Global Finance: 'A New World Order'

(Comment on this article at http://www.financialwire.net/2010/05/07/global-finance-a-new-world-order/)

- Editorial Market Commentary -

May 6, 2010 (FinancialWire) (Investrend Forums Syndicate) (Via Craig Drill Capital) (By Steve Reynolds) -- Editor's note: Perhaps of relevance particularly to our readers with an interest in foreign and international financial ETFs, as well as broader-spectrum domestic financial sector ETFs -- such as the WisdomTree International Financial Sector Fund DOO, the Financial Select Sector SPDR Fund XLF, the iShares S&P Global Financials Sector Index Fund IXG, the Rydex S&P Equal Weight Financials ETF RYF, the First Trust Financials AlphaDEX Fund FXO and the PowerShares Dynamic Financials Sector Portfolio PFI -- FianancialWire(tm) contributor Dill Capital offers the following commentary by the firm's Chief Investment Officer:

Over the last few years, we have navigated through the building and bursting of a global credit bubble, the collapse of our modern financial system, a severe worldwide recession, unprecedented government stimuli, and a historic rebound in financial asset prices from panic lows.

The post-crisis United States is left in a proverbial "Goldilocks" environment: neither too hot (inflationary) nor too cold (recessionary). Liquidity is plentiful, interest rates are low and stable, inflation is muted, consumer spending is no longer a drag, exports are reviving, and profits are soaring. In fact, it appears that corporate profitability will achieve record levels in 2010.

Despite a number of headwinds -- including scarcity of business and consumer credit, excessive structural fiscal deficits, mounting foreign sovereign debt risk, the burden of household debt, high level of unemployment, and political uncertainty -- the economy is transitioning to a self-sustaining expansion (albeit slower than we would expect based on history).

Investors are becoming more optimistic while holding historically high amounts of cash and fixed income investments. Across the broad spectrum of institutional and individual investors, there are significant shortfalls in actuarial and retirement needs that have to be replenished. To satisfy these deficiencies, many may move to greater equity exposures.

After such a traumatic shock to the global economic and financial systems, it is unlikely the world will return to its pre-crisis state. The failures and their fixes have altered the landscape. Thus, traditional methods of analysis may need to be modified.

By viewing economies through a different prism, investors can define "a new world order."

We visualize a world not segmented by geography (Asia, North America, and Europe) or stages of economic progress (emerging and developed markets). Instead, we see one in which countries are separated by their financial soundness: (1) those that entered the crisis with strong financial systems and (2) those that were over-leveraged and under-regulated.

To be sure, even those countries that were prudent in the regulation and supervision of their financial activities could not avoid the global meltdown. Most still suffered recessions, but their financial systems withstood the stress. Traditional monetary and fiscal stimulus proved effective, enabling their financial institutions to transmit public policies to private business and household activity.

As the result of a quick return to economic growth, several of these countries have already begun to withdraw their stimulus programs. Interest rates are being raised in Australia, Canada, Norway, China, and India, all of which stand out as countries that successfully survived the financial storm.

They have the advantage of financial flexibility and thus the ability to manage their economies more effectively. Over time, they should be able to generate above average growth and gain share of the world profit pie. From an investment view, companies that operate in or sell products and services to these countries should be secular market leaders.

In contrast, profligate countries were brought to their knees. Government actions were able to stabilize the system only through measures that were unprecedented in speed and size, creative in structure...and questionable in legality. The negative consequences of the financial crisis on their economies will be felt for years.

These countries remain saddled with three major structural issues. First, the extent of the bad debt problems soaked up inordinate amounts of financial relief that would normally have flowed through to the general economy. In the U.S., the political will for further meaningful assistance has been drained. Second, the consumer remains over-leveraged and is limited in his ability to accelerate housing and autos, the traditional jump-starters in a recovery. Third, the high rate of unemployment requires high levels of social welfare payments, exacerbating state and local government deficits. This has weakened the federal government's efforts to create new jobs.

In the countries with impaired financial systems, attempts at economic stimulation have in most cases provided only stabilization. These countries account for perhaps 40% of the global economy and their financial flexibility is hindered by fiscal deficits of over 10% of their GDPs. Their sub-par growth has reduced demand for imports, inhibiting trade and overall global growth.

Such countries may in the future implement policies that harbor unknown consequences. When their unconventional stimulus plans are inevitably withdrawn, their economies may be susceptible to relapse. Like the private banking sector, many of the governments' financial initiatives were "original" in construct. The financial engineers of Wall Street now have brethren in the global central banks and the Departments of Treasury. Their massive, complex, and often opaque schemes -- while successful in stabilizing the financial system -- may have only kicked the proverbial can down the global road (or the dromos, camino, vegur, or aopora). As these unconventional stimulus programs are unwound...watch out for the potholes.

The outlook for the financially damaged U.S. -- after the current snap-back in economic activity -- is for moderate growth. Ironically, this provides for a long "sweet spot" for market participants. However, it also encourages and enables speculators to create new bubbles, an outcome for which we are vigilant.

As the U.S. economy shifts from a recovery led by fiscal stimulus and inventory restocking to a more moderate expansion, the stock market is likely to become more selective. Many sectors, industries and companies will find it difficult to continue to make meaningful earnings progress on cost cutting alone. This results in two attractive areas of investment opportunity: (1) companies that can show strong top line growth in a sub-par economic expansion and (2) undervalued small-and micro-capitalization companies that have been overlooked by Wall Street.

In the early 1970's, the market leadership was defined as "The Nifty 50." This group was comprised of dominant companies that investors felt would have high levels of revenue and earnings growth for an extended period of time. Because of their extraordinary outlooks, they were called "one decision" stocks...never to be sold. Large, consumer non-durable companies, such as Disney and Avon Products, populated the list, commanding multiples well in excess of 50 times earnings.

As this bull market unfolds, a similar, but new leadership group will likely emerge comprised of companies that can achieve strong revenue, free cash flow, and earnings growth. This group will be broad-based in market capitalization and sector/industry representation. They will distinguish themselves by optimizing revenue growth from new technologies, product innovations, market share gains, and exporting to and operating in countries with sound financial systems. Investors may be drawn increasingly to this select group of growth companies whose valuations should expand from today's rather conservative levels.

The Great Credit Collapse and Severe Worldwide Recession were devastating to the typical equity, but even more so to most small- and micro-capitalization stocks. The market's illiquidity was extreme at the panic lows. Small- and micro-capitalization stocks in particular were divorced from fundamentals, in relation both to business models and balance sheets. In fact, many bottomed at prices near or even below net cash per share.

With limited Wall Street research coverage, market participants have been slow in returning to this sector, so that meaningful undervaluation persists. The combined benefits of increased research coverage, individual company earnings growth, rising merger and acquisition activity, and the eventual return of the public to equities make this area attractive.

Source: Steve Reynolds, Chief Investment Officer, Craig Drill Capital. Go to http://www.financialwire.net/2010/04/30/craigdrill-capital/ for important disclosure/disclaimer information and more about Craig Drill Capital.

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