Trends and Themes

Earnings and economic reports are coming in more consistently than was the case several weeks ago.  The recovery looks to be sustainable with some noticeable trends taking shape.

Over the past month, the top-performing S&P sectors were technology, energy, consumer discretionary, and healthcare.  Technology and energy were the runaway winners, up 10% and 8% respectively.  Recent earnings announcements from Intel and IBM gave further credence to the thesis that corporate spending is improving.  Comments from managers of both were as bullish as they could be without seeding speculative investor expectations.

As we have said many times before, we look years, even decades into the future, to shape our investment strategy.  The view is shaped by leading authors, strategists, economists, and personal observation.  The view is broken down in to major trends or themes that will drive and shape the future economy.  One of the most significant themes for the past thirty years is the baby boom and the effect that huge segment of our population has had on our economy and very culture.

One of today’s most obvious ‘elephants in the room’ isChina.  There is no doubt that it will have major influence on global economics for years to come, driving numerous long term investment themes.  A major influence will be the incredible global deflationary influence ofChina’s workforce.  As millions of Chinese are employed in new state-of-the-art factories to produce high quality goods in an increasing array of industries, global competition will reach unprecedented levels.  Global inflation from wage pressures will diminish for years to come given the huge numbers of people willing to work for a fraction of wages demanded by workers in the more industrialized nations.

Today, companies are unable to raise prices because of the huge deflationary influence of cheaper Chinese goods.  Perhaps European central bankers will realize what Mr. Greenspan and our Fed already understand – that European interest rates are too high and can be reduced without risking of inflation.  The action would stimulate European investment and slow or reverse the now economically and politically painful (inEurope) appreciation of the Euro relative to the dollar.

Another major Chinese influence will be that of consumption.  They simply cannot internally produce fast enough the infrastructure, raw materials, or technology they need to build the coming China, Inc. China represents 40% of the world’s oil demand, second only to the U.S. China represents huge growth in the microchip and software demand.  As the country builds infrastructure, companies such as Caterpillar and Deere benefit.  Boeing is seeing a dramatic rise in demand in China for their jets.

Closer to home, healthcare will continue to be a dominate force in our economy as the aging baby boom population places stresses on the system.  Rising medical costs are already having dramatic impact on businesses’ profits.  The biotech industry has been more effective in brining new drugs to market than the major pharmaceuticals companies.  Their role in the marketing of drugs has risen as their drug pipelines have shrunken.

The information economy is alive and well.  Intel’s fourth quarter revenues, just released, topped their pre-bubble levels of March 2000.  Two months ago Cisco reported its most profitable quarter ever.  Businesses are investing again and information technology including software, hardware, storage, and transmission are indispensable.

Remember the Chinese influence?  In order to effectively compete withChina, businesses will place unprecedented importance on productivity and innovation.  During the past three-years of business slowdown, productivity soared.  As a result companies generated greater profitability and likely employed more workers than they might have otherwise.  If managers had doubts regarding the benefits of their past technology investment decisions, they are gone now.

Outsourcing of processes and services is also becoming a vital component of the business mix.  Managers of leading companies realize that they must ‘do what they do’ quicker, better, and cheaper than their competition.  If their business models closely resemble their competitors, it is unlikely they can outperform them.

Other major trends we have discussed before include education and re-education.  As businesses must become more flexible and adaptive so must workers.  Increasingly, the American workforce will become more dynamic and fluid.  Life-long employment with one or two service or manufacturing companies will become a thing of the past.  Employees will increasingly contract with employers for their services.  Continuing education will be more important than ever to maintain their attractiveness to employers.

As you can see in the table above, the economic news continues to be generally positive.  Most notable were the Empire Manufacturing and the Philadelphia Fed reports.  They suggested that business spending is significantly improving in those areas and that consumer spending is healthy.  The trend in employment continues to be positive too, but is still sluggish in its rate of improvement.  This week’s Initial Jobless Claims report represented the 15th month in a row the total remained below 400,000 – a good sign.

The long-term case for equities is a strong one, particularly in the areas that we and our top advisors believe will represent the sweet spots in our economy.  Barring any shocks, we believe interest rates will rise gradually as the economy improves, but without inflation pressures the rise will be slower than those of previous recoveries.  The Fed has communicated with unusual clarity its willingness to keep short term rates at current levels until the economy sufficiently heals and is able to sustain growth.  In short, we are bearish on bonds and bullish on stocks – specific stocks.