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Market Update – July 2, 2015

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The first half of 2015 has been marked by some surprises, but at the end of June, the markets were in neutral, without any clear directional trend. While events such as the Fed move, oil price stabilization and disappointing economic indicators in the U.S. are all worth exploring, the Greeks are currently stealing the summer headlines. This update will address the current events in brief, while focusing on the prospects that we see for the second half of the year in what I’m calling the “durable economy.”

Thus far, the financial markets in the U.S. have generated negligible returns. Although there are some bright spots over the past six months, the collective S&P 500 is hovering around 2%, and the Barclays Aggregate Bond index remains slightly negative. Overseas markets are better in some areas, such as developed European markets, but with the prospect of a Greek exit from the euro, those returns just got halved for the year. The drag on overseas returns is China, which just entered a bear market this week after a series of missteps and miscues around sustained growth.

We don’t see this as all bad, and in fact, we are fairly optimistic about the prospects for the second half of the year. In a sense, the pause that the past six months have provided is beneficial to the markets over the long term. Keeping in mind that we’ve had a raging bull market for many years now, a breather in the climb gives the economy a chance to catch up to market expectations. In addition, we are also experiencing a significant shift in the manner in which the domestic economy generates growth.

I will address these factors in a longer Research Note this month, but for now, we appear to have shifted into a domestic economy that is resilient to a recession, yet unlikely to grow at the four to five percent pace that we have come to expect in past expansions. Two percent growth is all that the Fed projects for the next couple of years – not one of the most reliable predictors, but a good proxy. Given our heavy reliance on consumption for growth and a movement away from manufacturing, the modest expectation is reasonable. We appear to be shifting away from consumption as the primary driver of new growth and creeping into an innovation economy that would provide for a durable expansion over many years.

The downside to two percent growth is the threat of recession should there be any significant shock to the economy. Global events such as those in Greece, or conditions in Russia ranging from erratic military action to a decimated ruble, all have the ability to be that shock. Other possible shockwaves could emanate from increased occurrence of financial dislocation in markets driven by financialization (explained later), such as we experienced in the 2008 collapse. Similarly, more recent events, such as violent movements in the price of gold, the Swiss franc or oil could have an impact. But, we view the domestic economy at this time as stable enough to withstand most shocks.

With this in mind, we are looking at a variety of investment areas for the second half of the year. Energy, with the halving of oil prices last year, is one of the brightest spots in the durable growth scenario. Carbon-based sources and other alternative energy sources, plus the combination of an innovation economy with the dramatically lower energy prices this year, have stoked demand globally. That demand is translating into economic stability in some regions, and unexpected growth in others. We are incorporating the perspective of Mike Rothman at Cornerstone Analytics, which posits that demand for oil will outstrip supply by the end of 2015. While this prediction is counter to prevailing market sentiment, the growth in demand combined with a dramatic slow-down in drilling in the U.S. and declining well production in all other regions makes a strong case for this inversion later in the year.

Aside from energy, the disruption from Greece could present some interesting opportunities in Europe. Despite their market rally in the first quarter, the earnings multiples of European equities are still relatively modest, and the prices are even cheaper in dollar terms because of the devalued euro. If the region slips into another recession, then those valuations are too high; if the current situation resolves without significant economic damage to the broader continent, then the prospects are strong. Add to the picture the extensive exports by Europe to the U.S. and China — both of which are growing at a substantial clip on an absolute basis — and there is important upside for the European companies that operate globally.

 

Market Review

The context for the markets is fairly consistent with our discussion back in January: we’ve seen a relatively flat market with noted volatility around specific events.  The flat markets in the U.S. are striking — equities have struggled to improve their gains for the year, while bonds are showing losses.  Although some of the chronic underperforming markets had a strong start to 2015 (Europe in particular), the perpetual Greek crisis has already derailed many of those gains.

The chart below shows the three major asset classes in the US: the S&P 500 equities, Barclays Aggregate Bond Index, and the Deutsche Bank Commodities index, our rough benchmarks for most accounts.  They are not ideal reference points, but here they show you the general trend for the markets this year, keeping in mind that we’re seeing a very narrow trading range in all three asset classes.

Chart1Chart 1 – Market Total Return 2015. Source: Bloomberg

As you’ll see in this chart, U.S. stocks have had a year of relative quiet with gains of 1% – 4%.  Bonds, with the anxiety around Fed policy and interest rate movements later in the year, have moved only slightly.  The stock and bond indices combined, on a 60/40 basis that is typical of a diversified asset allocation model, yields a return this year of about 0.8%, depending on the week.

Also note the relatively tight range of trading on these assets – stocks have moved in a total range of 6% from high to low. Even commodities, a volatile asset class this year, has stayed within a 9% range.

Despite the perception of turmoil for the year, the volatility measures have been remarkably quiet. In fact, the equity markets have had their narrowest range of movement in the past two decades. According to Bloomberg, the range of movement from highest to lowest points for the year is just 6.5% a very modest move where the range is typically 10% – 40%. Add the VIX to the picture — the measure of expected future volatility in the S&P 500, which has not traded above 20 since January — and the realized and expected volatility is the lowest it has been in a very long time.

The key exception to this flat market with a narrow trading range is energy. Oil, in particular, has been all over the place. Starting with a 50% drop in crude prices going back to last fall, we saw a 30% jump in the early spring. The short-term impact of trading dynamics on oil prices far outweighs the impact of the supply and demand situation. Specifically, the amount of financial products that are traded daily on oil is roughly twenty-four times the actual demand for oil. This financialization is not new to the asset class. The phenomenon is a function of both growing derivative markets and the computerization of trading strategies, and drives many of the market dislocations across asset classes that we experience on an annual basis.

The take-away from financialization is the fragility of many markets, which are influenced by perceptions on any given trading day. Whether we are discussing gold, Swiss francs, corn, oil, or even Apple stock around a product release, the disconnect between fundamental value and trading price can be severe. Despite the anxiety that can arise around these fluctuations, financialization also creates enormous opportunity when actual value is separated from perception.

 

Economic Review

The factors that we continue to monitor for predictive market behavior are employment, GDP, and housing. We have gradually added energy to this discussion, given the volatility in the energy markets and the skewed dynamics it has created.

The U.S. economy is again expected to show slow growth in the past quarter, somewhere in the 1.8-2.0% per annum growth rates. Unemployment dropped again over the quarter, and the jobs creation picture is holding steady and promising. With close to 300,000 new jobs created every month, we are slowly mending the employment picture. But labor participation rates hide the broader story, as many folks simply are not participating in the trend. This causes a drag on domestic consumption, but also gives us tremendous room for growth before serious inflation is triggered.

Chart2Chart 2 – Labor Participation Rate in the U.S. 1945 – 2015. Source: Bloomberg

While our labor market has shown tremendous tightening in the past two years, the broader employment picture is masked by the historically low participation rate in the U.S. Driven by a combination of changing worked demographics (retiring boomers, for instance) and the perception of poor opportunities, we are at a level not seen since before women entered the labor force in earnest.

The part of the picture that I am most optimistic about is housing. New home construction (housing starts) have reached the one million annual level again – and are holding that level – after a dismal slowdown in the Great Recession. With a long-term average of roughly 1.5 million new homes per year, we have a long way to go. The competing factors here are housing stocks, which decline every year as homes are demolished, and the growing population, the impact of which has been partially offset as retirees team up with Millennials to consolidate households. Doing some simple economic math, an extra 500,000 new homes a year with the associated jobs, materials and durable goods purchases can add 1.0 – 1.5% to the annual GDP figure. In an economy still in need of consumption for growth, that could prove to be a tremendous stimulus for economic stability and market gains.

Chart3Chart 3 – Housing Starts 1970 – 2015. Source: Bloomberg

Housing starts hit epic lows after the Great Recession, bringing that sector of the consumption cycle to a virtual standstill. We are seeing significant gains in housing prices, and with eight years of contracting housing stock, we are poised to see a return to healthy housing starts. Between the jobs, materials and consumption that go into each new home, this recovery would add significantly to the GDP.

Turning to energy, U.S. “energy independence” threw a theoretical monkey wrench into the oil market. Lower prices have caused supply growth to decelerate with the prospect that OPEC might be fully tapped out. U.S. oil producers may be headed for annual declines in production by Q4 2015 due to a halving of capital expenditures and the high depletion rate of fracking wells. Yet demand growth seems to be picking up faster than economic surveys would suggest. Interestingly, this latter fact points to increasing economic activity in many emerging markets, even though traditional commodity prices have yet to show the correlated movement.

Overall, we are monitoring the energy picture extremely closely given the manner in which it can impact global demand and domestic inflation. Factors such as ISIS or the Iranian nuclear talks are just a few of the wildcards in this equation, with the ability to derail all of the models described above. It also continues to prove the case for alternative energy sources and inventive ways to use energy, stimulating innovation that will ultimately change the way our economy grows and how we live.

We are weighing all these factors as we rebalance our commodity exposure for the second half of the year. In recognition of the volatility in the commodities market driven by financialization, we are shifting to companies that profit from increasing demand as opposed to futures-based ETFs. The shift on specific commodities is also changing, with a heavier emphasis on energy and a movement away from metals and some agricultural commodities. On agriculture, our view is that the middle class growth will continue to drive food demand, but that going forward, we will invest in that area in a way that avoids the vagaries of temporary oversupply and political intervention.

 

Greece

The biggest risk as of this writing to the global growth scenario is Greece. We have never seen a country exit the euro, and the last time that a major borrower defaulted on their debts was the Lehman collapse of 2008. Back then, the global markets came to a freeze, with the prospect of a collapse in the financial system, as a trillion dollars of assets were wiped from the system and dozens of institutions teetered on the brink of failure.

Today, the situation is very different. Institutions have had years to assess the prospects of a Greek default, shoring up balance sheets and putting risk management tools into place. Most important, key institutions have trimmed their holdings of Greek sovereign debt to nominal levels. That said, someone is holding the debt and will suffer the consequences. In many cases, these are the hedge funds that once played this gambit with tremendous success. A Greek default would most certainly torpedo these funds, either through complete insolvency or a gradual rush of redemptions over the coming months.

The Greek financial system, however, would be in tatters. Aside from massive financial failures, the basic system of currency and payments will go into a tailspin. As one analyst put it, the Greek voter will be sorely disappointed when the supermarket is out of food and their ATM card no longer works. For these reasons, we don’t expect Greece to take themselves over the cliff. The political posturing is dangerous, yet the uncertainties of a break would do so much damage to their domestic situation that it would amount to national suicide.

 

Conclusion

“May you live in exciting times,” my Chinese cookie fortune recently told me. What we are seeing today is unprecedented, potentially dangerous, but rife with opportunity. The resilience of the capitalistic model is being tested, and at the same time, the benefits of technology are expanding in ways that are beyond comprehension. Many social issues need to be addressed now and for the long-term, but with the right perspective and an ability to see past the fears, we see this as a time to be thoughtful, cautious, and creative in our investment strategies.

 

Regards,

sig

David B. Matias

Managing Principal

Greek Shocker

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Today was another one of those moments in the history of finance that will be recorded as a “shocker”.  The Greek Prime Minister Alexis Tsipras, in an attempt to save his political career, is playing the ultimate brinksmanship by putting the fate of the European debt relief package up to the Greek voters.  By calling a referendum, he effectively dismantles the negotiations process and destroys his credibility with the rest of Europe.

The issues are simple yet complex.  In a simple sense, a rejection of the bailout package will generate a default on Greek sovereign debt and trigger a departure from the euro.  Anyone holding Greek debt will have to mark down its value severely and reflect the loss in their books.  Given the number of European banks and hedge funds that hold the debt you run the risk of seeing key institutions in the financial system need new investor capital to avert closure.  In the case of some hedge funds, it will be straight out failure.

With the banks and stock exchange closed for the week, and the referendum happening over the weekend, we’ve created the perfect storm for a financial shocker.  Placed on top of a holiday week for the U.S. and you’re increasing the market volatility even further.

While the risk of bank failure sounds similar to the Lehman Collapse of 2008, it is a vastly different situation.  First off, the total amount of Greek debt we are discussing is only $360 billion.  That sounds like a big number, but in the age of trillion dollar balance sheets it isn’t.  Second, this has been in the works for years now, giving key institutions a long time to sort out their reserves and plan for this contingency, or simply get rid of the investment.  Not that they would have done it well, but at least it has been done.

In the end, this is most likely to blow over by the end of the summer and make way for the positive effects of the growing and massive economies around the world.  The damage to the euro, and the implications for future exits by rogue economies, would persist for years.  And Greece will again issue debt, this time denominated in grape leaves.

The complexity is fear, and the reaction to fear, which is based in the unknown.  A default by a euro denominated country has never happened.  The follow-on effects are simply too subtle and complex to predict.  So in typical investor fashion, every asset is punished until a resolution is in hand.  Historically, it takes only a couple of weeks to recover from such a shock (Bloomberg, “A Freight Train of Unknowns Confronts Investors with Greece“).  But in that rare occasion, such as 1987 or 2008, the recovery can take up to a year.

Time will tell, but until we see a true shift in fundamentals, we view this as a nasty but passing storm.

David Matias.

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.

Market Update: October 2011

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Market Update – October 2011

Since my last market update, we have witnessed another collapse not unlike the fall of 2008.  In many ways this time is different.  The markets have lost only 17% from their highs, no banks have failed and many asset classes are still holding onto their fundamental value.  But in a troubling manner, this time is quite similar to 2008 when one looks at volatility and fear.  Once again at Vodia we are asked the questions about economic Armageddon and depression.  New records are set based on daily market movements, and assets bubbles are formed and deflated on a weekly basis.

This market review will look at the major trends over the past two months, both economic and psychological.  What I will leave to a different writing are the reasons that we are here – a culmination of factors and behaviors that have come together after decades of erosion to our economic core and serial financial bubbles.  Look for our Research Note in mid-October that directly addresses the origins of our economic troubles.

Fear for Fear Itself

At the core of our investment philosophy is the understanding and management of risk.  In its simplest form, we as human beings abhor uncertainty.  Whether it be the ancients calling on the gods for a rationale behind randomness or the television weather forecasters pinpointing the next storm (with about as much success as the ancients), we simply want to know what happens next.  In the converse, the presence of certainty creates a level of value in itself.  For instance, those companies that pay an increasing dividend, come thick or thin, are valued far higher than those companies who have a variable dividend policy.  And a known income stream from a bond is more attractive than a higher income stream that might include losses.

This dynamic has stretched to a level that we have never seen before.  In its most direct form, the bond market with its “knowns” has fared far better than the stock market this year.  In fact, despite the downgrade on US Treasuries, they are the best performing asset class for the quarter.  But not just on a relative basis.  Last month, the return on a 10-year Treasury traded as low as 1.7% per annum.  On an absolute basis, the 10-year has never traded at that level – ever.  The investment here is a stark one – agree to give the government your money for the next ten years and receive 1.7% (taxable) per year, irrespective of inflation or the value of the dollar.  Given that inflation averages 3% per year, you are accepting a known loss for this certainty.  That is fear in its simplest version.

There are a number of factors that have driven rates to those levels, many of which relate to the economy and the current political situation in Washington.  But one of those factors is indisputable – the wild gyrations of the stock market.  The chart below shows the movement of the S&P 500 for the year to date.  While all was cozy during the first half of the year, with the market moving in a range of +1 to +10%, August was a collapse.  On the heels of Standard & Poor’s debt downgrade of the US (I won’t waste any more of your time or ink on that debacle), the market lost 11% in the span of just two days.  It was a movement straight down and one that we highlighted in our August Market Update, when we also indicated that these lows on the S&P 500 would be seen again.

Over the past three years we have seen the S&P 500 go from highs to extreme lows and back again.  From where we stand now, the market could easily break in either direction – back to the lows or back to the highs – dependent as much on economic fundamentals as investor psychology.  Volatility will have a heavy influence on the next set of moves.

When isolated from the broader movements, the past three months witnessed a steep decline followed by seven weeks of volatility with the market in a holding pattern relative to the overall trend.

Since those few days in August, it has been a form of volatility that I’ve never seen in the markets, either current or historically.  While the daily movements regularly range up to 4%, and movements of 10% almost every week, the market has not gained or lost any value.  We are “range-bound” – stuck between 1100 and 1218 on the S&P 500, while showing no signs of leaving that range.  Yes, we have hit those early August lows again, and again and again (as of this writing, we are hitting them for the 5th time in two months).  But never any lower.  It is volatility for the sake of volatility.

This has a devastating effect on the markets, not unlike the collapse of a bank.  Individual investors are simply driven from the market, leaving just the gamblers and day traders.  Mutual funds and institutional investors are forced into defensive positions to attempt to protect their funds and fear becomes the trade.  The only ones who benefit, ironically, are the banks who run their own trading desks that profit on fear and volatility.

The impact can be seen across a range of assets and investments.  I already touched upon the Treasury market, but all bonds have gone through gyrations and twists that defy a simple explanation.  Some examples from the past three weeks alone:  Gold was down -16% in September after being up +18% in August.  Silver was down -38% in September after a +60% run-up during the year.  And junk bonds are down -6% in just a few days being stable throughout the quarter.

The volatility of the equity markets has generated its own trading dynamics, driving up volatility in many of the safer assets and driving down prices.  In this respect, we are witnessing a very similar set of dynamics to 2008.  Yet the causes are different, and the effects will also render different results.

Economic Stresses

The impetus to these market conditions is surprisingly a set of conditions that are not a surprise.  As at least one economist put it on NPR last week, we are coming to realize the full extent of the economic malaise and recession that began in 2006.  While the National Bureau of Economic Research pinpointed the recession to the end of 2007, it seems that the economy was in a retracted state for quite some time, and has likely never left that state.  And while the economic stimulus from 2009 helped to avert further declines, it was not enough to reverse the contractions on a permanent basis.

This dynamic is evident in the employment figures that we have been tracking since the recession began.  As a reminder, we look at total US employment as a measure of economic health, not the unemployment figure as widely reported.  While they should intuitively be the corollary of each other, the latter statistic is deeply flawed.  Only by looking at true employment do we get a sense of where we have been as an economy and where we might be headed.  Looking at the percentage of Americans who are employed today, it has experienced a massive decline from the employment highs of the past 20 years, putting us at sustained levels not experienced since the 1970s.

While the American economy and demographic has evolved since the 1940s, our employment situation has deteriorated to the same levels as forty years ago.

When combined with the very real demographic and cultural shifts in America, our current employment level introduces a new standard of living for Americans.  With healthcare and educational costs rising 10-fold since the 1970s, combined with elevated debt levels, our standard of living increasingly depends on dual-income households which have gone from the norm to a luxury in this recession.  The shift is not a subtle one, nor a happy one.  From recent college grads who bemoan living at home while they take on internships, to 50-somethings who are forced into retirement after corporate downsizing, the changes are inescapable.

Beyond the employment picture, we have the continued overhang from the real estate bubble.  With so many mortgages underwater, millions in foreclosure, and banks unwilling to lend to anyone but the perfect borrower, the primary asset class and savings vehicle for Americans is stuck.  Given the magnitude of the problem, it will be several years until we begin to see certainty in real estate price appreciation.  Although some regions are still faring well, there are entire swaths of homes across the South and West that will need to find buyers or be demolished.  A sad waste of resources and economic capital.

Rest of the World

And while we struggle here at home to find our economic footing, alongside a political dysfunction that could be a tale of self-interest for the ages, Europe and Asia are struggling in different but equally damaging ways.  Again not new, Greece’s woes are still at the center of a potential European collapse.  In this situation, it is not the prospect of a Greek default that is the problem.  It is the follow-on failures of the holders of Greek debt that worries the financial world.  In a manner not that different from Lehman’s collapse of 2008, Greece could trigger a broader meltdown.

The prospects for stemming this collapse are tangled yet again into political inaction.  The solution could be a simple one that begins with shared sacrifice.  But it appears that few of the participants are willing to accept responsibility for these decisions while the citizens of these countries cry out in despair at the thought of losing their socialized state.  Change and uncertainty is difficult for everyone – whether it be in the form of market volatility or smaller pensions.  Yet this is the prospect that we must all face.

So while Europe deals with their decades of indecision and bloated budgets, Asia is facing a far different yet equally daunting challenge.  China in particular is starting to show the cracks of an overambitious expansion plan that ignores the impact beyond its borders.  Starting with a decade of currency manipulation, China finds itself the lender to the world holding onto collateral that might be worth far less than previously assumed.  By being the low-cost provider while effectively banning imports for the past twenty years, China has amassed trillions in foreign currency and foreign debt while the rest of the world struggles to manage their debt obligations.

China pursued this policy in the modernization of one billion people while maintaining tight control of society.  The policy extended to research and development, where China unabashedly steals from the world what they view as important to their economy.  The disregard for intellectual property (IP), namely the theft of all IP that enters the country, may have shown its first fatal flaws this summer.  While there is no definite evidence of such, The Wall Street Journal reported that China’s fatal high-speed train crash might be a by-product of a foreign firm’s unwillingness to share proprietary details on the collision avoidance systems that China employs.  Knowing that anything sent to China will be reverse-engineered, the Japanese provider of these systems put the controls into a “blackbox” solution that protects their design.  Unfortunately, it also prevents diagnostics on these devices, leaving testing to real-life events.  On the heels of short-cuts from rapid development, the entire rail system is now exposed to failures that are absent in high-speed rail systems around the world.

Painful Decade or Bad Century

As we will address in our Research Note, we are facing the pain for decades of failed government policies, a short-sighted consumer society and a financial services sector run amuck.  And in the same way that it took decades to get here, it will be at least a decade to get out of this hole.  The asset bubbles of the 1990s and 2000s only served to mask the problem, and deepen the hole.  Now is time to inch out of that hole.  As Thomas Friedman recently said, we can have a painful decade ahead or a bad century.

In the short term, we need for some calm in the markets to restore values to their intrinsic level.  What happens on a monetary and fiscal level will help with the short-term loss of values, and maybe even aid in the recovery.  But it will require a shift in the way that we function as an economy and society for these troubles to be permanently eradicated.

Fortunately, some signs of those changes are starting to happen.  The outsourcing of jobs to China and other countries is no longer a panacea.  Ford announced recently that they will bring some of those jobs back, at competitive wages based on negotiations with the labor unions.  Americans now have a completely different view of debt, and are far less willing to surrender their financial future to the whims of a monolithic bank.  And households will learn to live on a single income and adjust their spending decisions accordingly.

In the meantime, despite society’s kicking and screaming (whether it be riots in Europe or delusional political rhetoric in the US), we are going to suffer through the shift in consumption, savings, and investment that lead to a sustainable economy.  There are times when volatility will reign, such as now, and there will be times when it looks like this was all a bad dream.  Let us hope in the process we don’t continue to damage what we do have left.

All the best for fall.

Regards,

David B. Matias, CPA
Managing Principal

Market Update: August 2011

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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

Market Update – June 2011

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In a sign of our times, economies are slogging towards something yet-to-be-understood, revolts crop up around Facebook pages, and market pundits continue to drivel about a recovery “around the corner.”  Taking a step back from the daily static of mass media reporting, we are in the midst of a tectonic change in finance and economics that began a decade ago and signaled its presence in the collapse of 2008.

How we manage out of this change and ensuing crisis is yet to be seen, but the patterns are developing.  Unemployment, real estate and inflation are the factors we continue to focus on for the U.S.  Commodities, food and shifts in regional comparative advantages are the themes for our international investing.  Cash flow, value creation and sustainability are the core tenets for our investment strategy and will continue to be so for the coming months and years.

In this market update, we look at how these patterns have solidified in 2011 and the global factors we feel are most likely to influence our outlook.

Revolts in the Air – Still Looking for Progress

The news of global unrest in the Middle East has certainly been on the forefront of our minds in the past few days and weeks.  Peaceful protesters, tribal leaders, and indoctrinated dictators continue to vie for power throughout the region.  Domestic conflicts, like we are seeing in Yemen, have the potential to reverberate around the world as important oil powers like Saudi Arabia get involved.  All this has substantial impacts on the U.S.’s geopolitical hegemony.  The U.S. has appeared to play catch up to the political changes in the Middle East—changing policy as protesters gain power over dictators.  What is becoming clearer every day is that the U.S. will be challenged to maintain its position in terms of political or economic influence.  Democracy for all is a wonderful idea – but not a reality in a region that is still struggling with the basics of gender rights and religious freedoms.

The impact on the financial markets can be viewed through the lens of oil.  With the Middle East representing about 44% of current global production and 54% of worldwide reserves, any notable disruption to that region’s oil producing infrastructure will cause dramatic spikes in the cost of energy.  While short-term this drains current income for consumers and business, long-term it has the potential to create a nasty global recession.  Oil-producing countries have incentives to keep prices reasonable to ensure steady long-term demand.  Hence, OPEC’s intense interest in maintaining stable and predictable oil prices.  With Yemen on the southern border of Saudi Arabia and their close ties to Al Qaeda, many do not miss its importance in the global economic balance.

Any transition in Yemen’s government will set the tone for similar disruptions in the region.  Syria is to be closely followed for many of the same reasons – proximity to Israel and Iraq, close ties to Iran, and the potential for extreme violence.  The administration realizes the importance of these changes to our economic welfare.  The view of the U.S. as a fair negotiator may be critical to holding sway in key discussions between yet-to-be-known regional parties.  It is no surprise that Obama is attempting to take the initiative in the region with a hard line on Israeli-Palestinian peace talks: our ability to continue to shape the region is going to hinge on perception as much as reality. Time will reveal all as we closely watch this region.

U.S. Market Fundamentals

While the events in Yemen and the surrounding countries continue to evolve almost hourly, here in the U.S. the same themes from the past few months predominate— real estate, employment, and inflation.  The newest numbers point to more of the same in the labor markets, with limited job creation.

The most recent employment numbers remain just as distressing as ever.  The employment level, as opposed to the deeply methodologically flawed unemployment numbers, continues to stay at historically low levels—about 58%.  We haven’t seen numbers this low since the early 1980’s when the composition of the labor force was drastically different.  This is due to the increase in the number of women leaving the home sector to be “officially employed.”  So while the employment level is currently on par with the early 1980’s—a time of recession, it actually represents a worsened situation because the number of people seeking to be employed has grown in the past 30 years.

The employment level for the U.S. continues to remain at historically low levels dating back to a period in which women were a smaller component of the workforce.  The monthly movements up and down represent statistical noise in the overall picture.

Meanwhile, the outlook in real estate prices and future inflation continue to be troubling.  After a slight increase in 2010, real estate prices have declined again back to 2008 lows.  On a more local level Boston has faired better than average—we’re seeing prices around the 2004 level.  Atlanta, on the other hand, has taken a serious hit, losing more than a decade of appreciation and placing most mortgages under water.  As an asset that is illiquid and at the core of the real economy, these declines have wiped out trillions of family net worth.

The above chart shows the Case-Schiller composite Home Price Index going back to 2000, not seasonally adjusted.  While the drop-off in prices was severe, it has shown no signs of short-term improvement and in fact a bit of deterioration over the past few months.  Eight and one-half years of price appreciation has been eliminated from this collapse.

While some cities have fared better, Atlanta’s home prices (shown above) have suffered draconian effects from both the collapse and the ensuing foreclosures.  With prices retreating to levels not seen since the 1990s and falling a third from their highs, homeowners have lost a tremendous portion of their net worth and are underwater in most cases.

The slow real estate market continues to hamper the economic recovery on a host of levels.  On a macro level the perennial obstacle the housing market is facing is the foreclosure glut—banks are still dealing with a record number of homes that they have to move on a scale unimaginable before the crisis.  Homes remain vacant for months or even years in some cases, driving down the value of the surrounding homes.  With the banks relying heavily on valuation comparables and reluctant to lend in any situation that isn’t completely consistent with their stringent guidelines, the foreclosures enforce the cycle of declining values.

This all affects the labor markets when people have difficulty moving to identify or fill new jobs, causing extra friction that the economy doesn’t need.  In turn this trickles down to consumption spending.  The seemingly insignificant purchases that folks make when they move—throwing out old appliances in favor of newer versions—add up and create a real impact on the economy.  During the boom, this housing based consumption led to the massive trade imbalance with China and their multi-trillion U.S. dollar currency reserve.  Today it starves the economy for a source of growth.

Unfortunately we expect the situation in housing to remain fairly dismal until the banks get ahead of the foreclosure problem.  While it is conceivable that a recovery could occur without consistent real estate appreciation, we doubt that to be the case.  Look for this indicator to be closely watched in future updates as a gauge to domestic economic growth.

Turning to the treasury market we are getting an indication of the worries that surround the U.S. economy.  The interest rate on medium-term treasury bonds recently dipped below 3% in early June, a level not seen since last year.  From an investment standpoint the paltry returns on treasuries mean that holding a ten-year treasury to maturity will not keep pace with inflationary pressures, resulting in a negative real yield.

While changes in the equity markets often reflect the mood of investors, fluctuations in the returns on treasuries are more representative of educated institutional views on the economy.  Looking to Washington, these views seem validated as politicians continue to bicker across partisan lines as opposed to finding real solutions.  While the bickering over the debt ceiling is frivolous showmanship, and discounted as much by the market, a new round of quantitative easing would further devalue the dollar with the commensurate increase in inflation.

In terms of the U.S. equity markets the current volatility is in line with our expectations.  It can be easy to get caught in the day-to-day fluctuations (just watch CNBC for six minutes), especially when they seem to be predominantly negative, but it’s important to remember that on a year-to-date basis the market is up 1.5% (as of this writing).  The generally anemic growth in U.S. equities is to be expected considering the current economic outlook.

While the volatility in the U.S. equity markets appears daunting, it simply places us back at a 1.5% gain for the year during a period of strong economic uncertainty.  With a current price-to-earnings ratio on the SPX at 14x, and a future P/E of 12x, this level is consistent with corporate profit levels and expected growth.  While we don’t like to use these measures as a predictor of market movement, it does give us comfort in this level as a floor to short-term market volatility.

Because of the Fed’s loose monetary policies, we see inflation as a significant risk as the supply of dollars grows and excessive cheap money triggers future jumps in economic growth.  Core CPI, which excludes important variables like food and energy, remains almost insignificant at 1%.  Common sense, however, dictates that these are probably two of the most sensitive spending components for any inflation indicator.  Looking at the “All-Items” CPI data, which includes these numbers, inflation picks up a bit to 3%.  While this is notable, barring another recession we expect inflation to further rise to 5% or more in the near future.

This view is already being realized in the commodities markets.  While equities have declined by upwards of 7% in the past few weeks, commodity indices are flat or up.  Traditionally a soft economy drives down demand for commodities, but this disparity can be explained if we take a look at role of increased global demand.  We expect this development to continue, a view that is driven largely by changes in the global demographic.

Global Changes

To understand this trend we begin with the recent policy changes coming out of China.  It recently released the 12th Five-Year plan, instituting a dramatic change of policy from headline growth to the welfare of its citizens.  This is a much more realistic vision of where China needs to go if it wants to avoid a repeat of the trouble that’s been brewing in the Middle East.  Rising inequality has been a concern for China since it first began developing the urban coastline at the expense of the more rural inland population.  As a whole the country is still relatively underdeveloped, with only 50% urbanization and an average income that’s 1/10th of the United States.

The largest problem China will face in the coming years is a demographic shift as its one-child policy and declining mortality rates change the composition of the population.  With the labor force expected to peak in 2015, China faces the same situation as the U.S.—supporting a growing elderly population with a declining number of workers.  This means that increased health care and pension costs will eliminate the low wages that have effectively subsidized cheap products for Americans.   We will need a new source of cheap labor to keep the consumable economy ticking along.  Given our strong bias towards sustainability, I am intensely curious to see where the beast of cheap manufacturing goes next in search of higher corporate profits.

As China transitions to a consumption economy and as the size of their middle class grows, we expect resource use to become a major issue.  The continued urbanization and infrastructure needs will place demands on commodities for years to come.  However, China is at the forefront of renewable energy development, which is a promising sign.  All these changes coupled with the size and influence of China’s economy make it the global wildcard.  As China moves to secure its future and the necessary raw resources, we expect commodity prices to reflect these changes.

The Role of Resources in the Middle East

It is precisely the role of resources that has put the disruptions in Yemen on the front page of the news in the past few weeks.  The U.S. has been conflicted in its policy towards Middle Eastern nations like Yemen—preferring the dictator we know to potentially unfriendly democratically elected governments.  Yemen has historically been a haven for terrorists, and it is also located in a highly volatile area, just southwest of Saudi Arabia.  With 10% of global oil production, any disruption in Saudi supply will have far reaching effects for the United States.  Not just gasoline but also the transportation costs for virtual every item, from food to clothing, would increase if Saudi Arabia reduced its production.  Suffice to say the tenuous economic recovery would be wiped out.

A more immediate threat for Yemen is water supply.  With one of two major pipelines already destroyed by the fighting, the country’s capacity to pump water from the aquifers has been significantly reduced.  This may be a prelude to a truly global problem as populated areas all over the world deplete their water supplies.  The current disputes over oil will be dwarfed in comparison.

Summers in Greece

Needless to say, it will be an interesting summer.  Starting with 2007 and the sub-prime collapse, each summer has brought some form of volatility and a commensurate increase in the perception of risk.  Just like 2010, we are again faced with the prospect that Europe and the Euro are going to rain on everyone’s summer vacation.  While this is old news – Greece might default on their sovereign debt – it is news yet again.

The hope was that Europe’s various institutions, from public to private, would bail out Greece long enough for it to put austerity measures in place and regain its financial footing.  For a host of reasons, from cultural to political to simple realities, that is looking dubious at the moment.  The concern is simple – if Greece does not fully pay back their debt obligations then the value of similar debt from Spain, Portugal, Italy and Ireland will decline markedly in value.  If that occurs, banks with that exposure will take a large hit to their balance sheets and place their financial solvency into jeopardy.

This is not that different from the financial crisis of 2008, when real estate backed assets were the culprit and a host of banks needed temporary capital to ride through the losses.  The differences this time, however, are notable.  The amount of Greek debt is fairly limited, the exposures are mostly known and the banks are actually generating profits.  While I don’t want to dismiss the risks, the realities are likely to be far less draconian than the predictions.

Stepping back, while the U.S. indicators are weak and there are again riots in the streets of Europe, there is little new news.  What has changed, most likely, is that the “bull” market has run out of buyers and the reality of a paradigm shift in our economy is beginning to sink in.  We have a long haul ahead of us, and no quick fix is going to shorten that road.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA
Managing Principal