Counterpoint — A Commentary of Jurika, Mills & Keifer LLC
Second Quarter: April 2011

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What, Me Worry?

This ironic motto routinely uttered by Mad Magazine’s eternally optimistic mascot, Alfred E. Neuman, usually in the face of formidable adversity, could also be the motto for the U.S. stock market.

In our last Commentary “The Good, the Bad and the Ugly” we wrote that the positive forces in the economy – specifically global economic recovery and innovation - were strong enough to outweigh the negatives, including Sovereign Debt, inflation and geopolitical risk.

What, Me Worry?

Since that time, the world away from Wall Street took a turn for the worse. The spreading crisis in the Middle East and the tragic trio of disasters in Japan are the two most visible negatives. But the resurgent debt saga in Europe, the rising tide of inflationary pressures around the world, and the growing battle between loose and tight monetary and fiscal policy are also significant challenges to confidence and recovery.

So far, after a few setbacks, the U.S. stock market has managed to maintain it’s “What, me worry?” attitude, shrugging off these and other challenges and moving higher; posting its best first quarter since 1998.

We still believe that for now, the force of domestic recovery, fueled in part by an ongoing dosage of fiscal and monetary stimulus, is enough to maintain forward economic momentum and generally rising stock prices. But the headwinds are greater, and the time of stimulus is coming to an end.

Given overall valuation levels, and what we perceive as general complacency about these problems and their long-term impact, the recovery and financial markets are more vulnerable to these and further shocks.

We have therefore adjusted our client asset allocation to a more cautious and defensive position than we held in January.

These challenges have also shifted the investment landscape somewhat, including the outlook for energy and other commodities, currencies and interest rates, and how we choose to allocate client assets around the globe.

We continue to find the most attractive investment opportunities in large capitalization stocks, especially those with a global focus involved with technology, capital goods and consumer products. Many of these companies have large cash reserves and offer attractive dividends and represent a better store of value and source of potential return than government bonds. There are also a number of very good companies that have fallen out of favor with investors for a variety of reasons and offer particularly attractive value relative to risk.

Commodities, including gold, precious and industrial metals, food and energy continue to attract investor assets, primarily as a hedge against inflation. Although this is a consensus investment thesis, as long as global growth and/or loose monetary policy rule the day, it should be one that keeps working.

Similarly, there is a consensus opinion that interest rates of developed nations must eventually rise. Barring a new deflationary spiral, this almost certainly has to be the case, especially now that the main marginal buyers of U.S. Treasuries, including the Chinese, the Japanese, many notable bond managers and the U.S. Treasury itself, are all in the process of curtailing their investment in Treasuries, while the supply of new Treasury debt to be issued continues to climb.

The Recovery.

Chart I

The good news is that the near-term economic trends continue to improve along multiple fronts. Industrial production, durable goods orders and capital investment and spending are still growing at a healthy rate. The ISM Manufacturing index, shown in Chart I above, a sign of business confidence and activity is at record levels. The Economic Council of Research and Investment (ECRI) index, which is a broad index of economic inputs is also near record levels as seen in Chart II below.

Chart II

Consumer confidence and retail sales are also strong. Corporate profits and profitability are at record levels.

Employment and housing remain the two most significant problem children of the recovery.

Employment has bottomed and is on the upswing, but as Chart III shows, between peak and trough, our economy lost close to 9 million jobs. Monthly non-farm payroll results show that we are now adding over 200,000 jobs a month, which is in line with historical averages, but at this rate, it will take almost four years to replace all the lost jobs.

Chart III

Housing, which was the area of greatest excess in the credit bubble, will also have a long recovery as the economy absorbs years of excess home building. Housing will also depend on employment since people need jobs and steady incomes to buy homes.

Exporting Inflation.

Concerns about inflation are on the rise, fueled by a perceived imbalance between the growing demand for commodities relative to available supply, and by the systematic devaluation of the dollar; the currency in which most commodities are priced.

Although we are most certainly seeing a rise in inflationary pressures in this country, the greater problem lies abroad. As Chart IV shows below, the broad-based Consumer Price Index (CPI) shows a modest increase in inflationary pressure, but the rate of change is still far below where it was before the credit crisis. The CPI measure is often criticized as a useful tool because it gives much greater weight to wages, rent and durable goods such as cars and appliances than it does to input costs like food and energy. There is a good reason for this since in the United States, as much as people lament about the cost of food and gas, they spend a greater proportion of their income on mortgage, rent or car payments than they do on groceries and gas. So while inflationary pressures are on the rise here, and are even starting to get attention from the governors of the Federal Reserve, at current levels they are currently less of a problem than they are perceived to be.

Chart IV

Conversely, they are a greater problem than they are perceived to be in other countries, especially in less developed nations that have to import and pay for their resources in dollars, and for whom food and energy represent a large portion of discretionary income.

It was the sudden rise in food prices that sparked the riots in Yemen that led to the riots in Egypt that then started to spread throughout North Africa and the Middle East.

It is the fear of inflation that has the Chinese Government concerned about rising food and materials prices relative to employment and income levels.

It is the fear of inflation that is leading the European and other Central Banks to start raising interest rates while the Federal Reserve maintains its policy of low rates and Quantitative Easing. Although these two policies may help our own economic situation in the short-term, they do create inflation as a side effect and the consequences of this policy are likely to have much greater impact on other nations than they do on ours. Inflation is becoming one of our leading exports and is sowing the seeds of global instability. We need to be mindful that in a closed-loop system like the global economy, what goes around comes around.

The Paradox of Crisis.

On a final note, in our experience, events like the Japanese earthquake/tsunami/nuclear disaster and the conflicts in the Middle East, tend to create a paradox of crisis, where things are both better and worse than they seem. By this we mean that the near-term drama tends to get blown out of perspective, while the longer-term effects are under appreciated. There are almost always unintended and unimagined consequences as the chain of cause and effect works its way through the global economy and capital markets. This process often takes weeks and sometimes months to be fully understood and properly discounted in asset prices.

A year after the British Petroleum oil spill in the gulf, offshore drilling and exploration activity in the United States has been greatly curtailed, resulting in a greater reliance on imported oil from the Middle East.

After Japan succeeds in neutralizing its Fukushima nuclear plants and stemming the flow of radioactive waste into the air, ground and ocean, the process of rebuilding will begin. But this rebuilding will be financed by an economy that is already overleveraged and vulnerable. The full impact of the Japanese earthquake and tsunami may not be known for years, but given Japan’s prominence in the global economy and critical role in the global industrial supply chain, not to mention its demographic challenges and high levels of indebtedness relative to GDP, the longer-term risks are significant.

Similarly, while we have no special insight into how events in the Middle East will play out, we are quite certain that they will not resolve themselves quickly. There will be a higher level of uncertainty and instability for “an extended period of time,” as the Federal Reserve likes to say. There may be positive outcomes including democratic reform across the region, and a renewed focus on alternative energy sources such as natural gas, wind and solar.

But these changes will happen slowly. In the mean time, we expect high energy prices to endure.

Putting it all together:

And so as we put it all together, we see a world where the recovery is likely to continue, but where the overall risks and challenges to it have increased, while general stock prices have risen as well.

Some of these challenges are almost certain to work their way into the first quarter earnings reports and guidance of companies, which will begin shortly. We will likely hear of rising input costs, shrinking profit margins, and disruptions to company supply chains.

Other challenges, such as European sovereign and U.S. municipal and federal debt remain large problems without easy solutions. European bond rates have risen sharply since the beginning of the year, even in Germany. Rising interest rates and austerity programs are not positive for global growth.

Given that current stock valuations are still above where they were at the beginning of the year, we are concerned that expectations have moved ahead of reality and are not comfortable taking a “what, me worry approach” with our clients’ assets. We are much more biased towards erring on the side of caution, while still maintaining a sensible long-term allocation to the global capital markets.

We continue to favor large capitalization, high quality stocks, primarily in the technology and industrial cyclical sectors, as well as global consumer franchises.

After reducing our exposure to emerging economies stocks earlier in the quarter, we have added back some during the recent market downturn.

We are maintaining a meaningful weighting to gold and industrial, agricultural commodities and energy.

The more defensive portion of client portfolios are invested in domestic bond funds focused on shorter maturity corporate bonds and developing economy bonds.

Finally, we are maintaining a cushion of cash as we evaluate new opportunities.

Perhaps, like Alfred E. Neuman, there is nothing to worry about, in which case stocks should have smooth sailing ahead. But we think the odds favor a more cautious approach for the time being.

Jurika, Mills & Keifer
April 2011.

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.