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March Jobs Report

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One major economic headline took the news on Friday just as all were preparing for the weekend religious double-header of Passover and Easter.  Namely, the jobs figure for March was surprisingly weak with just 126,000 new jobs created.  On top of downward revisions for January and February, it was a very weak quarter for creating new employment opportunities.

This is in the context, however, that we had the same aberration last year at this time when Q1 2014 saw a drop in GDP because of the weather.  This year, it might have been the same with a colossal amount of snow in the Northeast and cold weather across the nation.

The other headwind was the strength of the US dollar which was on a tear all of last year.  At elevated levels, it left our exporters in a difficult spot as our goods became much more expensive to foreign consumers.

If this slowdown in jobs does not worsen, it could be a good thing for the US economy.  There is discussion that it might delay the Fed’s plans to raise interest rates, and with a slower growing US economy the dollar could weaken from these highs.  Both of those factors ultimately feed better long-term growth.

The economy is a cycle that ebbs and flows, each of these states providing possible benefits if the overall structure is sound.  But with all such data, time will tell as well look to spring and thaw from this snow season.

 

David Matias

Managing Principal
Vodia Capital, LLC

Good Economic News

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There has been a spate of good economic news over the past week: GDP in the third quarter of 2014 was 3.5%, and jobs growth continues to be steady at over 265,000 per month for the entire year. The GDP number is particularly encouraging, given the 4.6% growth in the second quarter. Keep in mind that we need at least 2% to buffer the economy from outside shocks, and it has been a long while since we sustained anything close to 4% on average.

The jobs number, while encouraging, doesn’t address the participation rate which is now down to 62.7%, the lowest since 1978. That is bad news for a sustained economic recovery as fewer people are participating and wealth continues to be concentrated. For a consumption-based economy to maintain robust growth, all need to experience an increase in wealth to increase spending.

But the flip side to the labor participation figure – from a markets perspective – is that the Fed is likely to continue a very accommodative monetary policy. If there is a real increase in jobs and participation combined, the US economy could be on a good footing for many years ahead.

David B. Matias

Research Note, Thailand – June 4, 2014

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You have possibly heard about the military coup that occurred in Thailand on May 22, 2014. In brief, the military imposed martial law and has dissolved much of the elected government. They are establishing a new economic plan, and have temporarily installed the head of the military as the prime minister. In short, democracy in one of the world’s strongest economies is now dead.

Like most news events, this is a story that requires a far deeper understanding to appreciate all of the ramifications. While an objective assessment would be prudent, I am clearly biased by my connections and friendships in the country. What I see is a logical progression that started many years ago with the dismantling of their democracy when Thaksin Shinawatra’s political party (Thai Rak Thai) was elected into power – the man whom this is all about.

A quick history of recent developments in Thai politics begins with Thaksin, a former policeman-turned business leader who was elected prime minister in 2001 through the support of the mostly rural and poor farmers of Thailand. Thaksin did some good for the country in the form of rural development programs. But the downside was corruption – he is a deeply corrupt politician who used his control of the elected bodies to neuter the country’s enforcement agencies and anti-corruption safeguards. In the end, he fled Thailand for Dubai with billions in illegal wealth, escaping a two-year prison term.

In the next act of this drama his sister, Yingluck Shinawatra, who was elected prime minister in his wake on essentially the same platform as her brother, brought further economic revival to the countryside. Her method was far cruder than her brother’s. She promised and delivered on artificial price supports for rice farmers by raising the price that the Thai government would pay per ton of rice. The effect was devastating for the government. Farmers benefitted, but the government incurred at least $4.4 billion in losses (WSJ, June 17, 2013) as the rice they bought rotted in warehouses while rice prices continued to decline due to global overproduction.

This might all have been put under the rubric of bad economic policy if it were not for her last significant move as prime minister – to propose amnesty for her brother to return to Thailand and Bangkok politics. It was this last straw that led to protests, riots, and various forms of political maneuvering, rendering the current government ineffective with no clear path for bringing in a newly elected government.

While it is still not clear what precisely triggered the military’s move at this point in the drama, it is not unexpected. Thailand has a long history of military coups, the vast majority of which are without violence or bloodshed. The military is loyal to the King and only acts when there is a significant threat to the royalist nature of the country. If things go as hoped, the military rule will eventually give way to a political body that is largely in line with the King and a pro-economic ruling party. The issues of corruption still exist, and it will be quite some time until truly elected bodies will be able to function as a democracy, but this is a positive step forward.

From an investor’s perspective, this is welcome news. The market value of our holding, an ETF based on the Thai SET 50 Index (THD), moved in a narrow range immediately following the coup and is now up 4%. The larger volatility in the related index occurred many months ago when uncertainty around the Yingluck government arose and the prospect of Thaksin’s return was real. That was when we first entered the position – after a 20% drop in the Thai index on the fears of a political upheaval.

 

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

 

Our focus now will be on how the military stabilizes the economy and sets a path for the transition to an elected government. The real damage has already occurred – Thailand’s economy contracted last quarter due to the turmoil and poor economic policies during Yingluck’s tenure. Nicknamed the “Teflon economy,” Thailand has one of the most resilient economies in the region, capable of strong growth based in Southeast Asia’s global expansion. With the elected government’s dysfunction out of the way, the country can return to stable growth as the civil administrators, business leaders and foreign investors are again able to return to the business of doing business.

All the best for an enjoyable summer.

David B. Matias, CPA

Managing Principal

Market Update: January 2014

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It is a little tough to believe that it is 2014 and already a new year. But in a sense I am quite relieved that 2013 is done and behind us. It was a defining year in the modern era of finance. This time, the disparity between developed market stocks (US, EU and Japan) and the rest of the asset world (emerging markets, bonds, and commodities) was the largest ever. In fact, there has never been a time when developed stocks surged, surpassing all other asset classes. There was a period in the late 1990s when there was a strong divergence, but even in those markets, the other asset classes posted modest gains.

The history books on finance are being rewritten as we speak, because financial stimulus in the developed markets has been unprecedented while global economic growth has been anemic. This massive flow of capital into specific markets caused those markets to bolt ahead, while giving impetus for economic growth. Some of that growth is just from folks feeling safe to spend again; some of it is from further wealth concentration and investment by an ever-smaller segment of the population. Until the economic growth is diverse and stable, however, markets will be at risk. Witness the events of Friday, January 24th, when the Dow lost over 300 points over concerns of the impact of Fed stimulus tapering on emerging market currencies.S

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Chart 1: Major Asset Class Returns in 2013. While the US and International Developed Markets (the EU and Japan, namely) surged in 2013, the remaining asset classes had losses for the year. At no other time in modern finance has such a disparity existed. [Notes: within fixed income, junk bonds posted a modest gain. The modern era covers 1980 forward, when the advent of IT and derivative markets changed market fundamentals.] Source: Bloomberg

Chart 1: Major Asset Class Returns in 2013. While the US and International Developed Markets (the EU and Japan, namely) surged in 2013, the remaining asset classes had losses for the year. At no other time in modern finance has such a disparity existed. [Notes: within fixed income, junk bonds posted a modest gain. The modern era covers 1980 forward, when the advent of IT and derivative markets changed market fundamentals.] Source: Bloomberg

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We have Ben Bernanke and his leadership to thank for both this blessing and curse. The blessing is the remarkable recovery we have seen from the Great Recession – a period which could have become much worse had the Fed not engineering a global life preserver. Now that Bernanke is stepping down next month as Chairman of the Fed, it is worth examining this legacy.

Bernanke and His Legacy

Ben Bernanke effectively navigated the US economy through a financial crisis that had the potential to tear down our entire economy and recreate another Great Depression. We came very close to true economic devastation. Bernanke, in all his academic prescience, saw what could happen and in the absence of solid fiscal measures because of political dysfunction, he used the Fed’s balance sheet to pump trillions into the financial system. Frankly, he saved our economy.

What we don’t know as of today is how that legacy will bear out. As we saw with Alan Greenspan in the 1990s, what was then viewed as pristine policy turned out to be irresponsible stimulus that helped create the dotcom bubble and trillions of lost asset value. The most relevant impact of this stimulus has been the explosion of consumption in the US driving much of our economic growth at the expense of exports. Where consumption used to be 50% of our GDP in the 1950s, it has grown to 70% today. This increase was the impact of the easy money policies of the 1990s and 2000s, where we saw capital flood the equity markets and then the real estate markets, creating paper wealth for millions. Unfortunately, that vanished in just weeks and months.

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Chart 2: The S&P 500: 1990 to 2013. In the chart to the right, we see how market volatility has changed dramatically since the mid- 1990s. Highs are far higher during bubbles, and the drops are extreme, averaging 50% during recessions. Loose monetary policy and the resulting dependence on consumption for GDP growth is a primary underlying cause of these extremes. Source: Bloomberg

Chart 2: The S&P 500: 1990 to 2013. In the chart to the right, we see how market volatility has changed dramatically since the mid- 1990s. Highs are far higher during bubbles, and the drops are extreme, averaging 50% during recessions. Loose monetary policy and the resulting dependence on consumption for GDP growth is a primary underlying cause of these extremes. Source: Bloomberg

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For Bernanke, the final test will be future inflation. If this recovery does in fact hold, then the challenge will be removing the vast liquidity from the market in time to head off excessive inflation while maintaining the base level needed for economic growth. As we witnessed in the 1970s, inflation can create a vastly damaging problem that is tamed only through high restrictive monetary policy, followed by recession. The counter to that scenario is deflation – an equally devastating situation of falling prices which throttles growth that has begun to shape the global debate on emerging economic threats.

The US Economy and The World

Another recession would be devastating given the current state of our economy. The employment picture is the key to this concern. Bernanke, in comments he made on January 3, 2014 at the annual meeting of the American Economic Association, cited the 7.5 million new jobs since 2010 as evidence of a stabilizing economy. The dark side of that statistic is that since 2010, the US population has grown by just as much through a mix of immigration and births. Accounting for work force participation rates, we have created only enough jobs to support new workers, the preponderance of which is in low wage jobs. We lost 8.5 million jobs in the recession – that loss has yet to be addressed. A new recession would push down employment levels down to a place not seen since the 1930s.

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Chart 3: Percentage of Americans with Jobs: 1945-2013. We lost 8.5 million jobs in the recession, and while we have gained 7.5 million jobs since then, the US population has grown by almost 10 million people. The effects of the recession are still with us, limiting the spending power of the broad worker base and accentuating the wealth disparity of the recovery. Source: Bloomberg

Chart 3: Percentage of Americans with Jobs: 1945-2013. We lost 8.5 million jobs in the recession, and while we have gained 7.5 million jobs since then, the US population has grown by almost 10 million people. The effects of the recession are still with us, limiting the spending power of the broad worker base and accentuating the wealth disparity of the recovery. Source: Bloomberg

 

We do not yet know how successful Bernanke has been. We can see the evidence right now – the stock market raged ahead to new levels that even the most optimistic economists did not predict – but the legacy will be written over the next few years as we see either economic dividends or carnage from this policy.

The unanswered question is whether the stock market rise is anticipating a return to stable growth. Thus far, the news has been encouraging. GDP growth in the US surged ahead in the 3rd quarter of 2013, to 4% – a level that we have not seen sustained in quite a while and would be necessary to justify further market gains. Globally, economic growth is also beginning to creep up as the World Bank and the International Monetary Fund in the past two weeks have both increased their estimates for growth, something that hasn’t happened in several years.

These revisions are critical to the state of our economy in the coming year. For the equity market levels to be sustained and increased, we need companies to continue to increase their global revenues and not just depend on the American consumer. As the employment picture illustrates, the recovery in the US has been spotty and erratic. A further reliance on consumption domestically could work to push us ahead, but that is a risky bet right now. Exports will have to be a part of longer, sustained US recovery.

To whom we would export however, is a question. Right now, the EU counties and the broader European region have the largest global economy, but that economy has been shrinking, not growing. Part of the encouraging news from the IMF and World Bank is a belief that Europe might actually grow again in 2014. That in itself would be an enormous boost for the US and the other economies that supply Europe.

China is the other economy that can dramatically impact our recovery. At their growth rate and the size of the economy (7.6% growth on a $9 trillion economy, as compared to 2.2% growth on a $16 trillion economy in the US) largely dictates the health of global consumption. While China consumes about half of what we do for every dollar of GDP, the central government has pinned the hopes of sustainable growth on the Chinese consumer. Should that model bear out, it presents tremendous opportunity for US companies. Should it fail, global assets will see another correction in prices with ensuing volatility.

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Chart 4: Comparing the major global economies: Using 2013 figures, actual and estimate, we see the world’s dependence on Chinese growth. Their annual incremental economic growth (Growth Dollars) is double the US. [Growth/Capita shows incremental consumption dollars per individual in that economy]. Sources: Bloomberg, IMF, World Bank, US Census Bureau

Chart 4: Comparing the major global economies: Using 2013 figures, actual and estimate, we see the world’s dependence on Chinese growth. Their annual incremental economic growth (Growth Dollars) is double the US. [Growth/Capita shows incremental consumption dollars per individual in that economy]. Sources: Bloomberg, IMF, World Bank, US Census Bureau


For economic growth to continue for several more years, we need to see the dual support from increased exports and increased domestic consumption. The first part – exports – is being tremendously aided by the energy boom we are experiencing in the US. With the benefits of shale oil and fracking (long-term environmental destruction aside), we are both a cheap energy source for manufacturing and an exporter to the world. For instance, gas exports have increase 3x in the past five years – a mind-blowing change that will have an impact on both economics and global politics.

The silver lining for domestic consumption is housing. We have seen only modest recovery in this sector – existing house prices have recovered just a third of their decline from the recession, and new home construction is still at half the level of long-term needs. With every new home, there is both job creation and increased demand for the goods and services that fill the home. There is room to double the sector in a stable economy, resulting in increased jobs and economic growth, not just for the US but the countries who export to the US. There is enormous potential in the housing sector, but only if Americans feel confident to invest in a new home and have the job stability to do so while the banks continue to lend at low rates.

Markets and Psychology for 2014

As we have seen in the last two growth economies, the equity markets get well ahead of themselves and collapse in a fury. A simple measure to assess this exuberance is the price-to- earnings ratio (P/E) on the market, as well as some key stocks. Right now, the P/E on the S&P 500 sits around 17x, a good clip above its long-term average of 15x. A simple analysis says that if earnings do grow this year by at least 15%, then the stock prices are justified. If not, prices are high.

But is it really so simple? Google has been trading at 25x for many months now, well outside a sustainable range. And the price keeps going up. Retail stores are trading at 30x; some large pharmaceuticals trade at even higher ratios.

Historically, the P/E will continue to climb well past these levels before investors notice that the punch bowl has been drained. During the last two bubble markets, the S&P 500 reached 25x and 30x, both well above where we stand today. This doesn’t imply that the market will go up without some further developments to sustain investor’s excessive optimism, but don’t be surprised if there are new predictions in the coming months about how we are again seeing a “new economy” in which fundamentals are worth ignoring. History will repeat itself.

With this in mind, and all of the economic realities outlined thus far, we remain cautiously optimistic in our asset allocations. We continue to maintain our equity exposure at levels to reflect the risks, but have made incremental changes to capture the market psychology (called “risk-on”) and expectations of better global growth. We are also very active in the management of the bond side, keeping durations rather tight, using bond ladders and actively trading some positions to manage total return rather than allow market movements to dictate returns.

Commodities were a challenge for us in 2013, with metals and agriculture taking a beating while partially offset by timber and energy. Given our global view, commodities could do quite well in the coming year with increased demand for many raw materials. Housing may start driving up timber prices, and food prices may be impacted by continued meteorological and demographic disruptions (who knows how the Polar Vortex that has held the nation in a frozen grip will affect food production and sales?). We will continue to maintain these exposures with some adjustments to reflect our core values at Vodia.

All in all, we are again facing challenging times. The global economy is shifting in ways that are impossible to predict, with secondary and tertiary effects that reverberate throughout all asset classes. There are many positives to embrace in the short term, and many disturbing issues that must be resolved in the long term. Our approach – to reassess every quarter and step forward with caution – will continue to be our mandate as we continue to be thoughtful while we observe the world around us.

Best of luck with this winter and the Polar Vortices!

Regards,

David B. Matias, CPA

Managing Principal

Market Update: October 2013

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From Tapering to Teetering

As has been the pattern of the past six years, the summer always brings an interesting set of challenges for the financial markets.  This summer was no exception, from continued uncertainty in the financial markets soothed over by unprecedented Fed stimulus to geopolitical developments that are still unfolding.  Unfortunately, the political dysfunction that has riddled the nation for the past fews years has reached a stage that will only continue to harm the economy and the country.

The positives, however, are fairly obvious: the US continues to pump $85 billion of newly printed money into the system on a monthly basis, with the stock market as the primary beneficiary.  While the numbers vary week to week, the S&P500 is up around 15% year-to-date.  The other bits of good news are real estate prices, which are on a remarkable recovery, a nominally growing US economy, solid corporate profits, and the recent changes in our energy dependence.

Unfortunately, each of those positives are countered by negatives:  the stock market went apoplectic when Ben Bernanke suggested tapering of the stimulus, growth from the emerging markets has faltered, US overall employment levels are the same as five years ago (mid-recession), and the economic growth in the US is significantly below the long-term average needed to insulate us from negative shocks.

The employment picture is perhaps the best place to find reasons for caution.  Although the unemployment figure we so often read about is significantly down from the high of ten percent, the employment picture is a bifurcated situation.  In the recession, we lost nearly 10 million jobs in the span of just a few quarters.  And while we have created 7 million jobs since then, our labor force has grown in those five years by roughly the same number.  So in short, the labor participation rate among Americans is at a 30-year low.  The following chart shows this fairly well.

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Chart 1: Data from the Bureau of Labor Statistics shows the percentage of people employed between the ages of 16 and 65. This chart covers 1981 to present, and shows that the labor rate has not changed since 2009. With a labor rate equivalent to the 1980s, we are creating only enough jobs to satisfy the growing population base, but not replacing those lost in the recession.


The anecdotal evidence suggests the jobs we’ve created in the past five years are of far lesser value than the jobs lost.  Most are at minimum wage, there is a tremendous underemployment problem, and the divisions among social classes continues to widen.  These issues only make the next conundrum even more challenging.

Market behavior continues to indicate that we are in a cycle of bubble markets driven by consumption economics.  The next chart shows the movement of the S&P 500 over the past 30 years, in which the market is pushed to new highs in each cycle.  The driving force behind these peaks is external stimulus leading to bubble asset valuations (dotcom in the 90s, real estate in the 00s, and Fed stimulus in the 10s).  In the collapse of the two prior bubbles, the damage to the financial condition of the broader society was extensive – far greater than the benefits from those bubbles.

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Chart 2: The US stock market over the past 20 years (S&P500) has shown a broad trend of asset inflation followed by steep drops as the economic growth falters. These asset bubbles have been extraordinarily damaging, with the potential that we have formed another one. Corporate profits will ultimately determine the breath and depth of the rise and fall.

For the current market rise to continue (as opposed to correcting by 20%-50%), we need corporate revenues to grow.  Thus far, corporate profitability has backfilled the market as price-to-earnings ratios remain at or below historical averages (16x).  This has been primarily achieved through layoffs and productivity increases with some revenue increase.  With the internal measures largely exhausted, revenue growth is going to be front and center for the next several quarters.

This picture could work but demand needs to come from a mixture of domestic and global consumers.  The global scene is dominated by Europe – still struggling to get out of a recession – and Emerging Markets.  As we have seen in China and elsewhere, the massive boom in the emerging markets over the past decade has created disruptive air pockets that make predictable growth elusive.  Hence, the need for the American consumer to find additional disposable income or a willingness to once again increase personal debt levels.  With such a stagnant US employment situation, neither are likely soon.

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Chart 3. As the US equity markets surged ahead (S&P 500 shown in red) in the first two quarters, Q3 saw the Emerging Markets (shown in green) stage a partial recovery while Europe & Japan (shown in blue) also posted stronger gains.

It is for these reasons that we at Vodia Capital maintain a diversified asset allocation strategy for our portfolios.  Relying on just equities to drive gains would subject portfolios to far too much volatility and uncertainly.  While markets have shown an ability to recover in the past, these gyrations eat away at long-term returns and ultimately underperform when compared to a diversified strategy.  In response, we continue to use fixed income, commodities and derivates to both stabilize portfolios from global uncertainty and generate predictable growth.

Geopolitical

The biggest challenge to backfilling the equity asset bubble is global conflict.  Domestic issues are important and bleak, but with enough time and some basic legislation, our current situation will ameliorate or the domestic economy will simply adapt.  But until that happens, we do not have enough consistent economic growth to withstand a shock to the system and not enter another recession.

The global issues are less predictable, although we seem to have hit a moment of pause.  Despite my wildest expectations, the situation in Syria seems to have found a multi-lateral solution with Russia participating and China consenting.  While I have my doubts on the ability for the global community to truly disarm Syria’s WMD capabilities in the long-term, it is a relief to see it handled through cooperative diplomacy and through the UN.

On a separate but related front, Iran has consistently posed the greatest threat to global stability in the past few years.  Compared to Syria, Iran’s pursuit of WMD’s is a real problem with real ramifications.  Not to overstate the situation, but by many accounts this region was on the brink war if something was not done soon.  And while I also have serious doubts as to the authenticity of Iran’s overtures, we have taken steps to open a dialogue that has been closed for decades.  That is progress.

Where we do not have progress is in our own political structure.  As of this writing, we have a partial shutdown of our government, with another looming prospect of defaulting on our debt in another three weeks.  By some estimates, a complete shutdown of a few weeks could wipe out our economic growth for the quarter and possibly the year.  And defaulting on our debt is simply a non-starter – the financial ramifications are just too vast to play with.  While cooler heads will prevail, the damage to the economy through continued uncertainty has already taken a toll on lower economic growth.

Changing Energy Dynamics

The most promising development is the changing energy dynamic in the US.  The past six years have seen a dramatic and unprecedented change in our energy dependence.  Despite the mild economic recover, our use of oil has actually decreased by 10% from a combination of better vehicle fuel economy and alternative sources.  During this same time, our oil production has doubled from technological advances.  The net impact is to decrease our reliance on oil imports by half, to less than 10% of global production.

Combined with our natural gas boom, this is an incredibly positive development for the economy.  Much of our economic growth over the past decades has depended on cheap energy, creating a political structure and international presence that went to extreme lengths to protect the dynamic.  As net exporters or natural gas and coal, along with a far lighter dependence on the global oil market, untold resources will be freed up and could generate a new form of a “peace dividend” that we experienced post-Cold War.

The medium-term impact of our energy production and consumption is still of grave concern – from global climate change to the damage we are doing to our drinking water.  The shift to alternative sources, whether they be truly green or simply move us away from oil, is of paramount importance and must continue.  But the ability to shift a focus away from deeply disruptive policies to protect a bad oil dynamic is a start.  Where we take it next will determine just how much of a global leader we can be in the coming decades as the forces of economics increasingly determine our actions as a country.

All the best for an enjoyable fall.

Regards,

David B. Matias, CPA

Managing Principal

Market Update: June 2013

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What is NORMAL?

Normal is a much-overused but complex word. It can refer to societal values that reflect one group’s preferences to the exclusion of another. In a statistical sense, it refers to a baseline expectation drawn from reams of data. When you combine the two, you create statistical measures that can be used to determine behavior in certain situations, such as IQ tests. You see how this gets tricky, and fast.

Now let’s discuss the “normal” of economics. The financial markets are permeated with the statistical use of “normal” – without some idea of what “normal” looks like all of risk management and portfolio construction would fall apart. But now economists are trying to assess this current economic period as either a “new normal” or a return to the “old normal.” But what exactly does that mean?

As you will have gathered from my blog entries and market updates, I often point out where the statistical use of “normal” in the financial markets is broken. Whether it is the price movement on gold or the stock market collapse of 2008/2009, “events” have happened that simply should not have – they seem, to us, to be statistically impossible and “abnormal.” As an asset manager, it is terrifying at times that the statistical “normal” of the past 50 years is no longer valid.

Somewhere along the way, someone decided that the word “normal” will make it easier for people to understand a complex topic. We live in a world of mass media and shortened attention spans, where messages need to be simple and short or else they are ignored (think Twitter). Hence, the word “normal” has been redeployed in our current world without people stopping to think about what it really means, much as they don’t think about the incessant sound bites of recent political campaigns. Unfortunately, the word “normal” captures very little of reality, and leads to a misguided sense of safety for investors.

In the broadest sense, there is nothing normal about the economy today. We have a world population that now exceeds seven billion people and a method of supporting those lives through consumption-based wealth creation. That is not normal – it has never happened before and we don’t know if it can be sustained.

Yet here in the US, we are supported by an economic model that has been proven over decades. We have a population that grows at 187,500 people per month, and an economy that is just generating roughly that same number of jobs. We have been the center of innovation and entrepreneurship for the globe for a century, and combined with a tremendous level of investment over that period, we have an economic base that supports the wealthiest nation today.

The challenges here, however, are vast.

  • Job growth is able to support the current population growth, but does not replace any of the jobs lost in 2008 and 2009. Today, we have the same relative number of jobs as the 1970s – when most households had a single wage earner. To replace those jobs, however, we need to consume at a level consistent with dual-income households.
  • The economic growth necessary to build back those jobs might not be attainable – that is the core of the current economic debate. We need 4% annual growth – we’ve been lucky to see half that over the past fifteen years.
  • Wealth is more concentrated now than in the past 100 years. Middle income families have been decimated by the financial turmoil (retirement and real estate assets), while the top income groups have seen their wealth explode.
  • Our political structure is largely paralyzed in guiding the nation’s resources and regulations in a way that invests for the future – whether it be in education, transportation, or conservation of natural resources.
  • The explosion of the digital age has created large potholes in the road to certainty. Whether it be financial calamities from computerized trading systems, social unrest, or the leaking of state secrets, these changes are redefining expectations.
To reframe what “normal” means , I might like to suggest instead that we think about expectations. People, for the most part, like to know what will happen next – whether it be the length of a commute or the length of a retirement. In today’s world, those expectations are increasingly altered, erased, or shattered. And with it comes a deep sense of uncertainty – the bane of stable financial assets.

FINANCIAL MARKETS

With that introduction, I would like to say there is in fact good news to discuss. Last week’s dismal market performance masks one very important bit of news – the Fed believes that the economy is improving, so much so, in fact, that they might start to “taper” back on their historical stimulus program within a year or so.

Rather than treat this news with excitement, the market plunged. And it wasn’t just stocks – it was everything. (For those who wonder if this might be “normal” or part of the “new normal,” , let me point out that this 1.0 correlation broke all normal statistical expectations). It parallels the market behavior of this year – bad news is good for the markets, good news is bad for the markets.

People are saying that the US markets are up strictly because of all the stimulus. Without that stimulus, things will go back to “normal” – positive real bond yields, stock prices that follow company profits, and commodities prices that reflect demand. In other words, markets will have to reflect “normal” values for things, as opposed to the central bank inflation created by trillions in new money. That is not really a bad thing – in fact it is astoundingly good. The printing of money cannot continue without there being some serious damage to the global financial system in the form of currency devaluation and price inflation.

But like every aberration we have seen in the past five years, change is not taken well by the financial markets, even if the change in this case is a change in expectations about something that might happen a year from now.

Our role as investment managers is to determine what assets will be worth, based on their intrinsic value today and growth potential for tomorrow. To review the major asset classes and our perspective going forward:

Domestic Equities: US stocks have taken a beating, but only just so much. They were down 6% from their highs, but up 18% before the sell-off (for a net gain of 14% for the year as of right now). Whether we continue down or up from here is well beyond anyone’s control or foresight right now.

Our investment perspective on equities is essentially to stay steady – we have already kept a lower equity exposure precisely because of the inherent volatility, but do not believe that the recent volatility is reason to change that position. Instead, we are viewing this as an opportunity to increase investments in those individual equities that have the fundamental value and growth prospects to benefit from a growing US economy.

Valuations on the broad market are reasonable (S&P500 is around 15x earnings) and balance sheet structure of these companies is remarkably strong, thanks to years of cheap corporate borrowing. US companies have also shown further strength in their global customer base – as the world grows, so do the markets for many of the best US companies. If it is true that the economy is showing further signs of strength – as signaled by the Fed this week – then US companies are extremely well positioned to benefit.

The risk is a host of geo-political troubles that could trigger a global recession. There is no immediate indication that such a situation will arise imminently, but until we have see resolution in a couple of situations, we are going to maintain these equity levels as a buffer.

Foreign Equities: Here the story in remarkable contrast to the US. In short, the global stimulus from the central banks – not just the US – has propped up these markets for the past two years. Under the surface, however, the economic growth is weak. Europe has been in a recession for quite some time, Japan was on life support until recently and the emerging markets cannot support their economic growth through internal consumption.

The resulting equity performance is rough. Global markets have shown just a few percentage points of gain this year (if not a small loss right now). Emerging markets on their own are down 12% on average, with some markets taking a 25% beating.

As investment managers, we have avoided Europe almost completely but still maintain a modest exposure to the emerging markets. We’ve done this mainly through positions in US companies that sell heavily into those markets, and whose future profitability will depend on growth in those regions. We are still very positive for the growth prospects for the emerging markets and view the current swoon as a market psychology driven movement. Especially as the US slowly pulls into a higher growth mode, these regions will benefit significantly.

Domestic Fixed Income: This market has received an enormous amount of attention of late in the form of interest rate movements of historical proportions. Rates on the 10-year Treasury note have move from 1.6% to 2.6% in a matter of weeks, and the 30-year rates have gone from 2.8% to 3.6% in that period. Again – “normal” of any sort doesn’t compute.

The impact on bond prices is tremendous – market price move down as yields go up. But from the perspective of an investor holding bonds to maturity, it is good news. As long as your maturities are relatively short, you will get to reinvest your cash at higher rates down the road, once your bonds mature at par. There is no impairment of value in this situation – a fact that is often overlooked.

Commodities: Again, this market has taken a beating this year, although far less so than some of the global equities. As emerging markets are perceived as slowing down, so does the thinking for the commodities consumed by growth.

Our perspective is quite to the contrary. The slowdown in emerging markets growth is only temporary. The US is pulling out of its malaise, and population growth in developing regions will continue to fuel demand. China, for instance, is planning to urbanize 250 million people in the next decade. To put that into perspective, that is the same population of all the major cities around the world – combined.

In addition to the global demand for construction resources, we are holding a notable position in grains and agriculture. The dynamic is a simple one: populations are growing and the global middle class is consuming more meats and high value foods. Production is keeping up – but just as long as there are reliable and predictable methods. Climate change is for real, however, and creates mayhem in the production cycles through drought, flood, and changing weather patterns. As we saw last summer, with these disruptions comes significant supply constraints and rising prices.

The area that is least “normal” is metals. Gold and silver, the two metals that we use for hedging purposes have seen historic declines. The price of silver has been cut in half with all the reactivity to the central banks, gold is off a third. More disconcerting is the daily movement, which is down under every market condition – whether there is good news in the world or bad.

Seeing these risks, we exited our silver position many months ago, just at the high. We kept the gold, however, as a hedge against some of the events we have recently witnesses. But in the break from any form of “normal” that hedge has failed and the position has been a drag. Under the perspective that this is a market dislocation unrelated to the value of metals, we continue to monitor that market and the timing for when it may make sense to restore the positions to their original allocation.

CONCLUSION

In summary, it has been an unusual year. The markets went straight up for four months, creating a buzz reminiscent of the late 1990s. During that period, stocks went up at a blistering pace and there seemed to be no end in sight for the dotcom stocks. The buzz was a simple, yet persistent demand to be in the stock market. If you were not fully invested, then you were “missing out.” Unfortunately, those who did go full into the market saw a remarkable event – a -70% loss in their portfolio values.

That buzz has ended now, as we are reminded of the vast uncertainty in the equity markets. In the last month, we have begun to witness volatility across disparate asset classes, from US Treasuries to Japanese equities. During late May and early June, the Nikkei had five trading days of 3-7% losses. Then just three weeks ago, it saw a 5% gain in one day. Like the movement in gold just two months ago and again now, that volatility is well outside “normal” volatility. And it is happening in US equities, to a smaller but notable degree.

To make this point, for the months of May and June (since the Fed started to talk about “tapering”), we have had 24 days of 100+ point movements in the Dow Industrials average: thirteen times it was up, eleven times it was down. That contrasts to the first three months of the year in which there were just nine such days, only two of which were down. Volatility came back with a vengeance, and when it did losses ensued.

As reported by the financial website Seeking Alpha and others, May saw the highest equity weighting among individual investors since September 2007. As a reminder, September 2007 was the beginning of the equity decline that lasted 18 months and 50% down. In the parlance of market psychology, it is not unusual for individual investors to be the last to the party.

And this lack of “normal” is creating havoc for the institutional managers as well. Hedge funds, the massively concentrated pools of capital that supposedly can time these events, have done no better. With gains of roughly 2.7% for the year, they haven’t solved this problem – no one is immune.

Our view is that we are seeing the shift to an investment environment based in old-fashioned fundamentals as the US economy pulls forward and artificial drivers fade out. It could take years, but ultimately that is a good thing. In the process, there will be uncertainty and wild volatility.

In the end, there is nothing normal about these markets – old or new. We are going through changes on historic scales, and as we continue to remind folks, we are all sorting through the events and the data to find the best places to invest assets for the future.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA

Managing Principal

Market Minute – April 22, 2013

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Last week was another one of those moments in the market which reminds us that we are in troubled times.  Taking a completely agnostic, statistical perspective on last Monday’s events in the gold market, we again had an event that demonstrates the unstable foundation of the market.  In this case, gold dropped by 5.8% on Friday, April 12 and then 7.7% on the following Monday, for a combined two-day drop of 13.5%.

For perspective, using the prior 1,000 days of trading data as a baseline, gold typically moves around 0.5% per day.  A 2% move is big (once every couple of weeks).  3% is rare (three times a year).  A bigger move than 3% is statistically remote.  A two-day move of 13.5%, under these conditions, has a probability of one-in-a-trillion or roughly once every four billion years.  So maybe my assumptions are wrong (that market returns are normally distributed), but then you would have to discredit an entire generation of financial theory and models.

So where does this leave us?  In the span of two days, gold prices (and a host of other commodities) moved in a way that is not supposed to happen unless we are facing the most dire of global circumstances.  In effect, something snapped in commodities.  There are a host of explanations as to why (Cyprus might sell all their gold, Goldman Sachs starting bad rumors, North Korea did it, Paulson did it…. and so on), but the result is rather simple.  We are in an investing world in which market mechanics are evolving into a dynamic that is both unpredictable and challenging to comprehend.

[To emphasize the volatility problem, yesterday someone hacked the AP twitter account and sent out a false report of an attack on the White House.  The Dow dropped 140 points in a few seconds, then recovered.  Someone made a small fortune on their put options.]

My suspicion regarding gold is that the Exchange Traded Funds (ETFs) which hold a large percentage of the World’s gold supply are causing distortions in the market and led to the market dislocation.  It is a rather nuanced explanation based on the way that ETFs are created, but the theory also helps to explain the Flash Crash of 2011.  Whatever the answer is, since 2008 we have been in a new world of investing and markets.  Gold is supposed to be a safe haven, stable asset with limited volatility.  While it still may be safe in the long term, it is now subject to the same randomness as the rest of the market.

I will later elaborate about other such events during the past three weeks, but the conclusions are the same.  Under the veneer of a bull market in US stocks, there remains tremendous unpredictability and dislocations continue to manifest.

As an investment manager, we have mitigated these risks through our asset allocation strategy and the manner in which we use specific securities.  And in all likelihood, the dislocation in gold is temporary.  But time will tell, as always.

Regards,

David B. Matias, CPA

Managing Principal