January 14, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Monetization: The New Normal. Following the sharp increases in food and energy prices in December, we are surprised by Wall Street anticipation of 2011’s return to health and normalcy with no concern for this variable. Inflation seems to float well below the radar, and remain ignored by many on the Street. Let’s watch and see if the news network pied pipers can play an enticing tune for the public and convince them that that pinch in the pocket book isn’t really happening.

If 2010 was defined by concerns over sovereign- and bank-debt contagion, surely 2011 will in the end be characterized by stagflation. We borrow the term from our good friend Harry Schultz, who coined the term in the ’70s as he witnessed chronic unemployment matched with a brisk rise in the cost of living. If you were lucky enough to have a job, wage inflation never kept pace with the increase in prices all around you, and thus you had stagnation with inflation (not to mention immolation with frustration).

Our topics today could include PPI (14% annualized inflation), CPI-U (6.2% annualized inflation), December retail sales, or a host of other numbers – all of which hold great value, assuming you dig deeper into the details. We would rather focus on a recent issue, which serves to illustrate how easily the market accepts information uncritically.

This week we had a European bond auction go off without a hitch. Specifically, Portugal issued debt to the tune of 1.25 billion euros (following last week’s $1.1 billion private placement with China). It was fully subscribed, and rates remain on a stable footing (not spiking higher), even with background concerns over that country’s debt levels and income deficiencies. The profound event that occurred immediately following the bond auction leaves us stunned: the news media simply raced on as if to say no news here.

The issue is simply this: The market is now accepting monetization without pause or concern. Out of the €1.25 billion in bonds sold, 80% were bought by the ECB, and only 20% by the market. Looking at that another way: Without a prop from the central bank, the auction would have failed on a scale rarely seen. Instead, we move further into a brave new financial world where these are normal events. After all, if monetizing Treasuries works for the Fed, it should work for every other central bank.

What the market has assumed is that a central bank is a natural buyer (of first or last resort) for government securities. The only dissenting voice is from Germany, where these purchases may be contested in court due to Bundesbank opposition.

What strikes us about this auction, and others similar to it, is the way monetization is now regarded as a non-event. No one questions it, and no one takes it out of the equation when assessing how far we have to go to return to a state of economic normalcy. It’s like pretending that deficit spending has no relation to GDP growth (As if spending over a trillion dollars that we didn’t have to begin with is a mere trifle, at roughly 10% of GDP.)

So, as we witness monetization become the norm, and inflation with it, we return to that pocketbook-pinching experience felt by the man in the street, and the disconnect between piper and rodent.

The lesson of the week: Always ask more questions, and be willing to slow down when others speed up.

2. Semiconductors: A Zero-Sum Gain? For a while now, I’ve been chirping about how the momentum in earnings growth has begun to slow to a near standstill on a sequential (Q to Q) basis. This is partially due to higher raw material (commodity) prices squeezing margins, and partially due to lagging demand growth (especially in the U.S.). Alcoa is a perfect example, now earning nearly 50% less at the same level of revenues it registered over six years ago. Investors were unenthused at this news, throwing Alcoa shares for a 2% loss following the announcement. Industrials traded rather flat in sympathy.

Technology firms appear to be a different story, at least on the surface. Reporting at the close yesterday, Intel posted a sequential 3.2% increase in revenues and a 13.4% jump in earnings on record gross margins of 67.5%. The year-over-year comparisons were even better, with an 8.4% increase in sales and a 47.5% increase in earnings.

Sounds great, right? But the year-over-year comparisons were positively impacted by a $1.2 billion one-time charge (last year) against earnings derived from a settlement over a lawsuit with AMD. Taking the charge into account, earnings would have increased by 7.2% instead of the 47.5% touted. Also lurking behind the scenes was a $1.5 billion share buyback (cash outflow), which was not expensed, to retire its float associated with option-derived compensation for employees (why were they selling the shares, we wonder?) If it were expensed, it would have negatively impacted earnings by as much as $0.26, or 44%. There were some other “minor” developments, such as a 23.9% increase in inventories and a 36% increase in deferred taxes that helped in the quarter.

In essence, Intel may not be making fair quarter-over-quarter comparisons, and has chosen to omit cash outlays that should be expensed. So, when you factor out the cost of doing business (pro forma), things looked pretty good. However, investors weren’t fooled. Intel shares were off on the day, still hovering below the 50-day moving average.

This didn’t stop the feeding frenzy in technology stocks on Friday. Semiconductor equipment makers in particular were all the rage following Intel’s cap-ex number of $1.869 billion – an unexpected surprise, partly due to Intel’s relationship with Apple. The top five U.S. equipment makers, including Applied Materials, ASML Holdings, KLA-Tencor, and Lam Research, added a combined $3.638 billion in market-cap by the close of trade – irrationally doubling the effect of Intel’s cap-ex – in one day!

How long the animal spirits last in the tech sector is a subject of debate, but I doubt that they can continue much longer. Recent pressure from higher interest rates, relatively flat wages, rising jobless claims, higher energy/food prices, and Chinese efforts to stave off inflation will all have a dampening effect on consumer spending over the next few quarters. Plus, it is doubtful to me that Americans will opt to replace their current computing and TV needs with an iPad or any one of the plethora of iPad imitators, as integration has become a more dominant theme across all electronic devices. It may be possible that, as the industry becomes crowded with competing “me-too” options, weaker profits for all could be in the offing. That’s certainly not the prevailing attitude at the moment, but we shall see.

Have a great weekend.

David McAlvany
President and CEO

David Burgess
VP Investment Management


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