Volatility Reigns for Summer 2010

Precious Metals in the Silver Lining

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

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

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

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

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

Elevated Volatility

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

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

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

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

Investment Direction

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

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

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

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

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

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

Regards,

David B. Matias, CPA