The Money Map Advantage
Monday, July 24, 2006
By Horacio Marquez
Email – #50
** Examining the “Wall of Worry” – Profit In the Face of Inflation, the Fed, the Housing Bubble and Geopolitical Risk
The market remains very oversold. But what about the fundamentals? There is a huge “wall of worry” depressing prices and risk appetite. And as these uncertainties get resolved, the market will resume its climb, propelled by global synchronic growth and strong corporate earnings growth.
Let’s list the “wall of worry” items that are temporarily impeding higher valuations:
- Fear of inflation
- Fear of excessive Fed tightening, resulting in U.S. recession and/or dampening of global growth
- Fear of a housing bubble meltdown
- Geopolitics: Fear of Syria and/or Iran being drawn into the Israeli/Hezbollah confrontation
As you can see, the list is long and the concerns are not small. This means that the “discounts” that current stock market prices are reflecting are very sizable.
So, if these risks do not materialize into something much bigger, and these uncertainties disappear or are reduced significantly, as I soon expect, prices should adjust upward very strongly. And in the meantime, companies keep growing and posting more and more profits – and the clock on the very sizable shorts, which is very short, keeps ticking.
Let me explain what I expect:
Fear of inflation: As I have been writing, inflation is a trailing indicator and, as Fed Chairman Bernanke just stated to Congress, since the U.S. economy is showing unequivocal signs of cooling off and inflationary expectations remain contained, the slowdown of the U.S. economy (already underway thanks to having raised interest rates from 1% to 4.25%) will bring core inflation down to the 1%-2% range that the Fed is comfortable with. In the meantime, the Fed can refrain from continuing to increase interest rates (since monetary tightening works with lags), and monitor the situation to ensure that inflationary expectations remained anchored.
Fear of excessive Fed tightening: We tasted a prelude of what happens in the markets when this fear subsides. We enjoyed a sharp rally in our picks last Wednesday, as Chairman Ben Bernanke testified in front of Congress his view of a U.S. economic non-inflationary soft landing.
His views are very similar to what I have been communicating to you in this publication: The U.S. economy slows down to trend growth of around 3%; inflation drops to the comfort zone as a result; and the housing market cools off significantly, but does not blow up.
This scenario is not only the most probable, but also the most desirable, since the economy’s risk of a recession is quite considerable, now that the consumer is overleveraged. Therefore, I believe that the Fed will go to great efforts to ensure that the U.S. economy avoids a recession. In the meantime, the global economy is doing fantastic:
- China just announced more than 10% GDP growth in the first half. This has prompted the People’s Bank of China (China’s central bank) to announce an interest-rate increase of 27 basis points and to increase reserve requirements in the banking system. This approach, which is too-little-too-late, will not be effective in curbing demand and controlling some inflationary pressures without allowing their currency to appreciate further. And it will not cool off demand and prices for steel, iron ore and other industrial metals from China, as some predicate.
- Brazil announced that government debt as percentage of GDP has dropped from 64% in 2002 to 51% today. This, together with inflation registering the lowest level in two decades, allows the Central Bank to keep reducing interest rates, which in turn reduces the government’s borrowing costs and allows for the expansion of credit and economic growth.
Fear of a housing bubble meltdown: For starters, there is no “housing bubble.” All real estate markets are local and fragmented. Therefore, the corrections to prices can be huge in local markets where speculation was rampant, like Miami, but will be moderate or non-existent in other markets where there was little if any speculation (the Midwest). In general, the top of the market and the prime areas in both coasts are the most vulnerable, but the majority of the nationwide market will not see anything beyond a normal slowdown.
Geopolitical risk is last, but not least, since right now it is the one prevailing. This risk is subsiding as we speak. As Iran was being referred to the UN Security Council for its unacceptable pursuit of nuclear weapons technology, Iran’s close ally, the terrorist organization nested inside Lebanon, launched a provocation of Israel. Some speculate that the timing of Hezbollah’s provocation was intended to distract the international attention from the condemnation of Iran by the UN Security Council. The kidnapping of two Israeli soldiers by Hezbollah and Hezbollah’s subsequent attacks with rockets on Northern Israeli towns were, understandably, too much for Israel to tolerate.
Israel found itself attacked and threatened in the north, even after having in recent months shown very significant overtures for peace and having pulled out entirely from Gaza at great internal political cost.
The carefully measured and executed Israeli military response was extremely successful. By last Tuesday morning, The Jerusalem Post reported that Israeli generals had characterized the degradation of Hezbollah’s capabilities due to the air strikes to 40-50%, without having set foot in Lebanon. We learned from senior Israeli politicians that their objective was to eliminate the Hezbollah threat of rocket attacks, so that it would be rendered harmless for a few years at least. Therefore, pausing in an action that was achieving such an important long-term defensive objective in a short period of time – and with very limited unintended human cost – did not appear reasonable.
What’s more, in order to complete the objective, it would be necessary to have ground troops complete the job and finalize the actions with some sort of cease-fire agreement, preferably enforced by reliable and powerful third-party peace forces.
Now, with U.S. Secretary of State Condoleezza Rice visiting the Middle East in a mission to achieve some agreement that will end the fighting, the mere hope of her efforts moving forward to fruition and the favorable development of the actions of the Israeli offensive are bringing market fears down.
How to keep playing the market?
The badly-justified attempts to create market fear by some market participants, their obvious discontent with the Bernanke comments about a soft landing, and the violent market action during short-covering leads me to conclude that they are short, unable to cover profitably and especially short cyclicals. And their clock ticks faster than ours, whence their trading horizon is formally established.
This view is confirmed by the similar evidence in the investor world from the recent Merrill Lynch survey of fund managers, which shows:
- Expectations of the U.S. economy slowing down (60%)
- Cash levels very high
- Risk appetites lowest since 9/11
- Expectations of corporate profits being vulnerable
However, at the same time that a Citicorp strategist comes on TV to explain how investors should shift exposure from emerging markets to defensive stocks, Citicorp is hiring 30 analysts to expand emerging market coverage. And another huge broker was evaluating internally last week their past involvement with emerging markets equities, considering expanding the area. So we reaffirm the unique buying opportunity that these prices represent, as our portfolio flies – led by Brazilian banks and energy.
I will soon be adding a new very important pick. In the meantime, keep building these positions across the board.
Enjoy and profit,
Horacio Márquez
Stock & Symbol
Current Price
Comments
Telivisa (NYSE: TV)
$19.13
Buy
Unibanco (NYSE: UBB)
$65.78
Buy
Peabody Energy (NYSE: BTU)
$45.55
Buy
IShares Brazil Fund (Amex: EWZ)
$38.29
Buy
BHP Billiton (NYSE: BHP)
$42.33
Buy
Banco Bradesco (NYSE: BBD)
$31.80
Buy
Petrobras (NYSE: PBR)
$88.63
Buy
Mitsubishi UFJ Finan. (NYSE: MTU)
$13.51
Buy
iShares Japan Fund (AMEX: EWJ)
$13.02
Buy
Tenaris (NYSE: TS)
$38.04
Buy
MSCI Austria Fund (AMEX: EWO)
$29.80
Buy
Market Watch
NASDAQ
1528.95
0.00
SP 500
813.88
0.00
DJIA
7749.81
+89.84
As Of 6:12AM 3/26/2009
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