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Market Update: June 2013

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What is NORMAL?

Normal is a much-overused but complex word. It can refer to societal values that reflect one group’s preferences to the exclusion of another. In a statistical sense, it refers to a baseline expectation drawn from reams of data. When you combine the two, you create statistical measures that can be used to determine behavior in certain situations, such as IQ tests. You see how this gets tricky, and fast.

Now let’s discuss the “normal” of economics. The financial markets are permeated with the statistical use of “normal” – without some idea of what “normal” looks like all of risk management and portfolio construction would fall apart. But now economists are trying to assess this current economic period as either a “new normal” or a return to the “old normal.” But what exactly does that mean?

As you will have gathered from my blog entries and market updates, I often point out where the statistical use of “normal” in the financial markets is broken. Whether it is the price movement on gold or the stock market collapse of 2008/2009, “events” have happened that simply should not have – they seem, to us, to be statistically impossible and “abnormal.” As an asset manager, it is terrifying at times that the statistical “normal” of the past 50 years is no longer valid.

Somewhere along the way, someone decided that the word “normal” will make it easier for people to understand a complex topic. We live in a world of mass media and shortened attention spans, where messages need to be simple and short or else they are ignored (think Twitter). Hence, the word “normal” has been redeployed in our current world without people stopping to think about what it really means, much as they don’t think about the incessant sound bites of recent political campaigns. Unfortunately, the word “normal” captures very little of reality, and leads to a misguided sense of safety for investors.

In the broadest sense, there is nothing normal about the economy today. We have a world population that now exceeds seven billion people and a method of supporting those lives through consumption-based wealth creation. That is not normal – it has never happened before and we don’t know if it can be sustained.

Yet here in the US, we are supported by an economic model that has been proven over decades. We have a population that grows at 187,500 people per month, and an economy that is just generating roughly that same number of jobs. We have been the center of innovation and entrepreneurship for the globe for a century, and combined with a tremendous level of investment over that period, we have an economic base that supports the wealthiest nation today.

The challenges here, however, are vast.

  • Job growth is able to support the current population growth, but does not replace any of the jobs lost in 2008 and 2009. Today, we have the same relative number of jobs as the 1970s – when most households had a single wage earner. To replace those jobs, however, we need to consume at a level consistent with dual-income households.
  • The economic growth necessary to build back those jobs might not be attainable – that is the core of the current economic debate. We need 4% annual growth – we’ve been lucky to see half that over the past fifteen years.
  • Wealth is more concentrated now than in the past 100 years. Middle income families have been decimated by the financial turmoil (retirement and real estate assets), while the top income groups have seen their wealth explode.
  • Our political structure is largely paralyzed in guiding the nation’s resources and regulations in a way that invests for the future – whether it be in education, transportation, or conservation of natural resources.
  • The explosion of the digital age has created large potholes in the road to certainty. Whether it be financial calamities from computerized trading systems, social unrest, or the leaking of state secrets, these changes are redefining expectations.
To reframe what “normal” means , I might like to suggest instead that we think about expectations. People, for the most part, like to know what will happen next – whether it be the length of a commute or the length of a retirement. In today’s world, those expectations are increasingly altered, erased, or shattered. And with it comes a deep sense of uncertainty – the bane of stable financial assets.

FINANCIAL MARKETS

With that introduction, I would like to say there is in fact good news to discuss. Last week’s dismal market performance masks one very important bit of news – the Fed believes that the economy is improving, so much so, in fact, that they might start to “taper” back on their historical stimulus program within a year or so.

Rather than treat this news with excitement, the market plunged. And it wasn’t just stocks – it was everything. (For those who wonder if this might be “normal” or part of the “new normal,” , let me point out that this 1.0 correlation broke all normal statistical expectations). It parallels the market behavior of this year – bad news is good for the markets, good news is bad for the markets.

People are saying that the US markets are up strictly because of all the stimulus. Without that stimulus, things will go back to “normal” – positive real bond yields, stock prices that follow company profits, and commodities prices that reflect demand. In other words, markets will have to reflect “normal” values for things, as opposed to the central bank inflation created by trillions in new money. That is not really a bad thing – in fact it is astoundingly good. The printing of money cannot continue without there being some serious damage to the global financial system in the form of currency devaluation and price inflation.

But like every aberration we have seen in the past five years, change is not taken well by the financial markets, even if the change in this case is a change in expectations about something that might happen a year from now.

Our role as investment managers is to determine what assets will be worth, based on their intrinsic value today and growth potential for tomorrow. To review the major asset classes and our perspective going forward:

Domestic Equities: US stocks have taken a beating, but only just so much. They were down 6% from their highs, but up 18% before the sell-off (for a net gain of 14% for the year as of right now). Whether we continue down or up from here is well beyond anyone’s control or foresight right now.

Our investment perspective on equities is essentially to stay steady – we have already kept a lower equity exposure precisely because of the inherent volatility, but do not believe that the recent volatility is reason to change that position. Instead, we are viewing this as an opportunity to increase investments in those individual equities that have the fundamental value and growth prospects to benefit from a growing US economy.

Valuations on the broad market are reasonable (S&P500 is around 15x earnings) and balance sheet structure of these companies is remarkably strong, thanks to years of cheap corporate borrowing. US companies have also shown further strength in their global customer base – as the world grows, so do the markets for many of the best US companies. If it is true that the economy is showing further signs of strength – as signaled by the Fed this week – then US companies are extremely well positioned to benefit.

The risk is a host of geo-political troubles that could trigger a global recession. There is no immediate indication that such a situation will arise imminently, but until we have see resolution in a couple of situations, we are going to maintain these equity levels as a buffer.

Foreign Equities: Here the story in remarkable contrast to the US. In short, the global stimulus from the central banks – not just the US – has propped up these markets for the past two years. Under the surface, however, the economic growth is weak. Europe has been in a recession for quite some time, Japan was on life support until recently and the emerging markets cannot support their economic growth through internal consumption.

The resulting equity performance is rough. Global markets have shown just a few percentage points of gain this year (if not a small loss right now). Emerging markets on their own are down 12% on average, with some markets taking a 25% beating.

As investment managers, we have avoided Europe almost completely but still maintain a modest exposure to the emerging markets. We’ve done this mainly through positions in US companies that sell heavily into those markets, and whose future profitability will depend on growth in those regions. We are still very positive for the growth prospects for the emerging markets and view the current swoon as a market psychology driven movement. Especially as the US slowly pulls into a higher growth mode, these regions will benefit significantly.

Domestic Fixed Income: This market has received an enormous amount of attention of late in the form of interest rate movements of historical proportions. Rates on the 10-year Treasury note have move from 1.6% to 2.6% in a matter of weeks, and the 30-year rates have gone from 2.8% to 3.6% in that period. Again – “normal” of any sort doesn’t compute.

The impact on bond prices is tremendous – market price move down as yields go up. But from the perspective of an investor holding bonds to maturity, it is good news. As long as your maturities are relatively short, you will get to reinvest your cash at higher rates down the road, once your bonds mature at par. There is no impairment of value in this situation – a fact that is often overlooked.

Commodities: Again, this market has taken a beating this year, although far less so than some of the global equities. As emerging markets are perceived as slowing down, so does the thinking for the commodities consumed by growth.

Our perspective is quite to the contrary. The slowdown in emerging markets growth is only temporary. The US is pulling out of its malaise, and population growth in developing regions will continue to fuel demand. China, for instance, is planning to urbanize 250 million people in the next decade. To put that into perspective, that is the same population of all the major cities around the world – combined.

In addition to the global demand for construction resources, we are holding a notable position in grains and agriculture. The dynamic is a simple one: populations are growing and the global middle class is consuming more meats and high value foods. Production is keeping up – but just as long as there are reliable and predictable methods. Climate change is for real, however, and creates mayhem in the production cycles through drought, flood, and changing weather patterns. As we saw last summer, with these disruptions comes significant supply constraints and rising prices.

The area that is least “normal” is metals. Gold and silver, the two metals that we use for hedging purposes have seen historic declines. The price of silver has been cut in half with all the reactivity to the central banks, gold is off a third. More disconcerting is the daily movement, which is down under every market condition – whether there is good news in the world or bad.

Seeing these risks, we exited our silver position many months ago, just at the high. We kept the gold, however, as a hedge against some of the events we have recently witnesses. But in the break from any form of “normal” that hedge has failed and the position has been a drag. Under the perspective that this is a market dislocation unrelated to the value of metals, we continue to monitor that market and the timing for when it may make sense to restore the positions to their original allocation.

CONCLUSION

In summary, it has been an unusual year. The markets went straight up for four months, creating a buzz reminiscent of the late 1990s. During that period, stocks went up at a blistering pace and there seemed to be no end in sight for the dotcom stocks. The buzz was a simple, yet persistent demand to be in the stock market. If you were not fully invested, then you were “missing out.” Unfortunately, those who did go full into the market saw a remarkable event – a -70% loss in their portfolio values.

That buzz has ended now, as we are reminded of the vast uncertainty in the equity markets. In the last month, we have begun to witness volatility across disparate asset classes, from US Treasuries to Japanese equities. During late May and early June, the Nikkei had five trading days of 3-7% losses. Then just three weeks ago, it saw a 5% gain in one day. Like the movement in gold just two months ago and again now, that volatility is well outside “normal” volatility. And it is happening in US equities, to a smaller but notable degree.

To make this point, for the months of May and June (since the Fed started to talk about “tapering”), we have had 24 days of 100+ point movements in the Dow Industrials average: thirteen times it was up, eleven times it was down. That contrasts to the first three months of the year in which there were just nine such days, only two of which were down. Volatility came back with a vengeance, and when it did losses ensued.

As reported by the financial website Seeking Alpha and others, May saw the highest equity weighting among individual investors since September 2007. As a reminder, September 2007 was the beginning of the equity decline that lasted 18 months and 50% down. In the parlance of market psychology, it is not unusual for individual investors to be the last to the party.

And this lack of “normal” is creating havoc for the institutional managers as well. Hedge funds, the massively concentrated pools of capital that supposedly can time these events, have done no better. With gains of roughly 2.7% for the year, they haven’t solved this problem – no one is immune.

Our view is that we are seeing the shift to an investment environment based in old-fashioned fundamentals as the US economy pulls forward and artificial drivers fade out. It could take years, but ultimately that is a good thing. In the process, there will be uncertainty and wild volatility.

In the end, there is nothing normal about these markets – old or new. We are going through changes on historic scales, and as we continue to remind folks, we are all sorting through the events and the data to find the best places to invest assets for the future.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA

Managing Principal

Market Minute – March 10, 2013

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It is nice to see the winter finally start to come to a close, with daylight savings restored this morning, the foot of new snow in my front yard notwithstanding. Less pleasant that the onset of spring is the reaction to Friday’s unemployment figures.  I fear that we are seeing a repeat of the market myopia that so widely devastated portfolios in the last financial crisis.

By all means, the report on Friday – a gain of 236,000 jobs for the month of February – is a welcome sign.  Construction spending and hiring continue to increase at a vigorous pace, and the medical industry leads the hiring trend.  But the figures still reflect a troubled situation.

The unemployment rate reflects only those who are looking for jobs; another 130,000 people chose to leave the workforce, hastening the decline in the unemployment rate.  And an equally important measure is the long-term unemployed, which increased to 4.8 million people, or 40% of those reported as unemployed.  Furthermore, the gains in February are tempered by a downward revision of 38,000 fewer jobs in January, which was already a weak month.

We need 150,000 new jobs a month to maintain stable employment given population growth – a level we have yet to maintain during this recovery.  During the financial crisis, we lost over 7 million jobs, which we have not begun to restore, factoring in population growth since then.  Certainly the momentum is in the right direction, but it has been five years since the recession began, and we are only beginning the process of restoring lost jobs and incomes.

When we factor in mediocre economic growth of around 2%, the impact of the sequester cuts, and the consumption-dampening effects of higher gas prices combined with a payroll tax increase, we can see that we are still skating on extremely thin ice in the short-term.

Yet, the stock market has reached an all-time high.

The disconnect is a result of the Fed’s $85 billion monthly monetization program.  By “printing” money in such vast quantities at a sustained rate, they are able to inflate the various markets beyond values that reflect the true economic risks.  Yes, companies are profitable and cash is abundant on their balance sheets, but the prospects for strong continued growth are dubious at best.  We need some impressive magic to make it all work in a way to support these values.  Anything short of magic will be another collapse.

As with every other asset bubble human emotion reigns – with a healthy dose of marketing.  The financial media loves to fixate on stock prices and stock highs.  You cannot walk 50 feet in today’s cities without seeing some headline, quote or other reminder of the stock market and the related hype.  With the strong propensity for people to forget past events and fixate on the immediate market news, the bubble has plenty of fuel to grow to dangerous proportions.

How we proceed from here is with caution.  What we need to remember is that volatility will remain, and until we fix the more pressing issues these market highs are not likely to persist.  As a reminder, our investment strategy reflects these risks through a broad asset allocation that enables growth from stocks as well as several other asset classes.  The success of this long term approach will fluctuate with market distortions, but it is a steady perspective that favors stable growth over extreme highs and lows.

Regards,

David B. Matias, CPA

Managing Principal

Market Update: June 2012

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Thus far the first half of the year has kept up to expectations.  The first part of the year was a straight run up in the equity markets.  Unemployment in the US has remained exceptionally high and isn’t coming down, the global economy is still suffering from a dramatic hangover and the euro threatens to break up as I write this update.

(Note that I could have written the exact same paragraph in June 2011 or June 2010.  Hope springs eternal at the start of each year – now we need to see real change before market growth is warranted.)

Our perspective on these events, as outlined in my previous articles on the paradigm shifts in our economy, is that we are only part way through a decade long shift back to a core of economic growth.  Asset bubbles in the 90s and 00s helped to mask the true problems, and those bubbles made the economic situation far worse as each popped in a destructive fashion.  Behind these bubbles, aside from the political aspects, is a financial services industry that has learned to extract a hefty toll from investors with the support of our political system.

Yes, it may be a dour assessment, but the realities are there to be seen.  It is more a function of our willingness to see.

Facebook – Anatomy of a Botched IPO

What many failed to see, or were unwilling to admit, was that Facebook’s initial public offering (IPO) was flawed from the very outset.  Before Morgan Stanley juiced the price, before Facebook’s CFO ignored conventional wisdom, before Goldman Sachs started their own fund to cash in on the hype, Facebook was a bubble created by the financial services industry.  The surprise was not that Facebook was grossly overvalued (as I have asserted for the past six months), but that the bubble popped so soon.

Normally with these bubbles, they perpetuate until the inflated asset is so far down the investor food chain that no one person or institution can make a significant stink about getting fleeced.  Those folks are the “average” retail investor who either believed in the hype and bought the shares at the wrong time, or are heavily invested in mutual funds which are holding the shares.  With trillions of dollars sitting in 401(k) plans with such funds as their only investment choice, the least informed of investors are the ones most harmed.

What was unusual this time was that the music stopped early.  On the first day of trading, the share price struggled to stay positive.  Within a week it had lost 15%.  As of this writing, Facebook is down 27% from the IPO price, and 34% from the high.  This infers an actual loss to investors of $4.3 billion who bought shares in the IPO.  While that seems to be enormous, it is insignificant compared to other overblown IPOs of the past, where hundreds of billions were lost when stock prices came down from dizzying heights at the peak of the dot-com bubble.

But the timing here is different.  The decline began the day after the IPO – concentrating the losses among a handful of early buyers and those who own shares from the IPO.  As a result, lawsuits are piling up and the debacle is still on the front page.

When viewed from afar, there is little doubt that the IPO would not end well.  The initial IPO valuation of Facebook started at $50 billion last winter.  It quickly climbed to $100 billion as Goldman peddled the shares in the pre-IPO market.  Under current SEC guidelines, Facebook could have up to 500 shareholders before being treated like a public company.  These 500 institutions and investors swapped shares, and reaped profits as they cashed out on the hype.

The next step was to allow those 500 to cash out to the public.  That was the IPO.  What was initially supposed to be a $5 billion cash-out became a $16 billion cash-out as the greed spread.  And the bubble would have continued in the public markets if the initial trading was not botched, and if Facebook had not oversized the float.

A good anecdote is a friend’s grandmother who asked her broker to buy shares on Facebook on the day of the IPO because of what she was reading in the newspaper.  She is in retirement and living off the income from their savings.  The misaligned risk of such an investment would have been enormous.  The fact that she was convinced that Facebook would make them money is a revealing insight into human psychology.  (The broker did not buy the shares – fortunately)

JPMorgan (Chase*)

Another good example, but less obvious, is the trading loss reported by JPMorgan.  What was initially estimated as a $2 billion hedging loss ballooned to $3 billion a week later and may reach $5 billion.  The fact that they can lose this much money so quickly is alarming.  The fact that just three weeks earlier their CEO dismissed the rumors as “a tempest in a teapot” is sheer arrogance.[1]  The fact that they were doing this with government insured funds is nauseating.[2]

Remember, JPMorgan’s full name includes “Chase Bank”.  Chase is one of the largest consumer banks in the country.  They sit on $1.1 trillion of customer deposits.  They invest those funds as they see fit to generate larger profits.  Those are the investments they were “hedging” with this trade.  The losses themselves are not going to threaten the viability of the bank, but the pattern is distressing.  It was just four years ago that most of the major banks suffered enormously because of unbridled risk-taking in the sub-prime mortgage market.  Having survived that crisis intact, JPMorgan repeatedly reminded the regulators that they were “special” – because of strong management they do not need strict oversight.  This argument has been at the core of the current debate over bank regulations.

What seems to have happened, consistent with so many debacles in the past twenty years, is that the drive for profit and personal enrichment eventually outstripped common sense.  Don’t be fooled by the technical jargon, fancy strategies or elevated titles.  The mistake they made is simply foolish.  The same trader had previously made some large bets that paid well.  So if big bets can work, let’s make a ginormous bet – as the thinking goes.  The notional value of the bet was so large (estimated at $100 billion) on such an arcane trade (risk of default on just a handful of companies) that they went from playing in the casino to becoming the casino.  As is almost always the case, the trade eventually went against them and they barricaded themselves inside a burning building.

That fire is still burning, and while their CEO is desperately trying to salvage the bank’s reputation (and his job) the lesson is a simple one.  JPMorgan is allowed to gamble in the casino with nearly unbridled risk taking.  Yet they are one in the same as Chase Bank, the depository for millions.  Until the 1990s, this type of combination was strictly forbidden for obvious reasons (which became obvious in the crash of 1929).  Somehow the bankers were able to convince the politicians that bankers were smarter and better than before.  Hence, there was no need for separation between investment banks and deposit banks (also know as the Glass-Steagall Act)[3].  Fast-forward ten years, and the verdict is fairly plain.  Greed does not change.  Bankers are just smarter at making sure that they don’t have to pay for failure.

If the point needs any further clarification – look at the salaries and bonuses at the heart of the crisis.  The CIO in charge of this failed bet made $14 million last year alone.  She is one employee out of dozens who make that kind of money for taking these sorts of bets.  Expand this  across the entire bank, across all the major investment banks, across all developed markets, and it amounts to billions of dollars that are generated from these activities that end up in the pockets of a few.  My statement is a simple one: How does one justify such outsized compensation for potentially irresponsible behavior?  If the investment banks want to pursue these trades then they need to bear the cost of their failures as well without putting the economy at risk.

To be fair, there are plenty of legitimate banking activities that occur every day which create true value in a fair and equitable environment.  The issue I address here is the major investment banks who are too-big-to-fail while being funded with government insured consumer deposits.  They have engineered a government-sanctioned mandate to take irresponsible risks with those deposits while maintaining full protection from failure.  It is a dynamic that creates repeated asset bubbles, in which the repeated loser is the individual investor who has few choices beyond the mutual funds in their 401(k) accounts.  The system does not serve them well.

Iceland, Inc.

While the anecdote of Facebook or JPMorgan may seem limited in scope, the pattern does not end here.  Our next stop is Iceland.  For those of you who don’t remember, the three major banks of Iceland went insolvent in 2008 requiring such a massive government bailout that the entire nation was on the verge of bankruptcy.  As The Economist stated in December of that year, relative to the size of the economy it was the largest banking collapse ever suffered in economic history.

The source of the collapse was – you guessed it – asset bubbles.  In this case, it was cheap loans to foreign investors to support real estate speculation.  Everyone in the financial food chain profited from the speculation until the real estate market collapsed.  The taxpayers were left to clean up the mess.  Governments from around Europe compensated their citizens for deposits lost to these banks, to the tune of billions of euros.  Again, irresponsible risk taking by the banks was condoned by the government until the game ended.  Individuals profited enormously.  Entire economies suffered.

While the Iceland collapse was minor relative to the global economy, the pain was acute in a handful of places.  Greece, however, will not be so localized.  While much has been written here the message is the same:  ridiculous borrowing by the government that was unsustainable and facilitated by you know who – the banking sector.  Greece’s ultimate default – albeit an orderly default – impacted the global banks to the tune of billions.  Those banks are now receiving government funds to supports the losses.  If Greece does not abide by the terms of their bailout or withdraws from the euro the losses will grow rapidly.

And the fun continues as move across the Mediterranean to Spain.  Their banks are now suffering from the effects of a real estate asset bubble. With losses mounting, unemployment reaching 25% and the government doubling their debt to keep it all afloat, a European bailout looks imminent.  Just recently they asked for $125 billion in help from the broader European monetary institutions after insisting that they would not need help.

Here in the US we have a real problem to face.  As Europe goes through their annual summer games of economic Armageddon, we are again facing the prospect of a failed currency, the euro.  It is not clear what would happen if the euro were to break, and it is not clear that the euro could break, but the consequences could be severe.  Again, it would focus on the solvency of the global banks and ultimately how much in government funds are needed to keep them afloat.  The mitigating factor is Germany, the key industrial power in the region that has fueled much of their growth.  With Germany’s cooperation, it is possible to protect the euro and stem any systemic collapse.  The cultural divisions are large, however, and go back decades to the original efforts to bring a single currency to the region.

Here in the US, this government support has spread to every corner of our economy.  The stimulus that has been generated is in the neighborhood of a trillion dollars.  Through extreme monetary and quantitative easing programs by the Federal Reserves, both the bond market and stock market have been propped up.[4]  The ancillary effect has been to provide a massive subsidy for banks – ultra cheap deposits that they can then deploy into profitable investments such as mortgages.  Yes, they need support, and in that support it is believed that unemployment can be ameliorated, but that should not infer that irresponsible risk taking is also condoned.

Investment Perspective

With all this depressing analysis, there are still bright spots in the world.  First, it is in no one’s interest to see the system fail.  Even the financial services sector realizes that if the entire economic equation fails then their profits end.  Whether it be the Greek Parliament or JPMorgan, at some point self-interest must give way to self-preservation.  And while I talk about stalled economies and bailouts, we should not lose sight of the strength in the global economy.  Trillions of dollars in production is generated every month and while the growth may not be all we need to rescue us from our mistakes in this moment, the prospects are strong.

Put another way, all these issues go away with global growth.  Create jobs, increase consumption, increase production, and the cycle supports itself.  While it could be an easy “out” through another job-creating asset bubble, it will take years to get there in a sustainable manner.  In the interim, we just don’t want to inflict too much additional damage in bubbles that mask the problem.  (Yet we continue to ignore the deeper issue regarding the sustainability of the consumption cycle – a topic for a different day)

At Vodia, our investment direction has remained the same as it has over the last four years.  Invest in company stocks that have stable and growing cash flow streams.  Don’t overemphasize our reliance on these stocks, but instead rely on undervalued debt instruments that have greater predictability and protection. Hedge further risks with hard commodities, heavier cash balances, and derivatives where appropriate.

For the summer we are taking a cautious view of Europe with a mildly positive view of the US.  As the US economy mends itself, emerging markets will continue to benefit.  Emerging markets will also benefit from their own prosperity, as local consumption begins to replace exporting as the primary economic driver.  In the immediate term, emerging markets have suffered as consumption in Europe and the US slowed down.  The short term movement in the emerging markets has had a sharp impact down on commodities – positions that we will continue to hold in  moderate quantities as a hedge against the long-term effects of domestic monetary easing programs.

Note that our view of the emerging markets focuses mainly on Asia and the commodities that support these economies.  We currently exclude India from any investment opportunities due to their deep-seated social issues, and avoid direct investments in China for a lack of transparency and long-term sustainability.  Yet China continues to drive the general direction of commodities as the largest consumer in a number of areas.  They need to push for blistering growth to support rapid urbanization of the population, growth that could create substantial economic disruptions if not closely managed.

The global healing process takes time, and will be quite bumpy along the way.  If the euro does break, then those bumps could be quite severe.  That is the challenge that we are addressing today.  But if we get through the summer and Europe plods closer to substantive solutions to a one-currency/multiple economy region, then we again have time for economic growth to reestablish itself.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA

Managing Principal

[1] It was on April 6, 2012 that The Wall Street Journal first reported an outsized derivatives position based out of JPMorgan’s London trading desk ( “London Whale Rattles Debt Markets”).  The trade was so disproportionate to the market that the trader was nicknamed the “London Whale” by the street. Just a week later, when confronted with this information, Jamie Diamond, JPMorgan’s CEO publicly stated that any report of inappropriate risk was overblown and later called it a “tempest in a teapot”.

[2] This loss never put JPMorgan at risk of default.  They generate nearly $20 billion a year in profits and have a capital base that is approaching $200 billion.  Instead, the nature of the loss is the troubling aspect.

[3] Ironically, it was the merger of Citibank and Travelers in 1996 that prompted the repeal of the Glass-Steagall Act. Their argument at the time was that bankers were more sophisticated now and were able to manage the risks appropriately.

[4] The debate still rages as to whether that was enough stimulus or whether the funds were used effectively – both of which are valid arguments in this current political environment of self-serving deficit hawks.

Market Update: April 2012

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Spring Is Here and the Birds Are Chirping

This was quite a remarkable quarter: the stock market was up 12.6%, Apple just declared a dividend pushing it above $600 per share, and I hear birds chirping from my window.  Markets around the world are going straight up – what could be wrong in the world?

In my typical dose of caution and concern, there is a lot.  But rather than worry about what might be the issues for us to face – which frankly have not changed a bit since my last Market Update from January 2012 – I’d rather focus on some of the psychology that emerges in these situations.  Unfortunately the history of our “efficient” markets is littered with examples of gross inefficiencies driven by investor psychology.

One simple example is to look at the market volatility from 2011.  The chart below shows the S&P500 for the year of 2011, a chart that I have used in the past.  While the course of the market was remarkable – record setting in fact – the end result was eerily simple.  When looked at from point-to-point (January 1 to December 31), the market was dead flat.

The second chart shows a comparison of January-February on the left side against August-September on the right side.  Two very different charts from the same year – polar opposites in fact.

2011 generated stock market movements at the polar opposites of market theory. The left side is the calm market of January-February, while the right side is the historical choppiness of August-September.

In the first part of the year there was all the buzz of a strong economic recovery, jobs growth, real estate price stabilization and stock market recovery.  As we now know, most of these claims were either false or premature.  What came to the fore later in the year was the reality of debt overload, sovereign defaults, and a European recession.  When you look at the side-by-side, the impact of psychology leaps from the page.  During Jan/Feb of 2011, the market rise was steady, stable and predictable (low volatility).  During Sept/Oct of the same year, the market was choppy, erratic, and unpredictable.

To put this into context, traditional economic and finance theory relies heavily on the notion of efficient markets and statistical trends based in a lognormal distribution of stock market returns. In that paradigm, the likelihood of the right chart occurring is roughly a 6-sigma event.  In more pedestrian terms, these events are likely to occur once every 5,480 years (roughly since the start of history according to the Jewish calendar).  That should give you a moment of pause.

My point is a simple one.  Conventional theories about the economy and markets are severely limited in describing current events.  In many ways, broken.  Yet, the underlying fundamentals of our world are deeply challenged – American society has been turned inside-out, developed economies are carrying debt loads that are unsustainable, and global conflicts are playing out in ways that can no longer be managed.

A more likely explanation for the first quarter performance is a host of factors that have nothing to do with fundamental strength.  I’ve heard one theory of investor boredom – too much bad news has resulted in a form of indifference.  Another theory is manipulation by the Federal Reserve Bank – with near-zero interest rates and over a trillion dollars flooded into the banking system, money needs a home to generate profits.  You won’t get it in the traditional bond market, with short-term rates near zero.  But you will get it in the form of dividend paying stocks.

To support the second theory, The Wall Street Journal reported that this year $9 billion of investor money flowed into mutual funds and ETFs with stock-dividend strategies.  All other funds had a net outflow of $7.3 billion. (see Jason Zweig article, “The Dividend-Fund Dilemma” on April 7, 2012).  Investors are chasing some sort of return, irrespective of the risks.  While a stable stock could lose half its value in the matter of a few weeks (such as 2008), the prospect of a 3% dividend yield is enticing enough to warrant the risk.  Wow.

To add a bit of punctuation to those thoughts, take a look at the next chart comparison – the start of 2011 and the start of 2012:

The start of 2012 look eerily similar to the start of 2011. How the rest of this year progresses is the question.

Since the collapse of 2008, we have gone through a number of cycles around volatility that repeat.  I never mean to predict where the market goes next, but I do want to point out the irony of the volatility pattern and the interplay with investor euphoria.

Apple and Facebook

Perhaps another sign of psychology gone awry is Apple.  While Apple is by far my favorite company in the history of the planet (and a stock that many of our clients hold and have handsomely profited on), the psychology around Apple is unmistakable.  Based on strong earnings and the resumption of their dividend, the stock was up 48% in Q1.  That gives them the largest market-cap in the world today of  almost $600 billion.  If Apple were a country, it would place them in the top-20 globally, somewhere behind South Korea and ahead of Poland.  Not bad.  And with $100 billion of cash, they can afford to pay a dividend now.

But what happens next?  Other companies of their size trade at roughly 11x earnings and experience growth rates in the single digits.  Never has a company been this large, and never has such a large company doubled in less than several years.  Yet the headlines defy common sense – “Apple to hit $1,001!”  I’m not sure which part of this is more comical.  Perhaps it is the inference that you should put your money into Apple now because it will soon double to become a $1 trillion dollar company (they would start to rival India).  Or perhaps it is the notion that they’re just messing with you, “Hey – let’s come up with a random number that people will love.  Like $1,000. That’s cool!  No, make it $1,001!  That’s cooler!!!.

Don’t get me wrong – there is a day when Apple will likely hit $1,000 per share (and yes, even $1,001).  But that day is more likely to be years away, with many gyrations in between.  You have market volatility, global conflict and product disappointment all standing between now and then.  You even have the potential for scandal and misdeed.  Apple is like any other company in the end, and while they have succeeded in changing the way that people use technology, it is still just a stock with all the failings that stocks hold.

What we cannot predict, or grasp, is the power of market psychology.  We saw it happen in the late 1990s with the dotcom bubble.  Crazy, stupid predictions were levied against company stocks.  And for a long time, those predictions held because of the sheer power of the herd.  When the bubble finally popped, it was a long fall.  The NASDAQ hit 5,100 at the peek.  It then fell 78%.  Today the NASDAQ sits at 3,000.  That is quite a powerful bubble that inflated in the 90s.  It will happen again.

And we didn’t have to wait long.  This morning, Instagram just sold for $1 billion.  They have no profit, no revenue, and thirteen employees.  (The first half of this article was written two days, before the announcement – honestly!).    Back in the height of the dotcom boom, companies were valued at roughly $2 million per employee despite a lack of profits.  Now, it seems that zero revenue can get you around $70 million per employee.  Insane?  Yes… and no.  Allow me to explain.

Facebook is the acquirer.  They have been trading in the private market at roughly a $100 billion valuation, or 150x earnings (at least they have earnings).  Again, a seemingly insane valuation.  Yet, the valuation is justified because the current buyers expect an IPO in May that will allow them an even higher valuation to sell their shares.  Because of the euphoric stock market, Facebook now has a “currency” – their stock – that allows for the type of transaction we saw this morning.  Without the public equity market, Facebook wouldn’t have the currency to make this deal.  Without a bubble, the equity markets wouldn’t place such a ridiculous value on the company.

But why should this matter if the markets are efficient and everyone has a chance to buy or sell at will?  The grim reality is that someone will be left holding the bag, a devious game of musical chairs.  And I can promise you, as we saw twelve years ago, those left with sizable losses are individuals who chase the markets in hopes of gaining a stronger retirement.  They are the ones that inflate the last bit of the bubble, when the institutional traders have started to make for the exits and the employees of Facebook and Instagram have cashed out of their stock.

While I don’t intend to inspire a debate about social injustice, this pattern has played out before.  And the results dragged down the US economy for a decade now, delaying retirement for millions of folks and stripped away jobs from an otherwise healthy economy.  Bubbles create extensive damage, far more than the benefits that are reaped during the inflation.

Investment Direction

As you will see in our current portfolios, we have maintained a conservative posture despite the market rally.  Our equity positions, at roughly a third of portfolios (or less), have done well on the heels of strong individual stock performance (namely Apple, Intel and Weyerhauser).  We don’t expect this range of outperformance again, but I also don’t expect this market rally to continue at this pace.

The balance of the portfolio is in bonds (40-50%) and commodities (10-15%).  Both have been remarkably stable over the past year, and this quarter is no different.  The bonds are geared to provide a stable income stream at above market rates.  We continue to do so with the use of unusual or illiquid pieces and ongoing in-house research to identify opportunities.  The commodities are a hedge against dollar deflation – a very real possibility as the economy stumbles through the next few quarters.  As the government expands the dollar base through Fed action and we pile up debts at the state and Federal level, the pressure on the dollar will increase.

Finally we continue to look at hedges against future volatility.  It is a very real concern, and could be an immediate problem with just a couple of global events.  As we saw in 2011, most hedges were ineffective as volatility reached well beyond historical trends.  We continue to integrate these lessons learned into our strategy while looking for situations in which the markets can challenge us in new ways.

I know that these updates create a certain level of dejection with a few of my fans, and wish that I could be more enthusiastic about the financial situation.  But the realities are tough to ignore, and I’ve always believed that accurate and full information is far more beneficial as we make investment decisions and life choices.

All the best for an enjoyable spring.

Regards,

David B. Matias, CPA

Managing Principal

Market Update: January 2012

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Overview of 2011

While I am certain to be accused of using clichés in the past, I am somewhat loathe to the majority of them.  In particular, the “roller coaster” ride of market volatility is used again and again and again anytime someone has a bad day in the stock market.  Well, despite my greater sensibilities, here we go.  The market performance in 2011 can be summed up in one phrase: “It was a roller coaster of a ride!”

In the sense that a roller coaster takes you to exciting peaks and nauseating valleys with the speed of a falling asteroid, it has another characteristic that is often ignored.  You get off the roller coaster exactly where you began, except for perhaps some subtle shifts in the earth or cosmos during your ride.  For 2011, the broad US Stock market (S&P 500) ended the year exactly 0.04 points below where it began, for a -0.0003% loss.  Combined with swings of 25% during the year, some of which occurred in the span of just a few hours and minutes, you had the roller-coaster ride of a generation.  In fact, you have to go back to the 1930s to find as volatile and quirky a market.  (To make the point perfectly clear, the market swung from a 3-point gain to its loss in the final 12 seconds of trading).

Another part of the cliché might be the residue that one collects on your ride.  In the same way that an open mouth on a roller coaster will inevitably result in a collection of bugs lodged between your teeth (they are protein), an investor in this market did come away with a nice collection of dividends during the year.  In fact, the 2.1% dividend yield on the market is the sole benefit to maintaining full stock exposure throughout the year.

It turns out that dividends are one of the main themes for stock investors in 2011.  If you had a portfolio of high dividend stocks, you were going to do far better than the broad market as investors sought their relative safety.  Another theme was domestic versus foreign.  We here in the US were fortunate – if you stayed in the market for the duration you came out intact.  Overseas was a far different story.  The most stable of the foreign indices – large-cap developed economy stocks – lost -12% last year.  If you were invested anywhere near the emerging markets, the loss was closer to -20%.

Another theme I’ve noticed is the lack of news about the year’s return.  Whereas I usually see a barrage of in-depth financial articles on the “year in review” they have been scant and thin this month.  Maybe it is early, or maybe this is just the year to forget.  Or maybe it is because there is no good news.  One tidbit I was able to catch is that 84% of large-cap mutual funds failed to beat the market, and most actually lost money.  My favorite whipping post, Fidelity, is a good case in point.  Of the 59 domestic equity mutual funds that they list on their website, six beat the market.  Only three of those beat it by more than 0.5%.  Yet another nail in the coffin of the mutual fund industry.

The message here is a simple one – volatility killed the year.  With so many days with such large swings up and down, it was a market that was going to punish anyone who tried to master it.  No matter what sort of risk you took, it got beaten down.  And while the market did limp back to neutral by the last week of December, it took a heavy toll on all asset classes and investors.

(NOTE:  As an aside, I want to address this disparity between the Dow Jones Industrials Average and the S&P 500.  The Dow was up +5.5% for the year with dividends, as compared to the S&P’s +2.1% rise, a wide disparity for seemingly similar measures of the market.  The difference is in the manner in which the Dow is calculated.  By averaging the prices of just a few companies (30 versus 500 for the S&P), and weighting those companies based on the share price (as opposed to the actual size of the company), the Dow can develop significant distortions.  In this year’s case, IBM with its $100+ stock price, generated half of the Dow’s returns.  Bank of America, on the other hand with a single digit stock price, had a far smaller impact on the Dow even though they lost -50% in value.

In the end, the Dow is not a true representation of the broader market or the general economic situation.  And don’t be swayed by the headlines in The Wall Street Journal promoting the Dow’s performance – the WSJ is owned by Dow Jones… who is now in turn owned by Fox.)

Analysis

The primary culprits from 2011 were politicians, debt and jobs.

Whether you look to the Greek parliament debating if they really need to pay back their debts, or our own politicians debating the best way to torch our economy, we encountered such dysfunction in the US and abroad that damage to the economy was an afterthought.  While I have not yet seen an analysis, I estimate that the debt-ceiling debates took at least 0.5% out of our GDP and increased unemployment commensurately.  Rather than find ways to govern, our leaders are finding new ways to fail.

The debt does not go away, however.  While Paul Krugman has made some interesting points about sovereign debt (namely, you don’t need to eliminate it, just keep it in check with economic growth), debt has grown so rapidly in most developed countries that it now challenges their economic prospects.  The fear is not default, which is irrelevant when you can print money, but instead a currency battle in which your dollars (or euros or sterling) are worth half their value tomorrow.  We saw this in Germany in the 1920s, and it led to disastrous consequences.  It can happen again, and the results will be unpredictable at best.

While debt in its many forms is a fuel for economic growth, in a stagnant economy it can lead to contraction and decay.  The impact that we see today starts with the banking sector.  Largely responsible for providing the credit necessary for business to function and individuals to monetize their future earnings, the banks control trillions in lending and new loans.  With their profits under fire from the excesses of the past decade, and in some cases their very survival dependent on government largess, banks have stopped taking on new risks.  In fact, they are so risk adverse that their behavior is not unlike a child who burns her hand on a stove.  It might take her months before she wanders past to that very stove without fear.  The banks are no better in this economy.

The global banking conundrum would not be as bad if the economy were stronger.  But with joblessness so high (pushing 20% depending on the true measure that you use), any contraction in credit is going to have a devastating effect on many businesses and families.  We have an economy that is rooted in consumption (73% by last measure), and without credit people cut back on consumption, whether it be personal items or new homes.  The problem continues to spiral as you incorporate the housing problems – millions of homes under foreclosure and banks unwilling to address the core of the problem.

The silver lining to debt is that it can become irrelevant over time.  As long as payments are made as expected and the economy moves back into a steady growth scenario the problem becomes self correcting.  We do eventually inflate our way out of the debt burden (over decades however) and investor confidence returns which allows for short-term debt maturities to be rolled over.  While I’m not saying with certainty that our problems will fall away, and a significant moral hazard is likely to develop, there is a road out of this that doesn’t lead to a disastrous outcome.

Outlook for 2012

Unfortunately I don’t have a resounding answer for “what’s next.”  It was a brutal year in 2011, one that emphasized the point that we’re experiencing a tectonic shift in the economy – a function of social and technological changes.  In the way that the last half of 2011 was a week-by-week affair, this year may be much more of the same.  There will likely be a period of relief where the market calms, as we’re starting to witness in the earnings numbers, but the problems are still lurking below the surface.  Iran and Israel is perhaps the most pressing of those problems – what happens there will impact all of us.

In a practical sense, some trends are likely to continue.  We expect:

  • Stable, cash-flow oriented companies to be the better performers in the equity markets
  • Fixed income to continue to be the better of the two investments, but with short maturities
  • The yield curve could suffer some dramatic shifts, impacting investment grade bond pricing in hard swings
  • Commodities to continue to be constrained from water scarcity and population growth
  • Currency movements and dollar devaluation being the largest risks to investment portfolios in 2012

This is just a brief overview of where we stand today – we will be publishing more detailed analysis of these trends and issues in the coming months.  In the interim, have a great winter.

Regards,

 

David B. Matias, CPA

Managing Principal

 

1 One of my favorite quotes of the year came from a Greek cabinet member, “Europe needs Greece more than Greece needs Europe” in reference to their obligations to pay back European debt holders.  This attitude still prevails today in many European countries that have ballooned their debts while gutting their economies.

Market Update: October 2011

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Market Update – October 2011

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

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

Fear for Fear Itself

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

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

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

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

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

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

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

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

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

Economic Stresses

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

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

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

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

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

Rest of the World

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

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

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

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

Painful Decade or Bad Century

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

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

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

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

All the best for fall.

Regards,

David B. Matias, CPA
Managing Principal

Market Update: August 2011

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Market Update – August 2011

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

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

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

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

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

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

Downgrade

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

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

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

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

Real Growth

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

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

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

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

Shift to Market Psychology

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

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

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

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

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

Regards,

David B. Matias, CPA
Managing Principal