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Market Update: June 2012

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Thus far the first half of the year has kept up to expectations.  The first part of the year was a straight run up in the equity markets.  Unemployment in the US has remained exceptionally high and isn’t coming down, the global economy is still suffering from a dramatic hangover and the euro threatens to break up as I write this update.

(Note that I could have written the exact same paragraph in June 2011 or June 2010.  Hope springs eternal at the start of each year – now we need to see real change before market growth is warranted.)

Our perspective on these events, as outlined in my previous articles on the paradigm shifts in our economy, is that we are only part way through a decade long shift back to a core of economic growth.  Asset bubbles in the 90s and 00s helped to mask the true problems, and those bubbles made the economic situation far worse as each popped in a destructive fashion.  Behind these bubbles, aside from the political aspects, is a financial services industry that has learned to extract a hefty toll from investors with the support of our political system.

Yes, it may be a dour assessment, but the realities are there to be seen.  It is more a function of our willingness to see.

Facebook – Anatomy of a Botched IPO

What many failed to see, or were unwilling to admit, was that Facebook’s initial public offering (IPO) was flawed from the very outset.  Before Morgan Stanley juiced the price, before Facebook’s CFO ignored conventional wisdom, before Goldman Sachs started their own fund to cash in on the hype, Facebook was a bubble created by the financial services industry.  The surprise was not that Facebook was grossly overvalued (as I have asserted for the past six months), but that the bubble popped so soon.

Normally with these bubbles, they perpetuate until the inflated asset is so far down the investor food chain that no one person or institution can make a significant stink about getting fleeced.  Those folks are the “average” retail investor who either believed in the hype and bought the shares at the wrong time, or are heavily invested in mutual funds which are holding the shares.  With trillions of dollars sitting in 401(k) plans with such funds as their only investment choice, the least informed of investors are the ones most harmed.

What was unusual this time was that the music stopped early.  On the first day of trading, the share price struggled to stay positive.  Within a week it had lost 15%.  As of this writing, Facebook is down 27% from the IPO price, and 34% from the high.  This infers an actual loss to investors of $4.3 billion who bought shares in the IPO.  While that seems to be enormous, it is insignificant compared to other overblown IPOs of the past, where hundreds of billions were lost when stock prices came down from dizzying heights at the peak of the dot-com bubble.

But the timing here is different.  The decline began the day after the IPO – concentrating the losses among a handful of early buyers and those who own shares from the IPO.  As a result, lawsuits are piling up and the debacle is still on the front page.

When viewed from afar, there is little doubt that the IPO would not end well.  The initial IPO valuation of Facebook started at $50 billion last winter.  It quickly climbed to $100 billion as Goldman peddled the shares in the pre-IPO market.  Under current SEC guidelines, Facebook could have up to 500 shareholders before being treated like a public company.  These 500 institutions and investors swapped shares, and reaped profits as they cashed out on the hype.

The next step was to allow those 500 to cash out to the public.  That was the IPO.  What was initially supposed to be a $5 billion cash-out became a $16 billion cash-out as the greed spread.  And the bubble would have continued in the public markets if the initial trading was not botched, and if Facebook had not oversized the float.

A good anecdote is a friend’s grandmother who asked her broker to buy shares on Facebook on the day of the IPO because of what she was reading in the newspaper.  She is in retirement and living off the income from their savings.  The misaligned risk of such an investment would have been enormous.  The fact that she was convinced that Facebook would make them money is a revealing insight into human psychology.  (The broker did not buy the shares – fortunately)

JPMorgan (Chase*)

Another good example, but less obvious, is the trading loss reported by JPMorgan.  What was initially estimated as a $2 billion hedging loss ballooned to $3 billion a week later and may reach $5 billion.  The fact that they can lose this much money so quickly is alarming.  The fact that just three weeks earlier their CEO dismissed the rumors as “a tempest in a teapot” is sheer arrogance.[1]  The fact that they were doing this with government insured funds is nauseating.[2]

Remember, JPMorgan’s full name includes “Chase Bank”.  Chase is one of the largest consumer banks in the country.  They sit on $1.1 trillion of customer deposits.  They invest those funds as they see fit to generate larger profits.  Those are the investments they were “hedging” with this trade.  The losses themselves are not going to threaten the viability of the bank, but the pattern is distressing.  It was just four years ago that most of the major banks suffered enormously because of unbridled risk-taking in the sub-prime mortgage market.  Having survived that crisis intact, JPMorgan repeatedly reminded the regulators that they were “special” – because of strong management they do not need strict oversight.  This argument has been at the core of the current debate over bank regulations.

What seems to have happened, consistent with so many debacles in the past twenty years, is that the drive for profit and personal enrichment eventually outstripped common sense.  Don’t be fooled by the technical jargon, fancy strategies or elevated titles.  The mistake they made is simply foolish.  The same trader had previously made some large bets that paid well.  So if big bets can work, let’s make a ginormous bet – as the thinking goes.  The notional value of the bet was so large (estimated at $100 billion) on such an arcane trade (risk of default on just a handful of companies) that they went from playing in the casino to becoming the casino.  As is almost always the case, the trade eventually went against them and they barricaded themselves inside a burning building.

That fire is still burning, and while their CEO is desperately trying to salvage the bank’s reputation (and his job) the lesson is a simple one.  JPMorgan is allowed to gamble in the casino with nearly unbridled risk taking.  Yet they are one in the same as Chase Bank, the depository for millions.  Until the 1990s, this type of combination was strictly forbidden for obvious reasons (which became obvious in the crash of 1929).  Somehow the bankers were able to convince the politicians that bankers were smarter and better than before.  Hence, there was no need for separation between investment banks and deposit banks (also know as the Glass-Steagall Act)[3].  Fast-forward ten years, and the verdict is fairly plain.  Greed does not change.  Bankers are just smarter at making sure that they don’t have to pay for failure.

If the point needs any further clarification – look at the salaries and bonuses at the heart of the crisis.  The CIO in charge of this failed bet made $14 million last year alone.  She is one employee out of dozens who make that kind of money for taking these sorts of bets.  Expand this  across the entire bank, across all the major investment banks, across all developed markets, and it amounts to billions of dollars that are generated from these activities that end up in the pockets of a few.  My statement is a simple one: How does one justify such outsized compensation for potentially irresponsible behavior?  If the investment banks want to pursue these trades then they need to bear the cost of their failures as well without putting the economy at risk.

To be fair, there are plenty of legitimate banking activities that occur every day which create true value in a fair and equitable environment.  The issue I address here is the major investment banks who are too-big-to-fail while being funded with government insured consumer deposits.  They have engineered a government-sanctioned mandate to take irresponsible risks with those deposits while maintaining full protection from failure.  It is a dynamic that creates repeated asset bubbles, in which the repeated loser is the individual investor who has few choices beyond the mutual funds in their 401(k) accounts.  The system does not serve them well.

Iceland, Inc.

While the anecdote of Facebook or JPMorgan may seem limited in scope, the pattern does not end here.  Our next stop is Iceland.  For those of you who don’t remember, the three major banks of Iceland went insolvent in 2008 requiring such a massive government bailout that the entire nation was on the verge of bankruptcy.  As The Economist stated in December of that year, relative to the size of the economy it was the largest banking collapse ever suffered in economic history.

The source of the collapse was – you guessed it – asset bubbles.  In this case, it was cheap loans to foreign investors to support real estate speculation.  Everyone in the financial food chain profited from the speculation until the real estate market collapsed.  The taxpayers were left to clean up the mess.  Governments from around Europe compensated their citizens for deposits lost to these banks, to the tune of billions of euros.  Again, irresponsible risk taking by the banks was condoned by the government until the game ended.  Individuals profited enormously.  Entire economies suffered.

While the Iceland collapse was minor relative to the global economy, the pain was acute in a handful of places.  Greece, however, will not be so localized.  While much has been written here the message is the same:  ridiculous borrowing by the government that was unsustainable and facilitated by you know who – the banking sector.  Greece’s ultimate default – albeit an orderly default – impacted the global banks to the tune of billions.  Those banks are now receiving government funds to supports the losses.  If Greece does not abide by the terms of their bailout or withdraws from the euro the losses will grow rapidly.

And the fun continues as move across the Mediterranean to Spain.  Their banks are now suffering from the effects of a real estate asset bubble. With losses mounting, unemployment reaching 25% and the government doubling their debt to keep it all afloat, a European bailout looks imminent.  Just recently they asked for $125 billion in help from the broader European monetary institutions after insisting that they would not need help.

Here in the US we have a real problem to face.  As Europe goes through their annual summer games of economic Armageddon, we are again facing the prospect of a failed currency, the euro.  It is not clear what would happen if the euro were to break, and it is not clear that the euro could break, but the consequences could be severe.  Again, it would focus on the solvency of the global banks and ultimately how much in government funds are needed to keep them afloat.  The mitigating factor is Germany, the key industrial power in the region that has fueled much of their growth.  With Germany’s cooperation, it is possible to protect the euro and stem any systemic collapse.  The cultural divisions are large, however, and go back decades to the original efforts to bring a single currency to the region.

Here in the US, this government support has spread to every corner of our economy.  The stimulus that has been generated is in the neighborhood of a trillion dollars.  Through extreme monetary and quantitative easing programs by the Federal Reserves, both the bond market and stock market have been propped up.[4]  The ancillary effect has been to provide a massive subsidy for banks – ultra cheap deposits that they can then deploy into profitable investments such as mortgages.  Yes, they need support, and in that support it is believed that unemployment can be ameliorated, but that should not infer that irresponsible risk taking is also condoned.

Investment Perspective

With all this depressing analysis, there are still bright spots in the world.  First, it is in no one’s interest to see the system fail.  Even the financial services sector realizes that if the entire economic equation fails then their profits end.  Whether it be the Greek Parliament or JPMorgan, at some point self-interest must give way to self-preservation.  And while I talk about stalled economies and bailouts, we should not lose sight of the strength in the global economy.  Trillions of dollars in production is generated every month and while the growth may not be all we need to rescue us from our mistakes in this moment, the prospects are strong.

Put another way, all these issues go away with global growth.  Create jobs, increase consumption, increase production, and the cycle supports itself.  While it could be an easy “out” through another job-creating asset bubble, it will take years to get there in a sustainable manner.  In the interim, we just don’t want to inflict too much additional damage in bubbles that mask the problem.  (Yet we continue to ignore the deeper issue regarding the sustainability of the consumption cycle – a topic for a different day)

At Vodia, our investment direction has remained the same as it has over the last four years.  Invest in company stocks that have stable and growing cash flow streams.  Don’t overemphasize our reliance on these stocks, but instead rely on undervalued debt instruments that have greater predictability and protection. Hedge further risks with hard commodities, heavier cash balances, and derivatives where appropriate.

For the summer we are taking a cautious view of Europe with a mildly positive view of the US.  As the US economy mends itself, emerging markets will continue to benefit.  Emerging markets will also benefit from their own prosperity, as local consumption begins to replace exporting as the primary economic driver.  In the immediate term, emerging markets have suffered as consumption in Europe and the US slowed down.  The short term movement in the emerging markets has had a sharp impact down on commodities – positions that we will continue to hold in  moderate quantities as a hedge against the long-term effects of domestic monetary easing programs.

Note that our view of the emerging markets focuses mainly on Asia and the commodities that support these economies.  We currently exclude India from any investment opportunities due to their deep-seated social issues, and avoid direct investments in China for a lack of transparency and long-term sustainability.  Yet China continues to drive the general direction of commodities as the largest consumer in a number of areas.  They need to push for blistering growth to support rapid urbanization of the population, growth that could create substantial economic disruptions if not closely managed.

The global healing process takes time, and will be quite bumpy along the way.  If the euro does break, then those bumps could be quite severe.  That is the challenge that we are addressing today.  But if we get through the summer and Europe plods closer to substantive solutions to a one-currency/multiple economy region, then we again have time for economic growth to reestablish itself.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA

Managing Principal

[1] It was on April 6, 2012 that The Wall Street Journal first reported an outsized derivatives position based out of JPMorgan’s London trading desk ( “London Whale Rattles Debt Markets”).  The trade was so disproportionate to the market that the trader was nicknamed the “London Whale” by the street. Just a week later, when confronted with this information, Jamie Diamond, JPMorgan’s CEO publicly stated that any report of inappropriate risk was overblown and later called it a “tempest in a teapot”.

[2] This loss never put JPMorgan at risk of default.  They generate nearly $20 billion a year in profits and have a capital base that is approaching $200 billion.  Instead, the nature of the loss is the troubling aspect.

[3] Ironically, it was the merger of Citibank and Travelers in 1996 that prompted the repeal of the Glass-Steagall Act. Their argument at the time was that bankers were more sophisticated now and were able to manage the risks appropriately.

[4] The debate still rages as to whether that was enough stimulus or whether the funds were used effectively – both of which are valid arguments in this current political environment of self-serving deficit hawks.

Market Update: April 2012

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Spring Is Here and the Birds Are Chirping

This was quite a remarkable quarter: the stock market was up 12.6%, Apple just declared a dividend pushing it above $600 per share, and I hear birds chirping from my window.  Markets around the world are going straight up – what could be wrong in the world?

In my typical dose of caution and concern, there is a lot.  But rather than worry about what might be the issues for us to face – which frankly have not changed a bit since my last Market Update from January 2012 – I’d rather focus on some of the psychology that emerges in these situations.  Unfortunately the history of our “efficient” markets is littered with examples of gross inefficiencies driven by investor psychology.

One simple example is to look at the market volatility from 2011.  The chart below shows the S&P500 for the year of 2011, a chart that I have used in the past.  While the course of the market was remarkable – record setting in fact – the end result was eerily simple.  When looked at from point-to-point (January 1 to December 31), the market was dead flat.

The second chart shows a comparison of January-February on the left side against August-September on the right side.  Two very different charts from the same year – polar opposites in fact.

2011 generated stock market movements at the polar opposites of market theory. The left side is the calm market of January-February, while the right side is the historical choppiness of August-September.

In the first part of the year there was all the buzz of a strong economic recovery, jobs growth, real estate price stabilization and stock market recovery.  As we now know, most of these claims were either false or premature.  What came to the fore later in the year was the reality of debt overload, sovereign defaults, and a European recession.  When you look at the side-by-side, the impact of psychology leaps from the page.  During Jan/Feb of 2011, the market rise was steady, stable and predictable (low volatility).  During Sept/Oct of the same year, the market was choppy, erratic, and unpredictable.

To put this into context, traditional economic and finance theory relies heavily on the notion of efficient markets and statistical trends based in a lognormal distribution of stock market returns. In that paradigm, the likelihood of the right chart occurring is roughly a 6-sigma event.  In more pedestrian terms, these events are likely to occur once every 5,480 years (roughly since the start of history according to the Jewish calendar).  That should give you a moment of pause.

My point is a simple one.  Conventional theories about the economy and markets are severely limited in describing current events.  In many ways, broken.  Yet, the underlying fundamentals of our world are deeply challenged – American society has been turned inside-out, developed economies are carrying debt loads that are unsustainable, and global conflicts are playing out in ways that can no longer be managed.

A more likely explanation for the first quarter performance is a host of factors that have nothing to do with fundamental strength.  I’ve heard one theory of investor boredom – too much bad news has resulted in a form of indifference.  Another theory is manipulation by the Federal Reserve Bank – with near-zero interest rates and over a trillion dollars flooded into the banking system, money needs a home to generate profits.  You won’t get it in the traditional bond market, with short-term rates near zero.  But you will get it in the form of dividend paying stocks.

To support the second theory, The Wall Street Journal reported that this year $9 billion of investor money flowed into mutual funds and ETFs with stock-dividend strategies.  All other funds had a net outflow of $7.3 billion. (see Jason Zweig article, “The Dividend-Fund Dilemma” on April 7, 2012).  Investors are chasing some sort of return, irrespective of the risks.  While a stable stock could lose half its value in the matter of a few weeks (such as 2008), the prospect of a 3% dividend yield is enticing enough to warrant the risk.  Wow.

To add a bit of punctuation to those thoughts, take a look at the next chart comparison – the start of 2011 and the start of 2012:

The start of 2012 look eerily similar to the start of 2011. How the rest of this year progresses is the question.

Since the collapse of 2008, we have gone through a number of cycles around volatility that repeat.  I never mean to predict where the market goes next, but I do want to point out the irony of the volatility pattern and the interplay with investor euphoria.

Apple and Facebook

Perhaps another sign of psychology gone awry is Apple.  While Apple is by far my favorite company in the history of the planet (and a stock that many of our clients hold and have handsomely profited on), the psychology around Apple is unmistakable.  Based on strong earnings and the resumption of their dividend, the stock was up 48% in Q1.  That gives them the largest market-cap in the world today of  almost $600 billion.  If Apple were a country, it would place them in the top-20 globally, somewhere behind South Korea and ahead of Poland.  Not bad.  And with $100 billion of cash, they can afford to pay a dividend now.

But what happens next?  Other companies of their size trade at roughly 11x earnings and experience growth rates in the single digits.  Never has a company been this large, and never has such a large company doubled in less than several years.  Yet the headlines defy common sense – “Apple to hit $1,001!”  I’m not sure which part of this is more comical.  Perhaps it is the inference that you should put your money into Apple now because it will soon double to become a $1 trillion dollar company (they would start to rival India).  Or perhaps it is the notion that they’re just messing with you, “Hey – let’s come up with a random number that people will love.  Like $1,000. That’s cool!  No, make it $1,001!  That’s cooler!!!.

Don’t get me wrong – there is a day when Apple will likely hit $1,000 per share (and yes, even $1,001).  But that day is more likely to be years away, with many gyrations in between.  You have market volatility, global conflict and product disappointment all standing between now and then.  You even have the potential for scandal and misdeed.  Apple is like any other company in the end, and while they have succeeded in changing the way that people use technology, it is still just a stock with all the failings that stocks hold.

What we cannot predict, or grasp, is the power of market psychology.  We saw it happen in the late 1990s with the dotcom bubble.  Crazy, stupid predictions were levied against company stocks.  And for a long time, those predictions held because of the sheer power of the herd.  When the bubble finally popped, it was a long fall.  The NASDAQ hit 5,100 at the peek.  It then fell 78%.  Today the NASDAQ sits at 3,000.  That is quite a powerful bubble that inflated in the 90s.  It will happen again.

And we didn’t have to wait long.  This morning, Instagram just sold for $1 billion.  They have no profit, no revenue, and thirteen employees.  (The first half of this article was written two days, before the announcement – honestly!).    Back in the height of the dotcom boom, companies were valued at roughly $2 million per employee despite a lack of profits.  Now, it seems that zero revenue can get you around $70 million per employee.  Insane?  Yes… and no.  Allow me to explain.

Facebook is the acquirer.  They have been trading in the private market at roughly a $100 billion valuation, or 150x earnings (at least they have earnings).  Again, a seemingly insane valuation.  Yet, the valuation is justified because the current buyers expect an IPO in May that will allow them an even higher valuation to sell their shares.  Because of the euphoric stock market, Facebook now has a “currency” – their stock – that allows for the type of transaction we saw this morning.  Without the public equity market, Facebook wouldn’t have the currency to make this deal.  Without a bubble, the equity markets wouldn’t place such a ridiculous value on the company.

But why should this matter if the markets are efficient and everyone has a chance to buy or sell at will?  The grim reality is that someone will be left holding the bag, a devious game of musical chairs.  And I can promise you, as we saw twelve years ago, those left with sizable losses are individuals who chase the markets in hopes of gaining a stronger retirement.  They are the ones that inflate the last bit of the bubble, when the institutional traders have started to make for the exits and the employees of Facebook and Instagram have cashed out of their stock.

While I don’t intend to inspire a debate about social injustice, this pattern has played out before.  And the results dragged down the US economy for a decade now, delaying retirement for millions of folks and stripped away jobs from an otherwise healthy economy.  Bubbles create extensive damage, far more than the benefits that are reaped during the inflation.

Investment Direction

As you will see in our current portfolios, we have maintained a conservative posture despite the market rally.  Our equity positions, at roughly a third of portfolios (or less), have done well on the heels of strong individual stock performance (namely Apple, Intel and Weyerhauser).  We don’t expect this range of outperformance again, but I also don’t expect this market rally to continue at this pace.

The balance of the portfolio is in bonds (40-50%) and commodities (10-15%).  Both have been remarkably stable over the past year, and this quarter is no different.  The bonds are geared to provide a stable income stream at above market rates.  We continue to do so with the use of unusual or illiquid pieces and ongoing in-house research to identify opportunities.  The commodities are a hedge against dollar deflation – a very real possibility as the economy stumbles through the next few quarters.  As the government expands the dollar base through Fed action and we pile up debts at the state and Federal level, the pressure on the dollar will increase.

Finally we continue to look at hedges against future volatility.  It is a very real concern, and could be an immediate problem with just a couple of global events.  As we saw in 2011, most hedges were ineffective as volatility reached well beyond historical trends.  We continue to integrate these lessons learned into our strategy while looking for situations in which the markets can challenge us in new ways.

I know that these updates create a certain level of dejection with a few of my fans, and wish that I could be more enthusiastic about the financial situation.  But the realities are tough to ignore, and I’ve always believed that accurate and full information is far more beneficial as we make investment decisions and life choices.

All the best for an enjoyable spring.

Regards,

David B. Matias, CPA

Managing Principal

Market Update: January 2012

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Overview of 2011

While I am certain to be accused of using clichés in the past, I am somewhat loathe to the majority of them.  In particular, the “roller coaster” ride of market volatility is used again and again and again anytime someone has a bad day in the stock market.  Well, despite my greater sensibilities, here we go.  The market performance in 2011 can be summed up in one phrase: “It was a roller coaster of a ride!”

In the sense that a roller coaster takes you to exciting peaks and nauseating valleys with the speed of a falling asteroid, it has another characteristic that is often ignored.  You get off the roller coaster exactly where you began, except for perhaps some subtle shifts in the earth or cosmos during your ride.  For 2011, the broad US Stock market (S&P 500) ended the year exactly 0.04 points below where it began, for a -0.0003% loss.  Combined with swings of 25% during the year, some of which occurred in the span of just a few hours and minutes, you had the roller-coaster ride of a generation.  In fact, you have to go back to the 1930s to find as volatile and quirky a market.  (To make the point perfectly clear, the market swung from a 3-point gain to its loss in the final 12 seconds of trading).

Another part of the cliché might be the residue that one collects on your ride.  In the same way that an open mouth on a roller coaster will inevitably result in a collection of bugs lodged between your teeth (they are protein), an investor in this market did come away with a nice collection of dividends during the year.  In fact, the 2.1% dividend yield on the market is the sole benefit to maintaining full stock exposure throughout the year.

It turns out that dividends are one of the main themes for stock investors in 2011.  If you had a portfolio of high dividend stocks, you were going to do far better than the broad market as investors sought their relative safety.  Another theme was domestic versus foreign.  We here in the US were fortunate – if you stayed in the market for the duration you came out intact.  Overseas was a far different story.  The most stable of the foreign indices – large-cap developed economy stocks – lost -12% last year.  If you were invested anywhere near the emerging markets, the loss was closer to -20%.

Another theme I’ve noticed is the lack of news about the year’s return.  Whereas I usually see a barrage of in-depth financial articles on the “year in review” they have been scant and thin this month.  Maybe it is early, or maybe this is just the year to forget.  Or maybe it is because there is no good news.  One tidbit I was able to catch is that 84% of large-cap mutual funds failed to beat the market, and most actually lost money.  My favorite whipping post, Fidelity, is a good case in point.  Of the 59 domestic equity mutual funds that they list on their website, six beat the market.  Only three of those beat it by more than 0.5%.  Yet another nail in the coffin of the mutual fund industry.

The message here is a simple one – volatility killed the year.  With so many days with such large swings up and down, it was a market that was going to punish anyone who tried to master it.  No matter what sort of risk you took, it got beaten down.  And while the market did limp back to neutral by the last week of December, it took a heavy toll on all asset classes and investors.

(NOTE:  As an aside, I want to address this disparity between the Dow Jones Industrials Average and the S&P 500.  The Dow was up +5.5% for the year with dividends, as compared to the S&P’s +2.1% rise, a wide disparity for seemingly similar measures of the market.  The difference is in the manner in which the Dow is calculated.  By averaging the prices of just a few companies (30 versus 500 for the S&P), and weighting those companies based on the share price (as opposed to the actual size of the company), the Dow can develop significant distortions.  In this year’s case, IBM with its $100+ stock price, generated half of the Dow’s returns.  Bank of America, on the other hand with a single digit stock price, had a far smaller impact on the Dow even though they lost -50% in value.

In the end, the Dow is not a true representation of the broader market or the general economic situation.  And don’t be swayed by the headlines in The Wall Street Journal promoting the Dow’s performance – the WSJ is owned by Dow Jones… who is now in turn owned by Fox.)

Analysis

The primary culprits from 2011 were politicians, debt and jobs.

Whether you look to the Greek parliament debating if they really need to pay back their debts, or our own politicians debating the best way to torch our economy, we encountered such dysfunction in the US and abroad that damage to the economy was an afterthought.  While I have not yet seen an analysis, I estimate that the debt-ceiling debates took at least 0.5% out of our GDP and increased unemployment commensurately.  Rather than find ways to govern, our leaders are finding new ways to fail.

The debt does not go away, however.  While Paul Krugman has made some interesting points about sovereign debt (namely, you don’t need to eliminate it, just keep it in check with economic growth), debt has grown so rapidly in most developed countries that it now challenges their economic prospects.  The fear is not default, which is irrelevant when you can print money, but instead a currency battle in which your dollars (or euros or sterling) are worth half their value tomorrow.  We saw this in Germany in the 1920s, and it led to disastrous consequences.  It can happen again, and the results will be unpredictable at best.

While debt in its many forms is a fuel for economic growth, in a stagnant economy it can lead to contraction and decay.  The impact that we see today starts with the banking sector.  Largely responsible for providing the credit necessary for business to function and individuals to monetize their future earnings, the banks control trillions in lending and new loans.  With their profits under fire from the excesses of the past decade, and in some cases their very survival dependent on government largess, banks have stopped taking on new risks.  In fact, they are so risk adverse that their behavior is not unlike a child who burns her hand on a stove.  It might take her months before she wanders past to that very stove without fear.  The banks are no better in this economy.

The global banking conundrum would not be as bad if the economy were stronger.  But with joblessness so high (pushing 20% depending on the true measure that you use), any contraction in credit is going to have a devastating effect on many businesses and families.  We have an economy that is rooted in consumption (73% by last measure), and without credit people cut back on consumption, whether it be personal items or new homes.  The problem continues to spiral as you incorporate the housing problems – millions of homes under foreclosure and banks unwilling to address the core of the problem.

The silver lining to debt is that it can become irrelevant over time.  As long as payments are made as expected and the economy moves back into a steady growth scenario the problem becomes self correcting.  We do eventually inflate our way out of the debt burden (over decades however) and investor confidence returns which allows for short-term debt maturities to be rolled over.  While I’m not saying with certainty that our problems will fall away, and a significant moral hazard is likely to develop, there is a road out of this that doesn’t lead to a disastrous outcome.

Outlook for 2012

Unfortunately I don’t have a resounding answer for “what’s next.”  It was a brutal year in 2011, one that emphasized the point that we’re experiencing a tectonic shift in the economy – a function of social and technological changes.  In the way that the last half of 2011 was a week-by-week affair, this year may be much more of the same.  There will likely be a period of relief where the market calms, as we’re starting to witness in the earnings numbers, but the problems are still lurking below the surface.  Iran and Israel is perhaps the most pressing of those problems – what happens there will impact all of us.

In a practical sense, some trends are likely to continue.  We expect:

  • Stable, cash-flow oriented companies to be the better performers in the equity markets
  • Fixed income to continue to be the better of the two investments, but with short maturities
  • The yield curve could suffer some dramatic shifts, impacting investment grade bond pricing in hard swings
  • Commodities to continue to be constrained from water scarcity and population growth
  • Currency movements and dollar devaluation being the largest risks to investment portfolios in 2012

This is just a brief overview of where we stand today – we will be publishing more detailed analysis of these trends and issues in the coming months.  In the interim, have a great winter.

Regards,

 

David B. Matias, CPA

Managing Principal

 

1 One of my favorite quotes of the year came from a Greek cabinet member, “Europe needs Greece more than Greece needs Europe” in reference to their obligations to pay back European debt holders.  This attitude still prevails today in many European countries that have ballooned their debts while gutting their economies.