Long and Winding Road. The much awaited economic recovery remains much awaited. Unemployment remains high at 9.5% and housing remains weak (although it perked up a little in August). Simply put, the economy continues to stagnate at best as rising commodity prices bewilders the smartest economists during a period of weak numbers. The double dip recession fears are waning as Warren Buffett recently stated the economy was improving. Federal Reserve policy remains in a quandary as weakness prevails though commodities have risen this year. The vociferous appetite for raw materials by the Chinese and Indian economies is crowding out US manufacturing pushing up costs for US corporations. Stagflation was very popular in the 1970’s as it capitulated in 1980 driving Treasury yields to double digits. It would be hard to imagine 14.5% on the 30 year bond as yields continue to be significantly below 5%.
A Hard Days Night. The commercial banking system is slowly being repaired and financial leverage lowered. Constructive discussion is being conducted regarding capital requirements for banks. Unfortunately, the community banks have been hit hard as the Federal government attempts to implement Glass-Stegall-like regulations. From 1935 to 1999, the Federal Reserve dictated levels of interest rates and banking did ok. Re-regulation is necessary as banks should never have been merged with investment banks. History does repeat itself. Banks should not be able to underwrite securities. Banks should not trade against its clients. Banks should not issue financial derivatives that are impossible to understand, especially those that take equity value away from American homeowners. Banks should hold deposits and make good loans to small businesses and consumers.
Helter Skelter. The stock market has started and stopped so many times this year reflecting the volatility caused by professional traders, hedge funds and computer driven trading platforms. Longer term prospects for higher stock prices look much improved as short-term interest rates remain low. Alan Greenspan kept interest rates below 1% for thirteen months from 2002 to 2003. Ben Bernanke remains steadfast to keep short-term rates low until some measurable improvement occurs for jobs and housing. Economic recovery takes time especially when so many manufacturing jobs went to China and India. We believe that it will take another eighteen months before we can say the economy is growing significantly. Government programs have benefitted some but small businesses remain the engine for economic growth. We look to some tax relief in the form of expanding tax credits for job creation and added deductions for small businesses.
Maxwell’s Silver Hammer. While on the subject of stocks, we still favor those companies that benefit from rising inflation. Financial assets do not fare well in inflation. Fixed income is less attractive during inflation because it reduces the investment return after inflation. Hard assets, including commodities and real estate, appreciate during inflationary times. Currencies in general lose their buying power during inflation times. So, for stocks, inflationary times are very challenging. In the late 1970’s, small capitalization stocks out-performed large capitalization stocks by 400 basis points per year from 1977-1980. High yield bonds do well during inflation as cash flow improves for these issues and bond ratings improve during inflation.
Lucy in the Sky of Diamonds. Structurally, the world’s central bankers have decided to unofficially adopt a gold standard. Gold standards have never worked on a long-term basis. But, from time to time, the bank reliquification process requires an extended period of inflation in order for banks to charge higher loan rates in order to survive. Since Bernanke has been staring down the barrel of hyper-deflation for the past two years, he is willing to accept modest levels of inflation. Like any other policy, it will only come to end once interest rates are higher and commodity prices much higher. Gold is trading at an all time high of $1300. The sheer magnitude of gold ETFs and gold funds will push prices even higher as gold is rare and the money going into the commodity far exceeds the existing supplies.
Let it Be. The oil business remains very attractive longer term. Short-term supplies are ample and should see some price weakness during the current quarter. The price equilibrium appears to be in the range of $70 to $80 per barrel as the Baker Hughes Rig count number has increased dramatically from twelve months ago. For the immediate future, we would not be making new investments in the energy business.
Strawberry Fields Forever. The pharmaceutical industry continues to be attractive as companies continue to acquire smaller companies to obtain new drugs to their pipeline. Historically, these companies trade at significantly higher PE ratios than they presently trade. The market is continuing to adjust for new health care legislation which will be implemented over the next three years.
Penny Lane. The housing industry remains anemic at best as housing starts continue to sputter just above 500,000 per month. During better times, the housing start number is usually around 1.5 million per month. With foreclosure rates remaining high, we believe that Washington will eventually get it right for Fannie Mae and Freddie Mac to free up the mortgage market. Creating a true Resolution Trust Company that takes the bad assets into an organized auction company and keep the good mortgages in another company makes the most sense. Congress can implement new tax credits that attract all buyers to the housing market.
Ticket to Ride. We favor small to mid capitalization companies over large companies during the current environment. Companies with lower price earnings ratios, dividend yield and company buy backs will be more favorable for investing than higher expectation companies. The market truly is very bipolar as a select few companies have done very well this year, while the remaining companies have moved sideways since the bottom which occurred in 2009. The recent rally in stocks during the month of September should improve sentiment as short-sellers were active in late July pushing the number of shares short to record highs.
Roll Over Beethoven. Cash is king as some $4 trillion is in bank deposits and money markets. The success in the bond market has attracted cash away from the stock market as well. The bond bubble will not last forever. Comparisons have been made between the US market and Japan in 1991. The lost decade of investments is now entering into the second decade. We believe that the stock market will surprise the bears and provide better investment returns than bonds over the next three years.
We Can Work It Out. We continue to perform our analysis to provide good investments for your portfolios. We attempt to make long term investments and avoid the perils of short-term trading. The market has done reasonably well despite the negative tones in the media. Any worldwide economic recovery should positively impact our financial markets. Should jobs return from overseas to the US will also contribute to better investment returns in our stock markets.
We remain steadfast in managing your assets. We appreciate your confidence in us and hope that you communicate to us should your investment objectives change.
Russell L. Robinson
Robinson Investment Group
5301 Virginia Way, Suite 150
Brentwood, Tennessee 37027