More on Cyprus

by Brad Houle, CFA Senior Vice President

With the bond market closing early and the capital markets closed on Friday, Brad Houle, CFA, gives a brief update on Cyprus for this week’s Weekly Market Makers entry.

The S&P 500 closed today at a new record, surpassing its previous closing high from October of 2007 and resulting in a 10-percent gain for the first quarter of 2013. Over on the other side of the Atlantic, the news was less celebratory, with focus on developments in the relatively small, but significant sovereign state of Cyprus.

Banks in Cyprus started reopening after two weeks during which a bailout was being negotiated with the European Central Bank. The reopening of the banks was less dramatic than feared as only small crowds of depositors lined up to withdraw the limit of €300 limit per day. The government has temporarily put in place strict capital controls on removing cash from Cyprus to limit the damage of a wider run on the banks.

Ordinarily, this story would be receiving little international attention due to the small size of the Cyprus economy; however, the news coverage we are seeing is a by-product of the nature of the bailout. Depositors’ funds in banks are thought to be sacred as the financial system runs largely on trust. Because this bailout involved the “taxing” of depositor’s money in order to assist in funding the bailout, it is seen as a taboo in the financial world to not give bank depositors their money back. Although these depositors are receiving equity in their banks, it’s just not the “standard operating procedure” we have seen from both sides of the Atlantic.

Initially, the plan involved a deposit tax on all accounts— regardless of size. This week, we saw the Cyprus solution altered to tax only deposits over €100,000. This policy change was more politically feasible because it was perceived to be impacting wealthy Russians who were using Cyprus banks as a tax haven, as opposed to local senior citizens.  

While this crisis has not reignited the broader European financial market stress, it has potentially given pause to investors and depositors all over Europe. Europe lacks a central deposit insurance organization, such as the FDIC. As a result, their deposit insurance is a comparatively more fragmented infrastructure. Using depositors’ money to fund a bailout may cause investors in bank bonds to be wary. Senior debt holders have mostly been made whole in bank bailouts both in the United States and in Europe. If bond investors fear the jeopardy of holding these European assets has risen—confidence may be further eroded in a business that functions on trust. 

 Disclosures

March Madness for Cyprus

by Shawn Narancich, CFA Vice President of Research

March Madness

With Italy still lacking a government after indecisive elections earlier this month and business on the island of Cyprus grinding to a halt because of a banking crisis there, Europe is again proving to be a thorn in the side of investors. Blue chip stocks were stirred but not shaken, ending the week modestly lower amid an uptick in volatility. Because Cyprus is a tiny economy with a total GDP a tenth of a percentage point the size of ours, one could easily dismiss the turmoil there as inconsequential if not for the otherwise surprising proposal by Europe’s power brokers, who recommended that a bailout funded by the European Central Bank, the European Commission, and the International Monetary Fund be accompanied by a tax on Cypriot bank deposits. 

Penny-Wise and Euro Foolish?

The fear is that a bank deposit levy could wash up on the shores of countries like Greece or Italy, where funding bailouts has left a bitter taste in the mouths of German citizens who would like to stop funding the profligacy of southern Europe. The situation in Cyprus is unique because its banking sector is almost entirely financed by deposits. With relatively little funding from bond investors, recapitalizing the oversized Cypriot banks by restructuring debt obligations wouldn’t accomplish much. So following a unanimous rejection of the European proposal, the ball is now in Cyprus’s court, and the shot clock is about to expire. If Cyprus fails to propose a Plan B acceptable to European lenders by Monday, the ECB has promised to eliminate lender-of-last resort funding for the Cypriot banks. With depositors chomping at the bit for their cash, a lack of central bank liquidity would almost assuredly sink Cyprus’s banks once they re-open, and likely lead to the country’s exit from the European Union. Yes, Europe remains a simmering menace to investors. Amid the turmoil this week, Treasuries caught a safe-haven bid that dropped the benchmark 10-year yield back below 2 percent. 

Just Did It

While Europe festers, Nike is prospering. Much to the delight of its shareholders, the sports apparel and footwear behemoth re-energized its stock by reporting better-than-expected sales and earnings that grew at the fastest rate in recent memory. After struggling with excessive inventories and upstart competition in China, Nike “checked all the boxes” this time around, reporting a healthy increase in gross margin profitability and a 7 percent increase in futures orders, including gains from the Red Giant.  On heavy trading volume, the stock raced ahead by 11 percent.

Just Didn’t

Contrast Nike’s success with a disappointing setback for Oracle, which reported February-ending financial results that fell short of estimates both on the top and bottom lines. In what appears to be a case of three steps forward and two steps back for the leader in enterprise software, management cited a lack of follow-through by the sales force, newer members of whom failed to close deals in a timely matter. After quarter end, Oracle booked several of these large deals, so bulls on the stock are left to expect that the financials will look better in Oracle’s seasonally strongest May quarter. Bears will argue that software as a service delivered over the Internet is denting Oracle’s business, but the company’s acquisition strategy has targeted many such “cloud” computing firms to strengthen its capabilities in this area. Meanwhile, the jury is still out on Oracle’s acquisition of Sun Microsystems, with hardware sales from this business continuing to fall. Also on heavy trading volume but with a much different result, Oracle shares fell nearly 10 percent on the news.

Our Takeaways from the Week

• Stocks remain well bid amid renewed turmoil in Europe
• Odd-month earnings reports were decidedly mixed

Disclosures

White Smoke and the Ides of March

by Shawn Narancich, CFA Vice President of Research

White Smoke and White Flags While Catholics worldwide reveled in the selection of their new pope, investors betting against stocks are licking their wounds, helping push equity prices higher after surrendering cash to invest or cover misplaced bets. After setting consecutive daily highs for a record ten straight days, the Dow Jones Industrial Average finally took a breather Friday, pulling back modestly despite a continuing cadence of supportive economic data. Market technicians are debating the significance of low trading volumes, but the results are adding to a wealth effect that is also being buoyed by rising home prices.

The Ides of March

February’s retail sales report is illustrative.  In contrast to expectations that ranged from negative to muted gains, sales actually rose 1.1 percent from the previous month. The numbers beat all estimates despite February being the first full month of higher payroll taxes that served to reduce consumers’ discretionary income. The takeaway from this report is that our economy probably stands to grow faster in the first quarter than the 2 percent commonly predicted by economists. Also supporting this notion is U.S. industrial production, which also rose more than expected in February. Just what the doctor ordered – after a fourth quarter earnings season in which companies once again under-promised and over-delivered, surprisingly good economic data will be key fuel if the bull market is to make new highs. As stocks melt up, longer-term Treasuries also gained, with the benchmark 10-year bond trading up to yield a hair below 2 percent.

On the Front Burner While blue chip equities posted modest gains for the week, natural gas-focused energy stocks rocketed higher with the commodity. The clean-burning fuel, much maligned by commodity bears who foresee an endless supply of shale gas keeping prices unrealistically low, gained 6 percent on the week and is now up 23 percent in the past month. Why the rush to buy gas? Cold weather in the past couple weeks has helped reduce a surplus of natural gas inventory, which now stands just 5 percent above 5-year average levels. Less commonly appreciated is the fact that gas production is beginning to wane. In key states like Texas, Colorado, and Louisiana which, as Morningstar points out, account for 40 percent of U.S. production, production is falling. Pennsylvania, which contains the prolific Marcellus Shale, is still reporting production gains, but at decelerating rates. All of which recognizes the fact that when energy producers fail to drill as many new gas wells, gas production will fall. So with natural gas now trading at $3.90 per million British thermal units, where to now? For that prediction, we believe that the oil markets are instructive. With U.S. crudes priced between 90 and 110 dollars per barrel, producers with oil and gas acreage will continue to choose oil, because in most cases, the returns are superior. Yes, producers with acreage in the ultra-low cost Marcellus will likely expand their gas drilling, but rigs can’t be moved on a dime and the Marcellus only accounts for about 12 percent of U.S. production. As natural gas production continues to decline in higher cost, more mature basins, and secular demand for gas continues to rise, economics should support higher gas prices into the $4-5 range.

Our Takeaways from the Week

• The Dow Industrials set a new high as stocks marched higher, driven by better than expected economic data

• After a long spell of depressed prices, natural gas is on the rise

Disclosures

Hat's Off to the Bull

by Jason Norris, CFA Senior Vice President of Research

Hat’s off to the Bull

The Dow Jones Industrial Average finished the week at an all-time high, eclipsing its previous peak from 2007.  Economic data continues to show some improvement, and with stocks under-owned, investors have been increasing their allocation to equities (as highlighted by a recent Barron’s cover story).  While the broader S&P 500 is just shy of its previous record set in October of 2007, we still believe there is upside for stocks.  The U.S. consumer has shrugged off the tax increase and the sequester drama and beginning to borrow again, and corporate America is maintaining high profitability.  Furthermore, Emerging Markets, specifically China, are reaccelerating and Europe is attempting to build a base.  With this in mind, we will continue to ride the Bull for the foreseeable future.

While U.S. stocks are either reaching, or on the verge of reaching new highs, this is not the case for those across both oceans.  The MSCI EAFE index is still 30 percent off of its 2007 highs, and Emerging Markets are 25 percent below their previous peak.  With this in view, we believe there are opportunities to expand international exposure in client portfolios through reductions in allocations to fixed income securities and gold.

Down on the Farm

Ferguson Wellman’s industrials sector analyst, Jim Rudd recently attended a conference highlighting companies in the agriculture space.  As global incomes rise, people are able to consume more protein, and as a result, demand for corn and soy will remain high.  However, global farmable acres are not growing, thus improving yield is key to meeting this heightened demand.  Fertilizers, herbicides, and seed manufacturers are all themes we are employing to take advantage of this secular shift.

As demand for agriculture products rise globally, we are going to see prices increase in both crops, as well as other food products (namely beef).  With corn as the main feedstock, ranchers will demand higher beef prices.  We will be watching this dynamic closely in 2013 as food prices may put some pressure on the consumer, as well as hit margins for restaurant operators.

Irresistible Force

Smart phone proliferation and the growth of wireless data were highlighted at the Mobile World Congress in Barcelona this week.  Growth of devices like Apple’s iPhone and Samsung’s Galaxy phones continue at a pace approaching 50 percent, with over 1 billion units shipped in 2013.  In fact, penetration of smartphones will eclipse 50 percent globally this year. Wireless providers such as Verizon Wireless and AT&T are spending billions to continue to upgrade their networks to handle the increased data demands that this shift has caused.  Spending on 4G/LTE networks will be peak this year in the United States. 4G/LTE networks give handset users the ability to download a 20 Megabit file in 25 seconds (compared to three minutes on a 3G network).  The increased amounts of data traveling across networks will grow the need for more storage and cloud capacity, as well as mobile security.  As such, storage and security are two themes that we are focusing on in our client portfolios.

We believe Apple and Samsung will continue to be market leaders in the Smartphone market with a combined market share of close to 60 percent, while earning over 100 percent of the profits.  The ecosystem that the Apple iOS and Android enjoy over other vendors should allow them to maintain this quasi-duopoly for the foreseeable future.     

Our Takeaways from the Week

• Even though US equities are close to all-time highs, we still believe there is more upside
• Mobile data growth will be a long-term secular theme in Technology

Disclosures

Let the Spending Cuts Begin

by Shawn Narancich, CFA Vice President of Research

Let the Spending Cuts Begin

Unexpectedly mixed election results in Italy forced investors to confront the consequences of a divided government in this important southern European economy, creating turbulence in global equity markets and sending risk-averse money back to the safety of U.S. Treasury bonds. Add today’s implementation of $85 billion in sequestered federal spending cuts to an equation that already factors in higher payroll taxes and income taxes on the wealthy, and one has to wonder if stocks will be able to hold their gains for the year. In economic terms, this triple threat represents a formidable headwind equal to about 1.5 percent of U.S. GDP, or roughly 75 pecent of total economic growth produced by our economy last year.

Puts and Takes Against a backdrop of U.S.-style austerity, housing and auto production have become key growth engines for the economy, and with the wealth effect from a stock market near record highs, it’s hard to imagine the economy falling back into recession anytime soon. To wit, the government revised away its initial reading of negative 0.1 percent GDP growth in Q4, as a smaller import bill and greater than originally projected exports reduced the net foreign trade drag. Since businesses drew down inventories in the fourth quarter, our economy in early 2013 should get a boost from inventory rebuilds, not to mention the reconstruction efforts from Hurricane Sandy.  Meanwhile, manufacturing is a stronger positive, with the monthly PMI Index for February signaling rising orders, production, and employment. All told, we believe the near stagnant 0.1 percent fourth quarter growth should morph into something closer to 2 percent GDP expansion in the first quarter of 2013.  However, with fiscal headwinds increasing, investors are correct to question how much better growth could get this year.

From Bad to Worse When we wrote about JC Penney’s new boss and retail model last year, we questioned how successful Ron Johnson’s radical makeover of the woebegone American retailing icon would be. If yesterday’s quarterly results are any indication, Americans are in no mood to experience his brand of retailing. The stock cratered 17 percent on news that sales fell even more, declining at an accelerating rate of 28 percent in the company’s most important quarter. Not only has new management failed to deliver the turnaround that was promised to have been occurring by now, but its strategy of shunning “the deal” is spilling an increasing amount of red ink on Penney’s income statement. All of a sudden, credit ratings agencies are on the scene questioning the company’s ongoing ability to service its $3 billion of debt, and management is changing course, promising to offer coupons and sales again.

A Contrast in Styles. . .and Results To all of which Macy’s responds by saying, thank you! The company behind the bright red star posted better than expected 18 percent earnings growth for Q4 and guided analysts to expect current year earnings ahead of estimates. While some customers may get weary of Macy’s seemingly never-ending sales promotions and one-day only coupons, the proof is at the cash register – and Macy’s is clearly winning. As for investors, the starkest contrast between the strategies and results of JC Penney and Macy’s is the relative stock performance of these competitors – Macy’s up 5 percent over the past year while JCP has plummeted 55 percent.

With major retailers having now reported their numbers, fourth quarter earnings season is complete.  To gauge the health of their companies, investors will now turn to the forum of industry conferences and the ongoing drumbeat of economic reports, headlined next week by Friday’s February employment report.

Our Takeaways from the Week

• Stocks treaded water as risks emanating from Europe re-emerged

• The retailers wrapped up a long earnings season with mixed results

Disclosures

The Pause That Refreshes... or Something More Sinister?

by Shawn Narancich, CFA Vice President of Research

A Pause that Refreshes? More than halfway through February, investors experienced a weekly loss in U.S. stocks for the first time this year. But a small pullback in blue chip equities masked potentially more troubling undercurrents. Release of the Federal Reserve’s minutes recalling details from its January meeting forced investors to confront the prospect of less accommodative monetary policy, namely the potential for our central bank to reduce quantitative easing prior to reaching its previously stated goal of reducing unemployment to the 6.5 percent level. To steal a phrase from JP Morgan CEO Jamie Dimon, the published debate amongst Fed officials appears to be a tempest in a teapot. Judging by yesterday’s CPI release showing the slowest rate of inflation since last July (at 1.6 percent), minimal pricing pressure appears far from that which would cause the Fed to take its foot off the gas in a race where unacceptably high unemployment has lapped the economy. As stock prices hesitate, the bond market appears to be confirming a default assumption of a slow growth, non-inflationary economy, evidenced by benchmark 10-year Treasury yields retreating back below the key 2 percent threshold. What fails to confirm a muted economic outlook, one likely to require additional monetary stimulus, is gold pricing, which has now fallen 6 percent so far this year and 12 percent since last fall.

Canary in the Coal Mine Consumers are facing a triple threat of higher payroll taxes, gasoline prices up 50 cents a gallon in the last month, and tax refunds delayed by the fiscal cliff debate at year end. If bellwether Wal-Mart’s quarterly earnings are any indication, these factors are beginning to weigh on consumer spending, the most critical driver of U.S. GDP. While earnings at the nation’s largest retailer beat expectations, Wal-Mart missed sales expectations and met bottom line estimates primarily because its tax rate dropped. Despite poor earnings quality, investors reacted warmly to an 18 percent dividend increase and management disclosure that sales had begun to pick up most recently. Nevertheless, America’s mass retailer of choice offered up expectations for flat sales in the current quarter, leading investors to question how lasting the apparent pullback in consumer spending might be. With the negative economic impact of sequestered spending cuts one week away, investors can be forgiven for thinking we are due for a more substantial pullback in a stock market experiencing its best start to a year since the early 1990’s.

Sell the Rumor, Buy the News Proving Wal-Mart’s mantra that low priced goods attract buyers, Hewlett Packard’s discounted stock price received a much needed boost after reporting better than expected sales and earnings following a series of well-publicized shortfalls over recent quarters. Despite reporting sales declines in every one of its divisions, the stock rallied over 12 percent on evidence that the company retains a heartbeat.  Based on upbeat management commentary, investors are left to conclude that CEO Meg Whitman and her team have finally lowered earnings expectations far enough that even a business in secular decline can clear the bar. One thing is for sure, spending on PC’s and printers is no longer a priority for either corporate America or the average consumer, a stark reality that will continue to challenge HP in a technology world now dominated by tablets and smart phones.

Next week, investors will see the last vestiges of Q4 earnings, book-ended by retailers like Target and Home Depot that have yet to report. Once again, corporate America has proven adept at under-promising and over-delivering, but earnings estimates for 2013 continue to moderate in a slow growth world.

Our Takeaways from the Week

• Stock prices finally paused as U.S. consumer spending slows

• After a decade long run, gold has become a notable underperformer

Disclosures

Brad Houle Hired as Senior Vice President

Ferguson Wellman is pleased to announce that Brad H. Houle, CFA, has joined the firm as senior vice president and member of the firm’s fixed income team.

With more than 20 years of experience in the investment management industry, Houle came to Ferguson Wellman after working for 17 years at Davidson Investment Advisors as co-portfolio manager for a large value dividend strategy and an intermediate-term fixed income strategy. Houle earned his Chartered Financial Analyst designation in 1999, completed an M.B.A. in business finance from the University of Oregon and graduated with honors from the University of Montana with a B.S. in business finance in 1991.

“Brad Houle brings a wide range of experience and a different perspective to the firm,” said George Hosfield, CFA, chief investment officer at Ferguson Wellman. “We are pleased to find someone with both investment experience and a desire to attract new clients.”

Bigger impact: fiscal cliff or renegade meteor?

by Ralph Cole, CFA Senior Vice President of Research

Currency War Devaluing one’s own currency is one of the easiest ways to stimulate a country’s growth.  By doing so, the products and services of your country become cheaper compared to those products and services of competing countries.  There is however, a great deal of risk associated with a weak currency policy. These risks include inflation, discouragement of foreign investment, not to mention the potential backlash from other nations.  A recent example of weak currency policy can be seen with Japan, whose currency has fallen 19 percent since October.

As a result, Japan is in the eye of the storm during this week's meeting of G20 Finance Ministers and Central Bank Governors. Following the country’s slow response to their 15 year bout of deflation (falling prices), Japan is now focused on causing inflation. They have the stated goal of expanding their monetary policy in order to rekindle growth in the moribund country.  While inflation often carries a negative connotation, a little bit can be a good thing.

The yen’s fall is even more staggering when you consider the actions taking place in the U.S. on the monetary front.  Furthermore, some emerging market countries (Brazil being the most vocal) are starting to push back against developed countries (mainly Japan and the U.S.) that have devalued their currencies. They are frustrated by the fact that their own currencies are appreciating against most of the developed world, therefore making their products and services less competitive.

While we don’t currently have a currency war on our hands, it is one of the bigger risks to global economic recovery going forward.  If countries begin to feel threatened by other’s devaluation, we would expect protectionist policies to begin to creep up, which would inhibit global growth.

Finally, in an environment with multiple central banks printing money, we would have expected gold to do better. However, up to this point gold is basically flat for the year.

"Bigger impact: fiscal cliff or renegade meteor?" That was the question Principal Mark Kralj posed to the audience at our Investment Outlook in Bend this week.   While the “fireball meteor” that rocked Russia this week is stealing most of the headlines, the fiscal cliff is starting to bite the consumer.  Earlier in the week the U.S. Commerce Department announced that retail sales in the U.S. inched higher by just 0.1 percent in January.  That was followed up by rumors from Wal-Mart that February sales were off to their slowest start in seven years (as a result the stock was down over 2 percent today).

The repeal of the payroll tax cut is starting to hit home for the U.S. consumer.  The 2 percent increase in the payroll tax will take approximately $126 billion out of consumers’ pockets this year.  For the average family this amounts to over $100 per month in decreased income. We expect this drop to affect retailers and restaurants at lower echelons.

It is however, unlikely that this slowdown in spending will lead to a recession, because of the positives occurring in the economy this year, including growth in housing, the stock market and jobs.

Our Takeaways from the Week

• Both the consumer and the stock market are taking a breather after robust runs
• Currency wars are a newer risk to the global recovery, and something that needs to be watched

Disclosures

Six for Six

by Shawn Narancich, CFA Vice President of Research

Six for Six

As a relatively upbeat fourth quarter earnings season enters late innings, stocks have maintained their upward momentum and generated nearly a year’s worth of returns in the first six weeks. Investors received relatively few new data points to inform their view of the economy’s progression this week, but we believe that a 7 percent rise in gasoline prices so far this year and higher payroll taxes could begin to bite. Consumer spending remains the biggest part of the U.S. economy, and with workers just now beginning to feel a pinch on their discretionary income, the likelihood of slower consumption will likely be seen in first quarter GDP. While construction spending and post-Hurricane Sandy inventory rebuilds are likely to help the economy early this year, government spending appears set to decline. If Congress fails to enact another workaround, $85 billion of sequestered federal spending cuts are set to take effect March 1, representing roughly one-third of expected GDP growth for the year. Given the government’s penchant for kicking the fiscal can down the road, we doubt whether this down-payment on deficit reduction is being factored into consensus estimates calling for 2 percent economic growth this year. 

Budgeting 101

The Congressional Budget Office (CBO) added fuel to fiscal debate fires this week when it projected continued federal budget deficits as far as the eye can see. While this forecast likely surprised few, what undoubtedly caused some to take notice is the fact that in the past five years, the country’s debt (excluding intra-agency holdings) as a percentage of GDP has doubled, from 36 percent of the economy before the financial crisis, to 72 percent currently. Financing the nation’s growing debt burden has arguably been eased by the Fed’s monetization of Treasury issuance, but with interest rates starting to rise, servicing the nation’s debt will become more costly. Investors are left to take heart in CBO estimates calling for the federal budget deficit of 2013 to fall below $1 trillion for the first time since fiscal 2008. Against this depressing backdrop, many on Capitol Hill are steeling themselves for sequestration, under the belief that federal spending needs to fall. With defense contractors set to suffer more than their proportionate share of the cuts, stocks such as General Dynamics, Lockheed Martin and Raytheon are underwater since year-end and notably underperforming a market (S&P 500) that is now up 6.5 percent year-to-date.

 Paybacks are #?%!

Hewing to the theme of government actions and private sector reactions, McGraw-Hill shareholders felt the pain caused by a $5 billion Justice Department lawsuit leveled against it, claiming the company’s Standard & Poor’s unit fraudulently rated collateralized debt obligations in the go-go years before housing crashed. The stock fell every day this week and cratered by a cumulative 27 percent on the tail risk that success from this and a raft of other state lawsuits accompanying it could put the company out of business. While McGraw-Hill clearly did a poor job rating subprime CDOs and other mortgage-backed securities, investors might ask whether competitors Fitch and Moody’s did any better. After all, neither of these ratings firms were charged. All of which leads a person to question whether Eric Holder & Co. are intent to extract their pound of flesh for S&P’s decision in 2011 to strip U.S. Treasuries of their AAA credit rating. While acknowledging its admittedly poor job of analysis preceding the last credit meltdown, S&P is arguably loathe to miss the next one.

Our Takeaways from the Week

• Stocks have now delivered nearly a year’s worth of returns in six weeks
• Federal budget pressures present rising headwinds for the economy

Disclosures

The Dow Hits the High Notes

by Shawn Narancich, CFA Vice President of Research

Dow 14,000

The Dow Jones Industrial Average became the latest blue chip equity index to signal the success that stocks have enjoyed so far in 2013, conjuring up images of the go-go days of the late 1990s and levels markets reached in 2007 prior to the financial crisis. Whether investors will once again be punished for participating in stock ownership at levels now within a few percent of all-time highs depends in part on how successfully the global economy deals with the continued deleveraging of mature economies, and how rapidly the faster growing emerging markets can pick up the slack. So far, so good. Commentary from fourth quarter earnings reports paints a reasonably constructive outlook for profits this year, aided by low unit labor costs, a relatively benign environment for commodity costs, and potentially better demand from faster growing economies in Southeast Asia and South America. Companies are cash rich and have erred on the side of caution, returning free cash flow to investors through dividend increases and share buybacks. Capital allocation strategies could change in 2013. For companies challenged to grow earnings in a late cycle environment, the pace of acquisitions could pick up at a time of reasonably priced equities and ultra-low interest rates. 

More Than Meets the Eye

Fourth quarter GDP was shocking at first blush, portraying an economy that contracted for the first time in three and a half years. Inventories dropped and government spending fell at the fastest pact since 1973, after unusually fast spending growth reported in the third quarter. Put those factors aside and the economy as measured by real final sales actually grew by 1.1 percent in the December quarter. While the government wouldn’t speculate about the magnitude of its impact, we know that Hurricane Sandy disrupted output in the Northeast, and rebuilding in the wake of that disaster is likely to help the economy early this year. Indeed, the monthly payroll report released earlier today supports the notion that our economy is moving ahead, albeit at a relatively slow rate probably not too far from 2 percent. That payrolls expanded at a rate of 157,000 in January is less surprising than the material revisions for November and December that retroactively added 127,000 jobs. Those revisions plus several others earlier in the year lead the Bureau of Labor Statistics to conclude that the U.S. economy created a net 181,000 jobs per month last year instead of the roughly 150,000 monthly average previously reported. Contrast the oft-revised payroll data with the purchasing managers index, a data series that isn’t revised after the fact and which portrayed manufacturing expanding at a pace that picked up from levels reported at year-end.

Black Gold

Another week, another intriguing development from the U.S. oil patch. Big Oil joined the ranks of companies reporting fourth quarter earnings this week, and while the numbers out of integrated giants Royal Dutch, Exxon Mobil and Chevron left something to be desired, the earnings out of independent refiners Valero and Phillips 66 were extraordinary. An old saw in the energy business observes that investors should buy straw hats in winter. In other words, the time to buy a refining stock would be about now, when earnings and stock prices often fall due to seasonally reduced gasoline demand and plant downtime used to prepare refiners for the summer driving season. Valero turned that common logic on its head by reporting quarterly earnings that nearly matched the previous quarter’s and surpassed even the most optimistic expectations. 

Credit Valero’s success to the U.S. oil boom. As it turns out, the glut of mid-continent crude oil that has advantaged refiners there with low cost feedstock for the past two years is now spreading to the GulfCoast, where Valero owns the majority of its refining assets.  The Seaway Pipeline (see map), which once was used to deliver imported crude oil to the Midwest, was reversed last year so that some of the Bakken Shale oil that was piling up in Cushing, Oklahoma could be delivered at a discount price to the GulfCoast, a key refining center.  As a result, neither Phillips nor Valero imported a barrel of crude oil in the December quarter, their refining margins skyrocketed, and our nation reduced its oil import bill.  Approval of the Keystone XL pipeline currently being contemplated by the federal government would not further reduce our oil import bill, but having an additional secure supply of Canadian crude oil would go a long way to promoting North American energy independence.

Our Takeaways from the Week

•  Stocks are on a roll as safe haven Treasury bonds lose ground
• The economy and corporate earnings continue to achieve forward progress

 Disclosures

Stocks on a Roll as Apple Sours

by Shawn Narancich, CFA Vice President of Research

Hear no Evil, See no Evil

As cautious investors continue to wait for a pullback to deploy cash on the sidelines, stocks continue to march higher, reflecting the US government’s latest attempt to kick the fiscal can down the road and surprisingly positive readings on the manufacturing sector globally. Despite our expectations for the payroll tax hike to dampen consumer spending domestically, the economy appears to be off to a reasonably good start so far this year. Blue chip US stocks have now gone four-for-four and are up 5 percent in 2013, rising each and every week of the New Year. Amidst increasing evidence that investors are rotating out of bonds and into stocks, Treasuries lost ground again, with yields on the benchmark 10-year security again pushing up against the 2 percent threshold.

 Adding Insult to Injury

A back-half weighted year, slowing sales growth, slimmer margins, and declining estimates -- investors are all too familiar with these conditions often associated with a company reaching maturity. However, in this case, the subject matter doesn’t involve once mighty tech titans Microsoft, Cisco, or Intel, but rather erstwhile growth company Apple. After already declining nearly 30 percent from its highs, Apple stock plunged another 12 percent Thursday following the release of disappointing sales and lackluster profits. And just like that, $60 billion of market cap disappeared.

 A Bad Apple?

That Apple’s sales growth slowed to 18 percent was not as shocking as the fact that its per share profits actually fell in the company’s December quarter, something that would have been considered heresy just months ago. Declining margins reflect a company struggling to manage a supply chain that was pushed to deliver enough inventory for Apple to sell 48 million iPhones and 23 million iPads in just 90 days. But factors beyond logistics are at play. Apple’s product mix has become less profitable, with telecom partners AT&T and Verizon Wireless reporting that an increasing number of new contract customers opted for older iPhone models.

Both market maturation and market demographics appear to explain Apple’s conundrum. First off, developed market smartphone penetration now exceeds 50 percent, so what might be called the “easy money” has already been made. New smartphone customers being signed up now are arguably less tech savvy and more price sensitive, so they are less willing to spend $200 for the latest iPhone 5 when a perfectly acceptable iPhone 4 can be had with a 2-year contract for free. Just as importantly, the huge potential to sell iPhones in emerging markets is complicated by the fact that fewer customers there make enough money to buy one, subsidized or not. Finally, and in a related vein, Apple is losing market share to the less expensive Android architecture delivered through competitors like Samsung, which offers competitively priced phones that carriers often prefer because of a lower subsidized cost.

We believe that Apple is working on lower-end devices to build market share, especially in international markets. However, those phones won’t be as profitable to sell. With diminished growth prospects, the onus is now on Apple to begin returning more of its prodigious cash flow to shareholders – through either share buybacks or a dividend boost.

 Earnings Intense

While Apple was the headline act, tech companies took center stage during a week when hundreds of companies reported fourth quarter numbers. Profits continue to beat expectations by a margin similar to Q3, but the proportion of company’s delivering sales above estimates has improved. In an example of maturing tech done right, Google’s stock rallied on news of slower erosion in the price that advertisers pay the company for clicking on Google-driven ads. Behind better than expected mobile ad pricing is the fact that both tablet and smartphone clicks more than doubled in Q4, reflecting people’s increased comfort with transacting in the wireless realm. Evidence that Google is successfully navigating the transition from PC to mobile search is a key reason why the stock rose 7 percent on the week.

Hundreds of companies across industries will report on a daily basis next week in what we expect will be the heaviest week of the fourth quarter earnings season. The Fed will also convene its first meeting of the year, the result of which we expect will be communication indicating a continuation of the quantitative easing programs instituted last fall.

 Our Takeaway from the Week

• Encouraging macroeconomic data and acceptable earnings results continue to put a bid into stocks

Disclosures

Resilience in the U.S. Economy, Further Contraction in the Eurozone

by Shawn Narancich, CFA Vice President of Research

Three for Three

 Encouraging economic data and an acceptable undertone to fourth quarter earnings underpinned the new year’s third consecutive week of stock gains, amid increasing evidence that retail investors are returning to the equity market. Mutual funds flow data showed investors once again adding cash to equity funds, a report that probably helps to explain another 1 percent gain in blue chip stocks despite ongoing concerns about U.S. fiscal policy and a flare-up of terrorist violence overseas. As investors speculate about the degree to which recent tax hikes will slow the economy, bond markets appeared to acknowledge the reality of a slow growth, low inflation environment by bidding Treasuries higher for the week.

Yen and the Yang

 Resilience is probably the best adjective we can use to describe a U.S. economy that continues to display evidence of forward momentum following Hurricane Sandy and the contentious fiscal cliff negotiations. From retail sales in December that outgrew expectations during a key seasonal period to the best housing starts number in four and a half years, the consumer continued to propel economic output at year-end. A key question is what consumption numbers will look like in the new year once workers experience firsthand the drag on their paychecks caused by expiration of the payroll tax cut. Despite the spending headwind created by higher taxes, the consumer discretionary stocks remains near the top of the sector performance charts year-to-date. The wealth effect of rising home prices, higher 401(k) balances, and lower gasoline prices are ameliorating factors that help explain why these stocks continue to do so well. 

While the U.S. economy continues to push ahead, Europe is at the other end of the spectrum, highlighted by further contraction in Eurozone industrial production and German GDP that finally fell into the red. Investors are well aware that the Eurozone is in recession, but the fact that it isn’t going out of business has so far been enough to support stock prices. What isn’t helping Europeexit recession is a resurgent euro, the common currency that has quietly risen from the low $1.20s last summer to $1.33 now. As developed economies struggle to support slow growth with expansionary monetary policy, major currencies are running a de facto race to the bottom that the euro is currently losing. Now, Japan’s new administration is staking its claim. With a yen that has quickly hit two and a half year lows against a dollar that has already lost ground to the euro, European exports suddenly look a lot more expensive to customers in two of the world’s three largest economies. Only time will tell how much deeper and longer a strong euro might make the Continent’s ongoing recession.

How’s Business?

As the interaction of currency markets impacts key economies, banks dealing primarily in U.S. dollars demonstrated the benefits of mortgage loan growth and better capital markets. Goldman Sachs, Morgan Stanley, and a host of regional banks delivered better than expected fourth quarter earnings and, despite the headwinds of rock-bottom interest rates that are pressuring margins, the outlook for this year remains reasonably constructive. In contrast, chip making giant Intel reported lowers earnings and warned that a declining PC market will continue to weigh on results in 2013. Investors turned tail and sent stock of the world’s largest semiconductor manufacturer down by a cool 6 percent.

With 15 percent of the S&P 500 having reported so far, about two-thirds of companies have exceeded earnings estimates. The pace of fourth quarter reporting picks up next week, with approximately one-fourth of the S&P 500 delivering results.

Our Takeaways from the Week

• Stocks continue to make forward progress amid fiscal headwind
• Earnings season is off to an encouraging start

Disclosures

Stocks Two-for-Two in 2013; Telecom Faces Headwinds

by Shawn Narancich, CFA Vice President of Research

Two-for-Two

On modest gains for the second consecutive week of the new year, large-cap U.S. stocks rose to a five-year high and are pushing up against levels reached prior to the global financial crisis of 2008. An old saying in the industry observes that stocks climb a wall of worry, and that characterization has never been truer as blue-chip stocks approach all-time highs. Investors were surprised to see the U.S. trade deficit increase by $6 billion in November, but a key trend of reduced oil imports remains in place, and slower exports late last year probably had more to do with port disruptions caused by Hurricane Sandy. Nevertheless, economists will likely reduce their fourth quarter GDP estimates because of a bigger trade drag. For 2013, we continue to expect that our economy will slog ahead at a 2 percent rate. 

A European Job Is Tough to Come By

Perhaps more meaningful, Europe confirmed that its economy remains well entrenched in recession, as it reported a new all-time high unemployment rate of 11.8 percent. But Mario Draghi quashed any speculation that Europe’s central bank would do more to help pull the Eurozone out of its funk, stating that it had no intention of lowering interest rates any further or engaging in quantitative easing. Predictably, the euro rallied, as it remains one of the few global currencies not being debased by monetary stimulus. For now, a disruptive break-up of the European Union seems less likely. Despite the Continent’s economic woes, taking Eurozone Armageddon off the table has been enough for investors, who have piled back into European stocks specifically and international stocks in general.

 Global Warming Anyone?

Whether the rally in Chinese stocks continues may depend on the cadence of inflation reports to come. After enjoying a long spell of disinflation, China reported that the price level rose in November rose at its highest rate in seven months. While 2.5 percent inflation is unlikely to prompt the People’s Bank of China to reverse its easy money policy, the likelihood of any further monetary easing by the Red Giant has diminished. The root cause of recent price increases?  China’s coldest winter in three decades, which has stunted crop production and boosted food prices. Export data out of China this week was surprisingly strong, and recent iron ore price increases are symptomatic of the world’s largest user replenishing depleted stockpiles. Despite the recent uptick in inflation, China’s economy appears to be re-accelerating.

Choppier Seas in Telecom

After outperforming the market last year, the U.S. telecom industry faces rising headwinds in 2013. The cadence of news flow from this sector has picked up notably, with Verizon declaring this week that it enjoyed record post-paid subscriber gains in the fourth quarter. The result? Wall Street analysts rushed to reduce their quarterly estimates to account for higher losses on smart phone subsidies used to attract new customers. AT&T also appears to have experienced robust smart phone uptake as both carriers sold a lot of new iPhone 5s before Christmas.

But beyond these shorter term issues, the telecom industry appears to be standing on shakier ground. Starting with last fall’s announcement that Deutsche Telecom’s U.S. subsidiary T-Mobile would acquire pre-paid specialist MetroPCS Communications in a complex deal, Japanese telecom pioneer Softbank agreed to acquire Sprint. Bankrolled by deeper Japanese pockets, Sprint in turn tendered for the 50 percent of broadband network owner Clearwire it doesn’t already own, in a bid to bolster its class b network. As if that wasn’t enough excitement for this normally staid sector, satellite TV maverick Charlie Ergen won approval late last year to convert satellite airwaves into more valuable cell phone spectrum, then this week launched its own bid for Clearwire at a price substantially above Sprint’s offer price. Whether Ergen’s Dish Network is truly attempting to become a new wireless operator in the U.S. or is just posturing to maximize the value of its spectrum remains to be seen.

Finally, AT&T is ramping up its capital spending to increase the quality of its 4G service. All this industry activity in such a short time period appears to be more than just coincidence, symptomatic of a wireless industry that is jockeying for position at a time of slowing subscriber growth and heightened competition. So while the juicy dividends of AT&T and Verizon remain attractive, telecom could be challenged to repeat last year's strong performance.

Next week, fourth quarter earnings kick into high gear, with 13 percent of the S&P 500 scheduled to report. Following Wells Fargo’s earnings released earlier today, money center banks Citigroup, Bank of America, and JP Morgan will report, as well as industrial bellwether GE.

Our Takeaways from the Week

•  Stocks added to recent gains as the first big week of earnings awaits
•  The telecom industry faces tougher sledding in 2013

 Disclosures

Fiscal Cliff Band-Aid, Budget Woes and Retail Lows

by Shawn Narancich, CFA Vice President of Research

Problem Solved?

The cliff is bridged, but the span is short, and daunting canyons remain to be crossed. A deal to avert across-the-board tax increases and immediate spending cuts prompted a nearly 3 percent rally on Wall Street, as traders betting against a last minute agreement scrambled to cover their short positions. As stocks shot higher, Treasuries lost a safe-haven bid and prices fell meaningfully, pushing yields on the benchmark 10-year bond to within shouting distance of 2 percent. Nevertheless, the 2012 Taxpayer Relief Act does relatively little to address the nation’s underlying deficit and debt problems. With sequestered spending cuts having been deferred by two months and Congress once again rescinding cuts to doctors’ Medicare reimbursements, federal spending continues largely unabated.  And although tax revenues may rise because of higher marginal tax rates for top earners, the sad fact remains that our U.S. government brings in only about $7.00 of revenue for each $10.00 it spends. 

Budgeting 101

The Treasury is now pulling unusual levers to keep funding itself because the nation has already reached its $16.4 trillion debt limit. So with the thorny issue of entitlement reform still unresolved, the question is whether this third rail of U.S. politics will finally be addressed. Without entitlement reform in an economy growing at 2 percent, the prospect of balancing the budget and arresting further substantial growth in the national debt is dim. In approximately two months, the Treasury will run out of rabbits to pull from its hat, so either Congress will legislate a higher debt ceiling or large portions of the government will shut down for lack of funding. Therefore, a key risk for equity investors is that political negotiations herein promise to be rancorous, putting spending cuts back on the table in exchange for votes to raise the debt ceiling. 

A Lump of Coal for Retailers?

Yes, it’s about that time again, and earnings season will take place against a fourth quarter backdrop that witnessed dislocations from Hurricane Sandy and increasing concerns by businesses and consumers about fiscal austerity. As such, earnings in an environment where estimates have been falling present another risk for equity investors. Investors gleaned some more clues about the economic backdrop for earnings following December sales reports out Thursday. Same-store sales at key retailers rose by 4.5 percent, but a mid-month lull appears to have forced them to accept lower prices in exchange for volumes. Target sales fell flat on a disappointing Neiman Marcus collaboration and Kohl’s cut earnings numbers despite beating top-line expectations. Bricks-and-mortar retailers appear to have been challenged by a post Black Friday lull, which challenged their ability to keep shoppers engaged over an unusually long holiday shopping season marked by another market share grab by online retailers. Best Buy is a good example. It serves as a de facto showroom for consumers who then buy from the likes of Amazon, which sells many of the same items for a price sans the cost of storefronts. Best Buy’s stock has lost almost half its value over the past year as its profitability has evaporated.

Wall Street trading desks return to full strength next week after a two-week holiday lull and investors will pay close attention to Alcoa’s earnings release, parsing its report for clues about how fourth quarter earnings will unfold.

Our Takeaways from the Week

• An eleventh-hour fiscal cliff deal helped produce a strong start to the year for equities
• Key fiscal issues remain unresolved, and with earnings season about to begin, markets are likely to be volatile

Disclosures

How the Compromise Affects Taxpayers … and the Economy**

With a fiscal cliff compromise just signed by President Obama, investors breathed a sigh of relief yesterday, bidding up stocks over 2 percent and sending bond yields up. The bill, H.R. 8: American Taxpayer Relief Act of 2012, covered many provisions of the tax code, but the major changes that high-income Americans will see in 2013 compared to 2012 include:

• A top income tax rate of 39.6 percent for individuals above $400,000 and for those with joint taxable income over $450,000
• A permanent Alternative Minimum (AMT) patch. The exemption amounts are now $50,600 for individuals and $78,750 for households, and indexes the exemption and phaseout amounts thereafter
• A top capital gains tax and dividend tax of 20 percent for income above the same amounts listed above
• Phaseout of exemptions and deductions for adjusted gross income above $250,000 for individuals and for those with joint taxable income over $300,000
• Expiration of the payroll tax cut, increasing the payroll tax rate by 2 percent on the first $113,700 of income
• The $5 million estate, gift and generation-skipping transfer tax for individuals and $10 million for households is now indexed to inflation, but sets the top estate tax rate at 40 percent

These tax increases, combined with the sequestration spending cuts to take effect on March 1, will result in a roughly 1.5 percent hit to GDP in 2013. Despite this austerity, the federal budget will still run in the red, increasing the U.S. national debt level. While the cliff crisis has been temporarily averted, politicians will deal with the sequestration budget cuts and debt ceiling limit over the next two months. The drama is definitely not over.

Even though GDP growth will be below long-run trend, the austerity measures may be coming at a relatively good time. With the housing market turning as well as oil and gas spending ramping up, economic growth should still be able to post 1 to 2 percent in gains. Corporate profits should therefore remain healthy, potentially resulting in gains for equities. Besides the political drama, our main concern in 2013 will be consumer spending. With the expiration of the payroll tax and the increase in taxes on higher incomes, the federal government is taking money out of consumers' pockets. Against this backdrop, the Federal Reserve continues to keep the financial system awash in cash, which should continue to provide some monetary stimulus in the face of fiscal austerity.

While interest rates are trading at the higher end of their recent trading range, we still believe rates will remain lower, longer due to slow economic growth and continued Fed stimulus. We will continue to maintain our bond positions while Washington still grapples with the remaining “cliff” issues on the table.

**Any tax information in this communication is not intended or written by Ferguson Wellman Capital Management to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing or recommending to another party any matters addressed herein. And advice in this communication is limited to the conclusions specifically set forth herein and is based on the completeness and accuracy of the stated facts, assumptions and/or representations included. In rendering our advice, we may consider tax authorities that are subject to change, retroactively and/or prospectively, and any such changes could affect the validity of our advice. We will not update our advice for subsequent changes or modifications to the law and regulations, or to the judicial and administrative interpretations thereof.**

The information provided herein is for educational purposes only and should not be construed as investment advice or as an offer or solicitation. Not all securities are suitable investments for all investors; therefore, Ferguson Wellman Capital Management will not necessarily implement any particular strategies discussed herein for all clients. We recommend that you discuss questions regarding your individual portfolio and investment strategies with your portfolio manager.