Market Update – August 2011

Perhaps the most interesting thing from the past two weeks has been the number of times that I’ve heard “2008” referred to by the mainstream press.  While the financial media is always doing some sort of hoopla around trends and comparisons, it is a far more telling indicator when the mainstream press chimes in.  And given the past week, it is no surprise.  With the market down as much as 20% from its high for the year, and intraday swings of up to 7%, fear has yet again gripped the market.

And yet, the comparisons to 2008 are perplexing.  They revolved around a notion that somehow that was a different period, in which some bad things happened and we are comparing ourselves to back then.  Remove the delusion of market psychology and asset bubbles, and we never moved past the crisis of 2008.  The correction that began in 2007 is still winding its way through the economy.  This time we have migrated from bank failures in 2008 to government failures in 2011 – the natural progression in this deep economic crisis.  Governments bailed out the banks.  Now who bails out the governments?

As we pointed out in our market update from June 2011, “the ‘bull’ market has run out of buyers and the reality of a paradigm shift in our economy is begging to sink in.  At that time, the S&P 500 was trading at 1300 – today is sits at 1140, hitting a low of 1104 on August 9.  We are likely to see that low again, and beyond.  The bond market, despite the downgrade of the US by Standard & Poors, has screamed ahead with yields on the 10-year Treasury bond dropping to historical lows of 2.1%.  Gold is trading at historical highs.  Bank of America is trading for less than their capital reserves.

Prior to August of this year the S&P 500 traded within a range of +0% to +10% gains for the year when priced in US dollars.  When priced in Swiss Francs, a stable currency that has avoided many of the pitfalls of the American economy and political system, the S&P 500 has been on a downward trend all year long.  The connection between these two facts is the Federal Reserves Quantitative Easing program that ended in June.  With the Fed pumping hundreds of billions of dollars into the markets, and indirectly into the equity markets, they became the primary buyer behind the “bull” run.  With their stimulus removed, we ran out of buyers.

But it is never that simple.  Like every crisis, there needs to be a series of factors at play to create an eventual collapse in psychology.  I will cover those events in the rest of this update, but had they not occurred, the Fed’s policy might have worked in creating enough positive psychological momentum to spur the economy.  Now, that opportunity is gone.

When the S&P 500 (SPX) is priced in the Swiss Franc (as opposed to using our dollar), the market has been on a downward trend all year long.

Downgrade

By now, everyone is somewhat familiar with the job of the ratings agencies. As an objective group with access to the complete financial information of the institutions they rate, they are to provide an assessment of the firm or government’s likelihood to meet its obligations. While the concept is an important one, historically we know this to be a farce. Whether you go back to Enron and the failure to identify basic cash flow problems, or the AAA ratings they issued on sub-prime backed mortgage products, Standard & Poor’s (as well as Moody’s and Fitch) have shown a propensity to cow-tow to their clients – the very firms they are rating.

Rather than debate the validity of their downgrade of the US government, let’s look at a comparison. The United Kingdom has had a host of problems in the past three years, including a massive bailout of Royal Bank of Scotland, which is reflected in the market price of their sovereign debt. Trading at yields 0.8% higher than the US, there are perceived as a riskier investment. Yet they maintain a AAA rating from S&P. Inconsistent, at best.

The manner in which S&P pursued the downgrade, with glaring discrepancies in their projections and a heavy reliance on possible future political events, points to a firm lost in their mission. Combined with the timing of the downgrade, they have done little more than create panic in the financial markets while degrading their product even further in the eyes of their audience. Now that the other agencies have affirmed the equivalent of a AAA rating for the US, S&P is left out on their own.

Despite the botched attempt at validating their existence, the message is still an important one. In essence, they are addressing the very crux of our financial crisis from the past 20 years. After decades of increased consumerism (from 60% of GDP in the 1960s to 73% today), decimating our manufacturing sector in favor of services, a reliance on asset bubbles to inflate the financial services sector, and declining real wages in the non-financial part of the jobs market, we have an economic core that has lost an ability to generate real growth. All of these factors created an enormous debt, both private and public. We are left on the verge of a recession and a massive hangover.

Real Growth

The other factors that lead to the excessive volatility are all related to growth. Here in the US, we learned that growth in the first quarter of 2011 was in fact anemic (0.4% annualized, versus a prior estimate of 1.9%). Second quarter, while better was still below the minimum of 2% per annum needed to keep our economy from shrinking. And with the budget battle in full gear, it is estimated that Federal government cutbacks will reduce GDP by 1.6% per annum. In essence, we have all the pieces in place to put us back into a recession.

Europe is not faring any better. While they suffered dramatically from the same damage we sustained in 2008, their finances were in a worse place to deal with the fallout. Governments in Europe have limited ability to cover the tab of failures, and with a single currency covering far reaching economies (Germany actually makes stuff – lots of stuff – Greece doesn’t) there is little room to allow a weaker segment to fail without bringing down the total European block. [Note that the UK does not use the Euro, giving them more latitude in monetary policy.]

Hence, Europe is facing a double conundrum. They are susceptible to a recession with few fiscal tools to help, and the banks are vulnerable to rotten assets as their lenders such as Greece or private Greek borrows (such as real estate developers) struggle to make debt payments. To add to the problem, we have learned that Germany’s economy has nearly stalled this year. While they do continue to be a leading manufacturer, they cannot escape the realities of a slowdown in consumption.

Asia is the antithesis to the situation in Europe and the US. With their expanding middle class and rapid urbanization, China continues to dictate the demands on global commodities. Yet their growth is a mixed bag, with concerns over asset bubbles and price inflation, the central government tinkers heavily in economic matters at the risk of creating a different sort of economic crisis. The result is a global price inflation for food and basic goods for all, while creating a cloud of uncertainty around steady growth in that part of the world.

Shift to Market Psychology

All of this has lead to a fundamental shift in market volatility for July and August. The message is a consistent one: we are suffering the hangover of massively inflated asset bubbles and misplaced capital. This will take years to resolve, as the US economy hunts for jobs growth using the basic mechanisms of capitalism. It is a process that can be soothed, but cannot be shortened. As one friend and bond trader recently said in reference to the Fed, they will continue to administer methadone to the economy until the addiction is somehow kicked. The addiction in this situation is consumption and real estate – for a solution we need real growth and jobs creation (not just in financial services), hopefully centered on innovation and value creation.

But until that happens, the denials continue to distort the markets. There is no uncertainty in this matter – corporations continue to generate sizeable profits. They have cut staff to a bare minimum, they have built up impressive balance sheets and cash reserves and they continue to explore global markets. The ability to continue to grow revenue is at question today, but their fundamental health is certain. [The glaring exception is the global banks. They have announced over 100,000 job layoffs in the past few weeks in an attempt to build their profit and capital base. It likely points to further erosion of their balance sheets.]

In this market volatility, we are seeing a free-fall of expectations that push market values out of line with fundamentals. It is tough to argue that gold is worth $2,000 per ounce, or that Apple should trade at less than 12x future earnings. Even more daunting is the notion that a 2% yield on your ten-year Treasury bond is a good deal. Eventually the market will again find the basic value relationships that govern long-term investing. But until that happens, psychology will govern the markets and fear will drive prices to extremes in both directions.

That, in fact, is not any different than 2008.

Let us all hope for a pleasant end to the summer of 2011.

Regards,

David B. Matias, CPA
Managing Principal