The Summer of ’09

What a summer this has been. One of the old sayings in money management, “sell in May and go away,” infers that the summer months are either slow and lackluster, or market losers. Not in 2009. Since the early spring lows, the market is up 48%, or 11% for the year to date. So what is happening here?

In full disclosure, I don’t think that I have a compelling explanation for this rally. The economic news is still pretty dismal when you look at it from afar. Our unemployment rate is climbing towards 10%, home prices are so far depressed that you had to purchase a home at least five years ago for a fighting chance of gains, and global banks are still reporting losses in the tens of billions of dollars. Let me parse these events with a bit of commentary.

A week ago brought some of the first good unemployment news in a while – the loss of only 247,000 jobs in July accompanied by a decrease in the overall unemployment rate. The good news is simple: rather than losing 500,000 jobs each month, we’ve cut the losses in half. A good start, but still not growth. The drop in the unemployment rate is more of a record keeping anomaly – folks are simply giving up on their job search, while many simply are not counted, such as recent college graduates. The relief is palatable. We can see the potential for an end, but as the Obama Administration continues to reiterate, unemployment will soon pass 10% as the employed population creeps closer to half of all eligible Americans from its current level of 57%.

Housing numbers were encouraging this past month with a main price index, S&P Case-Schiller, reporting that overall prices increased in the month of May. As I reported in my last update, we are seeing a trend to the bottoming of the real estate market. But once again, the data is misleading. Many cities are still in decline, and in fact the index shows a national decline when calculated on a seasonally adjusted basis. As with the employment picture, this is not a recovery but rather another month of less bad stuff.

Not until people have jobs and real estate values begin to appreciate again will we have a true growth scenario, a situation in which firms can begin to generate consistent earnings and the economy expands. This is evidenced by the banking sector. The headlines were dominated by firms such as Goldman Sachs reporting bewildering profits, but at the same time more regional banks are failing each week. Some of these failures are tiny but others encompass deposits in the billions of dollars. While these are mostly insured losses, nonetheless it is a strain on depositors and the FDIC. In addition, global consumer banks are taking further write-downs in the billions in anticipation of rising commercial loan, residential mortgage and credit card defaults.

This is not intended as a doom and gloom analysis, but rather a reality check. The year to date has certainly been a series of positive steps forward, but the pace and length of these steps is metered. It is my expectation that we still have many quarters until the global economy has repaired itself to levels prior to the financial and real estate crises. During this time the risks will be many, the most important of which is that the economy takes a turn for the worse. While I don’t see this as a likely scenario it could be triggered by a series of unexpected events ranging from international conflict to a series of miscalculations by bank executives.

Stealth Erosion from Inflation

In all likelihood the economy will continue to move forward, albeit at a stunted pace from what we experienced over the past three decades. The larger risk that we face are increases in the cost of living. Let me provide a startling example.

The decade of the 1970s is perhaps the most relevant example for our current economic condition, primed for inflation but suffering from anemic economic growth. During those ten years, the stock market had a modest but important overall increase of 75%, or 5.7% per year. The cost of everyday living, however, increased by much more – 116% or 8% per year. The disparity is disconcerting. In effect, the value of equities in America failed to beat inflation by 2.3% per year, accumulating a deficit in real growth of 26% for the decade. This current decade has been worse. Even with the current rally stocks are down 24% for the decade while inflation is up 25%. It is no wonder that folks have been in a panic. Although most cannot quote the statistics, the palpable effects on family wealth and purchasing power are very real.

Even matching inflation is not enough. In fact, capital needs to maintain some nominal real growth from year to year to account for the risks assumed by investors and the limited amount of capital that is available in the economy. Negative real returns contracts everyone’s asset base and ultimately the ability to maintain our lifestyle. While it has been generally assumed that stocks provide a solid long-term hedge against inflation, we now have two of the last four decades in which they failed to do so. Not everyone can wait another decade to make up for lost real value.

Healthcare – A Serious Matter

The situation does not get better when you factor in healthcare. The expense that we all bear to provide the current level of healthcare in the US is roughly 15-16% of our entire economic production. I heard a rumor that East Timor spends more than we do – and no one else. And it is increasing rapidly, by as much as 6% per year even when inflation is nonexistent.

And yet the metrics that measure quality, coverage and effectiveness of healthcare are not too encouraging. Tens of millions have no coverage, infant mortality is the highest of the developed countries, and healthcare expenses are the leading cause of bankruptcy. The list goes on, but the effect is the same for us. Whether we pay for it through healthcare premiums, direct expenses or in our taxes, the cost of healthcare is going to continue to erode our purchasing power and ability to maintain a stable quality of life.

While I want to avoid making any political statements, the current healthcare debate is the single most important set of policy decisions that will be made in this lifetime. As you peel back the onion, the issues are complex and the solution is subtle. Profit is good. It motivates firms and individuals to invest capital. But profit in the healthcare system represents a quarter of all healthcare expenses. We all want to receive the best care and live as long as possible, yet end of life care represents a wildly disproportionate share of all expenses. Medicare is extremely important to elder care, yet is easily manipulated by doctors and hospitals for personal gain. The list goes on, but the message is the same. We need a coherent and informed discussion at all levels to tackle the most expensive problem we have ever faced as a nation.

The End of Summer

As the summer months draw to a close, we look forward to slow but important changes in our economy. With the fall will come partial resolution to the current economic crisis. Some of our global trade partners have already exited the recession, and we may soon follow. The healthcare policy debate will likely reach the floor of Congress for a definitive vote. The globe’s hotspots, Afghanistan, Iraq and Iran, will each move closer to crisis or calm. And our financial markets, the most informed and dynamic collection of information in the history of mankind, will digest all these developments.

It is an exciting time for us at Vodia as we position the portfolios for these changes. It’s also a pivotal time in America, and a fearful one for those who take comfort in the status quo.

Regards,

David B. Matias, CPA