Why Big Banks Aren't Lending

Many thanks to a friend for passing along this chart from JP Morgan showing how much the world's largest banks have seen their equity collapse in recent months. This illustration not only shows how much the landscape has changed from the recent crisis, but also how universally banks have been crushed.

The tragedy is that by propping up these banks that are languishing under their a perpetually shrinking net worth, the federal government is jamming up the capital that could be lent out by other, smaller institutions.

How Much Debt Can the US Absorb?

Source: International Monetary Fund, World Economic Outlook Database, October 2008

This really is the trillion dollar question. All of the debt generated by the stimulus is being financed at very low rates, but eventually rates will start to creep up on their own. Part of the challenge in determining the number is because the US began the financial crisis with a level of debt equivalent to what we had at the end of World War II and part because Japan has already shattered any prior records for a stable country in peacetime. The US is a member of a club of delinquents; virtually every major economy's government has increased levels of debt in recent decades.
Source:Budget of the United States Government: Historical Tables Fiscal Year 2008

Market Commentary

2009 is not starting in an encouraging way. Virtually every investment class has been down in the first three weeks of the year. As we are again seeing weakness emerge in the markets, driven by poor employment and profit reports emeging from the 4th quarter, it seems appropriate to discuss my long term perspectives on the markets and explain their influence on my decisions and advice.

Broader Economy
The current US economic environment is highly uncertain. But, the intermediate term environment (5+ years) is generally quite positive.

We are currently in the worst recession since the end of the Second World War. It was largely caused by declines in the housing market and poor risk management at the largest global banks, coupled with a decline in consumer confidence. What has made this particularly ugly has been the seizing up of the credit markets and the Bush Administration’s inconsistent responses, which have undermined confidence in even the most conservative of investments.

High levels of press coverage of economic news and the recent election cycle caused a massive retrenchment by consumers, who drive the global economy. This has had the beneficial effect of transforming Americans from net spenders to savers, but the positive effects of this will take years to truly manifest themselves. This trend towards prudence has been devastating for the sales of high end retailers, homebuilders and auto manufacturers.

Unemployment rates are being driven by the massive dislocations in the financial, real estate and manufacturing sectors, but still remain below levels seen in the recession of the early 1990s. Unemployment rates in the 10+% range have been seen in several industrialized economies over the last 20 years, with eventual declines occurring once the recession ends. Because of technological and trade related forces, there remains a high level of probability that we see a “jobless recovery” with recessionary conditions, as employers seek cost saving technological solutions and restructure their budgets.

We are currently experiencing deflation, which is generally worse than inflation as a long term phenomenon. This deflation should be countered by the massive economic stimulus package being considered by congress, coupled with extremely low costs to borrow, which generate considerable problems with inflation once the current crisis ends.

Housing Markets

The environment for real estate remains extremely negative.

Housing is unlikely to recover to its highs achieved in 2005-2007 any time soon. The decline and recovery are likely to follow a much longer path, as houses are much less liquid than stocks or bonds. While mortgage rates remain persistently low, mainly due to radical government intervention, people simply aren’t buying. At the core of the problem is that the ratio of house prices to annual income has increased dramatically in recent decades, making it very unclear what ‘cheap’ means. A decade-long housing recession, followed by several years of slow growth may be possible in this space.

Investments in real estate can make sense as a “play for yield”, but I am reluctant to devote a significant percentage of client portfolios to these types of securities. Incomes need to increase relative to home prices in order to absorb excess supply, which seems to exist across the spectrum.

US Stocks

By most measures of valuation, US stocks look underpriced.

The current environment is extremely attractive to long term (5+ years) purchasers of US stocks. In the shorter term, the environment is very unclear.

The best values appear to be in the large cap growth space – in particular, companies with relatively low debt levels and solid brands. These firms will benefit from relatively low borrowing costs once the current panic is over. Value companies – which seem to be generally over-leveraged, are concerning. Dividend rates, while unlikely to be sustained at current levels overall, are extremely attractive to current income investors for the equity portions of their portfolios even at levels of yield lower than present.

International Stocks

International stocks, like US equities, look attractive, but considerably less so, due to currency issues and less transparency in terms of accounting. Virtually every problem, long and short term, that the US has, the Japanese and Europeans have worse. There are, however, some foreign markets that look particularly enticing – particularly so in Latin America and Southeast Asia.

Both developed and emerging markets performed far worse, relative to US equities, in 2008. There are several reasons for this, but in large part the declines were driven by mad dashes to build cash positions – selling anything that could be sold – and, from US investors’ redemptions.

Prominent exceptions are Australia and Mexico, where valuations and macro economic factors are extremely encouraging. China remains an appropriate holding for long term aggressive investors, as do the Emerging Markets generally.

Bonds

Bonds are an attractive investment outside of US government securities, which are extremely overvalued and pay an unacceptably low rate of interest. The most attractive bonds are those issued by banks and other financial institutions, but they are also the most risky.

The bond markets were extremely volatile and highly varied in how they performed in 2008, US Treasury bonds had one of their best years on record, but corporate bonds (a space dominated by financial companies) performing extremely poorly at the end of November and recovering rapidly at the very end of the quarter. For this reason, most bond mutual fund managers seem to have dramatically underperformed the Barclay’s Capital (formerly Lehman Brothers) Aggregate Bond index, as they generated cash to cover redemptions by selling (and thus, underweighting) investment grade corporate issues.

Due to their extremely high yields, I am inclined to invest in corporate bonds (although less so, in light of their recovery), high yield and preferred stocks, while keeping conservative clients core fixed income portfolios in short term bonds, money market funds and other investments unlikely to be affected by an eventual (and likely dramatic) increase in interest rates.

Commodities

Commodities performed extremely poorly in 2008. They are unlikely to (as a group) experience a dramatic comeback in 2009.

I am inclined to keep commodities exposure to a minimum because it is likely to be a poor investment long term (mainly due to technological factors) and because they have demonstrated that they do not possess the diversification benefits that their advocates saw in previous markets.

Gold reversed its negative post – Lehman trend, and I think that a powerful case can be made that it is a good long-term bearish investment. Oil seems like a better investment, however, given its centrality to the global economy and the fact that it’s price lies well below what most industry insiders seem to feel is an appropriate long term level. In general, however, I feel that commodity exposure should be viewed as speculative and should be limited.

Conclusion

This is the most challenging market for any current participant. We are currently experiencing uncertainties that are as substantial as at any time in the last 50 years. I encourage everyone to maintain perspective (as you all pretty much have – thank you very much) and remember that recessions, market declines and financial crises are part of the natural order.

That having been said, these are particularly challenging times and it is always a good time to talk, evaluate and review risk tolerance. As we reach out to clients over the next few weeks, please don’t wait for us to get in touch with you if you would like to review your portfolios. As we always have, we will get through this challenging environment.

Thank you again for your business.

2008: Good Riddance

2008 will most likely be remembered with the same sense of dread as any year since the Great Depression. By whatever measure (performance of the S&P 500, increases in unemployment, etc), 2008 was one of the most challenging for the economy, and for the capital markets, in the last 50 years. While there are many specific reasons for why - primarily related to declines in the housing market, underwriting standards and the excessive use of statistical methods in portfolio management - the primary reason why we saw such broad based declines in virtually every asset relates to a general collapse in trust.

By and large, trust appears to be returning and the capital markets repairing themselves. Most of the risky asset classes have appreciated significantly from lows established in November, with the notable exception of commodities. Most strikingly, corporate bonds by the higher rated issues appear to have fully recovered to pre-Lehman levels. High Yield ("Junk") bonds and preferred stocks have also staged impressive gains and, arguably, the credit crisis has ended. Equity markets remain mired at dismal (although higher) levels and are effectively as cheap as they have been since the 1970s- particularly in comparison to government bond yields. There remains strong expectation that corporate profits have declined and there is a lack of confidence in the accounting and financial projections of public firms, despite the intense regulation that has been imposed post Enron in the form of Sarbanes Oxley.

Stocks have always taken longer to recover from panics than other investments. This is because trust and confidence are much more easily destroyed than they are built. While the causes of the recent collapse in equity values were the product of an overreaction to what was happening in the real estate and banking sectors, what a rapidly reveals are the misrepresentations and outright fraud inherit in capitalism and an eternal component of Wall Street. Where confidence can be restored in the mortgage and bond markets relatively quickly - once investors keep getting their interest and principal payments they soon return to buying (particularly if the rate on cash is effectively negative), stocks require trust, confidence and faith in the future.

Recent events in the political space (Blagojevich) and financial (the recent revelations of corrupt practives at the rating agencies and Bernard Madoff) are part of why stocks will take a while to recover and while the riskiest stocks will probably be last to see significant capital appreciation. The quickest and most stark punishment of evil will have the best effect of repairing investor psyches in the short term, and thus the markets, but it is reasonable to expect that more ugliness and shame will appear in the headlines in the coming months, leading to volatile equity markets. And, rarely is the best solution for the short term, the best choice for the long term. Repairing the system that allowed for these abuses of trust to exist will require deliberation, debate and trial and error. There has been far too much seeking of a quick fix for our short term problems (like stimulus packages or the demand for a relaxing of accounting standards) at the cost of the long term stability (balancing federal and municipal budgets or encouraging Americans to return to long term savings strategies). Equities are a long term investment, and their performance is affected by long term trends.

This is not to say that current forces are not highly supportive of a near term equity rally. The ever expanding stimulus package proposed by the President and congressional leaders will likely stimulate great short term economic growth. Infrastructure investment, when properly spent, can have tremendous long term benefits to the aggregate economy. The national highway system, mass transit, the Internet and space exploration have all been government inspired infrustructure investments produced benefits far exceeding their cost. But the concern that I have is that in this environment of universal agreement that piling on more debts is the answer, cronyism and waste will likely result. The dominance of one political party (and yes, particularly the Democrats) doesn't help discourage me from this concern. I fear that massive "investments" will do little more than create long term problems of inflation and benefit obligations for newly created unionized laborers with little long term returns. There were several efforts to use the broadsword of government power to bring the economy out of recession in the early 1970s which probably made problems worse.

So, against this backdrop of uncertainty - what is one to do?

The answer is, I believe, very different depending upon a wide variety of circumstances (as it always is) and in each client's case, I am approaching the question of asset allocation and investment selection differently. While there are certain consistently logical approaches, such as maintaining exposure to blue chip, solid brand stocks (as represented by my Fortune Most Admired Companies strategy). However, I will discuss broadly my approch depending upon risk tolerance (remembering that each client is different):

For Aggressive investors, probably the most attractive equity investments remain US Large Growth companies, Emerging Markets and High Yield Bonds. I have generally been reluctant to enter back into emerging markets in a major way, but over the course of the next few months, I am increasingly interested in investing in this space. Emerging markets are currently very beaten up and the valuations look attractive, but this may be a several year story to work out. This is particularly true if oil remains at these depressed levels. Most emerging economies are heavily dependent upon resource intensive industries and this will likely have complicated and frequently conflicting economic and political impact. Broad diversification makes the most sense as a risk management strategy. But, for investors with patience and a long time horizon (20+ years), this seems like an obvious play given the eviceration of most emerging countries' equity markets over the last few months.

For Moderate investors, I am, and have been, adding Preferred Stocks, High Yield Bonds and Blue Chip stocks. High dividend yields are encouraging as has been strong support for the banks who are the primary issuers of preferreds. Given the unlikely event of significant calls of preferred or bond issues, this is particularly so. However, volatility is to be expected in the coming months, as more of the problems I alluded to emerge. I have also generally moved cash to bonds in these accounts, as I have been enticed by higher rates of interest than earlier last year and the capital gains that the recovery of bond and stock markets have delivered. I remain very concered about the potential problems that are likely to emerge within municipalities over the next few years, but I think that selective purchases in this space (coupled with a tolerance for volatility) may make sense - particularly in light of the effective total recovery of the corporate bond markets and what are now less attractive rates of interest. Inflation indexed bonds also make sense, as the likelihood of high inflation is considerably greater with all of this government debt issuance and the fact that investment markets seem to have completely ignored this possibility, pricing expected inflation at about 1% over the next few years.

For Conservative investors, well, this is a tough one. 2008 was a year of extreme volatility for "conservative investments" (bonds issued by banks, mortgage backed securities, inflation indexed bonds, etc.) Given the inherit reluctance of a conservative investors to take on risk, but balanced against the extreme attractiveness of risky assets, I am inclined to allocate equity money towards US Large Cap stocks (in particular the Fortune Most Admired) and add High Yield and Preferred Stocks to their mix. I have directed increasing amounts of money towards bonds from cash, but I am also inclined to keep cash levels fairly high.

I have regularly gotten questions about the appropriateness of gold and other commodities for client portfolios, particularly in light of the recent declines in oil. While commodities can perform well over shorter periods of time, their long-term trend in price, due primarily to technological innovation should be downward and this makes them a questionable long term investment. Historically, the primary justification for holding commodities is that that they are an excellent diversifier (they tend to go up as a result of things that drive stock prices down), but this has not been supported by recent events, and for this reason, I am reluctant to invest in any major way in these assets.

As we enter into this new year, I am generally optimistic about the potential for strong performance from most of the capital markets, and I expect positive returns for all types of clients. My concerns relate to the problems of inflation and long term government debt. Let's hope that the governments of the world do a better job of managing the stimulus package that is about to be injected in the economy than I and many others fear. Until long term macroeconomic stability emerges - particularly in the form of balanced budgets, positive savings rates and the absence of repeated massive injections of capital into the economy, my suspicion is that most risky assets will remain below their full potential.