A Peak Behind The Market's Five Masks

Bob Froehlich Hartford Investor September 29, 2011

A masquerade ball is an event attended by people wearing costumes and masks. The concept went mainstream here in the United States with the rebirth of The Phantom of the Opera, a story by a French writer first published in 1909. When it was released, the French novel sold very poorly and was even out of print several times during the 20th century. The novel was overshadowed by later film and musical adaptations—most notably, Andrew Lloyd Webber's 1986 Broadway musical, The Phantom of the Opera. A song from The Phantom of the Opera musical called "Masquerade" became a runaway hit. My favorite lyrics from this song go like this: "Masquerade! Seething shadows breathing lies. Masquerade! You can fool any friend who ever knew you!"

Our markets have been participating in their very own masquerade ball lately. With all of the "headline risk" over the last few weeks regarding our horrible housing market, terrible employment market, weak dollar, the political chaos in the U.S. and Europe, a tapped-out U.S. consumer, and banking systems in the U.S. and in Europe that are being called into question, you may have missed what was actually going on behind all of those masks. Let me reveal the five most important ones: corporate cash, inflation, Europe, sovereign wealth funds, and my favorite one: profits.

You may have heard that corporate America is "flush" with cash. Let's look behind this first mask so I can show you just how "flush" corporate America is. The single best measure for corporate cash is called "U.S. non-financial corporations' liquid assets." Over the past two years, this cash has increased $700 billion to $2 trillion. In the most recently released numbers for the second quarter of 2011, cash is up 19.2% on a quarter-over-quarter basis. This $2 trillion in corporate cash is the highest level ever recorded.

Looking at this a different way reveals another all-time record high. For the second quarter of 2011, corporate cash as a percentage of our economy (a measure called "U.S. non-financial corporations' liquid assets percentage of gross domestic product" (GDP)) came in at +13.8%. This is the highest number ever recorded.

Now you know what it means when someone says, "Corporate America is flush with cash." The good news about all of this cash is that once corporate confidence returns and this cash goes in motion, it could help our economy and our markets. Money in motion could go toward increasing mergers and acquisitions, dividends, share buybacks, capital spending to drive productivity, or even employment. Regardless of what the ultimate use is, money in motion can help our economy and our markets.

Let's look behind the second mask where we'll find the latest from the inflation front. The consumer price index (CPI) was up 0.4% for the month of August. On a year-over-year basis, inflation now stands at +3.8%. This is real inflation. Once year-over-year inflation approaches the +4.0% level, like it is today, inflation's no longer simply in the pipeline—it's arrived.

This is a wake-up call for U.S. investors who feel that we don't have an inflation problem in this country. Because the recent numbers prove otherwise, the most important "hedge" an investor needs over the next two years is a "hedge" against inflation. Remember, the laws of finance were not repealed. If enough Central Banks around the world print enough money to throw at a problem, there's no problem too big to solve. But, solving that problem by throwing money at it creates a new problem called inflation. When you sit down with your trusted financial advisor, please make sure you talk about whether an inflation hedge should be added to your investment portfolio.

Let's look behind mask number three so I can unveil what's going on in Europe. Let me start by telling you that I believe that only Europe can rescue Europe. So, while it was exciting for the markets when many of the world's central banks, including our Federal Reserve Board, the European Central Bank, the Bank of England, and the Bank of Japan announced coordinated efforts aimed at easing problems faced by European banks, this didn't really excite or impress me. Nor did it impress me to learn that China was having discussions with Greece and Italy to help out by buying some of their bonds. While these are important developments for the markets, they do nothing for my premise that only Europe can rescue Europe.

Let me reveal to you what does matter, because it's proof that Europe is now trying to rescue Europe. First, the Supreme Court in Germany ruled that financial bailouts of Greece and other struggling members of the European Union are legal. This lawsuit, in essence, dismissed all complaints that Chancellor Angela Merkel violated Germany's constitution in her handling of the European debt crisis. Second, Spain will reinstate a tax on the wealthy. Finance Minister Elena Salgado said the tax will be levied on citizens of Spain with net assets of more than 700,000 euros ($962,780) in both 2011 and 2012. The Finance Minister estimated that it will affect 160,000 taxpayers in Spain as it raises more than 1 billion euros a year.

Third, Italy's parliament approved Prime Minister Silvio Berlusconi's austerity budget. This 54 billion euros budget plan uses both tax hikes and spending cuts to balance the country's budget by 2013. This is what it looks like when I say only Europe can rescue Europe. Thank you Germany, Spain, and Italy for revealing your true selves from behind the mask!

In the fall of 1971, when I started college, there was only one sovereign wealth fund in the world in Kuwait called the Kuwait Investment Authority. It was created in 1953, the year I was born. Today, sovereign wealth funds are found in almost all of the emerging-market economies. Because of these new-found sovereign wealth funds, I've found more than four trillion reasons to like stocks. Said another way, let me reveal to you a few of the top sovereign wealth funds in the world today that collectively have more than $4.276 trillion in assets under management, according to the Sovereign Wealth Fund Institute.

Take a peek behind this fourth mask and see what I found. U.A.E. - Abu Dhabi's Abu Dhabi Investment Authority, has $627 billion. Norway's Government Pension Fund has $572 billion. China's S.A.F.E. Investment Company has $568 billion. Saudi Arabia's S.A.M.A. Foreign Holdings has $473 billion. China's China Investment Corporation has $410 billion. Kuwait's Kuwait Investment Authority has $296 billion. China and Hong Kong's Hong Kong Monetary Authority Investment Portfolio has $292 billion. Singapore's Government of Singapore Investment Corporation has $248 billion. Singapore's Temasek Holdings has $157 billion. China's National Social Security Fund has $147 billion. Russia's National Welfare Fund has $143 billion. Qatar's Qatar Investment Authority has $85 billion. Australia's Australian Future Fund has $73 billion. Libya's Libyan Investment Authority has $70 billion. U.A.E. - Abu Dhabi's International Petroleum Investment Company has $58 billion, and Algeria's Revenue Regulation Fund has $57 billion.

A few billion here, a few billion there, and pretty soon it adds up to real money to the tune of $4.276 trillion. These 16 separate sovereign wealth funds from 11 different countries that control $4.276 trillion are a tremendous source of investment capital that didn't even exist a few decades ago. This money could be one of the most important sources to determine the future direction of our markets. After all, money does make the world go 'round.

Behind the fifth, and final, mask is the most important factor: profits. My good friends and colleagues at International Strategy & Investment (ISI) out of New York recently completed a very compelling profits analysis, comparing profits to our economy. This is important because many U.S. investors are convinced that as long as poor employment and weak housing keep our economy down, there's no way that profits can go up. This most recent ISI study concluded that this isn't the case at all.

Since the trough in our markets in August of 2008 when the Dow Jones Industrial Average1 briefly traded below 6500, the economy and profits told two completely different stories. Since August 2008 Gross Domestic Product (GDP) (our economy) grew 8%, while corporate profits grew 65%. To put it another way, since August 2008, corporate profits grew 712% faster than our economy. How's this possible? The combination of a weak dollar and a strong global economy gave U.S. companies a competitive advantage around the globe because all of their products and services were on sale.

Finally, the masquerade is now over as I've removed the masks from corporate cash, inflation, Europe, sovereign wealth funds, and my favorite one, profits. As always, let me bring this commentary to a close with my customary pearls-of-wisdom quote. This one's from investment guru and legend, Peter Lynch. One of the highlights of my investment career was a one-on-one meeting with Peter Lynch in his secret office in downtown Boston. (When you're a guru and a legend, you need to stay under cover.) "Investors have all this data and yet they look at the wrong things. It's about earnings; they need to follow earnings." If you're an avid reader of my weekly commentaries, you probably realize that I couldn't agree more with that remark from my good friend and colleague, Peter Lynch. Remember to have a great day, keep a positive attitude, and please join me in resolving to remain a long-term investor in a short-term world.

You know you want to do it—go ahead and sing along with me: "Masquerade..."

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The views expressed here are those of Dr. Bob Froehlich. Dr. Bob Froehlich's views are not necessarily those of The Hartford and should not be construed as investment advice. They are subject to change. All economic and performance information is historical and does not indicate future results.

Dr. Bob Froehlich's sources of information include Bank of Canada, The Bank of England, Bank of Japan, Bloomberg News, Business Roundtable, China Investment Corporation, CIA. World Fact Book, CNBC, Congressional Budget Office, Deutsche Bank, The European Monetary Union, Federal Reserve Board, The Financial Times, Freddie Mac, FOX Business, Goldman Sachs, International Monetary Fund, International Strategy & Investment, Journal of Commerce, Merrill Lynch, PIERS Global Intelligence Solutions, Strategas Research, Thomson Reuters, Union Bank of Switzerland, U.S. Census Bureau, U.S. Department of Commerce, U.S. Department of Labor, U.S. State Department, U.S. Treasury Department, The Wall Street Journal, and The World Bank.

PAST ECONOMIC PERFORMANCE DOES NOT ENSURE FUTURE RESULTS.

Distributed by Hartford Securities Distribution Company, Inc.

1 The Dow Jones Industrial Average (DJIA) is an unmanaged, price-weighed index of 30 of the largest, most widely held stocks traded on the NYSE.

All information and representations herein are as of 9/11, unless otherwise noted.

P6170_092611 107527 9/11

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