Wednesday, March 23, 2011


JAPAN’S TRAGEDY, AND CONTINUING VIOLENCE IN THE Middle East combined to give the markets pause this last week. By the numbers, for the week ended Friday, March 18, 2011, the Dow Jones Industrial Average closed at 11,858, down 186 points, or 1.5%. The Standard & Poor’s 500 closed at 1279, down 25 points, or 1.9%, and the NASDAQ Composite closed at 2643, down 72 points, or 2.7%.

Japanese authorities have upgraded the severity of the nuclear crisis at the Fukushima nuclear plant. Many commentators around the world are questioning the viability of nuclear power. Areva, the 90% French government owned nuclear production entity, is working hard to maintain its profitability and viability in this environment.

According to the Federal Reserve, 19 banks have added $25 billion in earnings since 2008. This from a recent stress test, or Comprehensive Capital Analysis and Review, report. As a result, several banks, including Wells Fargo, JP Morgan Chase, BBT, and US Bancorp, have announced share buybacks, repayment of TARP funds, increased dividends, or some combination of the three. This whole marriage thing between the large banks and the federal government still leads to more questions than answers.

Berkshire Hathaway has announced plans to buy Lubrizol for $9.7 billion in cash and debt. With $38 billion in cash, Buffet & Co. are still shopping. ATT plans to drop about $39 billion in cash and stock on T-Mobile.

Federal Open Market Committee notes suggest that the Fed doesn’t believe a run-up in commodity prices will result in a sustained increase in inflation. Action by the FOMC is to leave current rates unchanged, and to continue to buy government bonds. Additional comments are that the economy is on firmer footing, the labor market is improving gradually, and underlying inflation is subdued. Guess we will see how all this works out.

Cisco Systems has announced its first ever dividend. The board of directors approved a six cents a share dividend for shareholders of record as of March 31, 2011. In-N-Out Burger has announced plans to open retail locations in Texas, primarily in the Dallas/Ft. Worth MetroPlex. To maintain the standards of fresh ground beef for which it’s famous, the company will be opening a beef processing facility in Texas.

In economic news, food and energy prices are up, though I question whether this tidbit is actually news to most of us. Housing construction permits are at their lowest levels since 1959, new jobless claims are lower, at 385,000, and leading economic indicators are up 0.8%, the eighth monthly increase in a row.

The Mid-March rate for six month CD’s was 4.39% in 2001, 1.14% in 2003, 2.05% in 2005, 3.63% in 2007, 1.14% in 2009, and 0.30% in 2011.

Historically the price ratios between gold and silver have been about twelve or fifteen to one. These ratios date back to the Greek and Roman empires, and as recently as the late 19th century, the gold/silver ratio was fifteen. This ratio peaked at 98 in 1991, and currently stands at about 40. Some speculate whether a gold/silver ratio has any meaning in the current environment. We reference it primarily to raise awareness.

Gold hasn’t served well as an investment, but has generally been held as an inflation hedge. This is especially true of the last thirty years, as in 1980 gold hit $850/oz. On an inflation adjusted basis, this is $2100/oz, compared to a current price of a bit over $1400.

Quote of the week:

"Adversity is the foundation of virtue"
                                                              Japanese Proverb

Tuesday, March 22, 2011

The Impact of the Japanese Tragedy on Financial Markets

THE EARTHQUAKE in Japan will have a negative impact on Japan’s economic growth in the near term. It will also disrupt operations of many Japanese companies (and even some non-Japanese companies who do business in Japan). Reflecting these concerns, Japan’s stock market has declined over 11% since Friday, so much of the short-term impact may already be priced into equities.

Longer term, we believe the earthquake is unlikely to have a material impact on Japan’s economic and stock-market performance, though it is too early to say what the economic cost of this tragedy will be. Japan’s last major earthquake, Kobe in 1995, was estimated to cost more than $110 billion, which the country was able to absorb. Today, Japan is a $5 trillion economy so even if this disaster proves more costly, the country should be able to absorb the rebuilding expense. Longer term, as history has shown, countries do recover from such disasters, often with economies stimulated by rebuilding damaged infrastructure. The risk is that Japan’s already high public debt (over 2x GDP) and large fiscal deficit (of nearly 7% GDP) constrain its ability to fund necessary expenditures. Japan’s household savings rates have declined tremendously over the last two decades and, as a result, more of its borrowing will come from foreigners than in the past. With debt servicing costs as a proportion of revenues at over 40%, even at current low interest rates of around 1%, the country is highly susceptible to a fiscal crisis if foreign investors force borrowing rates up.

We do not expect the Japan tragedy on its own to have a material short- or long-term impact to global economic or earnings growth, although as we write this the nuclear reactor problem is a wild card with the potential for serious consequences at least shorter term. According to the Bank Credit Analyst, an independent global investment research firm, Japan has contributed about 2% to 3% to global economic growth over the past five years on average, so it seems unlikely that an economic slowdown in Japan could bring about a global recession. That said, the global economy is already fighting what we think are more material headwinds, such as deleveraging from developed countries, higher oil and food prices, monetary tightening from emerging markets, etc., and it is possible that Japan could tip it in the negative direction. If the Japan tragedy does tip the world into a recession, we are well positioned for that given our underweighting to equity risk in our balanced portfolios.

Impact to Our Portfolios:

Japan makes up about 15% of a typical international equity index that includes emerging markets. Factoring the different equity weightings across our model portfolios, and taking the index weighting as a starting point, Japan’s weighting in our portfolios ranges from less than 1% to 3%. Most of our international managers are underweighted to Japan, so the true impact of Japan on our portfolios is even less than what this range suggests. Moreover, our Japanese exposure is well diversified across many companies. Of course, global equity markets have also declined in the aftermath of the Japan disaster, but not anywhere near the magnitude of the drop in the Japanese stock market.

We asked several of our international managers how the Japanese companies they own will be impacted by this natural disaster. In general, the response we have gotten is that there will be no material impact to their investment thesis or their estimate of the business’ long-term intrinsic value because of the earthquake.

The indirect impact to our portfolios, however, could be more material. As noted above, it is possible that Japan’s tragedy tips the world into a slowdown or a recession when combined with many other macroeconomic headwinds we see. Our portfolios, as we’ve mentioned in our recent commentaries, remain underweighted to equities in light of these risks.

Despite the recent market decline in Japan, we do not see Japanese equities as a tactical investment opportunity at this time. Both the Japanese economy and its stock market, we believe, have to contend with significant fundamental issues in addition to the problems created by the earthquake and as such we see more downside risks there. Japan continues to fight deflationary forces because of anemic consumer demand, and the current tragedy could depress consumer sentiment further. While the corporate sector—financial and non-financial—has deleveraged to a large degree over the past decade, the public-sector debt has ballooned to dangerous levels and, as we noted above, the country is highly susceptible to a crisis stemming from rising interest rates. These worries are not new and, as a result, over time Japanese equities have declined considerably, but not to a level where we think a tactical overweighting to them is warranted. There are other factors that give us pause. We hear that many Japanese companies remain unfriendly to stockholders. Also, from a purchasing power parity perspective, the yen looks overvalued and may be a headwind to returns for a dollar-based investor.

We will continue to monitor the events in Japan closely and take appropriate portfolio actions based on the risks and opportunities we see. Because we do not believe that Japan’s tragedy on its own makes much of an impact on our assessment of global earnings power and, as a result, valuations, if global equity markets decline further, we may use that as an opportunity to add to equity risk.

"Fall seven times, stand up eight."
                                                        Japanese Proverb

Monday, March 14, 2011

VOLATILITY CONTINUES, WITH THE MAJOR indices off over the last three weeks. By the numbers, for the three weeks ended Friday, March 11, 2011, the Dow Jones Industrial Average closed at 12,044, down 86 points, or 0.7%. The Standard & Poor’s 500 closed at 1304, down 15 points, or 1.2%, and the NASDAQ Composite closed at 2715, down 66 points, or 2.4%.

Japan has captured the world’s attention, with a major earthquake setting off a tsunami, and a string of other challenging events. It’s probably too early to assess the number of unknowns in this particular equation, let alone have an accurate assessment of the losses that have occurred, in lives, futures, and property damage. Let me encourage each of us to reach out, with prayer, dollars, and time, to those in Japan and around the world, who are hurting.

Actual inflation for the average American household continues to march unabated, if measured by nothing more than the price of gasoline and coffee. The official inflation rate, as measured by the federales, has been showing a fairly benign rate of growth. This type of statistical reporting calls into question all government statistics, though this isn’t new information for most of us.

Chris Liddell, who left Microsoft a year ago to become GM CFO, is stepping down. He is being replaced by Dan Ammann, a Morgan Stanley alumnus. Luxury brands, whether manufacturers or retailers, may take a hit in sales as a result of turmoil in the Middle East and North Africa. Everyone from LMVH to Mercedes generates an appreciable portion of both top and bottom lines from the money in this region.

In economic news, retail sales were up 1% in February, making for almost a 9% year over year increase. Consumer credit was up $5 billion in January, much of it for vacations and autos. Business inventories were up in January, the 13th consecutive monthly increase, and the U.S. trade deficit jumped to -$46.3 billion, meaning consumers increased their buying of foreign made goods. In general, good news.

Employment remains weak, however. Even more disconcerting, long term, is the unwillingness of politicians around the world to wean themselves from debt. Though national debt serves to keep politicians in office, and voters on the plantation either sated or numb, it is destructive to the long term health of economies.

There must come a point where all governments become willing to spend less than they make. Without this discipline, currencies eventually become worthless, terms such as “full faith and credit” become meaningless, and dictators making big promises thrive. We have read a white paper that describes several outcomes of this lack of discipline. If you’d like to read it, let us know, and we will forward it to you.

Quote of the week:

“The problem with socialism is that you eventually run out of other peoples’ money.”
                                                                                         Margaret Thatcher

Tuesday, March 1, 2011

Federales "Lost Revenue"

WHILE THE LAST THREE WEEKS HAVE BEEN a bit more volatile, the major equity indices finished up. By the numbers, for the three weeks ended Friday, February 25, 2011, the Dow Jones Industrial Average closed at 12,130, up 38 points, or 0.3%. The Standard & Poor's 500 closed at 1319, up 9 points, or 0.7%, and the NASDAQ Composite closed at 2781, up 12 points, or 0.4%.

On the political front, Wisconsin governor Scott Walker indicates he's prepared for an OK Corral showdown with the unions. Union leaders are singing the blues over Walker's stance. Most employees who see their employer in financial straits begin exercising options or exploring new opportunities, such as looking for a different job or starting a business.

According to the U.S. Census Bureau, the average household income in the U.S was just over $51,000 in 2008, the latest year for which figures are available. According to the Wisconsin Department of Public Instruction, as published by the USAProductsNow blog, the average wage and benefits for teachers is $86,297 in Milwaukee, $82,956 in Sussex, and $91,065 in Elmbrook. One Germantown assistant principal makes $123,000, a bus manager in Arrowhead makes $169,000, and an elementary principal in Elmbrook makes $142,000. I'm grateful that these folks have been able to serve and educate students, and have been able to make a living doing so. I'm confused as to why they are protesting.

Turmoil continues around the world, in particular the Middle East and North Africa. Hard assets, such as oil, metals, and commodities, continue to do well, whether from inflation, because of domestic and global uncertainty, or perhaps other reasons.

Buffet is back in fine form, with Berkshire reporting a more than 40% increase in profits, though Berkshire unloaded a few positions during the fourth quarter. Borders has finally filed for bankruptcy. Content distributors, especially in the books, music and movie category, face substantial challenges keeping up with, and being profitable in the face of, changing technology. Duetsche Bank plans to pay about $9.5 billion to acquire NYSE Euronext.

In economic news, consumer credit increased by $6.1 billion in December, about three times expectations. Both imports and exports increased in December, yielding a trade deficit of $40.6 billion. Jobless claims fell in December, either due to increased employment, or the unemployed giving up, or some combination of both.

P/E ratios remain constant in the face of rising stock prices, meaning corporate earnings continue to grow. About 70% of the S&P 500 companies reporting so far have beat analysts' estimates.

Bloomberg BusinessWeek shows "revenue lost" to the federales from the following tax breaks in 2009:

Mortgage interest deduction - $77 billion
Earned income credit - $55 billion
Child tax credit - $54 billion
Charitable contributions - $35 billion
Real estate deduction - $21 billion
Medical deduction - $9 billion

The language used in this BusinessWeek article, which apparently reflects the thinking in Washington, is Exhibit One for why we must reduce or effectively eliminate the federal government. Anyone who believes that wages you earn belongs to them is mentally and spiritually ill. Those who suffer in this way need either psychiatric and pastoral care, or a swift kick in the rear, or perhaps both. Yet, the halls of Congress, and legions of paid hangers-on, subscribe to this misguided notion, which flies in the face of freedom and liberty.