Posts

Market Update – February 2011

/2 Comments/in /by

Revolts in the Air – Looking for Progress

Well, 2011 has started off with a bang of sorts. The Internet has finally caught up to the developing world of autocrats and dictators. The leaders of Egypt, who reportedly have never written an email, were ousted by a youth movement harnessing the power of social networking. Not that the events have created any progress in that country – it is still run by the military and the constitution is now suspended – but change creates opportunity. And that change is trying to propagate throughout the Middle East. Our hope is that this change creates real progress. Unfortunately, history bodes otherwise.

As we look to the US and our little corner of the global economy, things have gotten a bit brighter during the past few months despite the blanket of snow covering my backyard. Or at least, that is what we are led to believe by the financial news. We’re not as bright on the news. As you’ll read below, we are of the same perspective from the past few quarters: the economic damage from the events of 2008 is going to take us years and possibly a decade to correct. Do not expect that all will be resolved quickly – do expect more volatility.

The Key Factors – Unemployment, Inflation and Real Estate

As you can see from the chart below, our employment level in the US has remained at rock
bottom for many months now despite the “good news” that unemployment dropped to 9.0% last month. The disparity in these facts has to do with the way that unemployment is calculated,
which masks the true numbers. Unemployment claims each week are still at exceedingly high levels, roughly 400,000 depending on the week. But the anomaly is that fewer people are actually in the workforce. Due to months and years of being out of work, folks stop looking and simply don’t get counted. The number of folks who have dropped out of the labor force over the past year is roughly equal to the number of new jobs. No change, no progress.

Combine that fact with regular population growth, and we are backsliding each month when we don’t have substantial jobs growth. January was no exception – 37,000 jobs growth in non-farm payrolls is nothing against the needs of a larger population. The problem grows, not improves.

A stagnant and immobile labor force leads to a tightening of the qualified labor pool, and hence our second concern for the current economy – inflationary pressures. Inflation is the silent erosion of future purchasing power. In a simplistic sense, you need to grow your assets and income at the rate of inflation to keep your standard of living. It seems like a simple task when inflation is typically 2-3% per year, but not so quickly. An ongoing study by Crescent Research points out that real growth in the stock market (gains from price changes and dividends, less inflation and taxes) is often flat or negative when viewed over a 20-year investment period. This data places a severe challenge to the notion of buy-and-hold equities to safely grow your portfolio.

Unemployment Index

Given where we stand today, we believe that inflation is prepared to once again enter us into a period of negative real growth if portfolios are not properly hedged. The factors are all present:

  • The Fed has again entered a period of loose monetary policy: near-zero short-term interest rates and massive amounts of liquidity infusion through the Quantitative Easing program.
  • Energy and food prices are escalating at a rapid clip due to global factors: namely general population and income growth in developing markets and failed harvests from the effects of climate change.
  • A tightening labor pool.

But wait, you say. A tightening labor pool? I thought we just established that people need jobs? In fact, the unemployment situation will factor heavily into the inflation problem because of the lack of mobile, qualified professionals and skilled workers. Those folks who are falling out of the job hunt are often times permanently out of the labor market. Skills degrade, their ongoing training is limited and they find ways to adapt to life without permanent employment. With many of these folks out of the competitive labor pool, you have rising labor costs as firms compete for the fewer qualified candidates.

Adding to the problem is the real estate market. Prices are still down 30% across the country from their highs in 2007 and back to 2003 levels. A third to half of all mortgages are under water, with no short-term prospects of improving. The only way to move is to hope for a short-sale or some other concession from the bank and torch your credit report. Yet the jobs have moved on, to other industries in other regions or in other countries. We have severely limited the portability of the labor pool even as they seek new jobs created by advancements in American productivity and innovation. In short, a tighter labor pool for those firms who are looking to hire skilled workers and professionals.

Contributing to the problem are the banks, those bastions of capitalism who create the efficiencies for our economy to prosper (if you listen to Jamie Dimon and a host of other bank executives). Talk to anyone who has applied for a mortgage of late, and you get an interesting mix of dismay, disgust and a desire to disembowel. With Bank of America/Merrill Lynch losing billions each quarter, they are not exactly inclined to lend money even if they have a claim on your first-born. They’re just trying to survive and justify their next engorged bonus. In the mean time important segments of the economy are starved for credit, the fuel for growth.

So we are left with an interesting mix of circumstances. All the monetary factors are present for inflation, raw commodities are in tight supply, and the labor pool is tightening. Yet, these same factors lead to tougher circumstances for many Americans – fewer jobs, higher costs for daily living, and a dramatic loss of family wealth from market volatility and decimated real estate values.

Companies are Profitable – Why Worry?

Not surprising, companies in the US are doing pretty well. They have managed to keep costs down considerably (lower payrolls is a big start), gained in production efficiencies and have learned to serve a global market. Most companies have beaten earnings projections for the past quarter (which makes one suspect of earnings projections). The stock market is doing well. Corporate bond spreads are very tight, a market belief of nominal credit risk in these firms. Apple has a cash balance larger than most economies. Life is good for the big firms. Life is even good for some of the smaller firms. So what is the worry?

The worry is around tensions. We have created an untenable situation – one that cannot last more than a few years at the current pace. The most obvious tension is the US government debt. Our receipts as a percentage of GDP have fallen dramatically in the recession, by over 20%. Yet government spending, and the annual deficit, continues to grow. From the trillions spent on defense and wars during the Bush administration, to the ongoing state aid in the Obama administration, we are running up the credit card balance. And unless the entitlement programs (Social Security, Medicare and Medicaid) are harnessed and tempered, it will get worse, not better.

That spending has caught up in a dramatic fashion. As Tim Geithner, Secretary of the Treasury
quietly noted in front of Congress, annual debt service will soon be 73% of the annual deficit. Simply put, we will spend a half-trillion dollars a year to keep current with our national credit card bill (kindly issued to us by the First National People’s Bank of China). And that teaser rate is about to expire. Interest rates are going up, slowly, and for every few basis points increase in the cost of borrowing for the US government, the interest costs go up by billions. Not a pretty picture for a consumer who is still shopping at the Blue Light Special on that same credit card.

Municipal Bonds – Another Ratings Game

We are seeing the first signs of this problem in the municipal bond market. Muni bonds, for anyone who has been following, took a drumming in the last half of 2010 despite every other asset class doing well. The problem is state budgets. States have run out of money, and some will face impossible decisions on budget cuts. Remember that in 2010 there was Federal Stimulus money to help cover their deficits – no longer the case in 2011. That means a host of issues for cities, towns and municipalities who depend on the states. Some of these entities might fail – some of their bonds might go into default. One of the most conservative, risk-free, stable asset classes is headed for a Lehman moment.

Analysis: Muni Bond Market from the view of an Institutional Trader

AAA Muni historical spread

This first chart shows the historical spread between the Generic U.S. Treasury 10-year yield and the Generic General Obligation AAA Municipal Bond 10-year yield (in Bloomberg speak: 049M10Y Index USGG10YR Index HS). The top chart shows the two rates going back to early 2006: Treasuries being the orange line and munis the white line. The bottom chart shows the difference in the two rates, with green indicating munis trading at a lower yield than Treasuries, and red is when they reverse. The top chart is measured in percentage points – the bottom chart is in basis points (100 basis points = 1 percentage point).

Back in the day (pre-summer 2007 when the sub-prime crisis began) AAA-muni’s typically yielded 1% less than Treasuries to account for their tax benefits, inferring that their credit risks were effectively the same. This relationship was broken during the crisis, and while the market attempted to restore the relationship in early 2010, it again fell apart at the end of the year. Today, AAA-munis and Treasuries yield approximately the same rate, despite the wide disparity in tax treatment and after-tax yields.

BBB Muni

This second chart shows the same data for the Generic BBB G.O. Municipal Bond yield compared to the Generic U.S. Treasury 10-year yield (Bloomberg: 631M10Y Index USGG10YR Index HS). Note that, as in the previous chart, back in the day BBB-munis had a lower yield than Treasuries by roughly 0.6%. This wasn’t as large as the 1% difference between AAA-munis and Treasuries, but still reflected an institutional trader’s view of them as a “safe” tax-free asset class warranting the lower returns.

Today, BBB muni yields have shot straight through Treasury yields by 1.5% (and peaked at 4.1% in March 2009), indicating a relatively risky asset class despite the tax benefits. Compared to a history of zero losses from defaults (as far as I’m aware), the institutional market has effectively established this as the next crisis asset class, and doubts the validity of the AAA ratings as seen in the first HS chart. Remember that once upon a time, a whole market existed for AAA-rated sub-prime CDOs, many of which trade near zero today. Lesson learned: don’t rely on the credit rating agencies to spot the next crisis.

Next… Patience

Where this goes next, we cannot predict. But in the big picture we need time to heal, with a bit of additional carnage along the way. Our feeling is that the stock market rally is another bubble, inflated by a cycling of asset classes. As an investor over the past few months, there are few places to invest and gain yield. Short-term debt is paying next to nothing (thank you, Fed), risky debt is just that, municipal bonds look like the next crisis, and people feel like they need to restore their 401k plan now. So what-the-hey, let’s get into the stock market! In short, a predictable outcome from the Fed’s policies – create some sense of calm by inflating the one asset class that everyone understands and can play through their web browser.

With all this in mind, our investment direction for 2011 has some of the same from 2010 along with a few new twists. We are maintaining an underexposure to equities in general, and will do so for the foreseeable future. Those equities that we do hold have a handful of important characteristics:

  • The ability to increase cash flow to shareholders in the event of strong inflation. High current dividend yield is an immediate indicator – strong cash flow is an intermediate indicator – and correct market/global positioning is the final indicator.
  • Revenue base that is global. Most of the firms that we hold have at least 50% of their revenues from overseas, and we look for those firms that are able to tap into emerging markets as well. This helps us hedge against a weaker dollar and a weak domestic economy.
  • Lower volatility in the event of a market dislocation. We do expect for increased market volatility, of the sort that we saw in the Flash Crash. Firms with currently low betas that tend to be less volatile are a start, those with stable cash flows augment the approach.

We expect for there to be continued uncertainty in the emerging markets as they grapple with inflation in many cases, and political instability in others. While we currently do not hold an emerging markets exposure, we consider it important to long-term growth in the portfolios. Entry points will be determined by specific events and inevitable market over-reaction.

The remainder of the portfolio is split between alternatives (namely commodities), fixed-to-floating rate corporate bonds, floating rate corporate bonds, and inflation-indexed US Treasuries. The mix will depend on available inventory, current pricing and individual risk profiles. Some interesting opportunities may also arise in the municipal bond market with any volatility or capitulation due to credit defaults.

Irrespective of the actual asset class or security, we will look for the opportunity to generate income to portfolio irrespective of the market conditions and in several cases use the asset to hedge against elevated inflation in the coming years.

Until our next market update, let’s hope that these markets sort themselves out in an orderly fashion and the snow gets a chance to melt. (I think our recycling bins are still buried out there somewhere!)

Regards,

David B. Matias, CPA
Managing Principal

The Summer of ’09

/0 Comments/in /by

What a summer this has been. One of the old sayings in money management, “sell in May and go away,” infers that the summer months are either slow and lackluster, or market losers. Not in 2009. Since the early spring lows, the market is up 48%, or 11% for the year to date. So what is happening here?

In full disclosure, I don’t think that I have a compelling explanation for this rally. The economic news is still pretty dismal when you look at it from afar. Our unemployment rate is climbing towards 10%, home prices are so far depressed that you had to purchase a home at least five years ago for a fighting chance of gains, and global banks are still reporting losses in the tens of billions of dollars. Let me parse these events with a bit of commentary.

A week ago brought some of the first good unemployment news in a while – the loss of only 247,000 jobs in July accompanied by a decrease in the overall unemployment rate. The good news is simple: rather than losing 500,000 jobs each month, we’ve cut the losses in half. A good start, but still not growth. The drop in the unemployment rate is more of a record keeping anomaly – folks are simply giving up on their job search, while many simply are not counted, such as recent college graduates. The relief is palatable. We can see the potential for an end, but as the Obama Administration continues to reiterate, unemployment will soon pass 10% as the employed population creeps closer to half of all eligible Americans from its current level of 57%.

Housing numbers were encouraging this past month with a main price index, S&P Case-Schiller, reporting that overall prices increased in the month of May. As I reported in my last update, we are seeing a trend to the bottoming of the real estate market. But once again, the data is misleading. Many cities are still in decline, and in fact the index shows a national decline when calculated on a seasonally adjusted basis. As with the employment picture, this is not a recovery but rather another month of less bad stuff.

Not until people have jobs and real estate values begin to appreciate again will we have a true growth scenario, a situation in which firms can begin to generate consistent earnings and the economy expands. This is evidenced by the banking sector. The headlines were dominated by firms such as Goldman Sachs reporting bewildering profits, but at the same time more regional banks are failing each week. Some of these failures are tiny but others encompass deposits in the billions of dollars. While these are mostly insured losses, nonetheless it is a strain on depositors and the FDIC. In addition, global consumer banks are taking further write-downs in the billions in anticipation of rising commercial loan, residential mortgage and credit card defaults.

This is not intended as a doom and gloom analysis, but rather a reality check. The year to date has certainly been a series of positive steps forward, but the pace and length of these steps is metered. It is my expectation that we still have many quarters until the global economy has repaired itself to levels prior to the financial and real estate crises. During this time the risks will be many, the most important of which is that the economy takes a turn for the worse. While I don’t see this as a likely scenario it could be triggered by a series of unexpected events ranging from international conflict to a series of miscalculations by bank executives.

Stealth Erosion from Inflation

In all likelihood the economy will continue to move forward, albeit at a stunted pace from what we experienced over the past three decades. The larger risk that we face are increases in the cost of living. Let me provide a startling example.

The decade of the 1970s is perhaps the most relevant example for our current economic condition, primed for inflation but suffering from anemic economic growth. During those ten years, the stock market had a modest but important overall increase of 75%, or 5.7% per year. The cost of everyday living, however, increased by much more – 116% or 8% per year. The disparity is disconcerting. In effect, the value of equities in America failed to beat inflation by 2.3% per year, accumulating a deficit in real growth of 26% for the decade. This current decade has been worse. Even with the current rally stocks are down 24% for the decade while inflation is up 25%. It is no wonder that folks have been in a panic. Although most cannot quote the statistics, the palpable effects on family wealth and purchasing power are very real.

Even matching inflation is not enough. In fact, capital needs to maintain some nominal real growth from year to year to account for the risks assumed by investors and the limited amount of capital that is available in the economy. Negative real returns contracts everyone’s asset base and ultimately the ability to maintain our lifestyle. While it has been generally assumed that stocks provide a solid long-term hedge against inflation, we now have two of the last four decades in which they failed to do so. Not everyone can wait another decade to make up for lost real value.

Healthcare – A Serious Matter

The situation does not get better when you factor in healthcare. The expense that we all bear to provide the current level of healthcare in the US is roughly 15-16% of our entire economic production. I heard a rumor that East Timor spends more than we do – and no one else. And it is increasing rapidly, by as much as 6% per year even when inflation is nonexistent.

And yet the metrics that measure quality, coverage and effectiveness of healthcare are not too encouraging. Tens of millions have no coverage, infant mortality is the highest of the developed countries, and healthcare expenses are the leading cause of bankruptcy. The list goes on, but the effect is the same for us. Whether we pay for it through healthcare premiums, direct expenses or in our taxes, the cost of healthcare is going to continue to erode our purchasing power and ability to maintain a stable quality of life.

While I want to avoid making any political statements, the current healthcare debate is the single most important set of policy decisions that will be made in this lifetime. As you peel back the onion, the issues are complex and the solution is subtle. Profit is good. It motivates firms and individuals to invest capital. But profit in the healthcare system represents a quarter of all healthcare expenses. We all want to receive the best care and live as long as possible, yet end of life care represents a wildly disproportionate share of all expenses. Medicare is extremely important to elder care, yet is easily manipulated by doctors and hospitals for personal gain. The list goes on, but the message is the same. We need a coherent and informed discussion at all levels to tackle the most expensive problem we have ever faced as a nation.

The End of Summer

As the summer months draw to a close, we look forward to slow but important changes in our economy. With the fall will come partial resolution to the current economic crisis. Some of our global trade partners have already exited the recession, and we may soon follow. The healthcare policy debate will likely reach the floor of Congress for a definitive vote. The globe’s hotspots, Afghanistan, Iraq and Iran, will each move closer to crisis or calm. And our financial markets, the most informed and dynamic collection of information in the history of mankind, will digest all these developments.

It is an exciting time for us at Vodia as we position the portfolios for these changes. It’s also a pivotal time in America, and a fearful one for those who take comfort in the status quo.

Regards,

David B. Matias, CPA

A Year Never To Forget

/0 Comments/in /by

There isn’t much that I need to say to emphasize just how bad this year was in the financial markets. The world went through a capitulation, and in that process all the cracks and flaws within the financial system were exposed. From dismal company 401(k) performance to the complete collapse of hundreds of hedge funds, we learned first-hand that we need to focus on the basics.

For comparative purposes:

  • The US equity markets lost 37% as measured by the S&P 500 stocks
  • The European markets lost 42%
  • The Asian markets lost up to 68%
  • Once again, US stock mutual funds lost more than the overall market. In many cases the losses approached 50% (such as Fidelity’s Magellan Fund)
  • TIAA-CREF’s managed equity funds lost 35-40%. These are supposed to be well-managed long-term retirement funds
  • Investment in Commodities such as energy, metals and agricultural lost 46% • Investments in Corporate Grade bonds stayed flat
  • Investments in Corporate Grade preferred stock lost 32%
  • Investments in US Treasuries gained over 10% – the sole bright spot last year

I point all this out to make a few points:

1. Our financial system has for years encouraged people to use mutual funds and corporate 401(k) as methods to invest for retirement and diversify our risk. For those who followed this approach, they witnessed a loss of nearly half their investments. This is an astounding depletion of value, at exactly the wrong time as the country heads into a prolonged recession and enormous job losses.

a. I have for years been a staunch opponent of mutual funds for their lack of true diversification combined with elevated fees, both disclosed and hidden. With the stresses and dislocation we’ve seen this year, these flaws came to the forefront. Most funds lost more than the market this year – at a time when risk mitigation was critical to preserving family wealth.
b. The tax benefits of deferred tax accounts are dubious at best. Placing money pre-tax into a 401(k) makes certain assumptions regarding tax burdens in retirement and the benefits of growth of pre-tax assets. With such an enormous national debt generating in the past eight years and the manner in which income is progressively taxed, it is possible that the tax benefits of deferred accounts won’t exist.
c. Firms such as Fidelity are going to have much to answer to the investing public and lawmakers as they try to explain why so much of America’s retirement savings was wiped out in a single year.

2. There was no place to hide in the markets. The traditional notion of diversification did not work, such as international versus domestic investing. Any exposure to any risk results in enormous losses. Even the sole winner, Treasuries, has likely formed a bubble and could fall quickly in 2009. That, combined with the prospect of long-term inflation would make investing in the sole winning asset class of 2008 a risky and speculative investment in 2009.

3. Cash is Always king. I have used this mantra as cornerstone of our investment philosophy, and it is true now more than ever. Whether it is the cash flow off an investment (such as dividends or interest payments), or the cash flow going to the corporation, it is the first determinant in our investment approach.

Economic and Market View for 2009

By every measure, we are in a tough economic environment. Unemployment, the primary measure of a growing economy, is headed towards a 10% level – higher than we have seen in a generation. While the Obama stimulus plan could eventually generate the number of jobs that he is projecting, it will be at a steep cost. This cost will be in terms of an enormous budget deficit and a strong potential for dollar devaluation. The only mitigating factor helping the dollar is that every major economy across the globe is facing similar issues. It is a matter of who will recover first and at what cost.

The markets, however, will advance prior to the recovery in the market. Any sign that the worst is over will generate significant inflows into the general equity markets. The bond markets are already going through a rapid recovery: high-grade corporate bonds (AA and above) have rallied to pre-crash levels, many other investment grade corporate bonds have shown a similar recovery and preferred stock are showing strength as well.

The long-term prognosis for the US is difficult to determine. Unfortunately, it will largely rest on the incoming Administration and their policies, both domestic and foreign. Through years of indulgence and short sighted (aka greedy) policies, we have gutted the core of America. Our auto industry is in need of a shot of arsenic, we have exported a large part of our manufacturing base, and our primary growth industry – financial services – is in risk of permanent impairment. We need to find innovation, productivity and vision.

The good news is that we have an incoming Administration that is addressing these very issues. Alternative energy, energy independence and the related innovation will be a crucial first step in these policies. America’s focus on savings and breaking the addiction with consumption are the other necessary steps. Frankly, as a consumer-oriented society we need to go on a 5-step recovery program and stay in that support group for some time to come. The recovery will bring a good amount of pain, and we’ll be prone to frequent relapses if the entire situation is sugar coated.

While it may sound like doom and gloom, as are still the leading innovators of the world, with our research institutions and entrepreneurialism unlike anything in the history of civilization. Most of our institutions will survive, including the corporations that produce good stuff and have strong intellectual property. The ones who produce poor goods and don’t innovate (i.e. the auto industry) are going to ultimately fail, or at the least be unrecognizable in the future. Those in between will struggle to find their place in the next economy.

Portfolio Positioning

At Vodia we had a number of successes and failures during 2008, the most destructive of which was the government take-over of the GSEs, Fannie Mae in our case (I am still pissed-off at the Treasury for this one). But to our credit, we also took many steps in advance of this crisis: we realized some impressive gains earlier in the year, we were already positioned with low equity exposure, our cash positions were high, we avoided the emerging markets and commodities collapses, and most of our investments were based on strong cash flows.

As a result, we were able to reduce the damage by half, give or take depending on your risk profile and account specifics. This is great news. With a horde of cash to invest at this market bottom and the prospects of an eventual recovery we are well positioned going forward, we can ride up with the markets at an accelerated pace, making back any losses and then some as the recovery takes hold.

For 2009, we are repositioning the portfolio as follows:

  • We have increased equity exposures over 2008’s lows. While we are not going to our long-term equity allocation level, we have found a mid-point between the low equity allocation from 2008 and your long-term target. We will be reassessing this exposure as more economic news unfolds, with the eventual goal of reaching long-term levels when we feel that the downside risks have mitigated.
  • To increase the equity allocation, we have used a combination of individual companies as well as a non-US ETF that is a composite of the global equity markets. This allows us to hedge against a declining dollar while gaining exposure to the world’s recovery.
  • Our focus will continue to be on health care, manufacturing, global sustainability and technology
  • We have been using corporate bonds as well, to take advantage of the greater yields (as high as 10%) with the protection of asset securitization and blanket liens against corporate assets. Many of these instruments have variable interest rates dependent on metrics such as yield curve steepness and inflation.
  • We have introduced a small level of commodities into many of the portfolios. With energy going through a bubble-burst, and the long-prospect for global population growth, we believe that commodities such as oil, metals and agriculture represent a solid lower-risk long-term investment.
  • Our cash positions will still remain elevated as we hunt for additional opportunities.

As usual, please call or write with questions or comments. A detailed performance report will be emailed or mailed separately. We also have our annually updated Form ADV available in print and electronic version. Feel free to write clemail@vodiacapital.com or call 978/318-0900 for a copy of it. Best wishes for a healthy winter, David B. Matias, CPA

Best wishes for a healthy winter,

David B. Matias, CPA

The Perfect Storm

/0 Comments/in /by

There is nothing pretty about the past three months. While the positives regarding the global economy remain, such as growing populations, growing demand and a phenomenal explosion around international trade, the US has entered the witching hour. Namely, our economy here has been battered by three concurrent forces that are creating what may prove to be the perfect storm.

The first of these factors is the ever-present subprime debacle. I have already explained this in length, but it is worth noting the situation in review and how it is still affecting us today. With grossly overinflated home prices and a lending practice that placed unrealistic demands on borrowers in a declining home price environment, the mortgage industry created an explosion of defaults and foreclosures during the first half of this year. The effects have been felt globally since these mortgages were repackaged into supposedly safe investments and placed into everything from bank portfolios to money market funds. To date, the reported losses by the financial institutions related to these subprime securities have reached $400 billion, and could still be climbing by some estimates.

The effects of the subprime debacle that we are still feeling are quite pervasive. In the US, it has accelerated foreclosures in many situations where it would not have occurred under normal circumstances, even with declining real estate prices. And second, it has erased the profits of the financial sector, dragging down the overall equity markets. Third, with so many aftershocks past and present, the bond markets are still reeling; and in the case of municipal bonds, go through fits and spasms, eek out some gains, only to be gripped by another seizure when more bad news is revealed.

This in itself would be enough to cause tremendous distress in the financial markets as we have seen starting exactly a year ago this month. The conventional belief just two months ago was that these issues would work through the system in time and after a correction in the markets we would resume with growth in the markets and economy, albeit anemic for some time to come.

Now enter factor two. While it may seem more like an inconvenience than a financial crisis, the US government deficit has grown astronomically during the past eight years (yes – read, Republican out-of-control spending). The effect has been singularly devastating-the rapid decline of the value of the US dollar. From 2001 to today, the dollar has lost over half its value and the decline could continue. I’ve been writing about this topic for four years now as a priority for our political and economic policies. Unfortunately, we are now here.

The follow-on effects are pervasive. In a simplistic view, it makes it more expensive to purchase international goods or to travel abroad. The opposing argument, that our manufactured goods are now cheaper and more attractive stimulates the US economy, is true to some extent. The larger issue is that we import far more than we export, including the bulk of our energy needs and many raw materials.

And now the third factor and the great behemoth that pervades our headlines: the price of oil. Unfortunately, or perhaps fortunately, oil is traded in US dollars. And we buy a lot of oil from overseas. For our cars alone, we spend $1.3 billion dollars a day on oil to convert to gasoline, more than half of which comes from overseas. Because of growing demand from growing economies such as China and India and the deteriorated value of the dollar, we are spending twice as much for our foreign energy sources than we did just two years ago. Viola – inflation.

So we have a dismal real estate market with increasing foreclosures, the prospect of real inflation for some time to come, and a recession that would have been a slowdown if it were not for these factors. Put it all together, and you have one of the worse financial markets that we have seen in decades.

That is the bad news. The good news is that our world is about to change. Gone for good is the era of cheap gasoline, and good riddance. While we may feel the enormous pinch today, the impact of the mighty buck will accelerate changes that have been needed for quite some time. Americans are driving fewer miles (by close to 10% according to some estimates), SUVs are no longer in demand, and energy conservation in every aspect of life is on the tips of EVERYONE’s tongue. These are good changes. We will use less, we will waste less, carbon emissions will decline, and in the long run we will be a more efficient and conscientious society.

While it would have been nice to do this at our own pace and in our own time, that luxury has been squandered. The time is now, and the pace is immediate-at least as immediate as humanly possible.

Going Forward

Prospects for the remainder of the year are a haze for all. We have officially entered a bear market, with the major US indices down 20% from their highs. The question is, do we recover to close out the year where we began (our initial forecast), or do we continue a decline and remain in this quagmire. In either case, it could be at least two years before we revisit a bull market with annually rising values. For the immediate term, we are waiting to see and gathering as much information as possible. The primary factor we’re watching is the price of oil: if oil remains stable or declines, then we will make it through this in short order; if oil continues its rise, then I fear the bear market will deepen.

Our investments have continued to emphasize the same principles we have held for the past few years – cash generation augmented by well-researched growth opportunities focused around technology and demographic changes. While we performed extremely well in the months of April and May, June was the worst month on record, leading to an overall loss for the quarter. Surprisingly (or maybe not, given the market), it was our cash generation portion of the portfolio that suffered the most, from stable defensive stocks such at United Technologies and GE to very high income, tax-efficient global preferred stock.

Our approach to weather this storm is going to be grounded in the fundamentals. Historically, even stronger bull markets follow bear markets, placing tremendous emphasis on riding this out while positioning ourselves for the recovery. While it is tricky to predict the bottom of the market, it is important to look for buying opportunities on undervalued equities and hold onto those positions that will survive and ultimately thrive in the next cycle.

Reports regarding your individual accounts will be going out in the coming week, with a brief analysis of what worked and didn’t work for the year to date. Depending on your investment profile, we may include research notes on companies that we are strongly considering as we look to boost equity positions in the coming months. As always, please write, call or simply stop by with questions and concerns.

Best wishes for an enjoyable 4th,

David