Review & Outlook

Our take on the investing, financial, & economic themes of the day

Second Quarter

8 July, 2009 by Mark O'Brien in Quarterly Letters

At the time of the last appraisal letter in early April, we did not know that a big rally in the capital markets was already underway. Similarly, we do not know today if that rally is running out of steam. Trading volume has slowed in recent weeks, which is often a sign that the market is getting ready to change direction. And there have been other signs, most recently the 223 point drop (2.6%) on Thursday July 2, the largest decline ahead of a July 4 holiday in more than 50 years.

But whether or not we are entering a stock market pull back (or a “correction” as we say in the business) investors ought to feel better than they did three months ago. Yes, asset values are sharply higher, but perhaps more important, we appear to know where bottom is. The sense that there was no bottom was the scariest part of the collapse during the fall and early winter. But now a good deal of evidence argues that the bottom, call it rock bottom, occurred on March 9, when the doom and pessimism were way overdone. We have moved on, thankfully.

The stock market rally surprised everyone by its size and its speed. In a mere six weeks stocks rose over 30% on average. Finance-related stocks did the best. They of course had suffered the most in the collapse in the fall and winter. While still at huge losses compared to their year-ago values, distressed banks (Citigroup, Bank of America, Wells Fargo) soared as much as 300% in price. Meanwhile high quality stocks like Exxon, Procter & Gamble, and Coca Cola turned in more restrained but still sizable gains in the 10 to 20% range. In keeping with the pattern in the stock markets, prices of junk bonds soared while prices of Treasury notes and bonds generally were flat to down over the period.

The worst may be over but there is still of course plenty to worry about. I mentioned the likelihood of a short-term correction, which would be a more or less normal occurrence after a big rally. In terms of longer-term problems, the economy contracted 6.3% in the fourth quarter of 2008 and 5.5% in the first quarter of ’09. Anything worse than minus 2% is a recession. Thus for the last six months the economy has been running at roughly three times worse than recession. It is the sharpest decline in economic activity since the end of World War II. No one knows the extent of the damage. In terms of good news, recent economic reports show unemployment, international trade deficits, corporate earnings, manufacturing activity and so forth getting worse but at a somewhat slower pace. If there is any good news, it is of the “bad news is getting less bad” variety.

The political sector is trying to administer the economy. Can it succeed? Experience would say no. Consider that the auto and financial sectors have been effectively nationalized. The health care sector, which constitutes nearly 20% of the economy, may be nationalized in coming months. And then there is the government spending. To pay for various stimulus and bailout packages, the Treasury is issuing four times the amount of debt it did last year. The amount of government debt as a percentage of the economy is projected to rise to 80% by 2012, up from 40% last year. Last time it was this high was in the closing days of World War II.

For reasons one could debate, opinion leaders in the country – – the financial media, the academic community, politicians and regulators – – treat the economy as a mechanical device that government-appointed managers can manipulate. They speak of priming the pump, of stepping on the gas, of putting on the brakes. If the present financial and economic crisis has one lesson to teach, indeed if the course of the twentieth century has one lesson, it is that the economy is more organic than it is mechanical. The economy operates more like a herd of cats than an automobile, and efforts to treat it like a machine are unavailing. Examples abound. This winter the Federal Reserve Board bought Treasury bonds (a.k.a printed money) to push interest rates and mortgage rates lower. It had the opposite effect; rates soared as investors feared inflation. Another example: In January of this year Council of Economic Advisors Chairman-designee Christina Romer said an $800 billion stimulus package was necessary to keep unemployment at 7%. Without the stimulus package, she said, unemployment might rise to as high as 9% by the present time. Well, the stimulus package was passed and employment is now 9.5%.

What do we think investors should do? Focus on liabilities rather than assets. This is a fancy way of saying that you should understand when you will need your savings and in roughly what amount. Tying assets to the expenses of living is a way of immunizing a person, or a business, from risk. We have been matching assets with liabilities for insurance company clients for years. The matching assets with liabilities was not so important when stock prices produced big annual gains, but it is likely to grow in importance, especially for individuals, in times of slower growth and higher price volatility, which may lie ahead. It is one reason for clients to keep us informed about unusual expenses.

In terms of specific investment recommendations, we like American companies that do business with China, India and other fast-growth economies. I am thinking of multi-national corporations like Exxon, 3M, Procter & Gamble, Microsoft. We think these strong companies will get stronger. Investors will also want to have direct exposure to fast growth economies through exchange traded funds (ETF’s), something we have been doing for some years. We also like capital equipment companies, and are looking for suitable commodity-related stocks. Generally we like stocks with dividends over stocks without dividends. As regards stocks and corporate bonds, we would focus on companies with access to capital, or companies in domestic or foreign markets that have learned how to operate without debt. Why the focus on debt? On top of the mushrooming Treasury debt referenced above, a huge wave of corporate debt is coming due, a leftover from the salad days of 2004- 2007. Debt-dependent companies could have trouble raising money in the next couple of years.

In my last appraisal letter I said that stocks would probably end the year in the black. I still think that. I also think the American economy is big and robust, even irrepressible. The President promised us change, and we are getting that, and then some. But there is always opportunity in change.


Mark O’Brien