Wednesday, May 14, 2008

A Visit to the Investment Committee

By Greg Donaldson, Mike Hull, Rick Roop, and Randy Alsman In our Investment Policy Meeting of two weeks ago we discussed a short list of important concepts to watch: The market appeared to be juggling three questions marks: 1) The Credit Crisis and its effect on US consumers; 2) The Strong Global Economy – could it last?; and 3) The Emerging Markets' ability to “decouple” from its dependence upon the US for their exports. Additionally, the spread between the 90 day T-Bills and the Fed Fund Target Rate carried important implications that banks still didn't trust each other. With all of the perceived risk present in banks, big money had parked their money in T-Bills for their safety, instead of in the banks, which had caused a pretty steady 1% premium of Fed Funds over T-bills, far greater than their average .20% spread. In mid April, 90 day T-Bill rates stood at 1.35% and Fed Funds were at 2.25%, still nearly 1% difference between the two, even after all the rate cuts and all the cheap money the Fed had offered the banks. It was very hard to believe that the 1% spread had not shrunk for going on 8 months. It was our thinking, as we have chronicled here, that closing this risk premium spread to a more normal level of near .20%, would signal that money was flowing back to the banks, and most importantly, that the banks were loaning money more readily to each other. That would also mean some normalcy was reemerging in the banks. In addition, such a narrowing of the spread between Fed Funds and T-bill yields would be a clear signal that the coast was clearing not only for the banks, but also for the economy, as well. Two weeks later, we see some change in these market movers: We think the market now believes that it can see the full extent of the damage from the Credit Crisis. The damage has yet to be totally absorbed, but the market acts as if it has an idea of the damage that is yet to come. And it is growing more comfortable that it is manageable. The market also knows these things: 1. The Fed rescuing Bear Stearns’ said to anyone who wanted to listen, “We will not let this economy (or markets) go down the tubes.” 2. Q4 2007 write-offs by most major banks were massive, and Q1 2008 write-offs probably went beyond what will ultimately be lost. 3. The banks have very easily replaced the lost capital resulting from the write-offs. Issuing new capital has been expensive, but with all the woes in banking, there was no shortage of investors both big and small who were willing to pony up more money. (We have seen issues of many of the new-issue bank preferred stocks rise in price since they came to the market.) 4. The first release of GDP data showed the US economy grew (albeit modestly) in Q1. And, we expect that small growth number, 0.6%, to be revised higher when the just-reported increase in Net Exports get factored in. 5. The unemployment data simply has not been as bad as most would have expected this far into an economic slowdown. 6. Inflation has remained under control. 7. Finally, the market has moved away from the Consumer Staples stocks, implying it is ready to leave the safety, consistency, and predictability the staples offer and move more toward growth.

8. Corporate earnings ex-financials rose by nearly 10%, a very welcomed surprise. While a slowing US economy will impact the rest of the world’s economies, the strong global economy seems to remain on track. Additionally, there is evidence that the emerging markets are continuing to decouple from their dependence upon the US. As we said earlier, historically, 90-day T Bills have traded at a 0.20% spread below the Fed Funds Target Rate. During the last two weeks, the 90-day T Bill has moved from 1.35% to 1.81%, almost exactly 0.20% below the Fed Funds Target Rate of 2%. This would indicate that the big investors believe that a level of peace has returned to the valley, thanks to the quick and creative work of the Fed. Given everything spelled out above, very low interest rates (long and short), and an economic stimulus package just now being mailed to taxpayers, it looks as though the coast is becoming clear for stocks to move higher, perhaps significantly higher. The one big bugaboo in the economy right now appears to be rising petroleum prices. Our discussion seemed to have arrived at the point that consumers are already finding ways to adapt to high gas prices and they will continue to pursue others. We will all be on the watch-out for continuing evidence of this theory.

We believe it is time to nibble on a short list of beaten down stocks that generate a large percentage of their earnings overseas. Since we have not bought them all yet, we will not name them, but the Industrial Sector still looks very strong to us.