Greed Trumps Fear

Posted on April 7, 2011 by David Laidlaw

Sitting in a hotel near duPont Circle in Washington recently, I took a rare opportunity to watch CNBC. Though entertaining, the hype and constant sales-pitches are difficult to watch for an extended period of time. Regardless, the commentators occasionally provide descriptive labels that resonate. One catch phrase that has merit is the description of current equities as a “Teflon Market.” Bad news arrives daily, but nothing sticks and upsets investors enough to cause stocks to fall.  

There are three global hotspots: the Mid-East, Japan and Europe.

The uprisings throughout the Mid-East appear to be monumental and much more widespread than recent flare-ups. Unrest started in Tunisia and spread to the unseating of Hosni Mubarak in Egypt. The currents then spread to Bahrain and Syria, where the Assads are violently putting down protesters on a daily basis. Finally, as everyone is aware, we are engaged in a third armed conflict in Libya, siding with the forces in opposition to long-time dictator Muammar Gaddafi.

All of the Mid-Eastern countries share populations that are impoverished, underemployed and very young. Throughout the Mid-East, the median age of the population is less than 25 years old compared to the United States where the median age is about 37. The disenfranchised youth are also realizing that their corrupt rulers have a much weaker hold on power than they believed possible. This combination is leading to massive revolts, some peaceful and many violent.

The potential for disruptions to the supply of oil has caused oil prices to spike from roughly $80 to about $105 per barrel. Prices could go much higher if anything interferes with Saudi Arabia’s ability to extract and deliver oil to the world.

Japan’s historic earthquake and tsunami are causing widespread suffering. This disaster has triggered the failure of nuclear facilities that are leaking radioactivity into the water and food supplies north of Tokyo. Aside from the humanitarian crisis, many supply chains in auto and telecommunications parts have been disrupted.  

Finally, Europe continues to neglect the debt crisis affecting is peripheral countries. Portugal faces debt maturities later this Spring that it will not be able to meet unless it receives money from the European Union (EU). Portugal also appears unwilling to accept the austerity measures from the EU and the International Monetary Fund (IMF) after seeing the pain that cutbacks are causing in Ireland and Greece.

It was also reported that the four largest Irish banks require 24 billion Euros in capital to shore up their solvency. This capital is in addition to the 46 Billion Euros that was already supplied by the Irish government. These figures are astounding given Ireland is a nation of 4.5 million people with a GDP of about 122 Billion Euros. As a percentage of Ireland’s GDP, the bank bailouts are 57%. This bailout is amazing compared to the US Troubled Asset Relief Program (TARP) where $700 Billion was committed with the total cost expected to be about $50 Billion lost or 5% of our GDP committed and less than 0.5% lost of our $14 Trillion economy.

Of the three problems, we believe the European debt crisis will present the most difficult challenges long term. The Mid-Eastern revolutions have the potential to cause oil prices to spike much higher in the short term if supply is seriously disrupted. However, drilling technology has opened vast new reserves of hydro-carbons (especially natural gas) throughout the world.

Japan’s disaster will lead to massive infrastructure spending and could help rally the country and focus its energies on something other than its seemingly intractable financial problems. The cohesion of Japanese society has been on full display with Japanese ex-patriots returning home to help family members and businesses. Howard Stringer, Sony’s CEO, wrote a poignant editorial in the Wall Street Journal on March 18th. In the piece he pointed to the phrase fukutsu no seishin which means “never give up.” Stringer noted how it is on the lips of many Japanese now and also how the saying is emblematic of the perseverance that is part of the country’s character. Therefore, we believe the quake, tsunami and radioactive contamination will not be a knockout blow to the country, but could provide a rallying point for future strength.

On the other hand, Europe’s sovereign debt crisis presents a lingering malaise that is not being addressed. How much deeper are Ireland’s problems? What do the European Ministers do with a country like Portugal that will not make the sacrifices necessary to reduce its debt? If the Euro fails, the peripheral countries’ currencies will weaken dramatically to become more competitive with Germany and France. However, relatively healthy countries such as Germany will find it much more difficult to export their products to its European neighbors due to currency differences.

The European situation also looks similar to the contagion that spread through the US financial sector in 2007 and 2008 where Band-Aids were applied to serious wounds. Nothing short of bold measures to reduce Europe’s public sector expenses and get the European banks to take the massive write-downs necessary will provide any movement to solving these problems.

Given these global problems, the stock market continues to advance. We believe there are three reasons that explain this phenomenon. The first is that corporate America is very profitable and able to find growth opportunities here and abroad. The second is that the US economy is recovering at a faster pace than over the prior 18 months. As evidenced by March’s jobs report, the private sector is now creating over 200,000 jobs per month. Finally, the Federal Reserve is still buying Treasury bonds and mortgage-backed securities which increases the money supply. Much of this money has wound up in the stock market and pushed prices higher.

Our sentiment is similar to last quarter when we felt that stocks were reasonably valued. Certain sectors of the market (discussed later in Ben’s piece) are experiencing bubble-level pricing where returns will not match expectations. However, conditions look positive for most holdings though we expect more volatility especially as Quantitative Easing ends in June.