Fourth Quarter 2009
ByQuarterly Review & Outlook
The debt and equity markets continued to generate positive returns as market participants breathed a sigh of relief. The economy stepped back from the precipice thereby diminishing the risk of “falling off a cliff” which was a legitimate concern this time last year. For the year, the equity indices had an outstanding year, particularly when viewed in the context of being down almost 11% at the end of the 1st quarter.
We continue to believe that this past quarter is a continuation of the bounce back from last year and the massive injection of liquidity into the financial system by the federal government. The equity markets have recovered dramatically from the March lows (about 64% in the S&P 500). Whereas, the market, by our calculations, was very undervalued in March, we believe that it is now overvalued by 10% to 25%.
With the benefit of hindsight, we should have been more aggressive during the second half of last year. Our dilemma is one of balancing capitalizing upon short term trends and preserving capital. We believe that the current market environment is driven in large part by the massive injection of liquidity by the Federal Government into the financial system. These “liquidity driven” markets are notoriously difficult to navigate and generally come to a bad ending once the liquidity is withdrawn. The markets last year had a strong wind behind its back in the form of massive liquidity injections, absurdly low interest rates and very reasonable valuations. Our concern for this year is that last year’s tailwind may become this year’s headwind.
The Federal Reserve has made it clear that they intend to stop the quantitative easing program by the end of March. This means that they will stop buying mortgage securities. For the past year, the vast majority of mortgages issued and refinanced have been through the government. This has helped maintain historically low mortgage rates which has helped buffer the decline in residential real estate. Additionally, the Fed’s purchases of mortgages provided the liquidity for the major banks to purchase over $1 trillion of government debt. The banks are loath to lend to non-governmental borrowers – the best credits don’t want to borrow! Besides, why do commercial lending when you (the Banks) can borrow from the government for almost nothing and lend the funds back to the government for 3% to 4%. As the guy from Lenox mortgage says “The greatest no-brainer in the history of earth”! Additionally, the government will need to borrow another $1.4 trillion or so to fund the deficit this year. Who will provide the capital in 2010, and at what rate? Logic would dictate that interest rates can’t go down much further and that there will be pressure on rates in order to attract purchasers.
The economy has also benefited by massive government “stimulus” (spending) last year. As this spending unwinds itself during the first half of this year, it is unlikely there will be a political appetite for another “stimulus” package in 2010. We have seen various studies that estimate that about ½ to ¾ of the growth in GDP during the 2nd half of last year was due to the one-time stimulus programs of the government (i.e. cash for clunkers, 1st time homeowner credit, etc.) The economy appears to be on the mend and we anticipate decent economic growth during the 1st half of 2010. However, once the “stimulus” funds are expended the rate of economic growth is likely to be sub-par. Also, looming on the economic horizon is the expiration of the Bush tax cuts at the end of this year. Without any legislative action, tax rates will be going up in January 2011. Additionally, there is talk in Washington about further increasing taxes on top of the scheduled increases. Increasing taxes in a weak economy is a singularly bad idea. Tax increases will act as a disincentive for consumers and businesses to expand their expenditures just at a point in time when they may well be willing to loosen their purse strings.
We have repeatedly voiced our view that we are in a long term deleveraging cycle that will take years to unfold. A new book by international economists, Carmen Reinhart and Kenneth Rogoff, This Time is Different; Eight Centuries of Financial Folly, has piqued the interest of many financial professionals. In their book, they studied over 250 financial crises over the past 800 years and analyzed them for similarities and differences. The analogies to the current state of US finances are not encouraging. Essentially, they imply that the corrective process of deleveraging has much further to go and that the “pain” cannot be avoided. The natural tendency of governments to avoid “pain” only compounds the problem. They believe that there is no way to avoid it. It is just a matter of when and how long.
Over the past 60 years, we have been the beneficiaries of very favorable economic “winds”. By increasing the use of debt we have grown the economy for many years. The efficiency of debt has greatly diminished over the past 20 years as has the ability to access debt (other than the government). Debt served as a “lubricant” to economic growth. The reduction of debt will likely serve as an element of “friction” to the economy. We do believe that this time it is different. In spite of our Macro view of the world, we do anticipate that most of the economic “news” during the first half will be favorable. Our challenge will be to position client portfolios to capitalize on the market while keeping a watchful eye on the level of risk embedded in our portfolios.
Notwithstanding our rather dour view of the world, we do believe that there will be pockets of opportunity for investment. Parts of the developed and most of the developing world economies are likely to do better than our domestic economy. Additionally, many high quality international U.S. companies are selling for reasonable valuations. We think that the next few years will bode well for funds run by “stock pickers” which constitute most of the funds held in client portfolios. We do think the current environment calls for a higher than normal level of caution and we intend to maintain a defensive tilt in client portfolios.
As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.
Sincerely,
James A. Martin, III