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Unemployment for February – Good News, Bad News

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This morning, the government released statistics for the unemployment situation in February – a strong jobs growth of 192,000 new jobs across both the private sector and the public sector with a drop in the unemployment level to 8.9%  Yet, the market responded as if this was bad news, with a drop of 150 points on the Dow as of mid-afternoon.  Let us add a little color:

In fact, the jobs growth was exactly what economists had predicted while simultaneously predicting a steady unemployment figure.  The drop in the latter, in fact, is more driven by folks leaving the job market completely.  In effect, just giving up and either learning a new role in life or entering very early retirement  The jobs growth over the past few months is not enough to both repair the economy and accommodate folks just entering the work force for the first time.  We are slipping in this task – not gaining ground.

The second bit of news is the wage growth figure, which remained flat for February at $22.87/hour.  That is bad news, because of increases in the real costs of living.  While core inflation may be tame, things like oil and gasoline are going up quickly with the events in the Middle East.  This is very bad news – especially for folks on fixed wages or in retirement.  If there isn’t a correction in energy prices, the economy could be at risk of stalling.

So again we have to wait and see if there really is a strong recovery taking hold, if we’re just treading water, or if we are on the edge of another slide downwards.  It wouldn’t be a hard slide like 2008, but it would be enough to truly discourage folks.

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

Ben Bernanke ready to act if Economy weakens further

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This week was full of economic data releases as well as some comments about the economy from the Federal Reserve Chairman, Ben Bernanke. To start the week, we had existing and new home sales fall well short of the 5 million annual run rate that was estimated.  The July 2010 sales came in at a dismal 4.11 million annual run rate, a 26% decline from the month before. Durable goods orders also missed estimates for the month of July.  It had been a bright spot in the economy but only grew 0.3% versus the estimate of 3.0%. Thursday’s initial jobless claims fell to 473k from last week’s revised 504k, although encouraging, the 4-week moving average edged up to 487k, the highest since December 2009.

Last month Q2 2010 GDP was reported at an annualized rate of 2.4%, today it was revised down to 1.6%, beating more recent estimates of 1.4%.  The markets seemed to cheer the beat since all the other economic reports were misses.  At 10:00Am today the Federal Reserve committee met in Jackson Hole, Wyoming to discuss the state of the economy. With growth being too slow and unemployment being too high, Bernanke indicated that they will provide additional monetary accommodations to make sure the economy recovers.  This sent the market up about 1% and is so far holding onto those gains.  We’ll have to wait and see what’s in store next week to determine if the market will continue its brief rally. Next week’s economic indicators include Personal Income and Spending, Chicago Purchasing Manager Index, Vehicle Sales, and the most significant of all, Change in Non-farm payrolls & the August Unemployment rate. Any surprises in the payroll report will surely increase volatility and consumer sentiment.

Economic data shows economy still struggling

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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.

Volatility Reigns for Summer 2010

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Precious Metals in the Silver Lining

On this Independence Day, when Americans headed to the ponds, lakes, oceans and mountains in search of ways to celebrate, the mood of the economy and financial markets was far from celebratory. In summary, we again have had another “worst.” This time it was the worst May since 1962 with an overall decline year to date of -6.65% and a decline of -14% from the S&P500’s high for the year. In a year that was supposed to continue the march of “return to even” from the lows of 2008, we are again faced with the prospect of a losing market.

Fortunately, the story is far more mixed than the pessimism currently portrays. For each of the negative economic data hitting the headlines there is a very distinct and measurable silver lining, most easily seen in the housing and employment figures.

Housing starts for June were 593,000, down 60% from their peak in 2007: This is an abysmal figure, indicating the lack of jobs in construction and all the consumer markets that go along with new homes. Yet this level is not sustainable long-term. To accommodate population growth and regular demolition of existing homes, we need a rate of roughly 1,500,000 starts. At the current level, we will be facing a housing shortage at some point. When and how that unfolds is debatable. Yet housing will see a strong rebound based on the basics of supply and demand providing relief to the largest and most depressed asset class for Americans.

Employment levels, at 58.5%, are at their lowest level in 25 years and declining: The lasting effects on America will be profound. (Note we are using employment statistics, which are far more reliable than unemployment reporting). The last time we saw these levels of employment, women had far fewer options in the workplace leading to a lower structural full employment level. Today, more women than men are employed. America has changed – and it will take at least a decade for the new dynamic to be fully absorbed.

The silver lining to the employment figures is corporate profitability. Companies are leaner, more able to survive on a lower revenue base and poised for tremendous profitability as the economy eases out of the recession. Companies have also been accumulating cash at startling proportions. Whether it is Apple and their $30B hoard or GE’s $70B, firms are finding ways to become self-sustaining in the face of an uncertain market. As long as one chooses wisely and is accepting of elevated volatility, this all points to some potentially strong equity returns on individual firms in the near term.

Elevated Volatility

The reality of the current stock market is that these are pretty decent levels to be investing in stocks. Companies such as Alcoa trade at one-fourth of their pre-crash market value despite profit margins that are better than ever. For Alcoa we now need for aluminum demand to increase – a forecast that changes daily with government policies from China to Australia.

The issue at hand is volatility. With volatility comes fear. And with fear comes risk aversion. The flash crash of May 6 was a rude awakening to many. The collapse of the value of BP has sent shock-waves throughout the global markets. Economic headlines are touting the risks of further collapse (I read one recent prediction for Dow 900 – that’s not a typo). Europe is a mess. The news has generated a self-fulfilling feedback loop of volatility and decline. Until these markets settle, it is possible that we will see another 10% drop or more in the S&P 500.

A very simple explanation for this volatility is a lack of buyers. In any market, there must be depth of both buyers and sellers to support asset levels. As I talk with institutional money managers around the US, the plan is the same: accumulate cash and wait for the volatility to decline. Recent headlines echo this sentiment. If the long-term buyers are not buying, then that leaves the short-term and high-frequency traders to dominate the daily trading volume. Quick in, quicker out.

While this trend will eventually revert back to the norm, with long-term buyers investing back into the equity markets, it could be weeks or months until we see it happen on a sustained basis.

Investment Direction

We have peaked in our cash accumulation. We sold off half the equity exposure early in the year and allowed cash to accumulate from bond maturities and calls. With an overweight of bonds for the year, upwards of 50% in many cases, our income has remained stable and mitigated any volatility in the portfolio from our equity exposure.

This posture, however, is temporary. While it is a nice thought to sit in cash and bonds for the rest of the year it does expose us to the risk of missing out on a substantial economic recovery. Additionally, a recovery would lead to higher inflation and rising interest rates, which would erode the value of a cash position and depress bond prices.

We will be reinvesting some of the cash this quarter in a few select companies. Characteristics that we are looking for are a strong long-term valuation, a solid cash flow base, significant dividend payments, and balance sheet stability.

Beyond individual firms, we will also be reintroducing exposure to emerging markets. Specifically, we have highlighted Asia as our primary investment focus on an international basis. This deliberately ignores Europe for a host of reasons related to growth, veers away from Latin America (at least temporarily) because of their heavy reliance on commodity prices, and India (namely due to a lack of understanding of the social situation).

Within Asia, we look at countries that will benefit from the rise of China while avoiding their inherent politic uncertainties. Namely, South Korea and Thailand are both in our short-term highlights for reasons unique to each (we will have further research available on each country). To augment the country exposure, we will also incorporate additional commodity exposures to capture the move to electric production and other infrastructure trends as China attempts to urbanize the population at a rate that is equivalent to building two New York Cities each year. The lone cost of replicating the Yankees may bankrupt that trend…

Hope everyone is able to stay cool in this heat, or has found a nice escape.

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

Another Ugly Month

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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