Another Ugly Month

February was an ugly month, and the first week of March was just as bad. This commentary addresses both the current state of the economy and the market movements over the past month. Keep in mind that the market, in its ever evolving hunt for profits, is typically six months ahead of the economy. Put another way, the market will recover as soon as there are signs that the economy shows early indications of mending, no matter how subtle they may be.

Economic Recession

What started as a mild recession in the spring of 2008 has turned into a mess, to quote just a few. The starkest result of this economic stalling is the steady rise in unemployment. Last week’s figures showed that another 651,000 non-farm jobs were lost in February. That creates a total unemployment level of 12.5 million people or 8.1%, the highest level since the early 1980s when it peaked at 10%. Interestingly, the bulk of the losses were low-wage jobs in the restaurant sector. While we are still trying to understand the ramifications of this fact, it is clear that the economy is propagating to almost every sector. Only healthcare has shown a steady increase in jobs in the private sector during the recession.

That is the worst news. Fortunately, this figure shows what has happened in the past, or a lagging indicator, and is not a leading indicator of what could happen next. While I am not overly optimistic, there are a handful of indicators that are looking up for the coming months. Although this is in no means a sign that all is getting better, it does help establish that the economy will pull out of this mess.

The largest impediment to the recovery is the status of the banking system. With most of the large banks carrying toxic assets on their balance sheets, their lending patterns have reverted to virtual non-existence. The buzz, and panic, is how the Obama Administration will deal with this. As witnessed by Japan in the 1990s, banks that simply hold on for existence become a drag on future growth, hording cash reserves and creating little credit in the economy. Dubbed “zombie banks,” the Japanese government was a main culprit in this cycle allowing the banks to operate intact whereas a complete restructuring and cleanout would have enabled the financial system to mend.

With this example looming, there has been varied calls to nationalize the “zombie banks” in the US, namely Citigroup. In such a scenario, the FDIC takes over the institution for as short as a weekend, replaces management, purges the balance sheet and re-opens a new bank based on the operational foundation of the old bank. The downside to such an event is the elimination of common stock value. The upside is a new bank and a clean slate.

While the Administration has repeatedly stated that such an event is not in their plans, it appears that the Treasury department is searching for a way to de facto nationalize the banks without eliminating shareholder value. When Treasury Secretary Geithner spoke two weeks ago and failed to elaborate on such a plan, the market went into the current tailspin. As of this writing, we are still waiting to learn how this will happen, the most critical step in the recovery of the economy.

What has ensued since Geithner’s speech is a market drop through a number of technical trading barriers. For the lay person, this means that everyone decided to sell, and no one has shown an interest in buying. Fear, panic and fear. Not a good way to build up market values. The market has dropped so far that there is no way to explain it in fundamental terms. Instead, it has been a market purely based on psychology and trading dynamics, as I’ll explain next.

Market Shorts – The Bubble of 2009

In the manner in which we as a society create investment bubbles from irrational exuberance, in everything from tulip bulbs and tech stocks to real estate, we are in the midst of a bubble on the downside, namely shorts. For the past six months, there is only one investment strategy that has consistently generated profits for folks: shorting stocks. It began with the financial service firms last year, then moved to the industrials this January, and now with healthcare in the past weeks. The market is often described as a stampeding herd, and in this case the herd is moving to short one stock class after the next.

Unfortunately, this behavior is creating a self-fulfilling prophecy. The two starkest examples are Bear Stearns and Lehman Brothers. Both of these firms were financially stable and prepared to weather the current environment. Through shorts and esoteric bets in the credit markets, the market was able to erode the confidence in these firms and precipitate their demise. With Bear Stearns, the damage was contained by a merger. Lehman Brothers, however, was not contained and spread exponentially as the Bush Administrations allowed them to fall into bankruptcy. That failure, on top of prior credit market seizures, created a complete freeze on business credit and turned a mild recession into an economic disaster.

While the real estate collapse certainly laid the groundwork for the current situation, it was a confluence of these events and more that has lead us to today. The equity markets have witnessed a decline not seen in 80 years, falling over 50% from their highs. Frankly, this sort of decline was unfathomable two years ago. In a technical sense, it appears the market meltdown has been exacerbated by the suspension of the uptick rule for stock shorts and growth of the Credit Default Swaps (CDS) market. Just a reinstatement of the uptick rule may be enough to stem the stampede of shorting and market malaise. Recent statements from Washington indicate that it may happen in the coming weeks.

To recover, we need a domino effect in reverse. We need the financial sector to recover for the markets to gain some footing. We need the real estate market to stabilize to gain confidence in the financial sector. We need foreclosures to subside and new supply to abate for the real estate market to recover. All of these events will occur, and some of them are already in the making. Foreclosures appear to be leveling off, and even declining in the past two months. That data, however, is still in the making since many lenders temporarily stalled their actitivies. We do know that new housing starts are virtually at a standstill. While we used to have 1.5 million new homes started each month, that figure has dropped to 300 thousand and has been at this level for nearly three months now. Mortgage rates are rock-bottom at rates around 5% for conforming loans. And capital is making its way into the distressed real estate markets, with investment funds buying homes off the bank balance sheets and getting families back into these homes.

The measures from the Obama Administration are designed to ensure that these improvements continue. By stemming the tide of defaulted loans, foreclosures will continue to decline. But these measures are going to take a few more months to take hold. Combined with the various stimulus packages being rolled out and the new budget that addressed many inherent flaws in American society from universal healthcare to energy conservation, we are not far off from substantive improvements in the state of the economy.

With an economy recovery will come a market recovery. And it won’t be just a little one. Based on any set of valuations you examine, we are so far below intrinsic market values it is laughable. Sadly, the current market has probably made you cry.

Investment Strategy

Our strategy has not changed. We are invested in companies and markets that have tremendous amounts of long-term value and will recovery substantially in an economic turnaround. We have also invested heavily in debt and other instruments which are providing current income, price stability, and upside appreciation.

We are still of the opinion that the equity markets are a solid place to invest for the long-term although current events have exposed a number of faults in the buy and hold strategy. Most stocks are trading below their intrinsic value – an objective assessment of the firm’s current operating profit and future growth. The challenge is to invest in companies that are not at risk of failure due to the economy, and timing those investments at or near stock lows. We believe we have identified a number of those firms, some we hold today and others we intend to purchase, but are still maintaining an underweight in equities from our long-term asset allocation target.

In the interim, that available cash is sitting in either money markets, corporate debt or structured notes, depending on the size and risk profile of the portfolio. This strategy has generated returns that range from simple asset preservation to 10% monthly gains, again depending on the tenor of the investment. As long as the credit markets are partially frozen and the equity markets gyrate we will continue to pursue this strategy with the excess cash in each portfolio.

As we see signs of a market bottom we will increase equity exposures with individual equities or ETFs as appropriate to the account. With an expectation that the market will eventually recover to the levels of 950 – 1,100 within a year (S&P 500), we expect sizable equity gains along with fixed income appreciation. The timing, of course, is the trick in both determining the entry point and realization of these gains. In both cases, we need to be patient.

Unfortunately this is not a situation that will improve in days or weeks, but months and years. We are diligently researching every corner of the market and economy to find value, predict future movements and envision an America of the future. While we are not perfect in this quest, I cannot remember a time in my life in which I believed we were in better shape to address the future as a country.

Enjoy the spring weather headed our way,

David B. Matias, CPA