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Out of the Woods, Into the Diner

July 12, 2009/0 Comments/in Market Update /by David Matias

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

The Torch Is Lit

August 8, 2008/0 Comments/in Market Update /by David Matias

It has been our practice to send out quarterly market updates, but given the anxiety about the economy, we are breaking practice and sending out more regular updates. As a quick aside, our portfolios in July remained relatively neutral showing us that the global economy still has strength even in the midst of a bear market. While there are certainly more surprises hiding in the dark corners of the market, we think we have seen the worse and are now focused on the timing of a recovery, whether it be months or years from now.

Ironically, the quadrennial event that starts this evening provides a useful analogy for our general economic condition. As the world turns its telescopic lens on Beijing for the Olympics, we are given a unique view into China and their economy. At once memorable, starting on auspicious 08.08.08, and controversial, the torch coming in on a tide of protests; the Games are a chance for China to fashion itself a new world image and lay bare its strength and weaknesses.

What China is experiencing economically can be seen as a microcosm of the conditions the global economy is struggling with. Intense inflation has pushed the consumer price index to over 7% in the first half of the year, making it hard for the country’s population to purchase necessities. Pollution, one of the worst in the world, has induced the government to take extreme measures to clear the sky for the Olympics. Half of all cars in Beijing have been ordered off the roads in the weeks leading up to the opening ceremony and rainmaking rockets have been utilized to clear away the smog. All this to no avail-the skies are still heavy with the weight of pollution. Oil supply is a major concern for China as it is for the rest of the world and the Chinese government has resorted to hoarding oil to ensure a steady supply when it takes center stage.

The Games are a source of pride for any host country, for any country sending a delegation for that matter. For the Chinese especially, it is a time to show the world that it has progressed socially, politically, and economically-all areas that would help the global economy as well as their own. We eagerly await the Games of the XXIX Olympiad.

As with the Chinese, the themes of inflation, pollution and energy dominate our thoughts as well. In our quarterly market update, we spoke of how these forces, combined with a housing collapse, came together to create the perfect economic storm. We believe that that storm has raged its worst and is now showing signs of abating.

Housing Market

The first force is the plight of the housing market. We have discussed extensively the short-term causes and long-term effects of the flawed subprime lending practices that has mired the housing market in foreclosures and defaults. The effects of these practices have rippled through the financial industry and have affected institutions that had little to do with the subprime collapse. As these institutions work to correct themselves, there are signs that the housing market is stabilizing, even strengthening in affluent communities. Weaknesses are still evident in developments and low-income housing and will take many years to recover; but, at the very least, the horizon looks a whole lot brighter.

Unfortunately, the two Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, are the latest casualties of the real estate collapse. While they did not extensively engage in subprime lending (by definition, subprime is a loan that does meet the standards of the two GSEs), the follow-on effects of the subprime collapse have driven up defaults on all types of mortgages. As a result, both GSEs are now projecting enormous losses that could jeopardize their capital base.

Historically, neither GSE has maintained high capital under the belief that the US government can provide emergency backing. That belief is now being tested. Our opinion is that both GSEs will survive intact with the need for a government infusion in the form of common or preferred stock purchases. While the final amount will be minor given the government’s other obligations and the prospect eventual profit from this infusion, it will lead to significant changes in the way they are regulated in the future.

Economic Downturn

The second force is a general economic malaise exasperated by a disastrous deficit, the weakening dollar, and rising inflation. Out-of-control governmental spending for the last eight years has detrimentally slowed our growth and contributed to the decline of the dollar. With a total debt approaching $10 trillion, we have spent our savings for at least a generation. Generating enormous interest costs and driving down the value of the dollar, Americans are paying more and getting less.

The Federal Reserve aggressively cut interest rates seven times since the end of 2007 bringing it down from 5.25% to 2%. But now the Fed is in a quandary. Its primary policymaking tool has not been able to spur the US out of an economic downturn despite the fact that interest rates are at a three-year low. Inflation, however, has risen to 4.1% in the last year, the largest rate in 17 years. Herein lays the problem-interest rates are decreased to stimulate growth, but increased to battle inflation. The Fed is, in essence, immobilized in an economic Catch-22 and hard pressed to choose a solution. Its decision then is to hold steady at 2% with the likelihood that it will not change interest rates if the economy continues as it has.

The Price of Oil

The third force is the omnipresent price of oil. After hitting record highs this summer at $147 per barrel, oil prices have dropped to a three-month low in August at $118. It is still undetermined whether this is merely a short respite or an indicator that oil prices will return to what has been deemed as normal. The hope is that the price of oil will stabilize around this level, but anything short of the sharp rise from the past two years will be a relief.

Alternative energy is painting the town green. Or maybe just a patina of green. Everywhere from politics to even oil companies, green is the catchphrase that lends a sense of conscientious credibility. The push for fuel-mileage regulation is gaining momentum in Congress as the US flounders for a solution to its energy crisis. Perhaps soaring oil prices have finally been able to imprint into our national consciousness the need for sustainable energy. Automakers are already feeling added pressure to meet the demand for more gas-efficient vehicles and Americans are driving on average 4% fewer miles since the onslaught of the oil price increase. Given that Americans account for 11% of global consumption, this is a significant decrease and a sure sign that good consumer behavior can positively affect global oil demand.

Change on the Horizon

The most important change about to occur, and frankly one that we desperately need, is the Presidential administration. As the race moves forth towards the national conventions, economic concerns top the agenda for Barack Obama and John McCain. Neither candidate has an economic platform that truly addresses the situation-all of the economic stimulus packages to date are little more than crowd pleasers. We hope that behind closed doors it is a conversation about changing the shortsighted, destructive policies of the past eight years. We will look for sound, long-term economic policies that emphasize sustainability and global responsibility. While this is an extremely tall order, we are optimistic that any change will help the situation.

To conclude, we have a guarded, yet optimistic outlook for the coming months. We view oil prices and the housing market as the keys to eventual recovery and will closely monitor them. Throughout this entire process, our investment strategy remains the same-careful and adaptive selection of equities and fixed income with an emphasis on cash flow. As the clouds begin to clear, we will stay in regular contact regarding any changes or fluctuations.

As always, feel free to call or email us with your thoughts.