Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
Fourth Quarter: October 2010

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Through the Drinking Glass

Imagine a proverbial glass of water, filled to its mid-point. A pessimist looks at the glass and declares it to be half empty. The optimist looks at the glass and declares it to be half full.

On Wall Street, where optimists and pessimists not only abound, but love to bloviate on such questions, the pessimist would say the glass is not only half empty, but would remind us that factoring in evaporation, the glass will soon be completely empty, after which point we will all likely die of thirst.

Pessimist, Optimist, Economist

Their optimistic counterparts, who might have once tried to convince us the glass is actually full if you count the air and all, would now argue that the glass is so badly depleted that it requires a major new round of government assistance. Party on!

In Washington, the politicians would also want to weigh in, and tell us that the glass’ problems are the fault of the other party, as well as faulty engineering and oversight, and demand a full congressional inquiry into “Water-Gate 2.”

And Ben Bernanke might tell us that while the outlook for the glass is unusually uncertain, the Federal Reserve and Treasury stand ready to print more water.

Meanwhile, through the drinking glass and out in the real world, a pragmatist might ask, “is it enough?” and if not, set about getting more water, or finding another glass elsewhere.

And so we are often conditioned to think about the world, narrowly, and in binary terms – full/empty, good/bad, bull/bear, right/left, inflation/deflation - and often centered around the wrong question... or glass.

Without proper context, an overly simplified framework for understanding a complex question rarely produces a good answer. This is not to say that the glass doesn’t matter. It does, but we live in a dynamic world of multiple glasses and ranges of probable outcomes, which are themselves in a constant state of change.

The New Normal is getting old.

This binary view of the glass and the world economy characterized the financial markets over the past quarter as investors vacillated between hopes for recovery and fears of a dreaded double-dip recession.

The New Normal

Actual economic results have been mixed. Corporate earnings were strong, especially relative to expectations, but management guidance was guarded. We also saw signs of a growing divide between winners and losers, among companies and countries. Sovereign debt stresses flared up in Europe long enough to remind us that they remain just below the floorboards. In Asia, China and much of the developing world continued to show strength.

A Cruise to nowhere on the QE2.

It appears that domestic growth is slowing, although it is not yet clear that it will turn negative. But the slowing growth and persistently high unemployment are of sufficient concern that the Federal Reserve has indicated a willingness to reverse prior course and embark on a new round of quantitative easing, referred to as “QE2,” at some point in the near future, as conditions warrant.

The prospect of a voyage on the QE2 caused stocks and other inflation-sensitive assets to rally with anticipation. This is not a cruise that will end well in the long run.

History shows us that rising government debt levels produce diminishing returns in economic growth, and quantitative easing programs are not the trademark of a healthy economy but the desperate efforts of a sinking one.

Our own analysis of marginal debt and GDP growth since the 1960s shows this in dramatic fashion in Chart I below. Especially in the last decade. Japan’s experience has been similar. Both economies have to borrow increasing amounts of money just to stay afloat.

Chart I

“QE2” is an ironically appropriate name for this new round of Fed intervention. The fabled QE2 ocean liner that was purchased by Dubai World in 2007 at the peak of the credit bubble for $100 million to be used as a floating hotel, now sits sadly abandoned at Port Rashid. It is hard to believe that a journey of systematic currency debasement will end much differently.

Back on shore, companies have taken advantage of low interest rates to issue or refinance their debt, providing capital for acquisitions and stock buybacks. Corporate balance sheets are in far better shape than they were three years ago.

Perhaps this is just another typical quarter in the New Normal, as investors’ moods swing from being overly optimistic to overly pessimistic, only to be reminded that things are, at least in the near term, neither as good nor as bad as hoped or feared.

But economic data and market action are symptomatic rather than causal. Although markets will likely continue to swing between interpretations of a mixed set of data, the trends and forces that drive and shape the data are directional and enduring.

The central focus of our investment thinking is therefore to continuously evaluate the flood of information in the context of our strategic framework to reach sensible investment conclusions.

We devote the rest of this Commentary to walking through our current framework and outlook for the rest of the year.

Our strategic investment framework has four structural steps, which lead to the determination of our investment strategy. They are:

I) Major Trends
II) Shaping Forces
III) Current Conditions
IV) Investable Outcomes & Conclusions

I) Major Trends:

Major trends are just what they sound. Large, long-term trends that will drive and determine the shape of things to come. There are three that we think are particularly important:

Debt and Deleveraging of the Developed Economies.

The Ascendance of Developing Economies.

Networked Knowledge and innovation.

Major Trend 1: Debt and deleveraging of the Developed Economies.

The United States, much of Europe, and Japan have allowed public debt levels to grow to unsustainable levels relative to their economic output and ability to support the debt load.

For several decades, growth in public and private borrowing financed overall economic growth and consumption, including mounting public retirement, healthcare and benefits obligations.

The credit crisis of 2007-2008 and the European sovereign debt crisis of earlier this year are both symptomatic of this long-term escalation of public debt to an unhealthy and unsustainable level.

The resulting recession was not cyclical but more secular in nature, the end of one era and the beginning of a new one as nations struggle to deal with their mounting debt load.

Although nations can historically maintain high debt obligations for a long period of time, and each case is different, as we have shown, rising debt levels produce diminishing returns in growth and prosperity. Invariably, when debt to GDP ratios approach 90%, the debt needs to be devalued or restructured.

Rising debt levels also render an economy increasingly vulnerable to increases in interest rates, especially if the majority of debt is short term, as is the case with the United States.

Since 2007 the private sector has been in the process of deleveraging, but public sector debt levels have escalated to pick up the slack. So aggregate debt levels continue to rise.

Which leaves governments with only a few options. They can embark on austerity programs like the Greeks that are politically difficult and rarely sufficient to make a difference, or they can try to devalue the debt by restructuring it, or by devaluing their currency if they happen to have their own currency and easy access to a printing press.

Currency Devaluation for Dummies:

The problem with the devaluation option is that two or more can play at that game. If everyone tries it at the same time, the game ends badly with lots of nasty side affects, including a loss of faith and credit in any of the major sovereign currencies or their debt.

Major Trend 2: The Ascendance of Developing Economies

In August, BusinessWeek reported that China officially surpassed Japan as the World’s second largest economy. And yet China, along with Brazil and India are still regarded in the West as “Emerging Markets.” This is akin to calling a full-grown tiger, “kitty.”

As Chart II below shows, these tigers are large and growing rapidly. In the five years ending 2014 they will account for a third of global GDP growth, eclipsing the United States and Europe. In the following five years, they should account for almost two thirds of global growth. By 2025, according to IMF estimates, China will surpass the United States in GDP and by 2030, according to Goldman Sachs, China’s capital markets will eclipse those of the U.S.

Chart II

In these countries alone, there are close to three billion people looking to improve their standard of living. This won’t be a completely smooth ride. They will need access to abundant and clean power, safe food and water, clean air and adequate healthcare. China is already the largest consumer of many natural resources including food and metals. Competition for scarce resources will only increase in coming years.

But consider how far these economies have come how quickly and then think ahead. Consider China’s growing political influence and power, not only as an economic might, and a nuclear power, but also as our largest creditor.

Ironically, because they are still considered “emerging” there is a huge disconnect between their economic power and promise and most investors’ asset allocations, as reflected in Chart III below. Investor allocations are still predominately weighted towards the United States, and to a lesser extent, Europe and Japan. “Emerging market exposure often commands a mere 10% - 15% of a conventional equity asset allocation, with China, the number two economy in the world, representing a mere 2% to 3% of the overall allocation. As this disconnect is bridged over the coming years, it will involve trillions of dollars of capital being reallocated to developing economies.

Chart III

Major Trend 3: Networked Knowledge and Innovation.

A third powerful trend involves what we call “networked knowledge.”

Networked Knowledge has to do with the connection of people, ideas and knowledge, anywhere in the world, based on the following ideals:

  • All the world’s knowledge and collective wisdom available to anyone, anywhere, at any time.
  • The ability for any one individual or group of individuals to collaborate freely with any other individual or group of individuals, anywhere in the world.

Our hypothesis is that these factors are causing a dramatic change in how we behave and make decisions in daily life, and more importantly, is causing rapid increase in the rate of advancement and innovation, worldwide.

Although it is hard to measure, it is easy to see happening. Populations can go from limited access to communications and expertise to full broadband wireless access almost overnight. What would have taken months or years can be accomplished in days.

Networked knowledge also democratizes the flow of ideas – internet access is essentially free to all – and opens up a world of low-cost competition for formerly high value service jobs. It makes the world flatter, to paraphrase Thomas Friedman. Advanced mathematicians in India, X-Ray technicians in the Philippines and geologists and web designers in Russia can sell their services online for a fraction of the cost of local talent.

Meanwhile social networks like Facebook, knowledge sharing network sites like Wikipedia, and online retail networks like Amazon or eBay allow people around the world to create connections and share valuable information and experiences and conduct commerce in a way that was never before possible.

This is an especially powerful concept when one thinks how doctors, scientists and engineers around the world can work together on breakthrough technologies and to solve global problems, whether related to energy, disease, or the environment.

A powerful combination:

We also think that networked knowledge will have a multiplier effect on the growth of developing economies. However fast they would have grown without it, they will grow and advance faster with it. The learning curves have all been sped up.

II) Shaping Forces:

Trends never quite play out in a straight line. They are influenced by various “shaping forces” along the way. We have identified five that we think are important to consider as part of our framework.

  • Politics
  • Fiscal and Monetary Policy
  • Availability and competition for capital and natural resources
  • Demographics
  • Environment

The two that are worth commenting on at this point are politics and fiscal and monetary policy.

Politics:

In the United States, all eyes are focused on the upcoming election. The consensus is that Republicans will capture control over the House of Representatives and gain ground in the Senate, resulting in a blissful state of gridlock.

The stock market tends to react favorably to gridlock, because it means that very little will be accomplished – even less than usual – but especially nothing new that will be hostile to stocks, such as higher taxes and bold new regulatory reforms.

The problem is, of course, that we actually need for a great deal to be accomplished. The lack of progress is not progress.

Without this, we will find that our challenges only grow greater from year to year as the nation falls further in debt, and further behind competitively.

We will also run the greater risk of turning to the dark side of trade, involving competitive currency devaluation and protectionism. This path does not end well.

More than anything, investors and businesses need to know what the rules are with respect to taxes and regulations. As long as the cloud of uncertainty remains, companies and individuals will save rather than invest.

Fiscal and Monetary Policy.

The current political appetite for additional fiscal stimulus is small, except if in the form of an extension of current “Bush” tax rates, which we give 50% odds of happening before yearend. This means that the Federal Reserve needs to try to stimulate the economy through monetary policy. With short-term interest rates at zero, the Federal Reserve’s only other tool

is quantitative easing. Quantitative easing is tantamount to printing money and stokes the fears of inflation as well as a melt up in hard assets and stocks, at least for a while. It can also cause large ripple effects throughout capital markets.

III) Current Conditions:

Current conditions are shorter-term, tactical factors that guide our decision making and allow us to make tactical changes around a longer term strategy.

Valuation:

We do not subscribe to the “Fed Model” of valuation that suggests that the Price to Earnings Ratio of the stock market should be the inverse of the 10 year Treasury Bond Yield. That may be true under normal circumstances, but should not hold now, when Treasury Yields are being artificially depressed. If the 10 year Treasury yield fell to 2%, would you really want to pay 50 times earnings to own stocks?

That being said, Domestic and European equity valuation levels are reasonable, assuming that current levels of profitability are sustainable and we don’t revert into another downturn.

Asian equity valuations are also fair, presuming strong ongoing economic growth and considering that earnings are likely undervalued in dollar terms.

Domestic bonds are becoming overvalued in our opinion, especially factoring in credit risk and the inevitable devaluation of the dollar and rise in longer term interest rates. Shorter term corporate bonds offer the best value relative to return potential.

Foreign Bonds, especially developing economy bonds still offer attractive yields and a currency hedge against the dollar.

Gold and commodity valuations are extended in the near term, but should continue to appreciate against the Dollar, Euro, Yen and Pound Sterling over the long term.

Sentiment:

Investor sentiment has improved since the end of August as a result of economic data that was either better than feared or worse than feared but supportive of additional stimulus by the Fed.

We think there is a false sense of security at the moment in that some stock investors seem to believe they can’t lose. If things improve, the market goes up. If things get worse, then the Fed will step in with QE2 and the market will go up. A fly in this ointment is that if we do see a marked economic slowdown, investors will start to worry that Fed action will not help and that the Federal Reserve is “out of ammunition.”

IV) Investment Outcomes and Conclusions:

These are the major outcomes and conclusions that flow from our framework and process and drive our portfolio strategy, asset allocation, and investment selection.

1) Developed economies face years of slow growth and debt hangover. Higher taxes, austerity measures and currency devaluation are the only way out.

2) Developing economies continue to develop and grow, flex their muscles and become less dependent on developed economies.

We think the rise of developing economies is one of the single most important investment themes of our lifetime, and one we want to get in the way of.

3) Networked knowledge speeds up the rate of growth and innovation, especially in the developing world. Companies that empower or benefit from it should do well.

4) Stocks are starting to look less worse than bonds, barring a new deflationary downturn.

Many companies are in better shape than many countries and much better shape than they were three years ago. They have reduced costs, excess capacity and inventory and have refinanced their debt.

The earnings and dividend yields on some high quality stocks are more attractive than corporate bonds and considerably more attractive than Treasury bonds.

Over time stocks have the best ability to generate capital appreciation in excess of inflation.

Bonds by contrast are overloved and provide a false sense of security. Especially U.S. Treasuries.

Massive public debt and competition for capital ultimately lead to higher interest and inflation rates. A bad environment for bonds.

Shorter-term corporate bonds are still attractive.

5) Competitive currency devaluation and competition for scarce resources and capital give commodities long-term tailwind.

6) The Dollar is getting to be over-hated. It’s not that much worse than the Yen, British Pound or Euro. We wouldn’t be surprised to see the Dollar bottom against the Euro, just as it did last year when everyone hated it, right around November.

7) Major systemic risks remain. Debt and structural imbalances are getting worse and not sustainable. The recovery is built on shaky ground. Expect higher levels of volatility and outsized events.

Investment Strategy:

And so, rather than contemplating a simple world with a single glass and a binary outcome, we construct portfolios that account for ranges of outcomes, both short and longer term, and multiple glasses.

Based on all this what are we doing in client portfolios?

First, we are staying conservative in our overall allocation as the systemic risks remain high and our prime directive is to preserve our client’s capital. The first rule of making money is not losing it.

Second, we have slightly increased our clients’ exposure to equities with a strong leaning towards global growth. We have accomplished this with a focus on global multinational companies, technology companies, and a large allocation to dedicated developing economy managers.

Third, we have reduced and reallocated our bond exposure to emphasize shorter-term corporate bonds, conservative total return funds, and developing economy local currency bonds.

Fourth, and finally, we have also allocated funds towards alternative, lower correlation strategies that have smoothed out the performance of our clients portfolios.

Put all together, we are pleased with how this approach has helped the portfolios mitigate losses in declining markets while generating respectable returns in rising markets.

If you would like to learn more about our current Global Allocation Model or if you would like us to give your own portfolio a review, please do not hesitate to call us.

Jurika, Mills & Keifer.
October 2010

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.