November Results

Akin to navigating through treacherous waters during the perfect storm in zero visibility, astute investors are forced to step back and re­address their investment strategy in a logical and meaningful way without falling victim to the excessive levels of panic that have washed over our financial system.

This is the time when a true Captain trusts his instruments and steers the ship towards profits and prosperity. JSK Partners will do just that, trusting our tools, and expecting above average gains as we head into 2012. Our panglossian outlook is a function of analysis and interpretation of our proprietary fundamentalmodels. In fact, very rarely do we get such strong fundamental signals from our models. We areplacing a very high probablity on an exceptional year in the US equity market that is coming in the next twelve months. More on that later, first we will discuss our monthly results.

November Results

The month of November proved volatile and challenging to navigate. Heading into early October, we increased our long exposure to take advantage of the ensuing rally towards the latter part of the month. Our clients observed a 13.3% increase in their portfolios for the month with equities leading the charge, up 24.5% for the month followed by our fixed income portfolio up 11.9%. Our anticipation of a follow through into the “Santa Claus Rally” was vanquished early on in November. For the month of November we saw a decline in our portfolio by 7.9%.

Since our launch earlier this year we are down approximately 12% compared to a decline of 9% for the S&P 500. We foresee sustained news coming out of Europe and the United States that will be “acceptable” to market participants and that should be enough to drive the market higher into the end of the year. We will maintain our “risk­-on” stance unless things deteriorate rapidly.

We continue to over weight our exposure to those sectors that will lead the charge during our next leg higher. Consumer Discretionary companies, and more specifically, highend retailers continue to be our largest holdings followed by Information Technology and Health Care.

While Health care is typically considered a defensive sector in nature, we own companies that have recently released cutting edge drugs or medical instruments that are driving growth in earnings and revenues well above their more conservative counterparts.

Strategic Market Positioning

Fundamentally, the US stock market is undervalued and quickly approaching a buy point that will start a long­term rally. We are confidently making this call based on the fundamental research we have calculated and analyzed.

Our fundamental model encompasses several valuation metrics in an attempt to arrive at a fair value for the US indices. The key elements within our fundamental model focus on:

1 ­The twelve­-month forward earnings yield for the S&P 500 (which is the inverse of the twelve-­month forward P/E ratio).

2 ­Expected earnings growth over the coming twelve months.

3 ­Yield differential against the ten-­year treasury yield to attempt to capture security rotation.

We have been tracking this model for over fifteen years and it has produced significant market directional opportunities. Unlike our behavioral model that seeks out more shorter-term directional movements in order to capitalize on excess returns through tactical portfolio rebalancing, our Fundamental Model provides information on larger secular shifts in the US equity markets and directs our strategic positioning. We are close to getting significant buy signals from the fundamental model. In fact, 4Q11 is only the fourth time since we started tracking this model in 1985 that we received an “Extreme Panic” reading. The first three times occurred in November and December of 2008 and March of 2009. Analysts are forecasting the components of the S&P 500 index to report an aggregate $106.46 in the coming twelve months putting the earnings yield at 8.6% (or 11.7 twelve­month forward P/E ratio). Expected calendarized earnings growth for the index is 12%, tracking below the average 18% and the anemic ten­year treasury yield has been tracking around 2% for several weeks.

By taking these measures into account, our belief is that the market has already priced in much of the current and expected market turmoil that has been reported over the last several weeks.

Barring an unknown event, such as a terrorist attack, natural disaster or the unlikely dissolution of the euro­zone, our opinion is one of bullishness. With the market trading near 11.6x forward earnings, (the level associated with fear) investors are still shellshocked from the massive shellacking taken in 2008 and took very little time to decide to run for the exits this time around. The twelve­month forward earnings forecast have come down approximately $1.65 from $108.11 in early September and earnings growth expectations have fallen from 20.9% in June to 12.0% today.

This indicates to us that much of the market turmoil has been worked into the existing forecasts. Once investors tolerance for risk increases, they will have the choice of remaining in treasuries yielding approximately 2% or moving cash into equities potentially yielding 8%. In search for greater returns, we are anticipating a rotation out of treasuries and into equities in the coming year.

When interpreting the fundamental model, one needs to wait for the trigger line (thin blue line) to fall below zero and buy when the trend line (thick orange line) starts to head higher.

As can be seen we are below the zero line and the trigger line has turned higher. This puts us on alert that we are approaching market bottoms and will increase our long exposure more aggressively when the trend line heads higher.

On the following page we have pinpointed the various buy signals provided by this model. As can be seen in these examples, our fundamental model has picked points in the market when the US equity indices have gone on to return 28% on average in the following year.

Taking a closer look at the historical market calls that our fundamental model has provided, one can see the lucrative opportunities presented. There have been six other buy signals since 1985 not including the one we are receiving today.

1 ­ Displays our fundamental model in the mid fourth quarter of 1988. Our trigger line alerted us to a potential opportunity in November 1988 and we received the actual buy signal in March 1989. The S&P 500 went on to rally 25% from those levels over the next year.

2 ­ Shows our fundamental model in the fourth quarter of 1990. The trigger line gave us the signal to be on watch in October 1990. The buy signal came relatively quickly in December of the same year. The S&P 500 moved higher by 29% in the following year.

3 ­ Came in December 1994. As the exhibit shows, the buy signal ultimately arrived almost a year later in October 1995. The S&P 500 moved aggressively higher over the next year and a half producing returns in excess of 35%.

4 ­ September 2002 is when we obtained the next fundamental trigger indication. As seen in the exhibit, the buy signal arrived in October 2003, over a year later. By January 2005, the S&P 500 had rallied close to 20%.

5 ­ Shows our fundamental model in the final quarter of 2005. The trigger line gave us the heads up in October and the trend line gave us the buy signal by July 2006. Within a year’s time the S&P 500 ran 20%.

6 ­ Trigger comes in December 2008.. The trend line though kept us out of the market until May 2009. Upon the buy signal the S&P 500 went on to return an astonishing 37%.

7 ­ We expect to see the S&P 500 to return in excess of 20% in the next twelve months.

Europe's Solution

Events out of Europe endure this week with further calls to lay out the road map towards a solution to their lingering debt crisis. Last week we laid out our ideas for Europe in providing confidence to the world markets and we are optimistic that this week may prove the turning point needed to get beyond the uncertainties. Before the European summit this week, German Chancellor Angela Merkel is again endorsing increased fiscal oversight through a centralized fiscal authority to address the underlying budgetary problems with southern European countries. Her intentions are to change or modify the European Union’s treaty to accomplish this goal. This would also require acceptance by other EU countries to accept increased supervision and loss of national sovereignty, so it was a huge message that was sent last week when both France and Italy insinuated adherence towards a new fiscal plan.

France put forth its desire for a deal that involves all 27 countries that comprise the EU but also noted the potential for a 17 eurozone member compromise if a larger deal is not possible. Prime Minister Mario Monte is scheduled to announce new austerity measures this week with hopes of saving up to $25 billion and balancing the budget by 2013.

As we commented last week, we are supportive of the process that has been unfolding and believe Germany and the European Central Bank have the right solution, albeit too slowly. The problem of too much spending and not living within ones means is a serious problem that will plague generations to come, but we are also weary of attempting to cramp what should be a twenty year fix into twenty weeks. Our opinion and hopes are that there will be a renewed discussion on, not only centralized fiscal discipline, but also centralized discussion for growth in Europe. Economic growth is the only way to avoid a downward, inescapable debt spiral.

Our support of the proposed Merkel solution is certainly mirrored by many. “Berlin’s alleged sin is its reluctance to write a blank check to save the euro –either by underwriting a new eurozone fiscal union, or granting permission for the European Central Bank to buy trillions in sovereign debt. The chant comes in unison from the debtor nations themselves, the bailout caucus in Brussels, an Obama White House concerned about its reelection, and liberal pundits worried that their welfare-state economic model is under assault.” – Blame It on Berlin – Wall Street Journal opinion, 11/30/11.

“Chancellor Merkel is putting up a brave fight to preserve the ECB as a bulwark of sound money…One can hope that Ms. Merkel can lead them towards a political solution that will save the euro, global securities markets, and maybe Europe’s chances for further economic progress.” A Political Solution for the Euro? – George Melloan, Wall Street Journal opinion, 11/30/11.

“So even if Europe addresses the banking­ capitalization crisis of the moment, and even if it struggles its way through the near-term fiscal crises of Greece and Italy, then what? With little prospect for growth in its South, Europe remains on the romantic road to nowhere –a road that merely runs in a circle. Without growth there will always be another fiscal crisis ahead for yet another country unable to balance its budget but prevented from devaluing and exporting its way forward.” – Europe’s Currency Road to Nowhere – Austan Goolsbee, Wall Street Journal opinion, 11/29/11.

One the other side of the argument, there are those that completely scorn the Germans for their fiscal efforts.

“Today, it is Germany that is making policy moves that seem insane. Locked into their modern ­day orthodoxies, German politicians look to Greece with something akin to contempt. Aid to Greece –aid that is given grudgingly, when it is given at all – must be accompanied by severe austerity measures the Germans believe, because the Greeks need to learn how to live within their means, the way Germans do.

For months, Germany has strongly supported the European Central bank’s unwillingness to do the one thing that might have stemmed the euro crisis: buy and guarantee large amounts of distressed sovereign debt.

Such a view is understandable –in America and in Germany. But if we –and they –can’t stop obsessing about what is fair, we’re never going to get out of our current messes. The only thing that should matter is what works. Even if it means bailing out club med nations or underwater homeowners.” Germany Cuts Off Its Nose – Joe Nocera, New York Times opinion, 11/29/11.

“But the truth is nearly the opposite. Although Europe’s leaders continue to insist that the problem is too much spending in debtor nations, the real problem is too little spending in Europe as a whole. And their efforts to fix matters by demanding ever harsher austerity have played a major role in making the situation worse.” Killing The Euro – Paul Krugman, New York Times opinion, 12/2/11.

“The real lesson from financial crises is that, at the pit of the crisis, you do what you have to do. You bail out the banks. You bail out the weak European governments. But, at the same time, you lock in policies that reinforce the fundamental link between effort and reward. And, as soon as the crisis passes, you move to repair the legitimacy of the system.” The Spirit of Enterprise – David Brooks, New York Times opinion, 12/2/11.

Central Bankers Step In

Early Wednesday of last week, investors received word that the world’s major central banks were working in unison to provide inexpensive, emergency dollar loans to European banks to stave off a global credit crisis. As we have noted in the past, central bankers have been forced to stretch the role of monetary policy in our global economy beyond traditional measures, as fiscal solutions are chronically stymied by fiscal befuddlement and political infighting.

Our initial reaction to this announcement was one of concern that left us pondering what possible doomsday scenario would entice the world’s central bankers to take such drastic action. We envisioned a day with the Dow Jones Industrial Average shedding 400 points but instead received the opposite. The market rallied strongly on the news and we postulate this was a direct message sent to the political participants in Europe to get their act together and quickly. We believe this also opens the channel for additional help from the ECB (through loans to the International Monetary Fund) pending acceptable results from this week’s European summit.

While the market celebrated the move, many did not share the sentiment.

“In short, nothing has been solved in Europe. The Europeans are not yet helping themselves. Why should the ECB write a trillion dollar check to near ­bankrupt governments? And how can the IMF borrow $800 billion from the ECB to give the same troubled governments even more money? And remember, the U.S. owns nearly 20% of the IMF. Is Congress really going to sign off on this massive ballooning of its mission and balance sheet?” Lawrence Kudlow – Stocks Get By With Little Help From Our Fed, IBD opinion, 12/5/11.

“This makes sense to prevent intrabank markets from seizing up, but no one should think it solves Europe’s larger problems of fiscal solvency.” Betting on Central Banks ­ Wall Street Journal opinion, 12/1/11.

“It doesn’t make the global economy better, but it might keep it from getting worse –and possibly much worse.” Did The Fed Save The World From Disaster – Robert J. Samuelson – IBD opinion, 12/2/11.

“In short, the global financial system is near collapse, and the central banks are madly pumping dollars into it to keep the collapse from happening. It’s an emergency, we get it. But while such actions might help in the short run, they won’t in the long run.” Fed’s Big Move Is No Solution – IBD opinion, 12/1/11.

“The Fed’s extraordinary intervention should impress upon the European Central Bank, as well as its paymasters in Germany, that it is high time it stopped sitting on its hands. Only aggressive action by the bank can arrest the government debt crisis that is spreading across the Continent and threatening the very survival of the euro.” The Fed and the Euro – New York Times opinion, 12/2/11.

America needs to be more like China...Really?

In one of the more bizarre opinion pieces I’ve read in a while, the Wall Street Journal published the views of Andy Stern, former president of the Service Employees International Union (SEIU) and currently a senior fellow at Columbia University’s Richman Center. The shocking views that articulate the fall of capitalism and this country’s idiotic adherence to a dead economic model are nauseating at best and dangerous at worst.

“The conservative­ preferred, free­market fundamentalist, shareholder­ only model—so successful in the 20th century—is being thrown onto the trash heap of history in the 21st century. In an era when countries need to become economic teams, Team USA's results—a jobless decade, 30 years of flat median wages, a trade deficit, a shrinking middle class and phenomenal gains in wealth but only for the top 1%—are pathetic.

This should motivate leaders to rethink, rather than double down on an empirically failing free­ market extremism. As painful and humbling as it may be, America needs to do what a once dominant business or sports team would do when the tide turns: study the ingredients of its competitors' success…

For those of us who love this country and believe America has every asset it needs to remain the No. 1 economic engine of the world, it is troubling that we have no plan—and substitute a demonization of government and worship of the free market at a historical moment that requires a rethinking of both those beliefs.

America needs to embrace a plan for growth and innovation, with a streamlined government as a partner with the private sector. Economic revolutions require institutions to change and maybe make history, because if they stick to the status quo they soon become history. Our great country, which sparked and wants to lead this global revolution, needs a forward looking, long­-term economic plan.” China’s Superior Economic Model – Andy Stern, Wall Street Journal opinion, 12/1/11.

And the response…

“Stern is wrong on at least two counts. The first is that what we have been practicing of late can hardly be called unfettered capitalism. We labor under the burden of ever-­restrictive regulation and the highest corporate tax burden in the world. The administration has embraced industrial policy to dictate where factories can be built and what energy can be developed. It, not the free market, picks the winners and losers.

If we were practicing capitalism, Boeing would be allowed to make its Dreamliner passenger jet in South Carolina without the commissars at the National Labor Relations Board interfering. We'd be building the Keystone XL pipeline to bring Canadian tar sands oil to American markets. We'd be drilling offshore and in ANWR.

If we were practicing capitalism, there would be no such thing as too big to fail. There would be no bailouts, no nationalization of health care or buying of car companies. There would be no Solyndras or government "investments" in failed alternative energy. We wouldn't shoot ourselves in the foot building high speed trains.

The second is that China is hardly the worker's paradise Stern portrays. Its progress has been built on the corpses of millions sacrificed for this or that great leap forward. China has perhaps the worst distribution of wealth on the planet…

In SEIU's world view, there is no room for dissent, or even a free market. Everything must be controlled by government and run by union members.

Sorry, Andy, the problem is not that we're not following China's example but that we've let big unions like your SEIU and the big government you crave strangle the economy. It's the capitalists, the entrepreneurs, the risk­takers and the taxpayers of America who must unite to throw off the shackles of the creeping socialism you and President Obama so warmly embrace.” Stern Touts Crony Communism – IBD opinion, 12/5/11.

Joseph S. Kalinowski, CFA