Posts

Short and Sweet – Status Quo

/0 Comments/in /by

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

/0 Comments/in /by

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

Good Luck, Goldilocks

/0 Comments/in /by

It has been over two months since my last market update and the stock market is just roaring ahead, repairing all the damage from last year’s financial collapse and indicating that the recovery is in full swing. Or is it? In fact, I feel like a backseat driver in the movie, “Thelma and Louise,” careening towards the cliff with the top down on my vintage convertible. The financial reality is that we are facing some of the greatest uncertainty seen in generations which is starkly exhibited in the markets today.

The stock market change since my last market update is a up 3.6%, not a robust return for anyone who jumped into the market this past September. Gold has beaten the living snot out of the market, up 19.5% and even TIPs are up by 3.8% (TIPs are the Treasury-Inflation Protected Securities, a safe haven that also indexes to inflation). But here is the paradox – there is no inflation and no one is predicting for strong inflation anytime soon, even though Gold and TIPs are traditionally used to hedge against inflation. The only other time there is a flight to these securities is during times of severe financial risk.

Yet the stock market shows no such signs of financial risk. In fact, the main volatility indicator for the stock market, the VIX, touched a low of 20.05 last month, the lowest point we have seen since August of 2008, well before the collapse of Lehman. In a nutshell, the stock market is plunking along as if all is fine in the world while traditional safe havens are seeing enormous inflows of cash. Where is this split view coming from, and what does it mean for the next few months and years?

These stark numbers were reported by Bloomberg last week. In November, the rate on 3-month treasuries went to zero (it even went negative for a brief moment) while the equity indicators are showing minimal risks after a 25% gain this year. This has happened once before in modern financial history. It was 1938: the stock market had gained 25% that year and short-term Treasuries were yielding 0.05% (read: 5/100 of one percent). For the next three years starting in 1939, the stock market lost one-third of its value. Is this where we are headed next? Maybe – it all depends on whether policy makers can get it right this time.

Economy

The biggest battle that the financial markets will face is the improvement of the economy. Almost 70% of our Gross Domestic Product depends on the consumer – their ability to spend money on everything from gel toothpaste to plasma TVs. This consumption has been driven by two factors, disposable income from earnings and the ability to borrow. A key impetus to spurring consumption was home growth – the purchase of a new, larger home and all the items needed to fill that home. Yet today, in every aspect of this dynamic, we are hurting.

The housing market is in the toilet for a while longer. Prices have increased for the past few months, but have done nothing to repair the enormous loss of home value and home equity. As reported last week by the Wall Street Journal, one-in-four homes are underwater (worth less than their combined mortgages) and 5.3 million homeowners are more than 20% underwater. While this collapse has headlined the news for two years now, the reality is that we have many more years before the residential real estate market again becomes an impetus for growth.

Credit is declining commensurate with these events. Credit card reform legislation takes effect in February, and already banks are increasing rates and limiting lines to “buffer” themselves against the changes (in fact, this is an egregious abuse of their banking privileges to be discussed in another article). Combined with the current job market and mortgage delinquencies, it will be years before the consumer credit market again extends credit to consumers to fuel consumption. In fact, expect to see major lenders from Bank of America to Capital One suffer enormous credit losses in the coming year, well beyond their current projections.

Jobs are scarce, and growing scarcer. The “official” unemployment rate has passed 10% this year, months earlier than expected. And while layoffs continue at a clip of over 500,000 per week, the creation of new jobs is stagnant. The reality is that employers are finding ways to do more with fewer employees, and this trend shows signs of continuing. At the current trajectory, we will soon hit an employment level of 57%. That is, roughly 1-in-2 working age Americans are working. That compares to 2-in-3 during a robust economy. The last time we saw these levels was in the 1970s, when far fewer women viewed career as a viable option. For the first time ever, more women than men now have jobs.

(As side note from December 4: this morning’s unemployment figures show an improvement for November. While this could be an encouraging sign, I suspect there is a distortion in the figures that would be revised in January. I don’t believe this marks a sudden change in the employment scene.)

Policy Makers

Simply put, the Great Recession is here and the damage will be felt for years to come. In my view, it will be a decade before we see a return to “normal.” America needs to find a new source of growth. The consumer is not in a position to be the growth driver this time around. They are overextended on credit, underwater on their home, underemployed as a family, and wondering what happened to their 401k plan. In short, things are tough.

For the interim, the government has filled this void. With spending measured in the hundreds of billions of future tax dollars, cheap capital is flowing into the markets. This may in part explain the run-up in equities earlier this year, and the current bubble in gold and other assets. But it also explains the dramatic losses in the value of the dollar as a currency and the rush to inflation-hedging securities. Fiscal stimulus can be a zero-sum gain if not managed well, with future generations holding the “tax bag.”

Back to our parallel crisis in the late 1930s: In response to the situation, the government tightened monetary policy for fear of inflation, with the hopes of stemming it before inflation dramatically eroded the dollar. Turns out that was a bad move – leading to a double-dip economy as inflation never materialized. They may have succeeded in one aspect, but killing off the economy was not the intention.

Ironically, Bernanke did his graduate work on the Depression making him one of the best candidates to take us through this economy. He has repeatedly asserted that monetary policy will remain loose for the next six months, if not longer, allowing for the economy to mend. Many of the current policy makers have also attested to the fact that they can remove the stimulus and tighten policy before inflation roars back – sort of like Goldilocks and her “not too hot, not too cold” foray into culinary arts. The other prospect is that Congress now wants a hand in this process – if that comes to fruition then it might be time to pack you bags.

In the end, it comes down to human judgment. If the Fed gets it right, all is ok. But if they get it wrong, we face two detrimental scenarios – either a stagnant economy or hyper-inflation. Remember these are some of the same folks who thought it would be ok to let Lehman fail (in case you missed it, that was an “oops”). While they will be employing some of the best minds at solving this conundrum, we think it prudent to assume that they won’t get it quite right.

Regards,

David B. Matias, CPA

The Summer of ’09

/0 Comments/in /by

What a summer this has been. One of the old sayings in money management, “sell in May and go away,” infers that the summer months are either slow and lackluster, or market losers. Not in 2009. Since the early spring lows, the market is up 48%, or 11% for the year to date. So what is happening here?

In full disclosure, I don’t think that I have a compelling explanation for this rally. The economic news is still pretty dismal when you look at it from afar. Our unemployment rate is climbing towards 10%, home prices are so far depressed that you had to purchase a home at least five years ago for a fighting chance of gains, and global banks are still reporting losses in the tens of billions of dollars. Let me parse these events with a bit of commentary.

A week ago brought some of the first good unemployment news in a while – the loss of only 247,000 jobs in July accompanied by a decrease in the overall unemployment rate. The good news is simple: rather than losing 500,000 jobs each month, we’ve cut the losses in half. A good start, but still not growth. The drop in the unemployment rate is more of a record keeping anomaly – folks are simply giving up on their job search, while many simply are not counted, such as recent college graduates. The relief is palatable. We can see the potential for an end, but as the Obama Administration continues to reiterate, unemployment will soon pass 10% as the employed population creeps closer to half of all eligible Americans from its current level of 57%.

Housing numbers were encouraging this past month with a main price index, S&P Case-Schiller, reporting that overall prices increased in the month of May. As I reported in my last update, we are seeing a trend to the bottoming of the real estate market. But once again, the data is misleading. Many cities are still in decline, and in fact the index shows a national decline when calculated on a seasonally adjusted basis. As with the employment picture, this is not a recovery but rather another month of less bad stuff.

Not until people have jobs and real estate values begin to appreciate again will we have a true growth scenario, a situation in which firms can begin to generate consistent earnings and the economy expands. This is evidenced by the banking sector. The headlines were dominated by firms such as Goldman Sachs reporting bewildering profits, but at the same time more regional banks are failing each week. Some of these failures are tiny but others encompass deposits in the billions of dollars. While these are mostly insured losses, nonetheless it is a strain on depositors and the FDIC. In addition, global consumer banks are taking further write-downs in the billions in anticipation of rising commercial loan, residential mortgage and credit card defaults.

This is not intended as a doom and gloom analysis, but rather a reality check. The year to date has certainly been a series of positive steps forward, but the pace and length of these steps is metered. It is my expectation that we still have many quarters until the global economy has repaired itself to levels prior to the financial and real estate crises. During this time the risks will be many, the most important of which is that the economy takes a turn for the worse. While I don’t see this as a likely scenario it could be triggered by a series of unexpected events ranging from international conflict to a series of miscalculations by bank executives.

Stealth Erosion from Inflation

In all likelihood the economy will continue to move forward, albeit at a stunted pace from what we experienced over the past three decades. The larger risk that we face are increases in the cost of living. Let me provide a startling example.

The decade of the 1970s is perhaps the most relevant example for our current economic condition, primed for inflation but suffering from anemic economic growth. During those ten years, the stock market had a modest but important overall increase of 75%, or 5.7% per year. The cost of everyday living, however, increased by much more – 116% or 8% per year. The disparity is disconcerting. In effect, the value of equities in America failed to beat inflation by 2.3% per year, accumulating a deficit in real growth of 26% for the decade. This current decade has been worse. Even with the current rally stocks are down 24% for the decade while inflation is up 25%. It is no wonder that folks have been in a panic. Although most cannot quote the statistics, the palpable effects on family wealth and purchasing power are very real.

Even matching inflation is not enough. In fact, capital needs to maintain some nominal real growth from year to year to account for the risks assumed by investors and the limited amount of capital that is available in the economy. Negative real returns contracts everyone’s asset base and ultimately the ability to maintain our lifestyle. While it has been generally assumed that stocks provide a solid long-term hedge against inflation, we now have two of the last four decades in which they failed to do so. Not everyone can wait another decade to make up for lost real value.

Healthcare – A Serious Matter

The situation does not get better when you factor in healthcare. The expense that we all bear to provide the current level of healthcare in the US is roughly 15-16% of our entire economic production. I heard a rumor that East Timor spends more than we do – and no one else. And it is increasing rapidly, by as much as 6% per year even when inflation is nonexistent.

And yet the metrics that measure quality, coverage and effectiveness of healthcare are not too encouraging. Tens of millions have no coverage, infant mortality is the highest of the developed countries, and healthcare expenses are the leading cause of bankruptcy. The list goes on, but the effect is the same for us. Whether we pay for it through healthcare premiums, direct expenses or in our taxes, the cost of healthcare is going to continue to erode our purchasing power and ability to maintain a stable quality of life.

While I want to avoid making any political statements, the current healthcare debate is the single most important set of policy decisions that will be made in this lifetime. As you peel back the onion, the issues are complex and the solution is subtle. Profit is good. It motivates firms and individuals to invest capital. But profit in the healthcare system represents a quarter of all healthcare expenses. We all want to receive the best care and live as long as possible, yet end of life care represents a wildly disproportionate share of all expenses. Medicare is extremely important to elder care, yet is easily manipulated by doctors and hospitals for personal gain. The list goes on, but the message is the same. We need a coherent and informed discussion at all levels to tackle the most expensive problem we have ever faced as a nation.

The End of Summer

As the summer months draw to a close, we look forward to slow but important changes in our economy. With the fall will come partial resolution to the current economic crisis. Some of our global trade partners have already exited the recession, and we may soon follow. The healthcare policy debate will likely reach the floor of Congress for a definitive vote. The globe’s hotspots, Afghanistan, Iraq and Iran, will each move closer to crisis or calm. And our financial markets, the most informed and dynamic collection of information in the history of mankind, will digest all these developments.

It is an exciting time for us at Vodia as we position the portfolios for these changes. It’s also a pivotal time in America, and a fearful one for those who take comfort in the status quo.

Regards,

David B. Matias, CPA

Out of the Woods, Into the Diner

/0 Comments/in /by

The numbers this past quarter are simply astounding, for both good and bad. The US stock market was up 16% for the quarter, the largest gain in the past ten years for a single quarter. The bond market had a similarly remarkable rebound. But at the same time, the US lost another million net jobs bringing the unemployment rate to 9.5%, and rising. On the flip-side, the percentage of total Americans employed continued its plunge to 59.5%, matching the lows in 1983. Factoring in demographic changes, we might soon face the lowest level of employment since the last World War. How does one explain such a dramatic dichotomy in the financial and economic news?

I would like to draw an interesting analogy to a book I am currently reading, Bill Bryson’s A Walk in the Woods, that tells the story of his hiking various portions of the Appalachian Trail with a good friend (to the best of my knowledge, he really did hike it). In the book, their daily routine would consist of hiking ten or more miles with heavy packs, sleeping in wet tents and subsisting on a daily allotment of dried noodles. Then after a week or more of this routine, they would temporarily leave the trail and look for a motel. Bryson remarks on the transformation from wilderness conditions to the conveniences of civilization such as home-cooked meals, a soft bed and a hot shower.

Bryson repeatedly describes just how amazing they felt reentering the civilized world, while in fact the motels they slept in and the meals they ate were probably some of the worst examples of modern hospitality. Given the contrast to living in the woods, it didn’t matter how dirty the motel or greasy the diner they frequented. It was simply delightful.

We have experienced much of the same in the financial markets. As recently as early March, the world looked like it could end. Fear ran throughout the financial world and stocks as well as bonds were sold into oblivion. Since then, we have migrated away from the Armageddon scenario and now simply face a crummy recession for the next year or more. In comparison to Armageddon, 10% unemployment looks simply stellar.

The reality is that we’re in one of the worst recessions in generations. The relief that we’ve seen in the past quarter is one based in the perception that things are getting “less worse.” Unemployment is increasing, but the rate is slowing. Home prices are still declining in many areas, but not all. In fact, April home prices improved in six of the twenty major city centers. And as recently as this week, China’s growth engine may be showing signs of resuming.

The hope is that as soon as bottom is reached in many of the key economic sectors the overall rebound will be quick. This could be the case, causing some of the spurt in the market this past quarter. It is by no means a guarantee, however, and we are still in a very difficult situation. The falling employment levels not only reduces consumption but puts a further strain on home prices. Banks are reluctant to lend, and have done little to increase credit since the heart of the crisis. Not only is employment down, but so are wages and hours worked. House foreclosures are clipping at a ferocious pace.

For these reasons, we continue to remain cautious in our risk taking and asset allocation strategy. we have cut our equity exposure to half of the long-term target and used the excess cash to purchase investment grade bonds with unique structures and attractive yields. The next part of this update reviews the markets in depth.

Equities

The stock market, or equities as I refer to them, is in fact the least interesting market for us today. Yes, the S&P 500 had a stellar rise this past quarter but for the year to date the stock market is still showing a loss (down 3% as of this writing). That is not a remarkable performance, especially given the level of volatility we have seen this year. The key driver here is the economy, with an expectation that corporate earnings are going to be depressed for several quarters to come.

There are still bargains to be had in the equities market, but they are going to take much longer to realize and it will be a bumpy ride. Information technology has been the best performer to date, showing a net gain of 10% for the year. Industrials, on the other hand, continue to face pressure from names such as General Electric and Alcoa. As the global economy begins to right itself, everything from commodities to industrial manufacturers will see the benefits to their bottom line. After more than a year of capacity reduction and expense trimming, the best managed firms will reap some of the greatest profits.

As we track the equity markets, we pay close attention to the VIX, or volatility indicator. Reported as the expected future volatility of the S&P 500, on an annualized basis, VIX is finally coming back in line with levels that we experienced before the crisis. In a stable bull market, VIX reached into the low teens. During the crisis when all the risk models collapsed, it peaked at 89. A level in the 20s indicates that we are back to market stability, above that is unclear. For us the magic number is 30, which is where the VIX is hovering right now. For the duration of this summer, we are likely to vacillate between these two ranges as the market consolidates and gains comfort in the notion of long-term stability despite a recession.

Consistent with much of the technical analysis we have seen in the past few months, we believe that the S&P 500 will continue to gradually slide this summer. After being down 7% from its recent peak on June 12, we would not be surprised to see another 7-10% drop. Longer-term, however, still shows that equities have some room for improvement this year, but unlikely to exceed a level of 1,150 on the S&P 500, or up 20% for the year.

This all depends on the factors above: a strong decline in job losses, home price stabilization, and of course an improvement in corporate earnings.

Fixed Income and Inflation

My biggest concern, and our closest focus this past quarter, is inflation. Currently the US Consumer Price Index shows that we are in a mild deflationary environment, or declining prices. This is due to a combination of price cutting by companies, excess labor, and a steep drop in commodity prices. As the economy strengthens, fueled by the tremendous stimulus spending by the US as well as foreign governments, there is a risk that inflation comes back with a vengeance. While a few economists are predicting hyperinflation, one thing is certain – inflation will kick back in again. It is less likely to be 2%, as targeted by the Fed, than 8% as predicted by some. We’re planning on something in between at roughly 4-5%.

Combined with this view and the current economy, we have been active in placing a variety of fixed income instruments into portfolios, from US Treasury Inflation-linked ETFs to LIBOR and CPI floating rate corporate notes, that will increase in value with inflation. Some of these instruments are insanely cheap from the aftermath of the crisis. Others are fairly priced given the current CPI and will increase rapidly with inflation.

In addition to inflation-oriented fixed income, we have also augmented the portfolios with strong yield corporate bonds that were battered by the liquidity crisis in February and March. Some of these are common names, such as FedEx and GE. Others are less common but still investment grade credits with solid balance sheets and cash flows. Irrespective of the method, the result has been the same. We are seeing either abnormally high yields with these corporate bonds or significant price appreciation, sometimes in just a matter of weeks.

The net of all these moves is that we have side-stepped the volatility from the stock market while maintaining upside as the economy improves. Our returns have reflected this positioning. While we have dramatically lowered the volatility and risk in the portfolios, we have maintained steady gains in line or ahead of the market. While your individual returns will vary based on the specifics of your risk profile and portfolio, we are happy to see solid performance across the board.

Look for a quarterly performance report with commentary in the coming two weeks. In the interim, if you have any questions or concerns, please do not hesitate to call or write..

Regards,

David B. Matias, CPA

Some Relief and Perspective

/0 Comments/in /by

This update is in three parts. The first two parts are links to articles of mine that were recently published in the Concord Journal. While these pieces are written for a less sophisticated audience, I hope you find them informative as I try to put the pieces together from last year’s events.

The first article addresses the dramatic shortcomings of the SEC and politicians, who effectively lay the groundwork for the market collapse that occurred in October of last year. Yes, we can point fingers at greedy bankers and amoral hedge funds, but in the end they did exactly as we as a society encouraged them to do. Click here to read.

The second piece reviews why the collapse was so remarkably devastating to the nation as a whole. Again, I point the finger at mutual funds as a business, and their myopic reliance on asset allocation as the sole form of managing risk for their portfolios. With diversified mutual funds down 50% and “safe” retirement funds down 25%, many families are facing tough choices from college funding shortfalls to dramatic deficiencies in retirement assets. Click here to read.

The remainder of this email is a look at the past month. While the nation’s psyche went through a remarkable change, the facts from the month are notably unremarkable.

Since my last update, the state of the markets has changed dramatically, while the state of the economy has remained largely the same. As I reflect on March, I come up short for anything of substance to report on how our world has changed in reality. Instead, the significant difference is perception.

March saw an outstanding rally in the equity markets. At one point the S&P 500 was up 13%, to close at a gain of 8.8% for the month. The first days of April have been equally impressive, with a 7.9% gain as of this writing. The larger picture is far more sobering: for the year to date the equity markets are down 4% and the bond market is down 5%. In any other year, this would be considered an alarming performance. In the context of where we have been, however, this is a relief.

The key differentiator is the near collapse we faced in 2009. With the equity markets down 37% last year, another 8% in January followed by 11% in February, it looked like the world was ending on March 6 when the S&P 500 hit a level of 666, a highly inauspicious number. CNBC was literally counting the days until the equity markets hit zero.

What has changed between now and then is perception. As I’ve outlined in last week’s article, the market reaction to the economy was exacerbated by greed and lax regulation. This in turn drove the economy far further into a recession, and at the same time created mass financial panic. The reality has always been the same, however. The economy does have a stable footing and the financial system will remain intact. Yes, the system needs help, and time, to regain its prior strength, but it will recover.

In a bubble of fear, the market overreaction seems to have exhausted itself. From that low point of 666, the equity markets have made a steady climb back to levels from the beginning of the year, before the banks reported their 2008 losses and the markets lost faith in the Administration’s response to the crisis.

That does not mean that a bull market is upon us and economic recovery is as imminent as the spring blossoms. We are many months away from economic growth, if not a year or more. Jobs will continue to be shed at a rate of over 100,000 per week and some companies will fail. What we are looking for are inflection points – moments when job losses are slowing down and company losses are no longer growing. If we can establish that the point of inflection is within our immediate grasp we can begin to establish the bottom to the economy.

Currently, we are in a rally that is working to establish a bottom in the markets, a predictor that is typically six months ahead of the economy. It is our belief that we will again see declines from these market levels, and that volatility will continue. In effect, we are working to establish the market bottom as well. And this is all predicated on the assumption that there are no “events” to further shock the system, such as the collapse of a major bank, or worse.

In our investment strategy we continue to hold a position in the equity markets that is underweighted from our long-term goals. The excess funds are being put to work in either money markets or the bond market, where we can seek consistent gains irrespective of the equity market volatility. As the market bottom is established, we will be increasing equity exposures into firms we believe have tremendous upside given the current stock levels. In some cases, we will also start to again use Exchange Traded Funds to gain diversified equity exposure where individual holdings are not appropriate.

As always, please feel free to write or call with questions or comments and wishing everyone a very enjoyable spring.

Regards,

David B. Matias, CPA

Another Ugly Month

/0 Comments/in /by

February was an ugly month, and the first week of March was just as bad. This commentary addresses both the current state of the economy and the market movements over the past month. Keep in mind that the market, in its ever evolving hunt for profits, is typically six months ahead of the economy. Put another way, the market will recover as soon as there are signs that the economy shows early indications of mending, no matter how subtle they may be.

Economic Recession

What started as a mild recession in the spring of 2008 has turned into a mess, to quote just a few. The starkest result of this economic stalling is the steady rise in unemployment. Last week’s figures showed that another 651,000 non-farm jobs were lost in February. That creates a total unemployment level of 12.5 million people or 8.1%, the highest level since the early 1980s when it peaked at 10%. Interestingly, the bulk of the losses were low-wage jobs in the restaurant sector. While we are still trying to understand the ramifications of this fact, it is clear that the economy is propagating to almost every sector. Only healthcare has shown a steady increase in jobs in the private sector during the recession.

That is the worst news. Fortunately, this figure shows what has happened in the past, or a lagging indicator, and is not a leading indicator of what could happen next. While I am not overly optimistic, there are a handful of indicators that are looking up for the coming months. Although this is in no means a sign that all is getting better, it does help establish that the economy will pull out of this mess.

The largest impediment to the recovery is the status of the banking system. With most of the large banks carrying toxic assets on their balance sheets, their lending patterns have reverted to virtual non-existence. The buzz, and panic, is how the Obama Administration will deal with this. As witnessed by Japan in the 1990s, banks that simply hold on for existence become a drag on future growth, hording cash reserves and creating little credit in the economy. Dubbed “zombie banks,” the Japanese government was a main culprit in this cycle allowing the banks to operate intact whereas a complete restructuring and cleanout would have enabled the financial system to mend.

With this example looming, there has been varied calls to nationalize the “zombie banks” in the US, namely Citigroup. In such a scenario, the FDIC takes over the institution for as short as a weekend, replaces management, purges the balance sheet and re-opens a new bank based on the operational foundation of the old bank. The downside to such an event is the elimination of common stock value. The upside is a new bank and a clean slate.

While the Administration has repeatedly stated that such an event is not in their plans, it appears that the Treasury department is searching for a way to de facto nationalize the banks without eliminating shareholder value. When Treasury Secretary Geithner spoke two weeks ago and failed to elaborate on such a plan, the market went into the current tailspin. As of this writing, we are still waiting to learn how this will happen, the most critical step in the recovery of the economy.

What has ensued since Geithner’s speech is a market drop through a number of technical trading barriers. For the lay person, this means that everyone decided to sell, and no one has shown an interest in buying. Fear, panic and fear. Not a good way to build up market values. The market has dropped so far that there is no way to explain it in fundamental terms. Instead, it has been a market purely based on psychology and trading dynamics, as I’ll explain next.

Market Shorts – The Bubble of 2009

In the manner in which we as a society create investment bubbles from irrational exuberance, in everything from tulip bulbs and tech stocks to real estate, we are in the midst of a bubble on the downside, namely shorts. For the past six months, there is only one investment strategy that has consistently generated profits for folks: shorting stocks. It began with the financial service firms last year, then moved to the industrials this January, and now with healthcare in the past weeks. The market is often described as a stampeding herd, and in this case the herd is moving to short one stock class after the next.

Unfortunately, this behavior is creating a self-fulfilling prophecy. The two starkest examples are Bear Stearns and Lehman Brothers. Both of these firms were financially stable and prepared to weather the current environment. Through shorts and esoteric bets in the credit markets, the market was able to erode the confidence in these firms and precipitate their demise. With Bear Stearns, the damage was contained by a merger. Lehman Brothers, however, was not contained and spread exponentially as the Bush Administrations allowed them to fall into bankruptcy. That failure, on top of prior credit market seizures, created a complete freeze on business credit and turned a mild recession into an economic disaster.

While the real estate collapse certainly laid the groundwork for the current situation, it was a confluence of these events and more that has lead us to today. The equity markets have witnessed a decline not seen in 80 years, falling over 50% from their highs. Frankly, this sort of decline was unfathomable two years ago. In a technical sense, it appears the market meltdown has been exacerbated by the suspension of the uptick rule for stock shorts and growth of the Credit Default Swaps (CDS) market. Just a reinstatement of the uptick rule may be enough to stem the stampede of shorting and market malaise. Recent statements from Washington indicate that it may happen in the coming weeks.

To recover, we need a domino effect in reverse. We need the financial sector to recover for the markets to gain some footing. We need the real estate market to stabilize to gain confidence in the financial sector. We need foreclosures to subside and new supply to abate for the real estate market to recover. All of these events will occur, and some of them are already in the making. Foreclosures appear to be leveling off, and even declining in the past two months. That data, however, is still in the making since many lenders temporarily stalled their actitivies. We do know that new housing starts are virtually at a standstill. While we used to have 1.5 million new homes started each month, that figure has dropped to 300 thousand and has been at this level for nearly three months now. Mortgage rates are rock-bottom at rates around 5% for conforming loans. And capital is making its way into the distressed real estate markets, with investment funds buying homes off the bank balance sheets and getting families back into these homes.

The measures from the Obama Administration are designed to ensure that these improvements continue. By stemming the tide of defaulted loans, foreclosures will continue to decline. But these measures are going to take a few more months to take hold. Combined with the various stimulus packages being rolled out and the new budget that addressed many inherent flaws in American society from universal healthcare to energy conservation, we are not far off from substantive improvements in the state of the economy.

With an economy recovery will come a market recovery. And it won’t be just a little one. Based on any set of valuations you examine, we are so far below intrinsic market values it is laughable. Sadly, the current market has probably made you cry.

Investment Strategy

Our strategy has not changed. We are invested in companies and markets that have tremendous amounts of long-term value and will recovery substantially in an economic turnaround. We have also invested heavily in debt and other instruments which are providing current income, price stability, and upside appreciation.

We are still of the opinion that the equity markets are a solid place to invest for the long-term although current events have exposed a number of faults in the buy and hold strategy. Most stocks are trading below their intrinsic value – an objective assessment of the firm’s current operating profit and future growth. The challenge is to invest in companies that are not at risk of failure due to the economy, and timing those investments at or near stock lows. We believe we have identified a number of those firms, some we hold today and others we intend to purchase, but are still maintaining an underweight in equities from our long-term asset allocation target.

In the interim, that available cash is sitting in either money markets, corporate debt or structured notes, depending on the size and risk profile of the portfolio. This strategy has generated returns that range from simple asset preservation to 10% monthly gains, again depending on the tenor of the investment. As long as the credit markets are partially frozen and the equity markets gyrate we will continue to pursue this strategy with the excess cash in each portfolio.

As we see signs of a market bottom we will increase equity exposures with individual equities or ETFs as appropriate to the account. With an expectation that the market will eventually recover to the levels of 950 – 1,100 within a year (S&P 500), we expect sizable equity gains along with fixed income appreciation. The timing, of course, is the trick in both determining the entry point and realization of these gains. In both cases, we need to be patient.

Unfortunately this is not a situation that will improve in days or weeks, but months and years. We are diligently researching every corner of the market and economy to find value, predict future movements and envision an America of the future. While we are not perfect in this quest, I cannot remember a time in my life in which I believed we were in better shape to address the future as a country.

Enjoy the spring weather headed our way,

David B. Matias, CPA