Rising Fears of Recession
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Hi Folks,
Click Here for a recent article by the New York Times about the current economic conditions and the possibility of another recession.
Regards,
David
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Market Update: August 2011
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 Snapshot – Volatility is Back
Market Snapshot – August 5, 2011
Volatility is Back
Not unlike the summer of 2010 (or the summer of 2009, or 2008, or 2007), we have seen the markets go back onto the roller coaster. While the reasons are disconcerting, and the prognosis is still uncertain, we are well positioned to ride through the volatility. In a brief snapshot of events this week:
- The broader U.S. market lost all of the gains for the year and slipped into negative territory. When this “slip” occurred on Thursday, it helped to fuel an extensive sell-off late in the day, resulting in nearly a 5% drop by closing.
- Bond prices have mostly held steady. Investment grade bonds are up, while high-yield markets have shown a little slippage. Nothing to cause a disruption in either direction, except for the temporary spike in Treasury prices and the commensurate drop in rates to extreme lows.
- Gold screams ahead – a traditional safe haven.
- Individual stock prices have shown more volatility than the index. Basic names such as Dow are getting hammered, while Apple has retained its short-term gains based on their recent earnings release.
- The S&P is trading at 12-times projected earnings, well below the historical mean of 16x.
The roots of these events, however, are not so obvious:
- The debt-ceiling debate, while resolved for the time being, did serious damage to the national psyche.
- The debt reduction measures, incorporated into the debt-ceiling legislation, will reduce our overall productions by 1-2% per year based on estimates.
- GDP growth in the first half of the year was anemic (<1%).
- All combined there is a real possibility that we could enter a recession again.
Through all this, we have not heard from the Federal Reserve Bank. While Congress is unable to discuss any stimulus given the political climate, the Fed is free to act independently. Most likely, if there is a serious threat of a double-dip recession they will again act to inflate asset prices through a variation of QE2.
Our portfolios have fared well in this environment. We took several steps over the past three weeks to hedge against this situation: raising cash, lowering equities and selling potentially volatile bonds. All of these steps are important to buffer against losses and now we are well positioned to increase positions at some very attractive prices. The challenge, of course, is to find the bargains that will retain long-term value.
Our work continues. But in the interim, I want to emphasize that we have stayed ahead of this correction while keeping options open to us.
Please write or call with questions.
Regards,
David
David B. Matias, CPA
Managing Pricipal
Vodia Capital
Economic data shows economy still struggling
Economic reports due out this week include new and existing housing starts, durable goods orders, and the revised estimate to Q2 2010 GDP. Housing sales will show about a 12% drop from June 2010 as the housing credits are now fully out of the system and natural market forces are coming back into play. The annual unit sales rate will come in close to 5 million, the lowest since March 2009. One bright spot remaining in the economy is durable goods which should show an increase of 3% compared to June. Friday’s GDP report will show the economy grew at a 1.4% annual pace, much less than the 2.4% that was estimated just a month ago. This new information is probably the reason why Federal Reserve Chairman Ben Bernanke has stated that they will reinvest payments on their mortgage holdings back into long-term treasuries.
The economy continues to show both strengths and weaknesses, which is probably why the VIX is still elevated and the treasury yields are so low right now. People are confused and the conflicting data isn’t helping to ease their fears of another drop in the market. Uncertainty in the economy is still a large factor and until there is clarity, there will be more volatility.
Craft Brewers and the Economy
As an avid home-brewer and beer drinker I wanted to share a few articles and some insight into the craft beer industry. Historically, the beer industry has been labeled recession proof because people drink when they have money and they drink more when they don’t. This time appears to be a little different as the total U.S. beer market actually declined 2.9% in overall sales volume. The one bright spot for the industry has been the craft breweries that had a 9.0% increase in total volume sales. In 2009 craft brewers made up about 7.2% of total industry volume compared to 5.9% in 2008. That doesn’t sound like much but it is a 22% increase year over year. Companies like Boston Beer Company, Sierra Nevada, and Dogfish Head are beneficiaries(and some of my favorite brews) of this trend. Our Senators are even looking at ways to reduce taxes on smaller breweries. The larger brewers are now developing plans to either start buying some of the smaller companies or re-branding some of their current beers to look more appealing to the craft brew crowd. Michelob has come out with a handful of “craft” beers, the most popular being the Shock Top. They did such a good job branding this beer you wouldn’t even know it was Michelob unless you checked the small label.
So why are craft breweries making a comeback and why are they appealing to consumers? I think part of it goes all the way back to prohibition when many of the breweries closed down, effectively strangling the U.S. beer industry. The industry was then dominated by a few very large corporations that formulated their beer to be enjoyable by the masses and not necessarily to the individual. Starting in the late 1970’s and early 1980’s smaller breweries started opening up in response to the bland beer and lack of choice. Today, a beer culture is starting to emerge the same way it did for wine many years ago. Craft brewers and micro-brewers are making all different types of beers and beer aficionados and connoisseurs are becoming more common. Whether you’re looking for a ridiculously hoppy beer or a fruity lambic, you can almost find any ingredient in beer these days. So raise your glass and have a craft beer, all while helping the economy. Cheers!
Marcus Green
Disclaimer: This post does not intend to constitute legal, tax, securities, investment advice, or an opinion regarding the appropriateness of any investment presented. It is not the intent to promote mis-use of alcohol, alcoholism, binge drinking or any other form of alcohol abuse.
Another Ugly Month
February was an ugly month, and the first week of March was just as bad. This commentary addresses both the current state of the economy and the market movements over the past month. Keep in mind that the market, in its ever evolving hunt for profits, is typically six months ahead of the economy. Put another way, the market will recover as soon as there are signs that the economy shows early indications of mending, no matter how subtle they may be.
Economic Recession
What started as a mild recession in the spring of 2008 has turned into a mess, to quote just a few. The starkest result of this economic stalling is the steady rise in unemployment. Last week’s figures showed that another 651,000 non-farm jobs were lost in February. That creates a total unemployment level of 12.5 million people or 8.1%, the highest level since the early 1980s when it peaked at 10%. Interestingly, the bulk of the losses were low-wage jobs in the restaurant sector. While we are still trying to understand the ramifications of this fact, it is clear that the economy is propagating to almost every sector. Only healthcare has shown a steady increase in jobs in the private sector during the recession.
That is the worst news. Fortunately, this figure shows what has happened in the past, or a lagging indicator, and is not a leading indicator of what could happen next. While I am not overly optimistic, there are a handful of indicators that are looking up for the coming months. Although this is in no means a sign that all is getting better, it does help establish that the economy will pull out of this mess.
The largest impediment to the recovery is the status of the banking system. With most of the large banks carrying toxic assets on their balance sheets, their lending patterns have reverted to virtual non-existence. The buzz, and panic, is how the Obama Administration will deal with this. As witnessed by Japan in the 1990s, banks that simply hold on for existence become a drag on future growth, hording cash reserves and creating little credit in the economy. Dubbed “zombie banks,” the Japanese government was a main culprit in this cycle allowing the banks to operate intact whereas a complete restructuring and cleanout would have enabled the financial system to mend.
With this example looming, there has been varied calls to nationalize the “zombie banks” in the US, namely Citigroup. In such a scenario, the FDIC takes over the institution for as short as a weekend, replaces management, purges the balance sheet and re-opens a new bank based on the operational foundation of the old bank. The downside to such an event is the elimination of common stock value. The upside is a new bank and a clean slate.
While the Administration has repeatedly stated that such an event is not in their plans, it appears that the Treasury department is searching for a way to de facto nationalize the banks without eliminating shareholder value. When Treasury Secretary Geithner spoke two weeks ago and failed to elaborate on such a plan, the market went into the current tailspin. As of this writing, we are still waiting to learn how this will happen, the most critical step in the recovery of the economy.
What has ensued since Geithner’s speech is a market drop through a number of technical trading barriers. For the lay person, this means that everyone decided to sell, and no one has shown an interest in buying. Fear, panic and fear. Not a good way to build up market values. The market has dropped so far that there is no way to explain it in fundamental terms. Instead, it has been a market purely based on psychology and trading dynamics, as I’ll explain next.
Market Shorts – The Bubble of 2009
In the manner in which we as a society create investment bubbles from irrational exuberance, in everything from tulip bulbs and tech stocks to real estate, we are in the midst of a bubble on the downside, namely shorts. For the past six months, there is only one investment strategy that has consistently generated profits for folks: shorting stocks. It began with the financial service firms last year, then moved to the industrials this January, and now with healthcare in the past weeks. The market is often described as a stampeding herd, and in this case the herd is moving to short one stock class after the next.
Unfortunately, this behavior is creating a self-fulfilling prophecy. The two starkest examples are Bear Stearns and Lehman Brothers. Both of these firms were financially stable and prepared to weather the current environment. Through shorts and esoteric bets in the credit markets, the market was able to erode the confidence in these firms and precipitate their demise. With Bear Stearns, the damage was contained by a merger. Lehman Brothers, however, was not contained and spread exponentially as the Bush Administrations allowed them to fall into bankruptcy. That failure, on top of prior credit market seizures, created a complete freeze on business credit and turned a mild recession into an economic disaster.
While the real estate collapse certainly laid the groundwork for the current situation, it was a confluence of these events and more that has lead us to today. The equity markets have witnessed a decline not seen in 80 years, falling over 50% from their highs. Frankly, this sort of decline was unfathomable two years ago. In a technical sense, it appears the market meltdown has been exacerbated by the suspension of the uptick rule for stock shorts and growth of the Credit Default Swaps (CDS) market. Just a reinstatement of the uptick rule may be enough to stem the stampede of shorting and market malaise. Recent statements from Washington indicate that it may happen in the coming weeks.
To recover, we need a domino effect in reverse. We need the financial sector to recover for the markets to gain some footing. We need the real estate market to stabilize to gain confidence in the financial sector. We need foreclosures to subside and new supply to abate for the real estate market to recover. All of these events will occur, and some of them are already in the making. Foreclosures appear to be leveling off, and even declining in the past two months. That data, however, is still in the making since many lenders temporarily stalled their actitivies. We do know that new housing starts are virtually at a standstill. While we used to have 1.5 million new homes started each month, that figure has dropped to 300 thousand and has been at this level for nearly three months now. Mortgage rates are rock-bottom at rates around 5% for conforming loans. And capital is making its way into the distressed real estate markets, with investment funds buying homes off the bank balance sheets and getting families back into these homes.
The measures from the Obama Administration are designed to ensure that these improvements continue. By stemming the tide of defaulted loans, foreclosures will continue to decline. But these measures are going to take a few more months to take hold. Combined with the various stimulus packages being rolled out and the new budget that addressed many inherent flaws in American society from universal healthcare to energy conservation, we are not far off from substantive improvements in the state of the economy.
With an economy recovery will come a market recovery. And it won’t be just a little one. Based on any set of valuations you examine, we are so far below intrinsic market values it is laughable. Sadly, the current market has probably made you cry.
Investment Strategy
Our strategy has not changed. We are invested in companies and markets that have tremendous amounts of long-term value and will recovery substantially in an economic turnaround. We have also invested heavily in debt and other instruments which are providing current income, price stability, and upside appreciation.
We are still of the opinion that the equity markets are a solid place to invest for the long-term although current events have exposed a number of faults in the buy and hold strategy. Most stocks are trading below their intrinsic value – an objective assessment of the firm’s current operating profit and future growth. The challenge is to invest in companies that are not at risk of failure due to the economy, and timing those investments at or near stock lows. We believe we have identified a number of those firms, some we hold today and others we intend to purchase, but are still maintaining an underweight in equities from our long-term asset allocation target.
In the interim, that available cash is sitting in either money markets, corporate debt or structured notes, depending on the size and risk profile of the portfolio. This strategy has generated returns that range from simple asset preservation to 10% monthly gains, again depending on the tenor of the investment. As long as the credit markets are partially frozen and the equity markets gyrate we will continue to pursue this strategy with the excess cash in each portfolio.
As we see signs of a market bottom we will increase equity exposures with individual equities or ETFs as appropriate to the account. With an expectation that the market will eventually recover to the levels of 950 – 1,100 within a year (S&P 500), we expect sizable equity gains along with fixed income appreciation. The timing, of course, is the trick in both determining the entry point and realization of these gains. In both cases, we need to be patient.
Unfortunately this is not a situation that will improve in days or weeks, but months and years. We are diligently researching every corner of the market and economy to find value, predict future movements and envision an America of the future. While we are not perfect in this quest, I cannot remember a time in my life in which I believed we were in better shape to address the future as a country.
Enjoy the spring weather headed our way,
David B. Matias, CPA
The Perfect Storm
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