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January 2011 Investment Journal 


Stock markets in January generally performed well, while bonds and gold sold off. The S&P 500 was up 2.2%, long Treasuries were off 3.1%, and gold was down 5.9%. Of particular note was the rising and firm tone in agricultural commodities, and a rise in oil prices in reaction to the turmoil in Egypt. 


On the global front, the annual World Economic Forum in Davos Switzerland produced a lot of re-assuring comments that the world economy was slowly gaining strength, with confidence returning. That should help release cash into productive investments going forward. There seemed to be a lot of emphasis on green initiatives, clean energy, etc. Early forms of a European "Brady Bond" style bailout emerged in the rumor circles, but there were no game changing pronouncements on the continuing debt problems of the developed nations. In the US, the Fed's FOMC statement emphasized the fragile nature of the recovery here and stubbornly high unemployment. Early signs of an up-tick in inflation emerged in the US Producer Price Index, but the Fed remains convinced that the "output gap" here is very deflationary and price signals are being downplayed (for now) in their policymaking. 


What is notable market-wise as the year begins is the pushback against the Fed coming from the US bond market as yields rise, even as the Fed steps in to buy up bonds (now holding more US debt than any single investor globally-including China). Perhaps sellers are anticipating higher rates of inflation, a weaker dollar, or a less creditworthy borrower. For bond "shorts", the wild card remains a large stock market reversal on the back of a renewed economic contraction, or, more probably, geopolitical turmoil. Bonds will again become an investors' best friend in such a scenario, and, as such, they have a role to play in most any portfolio. 


Meanwhile, almost pre-ordained, stock prices are rising, producing a "wealth effect" just as Bernanke "commanded" in November. Earnings season is in full swing, with many good, if not spectacular, reports. Exporters in the US, like Caterpillar, seem to have more upbeat outlooks, as emerging economies lead a "two speed" world (growing vs. flat/slowing). On a sector specific note, fourth quarters earnings for investment banks confirmed our thesis that profitability is going to be a moving target. If 2009 was the triumph of fixed income, currency, and commodities trading, 2010 was notable for the return of equity trading and underwriting, and M&A. What was missing was (now nearly extinct) securitization activities, and "prop" trading, which has been banned (can't bet the house money anymore.) When combined with the need to set aside more capital going forward to meet Basel III rules, the big banks are going to be hard pressed to come up with the returns on capital once enjoyed. They might be a trade, but banks face a stiff headwind that says long term investors may find more profitable activities elsewhere. 


Much has been written about the "January Effect", where a positive start to the year generally precedes an up year overall. But the "Third Year" Presidential effect has even stronger linkage to performance, and, if it holds, 2011 should be a good year. Almost all market prognosticators are predicting some type of stock market pull-back of the 5-10% variety, then all systems go for further gains. We are reminded that consensus is seldom rewarded in investing. 


Rising prices for all commodities, from copper to wheat to oil, are providing a supportive backdrop for now, but are always subject to sharp swings. The bull case is that a demand driven phenomena is occurring in the midst of a supply-constrained world (think Australian floods, Russian drought, etc.). The Financial Times reported on a UK government report that the era of cheap food is at an end, implying that the run-up in 2008 was just a taste of things to come. Food shortages and price rises lie behind much of the unrest in Tunisia and Egypt, and this feels to us like a long-tailed story (more to come, same storyline, other countries). 


Clearly Egypt is having an effect on thinking about secure energy supplies. Excess inventory in the US has caused a nearly $10 spread between West Texas Intermediate (WTI) and Brent oil (Europe, Africa, and the Middle East pricing), as the latter touched $100 a barrel recently. Like everyone else, we are watching this situation. The most perceptive comments seem to be "careful what you wish for", as the transitional El Baradei (who would conceivably succeed Mubarak) failed miserably to monitor Iran as the UN point man on containing nuclear proliferation. With the MB (Muslim Brotherhood) now surely going to have a seat at the power-sharing table, Egypt is looking more and more like a game changer that could re-calibrate the entire risk complex. Hang on to your energy stocks! 


Thank you for reading our Journal notes this month, and we'll be sending one your way again in early March.

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