On July 8, the Greek parliament approved major changes to the national pension system, a key element in the 110 billion euro (US$145 billion) agreement with the European Union (EU) and the International Monetary Fund (IMF) to restore the country's long-run financial stability. The reform cuts pension benefits and curbs early retirement. By 2050, IMF staff projections indicate that the reform could reduce annual pension expenditures for private-sector workers and civil servants by 8.5 percent of gross domestic product (GDP). The IMF also projects that these reforms will lower replacement rates from an Organisation for Economic Co-operation and Development–leading average at 75 percent of wages to around 60 percent.
Despite past mergers of pension funds, the Greek retirement system remains complex and fragmented. Benefits are generous relative to wages and often claimed before age 60. Furthermore, the benefit structure offers little incentive for older workers to remain in the labor force, especially for low-income workers, whose minimum pensions are not reduced for early retirement. Without reform, the EU projects that pension spending in Greece will increase by 12.5 percent of GDP over the next four decades, well above the EU average rise of 2.4 percent of GDP.
Under the reform, workers are likely to remain in the labor force longer because—
The reform also lowers pension benefits in the following ways:

On a personal note, I always find market statistics - like baseball statistics - interesting, but I would never base my investment decisions solely on them. All the same, it is the only month of the year that has historically been down more than fifty percent of the time.
[The 2 tables below have the same info just sorted chronologically and then by returns.]
If you didn't get a chance to catch the live broadcast of our CNBC appearance this morning - also the fifth anniversary of our firm's performance track record - please click here to see the replay.
As an exciting sidenote, August 18th is also the five year anniversary of our firm's investment performance track record, a significant milestone for our firm from a business development perspective. So far we're tracking solidly within the top quartile of our peer group, news which we will be sure to share as the numbers are finalized. Stay tuned!
The end of summer marks an amazing period of transition for the modern American family. Until recently, I never understood why so many waited until the very same two or three weeks in late July and early August to squeeze in a last minute beach vacation. The trend is so pronounced that in our industry, trading volumes markedly decline in August. Like the slowly falling waistlines of modern denim, I chalked it up to some invisible force of fashion, a period when those who were “cool” or “in the know” secretly colluded to slip out the back door of the office and take some time off, perhaps even together.
Now that my own children have gotten older, I’ve discovered that the reality is much less exciting and much more about the boring practicality of calendar logistics. Sandwiched between early summer sports and camp activities and the late summer back to school rush of fall sports practices and hot shopping deals, these few and precious weeks have become the equivalent of a modern day Sabbath, sacred days that we’ve somehow managed to keep pure and unspoiled by false demands on our time. As bizarre as it sounds, I think I’ve become smitten with the simple joys of trail running in new (at least to me) areas of the Cuyahoga Valley National Park.
Transition periods, of course, are not only common in modern American family life, but also for the economy at large, and on this note, there is much to report. Since our last Economic Update, additional evidence suggests that the economy has indeed shifted gears, a theme we’ve been suggesting for most of the year. The Federal Reserve Board’s more tempered outlook for the economy on Tuesday and Cisco’s more cautious earnings guidance last night mark the official nod to this point of view, an acknowledgement, at least in the initial stages, that has not endeared itself to the stock market.
As it was last month, the same question for investors remains. Will this transition period lead to a “soft landing” and a “new normal” of slower yet sustained growth or will we “double dip” back into a recession on a more severe pullback in consumer spending and related inventory correction? At this point, we still believe that a “double dip” is unlikely and that a period of slower, albeit sustained growth the more probable path.
While sustained cutbacks should enable corporate America to remain profitable at rates of overall economic growth previously associated with corporate downturns, it may also mean that employment trends won’t likely improve anytime soon. Given the Fed’s dual mandate to promote price stability AND full employment, the Fed’s more tempered comments and the likelihood of prolonged stimulus come as no surprise. While the notion of what constitutes “full employment” might realistically be debated in the new normal economy, politically speaking, ten percent just won’t fly.
The stock market took a big hit yesterday on the Fed’s acknowledgement of a slower growing economy, falling by nearly three percent. Personally, we expect the S&P 500 to remain range bound as it has been for some time, with 1000 on the low side and 1210 on the upside.
At the beginning of the year, we had emphasized three areas in the portfolio given our outlook: innovators, later stage cyclicals and early stage cyclicals that hadn’t yet participated in the market’s gains, but would in the event of an improving employment outlook. During late spring and early summer, we began to shift our thinking a bit given the stubbornly high unemployment rate, eliminating many of our early cyclical positions and replacing them with more stable growers or what are sometimes viewed as the classic “defensive” names. We continue to emphasize our basket of “innovators” which has continued to outperform, additional evidence – at least to us - that a soft landing is more likely than a double dip. (For those who were wondering, we haven’t included Cisco in our basket of innovators for quite sometime as we believe they are a more mature technology company whose growth, by their own admission, is influenced to a large degree by worldwide economic growth.)
One of the biggest developments in the markets of the past month has been the insatiable demand for bonds among investors, particularly all things treasury related. Usually, this is a bearish sign for the stock market, as falling short yields imply a reduced tolerance for risk taking. (When investors clamor for short term investments, it is typically because they foresee an uncertain future and don’t like to take on longer term commitments.) This time around, however, the stock market has performed okay, leading many to wonder about the discrepancy.
While I haven’t mentioned the concept of “fund flows gone wild” in quite some time, there is no doubt a certain degree of return chasing going on in the government debt market right now. A few days ago, I was surprised to read that U.S. investors had supplanted China as the largest holder of treasury securities, something that hasn’t been the case since 2007. The Wall Street Journal also noted this morning that hedge funds have been huge buyers of treasuries, perhaps following popular bond fund PIMCO’s lead.
Why this recent phenomenon? Here’s my take. Knowing that the Fed is likely to stay on hold for some time, shorter term investors may be buying bonds for the price appreciation instead of shunning their paltry yields. Ironically, in keeping rates low the Fed is usually trying to incent investors to move out on the risk spectrum, but instead, they may be encouraging the opposite! Normally, such bond price greed would be tempered by the fears of a reversal in Fed policy and a crushing blow to bond prices, but given the economic likelihood of a Fed on hold for quite some time, the bond junkies are feeling much safer than they normally would. (Japan, where rates have remained low for years, is their exhibit A!)
Typically, asset bubbles burst (housing, tech stocks) when price declines begin to deter additional investments. Eventually, falling prices cause an outright panic, which leads to a real decline in financing for the underlying asset class and a true change in industry fundamentals. In the case of the treasury bubble, investors have seen nothing but an upside move in bond prices for quite sometime. By making additional investment today, bond investors must implicitly believe in the Fed’s ability and willingness to provide more and more stimulus. In effect, these bond traders are front running the Fed and in the process may be playing with fire. If you are investing in treasuries at this point and to a certain extent even corporate bonds, remember who you’re swimming with; traders focused on the price, not the yield to maturity!
We’re paid, of course, to anticipate changing developments and trends in the market that may lead to relative outperformance for our clients. On this note, there is one outcome that could fit well within the framework of the current bond market craze and that is the idea of an increased focus on stock dividends. While speculators on bond prices may be leading the charge in the current environment, the long term holders will focus on available yields.
Most people would agree that one of the few shining areas of the economy today is the health of corporate balance sheets. While I will admit that a portion of rising rates of free cash flow is related to delayed capital spending and shrinking working capital, free cash flow yields are still high. Because of this, many companies are considering raising their dividend payout rates, with one company we own this week doubling theirs and suggesting they would now benchmark themselves to the S&P yield rate going forward.
Given the reminder of how bad of an idea it is to ever reduce your dividend rate (2008), these companies are likely only to raise their dividends if they are sure they can maintain both the level and trajectory. The prospect of rising tax rates on dividends at some point down the road – unlikely anytime soon – may provide further fuel for this budding trend we envision, particularly for companies with large insider ownership. It is worth noting that many companies we own and follow have stock price yields that are nearly as high as or higher than the yields on their outstanding bonds. Eventually, and as renewed focus on dividend yields grows, the long term investors in the bond market who invest for yield may become attracted to stocks as a suitable and more rewarding substitute.
Of course, there are many companies that have never paid a dividend; companies likely living in the 90’s who view dividend payers as mature companies with no internal prospects for growth. Given the economy we envision, I suspect that many of these companies, often those most capable of paying the largest sustained dividends, will come to the realization that they aren’t the innovators they once were and that they are much more mature, economically speaking, than they once thought.
Cisco may be exhibit A in this regard, with $40 billion in cash on the books and generating $3 billion in cash this quarter, far more than is likely necessary on a sustained basis. I am virtually certain that if the company were paying a dividend, their stock would attract a different kind of investor, one that wouldn’t punish it for the slightest miss relative to expectations. Each quarter for many years, the company has spent nearly all of its free cash flow to buy back its stock. While this has no doubt helped their earnings per share, an alternative would be to pay it all out as a dividend. Such payments could equate to a dividend yield of between six to eight percent annually! In the process, it might also attract some money out of the bond market, adding to the potential for some price appreciation.
In a new normal environment of slower growth, I suspect that corporate America could shift its mindset in the future on dividend policy, especially if the stock prices of those who pay dividends outperform those who do not. As investors come to realize that slower growth may mean more stable growth and that actual or potential dividend paying yields on stocks are higher than those in the gaga bond market, the trend may begin to go mainstream. It also doesn’t hurt that demographically speaking, the baby boomers are nearing their retirement years, a period where the emphasis in their portfolios will turn to yield, something they won’t be getting much of from government bonds.
Mark my words; we could be on the cusp of a major sea change in the markets, one in which cash rich companies – in far better shape than government – begin to compete for investors through the dynamics of dividend yield. Investors who can start to capitalize on these changes now are likely to benefit as the groundswell for all things bonds begins to find a suitable and potentially even safer path towards stocks with rising dividends.
For the past twenty or thirty years, yield has not played a major role in attracting investors to stocks, as investors have instead hoped to find the next high flying Cisco, Microsoft, or Apple. Over the long term, however, dividends have had a significant influence on total returns, accounting for as much as half of the total stock returns in most decades. The promise of capital appreciation as the motivator for buying stocks has waned as it has repeatedly failed to materialize as a benefit for investors – including companies who have regularly bought back their own stock.
Parents and students across America are finishing their last weeks of summer vacation and preparing for the back to school season. While most students are understandably upset that summer is coming to an end and some are excited and anxious about new grades and school buildings, most parents are ready for a return to normalcy.
Investors today are in a similar situation, eager to see some sense of normalcy returning to the financial markets. Getting back to the basics by emphasizing dividends may seem boring, but may be the best medicine for encouraging long term ownership in a new normal.
We recently were made aware of an honor and I wanted to pass along the news.

I just returned from a family vacation last week where I took this picture and had a fantastic time. It was a strikingly beautiful and temperate place, with some of the most exotic sands I've ever witnessed. I even lost weight during the week, something that hasn't happened since backpacking at Philmont Scout Ranch twenty-eight years ago. As a budding entrepreneur, I will also admit that vacations have been few and far between, making each one more enjoyable and cherished than the last.
Before proceeding with this update, I'd encourage you to guess where we went, with the added hint that reality may not always be as it seems. On that note, we are in the thick of earnings season and in spite of record earnings and generally optimistic management teams, stock prices are performing poorly. For investors, the logical question is why?
In our opinion, there is no doubt that economic growth is slowing after a significant reacceleration off the Great Recession lows experienced sixteen months ago. The only question in our minds at this point, is how much it slows. After peaking in the four percent vicinity, most economists now expect GDP growth to slow to something in the 2% range, with those we respect the most seeing less than 2% as likely.
It is important, of course, to recognize that all economic recoveries experience a point at which the initial acceleration in growth off depressed lows begins to slow. It is nearly always the case that when this deceleration occurs, folks in our industry begin to wonder if growth will merely slow to a "soft landing" outcome or if we will crash land in a much too soon "double dip" recession .
In attempting to understand the apparent divergence between stock prices and earnings news today, it may help to remember that the markets tend to act in anticipation of future events rather than those that are being reported today. As we've mentioned in the past, leading indicators of economic activity like the ISM index are one of the few data points we follow that may legitimately provide clues on the performance of the economy six to twelve months out and thus, the stock market today.
During the second quarter, leading economic indicators, including the ISM index, hit new highs. As Francois Trahan from Wolfe Trahan points out, it is logical that the earnings results being reported today are strong since LEI's hit new highs during the very same period. It is also not too surprising that many management teams remain bullish and optimistic given such circumstances.
Unfortunately, there is yet another divergence occurring between what companies are saying and what they are actually doing. In spite of record cash flows, few companies are "bucking" up to their bullish outlooks by putting new money to work. Leading economic indicators, in spite of hitting new highs in the second quarter, also peaked in May and now appear to be declining. While a theme of earnings beats and slight revenues misses may hint at this change, it is likely that actual earnings results won't reflect it for another quarter or two.
So far this year, we've been correct in our view that the bulk of the market's cyclical gains are behind us and that a more defensive posture makes sense. Now that we've arrived at this reality, the next question becomes "soft landing" or "double dip?" For those focused on point C five years from point A today, the answer may matter little, but for those concerned about any point B along the way, it very well may.
In 1994, I experienced what turned out to be my first "soft landing" as an investor. Following the Persian Gulf War recession, the economy recovered and during this time, several new companies and industries, including Cisco Systems, came into their own. During 1993, the Fed began to raise interest rates in a tightening campaign designed to keep inflation associated with improving growth prospects at bay. As a result, the stock market began to struggle. (Note that interest rate policy is a leading indicator.)
Many companies at the time, including such beloved stocks as Parametric Technology and Cisco Systems, experienced price declines of more than 50% as the question of soft landing or recession was debated. While Cisco was an innovator whose fundamentals, like Apple most recently, had defied previous economic cycles, it was also experiencing its first product transition as the market shifted from an exclusive focus on routers to switching as well.
While it is never easy to discern the eventual outcome of a soft landing or double dip debate, two factors still lead me to give the edge to a "soft landing,". First of all, the Fed has not yet raised rates as they had been doing in 1994, likely given their dual mandate and the stubbornly high unemployment rate. In addition, foreign countries like China, who have already been raising rates, may now be taking their foot off the monetary brakes as their own inflation concerns subside.
Another perhaps more proprietary factor that might be considered is the relative performance characteristics of the three baskets of stocks we own, including those primarily influenced by the economic cycle, the credit cycle, and the innovation cycle. So far, classic cyclical stocks are discounting at least a slowdown in near term economic growth prospects, with most down 15-30% from their recent highs. However, it is interesting to note that the basket of innovation oriented companies we own and watch closely - companies similar to Cisco in the nineties and Apple today - remain near their all time highs.
A key sign as to whether or not the economy "soft lands" or ultimately "double dips" may lie in the relative performance of this group of stocks. While stock prices and earnings results of serial innovators may be resilient in the face of soft landings (absent product transitions as was the case for Cisco in 1994), these stocks usually get clobbered during recessions and double dips even in the face of their own improving fundamentals. (Apple nearly two years ago.) For now, the strong performance of this group of stocks may suggest that a soft landing may still be the most probable outcome.
We continue to believe a more defensive posture for the portfolio makes sense at this stage of the game and will be monitoring both Fed policy and the performance of our basket of innovators as clues on the eventual outcome of the raging debate over soft landings and double dips.
For investors with a longer term time frame, the outcome of the debate may matter little. In spite of an initial fifty percent decline going into the Great Recession, Apple's stock recovered all of its initial losses and now trades another fifty percent higher. To this end, successful investing may be far more about understanding your own personal time horizon, tolerance for volatility, and optimal asset allocation, than the buy or sell decision on any single security.
For those who made it this far or will simply admit to skipping the boring stuff in between, our family vacationed in Glen Arbor, Michigan last week, a small town located in the northwest corner of the state, sandwiched between Lake Michigan to the west and Little and Big Glen Lakes to the South and East.
While the water was Caribbean Blue and the sands of Sleeping Bear Dunes seemed other-worldly at times, the reality was Michigan just four hundred miles away.
Like the behavior of the stock market in the face of strong earnings reports, reality may not always be as it seems.
The stock market declined by just over 11% during the second quarter as European budget issues, the flash crash, the oil spill and continued sluggishness in the U.S. job market heightened concerns over the durability of the economic recovery. While stock market corrections are not unusual for this stage of the economic cycle, investor anxiety levels are elevated given painful memories of recent stock market losses.
For additional insights on our current market outlook and strategy, performance and related disclosures, please read the attached Second Quarter Performance Review.
This past weekend, my wife and I packed the car and drove our family to Miami University in Oxford, Ohio for our twenty year, college reunion. The campus remains as beautiful as it ever was, but the people and memories are always what make a place feel more like a home. In this sense, it was nice to share a stroll around campus with my wife, a few of her sorority sisters, several of my fraternity brothers, and our three children.
In particular, I looked forward to giving my kids, ages 14, 11, and 6, a glimpse of what college life is like, the centerpiece of which would be a stay in my freshman year dorm. While the new Farmer School of Business was an absolutely stunning Four Seasons experience, a Knights Inn could have given the dorm rooms a run for their money. They were far smaller than I had remembered, perhaps because the beds had been “unbunked” and the furnishings were exactly the same, just another twenty four years older. The air conditioning unit was a nice upgrade from the window fan I had used as a freshman, but in the end, lost a hard fought battle with a sweltering June. In truth, the dorms hadn’t changed, I had.
Our conversations with friends naturally focused on our families, careers, and recent events; my wife’s college roommate joked that the only good thing to come from the BP oil spill was that it made her husband’s job as a lobbyist for Toyota a tad bit easier. In a similar vein, the sting of continued bad news from Europe may be soothed by a market which has bounced off its 1040 lows and is currently trading towards the upper end of recent resistance.
At this stage of the economic recovery, unemployment trends should be improving, but they are not; the notion of a jobless recovery appears to be gaining steam. In spite of corporate cash balances resting at record levels and spending intentions remaining high, few executives appear willing to pull the trigger on additional people, plant and equipment. In the face of an unstable regulatory environment, the markets may be clueing into the notion that it is better to watch what these executives actually do with their money rather than what they are saying.
On the positive front, the household employment survey is considerably stronger than the private payroll survey, which like the weekly unemployment data, remains weak. According to ISI’s Ed Hyman, when there has been a divergence in the two surveys in the past, the household survey has tended to be the more accurate. In addition, various discussions with real estate professionals, surveys taken by institutional research firms, and company conference calls suggest that apartment rents are continuing to improve and that incentives are declining. This could suggest that employment may be better than generally advertised or it could simply mean that in the rent versus own battle, the decision is currently in the former’s camp. My bullish side would simply add that if the rental environment continues to improve, eventually rents will go high enough to make the incentives of cheap real estate and low mortgage rates stand out and begin to shift the pendulum back in ownership’s favor.
For most of the past two years, I have believed that some government involvement in the economy was necessary to keep it from falling into a second great depression. Now that we’ve recovered, the vilification of the private sector by the government is getting a bit old. I’ve heard too many tales recently of public sector employees retiring at fifty after as few as twenty years of service at 85% of pay. Such benefits haven’t existed for the average, everyday private sector workers for years. I, for one, know of few private sector employees under fifty who will receive a pension. At some point, the government must take care not to bite the hand that feeds.
Going forward, we may indeed be operating in an extended period of slower growth, the so called “new normal.” In such an environment, nominal gains in the stock market may be lower and dividends and active management may therefore play a more dominant role in generating outperformance for investors.
In recent months, we’ve been favoring stability over cyclicality, except where cyclical improvements have gone unrewarded, and innovators over those companies that participate in more mature markets. Though not as intentional, we’ve also favored domestic companies rather than those with international sales exposure. To be clear, we’re not in the double dip camp, we simply believe that the bulk of the market’s cyclical gains are now in the rear view mirror.
At the end of our Miami weekend, I asked each of my children what they thought about college life. Unencumbered by the trappings of a “used to” or “entitlement” lifestyle, my six year old son won the best of show award by telling me that the coolest thing was the long walk you got to take to go to the bathroom. He proudly insisted on leading the way on more than one occasion. At 4am and over forty, I would have preferred a bedpan.
When I was in college, I once loved the very room I could now no longer appreciate, simply because it was my own. Viewed from the perspective of youthful enthusiasm, a new normal needn’t be any different.
I've always liked the above map of the market, which shows how different investment styles have performed each year going back to the early 90's.
If you missed this morning's CNBC interview, you can click here for a replay.
Interviews generally follow the talking points provided to the show's producers the day before the event. Occasionally, however, the interview will take a turn and focus on something else entirely. This was the case this morning with Goldman Sachs. While we do what we can to prepare ahead of time, you still have to be quick on your feet. 1.) Outlook for 2010 2.) Are you more bullish or bearish on the markets and why? 3.) Where should you invest now? Favorite stocks and why you like them. As 2010 has progressed, we have gradually been: ROTATING TOWARDS LATER STAGE CYCLICALS, which include ENERGY AND INDUSTRIAL NAMES, SECTORS WHICH SHOULD OUTPERFORM AS THE RECOVERY TRANSITIONS TO AN ECONOMIC EXPANSION. NARROWING OUR FOCUS WITHIN THE EARLY CYCLICAL CONSUMER DISCRETIONARY SECTOR TO AREAS THAT HAVE GENERALLY LAGGED the huge gains experienced by that sector as a whole. In particular, WE'VE BEEN FOCUSING ON LAGGARDS LIKE THE HOMEBUILDERS AND AUTO SUPPLIERS, which should begin to outperform as employment improves. 4.) Anything you are avoiding right now?
For those that might have an interest, these were the talking points I submitted yesterday.
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, but perhaps not until later this year.
Okay, I honestly don't think I've ever forwarded stuff like this before (yeah, that's what they all say!), but I thought this was an excellent descriptive of what happens when you don't keep life's more important things in their rightful roles. Thanks Marnie!
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The Mayonnaise Jar
When things in your life seem almost too much to handle,
When 24 hours in a day is not enough,
Remember the mayonnaise jar and 2 cups of coffee.
A professor stood before his philosophy class
and had some items in front of him.
When the class began, without a word,
He picked up a very large and empty mayonnaise jar
and proceeded to fill it with golf balls.
He then asked the students, if the jar was full.
They agreed that it was.
The professor then picked up a box of pebbles and poured
them into the jar. He shook the jar lightly.
The pebbles rolled into the open areas between the golf balls.
He then asked the students again if the jar was full. They agreed it was.
THE professor next picked up a box of sand and poured it into the jar.
Of course, the sand filled up everything else.
He asked once more if the jar was full. The students responded with a unanimous 'yes'.
The professor then produced two cups of coffee from under the table and poured the entire contents into the jar, effectively
filling the empty space between the sand. The students laughed..
'Now', said the professor, as the laughter subsided,
'I want you to recognize that this jar represents your life.
The golf balls are the important things - family,
children, health, friends, and favorite passions -
Things that if everything else was lost and only they remained, Your life would still be full.
The pebbles are the other things that matter like your job, house, and car.
The sand is everything else --the small stuff.
'If you put the sand into the jar first', he continued,
'there is no room for the pebbles or the golf balls.
The same goes for life.
If you spend all your time and energy on the small stuff,
You will never have room for the things that are important to you.
So...
Pay attention to the things that are critical to your happiness.
Play With your children.
Take time to get medical checkups.
Take your partner out to dinner.
There will always be time to clean the house and fix the disposal.
'Take care of the golf balls first --
The things that really matter.
Set your priorities. The rest is just sand.'
One of the students raised her hand and inquired what the coffee represented.
The professor smiled.
'I'm glad you asked'.
It just goes to show you that no matter how full your life may seem,
there's always room for a couple of cups of coffee with a friend.'

I serve on an advisory board for my alma mater's business school, Miami University. The finance department formed this board a couple of years ago to help guide the curriculum of its students, better prepare them for careers in the field of finance, and foster relationships between students and alumni.
Given the financial meltdown of the past couple of years, the chairman sent us a series of questions ahead of a meeting we're having later this month soliciting our input on what we, as former students and current financial professionals learned from the ordeal and how professors might incorporate such thinking into a modern business school curriculum.
I thought the questions were great and was encouraged to see academia seeking our input. At the same time, I think the most valuable inputs from a course perspective might likely lie within the realm of humanities rather than business classes. Below are some thoughts I shared with the department chair. I think it will be an interesting discussion.
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A greater emphasis on philosophy, religion, organizational behavior, and history might likely prove fertile educational grounds for:
As you would likely agree, experience is the best teacher because it is real and often involves pain. There is nothing better than touching a hot stove to teach someone that touching hot stoves is not a good idea. That type of experience is hard to incorporate into an academic situation, but my guess is an intense course on personal struggles of individuals across a spectrum of careers could be useful. For instance, have a World War II vet talk to the class about dealing with Normandy, an astronaut about a faulty o ring, a catholic priest on dealing with their recent sex scandals, a politician on losing their recent race, or a Tiger Woods type on the cost of having an affair. You could design a whole class on these things that I believe would enable students to find similarities on the human condition that might prove useful in discerning appropriate course of action.
I would also note that one of the tell tale signs that an area of finance may be ripe for correction and/or comeuppance is when those types of jobs are the most coveted by undergraduate students seeking jobs. My guess is that two years ago, the hot areas of private equity and fund of funds would have been highly sought after. I don't know how this could be incorporated into a risk management discipline, but in my experience, bubbles are not identified by the characteristics most taught in finance classes like ratios etc, but in the flows of money to favored asset classes. The more people are aware of how greed and fear manifest themselves, the better.
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What are your thoughts? If you have anything unique to share, I will pass it along later this month.
A friend and reader of yesterday's blog entry shares another funny kid story. Keep 'em coming!
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Two little boys, ages 8 and 10, were excessively mischievous. They were always getting into trouble and their parents knew all about it. If any mischief occurred in their town, the two boys were probably involved.
The boys' mother heard that a preacher in town had been successful in disciplining children, so she asked if he would speak with her boys. The preacher agreed, but he asked to see them individually. So the mother sent the 8 year old first, in the morning, with the older boy to see the preacher in the afternoon.
The preacher, a huge man with a booming voice, sat the younger boy down and asked him sternly, 'Do you know where God is, son?' The boy's mouth dropped open, but he made no response, sitting there wide-eyed with his mouth hanging open.
So the preacher repeated the question in an even sterner tone, 'Where is God? Again, the boy made no attempt to answer.
The preacher raised his voice even more and shook his finger in the boy's face and bellowed, 'Where is God?' The boy screamed and bolted from the room, ran directly home and dove into his closet, slamming the door behind him.
When his older brother found him in the closet, he asked, 'What happened?'
The younger brother, gasping for breath, replied, 'We are in BIG trouble this time,'
(I LOVE reading this next line again and again
'GOD is missing, and they think we did it!'
A little girl was talking to her teacher about whales.
The teacher said it was physically impossible for a whale to swallow a human because even though it was a very large mammal its throat was very small.
The little girl stated that Jonah was swallowed by a whale.
Irritated, the teacher reiterated that a whale could not swallow a human; it was physically impossible.
The little girl said, "When I get to heaven I will ask Jonah".
The teacher asked, "What if Jonah went to hell?"
The little girl replied, "Then you ask him".
******
A Kindergarten teacher was observing her classroom of children while they were drawing. She would occasionally walk around to see each child's work.
As she got to one little girl who was working diligently, she asked what the drawing was.
The girl replied, "I'm drawing God."
The teacher paused and said, "But no one knows what God looks like."
Without missing a beat, or looking up from her drawing, the girl replied, "They will in a minute."
******
A Sunday school teacher was discussing the Ten Commandments with her five and six year olds.
After explaining the commandment to "honour" thy Father and thy Mother, she asked, "Is there a commandment that teaches us how to treat our brothers and sisters?"
Without missing a beat one little boy (the oldest of a family) answered, "Thou shall not kill."
******
One day a little girl was sitting and watching her mother do the dishes at the kitchen sink. She suddenly noticed that her mother had several strands of white hair sticking out in contrast on her brunette head.
She looked at her mother and inquisitively asked, "Why are some of your hairs white, Mom?"
Her mother replied, "Well, every time that you do something wrong and make me cry or unhappy, one of my hairs turns white."
The little girl thought about this revelation for a while and then said, "Momma, how come ALL of grandma's hairs are white?"
******
The children had all been photographed, and the teacher was trying to persuade them each to buy a copy of the group picture.
"Just think how nice it will be to look at it when you are all grown up and say, 'There's Jennifer, she's a lawyer,' or 'That's Michael, He's a doctor.'
A small voice at the back of the room rang out, "And there's the teacher, she's dead."
******
The children were lined up in the cafeteria of a Catholic elementary school for lunch. At the head of the table was a large pile of apples. The nun made a note, and posted on the apple tray:
"Take only ONE . God is watching."
Moving further along the lunch line, at the other end of the table was a large pile of chocolate chip cookies.
A child had written a note, "Take all you want. God is watching the apples."

Over five thousand years ago,
Moses said to the children of Israel
"pick up your shovel,
mount your asses and camels,
and I will lead you to the promised land".
Nearly 75 years ago,
Roosevelt said, "Lay down your shovels,
sit on your asses,
and light up a camel,
this is the promised land" ...
Now Obama has stolen your shovel,
taxed your asses,
raised the price of camels,
and mortgaged the promised land!
Furthermore, I was so depressed last night thinking about health care
plans, the economy, the wars, lost jobs, savings, Social Security,
retirement funds, etc...
I called Lifeline, the suicide help line.
Got a freakin' call center in Pakistan.
I told them I was suicidal.
They all got excited and
asked if I could drive a truck....
Men at Work stole Down Under
Australian band Men at Work copied a well-known children's campfire song for the flute melody in its 1980s hit Down Under and owes the owner years of royalties, a court ruled today (The Guardian). I'm going to have that song in my head for the rest of the day. My guess is their i-Tunes sales of the song get a spike.
**********
Good Humor/To Do List from our summer intern, Kevin Arbogast.
1.) At lunch time, sit in your parked car with sunglasses on and point a hair dryer at passing cars. See if they slow down.
2.) Page yourself over the intercom. Don't disguise your voice!
3.) Everytime someone asks you to do something, ask if they want fries with that.
4.) Put decaf in the coffee maker for three weeks. Once everyone has gotten over their caffeine addictions, switch to espresso.
5.) In the memo field of all your checks, write "For Marijuana."
6.) Skip down the hall rather than walk. See how many looks you get.
7.) Order a diet water whenever you go out to eat, with a serious face.
8.) Specify that your drive through order is "To go."
9.) Sing along at the Opera.
10.) Five days in advance, tell your friends you can't attend their party because you have a headache.
11.) When the money comes out of the ATM, scream "I won, I won!
12.) When leaving the Zoo, start running towards the parking lot, yelling "run for your lives, they're loose!"
13.) Tell your children over dinner, "Due to the economy, we are going to have to let one of you go."
***********
Cisco Systems reported stronger earnings relative to expectations than I've seen since they were a emerging growth story in the early 90's. Earnings came in five cents better than expected revenues driven by a broad based improvement across all product lines and market geographies. For most of that last ten years, Cisco has religiously come in a penny above expectations.
The breadth of what they are seeing in terms of results should at the very least provide some support on the downside and hopefully reduce worries that remain over the prospects of a double dip. Visa and Starwood Hotels had similarly strong comments and results.
Broadleaf Partner's was quoted in CNN Moneyline this morning on our 2010 outlook for the markets. For the full story, click here.
On another note, there has been a great deal of talk on new banking regulations and in particular the proposed Volcker rule. Paul Volcker was a former Fed chairman during the Carter and Reagan presidencies and now serves as chairman of the newly formed Economic Recovery Advisory Board under President Barack Obama.
I am personally in favor of re-separating commercial banking and investment banking activities. If banks are going to be deemed too big to fail because they are fiduciaries of average Joe savings account deposits that must be protected at all costs, then perhaps these entities should not be permitted to participate in more speculative endeavors. If, after all, these banks can't be trusted to make good mortgage loans - a bread and butter banking business - they probably should steer WAY clear of things like private equity, hedge funds and proprietary trading. While these activities may be a small portion of bank revenues today, there is no doubting the fact that these activities will expand as the economy recovers if rules aren't put into place..
I also agree with Volcker's comments to the Senate banking committee yesterday, especially the idea that some entities will try to get around the spirit of any new regulations. In particular, something may also have to be done to limit bank lending to the institutions that do participate in these activities, otherwise banks may end up holding the bag anyway the next time a speculative bubble bursts and equity holders are wiped out.
There is nothing wrong at all with speculative business activities. What is wrong is exposing low risk capital (bank deposits) to the loss of high risk activities. Banks should also, perhaps have to hold more of what they generate on the loan front, so they don't get as sloppy with their underwriting activities. Warren Buffett, I know, has been a big proponent of that idea.
For the full transcript of Volcker's comments, see below.
*************************************************************************
STATEMENT OF PAUL A. VOLCKER
BEFORE THE
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
OF THE
UNITED STATES SENATE
WASHINGTON, DC
FEBRUARY 2, 2010
Mr. Chairman, Members of the Banking Committee:
You have an important responsibility in considering and acting upon a range of issues relevant to needed reform of the financial system. That system, as you well know, broke down under pressure, posing unacceptable risks for an economy already in recession. I appreciate the opportunity today to discuss with you one key element in the reform effort that President Obama set out so forcibly a few days ago.
That proposal, if enacted, would restrict commercial banking organizations from certain proprietary and more speculative activities. In itself, that would be a significant measure to reduce risk. However, the first point I want to emphasize is that the proposed restrictions should be understood as a part of the broader effort for structural reform. It is particularly designed to help deal with the problem of “too big to fail” and the related moral hazard that looms so large as an aftermath of the emergency rescues of financial institutions, bank and non-bank, in the midst of crises.
I have attached to this statement a short essay of mine outlining that larger perspective.
The basic point is that there has been, and remains, a strong public interest in providing a “safety net” –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions.
Those quintessential capital market activities have become part of the natural realm of investment banks. A number of the most prominent of those firms, each heavily engaged in trading and other proprietary activity, failed or were forced into publicly-assisted mergers under the pressure of the crisis. It also became necessary to provide public support via the Federal Reserve, The Federal Deposit Insurance Corporation, or the Treasury to the largest remaining American investment banks, both of which assumed the cloak of a banking license to facilitate the assistance. The world’s largest insurance company, caught up in a huge portfolio of credit default swaps quite apart from its basic business, was rescued only by the injection of many tens of billions of dollars of public loans and equity capital. Not so incidentally, the huge financial affiliate of one of our largest industrial companies was also extended the privilege of a banking license and granted large assistance contrary to long-standing public policy against combinations of banking and commerce.
What we plainly need are authority and methods to minimize the occurrence of those failures that threaten the basic fabric of financial markets. The first line of defense, along the lines of Administration proposals and the provisions in the Bill passed by the House last year, must be authority to regulate certain characteristics of systemically important non-bank financial institutions. The essential need is to guard against excessive leverage and to insist upon adequate capital and liquidity.
It is critically important that those institutions, its managers and its creditors, do not assume a public rescue will be forthcoming in time of pressure. To make that credible, there is a clear need for a new “resolution authority”, an approach recommended by the Administration last year and included in the House bill. The concept is widely supported internationally. The idea is that, with procedural safeguards, a designated agency be provided authority to intervene and take control of a major financial institution on the brink of failure. The mandate is to arrange an orderly liquidation or merger. In other words, euthanasia not a rescue.
Apart from the very limited number of such “systemically significant” non-bank institutions, there are literally thousands of hedge funds, private equity funds, and other private financial institutions actively competing in the capital markets. They are typically financed with substantial equity provided by their partners or by other sophisticated investors. They are, and should be, free to trade, to innovate, to invest – and to fail. Managements, stockholders or partners would be at risk, able to profit handsomely or to fail entirely, as appropriate in a competitive free enterprise system.
Now, I want to deal as specifically as I can with questions that have arisen about the President’s recent proposal.
First, surely a strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multi-national banks and active financial markets. The needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood.
Second, the functional definition of hedge funds and private equity funds that commercial banks would be forbidden to own or sponsor is not difficult. As with any new regulatory approach, authority provided to the appropriate supervisory agency should be carefully specified. It also needs to be broad enough to encompass efforts sure to come to circumvent the intent of the law. We do not need or want a new breed of bank-based funds that in all but name would function as hedge or equity funds.
Similarly, every banker I speak with knows very well what “proprietary trading” means and implies. My understanding is that only a handful of large commercial banks – maybe four or five in the United States and perhaps a couple of dozen worldwide – are now engaged in this activity in volume. In the past, they have sometimes explicitly labeled a trading affiliate or division as “proprietary”, with the connotation that the activity is, or should be, insulated from customer relations.
Most of those institutions and many others are engaged in meeting customer needs to buy or sell securities: stocks or bonds, derivatives, various commodities or other investments. Those activities may involve taking temporary positions. In the process, there will be temptations to speculate by aggressive, highly remunerated traders.
Given strong legislative direction, bank supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and of the relative volatility of gains and losses would go a long way toward informing such judgments. For instance, patterns of exceptionally large gains and losses over a period of time in the “trading book” should raise an examiner’s eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements.
Third, I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a “customer”, i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. “Inside” hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same “inside” funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades.
I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses. But neither am I so naïve as to think that, even with the best efforts of boards and management, so-called Chinese Walls can remain impermeable against the pressures to seek maximum profit and personal remuneration.
In concluding, it may be useful to remind you of the wide range of potentially profitable services that are within the province of commercial banks.
• First of all, basic payments services, local, national and worldwide, ranging from the now ubiquitous automatic teller machines to highly sophisticated cash balance management;
• Safe and liquid depository facilities, including especially deposits contractually payable on demand;
• Credit for individuals, governments and businesses, large and small, including credit guarantees and originating and securitizing mortgages or other credits under appropriate conditions;
• Analogous to commercial lending, underwriting of corporate and government securities, with related market making;
• Brokerage accounts for individuals and businesses, including “prime brokerage” for independent hedge and equity funds;
• Investment management and investment advisory services, including “Funds of Funds” providing customers with access to independent hedge or equity funds;
• Trust and estate planning and administration;
• Custody and safekeeping arrangements for securities and valuables.
Quite a list. More than enough, I submit to you, to provide the base for strong, competitive – and profitable - commercial banking organizations, able to stand on their own feet domestically and internationally in fair times and foul.
What we can do, what we should do, is recognize that curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services. Recurrent pressures, volatility and uncertainties are inherent in our market-oriented, profit-seeking financial system. By appropriately defining the business of commercial banks, and by providing for the complementary resolution authority to deal with an impending failure of very large capital market institutions, we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek
I’ve taken great interest in the masculine characters of several Clint Eastwood films recently, including Unforgiven’s William Munny and Gran Torino’s Walt Kowalski. This past weekend, I was also introduced to Robert Redford’s Jeremiah Johnson, a movie by the same name. These films elevate the state of manliness – even with its flaws - to a level worthy of respect rather than scorn as is often the case in today’s culture. Courage is displayed in a noble light, but is neither easy nor free.
Throughout much of January, I heard the phrase “easy money” to describe the gains of 2009. With the “easy gains” now behind us, the implication is that further progress for the markets will be more difficult. While I agree with the idea that future gains may be measured, I disagree with the notion that the gains of the last ten months were somehow “easy”. Employers, employees and investors alike have suffered greatly over the last eighteen months and in some cases, the pain remains severe.
In spite of January’s market decline, we believe the economic recovery remains intact. Jason Trennert of Strategas Research Partners points out that of the 45% of S&P 500 companies that have reported earnings results, 78% have beaten bottom line estimates, while a whopping 70% beat top line revenue estimates. This latter figure is a tremendous improvement from year ago levels when only 30% of companies exceeded their goals. Revenue growth is important as it is a useful indicator of a healthy recovery and future employment gains.
ISI Group takes the argument a little further, suggesting that at current rates of improvement, S&P 500 profits could be back to the peak levels achieved in 2006 by the second quarter of this year. It is worth noting that the last time profit levels were that high, the S&P 500, in spite of 2009’s gains, was nearly thirty percent higher than it is today. The rate of decline in unemployment claims has also been surprising, exceeding the average declines of the prior two slow/jobless recoveries in 1991 and 2002 by almost three fold.
On an individual stock basis, the prices of a few companies are already back to or near their former all time highs. In general terms, these companies seem to be from one of two camps, each on opposite sides of the capitalist spectrum. On the one side are companies that have been the beneficiaries of rare levels of sustained innovation and new highs in profits (Apple Computer) and on the other are those that have been beneficiaries of “too big to fail” government policy (A few banks). It will be interesting to see in the months and quarters ahead if the “too big to fail” premium reflects hoped for market share gains at the expense of the weak or out of business or simply the government’s implicit guarantee of equity shares.
As we look forward, we see a recovery based on the strength of corporate profits and business spending rather than the consumer as has often been the case in recent history. For all the bashing of the U.S. that goes on these days, our companies are able to change directions relatively quickly on a global scale, as market pressures dictate.
Today, U.S. companies are generating significant cash flow and like it or not, have leverage over the labor force. With aging corporate infrastructures, we would look to the capex cycle and improved exports to take the traditional place of the consumer in recent recoveries and eventually, as stimulus is curtailed, government spending as well.
The economy, as the recent GDP report suggests, may be stronger than most expect, but this won’t necessarily translate into another outsized year of stock market gains. Earnings will play a more dominant role in valuations as reality catches up with already expected improvements. This is likely one reason that the response of recent stock prices to earnings reports has been underwhelming.
We are firmly in the camp that the recovery is intact, but fully expect some backing and filling along the way. As the year progresses, it may behoove investors to look at companies with stable growth prospects that are less dependent on the economic cycle for outperformance in addition to those cyclical companies that have not yet fully participated in the expectation of recovery.
Gains won’t be easy, but in spite of the rhetoric, they rarely are. Buying stocks last March wasn’t a very “easy” thing to do for anyone being honest with themselves. Only in hindsight do the rewards of success appear “easy”. Unfortunately, such views are most often shared by Monday morning quarterbacks and perhaps politicians lacking a majority.
William Munny, Walt Kowalski and Jeremiah Johnson would not approve.
I found this beautiful winter poem and thought it might be a comfort to you. It was to me and it's very well written. I hope that you enjoy it too .
' WINTER '
by Abigail Elizabeth McIntyre

Shit....It's Cold
The End
Each year at this time, I like to reflect on the year that was with the hope of gleaning a few nuggets of wisdom. With the caveat that the last two years have been anything but ordinary, these are our observations on 2009:
1.) Investment decisions made on the notion that “it’s different this time” usually end up in the bucket of dumb investment ideas. When fear ran rampant last March, it was easy to expect the worst. Very few – including ourselves - would have guessed that the stock market would prove capable of climbing 70% off those lows, but that is exactly what happened. For our portfolio, the most difficult investment decisions also proved the most profitable.
2.) I don’t remember a year when so many folks were so distraught by the change in Washington and what it might mean for their investment portfolios. As is so often the case, reality rarely ends up the way right wing or left wing extremists paint it to be, whether we’re talking global warming or the end of capitalism. This year once again reminded me that politics and investment policy make for very poor bedfellows.
3.) Selling anything in 2009 was a mistake, just as buying about anything proved to be in 2008. Good results are easier to come by when the markets are strong like they were this year.
4.) Hiring and training new employees is alot of work but it sure beats the alternative. Installing new, firm wide software isn’t for the faint of heart either, especially if you lack an IT staff.
5.) The S&P 500 has been moving sideways at the 1100 level for most of the last six weeks, roughly the level it traded when Lehman Brothers went under fifteen months ago, ushering in a recession that far exceeded garden variety expectations. Breaking above this level in 2010 could symbolize a similarly important healing point for the economy, the stock market and investors at large.
Warmest Wishes for a Prosperous 2010!
It has been quite a yawner for the markets since we published our last Economic Update, Painting the House, in mid November. The S&P 500, our proxy for the stock market, has moved in an uncharacteristically narrow channel since then, with 1090 as the low and 1110 as the high, a whopping 1.8% in heart pounding variability.
In our view, this sideways move is a natural one, as the market digests its significant gains coming off the nearly fatal March lows and as the economy prepares to shift gears as it enters the 2010 straightaway. We believe there is a higher probability of above average gains for the coming year than most folks expect.
Why do we believe in an upside bias? Three reasons.
First, employment should not only stabilize in 2010, but should begin to increase, perhaps as early as next month. According to work done by ISI Group and thoughts echoed by former Fed Chairman Alan Greenspan this weekend, corporate managements likely cut employment too far as they prepared for Economic Armageddon over the past year. Historically speaking, a GDP decline of the recent magnitude would have resulted in a 3% cut in payrolls as opposed to the much more significant 6% decline that actually occurred.
Employment is, of course, a lagging indicator and as a result, improvements may not necessarily signal higher stock prices from here. Nevertheless, they should provide the basis for improved sentiment and clearly remove a key thesis for the market’s bearishly inclined.
In addition to an improvement in employment, we also believe we are on the cusp of what will prove to be a significant increase in capital spending, particularly among cash rich, downsized and restructured corporations. As company executives become more comfortable with the sustainability of the recovery, they will likely move beyond simply replenishing inventories and hiring more folks and restart longer term investment projects that have been on hold.
As we’ve pointed out from recent earnings results, most companies have generated significant improvements in free cash flow as they’ve downsized, freed up working capital and curtailed longer term investments. But in addition to the improvement in internal cash flows, the credit markets have also thawed considerably, providing a refreshed source of external cash flow.
Recent mergers and acquisitions activity – Buffett’s purchase of Burlington Northern and Exxon’s purchase this week of XTO – are evidence of both improving corporate sentiment and the ability of the capital markets to finance future strategies. Increased M&A activity is a noteworthy and bullish leading indicator.
Finally and perhaps most importantly, is the relationship between the depth of economic downturns and the strength of subsequent recoveries in the past. History suggests that deep downturns have almost always been accompanied by stronger than average recoveries. Again, according to work from ISI Group, the depth and duration of the recent recession would normally suggest a GDP rebound of eight percent. With many economists forecasting more tepid GDP growth of just four percent in the coming year, expectations appear conservative and the variation could prove to be on the upside.
While no downturn is ever fun, I find myself increasingly more comfortable with experiencing the reality of asset bubbles and economic recessions. Economic cycles are an inevitable trait of the capitalistic lifestyle. As long as humans are inclined to believe in money in an unhealthy fashion, we will not only succumb to the allure of greed, but also fall prey to fear. In harnessing the relative calm afforded by the reality of past experience, I’m hoping we can all improve our investment returns during future calamity.
Over ten years ago, I bought a new Dodge Viper. While I no longer own it, I loved nothing more than the rush I could get from shifting gears as I accelerated down a highway entrance ramp. On many occasions, I’d drive from my home to downtown Akron on State Route Eight, entering and exiting the freeway far more times than was truly necessary. While the car always got its share of admiring looks and could certainly have pushed the threshold of a prudent speed, it was the shifting of the low gears, the sound of the engine, and the feeling of torque that I will always remember the most.
As 2009 comes to a close and 2010 begins, I can’t help but anticipate the excitement of shifting economic gears.

It has been awhile since we published our last Economic Update and now that earnings season is largely over, the time is right for one.
At the end of October, the markets began to weaken with many stocks - outside of Amazon - responding poorly to their earnings releases. In a blog entry at that time, we made the following now paraphrased comments:
"The double dip drum has been beating once again given the recent pullback in the markets. While any pullback is worth monitoring, corrections are actually quite common. In fact, we've had several 5% plus peak to trough corrections since the recovery began in March.
During June: The S&P 500 "corrects" from 948 to 870, an 8% decline.
During August: The S&P 500 "corrects" from 1035 to 990, a 4 decline.
During September: The S&P 500 "corrects" from 1070 to 1020, a 5% decline.
During October: The S&P 500 "corrects" from 1100 to 1040, a 5% decline.
As the data suggests, each correction has been followed by higher subsequent highs. Alot of money is still on the sidelines and these corrections have provided opportunities to buy rather than sell. I believe the pattern will hold."
Now, two weeks later, the S&P 500 has reversed course and is resting at 1100 once again, pondering its next move. We believe the markets will resume their upward march over the next two to three quarters, but also recognize that some positive news may be necessary to catalyze a sustained breakout above current levels.
So, the logical question is what might be the source of a positive surprise?
With earnings now behind us, the likely source of positive news may come on the macroeconomic front. And since the greatest concern over this recovery's sustainability seems to rest on the outlook for employment, it stands to reason that a recovery in employment could be and perhaps should be the source of that very surprise.
Before we discuss our thoughts on the employment outlook, however, it probably makes sense to provide a quick summary of our thoughts from the third quarter's earnings season just ended, thoughts which we've collected from reviewing forty or so earnings call transcripts as well as summaries of many more.
Earlier this week, JP Morgan provided a top down analysis of earnings results. Of the 440 companies in the S&P 500 that had reported their results as of Monday, 80% posted earnings that were ahead of expectations, the largest figure on record. In addition, 60% of these companies also reported revenues ahead of expectations, which may help offset concerns that recent gains have been solely a function of cost cutting.
From our own bottoms up perspective, technology companies have been the most bullish in their outlooks. Cisco Systems, in particular, declared the first quarter as the trough for results, the second as the tipping point, and the third just ended as the start of a worldwide economic recovery.
The bullish outlook from technology companies can also be supported by the large number of M&A deals in the space, including last night's announced acquisition of 3Com by Hewlett Packard. We would also add that technology tends to be a sector with early cyclical characteristics as many companies try to delay the need for new hires by transitioning to next generations of productivity enhancing technologies first.
While the outlook from technology companies has taken the next step forward, I would characterize the outlook from other sectors of the economy as remaining "cautiously optimistic". In spite of their more tentative outlook, free cash flow generation is reaching historical highs for many sectors of the economy. In fact, it remains well above reported earnings, as a function of reduced production, leaner inventories, falling receivable balances, and lower employment levels.
A Rockwell Collins executive may have summed up the outlook best by saying "you can delay painting your house, but you can't not paint your house forever." Double negatives aside, spending may remain restrained for a time, but it can't be restrained forever.
In simple terms, our macroeconomic playbook reads something like this. Almost all economic recoveries begin with cost cutting. After the cost cutting, revenues eventually stabilize and pick back up as a function of overshooting production on the downside and a more stable demand environment. The final step in the recovery begins when companies start the process of "painting their houses" once again. As confidence returns, corporate spending will pick back up and along with it, employment.
Of course, this takes money, but on this front there is good news, given high rates of corporate profitability and cash flow generation, as discussed earlier. It is also worth nothing that while bank lending standards may still be tight, corporate debt issuance has been at record highs and spreads remain constructive.
Already, there are twelve countries outside the United States experiencing improving employment, including Australia, as reported by ISI Group. Within the United States, continuing claims have stopped increasing and in spite of a record unemployment level not seen since the early 80's, the four week moving average of weekly unemployment claims just declined for the tenth consecutive week.
The unemployment rate is generally viewed as lagging indicator since it has historically peaked well into the earlier months of an economic recovery. As we look to the winter and spring months ahead, we believe the biggest surprise will therefore be the employment outlook. (Note that the unusually high worker productivity level just announced - 9% - is likely unsustainable and may be a function of cutting payrolls too much.)
Of course, an improving employment outlook would be a major surprise in an investment environment that remains so skeptical of that very thing. But in spite of such skepticism, the recovery to date, has been far more textbook that most would care to admit. While there are always those who would say "this time it's different", in my experience, these words have invariably accompanied very poor investment decisions.
Tactically, we have been paring our significant gains in early cyclicals, particularly consumer discretionary stocks purchased a year ago when the death of the consumer was loudly proclaimed. We've been redeploying these gains into later stage cyclical stocks more recently - areas that should outperform as the recovery matures; primarily energy, industrials and materials.
If time proves our forecast correct, an improvement in employment should be on the macroeconomic agenda at some point in the next two or three quarters, setting the stage for continued outperformance as we enter 2010.
That's the picture we've painted. Now it's time to sit back and watch the paint dry.
The markets pulled back aggressively at 11:30am EST and are now down about a percent or so. According to some, the reason for the pullback was because of a reversal in the dollar and the fact that the markets hit upside resistance and couldn't break through. In short, I think this latter comment implies that the markets have pulled back because they couldn't go up anymore. How is that for simple brilliance!
For more outstanding examples of reasoning and a good chuckle, check out these children's answers to a recent science exam.
Q: Explain one of the processes by which water can be made safe to drink .
A: Flirtation makes water safe to drink because it removes large pollutants like grit, sand, dead sheep and canoeists.
Q: How is dew formed?
A: The sun shines down on the leaves and makes them perspire.
Q: How can you delay milk turning sour? (brilliant, love this!)
A: Keep it in the cow.
Q: What causes the tides in the oceans?
A: The tides are a fight between the Earth and the Moon. All water tends to flow towards the moon, because there is no water on the moon, and nature hates a vacuum. I forget where the sun joins in this fight.
Q: What are steroids?
A: Things for keeping carpets still on the stairs.
Q: What happens to your body as you age?
A: When you get old, so do your bowels and you get intercontinental. .
Q: What happens to a boy when he reaches puberty?
A: He says good-bye to his boyhood and looks forward to his adultery.
Q: Name a major disease associated with cigarettes.
A: Premature death.
Q: How are the main parts of the body categorized? (e.g., abdomen)
A: The body is consisted into three parts - the brainium, the borax and the abdominal cavity. The brainium contains the brain; the borax contains the heart and lungs, and the abdominal cavity contains the five bowels A, E, I, O, and U.
Q: What is the fibula?
A: A small lie
Q: What does "varicose" mean? (I do love this one...)
A: Nearby.
Q: Give the meaning of the term "Caesarean Section."
A: The Caesarean Section is a district in Rome .
Q: What does the word "benign" mean?'
A: Benign is what you will be after you be eight.
