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Market Climbs A Wall Of Worry

Let's see … Barry Sternlicht, Sam Zell and Larry Summers were all bearish last week, essentially saying that Wall Street and Main Street were disconnected. What happened?

The market had its best week of the year. This isn't to say that they are wrong, as it's not unusual for the financial markets to do well when the economy is not. After all, changes in interest rates influence valuation more than almost anything else as long as we are not falling into the abyss and financial risks are not rising. I have known Barry and Sam for well over 20 years and respect them tremendously. I wonder how their real estate businesses are doing. Pretty good, I bet. Well then, something is doing well in our economy. And we all know how smart Larry Summers is. I try to read everything he writes, including his speeches. He would have been a formidable Fed chairman.
 
I must admit that some of the pundits turned positive last week, but that was well after a 500+ point move up. It seems to me that the "experts" are always following the market rather than anticipating where it will go. I guess that they are momentum players like most of the quant, proprietary and technical traders. I don't pick bottoms; I pick entry points based on valuation, confidence, liquidity, risk and overall exposure. That's what took me to the industrial commodity stocks three weeks ago. Here I used the Larry Tisch method of investing- extreme undervaluation relative to the norm. There really is much more to it, which I will explain later. Needless to say, it was a good move. Morgan Stanley recommended this group last week, too. Overall, we gained over 6 percent to a new high for the year. GE is our largest position … Thank you Nelson! We go back 30 years together. It's all about change.
 
Not much really happened last week, but suddenly the glass went from half empty to half full. Stock markets rose, bond prices retreated, commodity prices rallied, including oil. The dollar fell and emerging markets did a lot better. It didn't hurt that the Chinese markets were closed for a holiday most of the week.
 
Let's take a look at the events that took place by region and see how our core beliefs are affected. Then lets look at our investment outlook including asset allocation, regional emphasis and stock selections.
 
As I told a dear friend last week at the Harmony Club, I have never seen an environment where asset allocation and stock selection were everything. It's all about management and the board's openness to change to survive and thrive in a global competitive environment.  It won't hurt that the stock will get revalued along the way. Just look at GE. I mentioned the name over a year ago, when the stock was around $20. How brave of the management and board to jettison virtually all of the financial businesses that Jack Welsh bought and to increase exposure to its high growth, high margin industrial businesses. All the more difficult as Welsh was considered a god after all. That decision took guts.
 
Everyone was waiting to read the Fed minutes that came out last week. Besides being concerned about weakness overseas, the Fed finally acknowledged that low inflation might not be transitory, as they repeatedly said over the year. I disputed that view time and again. Low inflation for the foreseeable future remains one of our core beliefs. Now the Fed is forecasting that inflation may not even hit 2 percent by the end of 2018. So imagine where interest rates will be over the next few years.I doubt that the 10-year will hit 3.5 percent by mid 2017. That's a change for us and a positive one indeed for stock valuation. 

The rest of the economic data that came out last week was a mixed bag: Consumer credit rose by $16 billion or at a 5.6 percent annual rate in August, down from a 6.6 percent annual rate of gain in July and a rate of gain of 9.6 percent in June; the trade gap widened to $48.33 billion as exports fell 3.8 percent, while imports fell 2.2 percent, reflecting lower oil prices; import prices declined 0.1 percent in September, which was less than anticipated; margin debt fell a record 6 percent in July to $473 billion, as the S&P declined 4.4 percent for the month; the Trans Pacific Partnership pact was finally approved, which gave a big boost to the Asian markets; and finally the National Retail Federation is forecasting a 3.7 percent increase in holiday sales, which is slightly below the prior year, but above the long-term average rate of gain. 

A study came out and supported that consumers spent 88 percent of the savings realized at the pump. Lower energy prices are a boon to consumers worldwide. Remember that the consumer is approximately 67 percent of our GNP. High total employment plus higher wages and new highs in consumer wealth paint a positive picture for continued growth in consumer spending and our economy. Yes, exports and insufficient capital spending are holding us down. Net, net, we continue to see lower highs and higher lows for economic activity down the road—one of our core beliefs. Pretty good for financial assets.

As we expected, economic activity in the Eurozone slowed in August and September: The PMI for manufacturing and services fell to 53.6 in September from 54.3 in August; inflation declined, yes declined, 01 percent in September; new business and backlogs rose at the fastest pace in four years, which forebodes an acceleration in growth for the remainder of the year and 2016; and German factory orders and exports fell in August.

We remain optimistic that the Eurozone growth has finally bottomed and better days are ahead. It helps that there is tremendous confidence in Mario Draghi and the ECB to do whatever it takes to support the economy and to accelerate growth with higher inflation. Consumer and business confidence is at a recent all-time high.
 
The passage of the Trans-Pacific Partnership was clearly the big event in the Pacific. Essentially it is a trade agreement between 12 countries, including Japan and the United States. This pact was formed to better compete for world trade versus China and better open trade and access for its members. I believe that the United States is a loser in this deal and Japan a winner. Congress should vote it down.

The BOJ maintained its current monetary policy even though exports are weak and inflation is well beneath its targets. I remain confident that Prime Minister Abe's policies to stimulate growth will succeed but take time to work, as the country still has to grapple with its high debt levels.

As I mentioned earlier, it was National Day Golden week in China, so news was sparse. The yuan rose to a four-month high as capital outflow concerns died down. Foreign exchange reserves fell by $43 billion in September, down from $93.9 billion the month before. Total reserves stand at a whopping $3.6 trillion. The Chinese government and people have patience, as the economy shifts to more domestic consumption, away from an over reliance on exports. We should too.

Last week we commented on Glencore, a global commodities powerhouse, which is having financial problems due to the dramatic decline in commodity prices and too much leverage.  There was a panic last week and the stock price fell to 76 pence. I was confident that the management would work its way through the problems, but come out a weaker company on the other side. In the interim, I had bought two of its financially strongest competitors, which were yielding over 6.5 percent—a figure well supported by cash flow. Besides selling stock, Glencore reduced zinc production and future spending plans, which I anticipated. Zinc prices skyrocketed. Glencore closed at 129.10 Friday and the stocks that I had bought rose 35 percent for the week. That's investing the Larry Tisch way. I do it all the time.

Oil prices surged to over $50 per barrel last week. The general consensus, and I agree, was that Russia's military actions in Syria played a major role in the rise. Clearly another failure in our foreign policy. I don't think the move up had anything to do with slowing shale output as many said. The House passed on Friday to lift the export ban on oil. I continue to hope that energy independence at any price remains a top goal of this country. I remain bearish on energy long term as the global supply and demand for crude remains way out of balance. That does not exclude counter trend rallies as occurred last week. As a hedge against the energy short, I am long some of the financially energy stocks that stand to pick up the pieces at distressed prices from the weak companies. Also they are yielding over 5.5 percent, which is secure.

So where does this leave us? Have we changed our view of the investment landscape and shifted our asset allocation and stock selection? Broadly, the answer to these questions is no. As we mentioned last week, we turned more positive on the markets after the employment data, as it indicated to us that the Fed was out of the picture to at least December and possibly March. Removing that impediment gave me an all-clear at least for now. I covered many of my shorts and puts, reduced my dollar exposure and added some transportation stocks. I had mentioned last week that the transportation index had bottomed out, which was a good omen for the market. 

Yes, this market has advanced on a wall of worry. Personally, I like the broad skepticism as voiced by Barry, Sam, Larry and so many others. Let me repeat, yet once again, that this is a market of stocks rather than a stock market. Stop looking at the averages and drill down to the companies. Change is everywhere and with positive change comes revaluation and higher prices. My longs are comprised of companies whose incremental returns are rising and I am short just the reverse, It's that simple, but clearly takes hard research to find the winners and the losers. That is our strength. By the way, this is a global search and not limited to companies domiciled here. We are global investors who combine a top down economic view with a bottom up in depth research. Hopefully the two come together in our portfolio. So far, so good.

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