Gimme Shelter But Not from Inflation

Are capital markets facing cyclical exhaustion? Are inflationary pressures overwhelming us?

As markets think about the Middle East tensions, as oil prices skyrocket, our capital markets seem to cringe. Global real interest rates are lifting while global liquidity seems to be falling. Macro risks are being re-priced to reflect these concerns.

The rising uncertainty does little to capture investor interest, let alone bravado. Earnings growth, at least based on what I have seen so far in earnings season, is slowing after a long spell of double digit earnings growth (for the S&P 500, it's been 11 quarters.)

The S&P lost 2.31% for the week with only energy (+2.49%) and utilities (+0.28%) rising. Particularly hard hit were consumer discretionary stocks (-4.53%) and information technology (-4.68%) But of note, industrials (-3.73%) and materials (-3.23%) were both poor performers. The underlying message to me is that the market is not sensing a surge in inflation. Despite, oil prices, neither am I. Natural gas prices are reflecting $35 oil not the current $78 world price. My belief is that the "real" price for energy that the economy will "see" is closer to that $35 price,

Some interesting additional information about the business outlook comes from the recent business outlook survey of NABE (National Association of Business Economists.) I am, in fact, a member, the only economist hat that I wear.

In their survey, there is some interesting commentary on price increases. Pressures on prices had eased somewhat from prior quarters. For July, the percent that reported prices rising was 27% down from April's 41%. In fact, 69% reported prices unchanged. Another interesting result related to 61% of those surveyed indicating that price increases in the second quarter that were attempted were "unsuccessful" or only "partially realized." The share that reported price increases as being "fully realized" was 29%, the lowest in over a year.

I am beginning to think that Ben Bernanke's tightening is done. Wednesday's release of CPI for June will be critical to markets, obviously.

The consensus viewpoint is that we are in a period of ongoing cyclical sector leadership with continued earnings growth particularly from that sector. I am not that sure. The world economy, to some degree has been sheltered from the impact of energy prices. Just recently, China announced that it was raising domestic gasoline prices for the second time this year. State-run economies have difficulty in sheltering themselves over an extended period from world oil prices. Tightening of monetary policy has been a worldwide phenomenon even including Japan putting an end to its zero interest rate policy. My suspicion is that we will see a slowdown globally from what has been five years of above-average growth.

What to do? Gimme shelter. Look for less economically sensitive sector exposure to your portfolio. Look for predictable, slower growing companies. Consumer staples and healthcare come to mind.

This week's Barron's has an interview with Larry Haverty of the Gabelli Multimedia Trust. In his view, the U.S. is in a consumer recession. As he mentions, WalMart had 1% same store sales gains for June, restaurants (check out our CBRL thoughts) are missing estimates, and MMM lowered forecasts. Though a hard landing for the consumer is possible, he and I are more optimistic. He suggests three different kinds of stocks:

1. Unscathed Entities-Phenomenal businesses with terrific fundamentals. He suggests YHOO, STN, NWS, LVS, AAPL, and BBY.
2. Mispriced Value-He suggests HD, and SSP
3. Companies Gaining Higher Share of Spending- He suggests gaming stocks such as MGM , HET, BYD, or PNK.

It's been a tough start to the quarter for most of us. In a slowing consumption period, there is downside in a lot of the consumer discretionary names. Stick to financial quality, stay larger cap, seek predictable growth. Again, this should be a good environment to switch into consumer staples and healthcare names. My suspicion is that the cyclical game is in its late innings. Industrials generally seem fully priced and may well have some significant downside in a slowing economy. Similarly, I would (and have) reduced my exposure to beneficiaries of inflation in the resource area. About the only aspect of this sector that still intrigues me is the paper and forest products.

Disclaimer: Neither I. nor my family have a current position in any of the stocks that were mentioned in this post. Some clients do have a current position in HD, and HET.