Quarterly Investment Newsletter – Q3 2010

October 29, 2010

Overview & Outlook

Toward the end of the second quarter, it appeared as though the stock market was finally beginning to price in the faltering recovery and likelihood of a double dip as the S&P 500 fell more than 11%. However, the third quarter reversed almost all of this decline in one of the best performing Septembers in over 50 years. Our analysis of U.S. economic and recent market performance indicates that fundamentals have been temporarily thrown out the window in favor of speculating around the actions of the Federal Reserve and other central banks, the third quarter rally took place in a backdrop of worse than expected economic data, some of which came in at or below lows not seen since the collapse of Lehman Brothers in 2008.

Although it seems contradictory, the rally was due in large part to the bad news that came out over the quarter. Ben Bernanke, Chairman of the Federal Reserve, gave a speech during the third quarter while the market was under heavy selling, in which he basically said that the Fed would do everything in its power to support the weakening economy and signaled that the Fed would engage in a second round of Quantitative Easing (QE2). On the day immediately following Bernanke’s speech, the S&P 500 began a significant rally.

You may be wondering what QE is exactly, it is a euphemism that economists and Central Bankers use to say “printing money and debasing the currency”; or as Brian Sack from the New York Fed would say, QE “adds to household wealth by keeping asset prices higher than they otherwise would be…

Isn’t artificially elevating asset prices normally considered “fraud” or “manipulation”? Apparently, the jargon of Central Bankers is a little different than that of most people. It would seem that the government has given up on trying to improve the real fundamentals of our economy – by investing in infrastructure, education, productivity, innovation and entrepreneurship – and is now deciding to play make-believe instead.

Since Bernanke’s speech on August 27th to the end of September, the market rose more than 10% but was paced by an almost equal rise in the price of gold and other commodities, reflecting investor beliefs that the result of QE2 would be inflation rather than actual economic growth. To illustrate the difference between nominal growth and real growth (nominal growth minus inflation) we have included the following chart below which shows the value of the S&P 500 when priced in gold. It’s important to note that since QE1 was first announced, the S&P 500 has rallied 33.05% in nominal terms but it has actually lost 11.86% when priced in gold.

S&P 500 Priced in Gold (1/1/2007 – 9/30/2010)

The secular trends that have caused this divergence remain in place and show no signs of dissipating, which is why we have increased client holdings of commodities and have begun to build a position in gold. We would of course reconsider this strategy if the Fed ever begins to tighten its monetary policy but we see this as a remote possibility for the foreseeable future.

In summary, QE is a monetary tool that is not well equipped to handle the structural issues facing America such as our weak housing and job markets, overleveraged private and public balance sheets, a bloated public sector that will be forced to downsize for years to come and shifting global trade dynamics that are increasingly centered around emerging economies. QE2 may succeed in raising asset values above their true level in the short term but in order to drive real economic growth, companies need to have sufficient visibility and confidence in the future in order to plan, hire and grow. Government interventions such as QE only serve to muddle normal market signals, slowing the process of a real recovery and continues our dependence on credit driven boom and bust cycles like we have been stuck in throughout the past decade which have never ended well.

U.S. Gross Domestic Product (GDP) Data
The rebound in corporate earnings persisted in the third quarter but top-line revenue growth continued to be sluggish. The disappointing GDP growth of 2.7% from the second quarter was revised downward to an annualized rate of 1.7% because of worse than expected net exports.

As we mentioned in our last quarterly newsletter, inventories continued to build up in the third quarter and slower order growth has not been able to keep pace, signaling the possibility of future markdowns. The ratio of new orders to inventories fell below 1, less than 18 months after our recovery began. Historically, our economy has slipped into recession 75% of the time shortly after the new order to inventory ratio went below 1.

This declining trend in GDP is especially concerning because we are usually growing at more than double our current rate by this stage of the recovery. Our unemployment situation is also so severe that according to most economists, it would take several years of 5%+ GDP growth just to bring the unemployment rate down to 8% but many investors don’t seem to care as they continue to disregard fundamentals in favor of chasing performance. A great example is how the S&P 500 rallied on the day that Q2 GDP was revised down to 1.7% because investors speculated that the GDP number was so bad that the Federal Reserve would be forced to step in with QE2 to support the market.

The market is no longer cheap, margins are at the peaks of their cycles, unemployment remains at decade-long highs so why is the market rallying? It feels like this Cinderella rally is getting close to midnight because the carriage is starting to smell like a rotten pumpkin. Considering the bleak state of the economy, the September 20th announcement by the National Bureau of Economic Research that the recession ended in June of 2009 feels like a “Mission Accomplished” moment. As Mohamed El-Erian from PIMCO recently said in a speech at the IMF, “We have won the war, but we have not secured the peace.”

Foreign Developments
A major positive during the third quarter was the resumption of strong growth in China following the cooling off period from the second quarter. The growth in China helped pull along other emerging economies with high exposure to mining, industrial materials and precious metals. We are however somewhat skeptical of the clockwork-like GDP numbers published by the Chinese Government because of the lack of transparency around their real estate and credit markets. There are entire cities in China that were built during the boom years and now remain largely vacant. There are also documented cases of partially constructed office buildings being demolished, only to have another building erected in its place. These actions create GDP growth on the accounting books, but destroy value in real terms. China may have enough foreign currency reserves to manage this situation but it is something we plan to monitor.

Another matter that we have been keeping track of is the ongoing financial troubles in the Euro zone. Protests of discontent have continued in Greece and have also taken place in Spain, Italy, Latvia, Poland, Portugal, Serbia and France. Most of the outrage is arising from large scale public sector job cuts and reduced pensions for Government workers in order to help close ballooning deficits. These protests could derail efforts to stabilize their debt and currency markets.

The stress tests of European banks conducted by the European Central Bank (ECB) helped to calm investor nerves about the precarious state of sovereign finances within the Euro zone following an announcement that only seven banks needed additional capital out of the 91 that were examined. The tests received widespread criticism for not being tough enough (they did not even include the possibility of a default on sovereign debt, which was the precise reason that investors felt the tests were needed in the first place) but investors shrugged it off.

A large reason for the calm in European financial markets came from the fact that Ireland (perceived to be one of the financially weakest countries) was able to raise cash by selling debt on the open markets instead of needing to crawl to the ECB or IMF for funds. Unfortunately, recently released data showed an almost dollar for dollar match in the amount of money that was raised by Ireland, and the amount of debt that was bought by the ECB and major commercial banks that act as intermediaries for the ECB. It seems that the Europeans have learned a great deal from the U.S. in terms of financial smoke and mirrors. For anyone familiar with the classic “shell game” where someone puts a marble under one of three cups and then moves them all around to confuse the onlookers as to where the marble is; the recent financial gimmickry out of Europe may seem familiar.

An additional piece of disturbing information came out on the very last day of the third quarter when Ireland announced that Anglo Irish Bank, which had previously been nationalized, would require an additional €34B in bailout funds due to continuing losses. Then ten days later, Ireland announced that it would also effectively be nationalizing Allied Irish Banks, bringing the total of nationalized major Irish banks to four since the beginning of the financial crises and bringing Irelands debt to GDP ratio to almost 100%.

Why are bail outs of major Irish banks due to insolvency needed less than two months after the ECB conducted stress tests and gave the all clear signal? If a huge multi-billion dollar bank managed to slip through the cracks, we wonder what else did. These concerns were exacerbated when a recent financial audit of Greece, conducted by EuroStat, the European Unions’ statistical office,  revealed that Greece had once again been misleading the public regarding the true scale of its debts. European credit markets do not seem very credible at the moment.

Labor Market
The official unemployment rate ticked back up to 9.6% from 9.5% during the third quarter. Unfortunately, this move was outpaced by U-6 unemployment (a more comprehensive measurement) which rose to 17.1% from 16.5% and is now just 0.3% shy of its all time high. Temporary hires have been gradually picking up which, in the past has been a leading indicator of future full time hires. However, in this instance, we believe that it is likely a result of employers using part time workers to accommodate busy periods while keeping overall payroll low. Small businesses remain slow to expand and hire new employees due to difficulties obtaining loans and a persistent lack of clarity regarding future taxes and the implementation of healthcare regulation.

The unprecedentedly high medium duration of unemployment in the U.S. is becoming more concerning as each day passes. The current level is already almost twice as high as any other time since World War II and gives further credence to the notion that many of the jobs that have been lost over the past few years have permanently disappeared or moved to other areas such as Asia, India and Latin America.

The notion that we can have a sustainable real economic recovery with U-6 Unemployment above 10% and a housing market that continues to muddle around at decade lows is simply not something we can put faith in. Some of the more optimistic analysts on Wall Street say that it is normal to have a jobless recovery based on strong corporate earnings growth but there are two main problems with this thesis.

1.) Where is future earnings growth going to come from? Companies have already laid of more workers in a one-year period than during any other time in recorded history so additional cost cutting is likely to cut into muscle rather than fat. Also, profit margins are currently rolling over from business cycle highs rather than turning up from the lows as they were at the beginning of the rally.

2.) This recession and recovery are not normal by any measure. Below is a list of serious conditions that are not in any way normal and need to be addressed as soon as possible.

a. The percentage of the long-term unemployed (over six months) has been above 40% for months. The highest this percentage has ever risen in the past ten recessions was 30%.

b. One in six American adults is either unemployed or underemployed. You could only call this normal if your baseline for normality is the Great Depression.

c. A record 20% of American disposable income is now coming from Uncle Sam in the form of Federal and State salaries, food stamps, unemployment benefits, social security, etc. Historically, economies that are highly concentrated in the public sector do poorly because it crowds out investment by small businesses and results in poorly allocated resources. This trend has been gaining momentum since the 1980’s (see chart below).

d. We are more than a year into the “recovery”, yet household income is still contracting instead of rising.

e. We experienced 26 consecutive months of job losses totaling 6.2 million during the Great Recession, followed by just three months of gains in which we only gained 883,000. Since then, we’ve had four more months of declines in which another 405,000 jobs were lost.

We are especially concerned about these pieces of data because of the extraordinarily stimulative backdrop that these problems are occurring under. The Federal Reserve is holding interest rates at zero while tripling the size of its balance sheet, bringing our annual deficit to GDP ratio to just over 10% (about three times higher than in 2008). The last and only other time that our annual deficit to GDP ratio reached double digits was in 1945 when we were ending the war with Germany and Japan.  In addition, we had the $787 billion stimulus package that was supposed to cap the unemployment rate at 8%. Under such conditions, the fact that the job market and overall economy are not vigorously roaring back to life is very troubling.

Housing Market
Although home prices continued to slowly grind higher during the third quarter, sales fell dramatically, bringing new sales to their lowest point since the Census Bureau began keeping records back in the 1960’s. Of the sales that took place, an average of approximately 25% of them were foreclosure/distressed sales, much higher than usual.

Despite the small gains in price over the past year, the 20-City S&P/Case-Shiller Composite remains almost 30% below its peak in mid 2006. The housing market continues to suffer from oversupply and low demand because of persistently high unemployment. Homes are more affordable in terms of price and mortgage rates than any other time in the last century, yet people are still not buying because of an unwillingness to take on new debts, economic uncertainty and the continually growing shadow inventory of houses which could cause further declines in price when they come on the market. Most economists believe it could take another 2-5 years until the housing market is able to reach a level of equilibrium.

When you take a look at the kind of gains some housing markets experienced during the boom years, it would be entirely reasonable to expect further declines in home prices (see graph below).

Market Summary

The S&P 500 recouped most of its losses from the second quarter by gaining 11.30% as speculation began to build around the prospects of a second round of quantitative easing by the Federal Reserve and other central banks around the world. Our defensive posturing, which benefited clients greatly in the second quarter, was a drag on performance during the third with our composite client account gaining a still respectable 5.75%. Our composite is now neck and neck with the S&P 500 year to date with a gain of almost 4%.

The MSCI EAFE (European, Australasian & Far East) index roared back to life in the third quarter with a gain of 16.53% as investor enthusiasm regarding emerging markets overshadowed concerns over worsening conditions in European financial markets. The EAFE is now up 1.45% year to date compared to 3.89% for the S&P 500. Despite the financial troubles in the Euro zone, we remain confident in our positions in the emerging economies in Asia, Latin America, and India as well as select developed overseas markets with little financial and currency exposure.

The Barclays Capital U.S. Aggregate Bond Index also benefited from quantitative easing fervor and continued to chug along with a gain of 2.49%, setting yet another multi-year record on August 25th. The index is now up 7.95% year to date, making it the best performing asset class for 2010. Bonds have had a great run but we will be watching for signs of weakness in the further out parts of the yield curve for signs that the credit markets are no longer responding to efforts by the Federal Reserve to support the market.

We are quite pleased with the performance of our composite of client accounts so far in 2010, having mostly matched the returns of the S&P 500 but with substantially less volatility. Although there is no crystal ball with which we can predict the future path of the markets, we believe that our client portfolios are well positioned going into the final quarter of 2010 for whatever uncertainties lay ahead.

Words of Wisdom for 2010

“If you lead the horse to water and it won’t drink, just keep adding water and maybe even spike it …”

Former Dallas Fed President, Mike McTeer, commenting on the wisdom (or lack thereof) of undergoing a second round of quantitative easing by the Federal Reserve