May You Live in Interesting Times

Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

Economist CoverWith the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

SPY is oversold

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.

Happy New Year

I hope that everyone is enjoying the festive season and taking advantage of this period to spend time friends and family.

New Year Thoughts

I am cautiously optimistic about 2011 but in the developed markets we still have wounded banks and governments with huge financing needs while in the developing world, excess money is putting pressure on inflation, interest rates and asset prices. With Europe’s problems largely out in the open for all to see, the next area of concern is the world’s second largest economy, China.

The story this year will most likely turn out to be about rising interest rates. Now that the worst of the Global Financial Crisis has been laid out for all to see, expect fixed income investors to climb out of their fallout shelters and start demanding a bit more interest. The market for capital is truly global so a sluggish US economy may not be enough to keep the bond vigilantes at bay. Central Banks will “lean against” the trend but there is little that even the Fed can do to keep interest rates at their current low levels.

Adding extra space in the Portfolio Management feature

If you have logged on lately, you will notice that we have added two more portfolios for you to store tickers on the Portfolio Management feature. This is in response to several requests that we have received from customers who would like to check several different portfolios without having to retype the tickers. While theoretically this feature should be able to support unlimited portfolios and unlimited tickers, in practice we are limited by bandwidth and other factors to four portfolios that you can select and three that we will recommend. Unfortunately, our attempts to increase the number of tickers beyond 20 at a time resulted in unacceptable levels of instability. Therefore, that part of the expansion will be put on hold until we can code our way around the problem.

Please keep the comments coming as this helps us to focus our efforts on the areas that you feel most useful.

Seeking Alpha Portfolio

Although I should have anticipated it and added plus one or two to the ‘tweak’ on the Seeking Alpha Portfolio, we have another switch this week. Turkey (TUR), which has been a turkey since we started the portfolio, has finally dropped out and made room for the Taiwan ETF (EWT). For the record, we sold 130 shares of TUR at 66.04 for a net loss of $1163.80 on the Monday close. That got us 550 shares of EWT at the price of 15.18 which leaves our cash position at $620.75. For the week, the portfolio climbed back 0.93% so we are still down 5.99% from the middle of November.

What does EWT have to offer? Quite a lot actually if you think that cashed up corporations may start spending money to maintain productivity gains in 2011. Information Technology makes up 58% of the ETF (iShare info page here) and that is the primary driver of the market. Although local brokers will occasionally make noise about the number of mainland Chinese tourists that are allowed in Taiwan, for now and the medium term future, the big question is how many Android phones and iPads will move in the marketplace. But Taiwan is not all consumer electronics. TSMC (which makes up 13% of the index) is the world’s largest and probably most advanced fabrication facility for custom made logic chips.

If you don’t like Taiwan or are worried about investing overseas, there is a very close correlation between the EWT and Nasdaq Composite (ONEQ) which you can see in this 5 year chart from Yahoo. While there is no guarantee that it will track as closely in the future, I would be very surprised if we did not continue to see strong correlation.