Japan Earthquake and Market Volatility

The world equity markets have been rattled lately by the devastating earthquake in northeastern Japan. It’s not the earthquake itself that caused such an enormous disturbance. Rather, it was the tsunami that followed and its ensuing damage to the nuclear power facilities of the affected area. Headlines of possible meltdowns at those nuclear facilities have clearly spooked investors and some of the Japanese over the past week.

While the human impact on those in the region is permanently devastating for the families involved, the economic impact is probably less permanent. We have been closely monitoring the affected investments, especially those located in Asia and Japan. The uncertainty of the event is, in our view, causing the most impact on the markets. While the nuclear situation still does not appear to be completely under control, it does appear that the Japanese and the international community are devoting every possible resource to gaining control of the problem.

Natural disasters have been and will always be one of the risks to the economy. In almost every example, however, those risks are concentrated in the near term following the event. The economic disruption is definitely felt in the immediate aftermath, but in the long term, the rebuilding process can make up for – or even eclipse – much of the initial loss of economic activity. This seems likely this time also, as Japan has unleashed nearly unlimited resources to battle the situation.

Clearly, the near term impact will be felt by many Japanese and U.S. companies with a presence in Asia and Japan. Depending on how you look at the numbers, you could argue that the event may or may not have much of an impact on the world economy. Japan remains the third largest world economy at about $5 trillion in GDP and accounts for over 8% of the world economic activity, which is very significant. However, the affected area accounts for a rather small portion of Japan’s economy. Furthermore, Japan does not contribute to global economic growth as the Japanese economy has been stuck in the doldrums for over a decade.

Without a doubt, the financial markets have reflected the uncertainty in Japan. Social unrest in Libya and elsewhere in the Middle East have only added to the volatility as the Dow Industrial Average has frequently traded higher or lower by triple-digit margins on a daily basis. The major averages, including the S&P 500 Index, are currently trading just slightly positive for the year after starting out the year with gains of nearly 7% through late February. The markets would rather have quantifiable data to trade on; oftentimes the uncertainty causes more commotion than if there was a known negative impact.

The fundamentals of the U.S. economy continue to strengthen through all of these geo-political situations. Even the slow to recover job market is showing signs that some strengthening may be on the horizon. It’s our position that the global recovery remains intact. But, of course, that does not mean that occasionally the markets or world events will not cause us to question that thesis.

While we are mindful that the human tragedy is the greatest concern, we will continue to closely monitor the affected investments and our portfolios under management. As always, we are available to discuss our strategy during this time if you have any questions or concerns.

Sincerely,
Eddie Wilcox

“Double, Double Toil and Trouble; Fire Burn and Cauldron Bubble”

From the Desk of Joe Rollins

At the opening of the fourth act of William Shakespeare’s tragedy Macbeth, the Three Witches, who represent darkness, chaos and conflict in the play, communicate to the audience that they seek doom for Macbeth and the other mortals around them by chanting the famous line, “Double, double toil and trouble; Fire burn and cauldron bubble.” Are the Three Witches now communicating the same perceived doom for the current investing atmosphere?

While meeting with clients the other day, I listed the negatives worrying some investors right now. By the time I finished, I couldn’t help but be depressed myself. See if you can add to my list:

The overturn of Egypt’s government

Civil war in Libya

Iran’s nuclear program

Soaring gasoline prices

Accelerating food prices in most of the world

Staggering federal deficits

An inept Congress

U.S. governmental interference in private industry

ObamaCare causing accelerating deficits

Medicare bankrupting America

Unsustainable Social Security payouts

Potential inflation

It’s often said that the stock market climbs the wall of worry. We certainly had enough to worry about during the month of February. But isn’t it amazing that even with all the worries and problems in the world, the stock market continues higher?

For February, the S&P 500 was up 3.4%, and for 2011 thus far, it is up 5.9%. For the last three month, it’s up 13%, and for the last 12 months, it is up a stunning 22.5%. Can you believe how well the markets have performed in spite of all the negatives listed above?

On an almost daily basis, I am disappointed by the number of investors who hold their assets in interest bearing savings/money market accounts. In many cases, these accounts are earning practically zero. I recently met with a client with over $2 million in deposit accounts that were earning a dismal 0.32%. I suppose they haven’t heard how well the stock market has performed over the last two years – it’s up nearly 100% since the low point on March 9, 2009!

February was interesting in a lot of respects. Not all the markets were as robust as the S&P 500. The emerging market funds actually took it on the chin. For 2011, most emerging market funds are down approximately 4%. Some of the European funds and broad-based international funds are actually up a comparable percentage to the S&P 500. Additionally, bonds also haven’t reacted well to the potential of inflation and higher interest rates, and governmental bond funds have produced a negative rate of return for 2011.

The top performer has been the very large capitalized stocks as represented by the S&P 500 and mid-cap funds. Portfolios under management at Rollins Financial are diversified among all asset classifications, which is a more prudent approach than being invested only in one class of financial assets like large cap stocks. In fact, we want to be invested in the emerging markets given the potential for growth in those markets. When you consider that China and India have GDP growth three to four times the GDP growth of the United States, I believe it would be a mistake not to be invested in these exciting and growing economies.

The reason the emerging markets have not done well this year relates to the very problems in my “list of worries.” Even though we are seeing democracy try to break out in North Africa, these markets rely heavily on the supply of oil from these countries. Why the price of oil is increasing in the United States continues to be a mystery to most commodities followers. There seems to be almost no reason for the wild appreciation in crude oil prices.

It’s well-known that Libya exports less than 2% of its oil outflow to the United States. Also, one must remember that Libya only provides 3% of the world’s total oil production. There should be absolutely no fear that Saudi Arabia would not happily make up for the 3% decline since at the current time everyone is clamoring to sell more oil at the exorbitant price of over $100 per barrel. There is no shortage of oil anywhere, and in fact, due to the high price, many producers are happily exploring and drilling for more oil.

Interestingly, in the United States, only one drilling permit has been issued by Washington since the BP Gulf oil spill. Additionally, because of the Obama Administration’s tough and unreasonable stance on the coal industry, the EPA has the power to delay or veto permits for coal mining projects. It seems to me that the entire energy industry is being crippled. It is interesting to see, however, that new oil is being produced in Montana and the Dakotas in the United States. There’s also a flood of oil coming out of Canada from the Athabasca oil sands. Since this type of oil can’t be produced as inexpensively as drilled oil, however, it requires the high price to justify the cost of production.

There’s also an absolute bonanza of natural gas discoveries. Natural gas has been uncovered throughout the United States in massive quantities. In many cases, natural gas is replacing oil in the industry energy complex. In the U.S., we are starting to see entire power plants generated by natural gas along with most manufacturing environments, and one day, nuclear power plants will be common in the U.S.

Even though the Obama Administration has plowed literally billions into alternative energy sources, none of them are proving to be economically feasible. It’s been known for years that the ethanol solution is a complete boondoggle – even Al Gore agrees. It doesn’t work as well as natural crude, it costs more to produce, and it isn’t as energy efficient. Additionally, the consumption of corn for the ethanol industry has led to skyrocketing corn prices and shortages in other types of commodities that utilize corn. Without massive government financial support in this industry (i.e., your tax dollars), it would quickly die.

In almost every case where solar or wind energy has been utilized, it has proven to be economically unfeasible. Again, without government guarantees and subsidies, these alternative energy sources wouldn’t even be remotely viable.

It would be interesting to see what happened if the U.S. removed 100% of all subsidies and tax support for every industry that provided energy. Which ones would survive if there was no intervention by governmental sources? No tax subsidies for the oil industry, no government credits for any type of alternative energy products, and each and every source would survive based on its own merits. I’d be willing to bet that if there were a level playing field, natural gas would be the energy of choice.

It’s important for investors to understand that speculators are running up the cost of oil and other commodities based strictly on fear. There is no economic justification for these price increases. My guess is that if President Obama announced that he plans on releasing some of the strategic oil reserves, the price of oil would fall over $20 a barrel overnight. Whether he actually does or not wouldn’t matter, but the fear would run the speculators out of the market. Since the price of oil isn’t based on reality, then there is just as good a chance that it could fall as it could rise. And if you believe that there’s an oil shortage, then you have not read the statistics.

The upheaval in the Middle East will not impact the price of oil as long as Saudi Arabia keeps a lid on its political foundation. There’s no indication now that there will be anything other than a constant flow of oil, and certainly, there will be no shortages as predicted by the speculators. In fact, due to the high oil price, there is more oil being produced in the United States than ever. While the production is insignificant to our usage amount, it does soften the economic blow somewhat.

In the meantime, the economy continues to strengthen just as I forecasted. There’s been slow but steady progress in the economic news. It’s certainly not giving blowout economic results, but the economy is gradually inching into a more positive direction. While unemployment is not dramatically improving, productivity has improved to such a level that it will take a long time to re-employ the jobless. However, the most important aspect is corporate profits, which continue to be downright explosive. It’s amazing to see corporate profits being realized in such staggering proportions.

Finally, Congress is at least discussing cutting the federal deficit. The Republicans recommended a $61 billion decrease in spending for the fiscal 2011 budget. Frankly, this amount is incredibly small and almost laughable; truly, it’s a rounding error. It hardly constitutes a dent in federal spending at $3.7 trillion. Even more remarkable is that the Democrats are suggesting that such cuts would be completely devastating to the U.S. economy. It’s hard to believe how out of sync and delusional these politicians in Washington are. It’s time for most of them to be replaced.

There is still hope that the junior politicians will make positive strides toward reducing the federal deficit. The problem doesn’t need to be solved overnight, but a good plan for reducing the deficit is imperative. It’s clear to me that President Obama has no plan nor does he intend on proposing a plan. Fortunately, with the Republican-controlled House of Representatives, maybe one will be forced upon him, and like any good politician, he’ll compromise.

There is no current evidence of a crack in the U.S. economy’s framework. Interest rates are low and will probably be low for years to come. Unquestionably, corporate profits are spectacular and there is no evidence that they’re going down. Corporate America is being driven less by oil today than ever, and a minor increase in oil prices should have very little effect on corporate profitability.

As before, I am very encouraged that gains will continue to be realized for the rest of 2011. It will not be a homerun every month like it has been for the first two, but I anticipate that by the end of the year, it’s very likely that returns for the financial markets could be in the low double-digit range. I can give you absolute assurance that you won’t find any fixed-rate guaranteed investment with equal rates of return.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins