Market Commentary

With the recent decision by the Treasury to request that congress authorize it to purchase up to $700 billion in unmarketable mortgages and guarantee the principal on money market funds, it seems appropriate to comment on these historic decisions.
While I have felt that the language used in the last week has been, at times, excessive (“Averting Financial Armageddon” and “New World Order” seem to overstate the severity of the situation), several events, including the short term breakdown of the London Interbank Offering System and the decline of the value of the Reserve Money Market Fund below one dollar, are historic in nature and would have been deeply concerning had immediate action not been taken by the world’s central banks. The cost of the various bailouts requested by Secretary Paulson (including AIG and Fannie Mae / Freddie Mac) will understandably lead to a wave of government regulations with substantial impact on the financial sector, in turn affecting the overall economy and having implications for the long-term returns of various investments.
While my views have not been dramatically altered, they have been somewhat refined by the recent events. The likely responses by congress (and the legislatures of various western countries) do suggest that certain sectors and asset classes will face specific headwinds for several years. Most obviously, all firms, not just financials, will be under pressure to reduce debt. Accordingly, the advice that I will be giving to clients in terms of overall investment policy, and what returns I expect from various investments has changed, particularly in terms of what types of fixed income and what classes of stocks clients should own.
While each client has a differing financial situation, and thus, my advice is different for each client, there are certain observations that are likely to influence what I recommend each client do. Specifically:
• Value stocks are likely to underperform growth stocks. This will probably affect both large and small companies, as value firms are more likely to rely upon debt financing and be interest rate sensitive. While I don’t expect interest rates to increase massively, access to credit for borrowers large and small will be more difficult in coming years. Growth firms will likely find equity financing easier and there will be a demand for growth firms as allocations to debt by institutions and individuals favor the most conservative types of bonds and seek to get their growth from equities.
• Large stocks will likely bifurcate in terms of regulatory headache. The most admired companies are likely to benefit, while companies in the financial sector or with complicated business models will find a challenging political environment. With a whole wave of new regulations coming, it’s reasonable to expect that some companies (e.g. Apple or Toyota) are likely to benefit as “good corporate citizens” while others (e.g. Citibank and Morgan Stanley) are likely to face stiffer rules that limit their ability to grow earnings.
• Traditionally, I have over-weighted small companies in portfolios relative to the overall stock market. While small cap stocks continue to be attractive, large cap seems more so. Small cap equities seem expensive relative to large companies by most financial ratios, and while they have outperformed large companies over the last year, a correction seems due. Given that small company stocks seem fairly valued or overvalued and large companies are probably undervalued, my bias is to neither under or overweight small stocks.
• European stocks are less attractive than US. While foreign stocks have been a traditional source of outperformance in portfolios for the last several years, the credit crisis has probably not reached its high point in Europe yet. Accounting is considerably less transparent in Europe and there are less shareholder protections. A regulatory response to any credit crisis is likely to be more severe. Recent strength by the dollar suggests that despite higher interest rates in Europe, demand for the greenback is growing. Given the fact that demographic and labor trends tend to be more challenging in the most developed EU countries, there seems to be little long or short term attractiveness to western European stock markets. Eastern Europe, particularly Poland, the Czech Republic and the Baltic countries seem to be very attractive in terms of growth potential, but that must be balanced against increased geopolitical risks, which can have substantial impact on domestic investment patterns.



• Emerging markets seem to be overheated. We have recently seen these markets break from their multiyear pattern of outperforming the US and other developed markets. Historically these are either the best or worst performing stock markets and have been highly sensitive to interest rates. For portfolios with shorter time horizons, it seems risky to invest in an asset that has performed so well in the past and which has a pattern of wild gyrations. Regression to the mean seems the primary risk, but there are plenty of compelling reasons to think that this space is overvalued in terms of financial ratios relative to US or other developed stocks.
Over the next few weeks, we will be scheduling investment policy reviews with clients. However, please don’t hesitate to take the initiative and contact me about putting an appointment on the calendar or if you would like to discuss your portfolio before then. In the meantime, we will be using the market downturn as an opportunity to harvest capital losses in taxable portfolios, so you shouldn’t be surprised to see various trades take place.
Best, Mike

Lehman Collapes - Whose next?

Today, the Dow Jones Industrial Average ended down by 504.48 points on Monday, off 4.4%, at its daily low of 10917.51. This brings the blue chip average down 18% on the year. The S&P 500 declined 4.71% and the Nasdaq, 3.6%. In both percentage and absolute value, this was the worst one day decline since September 11, 2001. The carnage was indiscriminate; every stock in the Dow declined.

The general drop can be attributed to Lehman Brothers’ declaration of bankruptcy this morning, following Treasury Secretary Paulson’s notification on Friday that no bailout package (ala Bear Stearns) was coming. It’s true to point out that any earlier effort to cut its losses would have meant a dramatic reduction in Lehman’s size and scope, but obviously, the alternative was worse. Lehman made a gamble that liquidity would return to the high risk mortgage market and it was wrong.

American International Group experienced a dramatic decline (60.8%!) as investors finally accepted the reality that the international insurer has very unclear exposure to risks coming out of Europe and that some kind of save the shareholder – type bailout seems unlikely. The insurer is facing substantial downgrades of its credit ratings, which would likely devastate the firm’s ability to continue as a growing company. It is, in fact, possible that AIG may not be able to honor insurance contracts. Given the massive capital that the company directs ($1 trillion by some estimates), the potential consequences to other companies of an AIG collapse seem to necessitate some kind of government – mandated recovery plan. A shareholder “wipe out” seems likely.

“Deleveraging” seems the order of the day. Trying to unload junk (bonds, loans) to make your balance sheet look better. Banks have been trying to shed risky mortgages, investment banks have been trying to shed commercial loans and everyone seems to be trying to shed real estate. Attempting to strengthen one’s financial situation has led companies to dump assets, which in turn has driven down prices; forcing banks to shed more assets and so forth; A classic viscous cycle.

The question now seems to be what degree of “spillover” will occur between the investment and commercial banks that are now deleveraging (or collapsing) and the broader economy. Will the losses that banks have taken on commercial and personal loans turn into tighter lending standards, which will, in turn, hamper broader economic growth?

My guess is that the effects are being overblown at present. While the collapses of Lehman and (potentially) AIG are concerning, they are a necessary and normal part of the gyrations of the capital markets. While their destruction has been hard on the company’s shareholders and employees, they will generally free up investor funds to be allocated to companies deserving of investors’ money. The bailout of Bear Stearns and the government sponsored enterprises (Fannie Mae and Freddie Mac), while necessary, sent a message (and gave hope) to corporate boards that the consequences of being poor stewards of investors money could be blunted by the taxpayer. Hopefully, this will encourage greater diligence and responsibility. Ultimately, these events are good things for investors in the short term.

So, does this mean that I’m doing anything differently?

By and large, these recent events aren’t affecting my investment strategy. Most of what I’m updating has been little changed by the recent turmoil in the credit markets.

As I have stated pretty much consistently since last summer; I believe that large financial companies are likely to find growth hampered by both governments and investors. It is likely that smaller banks will benefit in the environment going forward. “Too big to fail” are words that no one wants to hear and capital is likely to be much looser for smaller private banks, which will likely dominate aggressive (and profitable) residential and small scale commercial lending. Credit markets are likely to be more discriminate over the next few years, but not completely seize up. This is basically a good thing.

Value indexes, dominated by banks and insurance companies, are likely to experience slower growth for the foreseeable future. And it is for this reason that I think growth stocks are likely to outperform value in the next market upswing.
I suspect that companies that don’t enjoy high levels of investor goodwill and without high levels of transparency in their earnings (e.g. insurance companies) will underperform companies with high visibility. For this reason, I’m recommending that clients reallocate their portfolios towards companies with solid names and positive public perception.

Because of lower accounting standards and more friendly relations with regulators, I suspect that the worst isn’t over for European and Japanese banks. Given the greater sensitivity to banks that the non-US developed economies have historically experienced, I expect that European and Japanese equities will underperform the US for the next few years.

Emerging markets are highly sensitive to credit, investor appetites and regression to the mean. I continue to believe that the risks outweigh the potential benefits of holding these companies and I am recommending that we significantly reduce exposure to these stocks for all, but the longest time horizon portfolios.

For investors in fixed income investments, I have favored cash over bonds for some time. This has been generally the wrong approach, as interest rates have continued to decline over the last year, increasing the value of bonds. But, at this point, I am not intending to change this strategy, as I still feel that investing in longer maturities simply doesn’t justify the risk and the consequences of holding cash over bonds has not been particularly dramatic.

For the truly aggressive, spreads on high yield bonds are looking attractive and it makes sense to start delving into these spaces if one can handle a rocky ride over the next few years. The same thing is true for (shiver) mortgages, which represent probably some of the best buying opportunities for the next several years.

I plan on touching base with all of our clients over the next few weeks to review their portfolios as we approach the end of the year, but, as always, please don’t hesitate to give me a call to discuss your portfolio before then.

Unemployment getting worse...

Unemployment has reared its ugly head ever higher. The recent Bureau of Labor statistics data probably is overstating the rate somewhat at 6.1% (the initial data generally only captures larger employers), but we have clearly entered into the "ugly" realm of labor statistics. The only sector demonstrating growth in the last quarter has been health care - which is hardly the ideal growth engine of the economy.

I don't generally see unemployment as being strongly related to stock prices, but it certainly speaks volumes about the general consumer sentiment and will undoubtedly influence stock markets. What makes visibility tougher, however, is that oil has continued to decline with an increasingly less optimistic economic picture. Oil's price increases have been attributed to the stock market's difficulties this year, so there is some assumption that declines will have the reverse effect.

European and British Central Banks Hold Interest Rates Steady...

Increasingly concerned language regarding inflation has continued from both the European Central Bank and the Bank of England in virtually every policy paper and governor's comment over the last few months. Accordingly, both institutions' decision today to keep interest rates steady, despite significant evidence of a broad-based slowdown in Europe, was hardly surprising.

This, of course, begs the question "why isn't the Federal Reserve as concerned about inflation?" With European short term rates at 4.75% and US rates at 2%, it would seem logical that the US would be more concerned that low borrowing costs are likely to be similarly inflationary; Presumably more so...

While there is certainly dissention among the ranks at the US Fed, the general view in American circles is that the recent declines in commodity prices are likely to have disinflationary effects. Clearly, despite negative real interest rates, yesterday's Beige Book revealed that credit conditions have tightened throughout the country. But, as the ECB's report today pointed out, this appears to be the case in Europe as well. So, why are the Europeans holding rates at a relatively high level, while the Americans are not?

Largely this can be attributed to the labor market differentials between Europe and the US. One of the reasons why recent US recessions have been so mild can be attributed to the relatively weak influence of labor. By and large inflation has helped keep in check by slow growth in wages and increased productivity. The recent increase in unit labor costs of just 0.6% (vs. inflation that averaging somewhere around 4%) is an example of the flexibility that employers enjoy when business slows down. This avoids creating a stagflationary situation where the economy slows and inflation doesn't abate because wages continue to rise.

This stands in contrast to the far more regulated and unionized economies of Western Europe, where wages are often required to be indexed to inflation. This is particularly frustrating when inflationary pressures may be temporary or caused by highly volatile factors (like energy and food prices). For this reason, the ECB's President Jean-Claude Trichet has made it abundantly clear that the reason they are holding such a strong line against what they agree are temporary inflationary factors - which they agree are likely to abate (i.e. oil prices) is because of fears that high rates of inflation will cause a wage-inflationary spiral (i.e. stagflation).

The Governing Council has repeatedly expressed its concern about the existence of schemes in which nominal wages are indexed to consumer prices. Such schemes involve the risk of upward shocks in inflation leading to a wage-price spiral, which would be detrimental to employment and competitiveness in the countries concerned. The Governing Council calls for these schemes to be abolished.

What Trichet is essentially saying is that the indexing of wages to inflation reduces the flexibility that he and his fellow governors enjoy in determining monetary policy.
For these reasons, I think that we need to view the ECB and US Federal Reserve's divergence in policy as a consequence of the labor environment that both must operate within, rather than caused by a belief that commodity prices are likely to continue inflating.

Beige Book Looks Kinda Grey....

The Federal Reserve Bank's "Beige Book" - in which the 12 banks survey the conditions in their individual regions - was largely filled with little new or interesting data. More than likely, short term investors are going to focus on the high level of export growth seen over the last few months and the fact that while interest rates have not appreciated much (if at all), all reports are that credit is much more difficult to obtain than it was last year.

By and large, my experience supports the observation that most banks have become much less willing to extend credit. But, what I am seeing are those clients whose applications for business or personal loans conform to what were considered standard ratios just a few years ago, are finding credit fairly easily to get - at least from institutions who haven't been battered by the sub-prime debacle. In short, I would say that the period of easy credit (lets say from 2005-2008) has come to an end, but conditions are fairly conducive to responsible borrowing. And, those institutions who didn't expose themselves unduly to high risk lending are benefiting from less competition and low interest rates.

To me, this suggests a significant bifurcation has developed between institutions and borrowers. Highly rated credit seekers and well-run borrowers are likely to benefit, while more speculative enterprises are similarly more likely to suffer. Unfortunately, speculation is the primary method by which high returns on equity are achieved and by which aggregate growth is driven. Let's hope that those institutions who haven't been battered by the recent financial turmoil see this as an opportunity to extend their reach into more speculative sectors. But, that they do so with more prudence than their predecessors...