Market Update – October 2010

An Anxious Summer

It has been three years this fall since the financial crisis began, and by my estimation, it will be another seven years until we have fully recovered.  Yes, I see it as a decade-long event, beginning with the subprime crisis (July 2007) and reaching its height in the failure of Lehman Brother (September 2008).  Under that assumption, we’ve had a pretty good year.  The stock market is up 4% for the year (nearly half of which is dividends), the corporate bond market is up 12%, and commodities are up 4%.  These may not look like great returns, especially if you’re still trying to restore your retirement account from the collapse of 2008, but given the alternative it is pretty impressive.

This view is best understood when you look at the stock market against the VIX, commonly referred to as the “fear gauge.”  The VIX is a composite index that tracks the implied volatility on S&P futures.  Put into plain English, it is a measure of expected future losses.  The higher the VIX goes, the more expensive it is to insure against such losses.  The chart below shows that while the S&P has flat-lined for most of 2010, VIX looks like it went through a cardiac arrest.

Specifically, it was the “flash crash” on May 9 that created the anxiety and that stress lasted through the entire summer.  It was only when we arrived in the last week of August that the anxiety level returned to a more normal buzz and the US stock market began a 10% rise to recover the year’s losses.  The question remains – what caused such a stir in early May and why did it create such fear of equities.  While there is now a plausible explanation of the flash crash recently published by the SEC, in fact it could still happen again.  What we did experience through the summer was a rather tame pull-back.  Had things truly gotten worse in the economy and around the globe, we would have likely seen a persistent 20% drop or more.

Fortunately, the net result is a gain.  For the year to date the S&P 500 is up 4% with dividends, and the VIX is sitting at 23 – elevated but not unusually so.  For comparison, prior to the crash, VIX commonly sat in the low teens with 30 being a crescendo prior to a market decline.

My “decade-long recovery” prediction, while frankly a guesstimate, reflects the challenges that we face in all areas of the economy.  During this time, expect for economic growth to be slow and market returns to be in the single digits.  Under those conditions, a total return of 8% for the year is a very respectable figure.  With a 4% gain through the first three quarters, we’re on track to stay within those bounds.

Two of the factors that will determine a full recovery are employment and housing.  In fact, they are intricately tied together with bank lending at the root of the problem.  While large investment-grade public corporations have easy access to the credit markets (Microsoft raised 3-year paper at less than 1%), smaller businesses and private firms with less-than-perfect finances are having a nasty time of borrowing.  The mortgage market is even worse.  Mortgage assessments are driven by comparables, and with so many foreclosures out there the comps look awful in even the best neighborhoods.  To make matters worse, banks are simply not extending mortgages to folks without three years of steady income.

So with so many folks looking for work and valuations at such lows, it is simply impossible for most people to obtain a mortgage to buy or refinance.  With so much potential equity tied up in our homes, a large source of net worth has been frozen.  Complicating matters, it makes it nearly impossible to move cities to find work or change jobs.

Implied in all of this is the plight of small business, a common growth driver in the American economy.  No loans means little capital to expand and grow.  No growth, no new jobs.  The cycle continues.  While I am bullish on the American entrepreneur and our ability to adapt as a country, it will be years for the foundation to be repaired.

Repositioning of the Portfolios

To respond to these conditions, we are looking to reposition the portfolios accordingly:

Equities:  We increased some of our equity exposure in August when the market was experiencing a temporary low, although we continue to maintain an underexposure due to the current economic prospects.  The areas that we are increasing are related to cash or global growth.  Notably, companies with growing dividends are going to continue to be a focus along with industrials and medical technology firms.  Irrespective of the US’s prospects, these industries will continue to remain strong.

Alternatives:  To augment the equity exposure, we have increased our alternative asset class.  Ranging from commodities to REITs, these are assets that have low-to-zero correlation with equities yet maintain similar growth prospects.  The table below demonstrates these correlations against the S&P 500.  Although commodities have a similar growth prospect, a third of the time they move independently of the market.  Gold is far less correlated to stocks, and bonds are effectively not correlated at all.  Emerging markets, on the other hand, is almost always correlated with US stocks.  Incorporating lower-correlated assets allows us to maintain similar growth prospects in the portfolio with less extreme fluctuations in value.

Two-year daily correlations from October 2008 to October 2010. Because of the significant exposure to oil in the DB Commodity Index, it has a higher correlation over this period than prior to 2008.

Fixed Income: With the persistent fear in the markets combined with excessive monetary easing, bond prices have reached highs rarely seen.  Any issue that is less than 10 years is pricing at yields of 2-3%.  If you factor in any inflation into the economy during this period, your bond real-return is likely to be zero or negative.  As a result, we are selling any traditional corporate bond holdings that are less than a 10-year maturity.  This does not include any of the structured notes we currently hold or floating rate bonds, since most of these have mechanisms to generate solid returns in both recovery and stagnation scenarios.

We will closely monitor events this fall, with the election being the next hurdle in market stability.  As usual, uncertainly creates anxiety and just the resolution of the political shift in itself will help to stabilize equity returns.  Please don’t hesitate to contact us with questions or comments, and all the best for the fall.

Regards,

David B. Matias, CPA

Managing Principal