August 2011

“There are known knowns…. there are known unknowns… .there are also unknown unknowns---the ones we don’t know we don’t know. “ Former Secretary of Defense, Donald Rumsfeld

We are told that businesses are not investing because of uncertainty. But there is never perfect information. There is always uncertainty. Always.

The reality is American businessmen and women have historically thrived on uncertainty.

The easier argument to make is that businesses are not investing (or expanding) due to what is seemingly certain. High taxes, over-regulation, and divided government policy are all currently “certain.” But government policy is not the theme of this month’s missive.
Certainty vs. uncertainty is.

So let's break the mold a little and view the markets through the lens of Secretary Rumsfeld's knowns and unknowns.
Let's start with the known-knowns. We know:

  1. A US budget deal passed that guaranteed a debt ceiling increase without guaranteeing any serious spending cuts.
  2. Growth in the US and Europe lags growth in Asia, South America, & India.
  3. The European debt issues are not resolved.
  4. The world's third largest economy (Japan) continues to painfully deal with the after effects of a disastrous tsunami.
  5. Corporate earnings have bucked the pessimistic trend and continue to impress. (80% of Fortune 500 companies exceeded earnings estimates in Q2.)
  6. The world's population is growing, along with production and consumption.
  7. Technology gains are racing ahead at unprecedented speed.

Of course there are many others, but you get the idea. And since the first rule of investing is to not lose moneyàand since we know the knownsà it makes sense to avoid industries that are dependent on government. Thus, among others, avoid defense, hospital, banking, and education stocks.

It also follows that government debt is not the "safe-haven" that we were all taught. Just ask the Greeks.
Meanwhile, investing in dynamic companies, with global reach, that sell "must have" products might possibly carry less risk than a CD paying .25% (or, for that matter, a Treasury debt paying 0%!) while inflation is running north of 3%. In other words, you are losing money every day if it is in a bank.

Keep in mind, it is likely that Proctor and Gamble will sell diapers, and McDonald's will sell hamburgers, & Exxon will sell oil regardless of the latest financial crisis de jour.

And if you “lift the hood” under these company balance sheets, you’ll find them aggressively expanding in anticipation of future demand. Of course, investing in known- knowns is a little like investing “in the sunshine”---meaning everyone sees crowded Apple stores and lines at Chipotle. Those “sunshine trades” attract a lot of attention.

That doesn’t mean investing in the sunshine is easy… or unprofitable. Investors must have the discipline to stay with the winners, however, while many ”experts” are trying to make them sell by predicting doom-and-gloom in the company’s future. Many investors “pick their flowers” way too early.

Bear in mind, the trend is your friend in the known-known category….and the trend changes slower than you think.
Most investments, however, are not of known-known variety. Most investments are made “looking through the fog”…meaning investors must make educated calls based on imperfect information--- or known-unknowns.

Here is a short list of today's known-unknowns:

  1. Is Chinese growth sustainableà or are mal-investments in ghost cities, teetering banks, & over-valued real estate going to slow the world's growth machine?
  2. Is the Euro going to survive in its present form, or is re-structuring minus Greece, Portugal, (and possibly others) inevitable?
  3. Is the US economic recovery faltering, or is this just a “soft patch” caused by the Arab-spring, Japanese Tsunami, and unusual weather patterns?
  4. Will the Fed attempt new ways to stimulate if the economy slows?
  5. Will the world's mega-banks return to stability sooner, later, never?
  6. Is the Arab-spring movement exhausted, or is more unrest to come thereby disrupting world oil supplies?
  7. Can well-run companies continue to fight governmental headwinds and offer amazing products to a receptive world?

Again, making your own known-unknowns list could fill several hours of your day. We believe the over-arching theme of today's known-unknowns environment is that entrepreneurial private enterprises are embracing change, while governments (and firms dependent on government) are fighting it.

Looking successfully “through the fog” in the known-unknowns category requires considerable effort…and a little luck. At Talbot Financial we see the following good and bad events in our future:

  1. Governments will continue their “print to prosperity” policies rather than addressing structural governmental problems.
  2. Inflation will follow.
  3. Despite rising inflation rates, governments and central banks will work hard to keep short-term interest rates low via intervention in the currency and debt markets. Market forces, however, will force longer term rates higher.
  4. Debt downgrades will come and cascade down the food chain with increasing amplitudeà.meaning if sovereign government debt is downgraded, municipal debt will follow, and corporate bond spreads will likely widen.
  5. To-Big-To Fail banks will continue to off-load bad debt onto governments as long as they can. Derivatives trading will not abate and transparency will not be forthcoming. More "surprises" will follow.
  6. As we predicted in January, the Euro is looking more likely to break apart and currency devaluations in PIIGS nations would then follow. Northern European, Asian, and American companies will buy PIIGS assets at fire-sale prices.
  7. Technological advances will be integrated into "old-school" companies like Wal-Mart, American Express, and McDonalds leading to increased profits and productivity for both high-tech and low-tech firms that embrace the new technologies.
  8. Demand for "cool" products like Coach, Victoria Secret, and Apple will continue to grow at double digit rates.
  9. Companies like Chevron, Con-Agra, and Freeport (minerals) will sell more product world-wide next year than this year.

Believing the above must now be translated into action.

For example, based on the budget outcome, it is reasonable to see inflation in our future. Yet, oil companies were recently hammered down along with most other stocks. That doesn't seem reasonable to us long term. The world will likely need more oil next year (at higher prices) than it does this year.

Therefore, the short term trade would be to "harvest" tax losses. For instance, if you had a loss in Chevron, you would sell Chevron (thereby harvesting the loss for your taxes) and immediately buy a similar company like Conoco or Exxon. The tax loss taken today will protect gains in the future.

Beyond this, recognize that falling markets force margin calls. That means hedge funds and other highly leveraged institutional investors must sell winnersàeven if they don't want to. In this scenario, their loss is your gain, because companies like Mercedes Benz, ATT, and 3M go on sale--- even as their underlying fundamentals improve.

Finally, let's address the unpredictable category---the unknown-unknowns. For example, who could have predicted:

  1. 9/11?
  2. Katrina?
  3. BP oil spill?
  4. Tsunami leading to Fukishima?

These "black swan events" are statistically so unlikely they are not even considered when Wall Street's "quants" create their investment models. Yet, they happen far more often than we care to admità.and they affect investments.

So what is an investor to do in the unknown-unknown category?

First, when the unthinkable happens, keep your head. When the BP oil spill occurred, and the markets sold off, investors should have asked themselves, "Does this event really affect Apple's or IBM's sales in Boston or Shanghai?" If not, buy on the dip.

If, however, the answer is yes, then make a call regarding the duration of the black swan. Will it cause a generational change as 9/11 did, or only a seasonal change like the BP spill? Will the event be felt worldwide like the Japanese tsunami or is it a regional/national event like Katrina? Buying or selling becomes easier when you can pull back from the breathless reporting you see on TV (or the Internet) and think it through.

This clinical approach to tragedy may seem callous, but remember it is not inconsistent to protect your investments "in the office" and help the victims of tragedy "from your home."

In short, successful investing isn't easy, but understanding the difference between the knowns and unknowns certainly helps.


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