October 2011

“Do you feel lucky, punk? Well…do you?” Dirty Harry

After experiencing the worst quarter since 2008 and now a remarkable rally, Mr. Market seems to be playing the role of Dirty Harry…and we, the investors, feel like the punks who have to make prudent decisions that affect our financial future.

So, do we feel lucky? Before answering let’s look at the issues-of-the-day and offer some commentary on each.

The European Sovereign/Banking crisis: In our humble opinion, Greece has already defaulted, but European leaders do not want to acknowledge this reality until they have insulated themselves, and their countries, from the damage as best they can.

And, while it may seem negative, Greece’s official default will force the Europeans to deal with the inherent flaws of the Euro system. These adjustments are necessary….and messy. Moreover, Europe cannot approach their crisis the way we in the US did in 2008. Here is why.

Unlike the US in 2008 where we had one government dealing with millions of bad mortgage loans, Europe has 17 governments dealing with 5-6 really bad (and big) national loans. That means there are 17 Nancy Pelosi’s, John Boehner’s, and Tim Geithners trying to reach an accord. Good luck with that.

As we predicted in January, the solution will be for the stronger European nations to jettison the weaker ones and the results will be some governments will be toppled… and reformed. The re-set button will be hit.

Beyond this, expect to see nationalization/socialization of multiple insolvent banks on a country-by-country basis. This process will be both inflationary (governments will recapitalize the banks via the printing press) and economically disruptive. Standards of living will fall (more in the PIIGS nations than in the Nordic regions) and the European utopia of “cradle to grave” socialism will be dramatically reduced. The political European Union will maintain all its members, but the Euro currency will likely “regionalize” around the stronger economic nations. Weaker countries will revert to their previous/national currencies.

Of course this will be painful in the short-to-medium term. However, in the long term, this could be very positive for Europe as efficient and strong European companies will both survive and prosper, albeit at the expense of their weaker and less efficient competitors. Opportunities will be evident….just not yet.

China’s Hard Landing: While Europe has dominated the headlines; cracks in China’s economic machine may be beginning to show. According to Bank of America analyst, David Cui, “the prevailing interest rate in the private lending market is about 2-3% per month in Jiangsu and Zhejiang, or 24-36% p.a. We doubt many businesses can afford to pay such a high interest rate.”

The general concern is if defaults rise, private lenders will exit the market, credit contraction will begin, & Chinese business will downsize.

Couple this with pressure on the real estate market (due to centrally-planned over-building and “ghost cities”) and undercapitalized banks, and it’s easy to postulate that China’s 9% per year growth rate could be in jeopardy.

This is the primary reason why China-dependent commodity stocks have been hammered over the past few months.

Our view is that China and India are on the road to first world status, and while momentum may wax and wane, the longer term outlook is for continued above-average growth. This means commodity stocks, and in particular energy stocks, are oversold and due for a rally.

Unlike bread on the shelf, energy and mineral products never go stale. Well run energy & commodity producers can supply a lot of product when demand and price are favorable. Conversely, these companies can scale back when the environment dictates. And while this dynamic can create both short term euphoria and pain in the stock price, over time these are dependable (dividend-producing) stocks in an expanding world.

Fears of US Double Dip Recession: The economic debate currently revolves around the question of whether the US is:

a. Already in a recession

b. On the precipice of recession, or

c. Poised for a turn-around

The fact is, all are right…and wrong.

Obviously, housing continues to struggle. Manufacturing is either growing or contracting depending on what part of the country you are in. The service sector is prospering for those who cater to the upper-end customer---and muddling along (although slightly improving) for those who sell to the masses.

The same holds true for employment. Of note, high tech jobs are available and “techies” are in demand nationwide. Manufacturing jobs are going through a metamorphosis and blue collar jobs are not what they used to be. Those with specialty skills are being hired. Those, however, who are products of the “assembly line” or “entitlement” mentality/system are being left behind…and resentments are obviously growing.

Our view is that a clear bifurcation is happening in America and it isn’t just that the rich are getting richer (which they are), but the “smart and prepared” are getting richer as well…whether they be individuals or corporations.

This is why stores like Nordstrom’s & Lululemon (where yoga outfits cost $98) are posting solid profits, while Wal-Mart & Target are clawing for every dime of sales and trying to stave off competition from Family Dollar and Dollar Tree.

In short, many individuals and firms are in a recession (or depression) right now…but the majority are not. The trick is to invest in those that aren’t…or those that will benefit from the healthy winnowing that takes place when an economy transitions.

Omnipresent Banking Crisis: To think that European and Asian woes will be “contained” is not reasonable. Nor should those markets believe they are somehow immune from America’s challenges. The “we can go it alone” ship sailed a long ago.

The fact is, there is not a “contagion” that would start in Greece (or Spain, or Italy, or Belgium for that matter) and then “infect” other supposedly healthy banks. Almost all of the “big players” are already infected either directly by bad loans, or indirectly by ill-conceived derivatives exposure.

Our belief is the bail-out strategy of transferring private debt to the public balance sheet to “kick start” the economy will run its course shortly. The painful process of writing down the debts will accelerate. (And yes, write-downs have been occurring quietly--and with some discipline--since 2008.)

The concern is if the process spins out of control. If discipline is lost, and a herd-mentality-sell-off begins, then economic dislocations will be swift. Policy makers will be forced to “do something” and that something will likely be wrong.

This is why we believe the rush to US Treasury bills, notes, and bonds may seem wise in the short term, but incredibly wrong in the medium to long term.

The questions investors have to ask themselves is, “Where is there value?” Is a US Treasury Note of value when almost infinite amounts of them can be “printed” on political whim? Remember, despite the dollar’s recent strength, our debts still have to be paid and the entitlement programs funded….all while we carry a $14+ trillion debt. Where will this money come from?

Our view is there is more value in a company with a strong balance sheet that sells a product that the world needs…and wants. And, if that company happens to pay a 3-6% dividend (vs. 0-3% on US Treasuries), then all the more reason to position capital there.

Occupy Wall Street: Do you remember the old saying, “Don’t fight the Fed?” Perhaps today, it should be changed to “Don’t fight the government, regulators, bureaucracy, administration, & unions.”

We will not pass judgment on the Occupy Wall Street movement. How can we when the protests decry everything from pollution, the Fed, free-trade agreements, social programs, lack of social programs, China, greedy bankers, and fluoride-in-the-water for America’s woes?

And while we do not yet know how the Occupy Wall Street movement will morph and change, we do know that one of the main targets is the financial industry in general…with banks being at the center of gravity.

This sector is being assaulted from the “little guys” on Main Street and the “big guys” in Congress (Dodd Frank) and Pennsylvania Avenue. Beyond this, there is an eager bureaucracy prepared to implement ever tighter regulations so “this will never happen again.”

Clearly, as investors, the financial sector is one in which we at Talbot Financial will continue to be very light.

Meanwhile, the tech sector is enjoying record margins, solid revenue and profit growth, is not under the government’s microscope, and its leaders are being lionized and not pilloried. So, again, it leads us to be heavy tech and light financials.

So, for investors, Dirty Harry asked the wrong question…success has little to do with luck right now, but a lot to do with methodically finding value in an emotional and turbulent market.


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