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The Torch Is Lit

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It has been our practice to send out quarterly market updates, but given the anxiety about the economy, we are breaking practice and sending out more regular updates. As a quick aside, our portfolios in July remained relatively neutral showing us that the global economy still has strength even in the midst of a bear market. While there are certainly more surprises hiding in the dark corners of the market, we think we have seen the worse and are now focused on the timing of a recovery, whether it be months or years from now.

Ironically, the quadrennial event that starts this evening provides a useful analogy for our general economic condition. As the world turns its telescopic lens on Beijing for the Olympics, we are given a unique view into China and their economy. At once memorable, starting on auspicious 08.08.08, and controversial, the torch coming in on a tide of protests; the Games are a chance for China to fashion itself a new world image and lay bare its strength and weaknesses.

What China is experiencing economically can be seen as a microcosm of the conditions the global economy is struggling with. Intense inflation has pushed the consumer price index to over 7% in the first half of the year, making it hard for the country’s population to purchase necessities. Pollution, one of the worst in the world, has induced the government to take extreme measures to clear the sky for the Olympics. Half of all cars in Beijing have been ordered off the roads in the weeks leading up to the opening ceremony and rainmaking rockets have been utilized to clear away the smog. All this to no avail-the skies are still heavy with the weight of pollution. Oil supply is a major concern for China as it is for the rest of the world and the Chinese government has resorted to hoarding oil to ensure a steady supply when it takes center stage.

The Games are a source of pride for any host country, for any country sending a delegation for that matter. For the Chinese especially, it is a time to show the world that it has progressed socially, politically, and economically-all areas that would help the global economy as well as their own. We eagerly await the Games of the XXIX Olympiad.

As with the Chinese, the themes of inflation, pollution and energy dominate our thoughts as well. In our quarterly market update, we spoke of how these forces, combined with a housing collapse, came together to create the perfect economic storm. We believe that that storm has raged its worst and is now showing signs of abating.

Housing Market

The first force is the plight of the housing market. We have discussed extensively the short-term causes and long-term effects of the flawed subprime lending practices that has mired the housing market in foreclosures and defaults. The effects of these practices have rippled through the financial industry and have affected institutions that had little to do with the subprime collapse. As these institutions work to correct themselves, there are signs that the housing market is stabilizing, even strengthening in affluent communities. Weaknesses are still evident in developments and low-income housing and will take many years to recover; but, at the very least, the horizon looks a whole lot brighter.

Unfortunately, the two Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, are the latest casualties of the real estate collapse. While they did not extensively engage in subprime lending (by definition, subprime is a loan that does meet the standards of the two GSEs), the follow-on effects of the subprime collapse have driven up defaults on all types of mortgages. As a result, both GSEs are now projecting enormous losses that could jeopardize their capital base.

Historically, neither GSE has maintained high capital under the belief that the US government can provide emergency backing. That belief is now being tested. Our opinion is that both GSEs will survive intact with the need for a government infusion in the form of common or preferred stock purchases. While the final amount will be minor given the government’s other obligations and the prospect eventual profit from this infusion, it will lead to significant changes in the way they are regulated in the future.

Economic Downturn

The second force is a general economic malaise exasperated by a disastrous deficit, the weakening dollar, and rising inflation. Out-of-control governmental spending for the last eight years has detrimentally slowed our growth and contributed to the decline of the dollar. With a total debt approaching $10 trillion, we have spent our savings for at least a generation. Generating enormous interest costs and driving down the value of the dollar, Americans are paying more and getting less.

The Federal Reserve aggressively cut interest rates seven times since the end of 2007 bringing it down from 5.25% to 2%. But now the Fed is in a quandary. Its primary policymaking tool has not been able to spur the US out of an economic downturn despite the fact that interest rates are at a three-year low. Inflation, however, has risen to 4.1% in the last year, the largest rate in 17 years. Herein lays the problem-interest rates are decreased to stimulate growth, but increased to battle inflation. The Fed is, in essence, immobilized in an economic Catch-22 and hard pressed to choose a solution. Its decision then is to hold steady at 2% with the likelihood that it will not change interest rates if the economy continues as it has.

The Price of Oil

The third force is the omnipresent price of oil. After hitting record highs this summer at $147 per barrel, oil prices have dropped to a three-month low in August at $118. It is still undetermined whether this is merely a short respite or an indicator that oil prices will return to what has been deemed as normal. The hope is that the price of oil will stabilize around this level, but anything short of the sharp rise from the past two years will be a relief.

Alternative energy is painting the town green. Or maybe just a patina of green. Everywhere from politics to even oil companies, green is the catchphrase that lends a sense of conscientious credibility. The push for fuel-mileage regulation is gaining momentum in Congress as the US flounders for a solution to its energy crisis. Perhaps soaring oil prices have finally been able to imprint into our national consciousness the need for sustainable energy. Automakers are already feeling added pressure to meet the demand for more gas-efficient vehicles and Americans are driving on average 4% fewer miles since the onslaught of the oil price increase. Given that Americans account for 11% of global consumption, this is a significant decrease and a sure sign that good consumer behavior can positively affect global oil demand.

Change on the Horizon

The most important change about to occur, and frankly one that we desperately need, is the Presidential administration. As the race moves forth towards the national conventions, economic concerns top the agenda for Barack Obama and John McCain. Neither candidate has an economic platform that truly addresses the situation-all of the economic stimulus packages to date are little more than crowd pleasers. We hope that behind closed doors it is a conversation about changing the shortsighted, destructive policies of the past eight years. We will look for sound, long-term economic policies that emphasize sustainability and global responsibility. While this is an extremely tall order, we are optimistic that any change will help the situation.

To conclude, we have a guarded, yet optimistic outlook for the coming months. We view oil prices and the housing market as the keys to eventual recovery and will closely monitor them. Throughout this entire process, our investment strategy remains the same-careful and adaptive selection of equities and fixed income with an emphasis on cash flow. As the clouds begin to clear, we will stay in regular contact regarding any changes or fluctuations.

As always, feel free to call or email us with your thoughts.

Regards,

David

The Perfect Storm

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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

The Waiting Game

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As you have read, heard, and seen in hundreds of headlines and news clips, it has been a troubling year in the markets thus far. From the viewpoint of the general stock market, it was a tough quarter. The S&P500 lost nearly 10%, and down much more earlier in the quarter – a bad downturn, but we’ve seen worse. If you look at volatility, by one measure this was the most volatile market since 1938 when measured by the number of days in which the market was up or down by at least 1%. But on another level that we cannot quantify, we had many ingredients that could have led to a complete meltdown in the financial system.

As you will read in this update, there were some important counter-forces that prevented this scenario, but the confluence of events is alarming. Fortunately, I think the worst is behind us now.

To summarize:

It all starts with real estate. We are in the midst of the worst housing correction since the 1980s and perhaps far beyond. Housing prices have declined by as much as 30% in some markets, erasing over three years of house price appreciation. While some of the decline is cyclical in nature, the largest driver is the aggressive and sloppy lending practices of the banks originating the loans.

From these sour real estate assets, the global banks have reported losses of roughly $200 billion in just a few months, mainly driven by the subprime lending market. These loans were extended to folks with marginal credit and overvalued houses. To make the payments palatable for the borrower and attractive to the lender, most of these loans were structured with rapidly inflating payments. This structure, combined with the cyclical decline in real estate values, has led to a vicious circle of declining values and defaulted loans.

Exacerbating the situation, the subprime loans were sliced, diced and spun into a wide range of financial products used by institutions around the globe. Because of this financial engineering and sloppy rating practices, a number of these new products were classified as “safe” investments with AAA ratings. They were in fact illiquid and subject to steep losses.

These events led to the collapse of one financial insurance company (ACA Financial) and jeopardized the health of several others. The financial insurance companies were mainly engaged in the business of insuring municipal bonds in the event that a town or municipality defaults. Unfortunately, these same companies also insured some of the new subprime-backed financial instruments. As those instruments start to fail, so goes the capital of these insurance companies. In an overreaction to the situation, the market started to view any municipal bond with insurance as risky, even though municipal bonds are historically very safe and insurance is a recent addition.

The culmination of these circumstances led to the freezing of the credit markets. In short, banks and institutions refuse to trade bonds with each other. Starting with corporate bonds, then municipal bonds, then basically any bond that isn’t a US Treasury Bond, the market eventually said, “no way, not today.” If you’ve got bonds – you are stuck with them. On the other hand, if you willing to buy bonds, there are some great bargains to be found.

A freeze of the credit markets is akin to playing with fire in a refinery. Not a good idea. Fortunately, the Fed had some inkling of what was about to happen, and took a series of aggressive measures to avoid the obvious. They instituted four new lending facilities for banks followed by the purchase of Bear Stearns’ ailing mortgage debt, effectively dousing the entire financial system in a blanket of fire retardant foam. Not a promise of ultimate safety, but as close as we can get to one.

Oh, and did I mention that we’re in a recession? Of all the stuff going on, this is the least worrisome of the issues. Recessions happen – it is a part of the business cycle. Frankly, we’re in a good position to recover in a timely manner. While the economic recovery may not occur as fast as some would like, we will get back to economic expansion.

These events have had a profound effect on the markets. First, the equity market continued a decline that began last fall. Dropping another 9.5%, the market is skirting on bear market territory. While the downside may be limited now, the US equity markets will likely bump along for some time until there is certainty around corporate earnings and economic growth. By lowering our equity exposure last fall and early in the quarter, we have buffered ourselves from much of this volatility.

The larger problem has been the impact of the credit markets on our holdings. Some of you are already aware of these issues, but many of our bonds and preferred stock holdings have been priced at a discount because of illiquid markets and unusual pricing. We have responded in a number of ways. In some instances we have sold out of the highest-grade debt to take advantage of the high prices we can get for such instruments. In other cases, we have purchased debt and preferred stock with steep discounts and high yields. The risk here is the underlying credit – the company’s ability to remain a solid firm – placing emphasis on our analysis of the company and understanding of the debt structure.

For fixed income securities, we have been loading up on discounted bonds and preferred stock that will pay interest or dividends of seven to 14% for anywhere from a few months to 15 years. In all of these cases, we have been purchasing the debt of high quality firms with solid credit ratings and ample ability to cover their obligations. The availability of such high yields when treasury rates are so low is a by-product of the market’s aversion to any form of risk, no matter how slight it may be.

For stocks, we have followed our tried and true approach – buy value-based companies at low prices. Firms such as GE, J&J, CSX, FedEx and United Technologies constitute the core of our equity holdings. Other firms, such as Apple and Alnylam, have gone out and come back into some portfolio as we sold at peaks and bought at valleys. In such a volatile market, these opportunities abound. It is our job to find them.

In this next quarter, we are still in a wait-and-see posture. The first three weeks have been very positive, with some bond markets regaining their equilibrium and US stocks showing respectable gains. We expect the equity markets to slowly move off their bottom with the possibility of additional volatility. As volatility subsides, the perception of risk will also subside leading investors to slowly come back into the debt and equity markets. Combined with the Fed’s monetary actions and the stimulus package, we expect the economy to slowly stabilize as well.

Our research and investment focus will swing towards global commodity prices and the impact it will have on the basics such as food. Furthermore, water is increasingly becoming a scarce resource across the globe, a situation that will factor heavily into food prices. We have already incorporated these views into our portfolio with investments in companies such as GE and baskets of alternative energy stocks. Expect to see further investments of these types in the coming months.

As usual, please call with questions, comments, or the like. Also visit our retooled website with an updated look and new research.

Enjoy the spring,

David