The ISM manufacturing index came out about fifteen minutes ago and was a surprisingly strong 56.3 compared to expectations of 52.9.  Generally speaking a read of under 50 indicates contraction rather than expansion in the manufacturing sector.  Given the decline in the markets, this data is having a huge positive impact on stocks since the release at 10am.  For those of us who have believed this slowdown represents a soft landing/soft patch rather than an impending double dip, this data is very, very, very encouraging. 

Did I mention that it was very encouraging?

Generally speaking the ISM Index leads the real economy by three to six months.  Not too surprisingly, the indicator began to weaken last spring from all time highs and the market has been soft ever since in spite of great fundamental earnings results from most companies.   These weaker readings may have shown up in the tone of more cautious earnings commentaries in recent weeks like those of Cisco.  Now that the index reading has actually turned up rather than declined further, the tone of the markets could change, perhaps dramatically, in the coming months.  It could be expected that fundamental outlooks from companies would therefore once again become more positive by the end of this year.  (Granted, in July the reading was 55, so the 56 reading isn't a huge increase, but relative to some sub 50 expectations for August, it is definitely expectationally tradeable.) 

Of course, no one should get carried away with any single indicator - the markets aren't that simple or easy -  but in our minds it supports a soft landing view and will likely affirm the trading range for the S&P 500 of 1040 on the low side and 1200 on the high side.  With the market at the lower end of the band in recent days, I suspect we could see a very decent bounce. 

This reading may also not bode well for the bond bubble and may potentially bring about the first few cracks in the idea that playing bonds may be safe here because the Fed will be perpetually on hold.  If the ISM surveys remain surprisingly strong, then that assurance may be off the table and with it, the bubble in bonds closer to its end. 

In conclusion, our conviction in the slower growth theme rather than double dip scenario went up considerably with this release and probably even more so for the markets as a whole.  For now, this represents our best and most timely thinking on the matter, but as always, stay tuned!

Naomi Schaeffer Riley reviews an interesting new book titled Crisis on Campus, by Columbia University professor Mark Taylor in today's Wall Street Journal.  I've read one of Naomi's books in the past; she has been very successful as a journalist, particularly at such a young age. 

Miami University, my alma mater, made its budget woes public in yesterday's Cleveland Plain Dealer.  Unfortunately, coming up with viable solutions may prove difficult if those charged with developing and implementing change stand to bear a disproportionate share of the burdens.      

We've now come full circle; when some professors don't like to spend time with their customers...students...and actually spend time trying to avoid them, it may be a sign of a flawed competitive system.  Along with persistently higher costs of education, such phenomena suggest potentially fertile new ground for U.S. antitrust efforts.  (Seriously, I jest, or do I?)

Following up on last week's Terminator blog , Adam Pilz, Broadleaf Intern, sent me a link to Social Security online and an article on what Greece is doing to combat its ballooning pension obligations.  (For the convenience of readers, I have copied the text below.)  First and foremost, they've realized that curbing early retirement benefits may be a major help in combatting their crisis, something Arnold discussed last week.  Eventually, the U.S. will follow suit; but hopefully we won't wait for riots in the streets and social unrest to motivate us in that direction.  

On an added note, I've often commented on the presence of fund flows going wild (tech stocks, housing stocks, private equity investments, now government bonds) as a decent leading indicator of budding new asset bubbles.   In this sense, a brewing crisis in public pensions may be one manifestation of the potential damage coming from the bursting of a government asset bubble brought on by exponential and unreasonable funding obligations.

Greece Pension Reform Text:

 

Greece

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 statutory retirement age for women will be gradually raised from 60 to 65, by December 2013, to match the current retirement age for men. Beginning in 2020, the statutory retirement age for men and women will be automatically adjusted (every 3 years) to reflect changes in life expectancy.
• Early retirement will be restrained by limiting the minimum early retirement age to 60 by 2011, which includes workers in arduous occupations. The government aims to increase the effective average retirement age from the present 61.4 years to 63.5 years by 2015.
• The minimum contribution period to receive a full pension will gradually increase from 37 years to 40 years by 2015. Pension benefits will be reduced by 6 percent each year for individuals who retire between the ages of 60 and 65 with less than 40 contribution years.

The reform also lowers pension benefits in the following ways:

• Pension amounts will be frozen during the 2011–2013 period and indexed to changes in the consumer price index (instead of indexed according to changes in civil service pensions) starting in 2014.
• Benefits for new claims will be based on career-average earnings rather than the current highest 5 out of the last 10 years.
• The average annual accrual rate (at which entitlement to future pension benefits accumulate) will be limited to 1.2 percent of earnings, resulting in a less generous earnings-related pension. This benefit will top up a new means-tested, noncontributory monthly pension of 360 euros (US$474) for citizens older than the normal retirement age.
• A new flat bonus of 800 euros (US$1,053) per year will replace the seasonal bonuses (for Christmas, Easter, and summer) currently payable to pensioners. The new bonus will be available only to those with pensions less than 2,500 euros (US$3,290) a month. As a result, monthly pensions of more than 1,400 euros (US$1,806) will be reduced by an average of 8 percent. This reduction will affect about 10 percent of pensioners.
• Pensions greater than 1,400 euros (US$1,843) per month will be taxed by 5–10 percent starting in August 2010.

Sources: "The Economic Adjustment Programme for Greece," European Economy, May 2010; Greece: Staff Report on Request for Stand-By Arrangement, International Monetary Fund, May 2010; "Yesterday the Greek Government Approved a Bill Aimed at Achieving Pension Reform," Plansponsor.com, May 11, 2010; "Greek Parliament Approves Pension Bill," Reuters News, July 8, 2010; "Greek Parliament Ratifies Pension System Reform Bill," Xinhua News Agency, July 15, 2010.

Governor Schwarzenegger (aka Terminator) nails what I believe is one of the most pressing social/fiscal issues of a generation in an editorial  in today's Wall Street Journal.  The social contracts of 20-30 years of service and then retirement in the public sector  no longer make sense in the face of today's competitive realities. (ie retirement at 45-55)  The above graph clearly shows that the public sector has no competitive forces keeping it in check and that benchmarking the benefits of one public sector group against another is deceptively outdated. 

If and when such plans fail, the revolt of those who end up having to pay for their shortfalls will make today's tea parties look like harmless sandbox play.  This need not be an issue of class warfare - though there will be those who try to promote it that way - but one of cold hearted reality.   The debate ahead will not be an easy undertaking and and in this sense, it is fitting that the Terminator launched the first salvo.  

Let's all hope he'll "be back."     

With the kids going back to school and Halloween now just around the corner (can you believe it?), I thought I'd share some "spooky" data surrounding the month of September courtesy of my friend Danny Hurwitz of BTIG Group.  (source Bloomberg)

The month ranks #1 in both frequency of losses and total losses since 1929.  He tried looking at whether or not the preceding August or YTD performance foreshadowed September’s results but it was pretty evenly distributed.

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. 

 

 

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.   

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. 

The stock market continues to vacillate between the double dip and recovery crowds, but has also managed to hold the February lows now on two separate occasions.  We believe that the domestic recovery remains intact and that European concerns and BP's oil spill are exacerbating the typical shifting of gears that occurs at this stage of the economic cycle.  To be clear, our notion of shifting momentum isn't meant to imply a bearish stance on the markets, but rather the sense that what will work for investors and at what rate may likely be different than that experienced over the last year and a half.

Last year, the stock market acted very well, anticipating an eventual turn in the face of what was at the time very poor economic news.  For 2010, we continue to expect somewhat the opposite as the stock market experiences more measured gains even as the economy demonstrates solid growth.  A near term range of 1050 on the downside - the February lows - and 1150 on the upside may likely persist until we get some sense of closure on both Europe and offshore drilling.  If we can get past these issues, a year end target of 1250 would still seem plausible, roughly the level where the markets traded when Lehman went down a year and a half ago.  The good news is that this year end target now represents a fourteen percent gain from current levels as opposed to only five percent one month ago. 

We believe that three top down factors have a major influence on investment value and stock market return characteristics.  These include the economic cycle, the rate of innovation, and the availability and sources of credit.  The economic cycle, we believe, is the most important of the three since it tends to have a major influence on sector returns.  The rate of innovation, or the innovation cycle as we call it, is almost always an investable concept as serial innovators like Apple tend to create entirely new markets or better ways of doing the same old thing, often in spite of the economic climate.  The only caveat is that greater rates of innovation typically engender faster rates of growth, meaning that valuations tend to be higher and the penalties for missteps magnified for this type of company. 

The credit cycle, may be most useful in determining the sources and magnitude of investable funds and in offering potential warnings signs about the presence of new asset bubbles.  We have used the term "fund flows gone wild" in the past to describe the nature of the credit cycle, or the sources of money chasing newly favored asset classes.  In the early 2000's, venture capitalists and everyday stock market investors funded the bubble in technology stocks, during the mid 2000's, banks financed the housing bubble, and more recently, the rush to  private equity fueled a huge run up in commodities like oil and mergers and acquisition activity.  

So far, we'd be hard pressed to identify any major sources of "fund flows going wild" in the current environment, but government spending might be one place to monitor for the future.  Taken to the extreme, excessive government spending in an economy can engender an entitlement society, and the eventual popping of sovereign asset bubbles now being witnessed in places like Greece.  Ironically, a potential bubble in gold may also be a result of too much government spending, as investors trade their fears of deflating and inflating currencies for the hoped for "stability" of a "precious" metal.  

At this point in time, we are relatively sector neutral, or at least more so than we have been in the recent past.  This may reflect a budding sense that the economic cycle may have no more or less influence over sector dynamics than the credit or innovation cycles at this stage of the game.  At the same time, given the 10-15% decline in many stock indices over the past month, it is likelier that strong earnings reports in third quarter will have a more positive impact on stock prices than they had this quarter when they were near their highs.   

Recently, I finished watching the HBO DVD series on President John Adams.  Based on the biography of the same title, it provided great insight into the minds of our country's earliest leaders who sought independence from the British monarchy at the cost of their own lives and for the benefit of generations to come.  As soon as the war was won, Hamilton, Jefferson and Adams, among others, embarked on their own personal quests for power, each in his own inevitable way, mini-monarchs in search of their own kingdoms.  In a bit of irony, the world at large may now be hurtling down the same path, hoping that a king or queen of our own or new laws and regulations might somehow save us from ourselves.  With Greece as Exhibit A, I remain unconvinced.  

Over Memorial Day weekend, between the burgers, parades, and baseball games, I hope to find sometime to remember those who died to remove the very shackles we now seem eager to give a try.

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. 

A couple of observations stick out to me, while a third is not as obvious.  First, leadership in most years appears to be relatively random, with styles not often repeating as top performers in successive years.  Second, in spite of infrequent repeats at the top, U.S. bonds have tended to be the worst performers on multiple occasions (seven times) - nearly 40% of the periods studied.  

The data suggests that a diversified style based approach to investing makes sense.  It also suggests that U.S. bonds tend to underperform in all periods except recession years.  (2002 and 2003.) 

What is not as obvious is the observation that only U.S. bonds tend to have negative correlations with everything else.  In other words, the greatest diversification gains may simply be had by investing a portion of a portfolio in U.S. bonds. 

How much depends on what your income needs are and what volatility you're willing to give up for safety, both on the upside and downside.  All other styles will improve diversification, but perhaps more in relative terms than absolute.  (In other words, they will still tend to move up or down together, but at different rates, rather than opposite of each other as could be expected with U.S. bonds.)

For the second time in two weeks, a company in our portfolio announced a stock split.  I haven't seen more than a handful of stock splits in the last few years let alone weeks.  It may be another bullish sign for the markets, one that may indicate a move from economic recovery to expansion. 

On a different note, CNN Reporter Paul La Monica called us yesterday for our thoughts on the Euro and its impact on corporate profits.  You can access the article, "The Euro Ate My Profits" here.

For the first time since mid January, the markets have been under pressure.  The last correction lasted roughly three weeks and resulted in a market loss of approximately 7% from the January peak to the February trough.  This correction has lasted a little over two weeks and has resulted in a slightly larger market loss of roughly 8% so far.  Fortunately, the overall bullish trend remains intact, with the correction in January eventually reversing course and leading to new highs and the current correction not breaking the former February lows.  In technical parlance, this means that the bullish trend of higher highs and higher lows remains intact.  An additional decline of 6% or more to the 1050 January lows would give rise to greater technical concerns.

The current correction feels worse, however, than the one experienced a couple of months ago.  The solvency of Greece has reared its head in a far uglier fashion than it did in January, when the country's economy was dismissed as too small to affect the worldwide stage.  Recently televised riots on the streets of Greece, a collapsing Euro, and ineffectual monetary policy efforts by a politically divided EU have all heightened concerns and comparisons of the current Greece "fire" to our own mortgage mess a couple of years ago.  While our banks and financial system is much less exposed to Greek and European debt than the European banks were exposed to our own mortgage problems, our Fed and Treasury departments also stood united in doing whatever they could to prevent the second coming of a Great Depression.  The temporary but rapid downturn in the U.S. markets on "Fat Thumb" Thursday over the course of twenty short minutes has, no doubt, damaged the psyche of the average investor, just now coming to grips with the prospects for economic recovery.

For sometime now, we have been forecasting a year end target of 1250 on the S&P 500, which at the writing of our last update was a modest 5% upside.  We have been preaching a policy of "shifting gears" in preparation for a transition from economic recovery to one of potential expansion.  One indicator that we follow widely is the ISM Index, which is a monthly survey of some four hundred purchasing managers from twenty different industries in all fifty states.  The survey covers purchasing managers views of production, employment and new orders, among other factors, and has been a good leading indicator of turning points in the macroeconomic cycle and the stock market.  Historically, a reading above fifty indicates that the domestic economy is in an expansion mode. 

Last week, the survey reading for March was released and came in at 60.4, well within expansion territory.  The current debate among top strategists we follow on Wall Street is whether this level, achieved only fourteen times since the survey's launch, represents an imminent peak in the index measurement or whether or not it can remain at these currently high levels for an extended period of time.   

Our take has largely been the latter; employment is just now starting to improve, with 260k new jobs announced last week, the best measurement in a few years.  At the margin, we believe employment is a lagging indicator, one only likely to increase as business confidence reaches sufficient levels.  While recent earnings results have been outstanding, they have also remain couched in terms of cautious optimism.  It is doubtful that companies would finally begin hiring again if they thought an imminent downturn was at hand or if their optimism were set to wane.

Having said all this, we have been shifting gears not based on a peaking in the ISM index, but under the assumption that it can stay higher for awhile.  Rather than become more defensive by repositioning the portfolio into safer sectors like utilities, staples, and health care (as would be warranted by a peaking in and downturn in the ISM), we've chosen instead to focus on later stage cyclicals that stand to see gains as the economic velocity is maintained and early stage cyclicals that have not yet participated in the markets recent gains, but could be expected to particularly as hiring resumes. 

Until Greece's problems surfaced with renewed fervor in the past two weeks, China was the sole economy experiencing difficulty, a factor I attributed to their earlier monetary policy tightening campaign relative to others around the world.  Measured from the perspective of their stock market, China had been one of the few markets down on a year to date basis.  Such downward blips aren't unusual at the start of tightening campaigns, but often prove short lived.  (See our Economic Update, Fun with Charts .)

Many years ago, I had the opportunity to hear Margaret Thatcher speak to the clients of a former employer on two different occasions.  Both times,  she was adamantly opposed to the common currency movement "the Euro" spreading its way through Europe.  If my memory serves me right, she believed that monetary unity in the absence of political unity could be a huge policy mistake.  For Europe's sake, and potentially even our own, I hope these countries find the wherewithal to work together before it is too late.  In the absence of a unified front, the best defense for U.S. investors - if it comes to that - may be a purely domestic approach to investing, based on those that don't have any foreign sales or, if they do, would face limited losses due to the depreciating Euro.  Such an environment might be manageable, but would hardly be ideal.

At this point, I am sticking with the view that the U.S. recovery, though shaken by the events of the past two weeks, will remain on track.  Yet at the same time, I am curious to know what the bad news coming out of Europe might mean to the average views of purchasing managers who participate in the monthly ISM survey.  If Europe doesn't get its fiscal house in order soon, budding domestic optimism could quickly turn pessimistic.  Monetary policy and fiscal bailouts should indeed be solutions of last resort, but with few if any in the private sector stepping forward to buy distressed assets, now may be such a moment for Europe.   

Ever since I was a kid, visiting firemen and acting Scoutmasters would remind me to never try putting out a grease fire with water.  The seemingly obvious and instinctive approach will only make matters worse by spreading the liquid grease, as it flames even faster.  The best approach is to smother the problem with heavy rags, denying it the oxygen it needs to keep burning.    

For the first time in over a year, I find myself staring at a problem that needs a good smothering.   Hopefully, the Europeans will prove as creative in their approach to new problems as our own Fed did over the course of the past two, very trying years. 

Frist van Paasschen - CEO of Starwood Hotels:

On the hotel opportunity in India:

"To say that India today is under-hotel-ed relative to future demand is a massive understatement.  New York City alone has almost as many hotel rooms as the entire country."

On the improving economy:

"Things certainly have changed since we last spoke in January.  As you may recall, rather than make predictions, we were looking at a range of scenarios for 2010.  Of the many scenarios we considered, what we see today is without a doubt the good case scenario."

The important caveat:

"To borrow a phrase from Warren Buffett, we should be fearful when others are greedy."

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. 

For those that might have an interest, these were the talking points I submitted yesterday.

************

1.)  Outlook for 2010

• FOR 2010, THE ECONOMY SHOULD BE STRONGER THAN THE STOCK MARKET, THE REVERSE OF WHAT OCCURRED IN 2009.   
• We believe the economy will continue to show strong progress through the remainder of 2010, with AN EVENTUAL AND MORE DEFINITIVE IMPROVEMENT IN UNEMPLOYMENT. 
• We would then EXPECT THE FED TO BECOME MORE AGGRESSIVE IN REMOVING THE STIMULUS it has provided, but not likely until this time.

 

2.)  Are you more bullish or bearish on the markets and why?

• WE REMAIN BULLISH, but are mindful of the strong run we've had off the lows. 
• THE PRIMARY SOURCE OF OUR BULLISHNESS LIES IN THE STRONG CORPORATE PROFITS RECOVERY AND ULTIMATELY, WHAT THAT WILL MEAN FOR CORPORATE SPENDING, INCLUDING EMPLOYMENT. 
• A REASONABLE YEAR END TARGET FOR THE S&P 500 WOULD BE 1250, roughly the level it traded when Lehman collapsed eighteen months ago.  While the market could get through this important resistance point and then move as high as 1350, this would require a continued acceleration in leading economic indicators as opposed to a simple continuation of economic strength.  

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? 

• AS LONG AS LEADING ECONOMIC INDICATORS CONTINUE TO IMPROVE, DEFENSIVE SECTORS LIKE HEALTH CARE, STAPLES AND UTILITIES WILL LIKELY LAG THE OVERALL STOCK MARKET.  At the margin, we've been paring our strong gains in early cyclicals, including the consumer discretionary and technology spaces in favor or later stage cyclicals.

• THE TIME FOR INCREASING DEFENSIVES IS CLOSER, but perhaps not until later this year.

, but perhaps not until later this year.

 

 

Doug MacKay, CEO & CIO of Broadleaf Partners, will appear on CNBC's Squawk Box at 9:35 am tomorrow morning, Wednesday April 28th. 

Tune in as Doug discusses the economy and the markets with show hosts Mark Haines and Erin Burnett.

We have posted a new Economic Update entitled Chocolate and The Mathematics of Loss to our website.  If you know of anyone who would like to receive our thoughts on the markets please let us know!
 

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!

*******

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.'

 

Last night, I read an article about Alex Griffith, a young American Boy Scout whose eagle project involved building a playground at the Russian hospital where he was born and then adopted from some sixteen years ago.  Alex spent 2 1/2 years and raised $60k for the project.  The help of nearly five hundred volunteers from five countries was solicited using a broad, web based campaign according to an article in a National Eagle Scout Association newsletter.   

This story hit me as an amazing sign of just how global the economy has become and, in particular, how much more open Russia has become as a nation.   When I did my Eagle project twenty eight years ago, it was at the Bath Community Center five miles down the road (how lame is that?).  I had a highschool friend from Russia at the time, whose parents had escaped the country with him years earlier.  Every time I called, his parents would give me the third degree and they were always paranoid that the KGB could knock on the front door of their American home at any moment.  I marveled at his retelling of how they left everything behind in Russia, smuggling only cash by wrapping individual bills in cigarette cartons.  In planning for a highschool reunion ten years ago, I called the house once again and his parents still gave me the third degree.  "How did I know Eugene?", they asked, revealing little else.  Eugene didn't attend that reunion, but made it to the one five years later.

It's also interesting to think about the impact that international adoptions might have on the global economy a generation into the future as these youngsters grow up and seek to reestablish contact with their homelands.  As I age, everything seems so much smaller than it once was...the elementary school where I played dodgeball for the first time, the highschool where I met my first date, and now even the college I attended, where I had my first of many beers.   

Now, it seems that even the world is becoming that way too.  

Our first quarter performance and market commentary is now available.  Please click here for our thoughts on what contributed to the quarter's strong absolute and relative results as well as our outlook on the year ahead.

Yeah, I know it's bad, but it still made me chuckle!  Easter's about more than eggs anyway. 

Have a blessed Easter, everyone, and if you're travelling with your family as I am, be safe!

Google has been in the news a great deal lately over their decision to exit the Chinese market on the principle of free speech.  Google, whose corporate motto is "Do No Evil", has decided that the revenue benefits associated with a Chinese presence aren't worth the silent stand against free speech made complicit by offering censored search results. 

The Wall Street Journal is running a poll on whether or not Google is a company more motivated by principle or profit.  While it is newsworthy and perhaps noble to suggest that a capitalist company is putting principle above profit, I'm not so sure there is a difference in this case. 

While Google will certainly forgo an immaterial revenue stream today by exiting China and may curb its long term rate of growth, it should also be pointed out that censorship makes for lower quality search results since you may not always be providing the customer with the full range of results that they may be looking for.   Google advertisers will not be served by the full potential benefit of meaningful keyword searches. 

One could also argue that the Chinese government could favor domestic companies over international ones by simply censoring certain search results which would improve its own domestic growth agenda.  By allowing for continued censorship in China, Google might be hurting some of its other customers.   

We know too much fat is bad for one's diet.  If Ben & Jerry's were required to remove fat from their ice cream as a condition for selling it in Ohio, I wouldn't blame them for passing on the opportunity.  Fat free ice cream just isn't all that it's cracked up to be and just might hurt the Ben & Jerry's brand.

In the long run, I think Google's profit incentive and its principles are in line with each other.  Censorship hurts Google's brand and makes it a lower return on investment product to its advertising base.  To require a company to provide anything less than their very best is communist by nature.   

At least in this case, profit and principle are one and the same.  Bravo Google.

We just published a new Economic Update titled Changing Seasons.  You can also retrieve the update by typing the following URL in your web browser: 

http://www.broadleafpartners.com/uploads/Changing_Seasons.pdf

Enjoy!

Today's New York Times had an interesting article on the declining costs associated with mapping a human genome.  This makes the age old, grade school ethics question a potential reality.   "If you could find out what disease you might have or die from in the future, would you want to know that today?

If someone gave you $50k with the condition that you have your genome mapped and that you study the results, would you do it?

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.

****

A greater emphasis on philosophy, religion, organizational behavior, and history might likely prove fertile educational grounds for:

1. Understanding that man is doomed to repeat the patterns of behavior surrounding fear and greed (if you are religiously bent as I am, this is our tendency to sin),
2. Gaining an understanding of what personal involvement in these two patterns of human behavior might entail (ie consequences), and
3. How an understanding of their inevitability might better prepare individuals for the future, whether it is on the trading floor, in the board room, or as a younger person planning their career options. 

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. 

****

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!

******

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."

 

My Excel charting skills are indeed amateur, but I nevertheless wanted to get a feel for the historical relationship, if any, between changes in the Fed's discount rate and the stock market.  If you hadn't heard, the Fed raised the discount rate by 25 basis points after the close of the market last night to 75 basis points.  Changing the discount rate - the rate the Fed charges banks for loans - is one of the many monetary policy tools available to the Federal Reserve. 

CNBC is providing intense coverage of the Fed's moves this morning, basically asking professional investors if the Fed's moves signal anything about a change in policy that may usher in additional rate hikes and what that might mean for the markets.  Bulls might interpret the move as a sign that the Fed is more comfortable with the economic outlook and is therefore taking initial steps to remove temporary stimulus that may no longer be necessary.  On the other hand, bears might argue that the move may be the first in a series of many hikes in the Fed Funds rate, moves which may prove too little too late in fighting inflationary pressures brought about be easy money.  

The top chart shows the discount rate and associated changes since 2003.  In the chart, you can see two primary monetary policy campaigns.  The first is the period from 2004 to mid 2006 when the Fed raised rates as the economy recovered from the tech wreck earlier in the decade.  The second period was from 2007 to just before last night, when the Fed reduced the discount rate to nearly zero to combat what nearly became a second Great Depression.  The bottom chart shows the S&P 500 over the same time period, with the blue dots representing dates when the Fed changed the discount rate.

To me, a couple of observations and conclusions might be made from these charts.  First of all, it is likely that yesterday's increase in the discount rate may indeed represent a change in Fed policy and that barring a double dip in the economy, will prove to be the first of many such rate hikes.  However, what is also interesting is that the last time the Fed started to raise rates, the S&P 500 climbed higher from roughly the 1100 level in mid 2004 to the high of nearly 1500 three years later, when the Fed first started to cut rates once again.

To me, the data suggests that investors need not panic.  The time to worry about Fed policy may not be for a few years, or at least until the Fed ends its rate hike campaign and begins cutting them once again.  If history is a guide, rate cuts won't likely occur until a period of economic expansion is over and the Fed begins to worry once again about signs of visible economic weakness.  Economic growth and even some inflation will likely be interpreted by the stock market in a positive fashion. 

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. 

We are in the thick of earnings season and so far, the reaction of most stock prices has been disappointing relative to the great numbers most companies have been reporting.  This may be another way of saying that a great deal of improvement in the economy was priced in with the gains investors experienced in 2009, at least in the short run. 

In general, I subscribe to the baseline view that while the economy may do great in 2010, stock market returns may be average.  What could cause the stock market to exceed this expectation?  In my opinion, the single greatest source of upside would be the employment outlook.  Right now, sentiment remains very negative, adhering to the notion that this recovery will be of the jobless variety.   Another alternative might be a sustained improvement in productivity, leading to a permanent step up in corporate profitability, beyond that which might be explained by inventory rebuilds, human or otherwise.  While not as politically desirable, it is a vision worth exploring.  Historically speaking, downturns have almost always given birth to technology transitions, perhaps because the costs of change are slight relative to the pressures of doing nothing.       

Last week, the markets took a five percent hit as several political concerns rose to the forefront of investors' minds.  Democrats will tell you that the swoon started when Brown won Kennedy's senate seat and plans for nationalized health care died, while Republicans might blame it on the proposed new banking regulations.  Those of both persuasions might lay the blame on Bernanke's prospects for reappointment.  As always, there are many explanations to go around.

Personally, I think Brown's election was a positive for the markets and that some of the banking regulations make a lot of sense, even though they won't, of course, prevent the next downturn.  Politics have rarely played a significant role for me on the list of stock market risks simply because the government is such a well oiled bureaucracy, cable of much talk but little change.  Brown's improbable win represents a fascinating case study in the perseverance of bureaucracy.  If you want to have faith in government, that's a type you can take to the bank!

As for Bernanke?   I'm so tired of the debates, I've kept CNBC on mute for most of the past two days.  While I'd never want his job, I'm certainly glad he had it over the past two years.  I'm with Buffet.  I'd keep him.

Our fourth quarter performance and market commentary is now available.  Please click here for our thoughts on what contributed to this year's 44% gain for the portfolio, lessons learned from 2009, and what may lie ahead for investors in 2010.

Alcoa's results last night represented the start to fourth quarter earnings reports which should shed some light on business intentions and plans as we begin 2010.  As always, it will be a volatile few weeks for the markets, with its own fair share of surprises.  Stay tuned!

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
 

We were on CNBC this morning.  At the end of the interview, Mark Haines wished me a Happy Birthday, commenting that I didn't look a day over 50.  At just 42, I should hope not!

Joking aside, here is a link to this morning's interview along with the comments I provided to the show's producers ahead of time.  

***

A. Are you more bullish or bearish on the markets and why?
 
We are more BULLISH than most.  Why?
 
1.)  We see employment gains as 2010 progresses, removing a key case for the bears.

2.)  Companies will begin spending again, not on just hires and working capital, but on longer term projects.  A corporate capex cycle should commence as 2010 progresses.  We are seeing some of this already in renewed M&A activities.

3.)  Historically speaking, the deeper the recession (and this one was long and deep), the bigger the rebound.  Normally, an 8% type GDP number might be expected considering the recent downturn, but most economists expect 4% at most.  Expectations appear conservative, with the potential surprise therefore, to the upside.
 

B.  Where are we investing now?  Favorite stocks and/or sectors and why we like them.
 
1.)  We still favor CYCLICALS over DEFENSIVES given the fact that we still see the economy in recovery mode and not likely to double dip. 

2.)  Favor LATER STAGE CYCLICALS like Energy, Industrials and Materials over EARLY STAGE CYCLICALS like Consumer Discretionary at the margin.  (Many consumer discretionary stocks have had very large rebounds and
as the recovery matures, money will likely rotate to areas with even greater leverage still ahead of them.)

3.)  Focus on INNOVATORS, companies whose success is tied more to their own unique offerings rather than the stage of the economic cycle.  
 

C.  What would we be avoiding right now?
 
1.)  We would generally still underweight DEFENSIVE sectors like Staples, Utilities and Telecom.  I would put HEALTH CARE in this basket as well, but it may enjoy a continued rebound now that the light at the end of the Health Care Reform tunnel can be seen.

2.)  We're still not making a big bet on FINANCIALS.  I think they've had a nice recovery but from current levels may now lag for awhile as TECHNOLOGY did following its bubble earlier in the decade.
 

D.  Topic We'd Like to Discuss?
 
1.)  It's my birthday today! 

2.)  HOUSING stocks could be a really interesting play in 2010 on the long side.  Unlike financials and many other areas of the market, these stocks really haven't done a thing.  So, they are still priced as junk and as a result, could enjoy the greatest gains from here as the economic recovery matures.

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. 

As gold hit new highs last week, I remembered a gift my father in law had given Lisa and I on our wedding day a little more than 18 years ago.  It took me sometime to find it, but I eventually did, buried under eighteen years of accumulated family video tapes located in one of my fireproof safes.

Ralph, Lisa's dad, had given us us a one ounce pure gold Krugerrand minted in 1979 as a wedding gift.  On our wedding day - according to the internet - gold was worth $356 an ounce, a substantial discount to the price Ralph and many folks like him had paid for the precious metal when it hit $800 an ounce in the early eighties.  I suppose Ralph had likely given up on the "investment", and advised us to keep it for a rainy day or a time when we could use it, perhaps to buy some "groceries".    

While it wasn't raining out and our fridge was reasonably stocked with food, when gold hit record highs near $1300 an ounce last week, I figured it was as good a time to sell as any.  

I checked out the prices for recent Krugerrand sales on eBay and decided to list ours in a no reserve, 3 day auction with a starting price of $50 and a Buy it Now price of $1350.  Of course, gold had its largest single day price decline in over a year the very next day (humor me), but I still managed to sell it for $1220 to a Virginian who, from the looks of his recent purchase activity, has been a large buyer of coins in recent months.  My listing had 150 views and 18 bidders over three days. 

It was also interesting to note the large number of Krugerrands listed on the site, almost all of which were coined in the late 70's and early 80's and then in 2008 and 2009.  There were very few coins for sale from the years in between.  According to the web, the export of African Krugerrands to the United States was banned due to Apartheid in the late eighties and early nineties, which perhaps limited the supply of coins available here.  Nevertheless, I can't help but think that the high prices of the late eighties, as now, pushed production levels up considerably.  

Historically, gold has done well during periods of high inflation or deflation.  While we do not have either of these scenarios today, the metal's rise suggests that a change may be coming.  Then again, the price rise may simply be another asset bubble, something we've seen a great deal of in recent years.  

Ralph's coin earned Lisa and I a four fold return in roughly twenty years, which as far as gold is concerned, is about as good as it gets.  Historically, returns on the metal have averaged 2-3% over long periods of time. 

Reversion to the mean, anyone?

It has been quite sometime since I last published a blog entry.  The good news is that I've been quite busy, the bad news is that this trend may continue.  As a result, I will likely publish less frequently, perhaps just sharing my thoughts in the form of our periodic Economic Updates.  If you would like to receive those, please visit our website and subscribe at www.broadleafpartners.com.

Over the next few days, I hope to synthesize my thoughts on the year ahead and what it might mean for investors.  I may put the update in a Q&A format, which worked well on an occasion earlier in the year.  To that end, if you have any questions you would like me to consider, please feel free to send them via comment on this blog or directly by email to dmackay@broadleafpartners.com.  

I also plan to provide my closing thoughts on the year that was as I do each and every year, critiquing what went well, what didn't, and what we might be able to improve in the future.

Until then, enjoy the holiday season!

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 double dip drum has been beating once again given the recent pullback in the markets.  While any pullback is worth monitoring, it is instructive to consider that corrections are actually quite commonplace.  In fact, we've had several 5% plus peak to trough corrections since the recovery began in March!  Did you even notice?  

Here's my chicken scratch math:  

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" so far from 1100 to 1040, a 5% decline.

Please keep in mind that these are intra month corrections rather than the declines the market posted for each of the months in question.  Corrections are commonplace during economic recoveries, and 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. 

Of the earnings I follow, results have generally been ahead of expectations on the bottom line and inline on the top line.  Stock prices, however, have often come under pressure on the results, even when guidance has been increased, at least on the initial report.  Fast money and whisper numbers may be to blame for the fast trading reactions, but with fundamentals improving rather than deteriorating, the upward bias should remain intact.  

Q3 GDP just came in at up 3.5%, the fastest rate since 2007.  Additionally, continuing claims came down, a positive sign and new unemployment claims came in at the low 500's.  Admittedly, these releases are all backward looking, but should set the tone for a basing process and an end to October's mini correction.

Once the earnings deluge is over, I hope to provide some additional insights, but for now, I'm knee deep in the earnings data and conference call transcripts.

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:  Name the four seasons.
A:  Salt, pepper, mustard and vinegar.

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.

 

If you own Amazon, you're one happy camper.  Unfortunately, I'm not one of them.

The stock is up a whopping 25% after announcing great earnings, which included news that the Kindle (a product that they own and manufacture) was their biggest selling product in both units and dollars.  This news gives the company a new Apple-like angle to it, as a manufacturer rather than just a low cost retailer that is giving the mighty Wal Mart a run for its money.  

Aside from Amazon, it has been a big week for other earnings as well.  But as a general observation, I would say the reaction of stocks like Amazon and Apple has been atypical.  Many companies that we actively follow have demonstrated strong results relative to expectations both as a function of leaner operations and - unlike previous quarters - some areas of revenue improvement.  In most cases, analysts estimates have increased based on improved guidance.  In spite of this generally positive fundamental news, more stocks seemed to have responded negatively the first day following their earnings releases.   For investors, does this mean anything?

The quick answer is that I don't know.  I've long resisted making changes to the portfolio during earnings season as it tends to be a very emotional time driven by technical trading considerations that often don't sustain themselves longer term.  One stock I'm thinking of in particular traded down ten percent the first day after their earnings release.  Today, three days later, it is trading back above its pre earnings price level.  I'm not sure why this is the case, but it is an example of why I'm careful around earnings season.      

Consistent with this pattern on an individual stock basis is the observation that the S&P 500 has hit 1100 on several occasions in the past few weeks but has each time failed to break convincingly above this important level of resistance.  My best guess is that the index will break through sometime before year end as earnings season winds down and folks conclude that the economic recovery remains intact.  (The 1200 level would seem reasonable to me as an end of year resting point, or about where the markets were before Lehman Brothers went under roughly one year ago.) 

A few other tidbits from the week that was:  

1.)  Brazil's leaders proposed a 2% tax on foreign investments into stocks and bonds in its country to slow down the speculative mass of money flowing its way.  

2.)  The decline in the dollar hasn't been kind to Brazil's residents and many others around the world.  In terms of the Brazilian Real, the 25% gain in the S&P 500 this year would actually translate into an an eight percent loss for Brazilian investors in the index because of Real strength/dollar weakness.        

3.)  About mid week, I noticed that the S&P 500 was up nearly 65% from its lows last March.  My guess is very few people would have guessed they could make sixty five percent on their money six months ago, but that is exactly what has happened.  What an important lesson!

4.)  Starwood Hotels indicated that revenues per available room continued to decline at a significant pace, but at a declining rate this quarter, which is expected to slow still further in the future.  While 2010 is still up in the air, they are seeing improved bookings in China and big markets like New York city.  As business profits improve, companies will likely feel more comfortable booking events once again.  

Stay tuned, even more earnings next week.

    

While the markets are pulling back a tad today, earnings results so far - from the likes of Intel, JP Morgan, and Goldman - have been encouraging.  Of particular note was a quote from Goldman this morning, which characterized the global economy as having continued challenges, but that "we are seeing signs of improvement and stabilization - even growth - in some areas."  This latter comment regarding "growth in some areas" is what I expect to see from more companies in the coming two quarters.  First, cost cuts, then improving revenues and even more leveraged earnings gains.

On an altogether different note, I'm taking my 13 year old son to his first rock concert tonight, as recently inducted Rock Hall of Fame members Metallica thrash Cleveland with their particularly loud and driving brand of heavy metal.  Somehow I didn't quite think my son's first concert would be with a group that was around when I was young, but in a way, it's cool.  Way cooler, in fact, than if it were someone like the Jonas Brothers.  I think Guitar Hero has done a lot to introduce classic rock to today's youth, which can't be a bad thing, can it?   

Although I'm not a metal afficianado, I like Metallica, particularly after having watched a recent rockumentary about the group.  I admire them for surviving rock n roll's ever present dark side, which seems to feast on the souls of everyone in the business, regardless of style or genre.  Surely, heavy metal fits the stereotype more than most, but few musicians prove immune to the temptations that accompany extreme levels of fame and fortune.  Founders Lars Ulrich and James Hetfield strike me as two highly creative, intelligent and enterprising musicians.  They are likable not because they are rock gods, but because they have experienced what it means to be human, face one's demons, and survive.  

At 7am this morning, I purchased several sets of earplugs, thinking that the one's I use with my chainsaw might be a bit much and perhaps a tad embarrasing, at least for my 13 year old.    

Bring it on Metallica...I'm ready.
  

It is hard to believe, but it's that time of year again.  The earnings parade commences in earnest this week, with heavyweights Google and Goldman Sachs both set to report on Thursday. 

As we have said before, we believe that earnings reports will be particularly crucial both this quarter and next.  It is true that a great deal of earnings surprises over the summer months came predominantly from the cost side of the equation.  Now, six months after the market lows, we should begin to see some faint signs of revenue improvements as well.  If so, the earnings gains may be even more leveraged as margins expand.

We continue to believe that the economy is in recovery mode and that a focus on the more cyclical sectors of the economy will likely generate the greatest relative gains for portfolios over the next six to twelve months.  The Fed will likely remain on hold, but be biased towards tightening at the first signs of improving unemployment.

What could lead to an improvement in the unemployment rate?  Aside from time, increased production levels and continued, strong free cash flow generation should give companies the confidence to start hiring again.  We suspect that this phenomenon will become more evident by the spring of 2010.

Aside from these macro comments, a couple of other items caught our eye this morning.  First of all, Meredith Whitney downgraded Goldman Sachs to neutral from buy.  She has been very good with her calls and it will be interesting to see how the call ends up looking when Goldman reports on Thursday.  Second, TIPS (Treasury Inflation Protected Securities) have gained 8% this year while Treasuries themselves have declined 3%. This divergence in performance is one of the largest on record.  Bond powerhouses PIMCO, BlackRock and Vanguard have been big buyers of TIPS lately, suggesting that "smart money" is positioning for resurging inflation.

Finally, I have been watching the prices of many bank stocks in recent weeks.  This morning, I was amazed to see that the stocks of several higher quality banks like JP Morgan and Wells Fargo are only 10% or so off their all time highs.  Really?  Perhaps that is what a government guarantee can do for you.  But perhaps I ought not to be so quick.  There also appears to be a group of lower quality bank stocks like Bank of America that remain 50% off their highs.  

With a great deal of our quarter end activities now behind us, we hope to be blogging more regularly.  If you have thoughts or ideas that you'd like us to discuss, please throw them our way.