The Year in Review

Sunday, February 20th, 2011


The Dow Jones Industrial Average is flirting with staying above the 12,000 mark for the first time since June 2008 and the S&P 500 is doing the same with 1300 (the S&P gets less face time in the headlines but is the more significant of the two benchmarks).  It is worth noting that the last time the Dow was at 12,000, oil was $130 per barrel, gold was $650 an ounce, the 10 year Treasury bond yielded 4.2%, and the unemployment rate was 5.7%. Real estate prices had retreated from their 2007 highs but were still for the most part irrationally exuberant and anyone breathing could get a loan.  All of these metrics are now substantially lower with the exception of gold and unemployment.  Daily fare in the financial press, Bloomberg Television and CNBC is the meteoric rise in commodity prices and whether the main culprit is inflation fears coupled with political instability or

demand in rapidly growing emerging markets.  It is fair to say that all do play a part.  There is, however one factor that is not debatable and that is the demand created by the exponential growth of commodity based exchange traded funds.

Before the creation of the most actively traded commodity ETF, the SPDR Gold Trust (GLD), an individual investor who wanted to own gold had buy coins or bullion through an intermediary who charged a substantial markup or take a shovel and pan out to the mountains.  There were the futures markets but there were many complications for individual investors so the Chicago and NYMEX trading pits remained largely the territory of large hedge funds and institutional investors.  But then along came the commodity and futures based ETF’s which allowed granny to play with the big dogs and go long or short almost any asset known to man. The democratization of the investment universe is by and large a very good trend. But it is important to proceed carefully and with knowledge of what you actually own in the every expanding ETF world.  Brokerage houses and the SEC which require a fair amount of financial disclosure to trade options, including prudent hedging strategies in IRA’s require none at all to trade ETF’s correlated to the most volatile and highly leveraged futures contracts. Still to date the most activity in the ETF commodity asset class has centered on gold. How did this happen?  As a recent Bloomberg News article recounts, a sea change occurred when James Burton, the former head of CalPers agreed during a round of golf in the UK to become CEO of the World Gold Council which spearheaded the creation of the gold ETF as a means for “the man in the street who would buy a lot of gold if he could find an easy way.”  When Mr. Burton was head of CALPERS, the investment portfolio he oversaw, according to the Bloomberg article, did not own an ounce of gold. When GLD, the ETF he created to buy and hold gold bullion for the “man in the street,” made its debut on the NYSE in 2004, the price of gold was $330 per ounce. It ended 2010 at $1390.

During 2010 the S&P as measured by the widely held SPDR ETF or SPY gained approximately 12.8%. Since we are discussing the ETF explosion, SPY was the progenitor of all the others.  Despite the double digit gain there was a disconcerting and volatile ebb and flow to the year.  In the first quarter the S&P gained roughly 4.75% only to give back 11.8% in the second quarter. On June 30, the S&P stood at 1030, down 7.6% from the beginning of the year and then produced a whopping gain in the ensuing quarter of 10.6% but struggled in the fall. On November 30 the S&P stood at 1180, which was 5.82% ahead of where it started the year.  In one of the more unusual December’s on record the S&P gained another 6.5%.  From the June 30 low of 1030, the S&P closed the year at 1257 for a valley to peak gain of 22% in the final six months. Such gyrations more often than make for a challenging investment landscape going forward.  When the S&P was losing almost 12% the problems in Greece, Ireland, a weak Euro, concerns about entitlement costs and an uncertain domestic regulatory environment were to blame.  Conversely when the S&P was rising by double digits, credit was given to upside earnings surprises in financials and technology, a favorable US election outcome and hoped for regulatory certainty. Past experience should raise plenty of caution flags on that front.  When the dollar was weak, that meant better export conditions for the likes of Apple and Caterpillar. But when the dollar strengthened that was confirmation that QE 2,  the Federal Reserve planned purchase of $600 billion worth of Treasury bonds, which by definition will be inflationary, was a good way to kick the can down the road.  So we end the first decade of the new century with a confusing but robust fourth quarter when everything-stocks, commodities and the dollar all went up.

Looking ahead it is not viable to see all of these trends continuing-certainly with the  dollar we can’t have it both ways.  Some of the problems of 2008, high unemployment and budget deficits still persist at home and abroad, plus inflation worries loom large in China and other rapidly growing economies.  Many of the upside earnings surprises in 2010 were based on weak comparisons from the prior year.  That will not be the case going forward, and whether we might actually get some real growth remains to be seen. But in some cases the 2010 act will be quite hard to follow especially for financial companies that will not be doing all of things they used to do and charging less for many of the others. In hindsight, 2010 ended up being a good year to throw a dart at the S&P 500; 2011 is starting off well and has the “January effect” working in its favor. Most market forecasts remain very bullish for 2011 with equity mutual funds seeing the first influx of new cash in a few years as small investors take money out of bond funds.  Government and high grade bonds which had a great decade do not look terribly appetizing with interest rates sitting at 25 year lows and the Fed committed to priming the pump. But these factors argue for being careful where you throw the darts and for sticking with a cash flow generating, total return oriented portfolio management discipline as the preferred way to navigate a difficult environment.


Stocks:  The Best House in a Lousy Neighborhood

Bill Gross Likes Stocks screamed the cover story on the August 2010 issue of Bloomberg Magazine.  Despite the earth shattering import of this news, it did not really cause much of an uproar.  Mr. Gross has managed the largest fixed income mutual fund on the planet for over two decades and has won the fixed income manager of the year award so many times it should be renamed the Bill Gross Award.  His bond and interest rate commentary can move markets and he predictably appears on the financial stations as the expert on the latest move by the Federal Reserve. Despite his shocking viewpoint about the equity market, he is seldom if ever asked about his take on the S&P or stock sectors he prefers.   Not too surprisingly his preference is for carefully selected dividend paying stocks with good growth potential and the investment funds that hold them -and he will find no disagreement here.

“First, let’s kill all the lawyers!” Shakespeare, Henry VI,

A New York Times article on the travails of the Greek economy noted that in addition to its sovereign debt problems, the cradle of Western civilization is mired in arcane regulations that stifle business formation with many restrictive laws still on the books from the 19th century.  Not surprisingly, despite its credit problems Greece is a great place to be a lawyer and boasts the highest number of lawyers per capita worldwide with one for every 250 people.  Not far behind is the USA with one lawyer per 270, and a very large chunk of those can be found in California, where regulatory and fiscal comparisons with Greece, according to some, are not so far fetched.  In absolute numbers the US has roughly 50% of the lawyers in the world. Spain, Italy and the UK are also in the top ten of lawyers per capita.   Perhaps we are seeing an important benchmark which might bear closer scrutiny: India is not to be found among the top ten in lawyers per capita and does China have any lawyers at all?

As The World Turns:  Thoughts On What May Lie Ahead

For 54 years beginning in April 1956  a popular daytime TV soap opera called AS THE WORLD TURNS was a small scale embodiment of a belief in what is termed American Exceptionalism. The show sponsored and produced by Proctor and Gamble, a leading US global brand, began with a spinning globe and some corny organ music then dissolved to the fictional setting, the center of the world–Oakdale, Illinois.  This “we are the world” viewpoint was not inconsistent with the view held by most Americans during this period.  An example of this type of continuing jingoism is that the baseball World Series still remains a contest between two US professional teams even though many of the players hail from elsewhere, particularly Latin America. Maybe at some point down the road the World Series will be played like the World Cup. But the world has turned and to get a sense of what this may portend, New York Times Op Ed columnist David Brooks points out that the US will need to adjust from assuming that we are still the center of things:

In the 20th century, America was the Big Dog Nation.  We had more money, more resources…and we could outcompete our rivals by pouring in more talent, greater investments and more resources. In the 21st century, the US will no longer be the Big Dog.  Human capital will be more broadly dispersed…To thrive, America will have to be the crossroads nation where global talent congregates and collaborates.

Many of the best companies in the US such as Google, Apple, Nike and Caterpillar anticipated these changes and have effectively taken advantage of the disbursement of human capital. At this writing the attention of the world is focused on the monumental transition taking place in Egypt. The success of the youthful revolutionaries in Tahir Square was attributed to a Facebook page created by a Cairo born and educated Google marketing executive Wael Ghnonim after he was detained for twelve days by the government.  As Fouad Ajami, Director of Middle East Studies at Johns Hopkins observed, “No turbaned ayatollah stepped forth to summon the crowd– a young Google executive energized this protest.”    David Brooks’ charge for the US to become a “crossroads nation” appears to be alive and well: two US technology companies enabled a momentous change in a country seeking democratic institutions and demonstrate how human capital is being broadly dispersed.   Significant and challenging investment opportunities will no doubt evolve as a result.

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