Overview & Outlook
As the euphoria faded from the large rally of the first quarter, the S&P 500 fell dramatically under price action that was reminiscent of 2008, giving back all of the gains from the first quarter and bringing the year to date performance down to a negative 6.65%. There have been a few much ballyhooed “rallies” on the way down but so far they have turned out to be nothing more than hopeful bounces.
Our cautious stance helped our clients to outperform the market during the second quarter by almost 8%. Needless to say, we are glad that we kept our powder dry by being underweight equities. We welcome the weakness in the market because our large cash position will allow us to strategically re enter at better prices when conditions begin to turn around. So far, our patience has been well rewarded.
Below, we will examine key developments and the important economic data that have been on investors’ minds and moving the markets, both domestically and around the globe.
Gross Domestic Product (GDP) Data
Corporate earnings and economic data had been strong going into the second quarter but we had expressed concern over the sustainability of this trend as well as the many caveats to the good news. The strong GDP growth of 5.6% from the fourth quarter of 2009 was not repeated in Q1 and GDP growth fell dramatically to 2.7% as we expected given that a large portion of the growth from Q4 was related to inventory restocking. Wall Street analysts went into the second quarter of 2010 with bullish GDP growth estimates as high as 4.5% but over the course of the quarter, they were slowly lowered down to where they now stand at approximately 2.5% (which we still consider to be a bit optimistic).
Even if we don’t get a double dip recession, a considerable contraction from previous levels of growth is likely similar to what took place in 2002 except with a few key differences: 1.) Back then the Central Bank still had the flexibility to lower interest rates, 2.) Former President George W. Bush had the fiscal leeway to dramatically cut taxes, 3.) Consumer credit was still expanding but it is now contracting at double digit rates and 4.) We started a war, which is very stimulative to the economy.
The biggest drivers of our recovery to date have been bailout spending, fiscal stimulus, monetary stimulus and inventory restocking. Bailout spending has likely seen some of its last days with strong popular backlash against further increases in our deficit and fiscal stimulus could actually contract in 2011 as expected higher taxes come into effect. The effect of inventory restocking has likely run its course which leaves monetary stimulus as our last leg of support and even this one looks weak because rates are already at all time lows as a way of begging investors to speculate in risky assets.
The official unemployment rate fell from 9.7% to 9.5% during the second quarter but a larger portion of the unemployed have been jobless for over six months. When workers are unemployed for long periods of time, they tend to miss out on gaining valuable job experience and become less attractive to potential employers who may think there’s something wrong with them. They also may become discouraged and stop looking for jobs entirely. The median duration of unemployment is now at an all time high of approximately 26 weeks and is about twice as high as any other time since they began tracking the data in 1965. It also goes to further support the notion that many of the jobs lost during the recession will not be coming back.
To give a better picture of the real impact of this recession, a recent survey found that 55 percent of the labor force has “suffered a spell of unemployment, a cut in pay, a reduction in hours or an involuntary spell in a part-time job” since it began. The most recent unemployment claims report showed a sharp drop but it was in large part because of the political stalemate over extending unemployment benefits which caused many people to not be eligible to make claims. The number would most likely have been somewhat disappointing without this statistical anomaly. Other leading indicators such as the ISM Manufacturing PMI and the Philly Fed Manufacturing Index have also begun to reverse course after months of positive gains.
One leading indicator of particular concern is the ECRI Leading Economic Index. Over the past 42 years, there has been an 80% chance that the economy was in recession or about to enter one whenever the index registered a reading of -3.5% or less and it has had 100% accuracy when the reading falls to -10%, although not with a large enough sample data set to consider it statistically significant. The latest reading was -9.8% and seems to go along with the recent steep drop in the manufacturing and lower GDP estimates.
Although leading indicators are valuable, there’s nothing better than looking at the actual data coming out of important sectors of the economy. Financial institutions and the real estate market are two of the best areas to watch because of their sensitivity to some of the most important drivers of our economy such as the credit and real estate markets, which play a large role in the strength of household balance sheets and contribute significantly to GDP.
Many analysts and commentators are arguing that the market is cheap on a forward earnings basis but analysts have been historically horrible at accurately forecasting earnings except for in very strong bull markets. Over the past 25 years, consensus estimates have been too high by almost 100%. The current forward price earnings ratio is ~14 which is still about the 6-10 that markets cycles have historically bottomed at. Even if we give analysts a chance and assume that they are only off by 25% instead of 100%, the P/E ratio would jump to 18 which certainly is not cheap.
Banks and Real Estate
Although financial institutions have been able to post pretty good numbers lately, their ability to continue doing so in the future is very linked to the residential and commercial real estate markets which are on very shaky footing. The problems in the residential market are well known and after years of foreclosures, banks now own a greater share of residential net worth than all other homeowners combined for the first time in history. The banks are still holding onto their shadow inventory to avoid taking write downs which would make their earnings look bad and because they are hoping that prices rebound. The problem with this is that they can’t make new loans to consumers when their balance sheets are tied up in non-performing assets. The major banks have been recapitalized by the Government for the moment, but there seems to be more trouble to come and it’s unlikely that this will work again if there is a second round of losses because of popular and political outrage over taxpayer money being used to support the banking industry.
Leading indicators for the domestic housing market have also not been very good. Building permits have fallen by over 17% since the new homebuyer tax credit expired and month over month pending home sells had their biggest drop on record during June, falling 30%. Approximately 31% of sales are now distressed, which will put further pressure on prices. It is especially disconcerting that all of this bad data is coming out despite the fact that the Government and Federal Reserve are doing everything possible to stimulate growth in the sector.
Market commentators have been talking about the commercial real estate shoe that’s “about to drop” for so long that it is beginning to sound like a boy crying wolf but we believe that the threat is still real. This is evidenced by the recent surge in commercial loan restructurings (more than three times the normal amount) which allow the banks to kick the can further down the road like was done in Japan in the 1990’s. When prices never rose, it caused the economy to stagnate and we can expect similar reactions in the United States as well. Analysts currently estimate that 9% of commercial loans are delinquent and that real estate values are approximately 42% their 2007 peak. If this shoe does drop, it will drop hard.
Politics – Regulation and Taxes
Going into 2010, there was a great deal of uncertainty around the end result of healthcare reform and financial regulation. Healthcare was resolved last quarter and financial reform was finalized at the end of the second quarter, allowing the markets to digest and evaluate the potential effects. As with health care reform, the details of the legislation matter much less than the fact that the uncertainty has been removed. The companies affected by the regulation can now decide how to proceed going forward with much more confidence.
Unfortunately, there is now a great deal of uncertainty in the energy sector because of the disaster in the Gulf of Mexico, which may cause a regulatory clampdown on one of our biggest contributor to growth and jobs. Also, it is extremely difficult for analysts to accurately gauge the full economic aftershocks from the spill. Some economists are estimating that it could take up to 2% off of our annual GDP while others predict that the money spent on cleanup activities could actually contribute to GDP in the near term.
The last major source of uncertainty relates to what tax rates people will be paying in 2011. Many people are already worried that the Government will increase their federal income tax rates to help fund our country’s increasing deficits but there is also a fear that the Bush Tax Cuts on capital gains and dividends could be allowed to expire in 2011. There is already a great deal of uncertainty regarding where the market will be a year or two from now and if the Government were to announce that the Bush Tax Cuts will be eliminated, it would provide a pretty big incentive for ultra high net worth investors and financial institutions to take profits at a lower tax rate while they can. These groups hold a very large portion of all financial assets and could potentially move the market dramatically as they attempt to sell.
Although a lot took place domestically in the second quarter, much of it was overshadowed by concerns about the rest of the world such as the slowing growth in China, the sovereign debt crises in Europe and by extension, the wild fluctuations in the value of the Euro which could crimp profits for their trading partners.
Slowing Growth in China
China exploded out of the recession because of a domestically oriented stimulus package that was more than five times as large as ours was relative to the size of their economy. Their stimulus was also particularly effective because their command style government was able to get banks to significantly increase their loans (even to bad credit cases) in order to stimulate growth. The stimulus has been almost entirely spent already and some recent studies indicate that a lot of the easy money went into Chinese real estate and their stock markets. Currently many new commercial properties remain vacant and the Hang Seng, Shanghai and Shenzhen indexes have been declining for months. These combined factors would indicate that a lot of the lent out money is underwater and that many of the loans made by the Chinese banks may go sour if growth does not continue at its current double digit pace.
Other indicators of Chinese growth have been cooling of late such as commodity prices and the Baltic Dry Index, which effectively measures demand for the raw materials that are essential to fueling China’s large manufacturing industry. The U.S. and Europe are large sources of demand for China so the deteriorating growth in those respective countries could strain its already fragile economy. It is becoming doubtful that China will be able to carry on as the engine of global economic growth in the same way that it has been. Lower growth in China would also lead to lower demand for commodities and raw materials, which would negatively affect resource producing countries like Russia and the emerging Latin American economies.
A key issue that we will be watching is whether or not Chinese consumers begin to save less and spend more. Stronger domestic demand in China would help alleviate global trade imbalances (such as with the U.S.) and will foster longer-term sustainable growth. China’s recent decision to let their currency fluctuate against a basket of other currencies is also a step in the right direction. We continue to feel that the shorter-term risks to growth in China are outweighed by the longer-term opportunities but we will nonetheless proceed with caution given the fragile state of the global economy.
During the peak of the recent financial crisis, investors were panicking over the build up of toxic assets on private sector and financial balance sheets. In Europe (as well as in the U.S.) they alleviated much of that fear by removing the bad debts from private balance sheets, and placing them on to sovereign balance sheets. This strategy of brushing the toxic assets under the rug worked for a bit but now investors are beginning to question whether even entire countries are strong enough to handle the debt burden because of declining tax revenues. The investor concern is currently already up in the form of widening yield spreads on sovereign debt and the inability of countries such as Greece and Spain to borrow money from the international community at non-usurious rates.
In order to counter the deflationary debt environment, governments have been simply creating more debt over the past couple of years. This has worked as a temporary bandage to the problem but by delaying the inevitable, the ultimate process of reducing debt-service to GDP ratios back to normal levels will become even more difficult and the social consequences could be even more severe. The nations of Europe are now facing an important dilemma and neither option looks very good. They can either A.) Continue deficit spending in order to fund social services and stimulate their economies out of recession, or B.) They can cut social services, welfare payments and draw back stimulus measures in order to reign in their deficits.
Fiscal conservatives argue that hyperinflation will be the result if deficits are not reined in within a timely manner and that governments need to cut spending. This would normally be a valid point except that we are currently in a deflationary environment (which is arguably much worse than inflationary) with high unemployment. Both of these factors put downward pressure on prices. The purpose of restoring the health of sovereign balance sheets is to rebuild confidence in the Euro and so that banks can resume lending and companies can go back to hiring. Unfortunately, cutting government spending is likely to have an almost opposite effect (in the short run at least) because governments are large employers and also represent a great deal of demand for private goods and services (solar subsidies for example) so any cutbacks in government spending would almost immediately translate to a worsening recession which is unlikely to inspire confidence.
On the other hand, you have the Keynesians who argue that the only way to get out of the recession is to use government spending to fill the gap left by the fall in private demand. This makes complete sense except that Keynesianism is based on the assumption that governments create surpluses during good times so that they can draw them down in times of crises. There is also very little popular and political will to continue deficit and bail out spending so even if governments do go this route, it may not get very far. However, we’ve already seen the effects of austerity measures being enacted in Greece where there were riots in the streets.
The S&P 500 took quite a tumble in the second quarter of 2010, shedding 11.43% of its value as economic data began to turn around to the downside. Our average composite client portfolio performed relatively very well with a decline in value of only 3.58%, benefitting from our cautious positioning going into the quarter.
The MSCI EAFE (European, Asian & Far East) index fared even worse, losing 13.75% of its value during the second quarter. The EAFE is now up only 6.36% over the past year compared to 14.42% for the S&P 500. We believe the recent underperformance to be directly related to the concerns over European sovereign debt and the value of the Euro.
The Barclays Capital U.S. Aggregate Bond Index had a good second quarter gaining 3.49% and setting a new multi-year record on June 30th. The index is now 9.5% over the past year reflecting a more cautious feeling in the market as investors begin returning to safer assets like bonds and away from equities.
The global economy is facing many daunting challenges as we enter the third quarter of 2010 but there is nothing new to this. We have faced seemingly hopeless challenges in the past and we have persevered and grown out of all of them. Even if you had bought during the peak before the Great Depression and then dollar cost averaged for the next five years buying at the beginning of each year, you would have made a profit of almost 100% by the end of the fifth year. This is why it is so important to maintain a long term perspective.
We believe that the global economy is going through a significant period of structural change in order to alleviate the imbalances that have led up to the current crisis such as under consumption/over saving in Asia and overspending and a reliance on foreign credit in developed countries. These changes will take time and are likely to have many false starts along the way as investor sentiment fluctuates between fear of losses and greed for profits, but we are confident that the U.S. and global economies will emerge from this transition much stronger (and sustainably so) than when we began. As human beings, it is easy to be afraid of the unknown but from an investing standpoint, pragmatic optimism has historically been much more profitable over longer time periods.
The challenges of today are laying the groundwork for the opportunities of tomorrow. For example, increased American consumer saving is a negative in the short run because they will be spending less, but it is a required step in restoring household balance sheets so that we can spend in the future. The slowing growth in China has so far been well controlled and will hopefully prevent their economy from overheating like many economists had feared and will enable them to continue contributing to global growth. Another major trend is the coming of age of many developing economies such as the Brazil, India, China, South Korea, etc. which are now emerging as major players in the global economy. Their increased strength and consumer demand will likely be a positive force in helping the struggling developed nations to get back on their feet.
Progress and innovation to do not stop for anyone or for anything. Even during the darkest days of recessions, there is research taking place that has the potential to revolutionize the world. The Internet as we know it, has only been around since the mid 1990’s, but it is already apparent how much of an impact it has had on the world, both socially and economically. Today, scientists are almost done mapping the human genome and technology (including biotechnology) is advancing by leaps and bounds. We do not know what the ultimate catalyst will be but we also expect the limited supply of oil and growing global demand to eventually spur massive public or private investment in clean energy technologies which could drive the economy for years to come.
We are certainly on a very bumpy road right now but we remain convinced that the road leads to a good destination. In the meantime, we are keeping our eyes wide open to spot potential potholes and maintaining a cautious outlook as we attempt to balance the favorable longer term opportunities with the current weak market environment.
We continue to be very proud of our long-term market beating track record as well as our performance during downward trending markets like we’ve had recently and we believe it is a testament to the effectiveness of our pragmatic investment approach and methodology. Over the previous five years, our composite portfolio performance tallied an increase of 18.78% net of fees and commissions compared to a loss of 3.93% for the S&P 500, and we did it with less than half of the volatility since inception*.
Words of Wisdom for the Third Quarter
“The return of principal is far more important than the return on principal.” – Will Rogers