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The End of the Bear Market Rally

Thu, 14 May 2009 09:55:33 -0700

The market is driven by economic expectations. Knowing this one should be able to make positive investment decisions, but in practice, timing the market is very difficult. We believe that the capital markets are generally efficient. Investors use available information to assess the economic outlook and make decisions on that basis. Changes in market values are driven by changes in longer term outlooks. If conditions appear to be improving, investors buy, driving up valuations to reflect a more positive outlook. If various events are seen to reduce economic output, stocks as a whole, decline in value.

The problem is, expectations are easily influenced by emotion. Towards the end of the first quarter, investors chose to focus on positive news items. The financial talk centered around possible stabilization of the housing market, a fix of the banking crisis, and improving credit market conditions. The subsequent rally was impressive. Though the Dow and the S&P are still down year to date, they are up considerably from their lows, while the Nasdaq closed up nearly 9% year-to-date through the end of April.

Unfortunately there’s much to be concerned about and for that reason we are remaining conservatively positions. We have increased our equity exposure, but only marginally. At the end of the year our average account held only 8% of assets in stocks. In more than 30 years we’ve never had so little exposure to equities. We’ve increased that exposure, but not in a meaningful way. There are some signs of improvement, but our expectation is for stabilization. In our view, real improvement is a long ways off and there is real risk that elements of the economy might get worse first.

Unemployment will go higher. This will continue to create downward pressure on consumer spending. So far spending has been affected less than we had anticipated, but it is weak and will likely get weaker with increased unemployment and stagnant wage growth.

Housing is stabilizing and in some areas showing real improvement. That’s not to say that prices are going up, however, inventory is moving faster and prices are more stable than they have been.

Expectations for GDP growth continue to be revised downward. Generally after a recession, growth accelerates as lean companies realize outsize gains in profitability as the economy and spending recovers. Current forecasts call for negative growth through the third quarter with only marginal subsequent gains. Due to tighter credit, neither consumer nor corporate spending is likely to bounce back.

The overall outlook has stabilized. We no longer hear the word depression bandied about. With this stabilization came the, somewhat predictable, first quarter rally. This recession has already run longer than any since the 1930s and by all accounts, the recovery is expected to take much longer. We anticipate stock market that reflects this. Some profit taking from the recent rally followed by very gradual gains assuming the outlook continues to improve.

De-leveraging the Age of Excess

Mon, 22 Sep 2008 12:09:21 -0700

The reduction of leverage is a painful process, particularly against the headwind of declining asset values. Consider your personal finances. To reduce your debt you have to spend less to pay down that debt. While your debt increased, you had your income plus the debt you incurred to consume more goods. When reducing your debt, your available funds contract. Debt interest and the repayment of debt principal must be subtracted from your income. The amount of discretionary funds available diminishes significantly. In the 1990’s and early 2000’s strong economic growth was fueled by the availability of capital. Wages increased, common stock values increased, then housing values increased and borrowing expanded dramatically. As economic growth has slowed, the ability to service the increased debt that both consumers and corporations amassed has faltered. As a result, we are witnessing a perfect storm - slower growth, an inability to borrow and a considerable reduction of debt, which are driving down asset values and further reducing wealth.

Our financial system now appears broken. Brokerages, banks and other institutions are hoarding cash in an effort to increase their capitalization in the face of declining asset values. Financial companies are scrambling to reduce the leverage that brought large profits in the good times and bankruptcy when things turned tough. Conventional wisdom on Wall Street is that the financials will lead the direction of the market. Often it’s the financials that decline even before economic data turns negative. The financials are also the first to recover from any recessionary period leading the rest of the market higher. Many professional investors consider the financial sector to be an early indicator of the direction of the market. The financial sector provides the critical foundation of our entire economy. The access to cost effective capital that make business possible is dependent upon a healthy financial sector. Without this lubrication, the economy grinds to a halt. What has caught so many professionals off guard in this crisis is that the overall economy looks relatively healthy. The recession predicted at the start of the year never materialized and while growth hasn’t been particularly strong, it has been positive despite declining home values and commodity price spikes. However, the continuing collapse of the country’s financial sector is a harbinger of declining economic growth in the next few years.

The meltdown in the financial sector is due to a massive readjustment from an excess in available capital. And it’s not just a U.S. phenomenon, this bloodletting is affecting the economies the world over. We believe that this readjustment will take years to process and will be painful for equities and even some fixed income values, particularly high-yield. We are now down to only two remaining major independent investment banks in this country, Goldman Sachs and Morgan Stanley and both are unsure they can continue as such. The reduction of leverage, the reset in value in several derivative assets and numerous bankruptcies of several “too big to fail” firms has shaken Wall Street’s confidence. Despite this, the U.S. economy continues to grow though at an anemic pace. We are concerned that the deleveraging will necessarily further weaken the overall economy in the near-term. In the longer-term we believe that we will see a protracted period of slower growth worldwide as we right the ship. In the meantime, our clients’ equity exposure is at a record low, we are increasing high quality corporate debt and hoarding cash. We have begun looking at selective investments in distressed housing values, anticipating long-term gains, though we do not anticipate a quick bounce.

Tightrope between Recession and Inflation

Thu, 26 Jun 2008 14:04:03 -0700

Currently the United States economy is in an extended phase of slower growth. Corporations are well balanced with low inventories and appropriate employment levels for the current environment. This is critical to keep wages, employment and corporate profits consistent despite the lack of growth. In other words, the environment for corporate profits does not appear to be worsening despite the sluggish growth. So far.

The primary risk in our view is the need to maintain the availability of credit to drive the little growth there is, and to support housing prices. Housing is a key part of the overall puzzle. If inflation forces the Fed to raise rates there is risk of increased housing credit defaults which will affect both the consumer and, more dramatically, the financial sector.

If a stabilization of housing is instrumental, then inflation also becomes critical. Again the Fed has a delicate balance of now needing to support the U.S. dollar to slow the rise in commodity costs by at least threatening to raise interest rates. We believe that the Fed is unlikely to actually raise rates in the near-term, preferring to verbally influence the market to support the dollar and keep inflation in check. If the Fed is forced to raise rates we become increasingly concerned that equity valuations will react negatively and a likely additional reduction in credit would impact housing and financials. Employment numbers are increasingly important in this equation since wage growth will likely change the outlook on inflation faster than rising commodities. The Fed hopes that corporations will continue to believe that there no leverage to either raise employee salaries or increase prices for consumers. At the same time, the slow economic growth is helping to keep employees from demanding wage increases.

So far this scenario can be positive as long as we continue to walk the tightrope between recession and inflation. The credit crisis has been sufficiently managed to keep it from upending the economy, but concerns remain and certainly continue to weigh on the financial sector. If inflation does become too significant, the Fed will likely be forced to raise rates which could drive the economy into recession.

Obviously there is considerable concern for both the near-term and long-term economic outlook. We expect the difficult environment for equities to continue at least through the fall. We have sought to limit exposure to stocks in 2008 choosing sectors carefully. Certainly commodities have been positive and we expect them to go higher. Technology fundamentals for the most part have been positive even if the stocks have been lackluster due to multiple contraction. The difficulties experienced by the financials have been beyond our expectations and are likely to continue. We have reduced our financial stock holdings in accordance with this view. Certain international equity markets appear attractive, particularly where growth is strong, such as Brazil. We continue to concentrate equity holdings in agriculture, industrials and multi-nationals that are benefitting from a weak dollar.

We have been reluctant to add significant corporate bond positions due to relatively low coupons and the prospect of potential rate increases. If inflation can remain in check, then corporate bonds around a 6% yield look attractive to us. Municipal bonds, on the other hand are very attractive and we have been accumulating issues in the secondary market that have sufficient credit worthiness. We have been able to accumulate 10 year California tax free municipals approaching a 5% YTM. In addition to municipal bonds, we have been adding structured notes tied to corporate interest rate yield curve spreads. With the prospect of rising rates, we expect these securities to yield more than 10% annually.

Lastly, we continue to look for opportunities in both real estate and private company debt instruments in an effort to reduce equity risk and increase income. So far this decade has been a very difficult one for stocks and we believe that this environment will continue for now. Through a narrowed sector focus and an increased exposure to alternatives we are adjusting client portfolios in an effort to maintain performance with an eye on the risks. Our primary goal is to preserve the assets of our clients. After preservation comes performance and we continue to expect positive returns for our clients in 2008 despite the challenges.

Looking Abroad for Equity Appreciation

Mon, 23 Jun 2008 01:02:00 -0700

With the Dow Industrials down more than 10% we have spent more time than usual looking for equity alternatives and safe havens abroad in an effort to stay in the black. Through the end of last week, our equity positions across all accounts remain ahead of all of the major U.S. indices, but they are still in negative territory. Due to the turbulent year, our U.S. equity allocation has been low all year, and fortunately, our international exposure has been even lower. In 2008, international equities have been anything but safe with most of the foreign exchanges posting steep declines. Even emerging stars, China and India, are down 40% and 30% respectively through June 18th.
The one bright spot has been Brazil. The interlinked nature of the global economy has ensured that generally speaking, global equities today are correlated and the opportunity to hedge an equity portfolio by looking abroad is not as successful as it once was. While most of the world readjusts to housing asset valuations and credit crisis Brazil's market is up nearly 16% this year. With new oil discoveries, new mortgages for prospective homeowners, growing infrastructure investment and rising foreign investment, Brazil looks very attractive.

Mixed Messages

Sun, 15 Jun 2008 23:19:48 -0700

We find ourselves pondering whether our anticipated rally has come and gone. As seems always to be the case, most of the economic data has been mixed. What's surprising is just how polarized the signals are. On the one hand it appears the sky is falling. On the other, corporate profits are holding up and we're poised to move forward. Look at the recent unemployment numbers. Jobless claims were better than anticipated. At the same time, unemployment jumping to 5.5% drew headlines of new economic crisis. This last week Lehman disappointing results brought the firm closer to joining Bear Stearns but then the retail data, buoyed by economic rebate checks, was better than anticipated and saved the week from disaster.
Looking back to our thoughts only a month ago we anticipated a rally. We advocated increasing concentration in technology, financials, industrials, and commodities. Equities subsequently rallied nicely only to stall out as oil produced a continuous stream of new record prices and fresh round of write-downs from several of the financials reminded us that the credit crisis is not yet behind us. Technology has recovered from this year's lows, industrials have outperformed nicely, commodities continue to march upward, but our call to increase financials was certainly premature. Generally, financials lead equities higher post recession. This time is different. The consequences of excess credit have not yet been purged from the system by the current availability of excess credit. We've given up on the financials for now. Hopefully this means they can finally move higher.
While the media and congress look for someone to pin the oil crisis on, the American consumer's insatiable appetites have likely kept us from recession in the second quarter. The economic stimulus checks have had a material effect with a surprising 1.0% increase in retail sales for the month of May. In addition, March and April were revised upward. Not all the rebates are going to gasoline and credit card finance charges.
There is still plenty to be concerned about and we do not anticipate a rapid reacceleration in economic growth. In fact, we expect the second half of the year to be similar to the first. Look for sluggish growth with continued high commodity prices. At this point Wall Street is already anticipating a rate increase by the Fed to combat the specter of inflation. We think the August meeting is premature, but an upward revision this year is in the cards. Although an increase won't be cheered by homeowners or equity investors it will likely bolster support for the dollar and slow the seeming endless rise in commodity prices and particularly oil.
In the mean time we've hedged ourselves with a little extra cash and a continued focus on commodities, mining stocks, oil exploration, industrials, agriculture, chemicals and fertilizer. We're holding much of our technology investments, but we have reduced them.