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Market Update: October 2011

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Market Update – October 2011

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

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

Fear for Fear Itself

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

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

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

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

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

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

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

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

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

Economic Stresses

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

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

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

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

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

Rest of the World

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

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

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

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

Painful Decade or Bad Century

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

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

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

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

All the best for fall.

Regards,

David B. Matias, CPA
Managing Principal

Market Update: August 2011

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Market Update – August 2011

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

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

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

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

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

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

Downgrade

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

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

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

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

Real Growth

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

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

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

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

Shift to Market Psychology

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

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

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

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

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

Regards,

David B. Matias, CPA
Managing Principal

Market Update – June 2011

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

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

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

Revolts in the Air – Still Looking for Progress

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

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

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

U.S. Market Fundamentals

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Global Changes

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

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

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

The Role of Resources in the Middle East

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

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

Summers in Greece

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

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

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

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

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA
Managing Principal

Market Update – February 2011

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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

Good Luck, Goldilocks

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It has been over two months since my last market update and the stock market is just roaring ahead, repairing all the damage from last year’s financial collapse and indicating that the recovery is in full swing. Or is it? In fact, I feel like a backseat driver in the movie, “Thelma and Louise,” careening towards the cliff with the top down on my vintage convertible. The financial reality is that we are facing some of the greatest uncertainty seen in generations which is starkly exhibited in the markets today.

The stock market change since my last market update is a up 3.6%, not a robust return for anyone who jumped into the market this past September. Gold has beaten the living snot out of the market, up 19.5% and even TIPs are up by 3.8% (TIPs are the Treasury-Inflation Protected Securities, a safe haven that also indexes to inflation). But here is the paradox – there is no inflation and no one is predicting for strong inflation anytime soon, even though Gold and TIPs are traditionally used to hedge against inflation. The only other time there is a flight to these securities is during times of severe financial risk.

Yet the stock market shows no such signs of financial risk. In fact, the main volatility indicator for the stock market, the VIX, touched a low of 20.05 last month, the lowest point we have seen since August of 2008, well before the collapse of Lehman. In a nutshell, the stock market is plunking along as if all is fine in the world while traditional safe havens are seeing enormous inflows of cash. Where is this split view coming from, and what does it mean for the next few months and years?

These stark numbers were reported by Bloomberg last week. In November, the rate on 3-month treasuries went to zero (it even went negative for a brief moment) while the equity indicators are showing minimal risks after a 25% gain this year. This has happened once before in modern financial history. It was 1938: the stock market had gained 25% that year and short-term Treasuries were yielding 0.05% (read: 5/100 of one percent). For the next three years starting in 1939, the stock market lost one-third of its value. Is this where we are headed next? Maybe – it all depends on whether policy makers can get it right this time.

Economy

The biggest battle that the financial markets will face is the improvement of the economy. Almost 70% of our Gross Domestic Product depends on the consumer – their ability to spend money on everything from gel toothpaste to plasma TVs. This consumption has been driven by two factors, disposable income from earnings and the ability to borrow. A key impetus to spurring consumption was home growth – the purchase of a new, larger home and all the items needed to fill that home. Yet today, in every aspect of this dynamic, we are hurting.

The housing market is in the toilet for a while longer. Prices have increased for the past few months, but have done nothing to repair the enormous loss of home value and home equity. As reported last week by the Wall Street Journal, one-in-four homes are underwater (worth less than their combined mortgages) and 5.3 million homeowners are more than 20% underwater. While this collapse has headlined the news for two years now, the reality is that we have many more years before the residential real estate market again becomes an impetus for growth.

Credit is declining commensurate with these events. Credit card reform legislation takes effect in February, and already banks are increasing rates and limiting lines to “buffer” themselves against the changes (in fact, this is an egregious abuse of their banking privileges to be discussed in another article). Combined with the current job market and mortgage delinquencies, it will be years before the consumer credit market again extends credit to consumers to fuel consumption. In fact, expect to see major lenders from Bank of America to Capital One suffer enormous credit losses in the coming year, well beyond their current projections.

Jobs are scarce, and growing scarcer. The “official” unemployment rate has passed 10% this year, months earlier than expected. And while layoffs continue at a clip of over 500,000 per week, the creation of new jobs is stagnant. The reality is that employers are finding ways to do more with fewer employees, and this trend shows signs of continuing. At the current trajectory, we will soon hit an employment level of 57%. That is, roughly 1-in-2 working age Americans are working. That compares to 2-in-3 during a robust economy. The last time we saw these levels was in the 1970s, when far fewer women viewed career as a viable option. For the first time ever, more women than men now have jobs.

(As side note from December 4: this morning’s unemployment figures show an improvement for November. While this could be an encouraging sign, I suspect there is a distortion in the figures that would be revised in January. I don’t believe this marks a sudden change in the employment scene.)

Policy Makers

Simply put, the Great Recession is here and the damage will be felt for years to come. In my view, it will be a decade before we see a return to “normal.” America needs to find a new source of growth. The consumer is not in a position to be the growth driver this time around. They are overextended on credit, underwater on their home, underemployed as a family, and wondering what happened to their 401k plan. In short, things are tough.

For the interim, the government has filled this void. With spending measured in the hundreds of billions of future tax dollars, cheap capital is flowing into the markets. This may in part explain the run-up in equities earlier this year, and the current bubble in gold and other assets. But it also explains the dramatic losses in the value of the dollar as a currency and the rush to inflation-hedging securities. Fiscal stimulus can be a zero-sum gain if not managed well, with future generations holding the “tax bag.”

Back to our parallel crisis in the late 1930s: In response to the situation, the government tightened monetary policy for fear of inflation, with the hopes of stemming it before inflation dramatically eroded the dollar. Turns out that was a bad move – leading to a double-dip economy as inflation never materialized. They may have succeeded in one aspect, but killing off the economy was not the intention.

Ironically, Bernanke did his graduate work on the Depression making him one of the best candidates to take us through this economy. He has repeatedly asserted that monetary policy will remain loose for the next six months, if not longer, allowing for the economy to mend. Many of the current policy makers have also attested to the fact that they can remove the stimulus and tighten policy before inflation roars back – sort of like Goldilocks and her “not too hot, not too cold” foray into culinary arts. The other prospect is that Congress now wants a hand in this process – if that comes to fruition then it might be time to pack you bags.

In the end, it comes down to human judgment. If the Fed gets it right, all is ok. But if they get it wrong, we face two detrimental scenarios – either a stagnant economy or hyper-inflation. Remember these are some of the same folks who thought it would be ok to let Lehman fail (in case you missed it, that was an “oops”). While they will be employing some of the best minds at solving this conundrum, we think it prudent to assume that they won’t get it quite right.

Regards,

David B. Matias, CPA

The Summer of ’09

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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

January’s Whipsaw and Relief

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From a contrarian’s view, January was both an abysmal month and a month of promise. Let me start with the abysmal. For the month, US equities were down 8.5%, one of the worst Januarys on record and one of the worst months period. One recently published statistic stated that 80% of the time that January is down, the market is down for the entire year. And the other 20% ain’t so good anyway. Doom and gloom.

To continue the bad news, we learned that the economy shrank significantly in December and home prices were in the toilet again in November. That, added to the horrifying losses by the banks in the fourth quarter does make one wonder when it will end. Of course, destroying general sentiment is the disclosure that in 2008 the major banks spent nearly $20 billion on bonuses while they lost tens of billions more. And I thought that my younger sister has a sense of entitlement! Seems that the bankers don’t get it either. Similar to how the three Detroit auto executives flew in three separate corporate jets to ask Washington for help, the egos running corporate America haven’t seen the writing on the wall.

As the contrarian, let me parse the news into a reality check. To start we knew that November was going to be a bad month for housing – no one could get a loan. And to that end, we knew that December was an awful month for the economy – just look around. In short, much of this is old news being recycled in an official capacity, which now sets expectations for the future. As a society people are incredibly myopic in their expectations: it is no wonder that doom and gloom is the standard in the New Year. Studies have shown that investors use the experiences of the past 30 days as four-fifths of their reference points in setting expectation for the next 30 days. Our sense of history is amazingly short, and when it comes to exuberance or fear, we often allow the tail to wag the dog.

Range-Bound

The most reported aspect of January was the performance of the equity markets. When viewed in the context of a “range-bound” market, January’s performance was actually well within expectations. If you look at the range of movement in the S&P 500 over the past four months, the length of the current market crisis, each month the S&P touched a low point during the middle of the month and then rallied during the last few days. January was the exception to this pattern, where the market failed to rally on the last two days of the month, closing near the month’s low.

Put another way, the market was at this same low each month, but you never saw that level on your statements since it didn’t coincide with the month-close. January did close at the low-point, making it look far worse in comparison. In addition, the media fixates on month-end figures making the hype all that more intense.

In fact, the market has been moving within a well defined high and low point for four months now, or trading within a “range.” It has not broken out of that range, either on the high side or low side, during this time. This is both good and bad news. The good news is that the market has not gotten any worse during this period, but conversely it has not gotten any better.

What has improved, however are the “fear statistics” that we closely follow. Two primary gauges, the implied volatility of the S&P futures (VIX) and the actual standard deviation of daily movements in the index have both dropped by half during this period. While we are still double levels seen during stable markets, we have significantly retreated from the hysteria of a market in collapse.

Another sign of improvement is the bond market. During the past two months, investment grade corporate bonds have shown dramatic improvement in price and liquidity. During the past three months, this market is up by nearly 20% with an enormous flow of new debt offerings coming into the market in January. In fact, while January was one of the best months ever for new debt issuances, the appetite of the market was insatiable – even more debt could have been issued.

Getting Better, Not Great

My message is simple, while this in the economy is pretty bleak, a lot of this news relates to damage that has already occurred. We believe that a “recovery” is still many months if not quarters away, but a bottoming of the economy may be taking hold right now. The evidence for this is in the market, as we’re seeing both a range-bound equity market that has not broken any new lows and a bond market that is as hot as ever. Again, it will be years until the equity markets recover their full value but the prospects to halt the losses is compelling as we look forward to how and when the recovery will take hold.

I have deliberately not commented on the Obama stimulus and bank rescue packages since the details are still being formed and the rumor mill is running overtime. I will add this commentary in my next update, eagerly looking forward to the details of the most important legislation in 80 years.

With only five weeks of winter left, I wish you all a healthy and happy February,

David B. Matias, CPA