Market Update – June 2011

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In a sign of our times, economies are slogging towards something yet-to-be-understood, revolts crop up around Facebook pages, and market pundits continue to drivel about a recovery “around the corner.”  Taking a step back from the daily static of mass media reporting, we are in the midst of a tectonic change in finance and economics that began a decade ago and signaled its presence in the collapse of 2008.

How we manage out of this change and ensuing crisis is yet to be seen, but the patterns are developing.  Unemployment, real estate and inflation are the factors we continue to focus on for the U.S.  Commodities, food and shifts in regional comparative advantages are the themes for our international investing.  Cash flow, value creation and sustainability are the core tenets for our investment strategy and will continue to be so for the coming months and years.

In this market update, we look at how these patterns have solidified in 2011 and the global factors we feel are most likely to influence our outlook.

Revolts in the Air – Still Looking for Progress

The news of global unrest in the Middle East has certainly been on the forefront of our minds in the past few days and weeks.  Peaceful protesters, tribal leaders, and indoctrinated dictators continue to vie for power throughout the region.  Domestic conflicts, like we are seeing in Yemen, have the potential to reverberate around the world as important oil powers like Saudi Arabia get involved.  All this has substantial impacts on the U.S.’s geopolitical hegemony.  The U.S. has appeared to play catch up to the political changes in the Middle East—changing policy as protesters gain power over dictators.  What is becoming clearer every day is that the U.S. will be challenged to maintain its position in terms of political or economic influence.  Democracy for all is a wonderful idea – but not a reality in a region that is still struggling with the basics of gender rights and religious freedoms.

The impact on the financial markets can be viewed through the lens of oil.  With the Middle East representing about 44% of current global production and 54% of worldwide reserves, any notable disruption to that region’s oil producing infrastructure will cause dramatic spikes in the cost of energy.  While short-term this drains current income for consumers and business, long-term it has the potential to create a nasty global recession.  Oil-producing countries have incentives to keep prices reasonable to ensure steady long-term demand.  Hence, OPEC’s intense interest in maintaining stable and predictable oil prices.  With Yemen on the southern border of Saudi Arabia and their close ties to Al Qaeda, many do not miss its importance in the global economic balance.

Any transition in Yemen’s government will set the tone for similar disruptions in the region.  Syria is to be closely followed for many of the same reasons – proximity to Israel and Iraq, close ties to Iran, and the potential for extreme violence.  The administration realizes the importance of these changes to our economic welfare.  The view of the U.S. as a fair negotiator may be critical to holding sway in key discussions between yet-to-be-known regional parties.  It is no surprise that Obama is attempting to take the initiative in the region with a hard line on Israeli-Palestinian peace talks: our ability to continue to shape the region is going to hinge on perception as much as reality. Time will reveal all as we closely watch this region.

U.S. Market Fundamentals

While the events in Yemen and the surrounding countries continue to evolve almost hourly, here in the U.S. the same themes from the past few months predominate— real estate, employment, and inflation.  The newest numbers point to more of the same in the labor markets, with limited job creation.

The most recent employment numbers remain just as distressing as ever.  The employment level, as opposed to the deeply methodologically flawed unemployment numbers, continues to stay at historically low levels—about 58%.  We haven’t seen numbers this low since the early 1980’s when the composition of the labor force was drastically different.  This is due to the increase in the number of women leaving the home sector to be “officially employed.”  So while the employment level is currently on par with the early 1980’s—a time of recession, it actually represents a worsened situation because the number of people seeking to be employed has grown in the past 30 years.

The employment level for the U.S. continues to remain at historically low levels dating back to a period in which women were a smaller component of the workforce.  The monthly movements up and down represent statistical noise in the overall picture.

Meanwhile, the outlook in real estate prices and future inflation continue to be troubling.  After a slight increase in 2010, real estate prices have declined again back to 2008 lows.  On a more local level Boston has faired better than average—we’re seeing prices around the 2004 level.  Atlanta, on the other hand, has taken a serious hit, losing more than a decade of appreciation and placing most mortgages under water.  As an asset that is illiquid and at the core of the real economy, these declines have wiped out trillions of family net worth.

The above chart shows the Case-Schiller composite Home Price Index going back to 2000, not seasonally adjusted.  While the drop-off in prices was severe, it has shown no signs of short-term improvement and in fact a bit of deterioration over the past few months.  Eight and one-half years of price appreciation has been eliminated from this collapse.

While some cities have fared better, Atlanta’s home prices (shown above) have suffered draconian effects from both the collapse and the ensuing foreclosures.  With prices retreating to levels not seen since the 1990s and falling a third from their highs, homeowners have lost a tremendous portion of their net worth and are underwater in most cases.

The slow real estate market continues to hamper the economic recovery on a host of levels.  On a macro level the perennial obstacle the housing market is facing is the foreclosure glut—banks are still dealing with a record number of homes that they have to move on a scale unimaginable before the crisis.  Homes remain vacant for months or even years in some cases, driving down the value of the surrounding homes.  With the banks relying heavily on valuation comparables and reluctant to lend in any situation that isn’t completely consistent with their stringent guidelines, the foreclosures enforce the cycle of declining values.

This all affects the labor markets when people have difficulty moving to identify or fill new jobs, causing extra friction that the economy doesn’t need.  In turn this trickles down to consumption spending.  The seemingly insignificant purchases that folks make when they move—throwing out old appliances in favor of newer versions—add up and create a real impact on the economy.  During the boom, this housing based consumption led to the massive trade imbalance with China and their multi-trillion U.S. dollar currency reserve.  Today it starves the economy for a source of growth.

Unfortunately we expect the situation in housing to remain fairly dismal until the banks get ahead of the foreclosure problem.  While it is conceivable that a recovery could occur without consistent real estate appreciation, we doubt that to be the case.  Look for this indicator to be closely watched in future updates as a gauge to domestic economic growth.

Turning to the treasury market we are getting an indication of the worries that surround the U.S. economy.  The interest rate on medium-term treasury bonds recently dipped below 3% in early June, a level not seen since last year.  From an investment standpoint the paltry returns on treasuries mean that holding a ten-year treasury to maturity will not keep pace with inflationary pressures, resulting in a negative real yield.

While changes in the equity markets often reflect the mood of investors, fluctuations in the returns on treasuries are more representative of educated institutional views on the economy.  Looking to Washington, these views seem validated as politicians continue to bicker across partisan lines as opposed to finding real solutions.  While the bickering over the debt ceiling is frivolous showmanship, and discounted as much by the market, a new round of quantitative easing would further devalue the dollar with the commensurate increase in inflation.

In terms of the U.S. equity markets the current volatility is in line with our expectations.  It can be easy to get caught in the day-to-day fluctuations (just watch CNBC for six minutes), especially when they seem to be predominantly negative, but it’s important to remember that on a year-to-date basis the market is up 1.5% (as of this writing).  The generally anemic growth in U.S. equities is to be expected considering the current economic outlook.

While the volatility in the U.S. equity markets appears daunting, it simply places us back at a 1.5% gain for the year during a period of strong economic uncertainty.  With a current price-to-earnings ratio on the SPX at 14x, and a future P/E of 12x, this level is consistent with corporate profit levels and expected growth.  While we don’t like to use these measures as a predictor of market movement, it does give us comfort in this level as a floor to short-term market volatility.

Because of the Fed’s loose monetary policies, we see inflation as a significant risk as the supply of dollars grows and excessive cheap money triggers future jumps in economic growth.  Core CPI, which excludes important variables like food and energy, remains almost insignificant at 1%.  Common sense, however, dictates that these are probably two of the most sensitive spending components for any inflation indicator.  Looking at the “All-Items” CPI data, which includes these numbers, inflation picks up a bit to 3%.  While this is notable, barring another recession we expect inflation to further rise to 5% or more in the near future.

This view is already being realized in the commodities markets.  While equities have declined by upwards of 7% in the past few weeks, commodity indices are flat or up.  Traditionally a soft economy drives down demand for commodities, but this disparity can be explained if we take a look at role of increased global demand.  We expect this development to continue, a view that is driven largely by changes in the global demographic.

Global Changes

To understand this trend we begin with the recent policy changes coming out of China.  It recently released the 12th Five-Year plan, instituting a dramatic change of policy from headline growth to the welfare of its citizens.  This is a much more realistic vision of where China needs to go if it wants to avoid a repeat of the trouble that’s been brewing in the Middle East.  Rising inequality has been a concern for China since it first began developing the urban coastline at the expense of the more rural inland population.  As a whole the country is still relatively underdeveloped, with only 50% urbanization and an average income that’s 1/10th of the United States.

The largest problem China will face in the coming years is a demographic shift as its one-child policy and declining mortality rates change the composition of the population.  With the labor force expected to peak in 2015, China faces the same situation as the U.S.—supporting a growing elderly population with a declining number of workers.  This means that increased health care and pension costs will eliminate the low wages that have effectively subsidized cheap products for Americans.   We will need a new source of cheap labor to keep the consumable economy ticking along.  Given our strong bias towards sustainability, I am intensely curious to see where the beast of cheap manufacturing goes next in search of higher corporate profits.

As China transitions to a consumption economy and as the size of their middle class grows, we expect resource use to become a major issue.  The continued urbanization and infrastructure needs will place demands on commodities for years to come.  However, China is at the forefront of renewable energy development, which is a promising sign.  All these changes coupled with the size and influence of China’s economy make it the global wildcard.  As China moves to secure its future and the necessary raw resources, we expect commodity prices to reflect these changes.

The Role of Resources in the Middle East

It is precisely the role of resources that has put the disruptions in Yemen on the front page of the news in the past few weeks.  The U.S. has been conflicted in its policy towards Middle Eastern nations like Yemen—preferring the dictator we know to potentially unfriendly democratically elected governments.  Yemen has historically been a haven for terrorists, and it is also located in a highly volatile area, just southwest of Saudi Arabia.  With 10% of global oil production, any disruption in Saudi supply will have far reaching effects for the United States.  Not just gasoline but also the transportation costs for virtual every item, from food to clothing, would increase if Saudi Arabia reduced its production.  Suffice to say the tenuous economic recovery would be wiped out.

A more immediate threat for Yemen is water supply.  With one of two major pipelines already destroyed by the fighting, the country’s capacity to pump water from the aquifers has been significantly reduced.  This may be a prelude to a truly global problem as populated areas all over the world deplete their water supplies.  The current disputes over oil will be dwarfed in comparison.

Summers in Greece

Needless to say, it will be an interesting summer.  Starting with 2007 and the sub-prime collapse, each summer has brought some form of volatility and a commensurate increase in the perception of risk.  Just like 2010, we are again faced with the prospect that Europe and the Euro are going to rain on everyone’s summer vacation.  While this is old news – Greece might default on their sovereign debt – it is news yet again.

The hope was that Europe’s various institutions, from public to private, would bail out Greece long enough for it to put austerity measures in place and regain its financial footing.  For a host of reasons, from cultural to political to simple realities, that is looking dubious at the moment.  The concern is simple – if Greece does not fully pay back their debt obligations then the value of similar debt from Spain, Portugal, Italy and Ireland will decline markedly in value.  If that occurs, banks with that exposure will take a large hit to their balance sheets and place their financial solvency into jeopardy.

This is not that different from the financial crisis of 2008, when real estate backed assets were the culprit and a host of banks needed temporary capital to ride through the losses.  The differences this time, however, are notable.  The amount of Greek debt is fairly limited, the exposures are mostly known and the banks are actually generating profits.  While I don’t want to dismiss the risks, the realities are likely to be far less draconian than the predictions.

Stepping back, while the U.S. indicators are weak and there are again riots in the streets of Europe, there is little new news.  What has changed, most likely, is that the “bull” market has run out of buyers and the reality of a paradigm shift in our economy is beginning to sink in.  We have a long haul ahead of us, and no quick fix is going to shorten that road.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA
Managing Principal

Market Update – February 2011

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Revolts in the Air – Looking for Progress

Well, 2011 has started off with a bang of sorts. The Internet has finally caught up to the developing world of autocrats and dictators. The leaders of Egypt, who reportedly have never written an email, were ousted by a youth movement harnessing the power of social networking. Not that the events have created any progress in that country – it is still run by the military and the constitution is now suspended – but change creates opportunity. And that change is trying to propagate throughout the Middle East. Our hope is that this change creates real progress. Unfortunately, history bodes otherwise.

As we look to the US and our little corner of the global economy, things have gotten a bit brighter during the past few months despite the blanket of snow covering my backyard. Or at least, that is what we are led to believe by the financial news. We’re not as bright on the news. As you’ll read below, we are of the same perspective from the past few quarters: the economic damage from the events of 2008 is going to take us years and possibly a decade to correct. Do not expect that all will be resolved quickly – do expect more volatility.

The Key Factors – Unemployment, Inflation and Real Estate

As you can see from the chart below, our employment level in the US has remained at rock
bottom for many months now despite the “good news” that unemployment dropped to 9.0% last month. The disparity in these facts has to do with the way that unemployment is calculated,
which masks the true numbers. Unemployment claims each week are still at exceedingly high levels, roughly 400,000 depending on the week. But the anomaly is that fewer people are actually in the workforce. Due to months and years of being out of work, folks stop looking and simply don’t get counted. The number of folks who have dropped out of the labor force over the past year is roughly equal to the number of new jobs. No change, no progress.

Combine that fact with regular population growth, and we are backsliding each month when we don’t have substantial jobs growth. January was no exception – 37,000 jobs growth in non-farm payrolls is nothing against the needs of a larger population. The problem grows, not improves.

A stagnant and immobile labor force leads to a tightening of the qualified labor pool, and hence our second concern for the current economy – inflationary pressures. Inflation is the silent erosion of future purchasing power. In a simplistic sense, you need to grow your assets and income at the rate of inflation to keep your standard of living. It seems like a simple task when inflation is typically 2-3% per year, but not so quickly. An ongoing study by Crescent Research points out that real growth in the stock market (gains from price changes and dividends, less inflation and taxes) is often flat or negative when viewed over a 20-year investment period. This data places a severe challenge to the notion of buy-and-hold equities to safely grow your portfolio.

Unemployment Index

Given where we stand today, we believe that inflation is prepared to once again enter us into a period of negative real growth if portfolios are not properly hedged. The factors are all present:

  • The Fed has again entered a period of loose monetary policy: near-zero short-term interest rates and massive amounts of liquidity infusion through the Quantitative Easing program.
  • Energy and food prices are escalating at a rapid clip due to global factors: namely general population and income growth in developing markets and failed harvests from the effects of climate change.
  • A tightening labor pool.

But wait, you say. A tightening labor pool? I thought we just established that people need jobs? In fact, the unemployment situation will factor heavily into the inflation problem because of the lack of mobile, qualified professionals and skilled workers. Those folks who are falling out of the job hunt are often times permanently out of the labor market. Skills degrade, their ongoing training is limited and they find ways to adapt to life without permanent employment. With many of these folks out of the competitive labor pool, you have rising labor costs as firms compete for the fewer qualified candidates.

Adding to the problem is the real estate market. Prices are still down 30% across the country from their highs in 2007 and back to 2003 levels. A third to half of all mortgages are under water, with no short-term prospects of improving. The only way to move is to hope for a short-sale or some other concession from the bank and torch your credit report. Yet the jobs have moved on, to other industries in other regions or in other countries. We have severely limited the portability of the labor pool even as they seek new jobs created by advancements in American productivity and innovation. In short, a tighter labor pool for those firms who are looking to hire skilled workers and professionals.

Contributing to the problem are the banks, those bastions of capitalism who create the efficiencies for our economy to prosper (if you listen to Jamie Dimon and a host of other bank executives). Talk to anyone who has applied for a mortgage of late, and you get an interesting mix of dismay, disgust and a desire to disembowel. With Bank of America/Merrill Lynch losing billions each quarter, they are not exactly inclined to lend money even if they have a claim on your first-born. They’re just trying to survive and justify their next engorged bonus. In the mean time important segments of the economy are starved for credit, the fuel for growth.

So we are left with an interesting mix of circumstances. All the monetary factors are present for inflation, raw commodities are in tight supply, and the labor pool is tightening. Yet, these same factors lead to tougher circumstances for many Americans – fewer jobs, higher costs for daily living, and a dramatic loss of family wealth from market volatility and decimated real estate values.

Companies are Profitable – Why Worry?

Not surprising, companies in the US are doing pretty well. They have managed to keep costs down considerably (lower payrolls is a big start), gained in production efficiencies and have learned to serve a global market. Most companies have beaten earnings projections for the past quarter (which makes one suspect of earnings projections). The stock market is doing well. Corporate bond spreads are very tight, a market belief of nominal credit risk in these firms. Apple has a cash balance larger than most economies. Life is good for the big firms. Life is even good for some of the smaller firms. So what is the worry?

The worry is around tensions. We have created an untenable situation – one that cannot last more than a few years at the current pace. The most obvious tension is the US government debt. Our receipts as a percentage of GDP have fallen dramatically in the recession, by over 20%. Yet government spending, and the annual deficit, continues to grow. From the trillions spent on defense and wars during the Bush administration, to the ongoing state aid in the Obama administration, we are running up the credit card balance. And unless the entitlement programs (Social Security, Medicare and Medicaid) are harnessed and tempered, it will get worse, not better.

That spending has caught up in a dramatic fashion. As Tim Geithner, Secretary of the Treasury
quietly noted in front of Congress, annual debt service will soon be 73% of the annual deficit. Simply put, we will spend a half-trillion dollars a year to keep current with our national credit card bill (kindly issued to us by the First National People’s Bank of China). And that teaser rate is about to expire. Interest rates are going up, slowly, and for every few basis points increase in the cost of borrowing for the US government, the interest costs go up by billions. Not a pretty picture for a consumer who is still shopping at the Blue Light Special on that same credit card.

Municipal Bonds – Another Ratings Game

We are seeing the first signs of this problem in the municipal bond market. Muni bonds, for anyone who has been following, took a drumming in the last half of 2010 despite every other asset class doing well. The problem is state budgets. States have run out of money, and some will face impossible decisions on budget cuts. Remember that in 2010 there was Federal Stimulus money to help cover their deficits – no longer the case in 2011. That means a host of issues for cities, towns and municipalities who depend on the states. Some of these entities might fail – some of their bonds might go into default. One of the most conservative, risk-free, stable asset classes is headed for a Lehman moment.

Analysis: Muni Bond Market from the view of an Institutional Trader

AAA Muni historical spread

This first chart shows the historical spread between the Generic U.S. Treasury 10-year yield and the Generic General Obligation AAA Municipal Bond 10-year yield (in Bloomberg speak: 049M10Y Index USGG10YR Index HS). The top chart shows the two rates going back to early 2006: Treasuries being the orange line and munis the white line. The bottom chart shows the difference in the two rates, with green indicating munis trading at a lower yield than Treasuries, and red is when they reverse. The top chart is measured in percentage points – the bottom chart is in basis points (100 basis points = 1 percentage point).

Back in the day (pre-summer 2007 when the sub-prime crisis began) AAA-muni’s typically yielded 1% less than Treasuries to account for their tax benefits, inferring that their credit risks were effectively the same. This relationship was broken during the crisis, and while the market attempted to restore the relationship in early 2010, it again fell apart at the end of the year. Today, AAA-munis and Treasuries yield approximately the same rate, despite the wide disparity in tax treatment and after-tax yields.

BBB Muni

This second chart shows the same data for the Generic BBB G.O. Municipal Bond yield compared to the Generic U.S. Treasury 10-year yield (Bloomberg: 631M10Y Index USGG10YR Index HS). Note that, as in the previous chart, back in the day BBB-munis had a lower yield than Treasuries by roughly 0.6%. This wasn’t as large as the 1% difference between AAA-munis and Treasuries, but still reflected an institutional trader’s view of them as a “safe” tax-free asset class warranting the lower returns.

Today, BBB muni yields have shot straight through Treasury yields by 1.5% (and peaked at 4.1% in March 2009), indicating a relatively risky asset class despite the tax benefits. Compared to a history of zero losses from defaults (as far as I’m aware), the institutional market has effectively established this as the next crisis asset class, and doubts the validity of the AAA ratings as seen in the first HS chart. Remember that once upon a time, a whole market existed for AAA-rated sub-prime CDOs, many of which trade near zero today. Lesson learned: don’t rely on the credit rating agencies to spot the next crisis.

Next… Patience

Where this goes next, we cannot predict. But in the big picture we need time to heal, with a bit of additional carnage along the way. Our feeling is that the stock market rally is another bubble, inflated by a cycling of asset classes. As an investor over the past few months, there are few places to invest and gain yield. Short-term debt is paying next to nothing (thank you, Fed), risky debt is just that, municipal bonds look like the next crisis, and people feel like they need to restore their 401k plan now. So what-the-hey, let’s get into the stock market! In short, a predictable outcome from the Fed’s policies – create some sense of calm by inflating the one asset class that everyone understands and can play through their web browser.

With all this in mind, our investment direction for 2011 has some of the same from 2010 along with a few new twists. We are maintaining an underexposure to equities in general, and will do so for the foreseeable future. Those equities that we do hold have a handful of important characteristics:

  • The ability to increase cash flow to shareholders in the event of strong inflation. High current dividend yield is an immediate indicator – strong cash flow is an intermediate indicator – and correct market/global positioning is the final indicator.
  • Revenue base that is global. Most of the firms that we hold have at least 50% of their revenues from overseas, and we look for those firms that are able to tap into emerging markets as well. This helps us hedge against a weaker dollar and a weak domestic economy.
  • Lower volatility in the event of a market dislocation. We do expect for increased market volatility, of the sort that we saw in the Flash Crash. Firms with currently low betas that tend to be less volatile are a start, those with stable cash flows augment the approach.

We expect for there to be continued uncertainty in the emerging markets as they grapple with inflation in many cases, and political instability in others. While we currently do not hold an emerging markets exposure, we consider it important to long-term growth in the portfolios. Entry points will be determined by specific events and inevitable market over-reaction.

The remainder of the portfolio is split between alternatives (namely commodities), fixed-to-floating rate corporate bonds, floating rate corporate bonds, and inflation-indexed US Treasuries. The mix will depend on available inventory, current pricing and individual risk profiles. Some interesting opportunities may also arise in the municipal bond market with any volatility or capitulation due to credit defaults.

Irrespective of the actual asset class or security, we will look for the opportunity to generate income to portfolio irrespective of the market conditions and in several cases use the asset to hedge against elevated inflation in the coming years.

Until our next market update, let’s hope that these markets sort themselves out in an orderly fashion and the snow gets a chance to melt. (I think our recycling bins are still buried out there somewhere!)

Regards,

David B. Matias, CPA
Managing Principal

Market Update – October 2010

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An Anxious Summer

It has been three years this fall since the financial crisis began, and by my estimation, it will be another seven years until we have fully recovered.  Yes, I see it as a decade-long event, beginning with the subprime crisis (July 2007) and reaching its height in the failure of Lehman Brother (September 2008).  Under that assumption, we’ve had a pretty good year.  The stock market is up 4% for the year (nearly half of which is dividends), the corporate bond market is up 12%, and commodities are up 4%.  These may not look like great returns, especially if you’re still trying to restore your retirement account from the collapse of 2008, but given the alternative it is pretty impressive.

This view is best understood when you look at the stock market against the VIX, commonly referred to as the “fear gauge.”  The VIX is a composite index that tracks the implied volatility on S&P futures.  Put into plain English, it is a measure of expected future losses.  The higher the VIX goes, the more expensive it is to insure against such losses.  The chart below shows that while the S&P has flat-lined for most of 2010, VIX looks like it went through a cardiac arrest.

SPX and VIX

Specifically, it was the “flash crash” on May 9 that created the anxiety and that stress lasted through the entire summer.  It was only when we arrived in the last week of August that the anxiety level returned to a more normal buzz and the US stock market began a 10% rise to recover the year’s losses.  The question remains – what caused such a stir in early May and why did it create such fear of equities.  While there is now a plausible explanation of the flash crash recently published by the SEC, in fact it could still happen again.  What we did experience through the summer was a rather tame pull-back.  Had things truly gotten worse in the economy and around the globe, we would have likely seen a persistent 20% drop or more.

Fortunately, the net result is a gain.  For the year to date the S&P 500 is up 4% with dividends, and the VIX is sitting at 23 – elevated but not unusually so.  For comparison, prior to the crash, VIX commonly sat in the low teens with 30 being a crescendo prior to a market decline.

My “decade-long recovery” prediction, while frankly a guesstimate, reflects the challenges that we face in all areas of the economy.  During this time, expect for economic growth to be slow and market returns to be in the single digits.  Under those conditions, a total return of 8% for the year is a very respectable figure.  With a 4% gain through the first three quarters, we’re on track to stay within those bounds.

Two of the factors that will determine a full recovery are employment and housing.  In fact, they are intricately tied together with bank lending at the root of the problem.  While large investment-grade public corporations have easy access to the credit markets (Microsoft raised 3-year paper at less than 1%), smaller businesses and private firms with less-than-perfect finances are having a nasty time of borrowing.  The mortgage market is even worse.  Mortgage assessments are driven by comparables, and with so many foreclosures out there the comps look awful in even the best neighborhoods.  To make matters worse, banks are simply not extending mortgages to folks without three years of steady income.

So with so many folks looking for work and valuations at such lows, it is simply impossible for most people to obtain a mortgage to buy or refinance.  With so much potential equity tied up in our homes, a large source of net worth has been frozen.  Complicating matters, it makes it nearly impossible to move cities to find work or change jobs.

Implied in all of this is the plight of small business, a common growth driver in the American economy.  No loans means little capital to expand and grow.  No growth, no new jobs.  The cycle continues.  While I am bullish on the American entrepreneur and our ability to adapt as a country, it will be years for the foundation to be repaired.

Repositioning of the Portfolios

To respond to these conditions, we are looking to reposition the portfolios accordingly:

Equities:  We increased some of our equity exposure in August when the market was experiencing a temporary low, although we continue to maintain an underexposure due to the current economic prospects.  The areas that we are increasing are related to cash or global growth.  Notably, companies with growing dividends are going to continue to be a focus along with industrials and medical technology firms.  Irrespective of the US’s prospects, these industries will continue to remain strong.

Alternatives:  To augment the equity exposure, we have increased our alternative asset class.  Ranging from commodities to REITs, these are assets that have low-to-zero correlation with equities yet maintain similar growth prospects.  The table below demonstrates these correlations against the S&P 500.  Although commodities have a similar growth prospect, a third of the time they move independently of the market.  Gold is far less correlated to stocks, and bonds are effectively not correlated at all.  Emerging markets, on the other hand, is almost always correlated with US stocks.  Incorporating lower-correlated assets allows us to maintain similar growth prospects in the portfolio with less extreme fluctuations in value.

 

SPX Correlations

Two-year daily correlations from October 2008 to October 2010. Because of the significant exposure to oil in the DB Commodity Index, it has a higher correlation over this period than prior to 2008.

 

Fixed Income: With the persistent fear in the markets combined with excessive monetary easing, bond prices have reached highs rarely seen.  Any issue that is less than 10 years is pricing at yields of 2-3%.  If you factor in any inflation into the economy during this period, your bond real-return is likely to be zero or negative.  As a result, we are selling any traditional corporate bond holdings that are less than a 10-year maturity.  This does not include any of the structured notes we currently hold or floating rate bonds, since most of these have mechanisms to generate solid returns in both recovery and stagnation scenarios.

We will closely monitor events this fall, with the election being the next hurdle in market stability.  As usual, uncertainly creates anxiety and just the resolution of the political shift in itself will help to stabilize equity returns.  Please don’t hesitate to contact us with questions or comments, and all the best for the fall.

Regards,

David B. Matias, CPA

Managing Principal

Volatility Reigns for Summer 2010

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Precious Metals in the Silver Lining

On this Independence Day, when Americans headed to the ponds, lakes, oceans and mountains in search of ways to celebrate, the mood of the economy and financial markets was far from celebratory. In summary, we again have had another “worst.” This time it was the worst May since 1962 with an overall decline year to date of -6.65% and a decline of -14% from the S&P500’s high for the year. In a year that was supposed to continue the march of “return to even” from the lows of 2008, we are again faced with the prospect of a losing market.

Fortunately, the story is far more mixed than the pessimism currently portrays. For each of the negative economic data hitting the headlines there is a very distinct and measurable silver lining, most easily seen in the housing and employment figures.

Housing starts for June were 593,000, down 60% from their peak in 2007: This is an abysmal figure, indicating the lack of jobs in construction and all the consumer markets that go along with new homes. Yet this level is not sustainable long-term. To accommodate population growth and regular demolition of existing homes, we need a rate of roughly 1,500,000 starts. At the current level, we will be facing a housing shortage at some point. When and how that unfolds is debatable. Yet housing will see a strong rebound based on the basics of supply and demand providing relief to the largest and most depressed asset class for Americans.

Employment levels, at 58.5%, are at their lowest level in 25 years and declining: The lasting effects on America will be profound. (Note we are using employment statistics, which are far more reliable than unemployment reporting). The last time we saw these levels of employment, women had far fewer options in the workplace leading to a lower structural full employment level. Today, more women than men are employed. America has changed – and it will take at least a decade for the new dynamic to be fully absorbed.

The silver lining to the employment figures is corporate profitability. Companies are leaner, more able to survive on a lower revenue base and poised for tremendous profitability as the economy eases out of the recession. Companies have also been accumulating cash at startling proportions. Whether it is Apple and their $30B hoard or GE’s $70B, firms are finding ways to become self-sustaining in the face of an uncertain market. As long as one chooses wisely and is accepting of elevated volatility, this all points to some potentially strong equity returns on individual firms in the near term.

Elevated Volatility

The reality of the current stock market is that these are pretty decent levels to be investing in stocks. Companies such as Alcoa trade at one-fourth of their pre-crash market value despite profit margins that are better than ever. For Alcoa we now need for aluminum demand to increase – a forecast that changes daily with government policies from China to Australia.

The issue at hand is volatility. With volatility comes fear. And with fear comes risk aversion. The flash crash of May 6 was a rude awakening to many. The collapse of the value of BP has sent shock-waves throughout the global markets. Economic headlines are touting the risks of further collapse (I read one recent prediction for Dow 900 – that’s not a typo). Europe is a mess. The news has generated a self-fulfilling feedback loop of volatility and decline. Until these markets settle, it is possible that we will see another 10% drop or more in the S&P 500.

A very simple explanation for this volatility is a lack of buyers. In any market, there must be depth of both buyers and sellers to support asset levels. As I talk with institutional money managers around the US, the plan is the same: accumulate cash and wait for the volatility to decline. Recent headlines echo this sentiment. If the long-term buyers are not buying, then that leaves the short-term and high-frequency traders to dominate the daily trading volume. Quick in, quicker out.

While this trend will eventually revert back to the norm, with long-term buyers investing back into the equity markets, it could be weeks or months until we see it happen on a sustained basis.

Investment Direction

We have peaked in our cash accumulation. We sold off half the equity exposure early in the year and allowed cash to accumulate from bond maturities and calls. With an overweight of bonds for the year, upwards of 50% in many cases, our income has remained stable and mitigated any volatility in the portfolio from our equity exposure.

This posture, however, is temporary. While it is a nice thought to sit in cash and bonds for the rest of the year it does expose us to the risk of missing out on a substantial economic recovery. Additionally, a recovery would lead to higher inflation and rising interest rates, which would erode the value of a cash position and depress bond prices.

We will be reinvesting some of the cash this quarter in a few select companies. Characteristics that we are looking for are a strong long-term valuation, a solid cash flow base, significant dividend payments, and balance sheet stability.

Beyond individual firms, we will also be reintroducing exposure to emerging markets. Specifically, we have highlighted Asia as our primary investment focus on an international basis. This deliberately ignores Europe for a host of reasons related to growth, veers away from Latin America (at least temporarily) because of their heavy reliance on commodity prices, and India (namely due to a lack of understanding of the social situation).

Within Asia, we look at countries that will benefit from the rise of China while avoiding their inherent politic uncertainties. Namely, South Korea and Thailand are both in our short-term highlights for reasons unique to each (we will have further research available on each country). To augment the country exposure, we will also incorporate additional commodity exposures to capture the move to electric production and other infrastructure trends as China attempts to urbanize the population at a rate that is equivalent to building two New York Cities each year. The lone cost of replicating the Yankees may bankrupt that trend…

Hope everyone is able to stay cool in this heat, or has found a nice escape.

Regards,

David B. Matias, CPA

Down for the Year

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The last 14 months have been all about economic recovery and the tremendous gains seen in the stock market. Yet this afternoon we are down 3% on the year after a 4% decline this afternoon. Just two weeks ago, the day before the “flash crash of 2010” we were up 5%, and saw a high for the year on April 23 (up 10% for the year).

So what gives? Once again, volatility reigns. Interestingly, on the day of the flash crash the S&P500 reached a low point of 1065, just 1% away from where we stand today. While the market mechanisms on the day clearly failed with some stocks trading at a penny, the overall level was not a mistake. This is where the market was headed, and the panic of electronic trading run amuck was just a diversion.

I don’t have any remarkable insight into the market volatility over the past two weeks, other than to reiterate our view that the equity markets were far too complacent. Despite a balance of news this week, some good and some bad, nothing was going to keep equities from falling. In many ways, this is a sentimental sell-off after another short-term bubble.

How are things different from the collapse of 2008?

  • Companies are already trading at low stock prices to their absolute highs. GE is trading at 1/3rd of its peak. Citigroup is 1/10th of their peak. Both have dramatically cut or eliminated dividends.
  • Companies have finished cutting jobs. Manufacturing has stabilized, people have cut back on their spending and debt levels are going down in the US (I don’t think we can say the same about Europe, however).
  • Other asset classes are reacting well. Government bonds are up. Corporate bond spreads have widened, but not significantly. Gold is stable, yet oil has shown some declines. Municipal bonds are up and utility stocks are flat.

There is clearly a set of economic unknowns around Europe and their debt levels, which could impact the US. That has got to be worked out over time with the corresponding impact known later. In a worst case scenario, the EU may have to drop the single currency. More likely, some of the EU “states” will have to rework their sovereign debt with a corresponding impact on the debt holders. But as far as we can see today, we are not revisiting the Armageddon scenario of 2008.

From an investments perspective, anyone who’s spoken to me in the last year has heard one mantra from me: bonds. This is why we use them, for their stability in these scenarios. We have maintained a highly underweight equity exposure, and been hording cash for the past two months. There will be a time to buy. Until then, it is wait and learn.

Regards,

David B. Matias, CPA

Short and Sweet – Status Quo

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With the first quarter of 2010 now at a close, I am happy to say that there is not much to report. Certainly there were headlines that will persist for years and decades ahead, the healthcare bill and the potential for default from an EU country (Greece) being the most prominent. Yet from the perspective of the market, both viewing asset price movement and economic indicators, we plodded along just fine.

The stock market saw an overall rise of 5.4%. Halfway through the quarter we saw a 5% decline in the market before it rallied 10% for its finishing close. A 10% swing in one quarter may seem like a lot but to put it in perspective, a year ago we were seeing 10% swings in a single day. Most of the movement for this quarter, however, could be viewed through the prices of just a few firms. GE, the whipping boy of the recession, staged a very impressive rally in March (they hinted at dividend increases next year.) Rising 21%, GE was the leader of the S&P stocks on a weighted basis.

This growth though is surprisingly lacking in support. GE, Boeing, and banks drove the bulk of the movement in stocks this quarter accounting for a third of the increase in the S&P500. The Dow Industrial’s performance is even more unbalanced, with GE and Boeing together representing half of the increase this quarter.

If you parse it further, GE was driven by a projected increase in the dividend, Boeing by the first flight of the 787, and banks by their increased profits. While it is assuring to see the markets move ahead, the rally is restricted to a few discrete events. It is by no means an indication that we are headed into a bull market, or even that these gains will hold.

The fundamentals from the economy have stabilized but remain discouraging. Unemployment remains at staggering levels, nearly 10% as reported and 17% of underemployed/unreported. The good news here is that we are no longer loosing jobs, and managed to gain a few last month. I underemphasize this news, however, since the bulk of the gain was driven by temporary census workers. Net of those folks it was just enough new jobs to keep pace with the growing population and labor. That is why the unemployment rate did not change last month.

The bad news is that the same folks are still out of work. Without jobs growth the traditional driver of the US economy, consumption, will remain below levels necessary for a full recovery. Without consumption, job growth will lag. We are currently experiencing a negative feedback loop that the market hopes will just go away. As the Economist astutely points out, America needs to change from a consumption-based economy to a savings and investment-based one. No longer will an overbuilt, shoddily constructed home serve us well. Instead, we need to see consumer debt levels decline as folks need larger asset pools for retirement. It will be a long road ahead for America, one in which we could lose our economic dominance, but it is a road that we can no longer avoid.

The one bright spot in consumption and technology, is Apple. With their amazing balance sheet including over $25 billion in cash, raging iPhone sales, the prospect of opening the iPhone to Verizon this year with a 4G model, and the iPad launch this week, they have successfully avoided the slump in consumer consumption. And yes, I am clearly biased, having received my new iPad this weekend. In case you have any doubts, it is a game changer.

In the mean time, enjoy the spring and let’s hope that the Northeast has a chance to dry out.

Regards,

David B. Matias, CPA

2010 and Beyond: Change as the Norm

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With the stock market up 26% in 2009, one could look back on the year with enthusiasm. Just about every asset class rallied for one of the best general market performances in ages. Gold was up 24%, bonds rallied by 13%, and emerging markets screamed ahead 79%. Wherever you looked, there was money to be made. But the story is not fully explained with just these numbers. As a friend reminds me, “There are lies, damn lies, and then there are statistics.” Statistics can be misleading – let me explain.

When viewed in the context of the past two years, the numbers from the past year start to look pretty weak. Remember, the S&P 500 was down 37% in 2008 setting the stage for a rally of some magnitude. When combined with the upswing of 26% in 2009, it leaves the index down by more than 20% for the past two years, and far more if you go back to the highs.

To give you a better context, over the past eighty years a 20% down market in just one year would be one of the worst returns on record (actually – 6th worse). Not a warm and fuzzy feeling. To truly understand the impact of the last two years and how statistics can mislead, I will give you a little primer on geometric compounding where it is far easier to post eye-popping percentage increases when you start from a small base.

Bank stocks are one of the better examples. By early March 2009, Bank of America stock was down 97% from its high in 2007, and then for the remainder of the year surged ahead a whopping 385%. This very statistic was recently published in the Wall Street Journal. But look at the numbers another way: Citigroup, another high-roller, went from a high of $30 to a low of $1. For it to go up by 300%, it has to climb back to only $3, which is roughly where it sits today. For anyone who purchased Citigroup at $30, your 300% return from the lows is not making you feel any better. Citigroup would still need to go up a further 1,000% from today’s price to return your money (or 3,000% from the low of $1… you start to get my point).

To avoid this recasting of statistics, you need to look at returns in their full context. A comparison of the one and two-year S&P 500 charts helps to illuminate the difference.

2009 S&P 500 Performance (1 year)

This past year had a rough start before it screamed ahead. When viewed over two years, however, the picture is much clearer:

2008 – 2009 S&P 500 Performance (2 Years)

The impact of all this statistical ping-pong is that despite the returns of 2009, the general market has still lost quite a bit. For it to come back to the previous high, the equity markets would have to see another 35% return from where we stand today – a tall order in an uncertain world. For many family’s savings and retirement accounts, they face a similar picture. The emphasis, therefore, is not on where we’ve been but where we are going next.

An Uncertain Recovery

The current recovery has many flaws. Home prices dropped an average of 7.3% last year. One out of every five mortgages is underwater, many by 20% or more. Real estate prices are primed to soften as mortgage rates start to increase. Consumer credit (credit cards and personal loans) is significantly throttled back, making it tougher to find “balance transfers” and other forms of credit to replace lost home equity borrowing. And of course, there is unemployment to consider. Officially 1 in 10 are looking for a job. An additional 1 in 10 are unofficially looking for jobs. In total 2 in 10 people over the age of 16 are looking for work. Only 5.7 in 10 have a job. 4.3 in 10 simply don’t work. The following chart that plots employment rate stretching back to 1969 paints a bleak picture.

After 2008, it was not hard to post strong returns if you recover only a minor part of your lost asset value. Given that there was significant risk aversion (i.e. over-selling) at the end of 2008, you could argue that 2009 was simply a correction of sentiment rather than a solid recovery of value. Add to this the unprecedented government stimulus pumped into the economy, I am far from concluding that we are back on track to robust growth.

Additionally, big questions regarding the nature of America’s economy and national character still loom large. A trillion dollar bailout of the financial system succeeded in ensuring those bankers will receive their exorbitant bonuses yet has failed to revive the main street economy. As we’re seeing across the nation, unrestrained populism threatens political and economic stability. The results of the recent Massachusetts special election are a stark reminder of the aversion to change that permeates America. Ironically, universal healthcare became a galvanizing issue in a state that already has it.

The reality is that change is afoot in America. Business as usual, from banking to real estate to healthcare, is no longer viable for the long-term as those models are either broken or untenable. As witnessed by the host of proposed banking regulations and taxes, Populism will win in the battle between bankers and the people. And despite a clear connection between the current economic malaise and the former administration, voters will place blame wherever they wish.

Uncertainty is high as we look at the future of the nation. As Heraclitus so poignantly captured, “nothing endures but change.”

2010 and Beyond

As we look forward into 2010, we are focused on the certainty of change in the world and how it will impact our investment direction. With change comes opportunity. To understand these opportunities is going to require a broader view of the globe in the context of human nature.

In the short-term China, Brazil and India’s new and crucial role in the world economy is paramount. All three of these nations may be viewed in the context of population growth, natural resources and a drive to middle-class stability. Whether it is China’s need to soothe the population through extreme economic growth, and the individual affluence associated with such growth, or India’s struggle to integrate religious extremism with technological growth, these economies and their success in becoming global leaders will determine the direction of capital flows and investment returns.

And while these economies are racing ahead, we have begun the process of adapting as a global society to a new paradigm. In a manner rarely fantasized just a generation ago, from the internet to the iPhone, the technology is morphing communications at an ever increasing pace. Local disasters are instant news in the world of Facebook and Twitter. Google now sits at the epicenter of social unrest in the world’s largest communist nation. Millions in disaster relief can be raised in days simply through texting. With awareness of social issues coming to the forefront in this networked world, we are witnessing change at a pace never before seen by mankind.

At home, the benefits of the great recession might be felt for decades. US firms that survived the financial crisis are now leaner and more efficient than they were beforehand. Without free-flowing credit, consumers will learn the hard lessons of savings and prudence. And with universal belt-tightening, waste will be squeezed from the system in everything from energy conservation to the efficiencies of the virtual office.

So while I am optimistic in a certain sense – that change is good and it will present opportunities – I am also extremely cautious about the next two years. It took a decade for the market to recover from the crash of the 1930s and the economic malaise of the 1970s. While we have avoided the abyss, we have not fixed the problems. Until then, there are a number of ways in which the market could go side-ways (stays flat after all the gyrations) or even retreats from the current levels.

Looking beyond the next year there is a significant possibility that US monetary policy will start to change, impacting interest rates and inflationary expectations. As you may have read in my last article, “Goldilocks,” the short-term fate of the markets and economy is largely dependent on the Fed and their ability to time their movements. On a longer horizon I expect to see some glacial shifts in energy policy, environmental influences and social interaction.

Balancing the risks that remain from the economic turmoil of 2009 with the opportunities presented in 2010 will be difficult. Being realistic about your risk profile has never been more important. We have already seen a year in which risk and reward have been grossly out of alignment. Safely navigating the continued risks will be our first priority –finding new areas of growth is the second. As we have done over the past year, finding those investment opportunities that capitalize on the changes ahead while buffering us from substantial downside risk continues to be our mantra into 2010.

All the best during these winter months.

Regards,

David B. Matias, CPA