raise cash when appropriate. We won’t be right 100% of the time, but over time, our process has shown to provide value for our clients while managing risk. And its a lot better than allowing a client’s money to languish in a defensive stock that hasn’t made them any money in over a decade.

My investment process, as most of you know, focuses on earnings growth and P/E expansion as the driver of share price appreciation. Earnings growth requires being in the right businesses, with the right customers, and operating as efficiently as possible. P/E expansion requires being in the areas of the market that investors place increasing value on because they have a catalyst for the future. Water desalination for an increasingly thirsty world is a catalyst for the future – an improved version of a familiar consumer product at a time of 9% unemployment, not so much.

I prefer to find the companies that allow us to play offense and provide above average returns for our clients. Defense can outperform for short periods of time, but even in the recent market crash, defense lost money. I’ll stick with playing offense – and raise cash if I see a market disruption coming – in order to serve the needs of my clients, even if it means extra work finding companies in Singapore, Bangkok, or Santiago.

Click Here to watch today\'s video on YouTube


Who Asked Him To Open His Mouth

Wednesday, March 16th, 2011

S&P 500 Today - One Minute Chart

The market opened pretty much as I thought it might – down a little but strengthening as the day progressed – UNTIL Günther Oettinger, the EU Energy Commissioner, said there could be catastrophic events within only a matter of hours in Japan. Japan’s crippled Fukushima nuclear power plant risks provoking a “major disaster” and was “effectively out of control.”

You can see when his remarks hit the airwaves on the chart above – an immediate nose dive. And, as far as I can see from reading analysis from various sources at major universities, things are not as dire as they are being made out.

Here is an analysis from the University of Michigan that another money manager sent me today: “I’m not expert on this particular engineered system (not a nuclear engineer); but rather a nuclear physicist. That said, I see no reason to expect that, even if attempts to cool these cores completely failed and there was a worst case so-called meltdown of the entire core, the ultimate container vessel would not completely contain the entire mass and it’s radiation indefinitely.

The radiation releases to date are quite well understood as simply radiation entrained in steam that undergoes controlled releases as it is generated in cooling the rods with water. The rods are indeed cooling and the steam releases are apparently decreasing. Meanwhile spent rods in the pools are not in danger of some full meltdown, but need to be covered in water to dissipate heat and suppress radiation.

These are of course serious matters; but no one should be telling the public that a ‘meltdown’ would release large amounts of radiation or contaminate large areas as long as there is no evidence that the ultimate container has ever been damaged. I have seen no such claims.”

Add to that the news reports that power is being restored so that water can be pumped into the reactors and that the AP is reporting that conditions are stable at Reactor No. 4, and this chief (note the small “c” in respect for the capital “C” Chief we all miss) caused baseless massive losses in wealth.

The good news is, we can call these buying opportunities for the right companies.

I thought I’d give you an idea of some of the things we’ve started buying. News driven panic provides the perfect opportunity to buy high quality companies at bargain prices.

Novo-Nordisk: This leading producer of insulin from Denmark is one of my favorite health care companies. Diabetes is one of the fastest growing cronic diseases and their earnings growth is following suit. However, they have an insulin plant in Japan (one of several around the world). Investors see this, and sell with impunity – providing an opportunity for us to buy it 18% off its high and at an important technical level at the bottom of the price channel (See below)

Novo Nordisk

Yara International: Another favorite, this Norwegian ag chemical company produce Nitrogen fertilizer with growing international demand. However, they are caught up in another disaster – the fight in Libya. They have a plant there which represents 1% of their revenue, but it is caught in a war zone. Investors see a plant in Libya and knock 23% off its price – way too drastic for an asset that represents only 1% of revenues. We are a buyer of this at that valuation after this panic induced selloff

Yara International

These are just two examples of quality companies in desirable industries that have had news-driven selloffs that far exceed the negative impact.

If we get some good news on the nuclear reactor situation in Japan, coupled with the Fed’s announcement of continued easy monetary policy for as far as the eye can see, we will likely get a rebound in the markets as the fear penalty is abated.

For our Best Ideas portfolio clients, we will be likely adding a Japan Rebound theme to client portfolios – probably a combination of reconstruction companies (maybe a Kubota?), the banks (we’ve owned Mitsubishi Bank in the past and we could revisit it?), a car company (how about Nissan as the Leaf fits our alternative energy theme as well?), and others that I’ve yet to determine. For our clients that also have our Developed Markets and ETF portfolio exposure, we will certainly add some Japanese equity to it.

Until the next post, I’ll let the Black Eyed Peas provide some sound advice to chief Oettinger the next time he thinks its wise to speak publicly:

Click here for video on YouTube


Japan Crisis Follow-up – Fed Policy Announcement

Tuesday, March 15th, 2011

S&P 500 Today

At 1:30, the Fed announced a continuation of their easy monetary policy and the stock market has rallied significantly off the lows of the day.

I thought it was important to point it out to you given all of the bad news on Japan in the earlier post – and my thesis that Fed policy trumps everything else relative to stock prices.

When it was announced, we started buying a few things, adding to some of the most beaten up position. I’ll give you more of those details later, but I thought you might like to read the announcement for yourself. Here is the story from Reuters:

Fed Maintains Easing Policy, Economy On ‘Firmer Footing’
Published: Tuesday, 15 Mar 2011 | 2:19 PM ET
By: Reuters

The U.S. Federal Reserve maintained its ultra-loose monetary policy on Tuesday, saying the economy was gaining traction while flagging potential inflation risks from costlier energy and food.

The widely expected decision comes on a day of steep selling on stock markets around the world as investors assessed the devastating toll of Japan’s earthquake and tsunami, and fretted over the possibility of a broader nuclear crisis.

The heightened uncertainty reinforced the case for a steady-as-she-goes policy decision from the Fed, which markedly upgraded its view of the U.S. recovery and labor market.

In a unanimous decision, the Fed vowed to continue its $600 billion government bond-buying program as scheduled, and reiterated a pledge to keep interest rates at very low levels for an extended period.

“The economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually,” the central bank said in a statement.

That was a much rosier assessment than it gave at the conclusion of its last meeting, in January, when it said that the recovery was still too weak to significantly bring down unemployment.

The Fed dedicated an unusually large portion of its statement to inflation concerns surrounding a recent spike in energy and food prices, which it said would most likely prove transitory.

“Long-term inflation expectations have remained stable, and measures of underlying inflation have been subdued,” the Fed said, suggesting that it was in no rush to raise interest rates.

The statement made no direct mention of Japan.

The worst earthquake on record for the world’s third- largest economy could have substantial ripple effects on the global recovery—as evidenced by a sharp pullback in global equity prices, with Japanese stocks down over 10 percent on Tuesday alone.

Even before the tragedy, U.S. central bankers faced confusing signals. Despite high unemployment, rising energy costs appear to be nudging up the price expectations of U.S. consumers, the first inklings of an inflationary psychology the Fed would like avoid.

Fed officials managed that tension by beefing up their assessment of economic conditions while emphasizing just how far the central bank remains from its targets for both inflation and employment.

Since the Fed’s last meeting in January, the U.S. economy has continued to show signs of promise. The U.S. unemployment rate has fallen rapidly, down to 8.9 percent in February from 9.8 percent in November.

Still, the pace of hiring suggests further progress will be painfully slow for the 8-million-plus Americans who lost their jobs during the economic slump of 2007-2009.

At the same time, higher gasoline costs have created fresh concerns for consumers, with a big hit to confidence this month raising concerns about whether a recent spurt in consumer spending can be sustained.

The U.S. economy expanded at an annual rate of 2.8 percent in the fourth quarter, a respectable performance but a faster pace will likely be needed to make a further appreciable dent in unemployment.

Some economists thought growth could approach 4 percent this quarter, but have pared back projections, in part because of an unexpected widening in the U.S. trade deficit.

The Fed effectively chopped overnight interest rates down to zero in December 2008 and then turned to buying mortgage and Treasury debt to keep long-term borrowing costs low. In all, it has committed to buying $2.3 trillion in debt.

The asset purchases have proven controversial, with domestic critics arguing the Fed is courting future inflation while officials in emerging markets have accused the central bank of trying to boost U.S. exports by devaluing the dollar.

With the economy strengthening, officials are also likely to have had a vigorous debate on how best to eventually tighten policy, but analysts will have to wait until Fed speakers take to the podium again to get a fuller flavor of the discussions.

Crisis in Japan

Tuesday, March 15th, 2011

S&P 500 Daily Chart

The crisis in Japan is a terrible thing. The loss of life and property are huge and will impact those living there for a long time to come, much like the 911 attacks impacted the US. The real question is whether it will impact the rest of the world the way the 911 attacks did.

In the chart above, you can see that the impact on our own stock market has been significant, but that we are currently trailing upward. There are several questions that we are trying to figure out, like: (1) will this have a significant impact on world economic growth going forward, (2) will it impact corporate earnings, (3) will it change the investment landscape such that the companies with growing earnings as reported in the most recent quarter will no longer have growing earnings, (4) will there be other market leaders coming out of the current crisis-induced selloff such that we need to make significant changes to client portfolios (focusing on “defensive” stocks instead of earnings-growth based stocks), or (5) will there be worldwide impacts to daily life beyond Japan.

Investment Guru Doug Kass wrote this today which helps to answer (1) above:

In rough terms, the Japanese economy represents one-tenth of the world’s GDP and about one-third of U.S. GDP.

Let’s guess that the Japanese economy suffers about a 1.5% hit to growth, bringing real GDP growth for 2011 to approximately flat year over year. World GDP will therefore be cut by only about 0.15% this year. (Estimates are that this would lower real GDP growth in the U.S. by about 0.4% and the eurozone by about half that amount.)

The current multiplier to profits of a 0.4% drop in U.S. GDP is roughly 6x-8x, bringing 2011 S&P 500 profits down by about $3 a share (7 x 0.40%). The $3 reduction in S&P earnings, using the pre-earthquake P/E multiple of about 13.5x, produces about a 40-point diminution in the value of the S&P 500.

The S&P sold at about 1325 the day before the Japanese earthquake. Forty S&P points taken from 1325 brings the intrinsic or “fair” value (based on the above analysis) of the S&P to about 1285, or about 22 S&P points above the current trading level. So, with S&P futures down by about 36 points now, most of the Japanese disaster seems to now be discounted, unless it morphs into a broadening nuclear disaster.

If the market is in the process of finding a bottom as Doug states, and the impact to worldwide GDP is as limited as indicated, then we can infer answers to the other questions as follows:

(2) will it impact corporate earnings? yes, but it seems as if it is priced into the market if the analysis is correct,

(3) will earnings growth cease? unless there is a major change to the investment landscape, the companies that have been seeing growing earnings should continue to see growing earnings – UNLESS there is a worldwide impact from a nuclear disaster,

(4) will there be new leaders to the market? there is no way to know right now if there will be new market leaders – you see companies like managed health care companies moving higher today because people are reacting to the news and assuming we will have a global recession – however, the analysis just doesn’t support it nor does history (we didn’t have a worldwide recession after the Japanese quake in 1995 which was also devastating – we may have a period of time where those defensive companies outperform, but making wholesale switches to strategy based upon a reaction and no data nor historical precedent is careless and not something we do, and

(5) will the crisis impact the entire world or just Japan? this crisis, as terrible as it is, is not the financial market collapse we saw in 2008 which put the entire world’s financial system in jeopardy nor the 911 attacks which started the Afghanistan and Iraq wars that have involved many countries to varying degrees – the likelihood is that it will negatively impact Japan for a few years, marginally lowering global economic activity, but will not in and of itself throw us into a global recession.

The biggest risk to the markets is still whether the Federal Reserve will end its accommodative monetary policy – going into the Japan crisis, you had already begun to see that some investors were selling some of my favorite areas of the market that have good long-term catalysts (small/mid-cap growth stocks, emerging markets, technology and basic materials) in favor of consumer stocks like McDonalds and P&G. These shifts last awhile – it will probably be until a combination of the next earnings announcements and actual action by the Fed.

My best assessment is that the Fed will not be able to tighten monetary policy – they may even have to continue to purchase treasury securities to fund our deficit. This is based upon the fact that their current stated reason to have an accomodative monetary policy is to increase employment via an increase in wealth (ie, keeping monetary liquidity flowing to support the stock market and drive stock prices higher, generating a “wealth effect” of making people feel better about their financial position and more likely to hire new staff). The current pullback needs easy monetary policy to continue, plus Japan is the third largest purchaser of our treasury securities. If their resources are going into rebuilding after the disaster, the Fed may by default have to continue buying treasury securities – and as we’ve seen the proceeds of those purchases have moved stocks and commodities higher.

In Summary: At this point, we are working under the premise that the stock market is near a bottom based upon the analysis of impact to GDP presented above. That bottom will not impact the long-term growth in earnings we are experiencing due to the economic rebound from the financial crisis. However, we are paying attention to whether anything happening in Japan (like a nuclear disaster with worldwide implications) would impact the broader world. The real impact to the financial markets is the actions or anticipated actions of the Federal Reserve ending an easy monetary policy – and right now we do not see that they can do that.

As the crisis passes and we take actions in client portfolios, I’ll be back to advise you what is happening.


Washington Fly-In

Friday, March 11th, 2011

I’ve been in Washington DC much of this week with several community leaders. Our goal has been to make sure that our legislators know what is important to Champaign County.

If our legislators know what we need then they can focus the limited dollars available toward the things that improve the livability and infrastructure in our community. That obviously leads to an improved business climate which helps the bank grow and prosper for our shareholders.

I was asked by the News Gazette to write a blog about the trip so that people interested in economic development could keep track of our efforts.

If you have an interest in reading it, you can find it at the link below. Just copy and paste the link into your browser.

I’ll be back to the regular investment posts when I return home.

Until then,


2nd Anniversary of Rally

Wednesday, March 9th, 2011

S&P 500

Two years ago, the market made a significant bottom after the sub-prime crash. You can see on the chart that we had one correction and side-ways pause but other than that its been a fairly straight move up.

Going into that bottom, we were very over-weight in cash in client accounts, but in a few days we were at our maximum allocation to equity securities in client accounts.

At the time, I wrote a lengthy blog post explaining why we believed that the crash had bottomed. You can find it here: March 10, 2009 Blog Post.

Sorry for the short blog post but I’m in a series of meetings this week, but I just wanted to make sure to wish you a happy anniversary as we’ve all made a lot of money in this rally.

Click here for video on YouTube

World’s Easiest Forecast: Taxes Will Go Up

Thursday, March 3rd, 2011

Unfunded Liabilities

There is an slide show presentation floating around the investment world called USA, Inc., by Mary Meeker (formerly of Morgan Stanley). In it, a fairly frank data-based assessment of the financial condition of the United States is presented, and it isn’t pretty.

Among all of the slides, it shows that we have been living way beyond our means for a few decades and we have dug ourselves a hole that will take a lot of money to fill.

The chart above shows you the current and unfunded liabilities of our government, and you can see that the unfunded liabilities of Social Security, Medicare and Medicaid dwarf everything else by comparison.

If you are not familiar with the term “unfunded liabilities” they are basically promises our government has made to people that it has no known source of revenue with which to fulfill them. In the case of Social Security and Medicare, the government does collect taxes, but those taxes are no where near enough to cover the amount that will need to be paid out based upon the promises that have been made.

At some point, Washington will get serious about this problem and address it – with higher taxes and broken promises – unfortunately, they view it as political suicide to bring up the topic.

Why is this in the investment blog? Because it reinforces the concept that the macro demographic trend in place that makes the emerging markets with positive demographics better places to invest than the developed world will continue for at least the next generation. The amount of taxes that will have to be raised in the US to cover our unfunded liabilities and structural deficit will on average cause our markets to under-perform those of places like South Korea and Singapore for a long time to come.

Click Here to Watch the video on You Tube