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Déjà vu all over again?

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Many investors who kept their portfolios in stocks throughout the financial collapse of 2008 seem to have recovered by now.

It looks as though it all worked out in the end – as long as you had the time.  The problem is that some were not so fortunate.   I can think of several people right off the top who were planning retirement in 2008 but because of the losses in their retirement plans, are still working today.  One person in particular was my neighbor who was planning on retiring when she reached 30 years of service at her company in Worcester.  She now has 37 years of service, has downsized to a new house that will shorten her commute and no plans to retire.  Her current plan of working till the end might seem a little extreme and perhaps is, but it demonstrates the extent of the trauma created by the economic collapse of 2008.

Today’s market reminds me, in some ways, of another bull market moment in 1999 when the market hit new highs.  That run culminated with what amounted to be a great opportunity to re-construct investment portfolios to best preserve the gains of the prior years.  Some did and some did not.  My conversations in 2003 with those who did not were laden with misgivings and regret.

Where do we stand today?  Could this be a moment when we should apply the lessons of history?  Or . . . is it different this time?  The recent volatility in the market suggests uncertainty.  One thing is for certain though – volatility hurts returns.  This is a great time to take a close, hard look at your investments relative to your retirement needs.

 

Dwight Davenport

Principal, Vodia Capital, LLC

The Supply Side of Oil

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After a brief rally at the end of January/beginning of February, oil prices are back at lows not seen since 2009 and the height of the Great Recession. With US production continuing to rise, now above 9 million barrels/day and storage volume at levels not seen in 80 years, the glut appears to continue.

The data behind the trend is quite interesting, however. Global production breaks down into three main groups: OPEC nations, Non-OPEC/Non-U.S., and the U.S. Of the three, only the U.S. is showing any sort of increase in production. OPEC was down slightly in February thanks to unrest in Libya and Iraq, and the Non-OPEC/Non-US figures are below 2014 levels. Note that the Saudi’s, with a third of OPEC production, is almost at full production and little room to compensate for further disruptions in the OPEC nations.

So the swing producer right now is the U.S.. Oil supply could change quickly, however, because of this. Active oil rigs in the U.S., the measure of future oil production in the US, is down by half in just a few months. With an inherent delay in production slowdown because of increased well efficiency, we won’t know the impact for many months.

And this does not take into account the impact of lower prices on demand.

It promises to be an interesting year for commodities. Oil prices are a wildly unpredictable dynamic… and one that will likely cause more disruptions in the financial markets this year.

 

David Matias

Managing Principal
Vodia Capital, LLC
 

Sources for data: Bloomberg.com and Cornerstone Analytics

Market Update: January 2015

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2014 presented a set of challenges that we have not seen in a long time. While the financial markets continue to have generally positive results, the global political situation is changing drastically. The continued dichotomy in financial returns — some markets up, others down – – is putting extreme stress on institutional money managers. In addition, the shifting fortunes of oil have changed global politics overnight, even as wealth inequality and social stresses continue to challenge our world in potentially disastrous ways.

The S&P 500 again finished the year with strong gains: 13.7% with dividends included. On top of 2013’s gains of twice that, one might think there should be little concern about markets and the ability to make money in them. Unfortunately, that is not the case. The developed markets in Europe and Asia had another year in which they vastly underperformed. In fact, both developed non-U.S. markets and emerging markets showed negative returns this year. Even within the U.S. market, performance among sectors and indices varied wildly, with the Dow lagging the S&P 500 by 4%.

Although the U.S. economy posted one of its best quarters for growth in Q3 with a 5% annual rate (the strongest in 11 years), most of the world’s major economies are shrinking, stagnant or slowing down dramatically. Europe is still in a recession; the threat of a broken Euro is being viewed as inevitable; and Japan continues to experience lost growth.

The 50% drop in oil prices over the past six months has created a geopolitical windfall for the U.S. that we could never have created on our own. Three of our major “adversaries” are reeling from the decline: half of Russia’s revenue comes from oil sales, Iran’s economy depends solely on oil, and 95% of Venezuela’s exports are oil. Each of those three countries are now forced to bargain with their U.S. surrogates as they face economic collapse. Even the renewal of diplomatic relations between the U.S. and Cuba has been connected to the oil situation, as Cuba faces the real prospect that Venezuela will stop subsidizing their economy.

Let’s take a look at how the three things I mention above – the financial picture, economic conditions, and political situations around the globe — played out in more detail:

 

Financial

This was a difficult year to make consistent returns, especially for institutional money managers who work with large pools of money and are solely assessed on their ability to “beat the market.” Equity mutual funds had their worst performance in 25 years, with 79% of U.S. stock funds failing to beat their market benchmark.[1] Ironically, the most common predictor of this trend is Apple stock: four out of five funds this year underweighted Apple stock anticipating the company to do poorly.[2] With Apple up 42% this year, that was a painful miscalculation. Those funds with market neutral or heavy Apple exposure were up 8% for the year. The rest were up just 6.2%.

Hedge fund returns are another set of indicators of a challenging year. These massive pools of capital are aimed at generating market-like returns with lower volatility. Their performance again has suffered with an average return of just 1.4%. As a result, the extreme volatility in December, with the market down 5% then up the same in just a few days, was blamed on these institutional managers trying to chase returns in the last month of the year. Bloomberg’s news service reported in December that hedge fund closings in 2014 were at the fastest pace since the collapse of 2008, all due to poor returns in the past few years.

Bonds, surprisingly, rallied another 6% this year, with the bulk of the gains being driven by long-term U.S. treasury bonds. While short-term bonds held mostly steady on rates, long-term interest rates on safe bonds plummeted from 4% to 2.8% on short supply and falling inflation expectations driving up long-maturity treasury prices by 24%. This flattening of the yield curve went against expectations, setting the stage for new challenges in 2015 as bond investors try to find yield while protecting against any unexpected movement in rates. With the Fed slated to raise short-term rates later this year, it promises to be a volatile asset class.

 

Global Asset Returns 2014

Chart 1: Returns for the major assets classes in 2014, with a wide disparity between sectors within the same asset classes. For comparison, the Dow 30 generated 10% while the Bloomberg Hedge Fund index was up 1.4%. Note that the bar for Energy was shortened for visual purposes – the actual bar would have gone down to the next paragraph.

Looking at market sectors, healthcare had one of its best years, with the sector up 25% and many of the major gains a result of frenetic merger and acquisition activity. Utilities, surprisingly, had a phenomenal year as well, with the fall in long-term interest rates making the dividends on these stocks extremely attractive. The rest of the sectors hovered around the market average, while key sectors like energy had a miserable year.

Investing overseas, however, was almost certain to generate losses this year. The major non-U.S. markets mostly suffered from very little growth on top of increasing volatility from political events. The biggest issue in global investing is the divergence in currency values. Specifically, the U.S. dollar is stronger than ever, battering the local currency price of any investment overseas. Although this trend may not persist, it would be a dangerous time to invest against it.

 

Economic

The economic situation in the U.S. seems to be improving and we have oil to thank for that. From an environmental perspective, I am loath to credit oil with anything good, but the economic reality is hard to avoid. For all its problems, fracking has done two remarkable things for our economy: it generated jobs and brought down the cost of energy through increased supply. As we outlined in our July 2014 update, the U.S. has increased production by roughly 5 million barrels per day, and in combination with improving consumption dynamics, has decreased our imports by 70% (depending on which source you look at).

The employment picture is the most critical aspect of our economy today. The labor participation rate – those who are employed or want to be employed – is the lowest it has been since the 1970s when women started to enter the workforce en masse. The factors I’ve heard are varied: changing demographics as baby boomers retire, hangover from the Great Recession, folks not being able to reenter the workforce and college debt overhang on the millennials.

But whatever the reason for the smaller workforce participation today, the number of jobs for those who are looking for work is back at pre-recession levels. What looked to be important wage rate increase earlier in the quarter fizzled out with a total annual gain below inflation. But with the addition of the actual savings from low gasoline prices, we see that disposable income suddenly increased for the first time in a decade.

The other aspects of the economy all continue to look encouraging: new housing starts are above one million per year, real estate prices are still climbing and back to pre-crisis levels in many communities, lending standards are relaxing for mortgages and equity lines, and disposable income is increasing with a lower cost of living from the decline in oil.

With all these tailwinds, the U.S. growth picture is the best in the world today, and in fact has once again passed China as the largest driver of growth dollars in the world. That is quite a change from just three years ago, when China took the definitive lead over the U.S. and Europe. The trick going forward, however, is that we won’t hit true long-term stability until global demand for our goods improves and there is a broader jobs base to drive consumption here at home.

The success of our overall economic situation is dimmed by a black cloud of wealth inequality in the U.S. and abroad. The disparity in wealth in the U.S. hasn’t been this great since the 1880s, and the gap continues to grow here and overseas. The challenges this presents are vast, from social unrest and nation-states at war, to an inability to support a growing consumption economy on the back of diminishing disposable income. Until this problem is addressed, the issues will grow and further threaten the financial markets.

 

 

Oil ProductionOil Res4

 

Chart 2: The disparity between oil producers and oil reserves is a startling insight into the longevity of the political and economic systems that depend on oil. Russia in particular is at risk within a generation, while the U.S. is highly dependent on new discoveries, without which we will deplete our reserves in five years.

Data: www.eia.gov, 2013 or 2014 used based on country.
 

Political

The foreign relations impact of the oil slump is startling. The significance of potentially bankrupting Putin and the Russian economy is not to be understated. As portrayed in my favorite Cold War movie, Three Days of the Condor with Robert Redford and Faye Dunaway, oil and energy security has dominated all aspects of our foreign policy for the past five decades. From the trillion dollars we spent over the last fifteen years to secure the Middle East (which arguably is in the throes of failure), to the massive drilling efforts within our own borders, oil overshadows all other policy matters.

The dynamics of oil are one of the most intricate issues I’ve had to grapple with. The chart above might shed some light on those dynamics. As you see, the top oil producers are Saudi Arabia, the U.S., and Russia. Each of those nations heavily depends on those oil revenues to keep their economy and society intact. The Saudis have used oil over the decades to keep a vastly underemployed and a religiously intolerant population at relative peace through expansive subsidies on everything from energy costs to quality of life. The Russians have taken the hundreds of billions in excess foreign currency to both enrich an elite class of oligarchs and to support regional conflict. And the U.S., as you know, has used cheap energy to drive a $16 trillion economy to generate the highest per-capita wealth in the world.

The fascinating part of this dynamic is the longevity of those oil sources. The Saudis can pump for decades, given the size of their reserves and health of the wells. The Russian wells on the other hand, have a short life-span. They have just a fraction of the Saudi’s reserves, and their well production is diminishing at an increasing pace. Russia has barely a decade to establish their place in a post-oil economy. It is a frightening prospect, given Putin’s quest for power and the prospect that his source of that power will disappear in his lifetime. He is not beyond actions and events that would bring us back to global conflict.

The Saudi/U.S. dynamic is even more intricate. According to popular thought, the Saudis are attempting to drive U.S. fracking out of business and regain their global dominance in oil. That narrative is fundamentally flawed, however. The U.S. must drill for an additional 1.7mm daily barrels of oil each year to compensate for the lost efficiency of their wells, with a cost of new production averaging $65-70/barrel.[3] The corollary is that fracking has an extremely short well-life, of just a few years, while the Saudis have a well life that spans generations.

The U.S. surge is a production surge, which is vastly different and has a finite impact. American energy independence is by no means assured, and in fact not likely to ever be complete. In 2012, the International Energy Agency reported that the US could become energy independent in the future, but that such a dramatic shift in production would be disastrous for greenhouse gas emissions. That fact was distorted in the American press to say that we will be energy independent, ignoring the obvious constraints associated with such a shift.

Oil is likely to cause significant upheaval and volatility in the financial markets in the coming year. The impact on debt markets is also non-trivial, as American energy producers face a cash flow crisis at these oil prices.

Change is a scary concept. It can be even more damaging to financial markets. Prosperity here will continue, but the durability of investments will be tested in this environment, and the volatility of the past will continue into the near future. Nevertheless, we at Vodia remain confident that our skillful, careful, and relatively conservative approach to wealth management and our vigilant eye on markets will steer us through rough waters.

 

Regards,

 

David B. Matias

Managing Principal

 

 

 

[1] WSJ, 27 December 2014, B1

[2] Bloomberg New Services, December 15, 2014,: “Shunning Apple Tops Long List of Bad Market Calls in 2014.”

[3] Two sources of data are The Economist (December 6th-12th, 2014) and the US Energy Information Administration, www.eia.gov.

Volatility can be a Tricky Thing

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This time it took only 10 trading days. Last time, in November, it took 30 days, and over the summer it took 44 days. In each case, this is the amount of time it took for the Dow Jones Industrial Average to regain all the losses from its stumble. (If you have a subscription to the Wall Street Journal, they talk about this whipsaw volatility in depth:  http://goo.gl/zpamFw)

While the first half of December is typically a time of selling in the stock market for tax reasons, and the second half usually sees a rally of around 2%, the sharp volatility we experienced has been increasing as the year goes on. One explanation is the lack of market-beating returns by mutual fund managers: 85% of which have failed to beat the market this year.  What we saw in the rally last week is a rush to get some last minute “alpha” in the hopes of catching up.

Another large pool of equity managers is the hedge fund community. Depending on which index you use, they are up as a group by only 2% this year (according to Bloomberg), to aggregate losses in most categories (hedgefundresearch.com). Either way, that is a large pile of money looking to explain why they have not made much money this year.

We were spoiled with a rapid rise in US stocks the past few years. That rise is causing significant fractures in the institutional money world. Going forward, we are likely to see increased volatility like we saw in December. Keep in mind, during 2008, we saw single-day stock market losses that equaled the entire market gains from the first 9-months of this year (8 percent in each direction)…  Volatility can be a tricky thing.

 

David Matias

Managing Principal
Vodia Capital, LLC
 

Market Update: July 2014

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If you’ve seen the news over the past two weeks, you’ll have noticed there is much joy in the U.S. financial picture. The Dow has reached an all-time high of 17,000, unemployment dropped again in June to 6.1% after 280,000 new jobs were created, and fear levels, as measured by the various “fear indices,” are at lows that have not been seen more than once a decade. Stocks are up another 8% for this year, on top of last year’s meteoric rise, and bonds, which were assumed to be poised for a significant decline, are, in fact, up this year by 4%. There is no shortage of good news when it comes to investing.

The risks and realities, however, are very different. The U.S. economy actually contracted, for the first part of this year; long-term unemployment is still at levels never seen in the modern U.S. economy; and the level of global conflict has risen to a level not seen since the 1970s. Globally, sustained growth is still in doubt: Europe has still failed to extract itself from a recession and risks deflation, Asia is looking for that “soft landing” of slowing the asset bubbles without cratering the economy, and wealth inequality is beyond comprehension.

We are in fact, looking at a tale of two minds. One mind believes in the ability of stocks to rise in any situation; the other mind is on constant alert for the next set of bad news that could impact the global balance.

If we stick to home, and take a closer look at the U.S. economy, we can get a better picture of how the goods news we are used to seeing in asset prices is still ahead of the good news we need about overall economic recovery.

 

All major asset classes have shown similar growth in 2014 thus far, indicating a “risk-on” market mentality as investors seek returns through greater risk taking. While not matching last year’s performance in equities, the consistency of returns in unique.

All major asset classes have shown similar growth in 2014 thus far, indicating a “risk-on” market mentality as investors seek returns through greater risk taking. While not matching last year’s performance in equities, the consistency of returns in unique.

 

Markets – Equities

On the bright side, markets continue their rise after a rocky start to the year. Last year’s meteoric upswing in equities was quickly met with a harsh pause in January, as stock prices closed out that month down 6%. What could have been a further rout of markets was, it appears, a retesting of market levels and a chance for some to take risk off the table. With the market more than doubling since the lows of 2009, it is not unusual for an entire group of investors to take a breather and turn those gains into cash thereby protecting themselves again sudden declines.

By the end of Q1, the markets regained their equilibrium, and demonstrated a slight gain for the year. That gain of just a few percent was tenuous for the next few weeks until May and June, when equities reached new highs and are now posting 8% gains for the S&P 500.

Interestingly, in this rally, the gains have been in the larger valuation companies, not growth firms. Specifically, large and mid-cap value companies have gained 8% and 11% respectively, while small-caps are doing only a fraction of that at 2-4%. This difference reflects an interesting change from the dot-com rally of the 1990s – investors are looking for some substantiation of the company’s stock price, not just a whiff of promise that the firm might make enormous profits later. Although this is not a strict trend, it points to some sanity in the current rally.

Markets – Fixed Income

As opposed to stocks, whose rise was almost universally projected at the beginning of the year – albeit to varying degrees – bonds were supposed to fall. I did not read a single prediction that bonds would rise in 2014; naysayers pointed to the Fed’s reduction in quantitative easing and rising interest rates. Instead, rates have stayed level or gone down, with bonds up across the board.

While the average bond market return of 4% YTD (8% annualized) is impressive in any environment, the composition is even more interesting. High-yield bonds (non-investment grade corporates), have some of the lowest spreads to treasuries in recent history, posting a 5.5% gain for the year, while thirty-year U.S. treasuries posted a 14% gain this year. The compression of spreads on high-yield is an indicator of the continued economic recovery, amid predictions that corporate defaults will be extremely low. These phenomena are consistent with the complacency we have seen in the equity markets. The explanation I’ve heard on the treasuries is a little more complicated, but in short, there are simply not enough bonds to go around. Institutional investors, who need these risk-free bonds to hedge portfolios and meet investment mandates, demand them while the available supply dwindles.

All these dynamics are reflective of the accommodative monetary policies of our central bank, the Fed, as well as the global central banks. The Fed grew their balance sheet by $3.5 trillion from 2008 to today – all of that representing “new money” in the banking system. Around the globe, the figures are similar in size. From that new money, and the Fed’s use of it to purchase bonds in the market, we have seen rates down and prices up.

The downside of this stimulus is difficult to predict. The Fed will stop printing new money in the fall, as anticipated, yet we have not seen any of the market reaction that we might have expected. Notably, inflation has remained negligible. The fear four years ago was that inflation would run to extreme levels and hamper the recovery; now, we are now faced with the opposite problem. We need some inflation to stimulate consumption (encouraging buyers today, when things are less expensive), yet global developed markets have seen flat prices and the US inflation index is under 2%.

The immediate impact is on retirement planning. In effect, if you wish to invest your money risk- free for the next ten years, the spread between income and inflation is nearly zero. Your money, in terms of real dollars, will not grow. This can have a potentially devastating impact over the coming years as the economy returns to historical averages for these measures. Namely, some areas of price inflation hit ordinary people very hard – food prices, for example. In fact, food prices have risen steadily over the past few years with some basics, such as meats, seeing 15-20% annual price increases. Yet food is not counted in the inflation gauge (called non-core CPI), and hence we are left to feel the impact without acknowledging the problem.

Economy

The perverse dynamic of inflation is best understood in the context of the jobs market. As we continue to remind folks, the measure of jobs health used by the media is misleading. Unemployment does not reflect the jobs participation rate, ignoring those who have simply left the market. Instead, we look at total employment as a percent of the population, as you’ll see below. While the trend has been encouraging, it shows only marginal improvement from the end of the recession five years ago.

An equally disturbing trend is the long-term unemployed. As you can see from the chart below, those unemployed for 27 weeks or longer as a portion of the total unemployed population spiked to levels never seen before. And while the trend has brought that level down from 1-in-2 unemployed to 1-in-3, it is still well above historical levels.

 

Long-term unemployed (27 weeks or greater) as a percentage of total unemployed. We reached levels (45%) double the long-term average, and have not employed most of these workers in the recovery thus far. While the level has dropped to 33%, we still have an unprecedented problem.

Long-term unemployed (27 weeks or greater) as a percentage of total unemployed. We reached levels (45%) double the long-term average, and have not employed most of these workers in the recovery thus far. While the level has dropped to 33%, we still have an unprecedented problem.

 

The impact is devastating on the economy and on people. There has been a wave of forced retirees, folks who were at the prime of their career with vast experience and education who simply cannot find suitable work. This has also fed the inflation dynamic mentioned above – people are unwilling to switch jobs for fear of losing theirs. With fewer employed folks job-hunting, this puts a damper on wage increase and ultimately lowers the cost of labor for firms. Labor costs, being one of the major components of inflation, have helped to tamper inflation as measured by the government. Yet, while wages remain flat, basic costs such as food and fuel continue to rise, creating an impact on Americans’ daily lives.

As we look at the other aspects of the U.S. economy, the message is equally mixed. We are seeing a renaissance in energy, with U.S. reserves and production of natural gas and crude exceeding even the wildest estimates from just five years ago. Yet energy prices continue to climb as global conflict creates uncertainty and the cost of refining keeps prices high on gasoline and heating oil.

Another paradoxical phenomenon is general economic growth. Consumer confidence, the general measure of how likely people are going to spend, is back to its long-term average and touching levels not seen since the Great Recession began. Yet, GDP, the measure of production, and by inference, consumption, contracted in the first quarter by -2.9%, again the first time since the Great Recession ended. Although much of that contraction has been blamed on the bitter winter, it is still a reduction in the economy that requires a steep recovery.

 

GDP quarter-over-quarter annualized change from 2000-2014. While we have shown steady growth since 2009, Q1 saw a -3% decline. Q2 numbers, due out shortly, will test the assumption of a sustained economic recovery.

GDP quarter-over-quarter annualized change from 2000-2014. While we have shown steady growth since 2009, Q1 saw a -3% decline. Q2 numbers, due out shortly, will test the assumption of a sustained economic recovery.

 

Global Conflict and Perception

One of my earliest lessons learned as a student of international relations was the damning relationship between the economy and global conflict. As discussed in the Wall Street Journal (“An Arc of Instability Unseen Since the ‘70s,” July 14, 2014), we are facing the most challenging set of circumstances we have witnessed since the late 1970s and the height of the Cold War. There are two civil wars that have the potential to spill over into U.S. interests (Syria and Iraq); Afghanistan is facing an electoral crisis; Russia is promoting ethnic strife in Ukraine after invading Crimea; the Israeli-Palestinian conflict is heating up with little signs of easing. In short, we are seeing some of the worst conflicts of our generation peak at roughly the same time.

[Note: This article was being finalized as a Malaysian Airlines passenger jet was shot down over the Ukraine, emphasizing just how volatile these conflicts have become]

I am loathe to make any sort of political commentary, but each and every one of these conflicts has the potential to draw the U.S. back into an armed conflict, even during a time when the US has resoundingly shown little interest in engagement. This perception – that the U.S. will not engage to resolve conflict – has created the adverse effect of increasing the belligerence of rogue actors. It is a perverse situation that echoes through the history of nation-state politics: perceived weakness breeds conflict, while the threat of might promotes peace. The impact on our economy is unmistakable. Put succinctly, what happens abroad can destroy our recovery at home.

These conflicts are developing rapidly against a backdrop of pressing global issues that are damaging our ability to grow. From climate change and viral outbreaks to food scarcity, we are facing a growing global series of challenges that will require a coordinated and intelligent response. Yet the denial is palpable. For instance, rising sea levels have put major roads in Miami under water during regular tide surges, a trend that will continue to engulf the city in sea water in the coming years. Yet real estate prices continue to climb in the city, development is robust, and elected politicians continue to deny there is a problem.

The math is undeniable: the economy will suffer and our quality of life will be threatened. To combat the rising tides in South Beach, the city of Miami has already committed $1.4 billion to shoring up the roads. That is money spent to stem a problem, money that could have been better used to invest in a technology or build up our educational system. We are increasingly short sighted as a society as the world quite literally “heats up.”

As a parting thought, I offer this last chart, which shows the fear gauge on the S&P 500, a broad measure taken from the futures market that shows how stock traders view the short-term future. A lower number indicates a perception of calm and rising markets, a higher number indicates rocky or down markets. For reference, the index bottoms out at 10 during strong bull markets, and peaks at 80 during market calamities such as 2008, with an average level of 20. In the past two weeks, VIX has hovered between 10 and 12. Perception of financial risk, at this moment in time, is the lowest it has ever been. Are we putting our heads in the sand? And what will the consequences of our denial be?

 

VIX from 1990 to 2014. At only three times in the past 24 years has the VIX reached a low of 10 – a level that shows perception of financial risk is at its lowest possible. Once in 1993, another in early 2007, and today.

VIX from 1990 to 2014. At only three times in the past 24 years has the VIX reached a low of 10 – a level that shows perception of financial risk is at its lowest possible. Once in 1993, another in early 2007, and today.

 

As I am fond of saying, perception is reality. Today, the markets perceive low risk and rising assets ahead. That perception, however, will be fragile as broader issues take root in daily life. And as perception changes, so will the financial risks that we all face.

I want investors to be aware that although some things are stabilizing, we live in destabilizing times. It is this balancing act of perception against reality that drives our portfolio composition. We have seen that managed volatility in our portfolios, while capturing growth from a variety of asset classes and strategies, leads to stable returns over the long haul. Put another way, these portfolios are designed as an all-weather strategy, a welcome approach when the line between perception and reality becomes blurred.

Rest assured that we at Vodia are keeping abreast of current issues in order to keep our investors informed and our assets as protected as possible. We remain optimistic, and realistic.

It is our job to monitor the world and manage the portfolios. It is your job to enjoy the summer.

Regards,

David B. Matias, CPA
Managing Principal

Market Update: January 2014

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It is a little tough to believe that it is 2014 and already a new year. But in a sense I am quite relieved that 2013 is done and behind us. It was a defining year in the modern era of finance. This time, the disparity between developed market stocks (US, EU and Japan) and the rest of the asset world (emerging markets, bonds, and commodities) was the largest ever. In fact, there has never been a time when developed stocks surged, surpassing all other asset classes. There was a period in the late 1990s when there was a strong divergence, but even in those markets, the other asset classes posted modest gains.

The history books on finance are being rewritten as we speak, because financial stimulus in the developed markets has been unprecedented while global economic growth has been anemic. This massive flow of capital into specific markets caused those markets to bolt ahead, while giving impetus for economic growth. Some of that growth is just from folks feeling safe to spend again; some of it is from further wealth concentration and investment by an ever-smaller segment of the population. Until the economic growth is diverse and stable, however, markets will be at risk. Witness the events of Friday, January 24th, when the Dow lost over 300 points over concerns of the impact of Fed stimulus tapering on emerging market currencies.S

SPACEPACE

Chart 1: Major Asset Class Returns in 2013. While the US and International Developed Markets (the EU and Japan, namely) surged in 2013, the remaining asset classes had losses for the year. At no other time in modern finance has such a disparity existed. [Notes: within fixed income, junk bonds posted a modest gain. The modern era covers 1980 forward, when the advent of IT and derivative markets changed market fundamentals.] Source: Bloomberg

Chart 1: Major Asset Class Returns in 2013. While the US and International Developed Markets (the EU and Japan, namely) surged in 2013, the remaining asset classes had losses for the year. At no other time in modern finance has such a disparity existed. [Notes: within fixed income, junk bonds posted a modest gain. The modern era covers 1980 forward, when the advent of IT and derivative markets changed market fundamentals.] Source: Bloomberg

SPACE

We have Ben Bernanke and his leadership to thank for both this blessing and curse. The blessing is the remarkable recovery we have seen from the Great Recession – a period which could have become much worse had the Fed not engineering a global life preserver. Now that Bernanke is stepping down next month as Chairman of the Fed, it is worth examining this legacy.

Bernanke and His Legacy

Ben Bernanke effectively navigated the US economy through a financial crisis that had the potential to tear down our entire economy and recreate another Great Depression. We came very close to true economic devastation. Bernanke, in all his academic prescience, saw what could happen and in the absence of solid fiscal measures because of political dysfunction, he used the Fed’s balance sheet to pump trillions into the financial system. Frankly, he saved our economy.

What we don’t know as of today is how that legacy will bear out. As we saw with Alan Greenspan in the 1990s, what was then viewed as pristine policy turned out to be irresponsible stimulus that helped create the dotcom bubble and trillions of lost asset value. The most relevant impact of this stimulus has been the explosion of consumption in the US driving much of our economic growth at the expense of exports. Where consumption used to be 50% of our GDP in the 1950s, it has grown to 70% today. This increase was the impact of the easy money policies of the 1990s and 2000s, where we saw capital flood the equity markets and then the real estate markets, creating paper wealth for millions. Unfortunately, that vanished in just weeks and months.

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Chart 2: The S&P 500: 1990 to 2013. In the chart to the right, we see how market volatility has changed dramatically since the mid- 1990s. Highs are far higher during bubbles, and the drops are extreme, averaging 50% during recessions. Loose monetary policy and the resulting dependence on consumption for GDP growth is a primary underlying cause of these extremes. Source: Bloomberg

Chart 2: The S&P 500: 1990 to 2013. In the chart to the right, we see how market volatility has changed dramatically since the mid- 1990s. Highs are far higher during bubbles, and the drops are extreme, averaging 50% during recessions. Loose monetary policy and the resulting dependence on consumption for GDP growth is a primary underlying cause of these extremes. Source: Bloomberg

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For Bernanke, the final test will be future inflation. If this recovery does in fact hold, then the challenge will be removing the vast liquidity from the market in time to head off excessive inflation while maintaining the base level needed for economic growth. As we witnessed in the 1970s, inflation can create a vastly damaging problem that is tamed only through high restrictive monetary policy, followed by recession. The counter to that scenario is deflation – an equally devastating situation of falling prices which throttles growth that has begun to shape the global debate on emerging economic threats.

The US Economy and The World

Another recession would be devastating given the current state of our economy. The employment picture is the key to this concern. Bernanke, in comments he made on January 3, 2014 at the annual meeting of the American Economic Association, cited the 7.5 million new jobs since 2010 as evidence of a stabilizing economy. The dark side of that statistic is that since 2010, the US population has grown by just as much through a mix of immigration and births. Accounting for work force participation rates, we have created only enough jobs to support new workers, the preponderance of which is in low wage jobs. We lost 8.5 million jobs in the recession – that loss has yet to be addressed. A new recession would push down employment levels down to a place not seen since the 1930s.

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Chart 3: Percentage of Americans with Jobs: 1945-2013. We lost 8.5 million jobs in the recession, and while we have gained 7.5 million jobs since then, the US population has grown by almost 10 million people. The effects of the recession are still with us, limiting the spending power of the broad worker base and accentuating the wealth disparity of the recovery. Source: Bloomberg

Chart 3: Percentage of Americans with Jobs: 1945-2013. We lost 8.5 million jobs in the recession, and while we have gained 7.5 million jobs since then, the US population has grown by almost 10 million people. The effects of the recession are still with us, limiting the spending power of the broad worker base and accentuating the wealth disparity of the recovery. Source: Bloomberg

 

We do not yet know how successful Bernanke has been. We can see the evidence right now – the stock market raged ahead to new levels that even the most optimistic economists did not predict – but the legacy will be written over the next few years as we see either economic dividends or carnage from this policy.

The unanswered question is whether the stock market rise is anticipating a return to stable growth. Thus far, the news has been encouraging. GDP growth in the US surged ahead in the 3rd quarter of 2013, to 4% – a level that we have not seen sustained in quite a while and would be necessary to justify further market gains. Globally, economic growth is also beginning to creep up as the World Bank and the International Monetary Fund in the past two weeks have both increased their estimates for growth, something that hasn’t happened in several years.

These revisions are critical to the state of our economy in the coming year. For the equity market levels to be sustained and increased, we need companies to continue to increase their global revenues and not just depend on the American consumer. As the employment picture illustrates, the recovery in the US has been spotty and erratic. A further reliance on consumption domestically could work to push us ahead, but that is a risky bet right now. Exports will have to be a part of longer, sustained US recovery.

To whom we would export however, is a question. Right now, the EU counties and the broader European region have the largest global economy, but that economy has been shrinking, not growing. Part of the encouraging news from the IMF and World Bank is a belief that Europe might actually grow again in 2014. That in itself would be an enormous boost for the US and the other economies that supply Europe.

China is the other economy that can dramatically impact our recovery. At their growth rate and the size of the economy (7.6% growth on a $9 trillion economy, as compared to 2.2% growth on a $16 trillion economy in the US) largely dictates the health of global consumption. While China consumes about half of what we do for every dollar of GDP, the central government has pinned the hopes of sustainable growth on the Chinese consumer. Should that model bear out, it presents tremendous opportunity for US companies. Should it fail, global assets will see another correction in prices with ensuing volatility.

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Chart 4: Comparing the major global economies: Using 2013 figures, actual and estimate, we see the world’s dependence on Chinese growth. Their annual incremental economic growth (Growth Dollars) is double the US. [Growth/Capita shows incremental consumption dollars per individual in that economy]. Sources: Bloomberg, IMF, World Bank, US Census Bureau

Chart 4: Comparing the major global economies: Using 2013 figures, actual and estimate, we see the world’s dependence on Chinese growth. Their annual incremental economic growth (Growth Dollars) is double the US. [Growth/Capita shows incremental consumption dollars per individual in that economy]. Sources: Bloomberg, IMF, World Bank, US Census Bureau


For economic growth to continue for several more years, we need to see the dual support from increased exports and increased domestic consumption. The first part – exports – is being tremendously aided by the energy boom we are experiencing in the US. With the benefits of shale oil and fracking (long-term environmental destruction aside), we are both a cheap energy source for manufacturing and an exporter to the world. For instance, gas exports have increase 3x in the past five years – a mind-blowing change that will have an impact on both economics and global politics.

The silver lining for domestic consumption is housing. We have seen only modest recovery in this sector – existing house prices have recovered just a third of their decline from the recession, and new home construction is still at half the level of long-term needs. With every new home, there is both job creation and increased demand for the goods and services that fill the home. There is room to double the sector in a stable economy, resulting in increased jobs and economic growth, not just for the US but the countries who export to the US. There is enormous potential in the housing sector, but only if Americans feel confident to invest in a new home and have the job stability to do so while the banks continue to lend at low rates.

Markets and Psychology for 2014

As we have seen in the last two growth economies, the equity markets get well ahead of themselves and collapse in a fury. A simple measure to assess this exuberance is the price-to- earnings ratio (P/E) on the market, as well as some key stocks. Right now, the P/E on the S&P 500 sits around 17x, a good clip above its long-term average of 15x. A simple analysis says that if earnings do grow this year by at least 15%, then the stock prices are justified. If not, prices are high.

But is it really so simple? Google has been trading at 25x for many months now, well outside a sustainable range. And the price keeps going up. Retail stores are trading at 30x; some large pharmaceuticals trade at even higher ratios.

Historically, the P/E will continue to climb well past these levels before investors notice that the punch bowl has been drained. During the last two bubble markets, the S&P 500 reached 25x and 30x, both well above where we stand today. This doesn’t imply that the market will go up without some further developments to sustain investor’s excessive optimism, but don’t be surprised if there are new predictions in the coming months about how we are again seeing a “new economy” in which fundamentals are worth ignoring. History will repeat itself.

With this in mind, and all of the economic realities outlined thus far, we remain cautiously optimistic in our asset allocations. We continue to maintain our equity exposure at levels to reflect the risks, but have made incremental changes to capture the market psychology (called “risk-on”) and expectations of better global growth. We are also very active in the management of the bond side, keeping durations rather tight, using bond ladders and actively trading some positions to manage total return rather than allow market movements to dictate returns.

Commodities were a challenge for us in 2013, with metals and agriculture taking a beating while partially offset by timber and energy. Given our global view, commodities could do quite well in the coming year with increased demand for many raw materials. Housing may start driving up timber prices, and food prices may be impacted by continued meteorological and demographic disruptions (who knows how the Polar Vortex that has held the nation in a frozen grip will affect food production and sales?). We will continue to maintain these exposures with some adjustments to reflect our core values at Vodia.

All in all, we are again facing challenging times. The global economy is shifting in ways that are impossible to predict, with secondary and tertiary effects that reverberate throughout all asset classes. There are many positives to embrace in the short term, and many disturbing issues that must be resolved in the long term. Our approach – to reassess every quarter and step forward with caution – will continue to be our mandate as we continue to be thoughtful while we observe the world around us.

Best of luck with this winter and the Polar Vortices!

Regards,

David B. Matias, CPA

Managing Principal

Market Update: October 2013

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From Tapering to Teetering

As has been the pattern of the past six years, the summer always brings an interesting set of challenges for the financial markets.  This summer was no exception, from continued uncertainty in the financial markets soothed over by unprecedented Fed stimulus to geopolitical developments that are still unfolding.  Unfortunately, the political dysfunction that has riddled the nation for the past fews years has reached a stage that will only continue to harm the economy and the country.

The positives, however, are fairly obvious: the US continues to pump $85 billion of newly printed money into the system on a monthly basis, with the stock market as the primary beneficiary.  While the numbers vary week to week, the S&P500 is up around 15% year-to-date.  The other bits of good news are real estate prices, which are on a remarkable recovery, a nominally growing US economy, solid corporate profits, and the recent changes in our energy dependence.

Unfortunately, each of those positives are countered by negatives:  the stock market went apoplectic when Ben Bernanke suggested tapering of the stimulus, growth from the emerging markets has faltered, US overall employment levels are the same as five years ago (mid-recession), and the economic growth in the US is significantly below the long-term average needed to insulate us from negative shocks.

The employment picture is perhaps the best place to find reasons for caution.  Although the unemployment figure we so often read about is significantly down from the high of ten percent, the employment picture is a bifurcated situation.  In the recession, we lost nearly 10 million jobs in the span of just a few quarters.  And while we have created 7 million jobs since then, our labor force has grown in those five years by roughly the same number.  So in short, the labor participation rate among Americans is at a 30-year low.  The following chart shows this fairly well.

Chart 1 Image

Chart 1: Data from the Bureau of Labor Statistics shows the percentage of people employed between the ages of 16 and 65. This chart covers 1981 to present, and shows that the labor rate has not changed since 2009. With a labor rate equivalent to the 1980s, we are creating only enough jobs to satisfy the growing population base, but not replacing those lost in the recession.


The anecdotal evidence suggests the jobs we’ve created in the past five years are of far lesser value than the jobs lost.  Most are at minimum wage, there is a tremendous underemployment problem, and the divisions among social classes continues to widen.  These issues only make the next conundrum even more challenging.

Market behavior continues to indicate that we are in a cycle of bubble markets driven by consumption economics.  The next chart shows the movement of the S&P 500 over the past 30 years, in which the market is pushed to new highs in each cycle.  The driving force behind these peaks is external stimulus leading to bubble asset valuations (dotcom in the 90s, real estate in the 00s, and Fed stimulus in the 10s).  In the collapse of the two prior bubbles, the damage to the financial condition of the broader society was extensive – far greater than the benefits from those bubbles.

Chart 2 Image

Chart 2: The US stock market over the past 20 years (S&P500) has shown a broad trend of asset inflation followed by steep drops as the economic growth falters. These asset bubbles have been extraordinarily damaging, with the potential that we have formed another one. Corporate profits will ultimately determine the breath and depth of the rise and fall.

For the current market rise to continue (as opposed to correcting by 20%-50%), we need corporate revenues to grow.  Thus far, corporate profitability has backfilled the market as price-to-earnings ratios remain at or below historical averages (16x).  This has been primarily achieved through layoffs and productivity increases with some revenue increase.  With the internal measures largely exhausted, revenue growth is going to be front and center for the next several quarters.

This picture could work but demand needs to come from a mixture of domestic and global consumers.  The global scene is dominated by Europe – still struggling to get out of a recession – and Emerging Markets.  As we have seen in China and elsewhere, the massive boom in the emerging markets over the past decade has created disruptive air pockets that make predictable growth elusive.  Hence, the need for the American consumer to find additional disposable income or a willingness to once again increase personal debt levels.  With such a stagnant US employment situation, neither are likely soon.

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Chart 3. As the US equity markets surged ahead (S&P 500 shown in red) in the first two quarters, Q3 saw the Emerging Markets (shown in green) stage a partial recovery while Europe & Japan (shown in blue) also posted stronger gains.

It is for these reasons that we at Vodia Capital maintain a diversified asset allocation strategy for our portfolios.  Relying on just equities to drive gains would subject portfolios to far too much volatility and uncertainly.  While markets have shown an ability to recover in the past, these gyrations eat away at long-term returns and ultimately underperform when compared to a diversified strategy.  In response, we continue to use fixed income, commodities and derivates to both stabilize portfolios from global uncertainty and generate predictable growth.

Geopolitical

The biggest challenge to backfilling the equity asset bubble is global conflict.  Domestic issues are important and bleak, but with enough time and some basic legislation, our current situation will ameliorate or the domestic economy will simply adapt.  But until that happens, we do not have enough consistent economic growth to withstand a shock to the system and not enter another recession.

The global issues are less predictable, although we seem to have hit a moment of pause.  Despite my wildest expectations, the situation in Syria seems to have found a multi-lateral solution with Russia participating and China consenting.  While I have my doubts on the ability for the global community to truly disarm Syria’s WMD capabilities in the long-term, it is a relief to see it handled through cooperative diplomacy and through the UN.

On a separate but related front, Iran has consistently posed the greatest threat to global stability in the past few years.  Compared to Syria, Iran’s pursuit of WMD’s is a real problem with real ramifications.  Not to overstate the situation, but by many accounts this region was on the brink war if something was not done soon.  And while I also have serious doubts as to the authenticity of Iran’s overtures, we have taken steps to open a dialogue that has been closed for decades.  That is progress.

Where we do not have progress is in our own political structure.  As of this writing, we have a partial shutdown of our government, with another looming prospect of defaulting on our debt in another three weeks.  By some estimates, a complete shutdown of a few weeks could wipe out our economic growth for the quarter and possibly the year.  And defaulting on our debt is simply a non-starter – the financial ramifications are just too vast to play with.  While cooler heads will prevail, the damage to the economy through continued uncertainty has already taken a toll on lower economic growth.

Changing Energy Dynamics

The most promising development is the changing energy dynamic in the US.  The past six years have seen a dramatic and unprecedented change in our energy dependence.  Despite the mild economic recover, our use of oil has actually decreased by 10% from a combination of better vehicle fuel economy and alternative sources.  During this same time, our oil production has doubled from technological advances.  The net impact is to decrease our reliance on oil imports by half, to less than 10% of global production.

Combined with our natural gas boom, this is an incredibly positive development for the economy.  Much of our economic growth over the past decades has depended on cheap energy, creating a political structure and international presence that went to extreme lengths to protect the dynamic.  As net exporters or natural gas and coal, along with a far lighter dependence on the global oil market, untold resources will be freed up and could generate a new form of a “peace dividend” that we experienced post-Cold War.

The medium-term impact of our energy production and consumption is still of grave concern – from global climate change to the damage we are doing to our drinking water.  The shift to alternative sources, whether they be truly green or simply move us away from oil, is of paramount importance and must continue.  But the ability to shift a focus away from deeply disruptive policies to protect a bad oil dynamic is a start.  Where we take it next will determine just how much of a global leader we can be in the coming decades as the forces of economics increasingly determine our actions as a country.

All the best for an enjoyable fall.

Regards,

David B. Matias, CPA

Managing Principal