Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
Third Quarter, 2007

The Debtly Hollows


And with a flick of his magical monetary wand, Federal Reserve Chairman Ben Bernanke restored liquidity, stability and confidence to the financial markets as they teetered on the edge of the sub-primal abyss.

The quarter started out well enough, with the S&P 500 index trading near an all-time high and with expectations for strong corporate earnings, which by and large came through as advertised. But towards the tail end of July, the markets and investors alike were vexed by news of distress among several major financial institutions with leveraged exposure to a witch’s brew of derivative securities. This fomented a viciously virtuous cycle of selling, margin calls and more selling and an overall seizing-up of the credit markets. Between July 19th and August 17th, the S&P 500 index lost over 8.2%. So much for the summer doldrums.

Enter the new Bernanke …

While the old Bernanke seemed much more concerned about the threat of inflation than the woes of sub-prime lenders, hedge funds or even homeowners, a new and improved Bernanke emerged on August 17th. . The new Bernanke established himself as a man of action, a defender of growth and most importantly, a friend of the stock market. He cast two spells, first lowering the discount rate to financial institutions in need and then lowering the federal funds rate by 50 basis points one month later. In both actions, he made it clear that he was in charge, understood the problem, and was ready, willing and able to provide relief.

The monetary stimulus provided an instant narcotic rush to investor sentiment, causing the stock market to rally more than 11% from the trough in August through the end of the quarter. Had you invested your money at the beginning of the summer and then gone away on safari or some other place without the benefit of 24-hour news, you would have returned to find your portfolio up 1.5%, but you would have missed all the thrills and chills in between.


He who must not be named:

You also would have missed the return of You-Know-Who. We are referring, of course, to none other than the formerly inscrutable Fed Chairman Alan Greenspan, who has reincarnated himself as a rather gabby and opinionated investment personality. With a new book to sell, he cast off prior inhibitions and filled the airwaves with fairly dour forecasts for the economy, unnerving many, but helping his book to top the charts at Amazon.

The Sub-prime Economy.

We have written for the past two quarters that we believe the problems associated with sub-prime mortgages and housing are reflective of a larger and more pervasive set of problems that will prove more challenging and take more time to resolve than is widely believed.

The same easy money dynamics that fueled the growth in sub-prime lending also provided easy financing throughout the rest of the economy without properly accounting for risk. There is a complex chain of cause and effect that plays out through time as the economy expands and as it contracts. This often takes years and tends to be a direct result of the magnitude and duration of whatever the excess. The market peeked during the bubble in March of 2000, but it took three years to hit a final bottom in February of 2003.

The markets welcomed the Fed’s 50 basis point reduction in the federal funds rate and are now making new highs despite a diet of negative domestic news. Perversely, bad news is good news in that it holds the promise of future rate cuts. But bad economic news also portends negative earnings revisions as companies take write-offs or report lower guidance to their forecasts.

W(h)ither the dollar?

Last time we checked, the dollar wasn’t doing so well relative to other currencies. Lower short-term interest rates don’t help to restore the dollar’s allure. They also drive up the costs of imported raw materials and finished goods. But they do make U.S. exports and assets more attractive to foreign buyers. The hope is that lower short-term rates will stimulate both growth and exports and set the stage for a stronger currency down the road. The fear is that easing monetary policy will be inflationary, and will ultimately lead to a significant increase in long-term rates as those who buy our government bonds to finance our burgeoning budget and trade deficits demand a higher interest rate to offset the likely loss in purchasing power of future dollars.

Perhaps the best thing that can be said for the dollar is that everybody seems to believe that it is going lower. Being good contrarians, when everyone starts to believe something, we start to question that belief. As U.S. assets become cheaper foreign investors will likely use dollars to buy them. We also think that Europe has its own share of challenges including slowing growth, high social welfare costs, an aging population and shrinking workforce. The current spread between the Euro and the dollar is likely overstated.

China is the new “Dot Com.”

Fortunately, against the backdrop of domestic worry, we have the enormous promise of the emerging economies of the world including Brazil, India, and China. And did we mention China? While the S&P 500 index is up 9.1% year-to-date*, the Brazilian (Bovespa), and Indian (Bombay Stock Exchange) stock markets are up 36% and 28.4% respectively*, and the Chinese Shanghai index is up a whopping 108%* including 45% just in the third quarter. It wouldn’t surprise us if it had gone up another 10% just since you started reading this commentary.

With a population of over 1.3 billion people moving their way up the economic ladder, and $1.3 trillion in reserves, the economic potential that China holds is even more staggering than its current might. China now provides an engine of global economic growth that is somewhat immune to our own problems at home. This has not been lost on investors who have flocked to any kind of company with “China” in its name, whether it be Petro-China, China Mobile, Aluminum Corporation of China, China Battery, China this or China that. It seems that if the company has “China” in its name, it’s up 50% to 100% since August (And we’re only being slightly facetious).

Just as putting a “dot com” in a company’s name was a surefire way to create instantaneous market value back in the late 1990s, executives of underperforming domestic companies, such as banks and brokers might consider putting China” in their name for an instant surge in market value. China Mortgage, anyone?

The China syndrome reminds us of the dot com syndrome of 1999. Investors were keen to put money into the bold promise of the Internet and any company that appeared to have a connection to the Internet, irregardless of business quality, fundamentals or valuation. The Internet wasn’t a fad and it didn’t go away. If anything it’s bigger than people imagined. But the future expectations that people placed on specific companies involved with the Internet were so lofty and unrealistic that their investment did go away, or at least suffered a severe decline in value. People are pouring money into Chinese investments in the same way. It has the allure of easy money, it seems disconnected from our problems at home, and who can argue with success? This can continue for a long time, but it won’t end well.

Please use the service entrance.

We think a much better way to invest in the growth in China and elsewhere in the world is through the service entrance. Specifically, by buying large, well-capitalized multi-national companies that sell into these markets. The majority of them are listed right here on Wall Street. They offer a wonderful way to participate in global growth at a reasonable valuation. They also offer diversification and, in many cases, a healthy yield.

We are particular fans of larger capitalization “growth” companies, especially in the area of technology, consumer products, healthcare, and even financial services. Growth stocks have underperformed value stocks since 2000 and small stocks outperformed large stocks between 2000 and 2006.

A belief in reversion to the mean suggests that the next investment cycle should favor growth over value and large over small. The fundamentals and valuations also support these conclusions. Until recently, oil and other raw materials have been a much better investment than computers and drugs, but economies that require massive amounts of raw materials also buy massive amounts of computers and medicine.

Larger stocks remain cheaper than smaller stocks and should be less prone to a domestic slowdown. They should also be less vulnerable to any contraction in the market price-to-earnings multiple, as either growth forecasts are reduced, or long-term interest rates rise. Finally, large multinational companies should offer a good hedge against a declining dollar as they derive a significant percentage of revenues in other currencies.

For now the stock market seems content with the belief that the global growth and a friendly Fed will prevail over any problems at home. Barring significant signs of either inflation or economic slowing — both of which we expect over the longer term — the near-term direction for stocks is likely higher.

Jurika, Mills & Keifer, LLC
October, 2007

*Returns 1/1/07 - 9/30/07

Important Disclosures

Past performance is no guarantee of future results.

Opinions expressed are those of Jurika, Mills & Keifer, LLC and are subject to change, are not guaranteed and are not recommendations to buy or sell any security.

Small and medium capitalization companies tend to have limited liquidity and greater price volality than large capitalization companies. Growth stocks tend to be more volatile than value stocks: however, value stocks tend to have a lower expected growth rate in earnings and sales.

The S&P 500 index is an index 500 large capitalization companies selected by Standard & Poors Corporation. The Brazilian (Bovespa), Indian (Bombay Stock Exchange) and China (Shanghai Stock Exchange) are leading indexes of major companies in each of these countries. One cannot invest directly in an index.

The Price to Earnings (P/E) Ratio reflects the multiple of earnings at which a stock sells.