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Market Update: October 2014

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It certainly was an interesting summer. From the Gaza strip through the Middle East and into the Ukraine, the global political landscape was rife with challenges and dilemmas. We look around the globe, and we see societies facing change on a scale that is unprecedented. While the financial ramifications are uncertain, we know that change is scary, and it is hard to predict who the clear winners will be, if there are any at all.

Against this backdrop, the financial markets have done… nothing. U.S. equities tried for a correction in early August, only to be stymied by reluctant buying two weeks later. Since then, the U.S. equity markets have progressed a couple of percentage points, but that gain has been tenuous as we saw last week.

The lack of strength across equities is notable. The large cap industrial index (Dow Industrials 30) has gained 4.6% this year against the S&P 500’s broader base with an 8.3% gain. [Note: The Dow has just 30 stocks in it and misses some key sectors that the S&P 500 represents with its 500 largest cap stocks.] But outside the U.S., the rest of the developed markets (namely Japan, The U.K., France, Switzerland and Germany) are flat for the year, kept out of the negative only by the dividends they generate. Their performance is anemic compared to the U.S. markets, and U.S. bonds have fared respectably at 4.0%.

Equities

As we have seen many times in the past, an extended bull market leads to some pretty odd behavior. Market bubbles, irrational exuberance, rising tides raising all boats: whatever you might be tempted to call these supposedly serendipitous trends, they have more to do with Fed policies than anything with financial fundamentals or dumb luck. We are seeing stock prices continue to climb in every situation, with individual companies getting valuations that induce acrophobia.

Amazon, one of the world’s largest online retailers, has yet to generate a consistent profit, but trades at a $150 billion valuation. On the other hand, Alibaba, which does generate a profit by selling just about everything online to everyone around the world, went public and pocketed $25 billion for its owners/investors; it now trades at 38-times the estimated earnings. Keep in mind that during the last equity bubble, Amazon hit a market capitalization high of $36 billion. Alibaba is now worth $220 billion.

The troubling aspect of the Alibaba IPO is the use of cash. When a company raises equity capital, such as with an IPO, it is generally expected that a large chunk of the new funds are used by the company while key investors are required to hold their stock for an extended period of time. This prevents the “pump and dump” incentive from those promoting the company to line their pockets at the expense of new investors. With Alibaba, up to half of the $25 billion that was raised in this IPO is going straight into the pocket of owners and past investors with no lockup period. The last time something this extreme happened during a bull market was the IPO of Blackstone. Back in 2007, they raised over $4.1 billion and the owners/investors were allowed to cash out immediately. That IPO coincided exactly with the top of the equity markets in 2007, and IPO investors have yet to see any gain on their investment after seven years.

But for all the crazy hype, the stock market has not gotten so out of hand that a correction would be as devastating as what we saw in 1999, when tech stocks lost 80% of their total value. As a reference point, the S&P500 is now trading at 18x earnings, which is notably above the historical average of 15x, but nothing close to the 30x that we saw in past bubbles.

October: image1

Chart 1. Year-to-date performance of three major indices without dividends (S&P500 in green, Dow in blue, and EAFE in orange) shows significant divergence and points to the sluggish nature of equity returns. Dividends are the only thing that keeps the EAFE (Europe, Asia and Far East developed) index positive.

This market rationality is seen in the way that individual sectors of the S&P have moved. Technology shares are doing well, but high-risk, nominal profit companies have fared poorly this year as investors shun the exuberant behavior of the past. In fact, the Russell 2000 (a small cap index) is down -4.4% for the year, as opposed to Healthcare being up 16.5% this year to date. These numbers are a far cry from 1999 and the dot-com bubble, when serious economists were predicting Dow 50,000].

Fixed Income

A big challenge we might face is the fixed income market. The “bubble” factors are fairly stark. The Fed has kept interest rates below historical norms for years now, with short-term rates near zero and 10-year rates barely above inflation. The inference is bleak if you invest in a safe, secure instrument now, you will lose out to inflation. Putting money away guarantees that you’ll lose purchasing power.

That dynamic has led to reduced bond rates across every bond class as investors chase returns, and inflated bond prices are a result. The hope is that the bond market is able to absorb any movement in interest rates without creating any significant disruption. The actual unwinding of the monetary stimulus by the Fed and a return to conventional interest rate structures could be far messier.

Another issue we face today is the changing bond market. Unlike stocks, which are relatively uniform (everyone knows what a share of Apple stock represents), bonds have thousands of different structures. The number of active CUSIPS (a unique identifier for each security) vastly differs between stocks and bonds: there are 18,000 active U.S. common stock CUSIPs, versus millions of active bond CUSIPs. To make the point even clearer, the total value of the top 500 stocks represents nearly 80% of public US companies. You would need tens of hundreds of bond issues to match that number in bonds.

Bonds trade in a very complicated manner as well. Unlike stocks, which have several electronic markets that are synchronized and relatively uniform, the bond market has fewer market makers with less inventory today, and trades are often completed with a phone call – how old-fashioned! With a total market cap that is significantly larger than the stock market, any sizable disruption to the bond market could result in mayhem. [On a side note: the departure last week of a key manager from PIMCO, the largest bond manager in the U.S., caused Treasury prices to drop. While he was an important figure in the building of PIMCO, it is disconcerting to think that one person in the private sector can influence the bond market that much.]

Because of such a disparate market, individual investors and advisors rarely use individual bonds in portfolios, and instead rely on mutual funds and exchange-traded funds. These funds need to reflect the market price of bonds each day, even if the bonds won’t sell for many years. As a result, public bond fund pricing can be far more volatile than the value of the underlying assets, which we have seen can lead to redemptions and selling into an already thin market. Such activity could make for the perfect storm for an asset devaluation.

There are many ways to mitigate these risks in individual portfolios (start by using individual bonds and sticking to known risks), but many institutions will be affected differently based on how they use bond investing. For those who are “hold-to-maturity,” it would take a major disruption in the economy, with significant bond defaults, to impair portfolio values.

Most institutional investors, however, do not have the luxury to look past current prices and plan for the long-term hold. They must mark their portfolios each day, reflecting “market” prices that are often grossly misaligned with asset value. The ramifications can be disastrous, as we saw in 2008, when the marks on mortgage products brought many institutions to failure. This is not a prediction of what is to come, but rather an outline of the concerns that are shaking the markets right now.

Economic Overview

The other factors we focus on have maintained a steady state these past three months. Labor force participation rates are still at historic lows, making unemployment numbers look quite good despite anemic job growth. While the number of people filing for unemployment continues to drop, the workforce itself remains at levels we haven’t seen in decades, harking back to the period when women began to enter the workforce. As I have emphasized for many quarters, the quality of our job growth is poor. The U.S. economy has not brought folks back into the workforce from the recession, and many of the jobs that we do create have relatively stagnant wages. The dynamic creates further strain on the divergent social classes in America, while slowing down economic growth.

October14 - image2

Chart 2. Workforce participation rates sit under 63% of the population, the lowest that is has been since women started to enter the workforce in historically large numbers. This trend undermines the notion that jobs growth in America is strong.

While slow, GDP growth in the U.S. does appears to be steady, in spite of the stalling economy we saw this past winter. The slow growth in Europe, combined with perceived weakness across the emerging market economies, has resulted in the U.S. looking like it is still the best place for equity investors. As I noted, the U.S. equity markets have substantially outperformed global markets, a trend that is interestingly based on this divergent economic picture.

The final piece of domestic activity that I closely monitor is real estate, which provided so many jobs in the last economic expansion. For good or bad, we are seeing slow but steady improvement in the housing sector, but not the sort of expansion necessary for stimulated economic growth. As an example, new home sales grew this summer to over 504,000 per year. This is a seemingly strong figure. That number, however, is less than half of where we were in 2005 when the real estate sector generated over 1,200,000 new single family home sales a year, even though our economy is 11% larger today. This might be good news, but we have a long way to go before the sector drives the economy forward.

Our view, whether looking at global politics, domestic wealth inequality, or equity market growth, is that we are facing a continued period of substantial change. The instability triggered by the global economic collapse in 2008 has not ended, and what we are experiencing right now is still based on extreme measures by central banks. When the global economy does eventually find its long-term footing, we will see a very different dynamic and balance of powers than we have ever seen. It is the change that creates panic, and so we at Vodia, focus our energies not only on the financial risks that are created by this change but the irrational market behavior it triggers.

All the best for an enjoyable fall.

Regards,

David B. Matias, CPA

Managing Principal

 

 

Market Update: July 2014

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If you’ve seen the news over the past two weeks, you’ll have noticed there is much joy in the U.S. financial picture. The Dow has reached an all-time high of 17,000, unemployment dropped again in June to 6.1% after 280,000 new jobs were created, and fear levels, as measured by the various “fear indices,” are at lows that have not been seen more than once a decade. Stocks are up another 8% for this year, on top of last year’s meteoric rise, and bonds, which were assumed to be poised for a significant decline, are, in fact, up this year by 4%. There is no shortage of good news when it comes to investing.

The risks and realities, however, are very different. The U.S. economy actually contracted, for the first part of this year; long-term unemployment is still at levels never seen in the modern U.S. economy; and the level of global conflict has risen to a level not seen since the 1970s. Globally, sustained growth is still in doubt: Europe has still failed to extract itself from a recession and risks deflation, Asia is looking for that “soft landing” of slowing the asset bubbles without cratering the economy, and wealth inequality is beyond comprehension.

We are in fact, looking at a tale of two minds. One mind believes in the ability of stocks to rise in any situation; the other mind is on constant alert for the next set of bad news that could impact the global balance.

If we stick to home, and take a closer look at the U.S. economy, we can get a better picture of how the goods news we are used to seeing in asset prices is still ahead of the good news we need about overall economic recovery.

 

All major asset classes have shown similar growth in 2014 thus far, indicating a “risk-on” market mentality as investors seek returns through greater risk taking. While not matching last year’s performance in equities, the consistency of returns in unique.

All major asset classes have shown similar growth in 2014 thus far, indicating a “risk-on” market mentality as investors seek returns through greater risk taking. While not matching last year’s performance in equities, the consistency of returns in unique.

 

Markets – Equities

On the bright side, markets continue their rise after a rocky start to the year. Last year’s meteoric upswing in equities was quickly met with a harsh pause in January, as stock prices closed out that month down 6%. What could have been a further rout of markets was, it appears, a retesting of market levels and a chance for some to take risk off the table. With the market more than doubling since the lows of 2009, it is not unusual for an entire group of investors to take a breather and turn those gains into cash thereby protecting themselves again sudden declines.

By the end of Q1, the markets regained their equilibrium, and demonstrated a slight gain for the year. That gain of just a few percent was tenuous for the next few weeks until May and June, when equities reached new highs and are now posting 8% gains for the S&P 500.

Interestingly, in this rally, the gains have been in the larger valuation companies, not growth firms. Specifically, large and mid-cap value companies have gained 8% and 11% respectively, while small-caps are doing only a fraction of that at 2-4%. This difference reflects an interesting change from the dot-com rally of the 1990s – investors are looking for some substantiation of the company’s stock price, not just a whiff of promise that the firm might make enormous profits later. Although this is not a strict trend, it points to some sanity in the current rally.

Markets – Fixed Income

As opposed to stocks, whose rise was almost universally projected at the beginning of the year – albeit to varying degrees – bonds were supposed to fall. I did not read a single prediction that bonds would rise in 2014; naysayers pointed to the Fed’s reduction in quantitative easing and rising interest rates. Instead, rates have stayed level or gone down, with bonds up across the board.

While the average bond market return of 4% YTD (8% annualized) is impressive in any environment, the composition is even more interesting. High-yield bonds (non-investment grade corporates), have some of the lowest spreads to treasuries in recent history, posting a 5.5% gain for the year, while thirty-year U.S. treasuries posted a 14% gain this year. The compression of spreads on high-yield is an indicator of the continued economic recovery, amid predictions that corporate defaults will be extremely low. These phenomena are consistent with the complacency we have seen in the equity markets. The explanation I’ve heard on the treasuries is a little more complicated, but in short, there are simply not enough bonds to go around. Institutional investors, who need these risk-free bonds to hedge portfolios and meet investment mandates, demand them while the available supply dwindles.

All these dynamics are reflective of the accommodative monetary policies of our central bank, the Fed, as well as the global central banks. The Fed grew their balance sheet by $3.5 trillion from 2008 to today – all of that representing “new money” in the banking system. Around the globe, the figures are similar in size. From that new money, and the Fed’s use of it to purchase bonds in the market, we have seen rates down and prices up.

The downside of this stimulus is difficult to predict. The Fed will stop printing new money in the fall, as anticipated, yet we have not seen any of the market reaction that we might have expected. Notably, inflation has remained negligible. The fear four years ago was that inflation would run to extreme levels and hamper the recovery; now, we are now faced with the opposite problem. We need some inflation to stimulate consumption (encouraging buyers today, when things are less expensive), yet global developed markets have seen flat prices and the US inflation index is under 2%.

The immediate impact is on retirement planning. In effect, if you wish to invest your money risk- free for the next ten years, the spread between income and inflation is nearly zero. Your money, in terms of real dollars, will not grow. This can have a potentially devastating impact over the coming years as the economy returns to historical averages for these measures. Namely, some areas of price inflation hit ordinary people very hard – food prices, for example. In fact, food prices have risen steadily over the past few years with some basics, such as meats, seeing 15-20% annual price increases. Yet food is not counted in the inflation gauge (called non-core CPI), and hence we are left to feel the impact without acknowledging the problem.

Economy

The perverse dynamic of inflation is best understood in the context of the jobs market. As we continue to remind folks, the measure of jobs health used by the media is misleading. Unemployment does not reflect the jobs participation rate, ignoring those who have simply left the market. Instead, we look at total employment as a percent of the population, as you’ll see below. While the trend has been encouraging, it shows only marginal improvement from the end of the recession five years ago.

An equally disturbing trend is the long-term unemployed. As you can see from the chart below, those unemployed for 27 weeks or longer as a portion of the total unemployed population spiked to levels never seen before. And while the trend has brought that level down from 1-in-2 unemployed to 1-in-3, it is still well above historical levels.

 

Long-term unemployed (27 weeks or greater) as a percentage of total unemployed. We reached levels (45%) double the long-term average, and have not employed most of these workers in the recovery thus far. While the level has dropped to 33%, we still have an unprecedented problem.

Long-term unemployed (27 weeks or greater) as a percentage of total unemployed. We reached levels (45%) double the long-term average, and have not employed most of these workers in the recovery thus far. While the level has dropped to 33%, we still have an unprecedented problem.

 

The impact is devastating on the economy and on people. There has been a wave of forced retirees, folks who were at the prime of their career with vast experience and education who simply cannot find suitable work. This has also fed the inflation dynamic mentioned above – people are unwilling to switch jobs for fear of losing theirs. With fewer employed folks job-hunting, this puts a damper on wage increase and ultimately lowers the cost of labor for firms. Labor costs, being one of the major components of inflation, have helped to tamper inflation as measured by the government. Yet, while wages remain flat, basic costs such as food and fuel continue to rise, creating an impact on Americans’ daily lives.

As we look at the other aspects of the U.S. economy, the message is equally mixed. We are seeing a renaissance in energy, with U.S. reserves and production of natural gas and crude exceeding even the wildest estimates from just five years ago. Yet energy prices continue to climb as global conflict creates uncertainty and the cost of refining keeps prices high on gasoline and heating oil.

Another paradoxical phenomenon is general economic growth. Consumer confidence, the general measure of how likely people are going to spend, is back to its long-term average and touching levels not seen since the Great Recession began. Yet, GDP, the measure of production, and by inference, consumption, contracted in the first quarter by -2.9%, again the first time since the Great Recession ended. Although much of that contraction has been blamed on the bitter winter, it is still a reduction in the economy that requires a steep recovery.

 

GDP quarter-over-quarter annualized change from 2000-2014. While we have shown steady growth since 2009, Q1 saw a -3% decline. Q2 numbers, due out shortly, will test the assumption of a sustained economic recovery.

GDP quarter-over-quarter annualized change from 2000-2014. While we have shown steady growth since 2009, Q1 saw a -3% decline. Q2 numbers, due out shortly, will test the assumption of a sustained economic recovery.

 

Global Conflict and Perception

One of my earliest lessons learned as a student of international relations was the damning relationship between the economy and global conflict. As discussed in the Wall Street Journal (“An Arc of Instability Unseen Since the ‘70s,” July 14, 2014), we are facing the most challenging set of circumstances we have witnessed since the late 1970s and the height of the Cold War. There are two civil wars that have the potential to spill over into U.S. interests (Syria and Iraq); Afghanistan is facing an electoral crisis; Russia is promoting ethnic strife in Ukraine after invading Crimea; the Israeli-Palestinian conflict is heating up with little signs of easing. In short, we are seeing some of the worst conflicts of our generation peak at roughly the same time.

[Note: This article was being finalized as a Malaysian Airlines passenger jet was shot down over the Ukraine, emphasizing just how volatile these conflicts have become]

I am loathe to make any sort of political commentary, but each and every one of these conflicts has the potential to draw the U.S. back into an armed conflict, even during a time when the US has resoundingly shown little interest in engagement. This perception – that the U.S. will not engage to resolve conflict – has created the adverse effect of increasing the belligerence of rogue actors. It is a perverse situation that echoes through the history of nation-state politics: perceived weakness breeds conflict, while the threat of might promotes peace. The impact on our economy is unmistakable. Put succinctly, what happens abroad can destroy our recovery at home.

These conflicts are developing rapidly against a backdrop of pressing global issues that are damaging our ability to grow. From climate change and viral outbreaks to food scarcity, we are facing a growing global series of challenges that will require a coordinated and intelligent response. Yet the denial is palpable. For instance, rising sea levels have put major roads in Miami under water during regular tide surges, a trend that will continue to engulf the city in sea water in the coming years. Yet real estate prices continue to climb in the city, development is robust, and elected politicians continue to deny there is a problem.

The math is undeniable: the economy will suffer and our quality of life will be threatened. To combat the rising tides in South Beach, the city of Miami has already committed $1.4 billion to shoring up the roads. That is money spent to stem a problem, money that could have been better used to invest in a technology or build up our educational system. We are increasingly short sighted as a society as the world quite literally “heats up.”

As a parting thought, I offer this last chart, which shows the fear gauge on the S&P 500, a broad measure taken from the futures market that shows how stock traders view the short-term future. A lower number indicates a perception of calm and rising markets, a higher number indicates rocky or down markets. For reference, the index bottoms out at 10 during strong bull markets, and peaks at 80 during market calamities such as 2008, with an average level of 20. In the past two weeks, VIX has hovered between 10 and 12. Perception of financial risk, at this moment in time, is the lowest it has ever been. Are we putting our heads in the sand? And what will the consequences of our denial be?

 

VIX from 1990 to 2014. At only three times in the past 24 years has the VIX reached a low of 10 – a level that shows perception of financial risk is at its lowest possible. Once in 1993, another in early 2007, and today.

VIX from 1990 to 2014. At only three times in the past 24 years has the VIX reached a low of 10 – a level that shows perception of financial risk is at its lowest possible. Once in 1993, another in early 2007, and today.

 

As I am fond of saying, perception is reality. Today, the markets perceive low risk and rising assets ahead. That perception, however, will be fragile as broader issues take root in daily life. And as perception changes, so will the financial risks that we all face.

I want investors to be aware that although some things are stabilizing, we live in destabilizing times. It is this balancing act of perception against reality that drives our portfolio composition. We have seen that managed volatility in our portfolios, while capturing growth from a variety of asset classes and strategies, leads to stable returns over the long haul. Put another way, these portfolios are designed as an all-weather strategy, a welcome approach when the line between perception and reality becomes blurred.

Rest assured that we at Vodia are keeping abreast of current issues in order to keep our investors informed and our assets as protected as possible. We remain optimistic, and realistic.

It is our job to monitor the world and manage the portfolios. It is your job to enjoy the summer.

Regards,

David B. Matias, CPA
Managing Principal

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: 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