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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.

Chart 3 Image

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

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 Update: January 2013

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I am going to make a bold statement here: I declare 2012 the least interesting year since 2006 – at least from a markets perspective. The stock market went up. The bond market went up. Commodities went up, a little. And more importantly, there were no market calamities. We have had a financial disaster every year since 2006: the sub-prime collapse in 2007, the banking collapse in 2008, the market collapse in 2009, the flash crash and Greek collapse in 2010, a political collapse in the United States and Greek collapse (again) in 2011. This year was actually pretty calm: markets generated rather steady gains, and we didn’t reach the brink of collapse. The only exception was the Fiscal Cliff political drama in the last weeks of 2012, and we won’t know how that plays out for a while longer.

A relatively sleepy year notwithstanding, I don’t believe that we are out of the woods yet. In fact, I’m still holding onto some concerns and worries that have affected our decision-making and strengthened our belief that Vodia’s commitment to stable, conservative investment strategies that manage risk effectively is what’s most needed as we make our way in an uncertain future. America, along with other developed economies in the world, is going through one of the deepest set of challenges we have faced as a nation. How we fare, and how the next generation thrives, is dependent on what we all do now.

Market Performance and Apple

The year’s equity market performance was remarkably steady. The market went up for the first three quarters of the year, despite some volatility in the spring. The fourth quarter was a lot bumpier. With a decline of several percent in Q4, the largest companies in the market indices led these declines.

The Q4 decline settled in immediately following the election in early November. With Obama’s re-election, it was clear that capital gains tax rates would rise. With this certainty, there was a large impetus for institutions and folks to realize their larger long-term gains, namely in stocks that have done exceedingly well in the past year such as Apple, Intel, and also Merck.

S&P 500 index performance for 2012: While there was a bounce down in May, it was relatively calm compared to the past five years. The post-election drop was largely driven by uncertainty around tax rates and locking-in long-term gains.

S&P 500 index performance for 2012: While there was a bounce down in May, it was relatively calm compared to the past five years. The post-election drop was largely driven by uncertainty around tax rates and locking-in long-term gains.

I want to focus on Apple for a few moments, not only because it has become a permanent fixture in the media, but also because it has been a longterm holding at Vodia. The tax selling is not the only reason for Apple’s decline, but it was a large part of it initially. With Apple being the largest company in the stock market at the time, it represented a significant part of the market’s daily movement. In fact, institutional portfolios are saturated with Apple and have no further room to allocate to the stock. Hence, any type of short-term aberration, whether it be tax selling or a slow down in growth, has the propensity for a dramatic movement in Apple’s market value. But that was not the entire picture.

Over the past twelve years, Apple created several new markets around portable devices and the software-based ecosystem to support those devices. The devices (iPod, iPhone, iPad or MacBook), the services (iTunes, Apps Store, iCloud or the support services to these offerings), and their operating software (OSX and iOS) all work together in an intuitive and seamless manner. And let me emphasize the intuitive user experience aspect here – whether it is my father or a toddler, nearly everyone can use Apple products. This level of ubiquitous access to technology is unprecedented, and the ramifications for everything from corporate productivity to education are enormous.

This unprecedented accessibility has been reflected in the company’s financial performance. Apple generates over $50 billion in operating cash flow each year – after all expenses are paid (for comparison, this is the equal to HP, Microsoft and Google’s operating cash flow combined). And they continue to grow at impressive rates. This past quarter saw revenue grow at 18% over the prior quarter, with the realization that they could not make enough of their hot products to meet demand. Put simply, they sold nearly everything they could make.

But there are glitches in the story. The cost of making the products has gone up. As a result, Apple profit this past quarter was roughly the same as a year ago, even though sales were up. They are also facing significant competition for the iPhone as knock-off and competitive products have matured. And of course, with the passing of Steve Jobs, we don’t know what markets Apple will reinvent next; one possibility is television, and Tim Cook’s drive to redesign the entire experience.

Although these threats exist, they don’t change the overall picture of Apple’s position in the markets – they are still growing extensively and globally. We have managed the Apple position accordingly, moving from an overweight risky equity at the beginning of the year to a neutral/underweight in the fall. The market decline, however, has placed Apple’s value far out of line with the fundamentals, and with near hysteria surrounding their recent decline we are again viewing them as a potential overweight.

Getting back to the equity markets, Apple’s impact was felt far and wide. Noting that Apple was still up 33% for the year, the S&P 500 with Apple in the index was up 16% for the year, while the Dow Industrials, which does not include Apple, was up by only 10.2%. That is a fairly wide disparity, and one worth tracking. Alternatively, the international markets performed even better, with the MS EAFE developed markets index up 17%. With far less volatility than we have seen in the past five years, it was a decent showing all around.

My overall assessment of equities remains cautious. I still hear the chatter from equity managers to “just stay the course” with the stock market. If you have twenty years to invest and wait, that has usually been a safe and wise way to go. But the pursuant returns (9% per annum for the past twenty years) do not justify the ridiculous volatility from a repeated cycle of price bubble and collapse. And the reality is that few investors have the ability to wait another twenty years. If markets collapse again, waiting to see what happens could prove to be a devastating experiment.

The Economy

What might happen in the next few years is not so clear. Equity performance depends on the ability for companies to grow profits, speculative bubbles aside. Profit growth in a broad sense can only occur with a growing economy. Our economic growth used to be around 4% per annum – a healthy and vigorous pace for a developed nation. But that was back in the 1960s and 70s. Today the pace has dropped to 2% or less when we are not in a recession. It used to take six months to recover lost jobs after a recession; we now are sixty months past the last recession and there is no jobs restoration horizon in sight.

Our economy is still strong – the largest for any single nation in the world. But it is not strong enough to sustain repeated blows: the financial crisis, sub-prime real estate disintegration, financial market dislocations, or political infighting and potentially devastating partisan divisiveness. Each and every one of these has happened in the past five years, and the debt- ceiling debate is still getting postponed. It won’t take too much to cause another recession, or further job loss.

While our growth has slowed considerably, we are still the largest single economy in the world. Sources: CIA Fact Book, Bloomberg

While our growth has slowed considerably, we are still the largest single economy in the world. Sources: CIA Fact Book, Bloomberg

I am optimistic that we will be able to continue growth, but it will have to come with change. Overall, we are witnessing the change from an industrial economy to a digital one. This has generated a level of income and wealth inequality that hasn’t existed since the end of the 19th century. And with changing geopolitical dynamics, we have become a nation driven by fear: not only do we see terrorism as a threat from without, but some believe we must arm every citizen with assault weapons to protect themselves from within. Change is scary.

But change can also be good.

With that change, we must look beyond the trends of the past for new valuation techniques and investment opportunities. It has been five years of disruption as change takes hold, and will at least five more years until we can find some certainty in the economy. To respond to this dynamic in the portfolios, flexibility will be key; awareness is critical.

Change and Disruption

This change is creating vast disruption and opportunity in society and the economy. As we refine our investment strategy, we see at least five primary dynamics to watch in the coming year:

  • Political histrionics – whatever the crisis du jour may be, it can do severe damage to the economy and our prospects. Manipulating the tax system in a haphazard way, for example, created the decline we saw in markets in November and December. The partisan entrenchment needs to stop before it leads to devastating self-inflicted wounds.
  • Investment in infrastructure –there is a need for a coordinated and concerted effort by government (state or Federal) to support and invest in an educated, skilled workforce and new technologies. Without these changes, the US economy will have dismal prospects for accelerated growth in a changing global economy. But Obama’s administration does have an eye towards investing in the workforce, as witnessed by his support of state-run education systems and the community college system. Even such a small change can point to bigger economic gains down the line.
  • Inequality and fairness – we have again reached income and wealth disparity reminiscent of the dawn of the Industrial Age. Moral implications of wealth and economic disparities aside, the economic impact of increasing inequality can be insidious. Income disparity at this level results in a concentration of power in the business and political realms. Witness the past election: the fractious debate over taxes for the highest income brackets and the “47%” was almost comical if it were not so real. Despite widespread fraud during the last financial crisis, all escaped punishment. This gets noticed, people get upset, and they lose confidence in the system.
  • Reshoring – the movement of our manufacturing sector overseas represented a gross misunderstanding of the importance of manufacturing know-how and innovation. There has been a trend to bring it back over the past two years, and it appears to be growing (witness Apple’s announcement to invest $100mm into a new US manufacturing base). It will only help to improve our trade imbalance and create job growth. Our service economy is not strong enough to provide the jobs growth alone – we need to be a manufacturing exporter again.
  • Debt – at all levels we have binged for decades on cheap money and skyrocketing debt. The Federal debt is a minor issue, but the current levels are sustainable if and only if the annual deficits are tempered. The bigger problem is educational and municipal debt. Both are growing enormously, and neither is being correctly measured. Municipal debt could cause a dislocated bond market; educational debt could squash an entire generation of income earners and consumers. Both need serious attention now.

All of these dynamics can be turned into positive change, but the systems are challenged and there is no deus ex machina in the wings. The underlying tension is the consumption cycle; with nearly three-quarters of our economy based on the ability of our citizens to consume, the economy will remain highly volatile and growth will be elusive. We need to get back to consumption levels in the 60% range, and addressing the dynamics above could advance that aim.

Investing for 2013
We are going to stick with an approach and process that has proven successful during these times. Maintaining awareness of the risks and issues, while recognizing that there are dozens more that can create equally devastating losses, is our first step. Overlaying those risks on a growth engine that is stable in some areas and failing in others is the challenge.

The US does have tremendous prospects for the coming years, despite political machinations. Driven by cheaper energy in the form of natural gas and our cultural propensity to innovation and entrepreneurship, I believe the economy will mend to again create sustained growth above 2% per annum. This could take several years, however, given the current trajectory of the factors above.

The rest of the developed markets are a problem, however. With Europe’s outrageous debt levels, socialist policies creating an unsustainable tax burden, and political dysfunction that makes the US look tame, their recession will likely continue for several years.

Emerging markets, with their population expansion, growing middle class, and unabashed theft of advanced technologies, are going to continue to drive global growth. Investing in any one of these markets is going to be a volatile endeavor as dislocating regional trends resolve, while finding companies such as Apple and CAT that sell into these markets mitigates much of that volatility.

Stocks are likely to continue for another positive year simply from the amount of global monetary easing in the markets. In some cases, the valuations will be strong, with high risk premiums assigned to stocks in general. In other cases, bubbles will continue to emerge and deflate – both on the upside and downside. For this reason, we will cautiously look to increase our stock exposure by 5-10% of overall portfolio allocation. Keep in mind, however, that we are still less than half equities in our managed accounts. Some of this increase might be expressed through the use of stock options rather than the actual underlying stock, giving us a little leverage with a capped downside.

Fixed income, the perennial highlight of our portfolios, is where the coming year will be trickiest. Risk premiums are at their lowest in a long time, on top of a yield curve that is historically low. Both of these factors indicate a bond market top. But unlike equities, there is a known floor on bond values (maturity value), providing a natural mitigation to any bond market volatility – as long as we hold individual bonds and not bond indices. As a result, our bond exposure will come down to fund the increase in stock exposure.

Our ability to hold individual assets (bonds or stocks) allows us to manage the systemic risks I’ve outlined. As a result, in our managed accounts we can make up for a lower-than-average stock exposure through strategies such as call options. The individual bonds also give us a natural hedge against bond market volatility. In accounts where we are limited to using exchange-traded funds, the allocations will vary this year to account for higher levels of systemic risk.

We are maintaining roughly the same commodities exposure as this past year – 10-15% of portfolios – but shying away from energy and focusing more on gold and agriculture. The reasoning in simple: inflation. I don’t see inflation on the immediate horizon, but I do see it as a sizeable risk in this era of unprecedented monetary easing.

And finally we will continue to hold larger cash reserves (10-20%) to buffer against systemic volatility and allow us buying opportunities in deeply stressed markets.

Please don’t hesitate to call or write, and I wish you all the best for a manageable winter.

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: 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 – June 2011

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In a sign of our times, economies are slogging towards something yet-to-be-understood, revolts crop up around Facebook pages, and market pundits continue to drivel about a recovery “around the corner.”  Taking a step back from the daily static of mass media reporting, we are in the midst of a tectonic change in finance and economics that began a decade ago and signaled its presence in the collapse of 2008.

How we manage out of this change and ensuing crisis is yet to be seen, but the patterns are developing.  Unemployment, real estate and inflation are the factors we continue to focus on for the U.S.  Commodities, food and shifts in regional comparative advantages are the themes for our international investing.  Cash flow, value creation and sustainability are the core tenets for our investment strategy and will continue to be so for the coming months and years.

In this market update, we look at how these patterns have solidified in 2011 and the global factors we feel are most likely to influence our outlook.

Revolts in the Air – Still Looking for Progress

The news of global unrest in the Middle East has certainly been on the forefront of our minds in the past few days and weeks.  Peaceful protesters, tribal leaders, and indoctrinated dictators continue to vie for power throughout the region.  Domestic conflicts, like we are seeing in Yemen, have the potential to reverberate around the world as important oil powers like Saudi Arabia get involved.  All this has substantial impacts on the U.S.’s geopolitical hegemony.  The U.S. has appeared to play catch up to the political changes in the Middle East—changing policy as protesters gain power over dictators.  What is becoming clearer every day is that the U.S. will be challenged to maintain its position in terms of political or economic influence.  Democracy for all is a wonderful idea – but not a reality in a region that is still struggling with the basics of gender rights and religious freedoms.

The impact on the financial markets can be viewed through the lens of oil.  With the Middle East representing about 44% of current global production and 54% of worldwide reserves, any notable disruption to that region’s oil producing infrastructure will cause dramatic spikes in the cost of energy.  While short-term this drains current income for consumers and business, long-term it has the potential to create a nasty global recession.  Oil-producing countries have incentives to keep prices reasonable to ensure steady long-term demand.  Hence, OPEC’s intense interest in maintaining stable and predictable oil prices.  With Yemen on the southern border of Saudi Arabia and their close ties to Al Qaeda, many do not miss its importance in the global economic balance.

Any transition in Yemen’s government will set the tone for similar disruptions in the region.  Syria is to be closely followed for many of the same reasons – proximity to Israel and Iraq, close ties to Iran, and the potential for extreme violence.  The administration realizes the importance of these changes to our economic welfare.  The view of the U.S. as a fair negotiator may be critical to holding sway in key discussions between yet-to-be-known regional parties.  It is no surprise that Obama is attempting to take the initiative in the region with a hard line on Israeli-Palestinian peace talks: our ability to continue to shape the region is going to hinge on perception as much as reality. Time will reveal all as we closely watch this region.

U.S. Market Fundamentals

While the events in Yemen and the surrounding countries continue to evolve almost hourly, here in the U.S. the same themes from the past few months predominate— real estate, employment, and inflation.  The newest numbers point to more of the same in the labor markets, with limited job creation.

The most recent employment numbers remain just as distressing as ever.  The employment level, as opposed to the deeply methodologically flawed unemployment numbers, continues to stay at historically low levels—about 58%.  We haven’t seen numbers this low since the early 1980’s when the composition of the labor force was drastically different.  This is due to the increase in the number of women leaving the home sector to be “officially employed.”  So while the employment level is currently on par with the early 1980’s—a time of recession, it actually represents a worsened situation because the number of people seeking to be employed has grown in the past 30 years.

The employment level for the U.S. continues to remain at historically low levels dating back to a period in which women were a smaller component of the workforce.  The monthly movements up and down represent statistical noise in the overall picture.

Meanwhile, the outlook in real estate prices and future inflation continue to be troubling.  After a slight increase in 2010, real estate prices have declined again back to 2008 lows.  On a more local level Boston has faired better than average—we’re seeing prices around the 2004 level.  Atlanta, on the other hand, has taken a serious hit, losing more than a decade of appreciation and placing most mortgages under water.  As an asset that is illiquid and at the core of the real economy, these declines have wiped out trillions of family net worth.

The above chart shows the Case-Schiller composite Home Price Index going back to 2000, not seasonally adjusted.  While the drop-off in prices was severe, it has shown no signs of short-term improvement and in fact a bit of deterioration over the past few months.  Eight and one-half years of price appreciation has been eliminated from this collapse.

While some cities have fared better, Atlanta’s home prices (shown above) have suffered draconian effects from both the collapse and the ensuing foreclosures.  With prices retreating to levels not seen since the 1990s and falling a third from their highs, homeowners have lost a tremendous portion of their net worth and are underwater in most cases.

The slow real estate market continues to hamper the economic recovery on a host of levels.  On a macro level the perennial obstacle the housing market is facing is the foreclosure glut—banks are still dealing with a record number of homes that they have to move on a scale unimaginable before the crisis.  Homes remain vacant for months or even years in some cases, driving down the value of the surrounding homes.  With the banks relying heavily on valuation comparables and reluctant to lend in any situation that isn’t completely consistent with their stringent guidelines, the foreclosures enforce the cycle of declining values.

This all affects the labor markets when people have difficulty moving to identify or fill new jobs, causing extra friction that the economy doesn’t need.  In turn this trickles down to consumption spending.  The seemingly insignificant purchases that folks make when they move—throwing out old appliances in favor of newer versions—add up and create a real impact on the economy.  During the boom, this housing based consumption led to the massive trade imbalance with China and their multi-trillion U.S. dollar currency reserve.  Today it starves the economy for a source of growth.

Unfortunately we expect the situation in housing to remain fairly dismal until the banks get ahead of the foreclosure problem.  While it is conceivable that a recovery could occur without consistent real estate appreciation, we doubt that to be the case.  Look for this indicator to be closely watched in future updates as a gauge to domestic economic growth.

Turning to the treasury market we are getting an indication of the worries that surround the U.S. economy.  The interest rate on medium-term treasury bonds recently dipped below 3% in early June, a level not seen since last year.  From an investment standpoint the paltry returns on treasuries mean that holding a ten-year treasury to maturity will not keep pace with inflationary pressures, resulting in a negative real yield.

While changes in the equity markets often reflect the mood of investors, fluctuations in the returns on treasuries are more representative of educated institutional views on the economy.  Looking to Washington, these views seem validated as politicians continue to bicker across partisan lines as opposed to finding real solutions.  While the bickering over the debt ceiling is frivolous showmanship, and discounted as much by the market, a new round of quantitative easing would further devalue the dollar with the commensurate increase in inflation.

In terms of the U.S. equity markets the current volatility is in line with our expectations.  It can be easy to get caught in the day-to-day fluctuations (just watch CNBC for six minutes), especially when they seem to be predominantly negative, but it’s important to remember that on a year-to-date basis the market is up 1.5% (as of this writing).  The generally anemic growth in U.S. equities is to be expected considering the current economic outlook.

While the volatility in the U.S. equity markets appears daunting, it simply places us back at a 1.5% gain for the year during a period of strong economic uncertainty.  With a current price-to-earnings ratio on the SPX at 14x, and a future P/E of 12x, this level is consistent with corporate profit levels and expected growth.  While we don’t like to use these measures as a predictor of market movement, it does give us comfort in this level as a floor to short-term market volatility.

Because of the Fed’s loose monetary policies, we see inflation as a significant risk as the supply of dollars grows and excessive cheap money triggers future jumps in economic growth.  Core CPI, which excludes important variables like food and energy, remains almost insignificant at 1%.  Common sense, however, dictates that these are probably two of the most sensitive spending components for any inflation indicator.  Looking at the “All-Items” CPI data, which includes these numbers, inflation picks up a bit to 3%.  While this is notable, barring another recession we expect inflation to further rise to 5% or more in the near future.

This view is already being realized in the commodities markets.  While equities have declined by upwards of 7% in the past few weeks, commodity indices are flat or up.  Traditionally a soft economy drives down demand for commodities, but this disparity can be explained if we take a look at role of increased global demand.  We expect this development to continue, a view that is driven largely by changes in the global demographic.

Global Changes

To understand this trend we begin with the recent policy changes coming out of China.  It recently released the 12th Five-Year plan, instituting a dramatic change of policy from headline growth to the welfare of its citizens.  This is a much more realistic vision of where China needs to go if it wants to avoid a repeat of the trouble that’s been brewing in the Middle East.  Rising inequality has been a concern for China since it first began developing the urban coastline at the expense of the more rural inland population.  As a whole the country is still relatively underdeveloped, with only 50% urbanization and an average income that’s 1/10th of the United States.

The largest problem China will face in the coming years is a demographic shift as its one-child policy and declining mortality rates change the composition of the population.  With the labor force expected to peak in 2015, China faces the same situation as the U.S.—supporting a growing elderly population with a declining number of workers.  This means that increased health care and pension costs will eliminate the low wages that have effectively subsidized cheap products for Americans.   We will need a new source of cheap labor to keep the consumable economy ticking along.  Given our strong bias towards sustainability, I am intensely curious to see where the beast of cheap manufacturing goes next in search of higher corporate profits.

As China transitions to a consumption economy and as the size of their middle class grows, we expect resource use to become a major issue.  The continued urbanization and infrastructure needs will place demands on commodities for years to come.  However, China is at the forefront of renewable energy development, which is a promising sign.  All these changes coupled with the size and influence of China’s economy make it the global wildcard.  As China moves to secure its future and the necessary raw resources, we expect commodity prices to reflect these changes.

The Role of Resources in the Middle East

It is precisely the role of resources that has put the disruptions in Yemen on the front page of the news in the past few weeks.  The U.S. has been conflicted in its policy towards Middle Eastern nations like Yemen—preferring the dictator we know to potentially unfriendly democratically elected governments.  Yemen has historically been a haven for terrorists, and it is also located in a highly volatile area, just southwest of Saudi Arabia.  With 10% of global oil production, any disruption in Saudi supply will have far reaching effects for the United States.  Not just gasoline but also the transportation costs for virtual every item, from food to clothing, would increase if Saudi Arabia reduced its production.  Suffice to say the tenuous economic recovery would be wiped out.

A more immediate threat for Yemen is water supply.  With one of two major pipelines already destroyed by the fighting, the country’s capacity to pump water from the aquifers has been significantly reduced.  This may be a prelude to a truly global problem as populated areas all over the world deplete their water supplies.  The current disputes over oil will be dwarfed in comparison.

Summers in Greece

Needless to say, it will be an interesting summer.  Starting with 2007 and the sub-prime collapse, each summer has brought some form of volatility and a commensurate increase in the perception of risk.  Just like 2010, we are again faced with the prospect that Europe and the Euro are going to rain on everyone’s summer vacation.  While this is old news – Greece might default on their sovereign debt – it is news yet again.

The hope was that Europe’s various institutions, from public to private, would bail out Greece long enough for it to put austerity measures in place and regain its financial footing.  For a host of reasons, from cultural to political to simple realities, that is looking dubious at the moment.  The concern is simple – if Greece does not fully pay back their debt obligations then the value of similar debt from Spain, Portugal, Italy and Ireland will decline markedly in value.  If that occurs, banks with that exposure will take a large hit to their balance sheets and place their financial solvency into jeopardy.

This is not that different from the financial crisis of 2008, when real estate backed assets were the culprit and a host of banks needed temporary capital to ride through the losses.  The differences this time, however, are notable.  The amount of Greek debt is fairly limited, the exposures are mostly known and the banks are actually generating profits.  While I don’t want to dismiss the risks, the realities are likely to be far less draconian than the predictions.

Stepping back, while the U.S. indicators are weak and there are again riots in the streets of Europe, there is little new news.  What has changed, most likely, is that the “bull” market has run out of buyers and the reality of a paradigm shift in our economy is beginning to sink in.  We have a long haul ahead of us, and no quick fix is going to shorten that road.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA
Managing Principal

Unemployment for February – Good News, Bad News

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

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

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

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

Regards,

David B. Matias, CPA
Managing Principal