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Brexit Explained: 99 Problems but No Solution in Sight

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To our readers,

Until now I have had the pleasure of writing the majority of our blog entries, but am very happy to now present the writings of Juliana Cusack.  Juliana is our analyst on the venture fund and works closely with investment team on economic matters.  While I will continue to write the quarterly Market Updates and some Market Notes, Juliana will now be a regular contributor to this space.

Her first piece on Brexit is below.  It will help to clarify some of the bigger issues was are facing as we head into the summer months.

Thanks,

David

 

On June 23rd, Britain will vote on whether to ‘Remain’ or ‘Leave’ the European Union (EU) in a move that has significant implications on the US’ biggest ally and the broader European community. The sentiment underpinning this vote is strong and frustrated. The vote itself was a concessionary promise made by David Cameron to a swath of reluctant supporters during his last campaign. While it seemed unlikely to materialize, thirteen days to go and the ‘Leave’ camp is leading by a percentage point in the polls, with 12% still undecided.

The ground-swelling of anti-European sentiment is in large part due to the expansion of the EU in geography and scope, as well as the emergent and fragmented terrorist threat. But like the Trump factor here in the US, the impact of globalization and displacement of blue collar jobs has exacerbated these issues and laid the foundation for xenophobic and isolationist attitudes to take hold. A discussion of each of these factors follows below.

Trade 

Trade is arguably the most important aspect of the European ‘project’, with the European Union initially established as a duty-free trade alliance. The EU currently absorbs 44% of British exports, linked to 3.3 million British jobs. The severity of the impact is, of course, debated and subject to post-exit negotiation, but if the UK left, trade would likely be governed by the WTO, where members can impose tariffs on imports that average 9% when no preferential deal is in place. The relative increase would almost certainly hurt both UK exports and consumers.

Moreover, firms located in London are currently granted a ‘passport’ allowing them to operate in other EU countries without undergoing separate regulatory oversight. This has implications particularly for London’s substantial financial services sector, which currently benefits from being able to clear transactions denominated in euros, a function not possible after an exit. While more limited free trade deals have been negotiated, as with Switzerland, Canada, and Norway, they are unlikely to be lenient in negotiations given the signaling towards the already weakening European unity and the competitive position of the UK’s financial sector.

No one, except European capitals eager to fill the void if London were to exit the Common Market, is arguing the trade benefits that come from membership. If anything, ‘Leave’ supporters are most frustrated with the EU’s evolution beyond a trade alliance, but are still confident that loss of trade will be made up for by trade with China, India, and the US.

Immigration

‘Leave’ supporters are certainly fired up about the EU limiting Britain’s ability to control the number of immigrants reaching their shores, a fact blamed for decreasing wages and an overheated real estate market. Part of this is due to the unprecedented enlargement of the EU. When free movement to the UK for citizens of new EU members was first agreed to in 2004, 100,000 migrants were expected in the first decade after enlargement. In the end, it was 1.4 million, roughly half from the original member states and half from the poorer new members of Eastern Europe. Eastern European arrivals are more likely than previous migrants to settle in small towns, presenting challenges for local authorities. And in fact, the loudest voices in the ‘Leave’ camp come from outside of the capital.

Terrorism

The issue of terrorism is delicately intertwined in immigration issues, particularly given the disparate and concealed threat posed by ISIS. Many people believe terrorists can slip in undetected with streams of migrants, only made worse by the imagery provided by the attacks in Paris and Brussels.

Consider the fact that Ibrahim El Bakroui, an organizer of the Brussels attack was put on a watch list in Istanbul after being arrested near the Syrian border, but no information was provided to Belgium authorities after he was sent back. Cooperation between France and Belgium would also have been prudent as attackers, originally planning to target France, easily shifted their plans to Brussels given their freedom of movement. Local police in Molenbeek, Belgium, also failed to pass on key information regarding the hiding place of the last remaining Paris attacker for three months.

Figure 1: A map indicating EU and Schengen membership across Europe highlights the issue of terrorism prevention when information is not shared between countries with open borders. source: ec.europa.eu

Europe faces unique challenges in preventing terrorism given their porous boundaries, bureaucratic complexities, and inclusion of former-Soviet territories. While the UK is not a member of the Schengen Zone, this prevents the tracking of dangerous persons and strengthens terror networks across borders. Each EU member, including those with freedom of movement, has different legal frameworks and rules on the classification of secrets. Europol has been at the heart of intelligence-sharing initiatives, but the authority has no ability to make arrests and has been slow to garner buy-in from its members.

Political 

The issues around trade, immigration and terrorism are all significant. But some also say that moreover, this is a struggle over identity. The UK is separated from the rest of Europe by language, geography, and culture. As the NYTimes put it, “In [the pro-Brexit] view, the country is being overrun by foreigners who not only take their jobs and welfare benefits, but also bring fundamentally different values into Britain.”

The European Union offers the UK a platform to spread its values and participate among its allies in the fight for human rights and safety in difficult times. This participation offers significant benefits.  But the cost of that is a loss of sovereignty to European officials, unelected by the UK populace but whose laws make up 15% of the UK’s total. People also focus on the UK’s contribution to the EU budget, which totaled 13 billion GBP in 2015.

article-2180177-143FE071000005DC-507_634x426Image 2: An image from the Opening Ceremony of the London Olympics in 2012 celebrated an eccentric image of British culture throughout the decades. 

Your Portfolio

Since polls showed a tip towards the ‘Leave’ camp earlier this week, the FTSE 100 Index (UKX) fell -3.49%, the Euro Stoxx Pr Index (SX5E) fell -4.58% and the S&P 500 fell -1.12%. Global fund managers’ allocation to UK equities are at the lowest levels since 2008 and the pound fell against all 16 major peers. Nevertheless, many say markets are still not prepared for a ‘Leave’ vote, and there would certainly be further fallout for global markets, and the UK and Europe in particular.

There is not much European exposure in the portfolios though there is a small amount of the Vanguard FTSE Europe ETF (VGK), which was added in July 2015. The ETF had a low in February but has been crawling back since. We have also had a rocky time with Santander (SAN), which has been subject to the European instability as well as internal challenges brought on by new leadership. Nevertheless, volatility is dangerous and market events are all felt across borders, including here in the US.

Market Update: November 2012

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Post Election Hopes

As I sit here on the morning after, there are a number of very important points that come out of the results from last night.  Most important, the difference in this election from four years ago is a stark one.  While I am no political pundit, it appears that the Obama campaign won every swing state and Democrats won every closely contested Senate seat except one despite an economy that should have dictated otherwise.  Yet all of those wins were by a much smaller margin, Florida being a good example.  In all of these races, the difference that put Obama over the line was the changing demographic.  Minorities are growing while the white middle class is shrinking.  The Obama campaign was able to tap this trend.  Not only was the Obama campaign also able to command the women’s vote, but the number of women in Congress will now be higher than ever.  In a very positive sign, we are diversifying as a country, and the vote is starting to reflect that diversity.

So the question is: what comes next?  Regardless of your politics, we have a raft of issues that need to be addressed now.  Not just in the coming months and years, but in the immediate.  Irrespective of one’s position on the various topics, the lack of lasting resolution is more damaging than one particular tact or another.  The two issues I’m thinking of now are the fiscal cliff that enacts a raft of automatic budget cuts at year-end, and the expiring tax laws.  Both of which has a dramatic impact on individuals and the economy.

Despite significant frailty, the economy is showing signs of improvement – there would not have been an Obama victory without them.  The most important of which is the improving GDP figures and the housing market.  Real estate prices are showing signs of stability – a significant positive – and personal debt levels are down as well – a function of foreclosures.  The last quarter’s GDP growth increased to 2% from the tenuous 1.3% of the prior quarter.  Without growth, we cannot create jobs.  And without jobs, we cannot grow consumption.  Without more consumption, we cannot grow the economy.  It is a vicious circle that we have embraced – but one that we cannot break right now.

The jobs recovery to date, however, has been anemic.  As you see from the employment chart below, we have barely witnessed any change in the overall employment levels.  Long-term structural unemployment has now become pervasive, with over 1.7 million people unemployed at least 99 weeks.  That statistic, unfortunately, is grossly understated – it does not account for those who have simply given up.  We are employing the same percentage of the population as back in the 1970s, when there was a radically different expectation on quality of life, family structure was more traditional, and the debts were miniscule as compared to today.

US Employment as a Percentage of the Population (Ages 16-65): 1970 – 2012 

As the economy went through the dot-com bubble of the 1990s and the real estate bubble of the 2000s, employment was broadly boosted due to increased spending. Today, with the current recession, those jobs have been erased and we struggle to find a way to recreate the lost jobs. In fact, we are experiencing the same employment levels as the 1970s, when the standard of living was far lower.

Fixation on Debt

There has been plenty of discussion and debate around the level of federal debt.  It is not pretty, but it is not unbearable.  If there is future economic growth, and if there is an ability to stem future deficit spending, then these debt levels are manageable.  The problem we are facing today is the continued deficit spending on top of anemic economic growth.  The two combined is a recipe for disaster, a la Spain-style.  Hence the importance of the election message – we need to deal with the concurrent problems of increasing deficits and a lack of jobs.

State debt, in our view, is far more troubling.  The states don’t have the ability to inflate their was out of their obligations, and those obligations are enormous.  While the public municipal debt market is already $3 trillion, there is at least another $4 trillion in unfunded obligations across the country (and some say more like $7T).  No way to make those payments – and limited ways to borrow to cover them.  Future defaults on these debts or obligations are a strong possibility.  These are typically pension obligations, an area that will have a direct and profound impact on retirement, health care costs, and our ability to consume.  The same problems that we face now as a country could further compound as the states grapple with the realities of poor fiscal management.

The silver lining to the debt story is real estate.  Personal debt, the area that exploded in the last real estate bubble, is actually coming down.  The reason is simple – much of that debt was tied to real estate borrowing.  With so many homes in foreclosure, and much of that personal debt eliminated through bankruptcy, individual debt levels are down dramatically.  It could be a good omen – people can not put those dollars to improving quality of life and building retirements – or a bad one if there is little personal constraint and new debts are accumulated.  How it unfolds will be an important factor for the economy.

The problem with growing debt – whether it be personal or government – is that the debt service eventually tears into your ability to spend on important items.  Those important items could be a car repair, or repairs to a school district.  Either way, it can start to eat at the current quality of life and our future prospects.  In a worst case scenario, that debt is so burdensome that one defaults – such as personal bankruptcy or by devaluing the currency.  A personal bankruptcy is not as bad as it used to be – you no longer have to go to debtors prison and eventually someone will give you a new credit card.  For a country, however, the devaluing of a currency can have a devastating impact.  Other countries refuse to lend at favorable rates, quality of life for those who are paid in the currency declines across the board, and wealth in general is slashed.

The debt accumulation in the US, however, is a byproduct of the bubble economy that we’ve fostered for the past three decades.  As I’ve outlined in my article, “Turning the Economy into a Casino” (from The Intellectual Origins of the Global Financial Crisis, Berkowitz and Tuoy, eds., Fordham University Press, 2012), our economy suffered a decline of our core growth drivers that dates back to the 1960s.  To mask this erosion of economic growth, asset bubbles were fostered through government policies that allowed for a false sense of wealth.  This “wealth” led to greater consumption, the core of economic growth for the past three decades.

But when these bubbles pop, individual consumption contracts drastically and jobs are shed.  A cycle of decline ensues unless you either fix the core growth issues or insert a new bubble.  By my count, we are in the midst of the third major asset bubble in the past 30 years – the Quantitative Easing bubble.  Or free money.  More on that later.

Analysis of 2012

Despite this week, the year to date has been a remarkably calm one despite the underlying tensions.  I believe it is mostly attributed to this bubble.  We see that stock market valuations have again risen to pre-crisis levels, and many corporate earnings have improved in lock-step.  Through the end of October, the market was up by 14% year to date (S&P 500).  The core of that rise, however, is limited to two key areas: iPhones and banking.

The first is centered around Apple, their suppliers and the cell operators.  From Apple to AT&T to Verizon to the iPhone supply chain, and the knockoff iPhones supported by Android, the combined impact of the iPhone on stock market valuations is anywhere from a quarter to half of the market rise year-to-date.[1]  Apple alone, the largest component of the S&P 500 index, represents 13% of the market rise.

Here is the irony – we have seen the profits from the iPhone/smartphone market flow back to some shareholders in the US, but an entire slice of that revenue stream flows to Asia in the form of a negative trade deficit.  Remember that we import roughly a $1 trillion of goods more than we export each year.  Over the past forty years we have rushed to move our manufacturing overseas because of cheap labor.  As a result, we lost both the manufacturing capacity and know-how.  As the late Steve Jobs stated, the US doesn’t have the ability to make the iPhone (labor is 7% of the iPhone cost). A domestically manufactured iPhone and supply chain would have gone a long way in solving our current employment conundrum.  Instead, we handed those jobs over to China and their Asian supply chain vendors.

The second factor is the Fed stimulus and its impacts on the banking industry (what I’m calling the QE bubble or free money).  Low interest rates, subsidized losses and protective regulations have allowed the banks to prosper again and are some of the biggest market gainers this year.  I hear stories of folks who are refinancing at insanely low levels, but those loans are rarely available to people who have less-than-perfect credit.  In effect, the banks are offloading the risk onto the public sector – using free money to generate safe profits and playing with those profits in the markets (witness JPMorgan and my last Market Update).

I fear that these benefits are limited in their ability to repair our domestic economy.  As you can see from the chart below, while we have the largest economy on a per-person basis, we are quickly losing ground to Asia, led by China’s growth.  Combined with the recession that Europe is facing, and the serious debt issues that have fostered their problems, there is a dramatic shift under our feet.  As we move from the industrial age to the information age, I fear that we have lost the ability to capture enough innovation and growth to support our outsized expectations. Put another way, wealth and quality of life expectations for the 99% are going to change.

The Three Largest Global Economies

While the US has been eclipsed by Europe, and China is rapidly catching up given their sustained growth rate (perhaps in ten years), our per capita economy still affords us tremendous wealth as a country.

Prognosis

This is not a condemnation of the US economy, but rather a reality check on where growth is found as an investor.  Many US companies are doing remarkably well.  Their ability to shed employees, improve productivity and fortify their balance sheets will server them for years to come.  There is still innovation in this country, especially in the areas of early stage life science and energy technologies.  In the interim, the ability for the US consumer to push our economy forward is still hampered, and will be until base employment is solved.

Which comes back to my opening points on the election results.  The policies of the next four years need to clear uncertainty while fostering a stable employment base.  The improvements in real estate will help, but we cannot depend on our own consumption to fuel those jobs, and Europe is not going to do it for us either.  Firms such as Apple, that have a truly global revenue base, solid cash and deep penetration into Asia are the growth prospects for the public equity markets.  Domestic firms that maintain stability of cash flow and have managed their risks are good investments for predictable, yet very modest, returns on investment.

In the immediate term, the uncertainty of the next few weeks and months could reek havoc on market psychology.  Apple is a great example.  With the enormous run-up in the past two years, many folks are sitting on large long-term unrealized gains.  With the prospect of capital gains tax rates rising, folks are unloading their Apple shares to lock in the current tax rate.  If those tax prospects were already resolved – and set at a modest increase of say 15% to 20% – much of this panic selling would be averted.  But with uncertainty comes volatility.

As a reality check, Apple’s fundamentals are astounding.  They have well over $100 billion of cash/marketable investments on the balance sheet, and generate another $50 billion each year.  Their growth rate is still projected well into the double digits.  The price to earnings ratio, ex-cash, is 8x (by comparison, J&J is trading at 12x).  And the iPad mini, with gross margins over 50%, is going to explode on the global market and likely change the face of education.

But psychology will always win over reason.  And that unfortunately is the prospect that we face as a nation.  Our demographic is changing, our vote is reflecting those changes, and our economy is drifting in the currents of a dynamic world.  Change is inevitable.  How we manage this moment is paramount to the future of this society.

All the best for the start of the holiday season.

Regards,

David B. Matias, CPA

Managing Principal

[1] This is a rough estimate based on the impact that those companies have on the S&P 500, and the amount that iPhone sales and related cellular service contribute to their earnings.

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.