In the January-February double-issue, we utilized the famous Charles Dickens’ quotation: “it was the best of (investment) times and the worst of (economic) times” to emphasize the dichotomy between strong equity price surges and weak economic trends. Back then, the year-end rally was followed by the February decline as the S&P 500 fell to a low of 1044½. Once again, this same theme has repeated itself. The March-April rally provided a 17% gain to a late April peak of 1220. This 2½-month rise has given way to a 1½-month “swoon-in-June” as the index settled at 1065. The “correction” took investors on a “round-trip,” as some call it. Today, when a pundit was asked, “Do you see the glass as half-full or half empty?” …he replied, “It’s both… and that’s how all should see it!” Investors seem to be riding the exhilaration of better earnings, a friendly Fed, a nice economic recovery and a smooth uptrend in stock prices to a roller-coaster dip from a falling Euro, an unnerving sovereign debt crisis …requiring a weekend orchestrated ECB-bailout that finishes with the threat of war from the Asian bully, North Korea. These half-full half-empty scenarios are becoming the standard fare in our recent Commentaries. As May began, we were being asked, “Are you still concerned with the sustainability of the recovery?” “Don’t you think you should buy more beta-plays?” “Is a risk-averse, defensive posture still required?” Now, we’re not hearing many similar inquiries. A wise observer said, “The news doesn’t determine the market; instead, the market writes the news!” We have an ever-changing political environment and an uncertain economic landscape. Their concerns have increased as the focus shifts from “it was a great earnings season” to a “what is the meaning of all the new concerns we see?” As we have been emphasizing for almost six months, there are two different worlds we live in.

This month, we will emphasize how the US (along with other developed nations) will have to print much more paper to extricate ourselves from the too much debt, too little GDP growth dilemma. To our way of thinking, this means only one viable asset class for the long-term investor. Stocks! Why? Because neither money-market funds nor bonds are an inflation hedge. Today’s smorgasbord of difficulties presents very complex, vexing problems whose remedies, if they truly exist, are neither easy nor simple. The two quotations above frame the themes of this essay. The first one calls attention to the fact we face the opposing menaces of inflationary and deflationary threats… each one provides bad outcomes, but from divergent ills. The second comment produces enlightenment as to the seriousness, intricacy, and political difficulties any crafted solution faces in an effort to provide a successful outcome to the European problems.

May’s Focus - Above average profit-growth + numerous economic and political difficulties = the necessity of an inflation hedge: stocks - Our top-down (macroeconomic) viewpoint still foresees a labored and shaky recovery as employment hurdles, big deficits, home prices and foreclosures …all act to retard GDP growth. Other signs of a less-than-typical rebound include lagging credit growth and proposed tax increases as well as cuts in government spending. The tepid GDP growth, the inability to reduce the deficit, not to mention the possibility of the need for more stimuli all point to greater likelihood of more inflation. We want to differentiate between the strict definition of inflation: the printing of money (or quantitative easing) and the rise in the price of goods and services (or the more universally understood meaning). Thus, we are advocating more inflation-hedge equities as the solution of the likely outcome of these woes (versus cyclical plays). We’d rather arrive a bit too early at the inflation-party rather than taking the chance of coming too late when the price of admission is high and the space is overly crowded! The somewhat sudden “sovereign-debt, Euro-currency” crisis had been under most pundits’ radar screens and its sudden eruption and magnitude has befuddled many investors. Why? Because these ‘foreign’ factors seem to be extraneous to the US economy and unrelated to profits of the companies in the S&P 500. Yet, some analysts tell investors, “These European troubles affect global trade, sovereign debt and the banks that hold these bonds!”

The key to risk-reward assessments is to recognize and understand any long-term risks, as well as realize the likelihood of (or lack thereof) effective solutions, and any unintended consequences. This month, we will try to explain these rather complex and distant conundrums. To guide our readers through our analysis, we like to revert to our question-answer layout. We find it useful to “play the devil’s advocate,” asking “tough” and critical questions of ourselves! It also lends itself to reviews of past editions and quick shifts in subject matter. Thus, we embolden the content being discussed above the query. The questions are in italics and a smaller font --while the replies are in normal type.

The PIGSs, the EURO, the bailout and the sovereign debt crisis.

Most investors and many financial types don’t understand the Greek Crisis or the reasons why it is affecting our markets. Can you briefly outline what’s going on in the Euro-zone, why their debt is unstable and why the solution doesn’t appear to be working?

Since late April, and, in spite of the ECB-rescue package, global markets have been under constant disruptions as a weak Euro, rising LIBOR rate and social unrest have continued almost unabated. These matters are serious for three reasons: First, since most banks in Europe hold sovereign debt instruments, the Euro-zone financial system is under attack. It’s affecting inter-bank confidence and this is reflected in the rising LIBOR quote. Second, the Euro is under attack for three reasons: lack of political union between the ECU members, absence of fiscal integrity within the union, and the reluctance of the affected countries (Portugal, Italy, Greece, and Spain …the so-called PIGS) to adopt the severe austerities proposed by the ECB and the IMF. The severity measures include reduced employment, higher taxation, lower wages and fewer benefits. Citizens are demonstrating and rioting. It remains to be seen whether the PIGS will enforce the legislated measures. Lastly, it’s widely believed that the PIGS cannot repay their outstanding debts. This is due to the combination of four factors: inadequate GDP growth, a lack of competitiveness, excessive debt levels and expensive social programs. The potential insolvency of a nation’s sovereign debt was ignored when the ECU was formed. Typically, a country would employ the usual remedy: currency devaluation. This boosts exports, restricts imports, thereby increasing GDP. In addition, the government cuts spending, while increasing taxes. The printing presses work overtime. However, the PIGS’ debts are denominated in Euros. These measures can’t work when the currency is spread throughout the Euro zone and can’t be devalued! The ECB’s temporary fix is to loan the affected countries enough money to get them through the next 2½ to 3 years with the hope they can stabilize their deficits enough to not only resume their payback for scheduled maturities, but also repay the ECB and IMF. (Hope is seldom a good or workable strategy.)

The proposed solution doesn’t seem likely given the amount of sacrifice required by the PIGS and the amount of surplus needed to repay their existing debt not to mention the ECB’s fix. As we see it, the problem is nothing more than the leading edge of the globe’s game of “kick-the-[debt]-can” down the road. When sovereign debt is threatened by insolvency, it is never voluntarily remedied by the government that created the liabilities. The doctor doesn’t heal himself when it comes to unbalanced fiscal budgets. Developed countries don’t see default of sovereign debt as a problem because they think it can only occur in undeveloped and emerging nations. Besides, the proposed solution -- grow your way out of your problems – is the most acceptable, because it’s the least painful! Yet, this is both a serious problem and one that doesn’t have an easy, cost-effective and political acceptable solution. And, once the temporary fix runs out, if the PIGS can’t repay the ECB and IMF, then the system becomes more vulnerable. And therein lays the root of the market turbulence. As one guru put it, “Neither the Euro nor the temporary fix have an ‘end-game’ to resolve the insolvency!”

That’s a lot to digest, understand and deal with from an equity investor’s viewpoint. It seems the entire developed world (the US, UK, ECB and Japan) plays kick-the-can as well as “hair of the dog that bit you.” The latter game refers to the solution to over-extended debt levels is to layer on another echelon of liabilities. As governments and central banks have become the ultimate lenders of last resort, we must be getting close to the “inflation gone wild” frenzy. I know you believe a lot of this debt will be monetized and this will be eventually reflected in inflation. But do these actions represent dangers from a US viewpoint? Isn’t it a liquidity crisis?

Many observers see this crisis similar to the Lehman situation. It’s not! Lehman was a liquidity crisis caused by too much leverage of securities whose value and collateral became suspect. The Authorities injected hundreds of billions into the system while the Fed bought trillions of (some argue) questionable mortgage paper to offset the panic the bankruptcy triggered. These actions, along with the TARP and $1.3 trillion of stimulus, prevented a financial meltdown. This time we’re talking a sovereign default crisis as well as a currency crisis. Greece couldn’t repay its debt as it matured; neither could they refinance them. There’s a material difference between sovereign insolvency and a lack of liquidity. And, it’s a serious distinction! Unless it’s successfully resolved, the financial institutions holding the PIGS-paper will suffer large losses impairing their capital. This will prohibit their ability to maintain their normal business dealings. This contagion could (but, not necessarily will) spread throughout the Euro zone. Today, the LIBOR lending rate has swelled during the past few weeks. Spreads are widening throughout all debt markets, not just European.

Addressing your first comment, it seems all the developed nations are following the same blueprint, as you noted. Due to how the election process and lobbying interests function, there is an unwillingness of politicians to provide balanced budgets and responsible fiscal policies. And there’s the same amount of reluctance for voters to face the reality that there is no free lunch. Eventually, there is a day of reckoning! There has to be. The likely outcome will be painful. As we see it, it has to be inflationary!

The US economic scenario. Let me summarize this Euro-zone situation. We’re dealing with the threat of sovereign debt default involving the PIGS. This is affecting both the Euro and the banking systems that hold the questionable debt. It’s not a liquidity crisis; instead, the ECB and IMF demand some tough austerity measures for their bailout loans. A rising LIBOR is hurting all borrowings tied to that global benchmark. The PIGS nations are emblematic of all the developed economies where expensive (social-program) promises remain underfunded. Now, will you examine the US economic recovery and its outlook for the rest of 2010 and 2011?

To us, the key economic questions for the US are three: What is the probable rate of GDP growth? Given the answer to the first inquiry, what will our fiscal policy be over the next few years? And, what are the inflation and interest rates outlooks?

As we have noted for more than a year, Knott Capital foresees a slower than typical recovery and lower than consensus growth for GDP during next few years. The reasons are based on several factors that together act to restrain spending and/or inhibit lending. Additionally, any reasonable attempt to rein in our trillion dollar budget deficit has to, by definition, result in increased taxes or reduced spending. While these steps undoubtedly improve our nation’s balance sheet, it does so at the expense of GDP growth. There are other headwinds that are often forgotten or ignored: the trillion dollar losses that Fannie, Freddie and the FDIC are sitting on, record home foreclosures, defaulting commercial mortgages to name a few. Conclusion: slower than consensus GDP gains.

Friday’s employment number was a big and unexpected disappointment. Our message on the jobs situation has been and remains: job creation will remain a difficult and lingering problem. Why? Three reasons: lack of GDP growth, excessive capacity, the need to shed labor costs to maintain profits and cash flow. Slower job creation means less consumer spending; this represents 70% of GDP. Without new jobs, it’s difficult to see how GDP can rebound, although some economists are pointing to higher wage and personal income as a source. There are three ways to boost wages or take-home pay: create more jobs, increase the hours worked, and/or provide raises to present workers. We’ve dismissed the first factor as a meaningful stimulus. While hours worked are improving, they are doing so in lieu of the creation of new jobs. Obviously, the first factor is preferable to a work-hour extension. Wage gains in many industries are small, spotty and used to retain the best of breed, so to speak. Finally, our job creation conclusion is best demonstrated by this argument: small businesses create two out-of-every three new jobs! When one examines the small business association’s numbers and looks at underlying surveys they take of their members especially the hiring intentions, they don’t support much optimism. And, these entities are starved for credit and available lending to meet their member companies loan demand.

Some economists have welcomed some of the retail spending data as good news heralding gains in GDP growth and household income. When the details of the sourcing of these increases are examined, we aren’t convinced of this conclusion. In the last four months, the savings rate fell from 4.8% to 3.1%. This is an unsustainable source of increased buying power. Another origin of spending-growth comes from those who have decided to stop paying their mortgages. Let’s look at the data: 1:4 mortgages are underwater; 1:10½ mortgage payments were missed in Q1; and more than 2,000,000 homes are in foreclosure. Studies disclose that when most homeowners decide to forego mortgage payments, that money is often spent “in a splurge-type manner on big-ticket consumer items.” One study annualized this amount of additional spending at $60 billion. Conclusion: poor job creation and an unsustainable pace of retail sales. We believe the recovery is beginning to lose some of its momentum.

A few more reasons support our economic outlook, as well as our risk-averse assessment and strategy. Monetary policy and interest rates play a crucial role. We have emphasized the lack of credit growth as the banks have chosen to borrow cheap and invest in the steep yield-curve market that is a truly no lose situation. Whether the banks defense of “there’s no loan demand” is accurate or just a justification of their actions is unknowable. What is known is: the better the loan growth …the better the GDP growth. We think the Fed will be on hold until 2011 at the earliest. Although they talk contained inflation, we believe that they are acting as if the deflationary consequences are the real threat. Lastly, home prices may not be able to rebound much further and you can’t eliminate the possibility of a modest decline. When you strip away the housing incentives, there appears the threat of weak home prices in some larger key markets in the more populated states. Conclusions: when the inventory-rebuilding ends, the stimulus wanes and census workers are dismissed, GDP gains will probably be in the 2%-2½% area. No Fed moves until 2011, at the earliest. Inflation is being held at bay temporarily, but the inability (or unwillingness) to cut the budget deficit will force more quantitative easing. The Fed will be forced to print more money. Now is the time to prepare for this on-coming inflation. As a notable investor once remarked, “I understand Noah built his ark before it started to rain.”

Your major points are: below consensus GDP that is showing signs of slowing; the Fed is on hold; poor job creation and weak home prices; any fiscal improvements come at the expense of GDP gains; retail sales are unlikely to provide sustainable increases; and some problems (Fannie, etc.,) are open-ended checkbooks. Importantly while there is some good news on CPI data, the continuing printing of money will ultimately call for stocks as the best asset class, especially those that have acted as a suitable inflation hedge. Like what, for instance?

In theory, material companies whose products have either scarcity value or reliable pricing power; gold-related firms as well as ETFs (electronic traded funds) whose underlying value is tied to precious metals; and, under normal circumstances, energy companies who either have proven reserves trading near the stock’s book value and/or have a strong and established ability to discover new and plentiful oil, gas and other valuable natural resource assets. We also put clean water and related utilities as well as infrastructure and distribution equipment. Gold-related investments are a controversial and unique strategy to capture the upside from the fact that the printing of money and its unending growth of outstanding dollars cheapens the purchasing power of all who hold it. In today’s global economy, fiat (un-backed paper) currencies compete for trade by allowing their value to decline versus their “trading partners” money. All things being equal, this boosts exports and GDP. As the game of competitive devaluation grows, those who have dollars lose purchasing power and often, an inflationary spiral can emerge. This time, there are sufficient deflationary forces and enough excessive capacity to blunt price increases over the near term. Nonetheless, gold prices have risen steadily over the past few years and almost everyone who has advocated buying these investments has cited the printing of money and the probability of eventual CPI type inflation as the basis of their advice. We think every investor should have some precious metals protection as part of a risk-averse portfolio.

Due to the uncertainty surrounding the moratorium surrounding offshore oil exploration, the huge liabilities tied to any accidents and the likelihood of new, onerous and expensive regulations that may apply to offshore and onshore wells, it is very difficult to make blanket statements about utilizing energy-related stocks as current selections. The good news is that we had no offshore drillers or oil service companies in our portfolios when the accident happened. With politicians raving about new claims and wide ranging contentions about what BP will pay for… it makes no sense to us to try and value any of the exploration plays - be it E&P plays, drillers or services companies. While the big integrated companies are probably the safest issues, they also offer the least rewarding gains. We seek stocks whose value will rise as they attract investors who recognize their ability to get and stay ahead of the inflationary spiral that we envision within the next few years.

Summing it all up and a defensive, inflation-hedging strategy.

GDP growth for the last half of 2010 will be 2%-2½%. It is rather early but we’d be surprised to see two consecutive quarters of 3%+ GDP in 2011. More likely GDP will fluctuate between +13/4% and 23/4%. Interest rates will remain in their present range and inflation will be subdued for the time being. However, when central banks use printing presses to meet shortfalls, inflation has always been and is likely to be the eventual outcome. That is why gold hit a recent all-time high. The US Dollar will be the currency winner due to lack of meaningful competition! The only contender was the lightweight and poorly conceived Euro, a coinage that recently shot itself in the foot. Dividends will rise modestly. Corporate earnings will be strong, but not as high as the S&P now project. The Dollar will be the strongest in a race to the bottom. We are overweight the Health Care and IT sectors. We think stocks are the only Long-term game in town, that’s viable. While stocks are not risk-free, they are the only asset class that can (at least) offer meaningful appreciation. Our watchwords are: be flexible and remain so!