The Perfect Storm

There is nothing pretty about the past three months. While the positives regarding the global economy remain, such as growing populations, growing demand and a phenomenal explosion around international trade, the US has entered the witching hour. Namely, our economy here has been battered by three concurrent forces that are creating what may prove to be the perfect storm.

The first of these factors is the ever-present subprime debacle. I have already explained this in length, but it is worth noting the situation in review and how it is still affecting us today. With grossly overinflated home prices and a lending practice that placed unrealistic demands on borrowers in a declining home price environment, the mortgage industry created an explosion of defaults and foreclosures during the first half of this year. The effects have been felt globally since these mortgages were repackaged into supposedly safe investments and placed into everything from bank portfolios to money market funds. To date, the reported losses by the financial institutions related to these subprime securities have reached $400 billion, and could still be climbing by some estimates.

The effects of the subprime debacle that we are still feeling are quite pervasive. In the US, it has accelerated foreclosures in many situations where it would not have occurred under normal circumstances, even with declining real estate prices. And second, it has erased the profits of the financial sector, dragging down the overall equity markets. Third, with so many aftershocks past and present, the bond markets are still reeling; and in the case of municipal bonds, go through fits and spasms, eek out some gains, only to be gripped by another seizure when more bad news is revealed.

This in itself would be enough to cause tremendous distress in the financial markets as we have seen starting exactly a year ago this month. The conventional belief just two months ago was that these issues would work through the system in time and after a correction in the markets we would resume with growth in the markets and economy, albeit anemic for some time to come.

Now enter factor two. While it may seem more like an inconvenience than a financial crisis, the US government deficit has grown astronomically during the past eight years (yes – read, Republican out-of-control spending). The effect has been singularly devastating-the rapid decline of the value of the US dollar. From 2001 to today, the dollar has lost over half its value and the decline could continue. I’ve been writing about this topic for four years now as a priority for our political and economic policies. Unfortunately, we are now here.

The follow-on effects are pervasive. In a simplistic view, it makes it more expensive to purchase international goods or to travel abroad. The opposing argument, that our manufactured goods are now cheaper and more attractive stimulates the US economy, is true to some extent. The larger issue is that we import far more than we export, including the bulk of our energy needs and many raw materials.

And now the third factor and the great behemoth that pervades our headlines: the price of oil. Unfortunately, or perhaps fortunately, oil is traded in US dollars. And we buy a lot of oil from overseas. For our cars alone, we spend $1.3 billion dollars a day on oil to convert to gasoline, more than half of which comes from overseas. Because of growing demand from growing economies such as China and India and the deteriorated value of the dollar, we are spending twice as much for our foreign energy sources than we did just two years ago. Viola – inflation.

So we have a dismal real estate market with increasing foreclosures, the prospect of real inflation for some time to come, and a recession that would have been a slowdown if it were not for these factors. Put it all together, and you have one of the worse financial markets that we have seen in decades.

That is the bad news. The good news is that our world is about to change. Gone for good is the era of cheap gasoline, and good riddance. While we may feel the enormous pinch today, the impact of the mighty buck will accelerate changes that have been needed for quite some time. Americans are driving fewer miles (by close to 10% according to some estimates), SUVs are no longer in demand, and energy conservation in every aspect of life is on the tips of EVERYONE’s tongue. These are good changes. We will use less, we will waste less, carbon emissions will decline, and in the long run we will be a more efficient and conscientious society.

While it would have been nice to do this at our own pace and in our own time, that luxury has been squandered. The time is now, and the pace is immediate-at least as immediate as humanly possible.

Going Forward

Prospects for the remainder of the year are a haze for all. We have officially entered a bear market, with the major US indices down 20% from their highs. The question is, do we recover to close out the year where we began (our initial forecast), or do we continue a decline and remain in this quagmire. In either case, it could be at least two years before we revisit a bull market with annually rising values. For the immediate term, we are waiting to see and gathering as much information as possible. The primary factor we’re watching is the price of oil: if oil remains stable or declines, then we will make it through this in short order; if oil continues its rise, then I fear the bear market will deepen.

Our investments have continued to emphasize the same principles we have held for the past few years – cash generation augmented by well-researched growth opportunities focused around technology and demographic changes. While we performed extremely well in the months of April and May, June was the worst month on record, leading to an overall loss for the quarter. Surprisingly (or maybe not, given the market), it was our cash generation portion of the portfolio that suffered the most, from stable defensive stocks such at United Technologies and GE to very high income, tax-efficient global preferred stock.

Our approach to weather this storm is going to be grounded in the fundamentals. Historically, even stronger bull markets follow bear markets, placing tremendous emphasis on riding this out while positioning ourselves for the recovery. While it is tricky to predict the bottom of the market, it is important to look for buying opportunities on undervalued equities and hold onto those positions that will survive and ultimately thrive in the next cycle.

Reports regarding your individual accounts will be going out in the coming week, with a brief analysis of what worked and didn’t work for the year to date. Depending on your investment profile, we may include research notes on companies that we are strongly considering as we look to boost equity positions in the coming months. As always, please write, call or simply stop by with questions and concerns.

Best wishes for an enjoyable 4th,

David