March 2011

"Never make predictions, especially about the future."
Casey Stengel

We at Talbot Financial are aware that wealth is not usually destroyed….wealth moves. Successful investors position their capital ahead of the flow of funds.

The majority of 2011 forecasts can be classified as either “2010 lite” or “2010 juiced” since it is safe to assume that past will be prologue.

Our advice is to not take comfort in these majority views…the crowd is most often wrong.

With that said, let’s set the stage for 2011.

First, the positives…

  • There is incredible positive momentum behind worldwide economic growth and expansion. In particular, most nations east of the Middle East continue to show strong metrics. China is not going back to third-world status. The same can be said for many South American countries. The world’s rising middle class will demand (and be able to afford) better water, food, housing, appliances, and consumer goods.
  • Next, the US Federal Reserve , and other International Central Banks have made it clear that they stand ready to intervene and “backstop” (some say manipulate) any threat of a substantial market fall. Plus, the Fed has made borrowing extremely cheap. Smart CEOs have taken advantage of this and rolled higher interest debt into lower interest rate debt. Having the Fed as your ally is profitable and historically, “fighting the Fed” has proven to be a loser’s game.
  • Politically, Republican control of the House of Representatives ensures a “grid-locked” US government thereby minimizing the chances of major tax or regulatory changes. Many corporations are cash rich and may now feel emboldened to deploy some of that cash by increasing dividends, expanding, hiring, and/or mergers and acquisitions.
  • Valuations are “reasonable” and dividend yields are rising. Many blue chips stocks have P/E ratios below 15 and are paying over 3% in dividends. This is very attractive in a zero interest rate environment.
  • Cash on corporate balance sheets is at record levels, and has earned virtually zero over the past two years. 2011 should be the year corporations put some portion of these funds to work or return it to shareholders via rising dividends or stock buy-backs.
  • There are now routine, but still incredible, technological breakthroughs that we have become accustomed to seeing in communications, data processing, healthcare, bio-tech, energy, & pure science. Billions of people are now linked world-wide via the Internet and are sharing ideas daily. People are not getting dumber, and tech advances are occurring at dizzying speeds.

Do not underestimate the strength of these mega-trends. Look at the following short list of negatives that occurred in 2010, and yet the world GDP grew for the 10th straight year, and US markets closed with strong double-digit gains.

  • Massive earthquakes---Haiti, Chile, China, New Zealand
  • Drought—Asia, Russia and Australia
  • Volcanoes---Iceland and South America
  • BP oil spill
  • Trillion dollar QE2 established to bail-out the US government
  • Euro Crisis and resultant riots/civil unrest—Greece, London, France, Ireland
  • Financial Scandals on Wall Street—Madoff, Robo-signings, et al.
  • Wars and rumors of wars—Afghanistan, Iraq, Korea, mystery missile off LA
  • Rising tensions—China vs. US, Iranian nuke program, Israeli and Sunni fears
  • Weak US economic recovery….seemingly disconnected President
  • Record deficits & debt at all govt. levels---Federal, State, City
  • Political turbulence--Congressional turnover
  • Record home and commercial property foreclosures
  • Accelerating small bank closings
  • Persistent unemployment and pervasive under-employment

As daunting as that list seems, the reality is these types of events occur in one form or another almost every year and the world keeps spinning….and companies keep growing. It is the companies that adapt and change fastest (and best) that succeed.

So, as an investor, the trick is two-fold. First, correctly anticipate the macro events that will shape 2011; and then, commit to the investments that will benefit most from the change.


So, let’s start with a broad brush and then get to specifics.

Broadly speaking, we believe government policy “successes” in 2009 and 2010 planted the seeds for some problems in 2011.

Unfortunately, governments will misinterpret the suppression of troublesome economic symptoms (via money printing and increased programs/regulations) as the cure.

We believe that the US Fed has misidentified a solvency problem as a liquidity problem. Thus, the wrong economic prescription has been applied.

Government action merely delayed the rebalancing that needs to take place; and, in doing so, made the inevitable rebalancing more difficult.

For example, we all know the US Federal Reserve printed hundreds of billions (over a trillion?) dollars and yet there was no immediate rapid rise in inflation. Thus, the Fed seemingly believes it can continue to print ad infinitum to fill gaping holes in the banking and government sectors without consequence.

History and common sense dictate otherwise.

For a moment, try to consider QE1 and QE2 the way a physicist would view potential energy.

Pouring gasoline on a pile of dry wood doesn’t appear to do much. You can even add more wood and gasoline with no effect. But, add a spark. Suddenly, all that potential energy becomes very real.

It is the same with money printing….all can seem fine until the spark. And, the spark could come in several forms---a failed US Treasury auction, war, a repudiation of the dollar as the world’s reserve currency, etc. And our leaders will say, “It came without warning! We didn’t see it coming!”

And even more disturbing, Fed Chairman Ben Bernanke says he is 100% certain (his words) that he can control the inflation conflagration should it occur. This comes from the man who did not see the dot com crash, the housing bubble, or the 2008 financial crisis. We are not reassured.

And this is not a “US only” phenomenon. The European Central bank continues to be schizophrenic in its treatment of member states, demanding austerity measures from the people, but rewarding fraud and incompetence by the banks with freshly printed money as needed.

Sound familiar?

In the east, China continues to build “ghost cities” and is pursuing extreme mercantilist policies so as to alienate its trading partners and simultaneously blow domestic banking and real estate “bubbles” that are likely to pop….but when?

And, despite a 20-year bear market, Japan has yet to address its debt, banking, or demographic problems. Japan’s answer is to continue to carry failed banks and add more debt.

The point is Asia cannot continue its mercantilist policies in extremis and the West cannot continue to live under the illusion that it can tax, borrow, spend, and consume its way to wealth.

In short, governments world-wide have distorted natural market forces and 2010 gave us a clear indication that cracks are showing.

The good news is, things that can’t go on… won’t. Policies will change. The distortions will be addressed—either proactively or reactively--and this will lead to investment opportunities.

Thus, here are our twelve macro-trends for 2011. Interspersed throughout the trends we will give a quick analysis and an occasional specific investment recommendation. This will give the reader insights into how we think and how we act.

  • The Euro will cease to exist as it is currently structured. A new “Nordic” Euro will be formed...anchored by Germany. Fiscally conservative countries like Finland, Austria and Holland will join. Italy, Portugal, Greece, Ireland, Belgium, and Spain will be jettisoned. The “crisis in Spain” will be the triggering event. Those countries will either unite under a “Latin” Euro or revert to their old currencies. In either case the so-called PIIGS (plus Belgium) will, devalue, default, and start over. Standards of living in those countries will fall; civil unrest will be the norm for a while--- and then exhaust itself as a new reality sets in. “Nordic” countries (along with US and Asian buyers) will buy “Latin” assets at deeply discounted prices.
    • An unfettered Germany will emerge stronger. Large, multi-national, German companies with strong balance sheets will succeed first. Their market shares will grow. They will have the opportunity to acquire weaker competitors at likely discounted prices. Investing in these firms now, while the Euro is in crisis, makes sense.
      • E.ON is a $60 billion German/European electric utility (that is also a leader in alternative energy) that pays a 6% dividend with a P/E ratio under 8. We believe this company will come through the Euro crisis stronger.
  • The dollar will begin to “share” its reserve currency status with an informal basket of currencies. Bi-lateral agreements that by-pass the dollar (such as the one China and Russia recently reached) will increase. OPEC will embrace trading oil in currencies other than the dollar. Thus, the dollar will fall against Asian currencies and natural resource based currencies.
    • As the dollar falls, economies that produce wealth and have a positive balance of trade will outperform service-based, debt-laden economies. These wealth producers can be defined as either manufacturing based or natural resource based economies. Companies that own wealth-in-the ground or manufactured-wealth for export will be winners. Service-based companies without go-to products (or pricing power) will struggle.
      • Freeport-McMoRan has been a Talbot Financial holding since June of 2010. Although it has already posted significant gains, we believe this world leader in mining and minerals will continue to outperform the markets and benefit from a falling dollar and growth of emerging market economies
  • Rising interest rates and the rising cost of entitlement programs will off-set increased tax revenues and any discretionary spending cuts that come through a more conservative Congress. Federal deficit numbers will continue to grow and “shadow quantitative easing” will go unchecked….meaning the Fed will monetize the debt via direct US Treasury and municipal debt purchases. City and State governments will request pension fund bail-outs citing AIG, GM, and the Too-Big-To-Fail precedent. All of these factors will pressure the dollar down.
  • Inflation will “surprisingly” reappear world-wide. “Stagflation” will be the in-vogue term for the US as unemployment stays uncomfortably high and the commodity price increases of 2010 work their way onto grocery and retail shelves. The falling dollar will also push up prices on most imports…..particularly oil and products from Asia. Clothing prices will rise for the first time in years.
  • International and domestic bond markets will suffer convulsions as currencies fluctuate wildly based on the “political economy” that governments seem keen on imposing. Interest rates will rise and the yield curve will steepen as the 30-year bull market in bonds exhausts itself.
  • Stock market volatility will increase as government intervention competes with free-market forces in the “price discovery” process. The result will be more tension in the markets as investors try to determine what companies are experiencing real organic business growth and what companies are experiencing artificially stimulated government growth.
    • The surprising upshot of sovereign debt uncertainty will be that well-run companies with solid management and “must have” products will be perceived as safer investments than some government backed instruments. Capital will thus flow to corporate stocks (and eventually bonds---depending on how inflation is managed) as investors will perceive the private sector as more honest and transparent than the government sector.
    • In 2011,“feathering into” companies on dips with the following characteristics will be profitable:
      • High dividends
      • Low debt
      • Large international sales/reach
      • Low PE ratios
      • Sell “must have” products
      • Small-Medium sized firms targeted by large, cash-rich, multi-nationals for take-over.
        • Although currently unloved, Microsoft fits 5 of the 6 categories. The firm is cash rich, has little or no debt, has huge international reach, a low PE, and a “must have” product. The stock has been moribund for years, but we expect positive changes at MSFT this year and believe the stock will outperform the market and increase its dividend.
  • US gasoline prices will go over $4.50/gal. Increasing global demand coupled with a declining dollar and “flat” supply will lead to “oil shocks.” Any increase in Middle East tensions will exacerbate the situation.
    • Energy and oil service companies that were over-punished in the wake of the BP oil spill will post record profits. Mid-level producers/ and explorers with proven reserves will become take-over targets. Big oil companies, (be they US or overseas-based) based will benefit and dividends to investors will rise. Alternative energy, uranium, and natural gas companies will also be star performers in 2011.
      • Hess Corporation is mid-sized, integrated oil and natural gas company with E & P (exploration and production) operations on 5 continents. Hess continues to be led by 84-year old founder John Hess. A possible take-over target, Hess has a PE of only 10…despite significant gains in 2010. (Talbot acquired shares in Hess 2008 and 2009.)
  • The world will increasingly become aware that the US and China (along with their proxies) are engaged in asymmetric warfare. China and Russia will continue to work to undermine the dollar as the world’s reserve currency…with some success. China will also continue to hedge and disgorge its massive dollar holdings via alternate currency and natural resource purchases. The US will continue to “muscle” China using its advantages in technology, military strength, and finance. Tensions rise.
    • Defense (and defense technology) spending will shift. Firms dependent on operations in Iraq and Afghanistan for profit will suffer. Firms that can offer “power projection” cheaper and more efficiently will be winners.
      • Northup Grumman has $78 billion worth of backlog contracts. Over the last 6 years it has tripled its earnings per share and has doubled its dividend since 2003. The company has secured additional contracts during the Obama Administration.
  • The US real estate market will not turn around, and in fact, grind lower due to higher interest rates and a massive inventory overhang. Prices will bottom when purchase prices are 15-20% below construction costs, which could still be a few years out. Unfortunately, higher lumber, copper, and building material costs will offset lower labor costs thereby putting a “hard floor” under construction costs.
    • There will be incredible (once-in-a–generation type) opportunities in “pre-foreclosure” real estate as desperate “owners” and banks face reality and purge bad loans at fire-sale prices. While the doom-and-gloom around real estate is palpable right now, it is remarkable how quickly this illiquid asset can change “investment wise”. Those who can lock-in costs now (before inflation rates rise) will find themselves sitting on cash-flow gold mines for years to come.
  • Cities and States are pack-rats; they acquire assets, but rarely sell. They also overpromise with respect to benefits and services. Rising overhead costs coupled with untenable labor agreements will lead to an increase in municipal bond defaults. Cities and States will begin to renege on promised pension benefits. This will not be the hundred billion dollar disaster that celebrity-analyst Meredith Whitney predicts, but will exceed the old $8 billion default record of 2008. The US Fed will contain the damage by direct purchase of municipal bonds with Congress’ tacit approval.
    • Cities and States will be forced to sell assets and to outsource services to balance their budgets. Privitization will become a necessity. Companies that acquire lands, properties, and contracts-for-service will benefit.
  • Gold will likely trade over $1650/oz. and silver likely over $50/oz. as a classic short-squeeze on the COMEX materializes. The falling dollar, coupled with rising inflation, will provide a floor under precious metals (PM) prices. Asian demand will also fuel PM growth.
    • The “easy trade” of investing in gold and silver ETFs, will not be the answer in 2011 as many of ETFs will be shown to be investing in “paper” silver and gold. Getting “physical” will no longer be considered the domain of the “gold-bugs” or “nuts” as Asian buyers in particular demand delivery from suspect custodians. ETFs that can prove non-fractional precious metals ownership will trade at increasingly high premiums. Operational precious metals companies (with large proven reserves) will perform well and mid-sized producers will be take-over targets as the industry begins to professional-ize and consolidate.
      • Investors wishing to participate in the precious metals markets should avoid SLV and GLD which operate in some part by using “paper” gold. CEF, PSLV, and PHYS are all ETFs that hold the physical metal.
  • Derivative problems will once again surface at the To-Big-To-Fail (TBTF) banks. Investigations will focus on bogus accounting and rating methods. It will become common knowledge that the Fed (via FNMA/FRE) continues to bail out the TBTFs with massive “pennies on the dollar” mortgage settlements. This will be tantamount to “shadow” QE programs designed to aide banks and governments.
    • The rally in financial stocks will falter as populist outcry over “hidden” bail-outs becomes too much for the Fed, or the Congress to bear. Moreover rising inflation rates will give voice to critics of current Fed policy. Financials will underperform and capital will leave the sector seeking safer havens in low-tech, less “sophisticated” sectors like energy and agriculture.

We do not want the above to seem overly gloomy. We recognize that that had we been clairvoyant enough last January to predict the negatives of 2010, you would have hidden your money in a mattress…and then missed an incredibly profitable year.

As we said at the beginning of this missive, wealth is not destroyed….wealth moves. And remember Mark Twain’s quote,

“Whenever you find you are on the side of the majority, it is time to pause and reflect."

Thus, our advice is to think independently and team with someone whose judgment and experience you trust. In that way you will “keep your head” when others don’t, and will be able to take advantage of the many opportunities that will present themselves in 2011.

(Note: Specific investment advice is reserved for clients. To become a client, call 425-533-0797 and ask for Greg)

 

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