More Positives than Negatives Ahead

Using an often-repeated term of Donald Rumsfeld, the job of investors looking to their future returns could be characterized as a search for the “unknown unknowns,” (as opposed to the “known unknowns”). This is the exact task before me today. Based upon past experience, I do not believe that the future will suddenly reveal itself to me with such sufficient clarity that I can immediately place orders for individual securities or funds. Since the unknowns are truly unknown to me, I start collecting what is apparently known to me. I cast my net wide to gather bits and pieces of the current scene with the hope that, in sum, I will get useful insights into the future. The members of this blog’s audience will have to determine whether what follows is useful or insightful for them.

In terms of the real economy, the most bullish press account that I have seen is about FedEx, which has been a long term holding of the PRIMECAP fund that we own for clients. FedEx stated on the busiest shipment day of the year that its shipments were up 17% over the busiest day in the prior year. Citing this improvement, the company announced that it would resume salary increases and make contributions to its retirement plan. This comes from a company that recently reported a 30% decline in earnings. While a possible reason for the surge of shipments is a shift in the behavior of clients’ inventory management, I find the company’s wage and benefit decision to be encouraging.

I find it somewhat ironic that the Russian finance minister announced last week that the Russian recession was over. Note that the US recession has not been declared ended, though many believe it to be over. Considering mineral production and mining are much more important than financial and other service sectors in Russia, the minister’s declaration is a good sign for the global recovery. (One wonders whether Russia is becoming more of a capitalist state as the US is becoming more socialist.) A possible sour note to the global recovery is the announcement that Tokyo Steel has reduced its prices for the second time in three months. This decrease is in the face of rising Chinese spot iron ore prices. Clearly there are leads and lags to the global recovery story.

Gold is always a barometer of people’s fears and the willingness of those who will take advantage of these feelings. There are six Indian gold ETFs which had a 57% increase in the number of shareholder accounts in the six months ending September 30th, 2009. In the same period, these six ETFs saw assets rise 72%, showing some fear for the value of the Indian Rupee. Taking advantage of this increase in demand for gold at the retail level, the United Nations has recently licensed its own gold bullion coins to be minted and sold in Europe. The so-called World Government appears to be taking advantage of the inflation that is being seen in practically all of its members. Judging by how well the UN manages its own fiscal affairs, my guess is that we may well be seeing a top in the price of gold. That does not mean a near-term peak in inflation fears.

In the heart of almost every stock market bull is a Chinese noodle. Not only is China becoming the paramount buyer of many commodities (it has been reported that Chinese-built Cadillacs are outpacing those sold in the US), Chinese interests are becoming increasingly active in a number of stock and bond markets around the world. The National Social Security Fund of China intends to raise its maximum overseas investment from 7% to 20%. Within two years the fund will be at $ 146 billion. The fund’s goal is to beat inflation by producing an average annual rate of return no smaller than 3.5% in the 2008-2012 period. In the “out years,” the gain must be higher, as it lost $5.77 billion in Fiscal 2008. There are similar demands on other sovereign wealth funds who have suffered losses in 2008, and in some cases 2009. This suggests to me that in so-called high quality paper, we will see more speculation. Too early to call it the next bubble, but one we need to watch.

As the Chinese become wealthier, one should watch their consumer behavior. One interesting trend is that expectant mothers in China are traveling to Hong Kong to give birth. There are three possible reasons for this trend. Healthcare is better in Hong Kong, the purported advantage of the child having a Hong Kong passport, and/or a decision on the part of the parents to have more than one child. (Interesting how individuals react to the plans for them dictated by their government. I believe expectant mothers are part of a global medical tourism trend.) As the Chinese become more concerned about inflation there will be a sharp increase in the proportion of car purchases that will be financed, expected to rise from 8% currently to perhaps the 70% found in India, but not as high as the 85% found in the US. This is important as it will drive greater use of financial services, which eventually will be a plus to the global financial services industry.

One of the safest bets about the future is that the US financial service industries will undergo material structural changes. In a well-reasoned opinion piece in The Wall Street Journal by Robert Wilmers, the CEO of M&T Bank, the financial results of the five largest bank holding companies are contrasted with the rest of the bank holding companies. The five are Bank of America, Citigroup, JP Morgan Chase, Goldman Sachs, and Morgan Stanley.

Through the first nine months 2009, these five banks earned $30.1 billion compared to combined losses at the remaining bank holding companies. The “big five” lost $14 billion last year. The turn-around in their fortunes did not come from increasing lending, but from their trading activities. The first three banks alone had trading revenues of $26.8 billion in the nine months, having lost $41.3 billion in the year before. The two new to the bank holding status probably did even better. The rest of the bank holding companies aren’t in that league in a meaningful way.

Prior to the 1920s there was a separation of commercial and investment banking which was stipulated under the National Banking Act. In the heyday of speculation of that era, it was repealed. Due to the collapses set off by the use of leverage and banks bailing out their lending customers by securities underwriting sold to their depositors, the Glass-Steagall Act was passed. Ten years ago the Graham-Leach-Bliley Act repealed two of the four sections of the separation of commercial and investment banking law. This week, Senators John McCain and Maria Cantwell introduced a bill to return to the separation. Something is going to happen. I will be watching it closely not only as a concerned citizen, but also as a portfolio manager and investor in a financial services hedge fund. Currently we have no positions in banks that are primarily commercial banks. We expect both long and short opportunities will present themselves in 2010 and beyond.

Bottom line: I see a market for opportunists in 2010 on the one hand and not a bad market for long-term investors on the other hand.

Ruth and I wish our readers and their families a very Merry Christmas.
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Next week I would like to focus on what I see in terms of mutual fund trends that will be of use to our members.

Please let me know your own thoughts on these topics.
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