Is the Market Turning Around?

 

Here we are with the blessings of spring upon us.  In these recent weeks the financial markets have started to rebound from the lows hit this winter. Yet, broad equity price indices remain well below the 2007 peak levels and from a long-term perspective are about 40% to 45% below the peaks hit in 2000 and 2007.  So, we have a long road to a full recovery however there are some signs that the market’s recovery is progressing.

 The first quarter company earnings reporting season is closing and it looks like things are turning around, after generally bad earnings reports for Q408.  The earnings turn looks to be partly due to a reduction in bank loan write-offs, but also due to company cost cutting and, despite dire predictions of deflation, some ability to avoid a collapse in the prices of goods and services sold.  Excluding energy, the Consumer Price Index (CPI) is up 2.2% over the last year including modest gains over all three months of this year. 

Of course cost cutting has its dark side.  The worker layoffs have pushed the unemployment rate to 8.5%.  Inventory cuts and a drop in spending on plant and equipment by companies accounted for nearly half of the 6.3% decline in fourth quarter GDP.  And various monthly data for the first quarter indicate further weakness. However, private sector actions in recessions, while painful, can be the most powerful factor driving recoveries.

 On the brighter side, some measures of home prices are showing a rebound in February and March and the sharp drop in home sales appears to be leveling off.  With home price declines, lower mortgage interest rates and, amazingly enough, still rising real personal income (due to lower energy prices), the housing affordability index is, by a large margin, at an all-time record high.  Speaking of energy prices, we are getting much needed sustained relief for households, with crude oil down about 65% from that terrible peak in July 2008 and natural gas down about 70%.  And consumer confidence rebounded strongly in April.

Though we are seeing some improvement, we are by no means out of the woods.  Uncertainty is still a factor that can impact market participation, and we still don’t know if the Obama administration policy actions, the Federal Reserve and other agencies’ plans will work well. I do think there will be some failures, but we are already seeing some positive results.  Many, but not all, of the big banks appear to be recovering and while big bank lending is down recently, smaller banks that stuck to their knitting have been expanding lending.  Interest rates on municipal, mortgage, corporate, commercial and other debt, previously viewed as “way too risky to invest in” have come down signaling renewed investor interest, allowing towns, states, home buyers, companies, and other borrowers expanded access to credit markets.  It’s not business as usual, but to me it looks a whole lot better than the “frozen credit markets” we saw earlier.

There is an expression “accelerating to the bottom” that means things are getting worse at a faster pace.  That would be bad.  However, looking across the financial and economic landscape I do not see that acceleration at present.  I see a moderate, but still jittery financial recovery, and an economy that is finding a bottom and struggling with a turnaround.  People talk about V or U or maybe L-shaped recoveries (though talk about a return to the Great Depression or replicating Japan’s experience is heard much less now).  The information on the markets and the economy looks to me to signal more of a U with the bottom probably behind us in financial markets and the economy headed for a flat summer with recovery starting in the autumn.  I am hoping for a better holiday season than last year’s, economically speaking. As always, please call me with any questions or concerns.

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Compliance tracking #536518

 

Financial Stability Plan: Not Clear Yet

 

Financial markets remain choppy and distressed as markets apparently view Treasury Secretary Geithner’s rollout of the “Financial Stability Plan” as a disappointment.  I certainly was underwhelmed by the plan and its lack of details.

 

As it stands, the plan outlines six big steps.  The first is to “stress test” major banks, increase disclosure, and if needed inject more capital and encourage private investment.  For me, despite my view that of some big banks deserve a lot of the blame for the mess we’re in, this idea falls in the “if I wasn’t laughing so hard, I would cry” category.  These banks are already totally stressed out and struggling to stay afloat.  Another round of major regulatory reviews and disclosure requirements may not be the best use of anybody’s time or money in the midst of this financial crisis.

 

Step 2 is to create a “Public-Private Investment Fund” to allow banks to sell troubled assets to others in the private sector.  In my opinion, the misstep here is that the new plan wants the assets sold at market prices.  Heck, the banks can do that already, but they think the bids are too low.

 

Step 3 is to have the Federal Reserve (the Fed) to fire up the Term Asset-Backed Securities Loan Facility (TALF), start buying consumer and business securitized loans, and then expand the program to commercial mortgage-backed securities and consider purchasing other assets as well.  The plan calls for up to one trillion dollars in Fed lending.  My concern here is that the size and flow of credit could become politicized. In any case, the Fed has been slow to get this program rolling.

 

Step 4 is a “Transparency and Accountability Agenda” which goes after banks requiring assistance; limiting dividends, compensation, lobbying and other restrictions.  Some of the restrictions make sense; others, despite my anger over some of these institutions’ behavior, seem draconian.

 

Step 5 is to spend money helping folks avoid foreclosure and support housing.  My heart is okay with this, but my head says it is not likely to be very successful.  It is hard to help out homeowners that are in way over their heads.  Sometimes it is just best to move on and live in something you can afford.  I guess it is worth a try, but I also wish I wasn’t paying for it.

 

Finally there is a “small business and community lending initiative” that allows the Small Business Administration (SBA) to make more loans and increase their guarantees on loans.  This program seems okay, but I worry about defaults.

 

As I said earlier, there are no details yet, and given the decidedly tepid response from the stock and bond markets, I suspect there may be some significant changes in the plan over coming weeks.  We will just have to wait and see.  I hope they go back and reconsider the model used to lift a lot of risk out of Citigroup and Bank of America late last year.  That model was simple and uncomplicated.  Although it seems to me that the government charged too high a price to guarantee the troubled assets, given those banks’ languishing stock prices, it would be pretty easy to change the two-page term sheet used in those transactions to fine-tune the outcomes.

 

A lot of big numbers are being thrown around in all these discussions, and it is easy to lose perspective.  Bear in mind that while total U.S. debt outstanding was about $52 trillion at the end of Q3 2008, total financial assets, after substantial write-downs and losses, were about $146 trillion.  And remember that there are still a lot of companies in good financial shape.  As always, please call me with questions or concerns.

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Compliance tracking #514979.

 

February 10, 2009

 

2008 posed a difficult market for investors.  A significant sell off in the fourth quarter added to losses in equities for the year.  The returns for most categories of the bond market were also disappointing as the crisis in the credit markets impaired liquidity and put downward pressure on prices. Combining stocks and bonds usually serves as a good diversifier—meaning a tough time incurred by one will be offset by the other—but this was not the case in 2008, as investors sold stocks and bonds indiscriminately in a search for liquidity with the goal of protecting assets. This correlation likely led to sub-optimal returns in your account. Even if your account beat its benchmark, the absolute return may not have met your expectations. We can agree that 2008 was a very difficult year.  However, I would like to take this opportunity to think about positive takeaways from last year and, even more importantly, formulate a plan for applying them to investing in 2009.

 

First, we believe that stocks and bonds, with the exception of Treasuries, are presenting investors with the opportunity to buy at significantly discounted prices. The widespread impact of the market downturns made a variety of assets relatively cheap. As you know, the goal of any investment strategy is to buy when the market has pushed prices down and sell when market forces have pushed prices higher.  As the axiom goes, “Buy low and Sell high” While the timing of a recovery is difficult to predict, we believe that this is a great opportunity to buy low.

 

This market also gave us all of us an opportunity to gain a better understanding of our risk tolerance and financial goals, which is, unfortunately, a lesson many of us learn best in difficult markets. If you have adjusted your own view of your risk tolerance, we may want to fine-tune your portfolio with that in mind, if you would like to do so.

 

Finally, we learned that managers and asset classes with a long track record of expected behavior can act in unexpected ways in extreme markets.  While this provided challenges for investment managers, it also reinforced the importance of diversification and elevated the importance of alternative investment mutual fund strategies. Such alternative strategies can work when market volatility is at extremes.

 

2008 felt like a year of many “firsts” in the markets. And while in many ways it was, the reality is that we have seen many of these situations before—just not all together and not to such extremes. As always, if you have any questions in the face of these difficult markets and want to discuss your portfolio, I encourage you to contact me. I continue to urge you to stay invested and focused on meeting your investment goals. 

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Compliance tracking #511184

Good News, Bad News: Where we are now?

 

Since his inauguration President Obama has been moving swiftly to address the recession and financial collapse, but in some areas the recovery effort has been stalled by the transition and other issues.  Also, a raft of post-September economic and financial market statistics have been coming out that document a serious recession around the globe.  All this bad news has slowed the “healing” in credit markets and led to further weakness in equity markets.  The S&P 500 is down about 10% so far this year, but still well above the low hit last November.  Hardest hit have been Financials, down nearly 30% year-to-date due to economic conditions and the dithering over how to use the Troubled Asset Relief Program (TARP).  Industrials and Consumer Discretionary are the second and third worst performers, while Healthcare and Utilities are down less than 2%.  Given the economic backdrop, this relative performance picture indicates that investors may be through with the undifferentiated panic selling we saw in the fourth quarter, and are returning to discretionary investing based on policy and economic indicators.

 

So far the economic news, while grim, is at least not as grim as expected.  For example, the consensus expected about a 5.5% decline in real GDP in the fourth quarter, but when that report came out last week it showed a decline of “only” 3.8%.  That is still the biggest decline since the first quarter of 1982 when GDP fell 6.4%.  There is some good news for us consumers; the price index for total personal consumption expenditures swung from an annualized quarterly rise of 5% in Q3 to a fall of 5.5% in Q4.  That is by far the largest quarterly fall in the price level seen since 1947 and the fastest swing from inflation to deflation.  The drop in the price level reflects discounting on many products and the sharp declines in energy and commodity prices.  The good news is that we got better deals shopping for the holidays.  The bad news is that many companies did not make much in profits.  The fall in energy prices is in my opinion unalloyed good news.  Compared to that horrible $145 per barrel oil price peak we hit last July, we have shaved more than $100 off oil prices, and this decrease will save U.S. consumers nearly $300 billion on energy spending.  In part, sky-high oil prices got us into this recession, and I think much lower oil prices will, over time, help get us out.

 

While all eyes have been on the President’s stimulus package, I believe the Federal Reserve (the Fed) has been busily expanding its anti-recession programs and working to prevent protracted deflation (a word the Fed studiously avoids).  Various measures of the money supply are accelerating, and the Fed is starting to buy “large quantities” of government agency and mortgage-backed debt.  They have announced a similar program to buy consumer and small business debt as well as, for some odd reason, longer-term Treasury debt.  In my opinion, all these actions are meant to help stabilize a badly damaged financial system and stop falling prices, including home prices.  Given near infinite financial resources, I expect the Fed’s efforts will be successful.  Of course, there may be a price to pay down the road in the form of a return to higher inflation, but it appears to be the right action given the extraordinary circumstances we are in today.

 

Where do all these developments leave us? 

 

I know I am not happy about much of what is taking place.  Bailouts are never pretty.  They are never fair, and lots of undeserving folks and institutions get benefits they do not deserve.  Like most of you, I didn’t spend a million dollars redecorating my office last year, nor did I get a big fat bonus from a company that lost money and ultimately required taxpayer assistance.  Neither I nor LPL Financial have required assistance from the TARP. 

 

I do think that we will work our way through this mess and return to growth.  I do not know if last November’s stock market low marked the bottom, but I think that market valuations look attractive and that the majority of U.S. companies will weather this recession and return to growing earnings.  However, for a while longer the picture will remain gloomy and uncertain. On a lighter note, for those believers in the groundhog indicator out there…the groundhog saw his shadow today. Historically, more often than not, that is associated with the markets’ heading upwards; of course only time will tell.  Certainly, as always, but especially in these troubled times, please contact me with any questions or concerns.

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Compliance tracking #509608

Assessing the Damage, Repairs in Progress

 

We start the New Year deep in the debris of the economic and market collapse of 2008. News coming in from the last quarter is still very gloomy, as consumers, businesses and government a like work to assess the damage, incorporate the right adjustments to carry on through this recession, and create the plan for clearing the fallout and rebuilding. 

 

Prior to September, the employment declines had been modest, averaging 82,000 a month, but as the financial system collapsed, employment fell 403,000 in September, 423,000 in October, and 584,000 in November. Today we got the employment report for December. It showed a jump in the unemployment rate from 6.8% in November to 7.2% and a decline in payroll employment of 524,000. One possible bit of positive news here is that the latest decline was smaller than November’s.

 

Companies appear to have been very prompt in adjusting to the onset of serious recession. Based on the employment figures, it is my guess that labor productivity rose about 3% in the fourth quarter, with total hours worked down 7.7% (annual rate) versus a consensus forecast of a -4.4% decline in GDP. That would indicate that companies are keeping productivity growth in line with wage growth and holding unit labor costs flat. I have harped on these cost control measures, because I believe they are key factors that will help moderate this still very serious recession. Typically, companies are slow to adjust in recessions and allow labor costs to pile up, making the ensuing employment decline deeper.

 

Given this cost control, one might expect okay profits despite the downturn, but such profits appear unlikely because of the sharp cuts in the prices of goods and services sold. Without adjusting for this deflation, the holiday sales data look very weak. For example, the retail store sales report shows a decline of 1.7% in sales compared to December 2007. But store prices, which have been falling since September, likely dropped sharply in December. So, in real inflation-adjusted terms, sales likely rose in December compared to 2007. This is good and bad news. It means that stores likely “moved the merchandise” in December and we consumers got some pretty good deals, but it also means that companies did not make much money on those sales.

 

I do expect further very sharp declines in the Consumer Price Index (CPI) and other price reports stemming from the decline in energy and commodity prices and the impact of the recession. That said, the Federal Reserve (Fed) has made it very clear that they intend to keep any deflation short-lived, and they have embarked on a huge expansion of the money supply to turn both prices and the real economy up again. With these and other major Fed actions aimed at unfreezing the financial system, I am already seeing some recovery in credit markets compared to the post-September collapse environment.

 

At the same time, I expect we will get prompt action by the incoming Administration on fiscal policy, with soon to be President Obama announcing an $800 billion program of infrastructure and other spending as well as tax cuts. These actions, combined with the recession impacts, will likely produce budget deficits in excess of a trillion dollars per year for several years to come. Meanwhile, I expect the “off-budget” activities of the Troubled Asset Relief Program (TARP) will resume under the leadership of incoming Treasury Secretary Geithner, and will lift more risk out of troubled financial institutions and other companies. And there is the FDIC, now out guaranteeing financial institution debt.

 

None of this activity leaves the financial planner in me sighing with relief or happy with these policies. All of these programs come with costs. The Fed program aimed at reflation may overshoot and lead to high 2010 inflation rates. All the troubled asset purchase and guarantee programs may yield substantial losses down the road and, as with all government programs, I expect some misallocation of the fiscal stimulus funds to pork and other poor investment choices. Also, we will be piling up debt again at a time when we should be pulling it down to help deal with the serious actuarial shortfalls in Medicare and Social Security.

 

I do think we can recover from this near unbelievable mess created by a bunch of irresponsible Wall Street firms, regulators, and politicians and return to growth and healing financial markets. While these are serious losses, all the hard working labor, capital equipment, technology and spirit of innovation are still here. We just have to clean out the stables and move on. And as part of the process, we will likely have a complete rewriting of the rules and regulations governing the U.S. and global financial systems this year. It will be a full agenda to be sure in this hopefully happier New Year.  Please call me with any questions or concerns.

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Compliance tracking #502819

 

 

U.S. Business Cycles: We are in a Recession

I want to wish you happy holidays and offer my best wishes for you and your family.  This Thanksgiving, many of us took some time to think about what we have to be thankful for over the last year.  My list was certainly shorter than last year, with all the economic turmoil and financial losses. We all know it has been a very troubled time for the economy and financial markets, so I am fervently hoping to add their recovery to my list next year.

 

While I think the economy will continue to produce ugly statistics in the months ahead, some things do appear to be getting better for financial markets over the last few days.  Importantly, President-elect Obama has been putting his team of advisors and Cabinet officers together, and I think he has made good choices of seasoned people.  He has designated the current head of the New York Federal Reserve, Timothy Geithner, as his Secretary of the Treasury.  I view this as a very good choice in that Mr. Geithner has been working very closely on many aspects of the financial recovery program with current Secretary of the Treasury Henry Paulson, Federal Reserve Chairman Ben Bernanke, FDIC Chair Sheila Bair and others.  So I think Geithner is already up to speed, and the last two weeks’ apparent divergences in opinions between the current and incoming administrations on what should be done will likely diminish.   And I think Paulson, Bernanke, and Bair have been doing a good job and will continue to do so through the transition.

 

As a big example of why I think they’re doing a good job, a week ago the Treasury, the Federal Reserve (Fed) and the FDIC announced a second round bailout of Citigroup (Citi) that, I think, signals a restart and a major change of direction for the Troubled Asset Relief Program (TARP). Rather than the Treasury just directly buying troubled assets, as was considered earlier, the term sheet gives the government a great deal of control over management of the securities and loans being guaranteed, executive compensation, and dividend payments, and provides for substantial up-front deductibles from Citi in the event of further loan losses. In return for the $20 billion capital injection to Citi by the Treasury, the Treasury and the FDIC got $27 billion in preferred shares and warrants. More importantly, a net of more than $250 billion of Citi’s troubled loans will be guaranteed by the Treasury, the FDIC, and the Fed, which provided a large non-recourse loan guarantee for losses.

 

Including all three government entities in this new TARP process appears to me to be beneficial, and this model may be a more workable one for lifting risk out of other banks. The FDIC has experience with troubled loan management, while the Fed has essentially unlimited resources to guarantee asset pools.  If the government can, in effect, lift a net of more than $250 billion in risk off the bank’s balance sheet for an upfront cost of $20 billion, then if need be they could lift more than $4 trillion in risk out of the banking system with the $350 billion second tranche in the TARP!  I doubt there is that level of need, but it now appears that the Treasury and the Fed have sufficient ammunition to fight this crisis.

 

All these changes have, one more time, breathed life into the very distressed U.S. equity and credit markets.  Is this the bell ringer that the stock and bond markets have hit bottom?  Again, nobody knows, but I am encouraged by these new policy actions and see both the incumbent as well as the incoming Administration as demonstrating renewed determination to do whatever it takes to resolve this financial crisis and limit the damage to the economy.  We’ve seen a solid rebound in equity markets last week. But we have a long way to go, and it is possible we could go back down again if, on balance, market participants decide they have not sufficiently priced in the depth or length of the recession or there is some new calamity. On the other hand, at the low hit Thursday, November 20, the dividend yield on the S&P 500 was above 4%, to me representing a valuation extreme in a low inflation environment. 

 

As we enter this holiday season, I expect the bad news on the economy will outweigh the good news for a while.  The recession will be difficult and trying.  Financial markets will likely remain volatile. There are a lot of things that are broken, but there are a lot of policy actions already underway to fix them, with more to come.  If there is one thing I am sure of, it is the ability of American people to absorb these shocks, pick up the pieces, and get going again. I want to wish you happy holidays and offer my best wishes for you and your family. 

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

 The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Compliance #462490

Behind These Down Days

As we wait for indications that the bottoming process is working through, we had another bad week.  The Dow fell 473 points over the week ended last Friday, more than erasing the 401 point gain the prior week.  And international equity markets started out this week badly, with Hong Kong’s Hang Seng equity index down 12.6%, Japan’s NIKKEI 225 index down 6.4%, the FTSE index down 1.7% and so on.  Emerging Markets have really been hammered, especially equity markets in countries that have a heavy reliance on energy, materials, or precious metals production and sales. In Brazil, for example, the Bovespa stock index fell 6.5% and is down 64% in dollar terms so far this year.

 

With the carnage overseas, U.S. equity markets finished with the Dow dropping “only” 2.4% today.  There are some grounds for this better relative performance.  We are energy and commodity importers, so those price declines will benefit our economy down the road.  Also, while the dollar exchange rate has been rising, it remains well below the 2002 peak and still offers, in my opinion, a solid competitive advantage to U.S. companies that export and compete with foreign companies.  Finally, Federal Reserve and Treasury programs aimed at restoring our financial system are starting to kick in.  Today one, in my opinion, very important program started – the Federal Reserve’s Commercial Paper Funding Facility (CPFF).  This program will provide a backstop to qualified issuers of commercial paper (CP), giving these issuers the ability to get three-month CP loans from the Federal Reserve at near-normal rates.  CP borrowing had fallen by $366 billion (25%) over the last six weeks, another credit area that seized up after the AIG/Lehman failures and that has created much stress on many traditional borrowers.  There are more programs coming.  It is nice to see that not everything barreling around the corner at us is bad news.

 

So why have equity markets continued to have so many bad days?  There are a whole host of factors, but two now stand out.  First, the swift fall in oil and other commodity prices has had an immediate negative impact on the producer economies and stocks, but the benefits to consumer economies and stocks, importers or users of energy and commodities, tend to show improvement only after a lag of six months or so. Second, a new source of downward pressure on markets appears to have come from hedge funds. 

 

Hedge funds that actually hedge risk and thereby reduce risk have generally done relatively okay (though most are still down).  However “hedge” funds that were actually using leverage to make long risky bets on all sorts of things, like troubled debt, long energy, and other commodity bets or risky positions have been hit very hard by the credit crisis, and now their investors are reported to be fleeing in droves.  No one has a full view of this market, because it is yet another unregulated part of the global financial system that will likely have to be completely rebuilt and subjected to significant regulatory oversight. However, for now I, among others, am guessing that there has been a lot of forced selling.

 

These leveraged “hedge” fund portfolio price declines coupled with investor demands for redemptions have delivered a double whammy to equity and fixed income markets around the world.  It appears that managers of such troubled “hedge” funds have had to throw everything not bolted to the deck overboard to keep their funds afloat.  One problem is that the stuff bolted to the deck is likely to be the really risky junk assets, the “illiquid” assets that cannot be sold (or liquidated) easily. Meanwhile, the relatively good or “liquid” assets are being sold.  These managers appear to be selling all sorts of securities without, in my opinion, much regard to price.  AAA municipal debt securities, equities with low valuations, investment grade corporate bonds, etc. have been dumped at what look to me like fire sale prices.

 

And while we have heard from bunch of hedge fund managers that they are okay and have raised a lot of cash, there is no way to know for sure, and given the lack of regulatory oversight, in the main I tend to distrust much of what is said.  I have heard way too much from way too many financial institutions over the last year that just was not true.  One important gauge I am watching here is, strangely enough, the Japanese yen exchange rate.

 

Many “hedge” funds used something called the “carry trade” to borrow money to lever up their portfolios.  The idea was to borrow in Japan at a very low interest rate and use the yen denominated proceeds to buy assets anywhere in the world for their portfolio.  This process in effect put the funds in a short yen and long some other currency exchange rate position.  So, as they have been selling stuff out of their portfolios, they have been eliminating the short yen exchange rate positions.  As a result, the yen has soared since the beginning of September, rising 17% against the dollar and 37% against the euro.  A slacking in the yen appreciation may mean hedge fund selling is tapering off.  So far, that has not happened.  And, hedge funds still foolish enough to have that carry trade on their books are getting hammered by the appreciating yen.  Good grief, another bad movie script!

 

All of these bad movie plots we have seen play out over the last few months have common themes: high prices (housing, energy and other commodities) followed by a price crash, very bad security selection with very high leverage, hidden problems, deep flaws in the financial system, and a lack of regulatory oversight.  Alan Greenspan, in testimony last week, said he was astonished at how bad things were at many large supposedly sophisticated financial institutions at the heart of our financial system.  While I deplore the lack of regulatory oversight on his watch as Fed chairman, I have to agree with his astonishment.  So, is there more bad news likely to come barreling around the corner at us?  Almost certainly.  But there will also almost certainly be good news as well.  And we just have to deal with what the markets have already priced in.

 

I know that, in this global financial market meltdown, fundamentals do not matter to many investors, but I do think that fundamentals will become important once again when forced selling and panic selling subside.  For example, by my calculation, the stock market value of all U.S. non-financial corporations is now down to about 44% of their aggregate net worth.  The municipal debt market appears to be pricing in widespread defaults on AAA general obligation bond defaults.  Meanwhile, despite facing huge new issues of Treasury debt that will be coming to finance the Treasury and Federal Reserve programs, the yield on the two-year Treasury note is only 1.5% and the 10-year Treasury note has a yield of only 3.75% (compared to a 10-year AAA general obligation yield of 4.5%).  While I do not think it is time to step in and buy more risk, I also do not think it is the time to be a seller of risk either.  With a longer-term view, “risk free” securities look overpriced and therefore actually more risky, and “risky” securities generally look increasingly underpriced, therefore becoming less risky as their prices fall.

 

I will continue to try to offer what insight I can into what is driving the markets, and where we may be in the bottoming process, how long or deep this recession will be, and how well or badly government agency efforts to return our system to better functioning are working. As always, please contact me with any questions or concerns.

 

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

 

 

Tightening up for the Recession

Equity markets around the world continue to experience high volatility as investors deal with a great deal of uncertainty about just about everything.  Although we still face a long list of unanswered questions, volatile markets, and yes, a recession, some of the right answers are starting to come in.

 

The ongoing list of unknowns is daunting: Are we in a global recession?  How deep will it be?  Are government and central bank actions sufficient to deal with the banking crisis?  Is OPEC likely to stick us with an oil production cut in an attempt to push oil prices back up again?  And so on. Yuck. 

 

Here in the United States, the Dow gave back all of Monday’s gain on Tuesday and Wednesday, but managed to close above the closing low set on Friday, October 10 and then closed up 172 points on Thursday—roughly flat.  International markets fared as badly, or worse, pretty much across the board.  It looks to me as though developed country equity markets are moving up and down trying to decide whether we’ve seen the bottom yet or not.  Also, while energy and materials stock prices took the immediate negative impact of the sizable drops in oil and commodity prices, the positive net effects of lower prices for the economy will take a while to show up in other stock prices.

 

Now that, in my opinion, we are in a global recession, I expect mostly negative economic news for the next three to nine months.  Consumers are tightening up, adjusting down spending in response to the economic uncertainty and lost net worth in housing and financial markets.  In aggregate, the tax rebates in May, June and July from the Economic Stimulus Act of 2008 did not deliver the desired impact on spending.  While consumer spending stayed relatively flat, personal saving increased by quite a bit more than the tax rebate, leading to a record decline in consumer installment credit in July.  I am actually happy to see that; it is a rational response to tough times.  However, I think that response does point to a fairly sharp downturn in consumer spending starting this quarter and extending into the first half of next year.  Home construction is already at deep recession lows, and banking is in recession.  But U.S. exports are booming, and I do continue to think that in aggregate U.S. non-financial corporations are pretty well positioned to weather a recession with well contained costs, low inventories, and capital spending programs under pretty tight control.  These companies’ biggest problem continues to be the decline in prices of goods and services sold. So much for fears of inflation.  So, while there is legitimate uncertainty over the magnitude of the recession, I still believe it will not be a deep one.

 

There are some positives.  The dollar exchange rate, while still low has been moving sharply higher, and the price of crude oil, while still high at about $68 a barrel today, is down sharply from that horrible peak of about $146 we hit in mid-July.  The high energy prices earlier this year took a while to damage the global economy, and lower prices now will, with a similar lag, help repair the economy.  It sure is nice to see gasoline prices below $3 a gallon again.

 

I continue to believe that the Federal Reserve, the Treasury and other federal agencies are headed in the right direction to repair the damage done by the meltdown in banking.  For example, bank reserves, which normally total about $44 billion, now total $180 billion and are likely to increase far more under announced programs.  And over the last four weeks, as non-bank borrowers exercised their revolving credit lines, bank lending has increased by about $300 billion, double the previous record four week gain.  So, it looks as though both bank and non-bank companies are awash with cash.  And households are piling up personal savings again.  In the short-run all these positives don’t help the economy or financial markets as everybody sits on this cash, but longer-term they should begin to ease the credit crunch and restart economic growth.

 

It’s clear to me that consumers, businesses, and investors alike are now tightening their belts and that we are entering a recession. There is plenty of pain in recessions; even a short and shallow recession means that some people will lose their jobs and some businesses will not survive. Once consumers and businesses are assured that the economic stimulus programs put in place are making real progress to their goals and can see positive results, the magnitude and the duration of the recession will become clearer and confidence should improve. Meanwhile, we will continue to see very volatile markets as investors react to every positive and negative indicator. As always, please contact me with any questions or concerns.

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

* There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

October 16, 2008

On Tuesday and Wednesday we gave up much of the ground we gained on the Monday rally in U.S. equity markets.  Then today, after being up and down, U.S. equity markets closed higher, with the Dow up 401 points.  This high volatility reflects a whole host of concerns.  Markets are worried about whether the government rescue plan will work, how deep the recession will be, a continued “freeze” in interbank lending, arcane but very serious issues involving “credit default swaps”, concerns that hedge funds may blow up, and on and on.  On the other hand, I think many stocks are looking cheap, attracting buyers.  I expect markets will remain volatile for some time. I hope we have seen the low but, of course, have no way to know.

 

Listening to various government officials, I think the message is that they intend to do whatever is needed to stop this financial market crisis and restore confidence.  Federal Reserve (Fed) chairman Bernanke made that pretty clear in his speech yesterday.  He also spoke very directly to fears of a return to the Great Depression.  He noted that back then the Fed seriously aggravated the downturn by allowing a wave of bank failures and allowing a collapse in bank lending and the money supply.  Nothing was done to help otherwise healthy banks to meet runs on them by depositors withdrawing their cash.  Bernanke pointed out that the Fed’s lack of support went on for three and one half years before positive steps were taken.  As he noted and I agree, that is definitely not the case today.  The Fed has moved promptly to flood the system with liquidity.  They have increased bank reserves by $132 billion in the last four weeks and increased total reserves supplied by $606 billion.  Based on their announced intentions, I expect they will increase bank reserves by more than $1 trillion over the weeks ahead.  I am seeing monetary policy that avoids the mistakes of Great Depression monetary policy and shows that we learned from those mistakes in a very big way.

 

Meanwhile the Treasury has taken $125 billion in preferred equity stakes in the nine largest U.S. banks and will take another $125 billion in stakes in other banks to shore up bank capital and restore confidence.  The FDIC is now temporarily guaranteeing all FDIC-insured institutions’ senior debt and will provide insurance coverage for all non-interest-bearing deposit transaction accounts. They are also working to get the Troubled Asset Relief Program (the TARP) up and running to lift bad assets off bank balance sheets. The problem is that this program and some other actions take time to get started, and the market does not want to wait.  I think they could move faster on some things. For example, I do not understand why the Fed is dilly-dallying on the announced program to become a big backstop buyer of commercial paper.  Heck, they already have a one page term sheet, and the Treasury has supplied the money—so why wait around until the scheduled start date of October 27?

 

As I have noted before, the enormous stress on global financial markets has exposed some very serious flaws and failures of the system.  Troubled mortgages have now taken a back seat to other failures.  One huge new problem involves the “Credit Default Swaps” (CDS) market.  This market imploded after the failures of Lehman and then AIG in mid-September, which were, in my opinion, the events that triggered the latest plunge in stock and bond markets and forced governments around the world to shift to direct equity injections into many banks to stop this huge new problem.  Given how swift and powerful the CDS meltdown was, I want to explain what I think happened.  The CDS market is an “over the counter” market for trading insurance on defaults on bonds and all sorts of other stuff.  “Over the counter” means there is no open, transparent, regulated exchange process.  Some analysts have compared a CDS to home insurance, which is not accurate.  Here is my best analogy.  Suppose somebody wants to bet that you are going to default on your mortgage and somebody else wants to bet that you will not.  Well they could enter into a CDS with one side betting on your defaulting and the other betting that you will not.  Since the swap is done “over the counter” you would not even know that folks were betting on whether or not you would continue paying your mortgage.  Also, a whole bunch of other people could make the same swap agreement on your mortgage.  You wouldn’t know and nobody else would know how many people had entered into a default swap agreement on your mortgage.  You could have millions betting for and against your potential to default on your mortgage.  I know this example sounds completely crazy, but it is a simplified, but I think accurate, characterization of the CDS market place.

 

When Lehman failed due to a host of factors, folks found out that CDS insurance agreements Lehman had made were now part of the bankruptcy process and possibly worthless, while those who were insuring (betting) against defaults on Lehman debt had to pay up.  And, while nobody knows for sure, it appears that the CDS swaps on Lehman’s debt totaled more than four times the face value of that debt!  And when AIG failed the next day, it was largely due to the company’s CDS exposure insuring (betting) against mortgage securities defaults.  These realizations caused an immediate meltdown in the CDS marketplace, estimated at $50-­­60 trillion globally (again, nobody knows for sure) and an immediate rise in global default risk all over the place in securities markets.  Interbank lending halted because nobody knew how much CDS risk banks really had, forcing governments into taking direct ownership stakes—it wasn’t just a “troubled mortgage asset” problem any more.  It is now pretty obvious that the CDS structure is a totally shattered part of the financial system that has caused great damage to financial markets and the economy and, I think, will have to be completely overhauled, converted to an open exchange process and heavily regulated.  Another really bad movie plot.

 

Where do we stand?  Well equity and credit markets around the globe remain highly unstable.  Securities that are viewed to be at all risky have had their prices fall to what I consider fire sale levels, while very low risk securities like Treasury debt are very expensive with low yields.  Risk avoidance is very high.  I do think that governments and central banks around the globe are now fully committed to resolving this financial crisis and stopping the carnage.  I think they will succeed.  And when we come out the other side, I expect we will rebuild a much stronger and safer financial system.  I do take some small comfort from the fact that while we have to endure the consequences of all this stupidity and cupidity on Wall Street, at least we did not contribute to it.  We will hit bottom somewhere; I hope it is near and soon or possibly behind us.  I continue to believe that selling now would be a mistake and that staying with a well diversified portfolio is the best course of action, but the next few months are likely to be very difficult for the economy and financial markets. Please call me with any questions or concerns.

 

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

* There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

October 13, 2008

Last week was awful, bad enough to push governments around the world into action against the underlying drivers of the financial panic that caused global financial markets to just plain crash. And today we’re seeing the markets around the world respond to these government efforts with sizable rebounds.

                                             

The Dow and the S&P 500 were down 18.2 % last week. It is cold comfort that international markets fared worse, with the EAFE international stock price index falling 21.7%. The carnage was everywhere. No sector was spared. While last week was not the worst percentage decline (the five days ending October 19, 1987 hold that dubious distinction in the post World War II period), it is close to the largest movement from the height of the market to the low point. At the close last Friday, the S&P 500 was down 43% in a little over a year, not far from the largest post-war decline of 49%, the drop from March 24, 2000 to October 9, 2002.

 

Thankfully, we are finally getting concerted global government and central bank interventions aimed at stopping the panic. The UK government has intervened, injecting government money directly into two of its largest banks, and over the weekend Germany, France, Germany Spain and other EU nations committed $1.8 trillion dollars to guarantee inter-bank lending and take equity stakes in their countries’ banks. Also over the weekend, the Federal Reserve committed unlimited funds to the European Central Bank, the Bank of England and the Swiss National Bank to meet any demands for short-term dollar loan demand. Today, the U.S. Treasury announced that it will also purchase equity in financial firms along with an accelerated program to buy or insure troubled assets at financial institutions and other measures aimed at stabilizing the financial markets. The U.S. Treasury has heavier compliance and oversight conditions that are slowing it down a bit compared to its counterparts overseas, but is committed to getting these programs underway quickly.

 

Today, equity markets around the world are higher. The UK ended up 8.3% measured by the FTSE 100 Index; France, Germany and Spain were up about 11% as measured by CAC 40 Index, DAX Index and IBEX 35 Index, respectively; and Hong Kong was up about 10% measured by the Hang Seng Index. Japan’s markets were closed today. Here in the United States, the Dow and the S&P 500 are up about 11% at the end of the day. Hopefully we are seeing the bottom, but there is really no way to say. In panics like this one fundamentals get tossed out, so we could move higher or move lower near-term. In times like this, when everybody else seems to be throwing out any consideration of fundamentals, it becomes especially important to keep them in sight.

 

At last Friday’s close, the S&P 500 index price was 899. That is not that far above the bottom of 777 it hit on October 9, 2002. But, despite all the difficulties we are in, S&P 500 reported earnings over the last four quarters were $51.68 per share, compared to $27.59 in 2002. And dividends per share are $28.71, compared to $16.08 in 2002. So we had a dividend yield of 3.2% as of the close on October 10, compared to a 2.1% dividend yield in 2002. And, as I have said before, I think that, in aggregate, U.S. nonfinancial companies are in good financial shape and generally well positioned to weather the recession I believe we are in without the severe dislocations we are seeing in the large financial firms.

 

So where do we go from here? Stopping this credit crisis is imperative; otherwise we will have a spreading credit crisis that would deepen the global recession. I do think the massive global fiscal and monetary policy stimulus will work to end the panic and preserve financial markets. Stock market bottoms usually follow major anti-recession policy actions, not the end of the recession itself. I, along with most folks I am sure, would love a “do-over” on this astonishingly large hit our financial markets have taken, but that is not the way the world works. We have to make do with what we have in hand. I think we are going to find a bottom somewhere not far from here at some time not far from here and then begin the process of recovery. I expect we will have to endure more extreme volatility due to the continued lack of clarity concerning financial market stability and the depth of the recession. There are some bright spots; gasoline prices are back under $3 a gallon, and home heating oil prices are down sharply.  However, generally speaking it is not likely to be a pretty picture for some time. Companies could still fail. We clearly have our work cut out for us to rebuild a financial system that has been sorely tried and found wanting. I know that the well balanced, well diversified* portfolio that I advocate has not provided much shelter from this financial storm, but while also sorely tried, I do not think it is broken. I think it is still the best investment option going forward. Please call me with questions and concerns.

 

LPL Financial

100 North Point Center East

Suite 530

Alpharetta, GA 30022

(770) 995-7101

 

* There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.