July 2011—Semi-Annual Wrap-Up

There is a new 4 letter word in Washington, M-A-T-H… David Walker, former Comptroller of the Currency

The good news, bad news stories continue to unfold in 2011…and it’s all in the math.

The good news is companies like Apple, IBM, and Conagra are using math in their favor.

The fact is, the world is growing; and more importantly, the world’s middle class is growing. At current growth rates, the world will have 1 billion more “middle class” people in 2020 than it has today.

Think about that. One billion more people who will want refrigerators, cars, computers, and cell phones…not to mention clean water and better food.

Beyond this, the world is getting younger….and more consumption oriented. In the Western Hemisphere this is hard to conceive as the aging boomers flex their demographic muscle in the US and Europe. But in Asia, India, and Latin/South America, the situation is far different.

According to a recent Societe Generale (SocGen) report, over the next 20 years consumption in the Emerging Markets will grow between 100-200%. Meanwhile, the world’s working-age population (aged 15-64) has already swelled from 2.1 billion in 1970 to 4.5 billion today.

Much of this increase came in Asia (ex-Japan) as the region’s population went from 1.2 billion (again since 1970) to 3 billion today. This is what demographers call the demographic dividend because these new workers/producers also consume and save.

Now had this trend occurred when world trade was slow and Asia isolated, its affect would be muted. World-trade, however, has exploded 10 fold since 1980 thereby allowing Asia to leverage its demographic and low-wage advantage to build a powerful (and productive) work force.

Large US multi-national firms have figured this out and are selling I-Phones, pharmaceuticals, automobiles, and consumer goods at impressive rates. This helps explain how these multi-national, export-driven companies can post record sales growth and profits (while smaller US-centric companies struggle) in a slow domestic market.

The long-term implications of this cannot be overstated, because while growing world consumption demand can be assumed, assuming commensurate resource/production gains cannot.

You see, over the past 30 years we have gotten used to the following paradigm---(thanks again to SocGen):

  1. Plentiful energy/resources.
  2. Strong competition resulting in low prices.
  3. Falling interest rates, deregulation, and “hands-off” economic policies.
  4. Appetite for risky investments.

In this environment, bonds, financial stocks, & speculative real estate (until 2008) were huge winners.

Holding on firmly to that old paradigm, however, could be financially foolish. It is not hard to imagine the next 20 years being marked by:

  1. Consumption booms leading to strains on energy, commodities, and resources.
  2. Competition ebbing if smaller companies are squeezed out of the market place and large companies dominate.
  3. Rising interest rates and increased governmental regulation/involvement.
  4. Less appetite (and potentially less reward) for risk.

In this environment, bonds, financial stock and speculative real estate lose. Meanwhile, industrial stocks, commodities (including energy), high-tech stocks (with international appeal), and low-risk, “meat-and potatoes” real estate will excel. That’s the good-news story.

On the other side of the coin, Western governments and mega-banks continue to squirm. Math is working against them. Let’s start with government.

By some estimates, 40-50% of the US population is either directly employed by a government (federal, state, municipal) or indirectly employed by government (think contractors, quasi-governmental agencies, non-profits).

The $14.4 trillion debt (along with the $60-$70 trillion in unfunded promises) is a direct result of bloated government payrolls, unaffordable pension plans, expensive wars, and budget-busting health care and entitlement programs.

The math says things can’t go on the way they have for government. Painful choices and disruptions lie ahead.

The near-term math for the big banks is equally bad, but for different reasons. Below are a just a few of the reasons that we at Talbot Financial have avoided investing in any big bank stocks (regardless of how “cheap” they are at this point).

  1. You can’t trust the balance sheets. Bank of America recently wrote off another $8.5 billion in underwater mortgages. B of A likely knew this was bad debt last quarter, (and last year), but under accepted accounting guidelines (GAAP), they carried it on the books at inflated values…until now. B of A was not alone in this practice. Bleeding out the bad news is now the norm and who knows how many more “surprises” are to come. Couple this with the “extend- and-pretend” tactic of not foreclosing on bad loans, and analyzing bank balance sheets becomes an exercise in futility.
    (There will come a time when the balance sheets are “trued up” and forward earnings will become dependable indicators of bank stock valuations….but, in our view, we are not there yet.)
  2. The lawsuits may have just begun. On June 29, the Wall Street Journal reported that Bank of America settled with a group of powerful investors that lost money on the Mortgage Backed Securities debacle of 2008. Some believe that this signals the “beginning of the end” of the 2008 financial crisis. Numerous class actions suits, however, are in various stages of the legal process and B of A’s settlement could embolden other investors to file suit on the premise that the only way to lose in the legal process is not to play. In short, B of A’s settlement could be first in a very long line.
  3. Bank exposure to Credit Default Swaps (CDS) is opaque. Credit Default Swaps are supposed to be a form of insurance that protects lenders in case of loan default. The difference between a traditional insurance policy and a CDS is that anyone can purchase one, even those with no direct interest in the loan being repaid. Thus, the CDS market has become a speculative casino where potential losses can be 100 times the premiums received. CDS losses are what took down AIG. Because CDSs trade among banks in private arrangements, it is difficult to determine what banks have what exposure and how strong the counterparties are on the other side of each trade.

To sum up, a great bifurcation is happening right before our eyes. The winners will win big. Apple will sell I-Phones in China whether the US raises the debt ceiling or not. Losers will lose big. Those dependent on government or large banks for their fortunes will painfully adjust to a new reality.

So, knowing this, how should you invest?

We at Talbot financial are proceeding cautiously and remain almost totally unleveraged. Now is not the time to take on speculation-driven debt. Beyond this, while we remain diversified, we are overweight commodities, metals, and energy stocks believing in rising inflation---as well as rising international production and consumption.

We are constantly looking for “real estate that makes sense.” Some projects are now selling for 10-15% below constructions costs. If the returns are reasonable and they “sharp pencil out.” it makes sense to invest in an area that many are shying away from. People will always need a place to live and do business.

Needless to say, we are extremely light in banking defense, and stocks with no clear path to profit.
And the reason for all of the above is simple….it’s all in the math.


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