Pendulum at the Apex

We bring you this message from the markets:

“The dollar is going away as the world reserve currency. The Federal Reserve is creating another bubble. Treasury bonds are a terrible investment. We are headed for runaway inflation. Gold is going to $2,000. Interest rates will skyrocket. The 10-year U.S. Treasury bond yields only 3.5%, but who wants that? This isn’t going to last; the Chinese won’t stand for it. With the Fed printing $1 Trillion dollars, Fed Funds at 0% and the budget deficit running over $1 Trillion for the next 3 years, we’re not just looking at inflation; we’re looking at hyper-inflation and double digit interest rates. Buy stocks!”

Of course, this is just a rather cynical summary of the somewhat contradictory picture we have seen financial markets craftily drawing up since the gut wrenching lows of March 2009. It is a marketplace with no diversification, little regard for risk-aversion, and a preponderance of highly correlated asset returns. Indeed, with gold recently breaking to new highs, the dollar under consistent pressure, and the Dow inexorably climbing from 6,500 to 10,000 you can actually see some confirmation of these proclamations.

It’s hard to dispute such prognostications. They seem as clear as the housing and tech bubbles look now in hindsight. They seem inevitable. Or do they?

Of course, we don't know what the future holds. There is no crystal ball and nothing in life is certain. If nothing else, the stock market has clearly demonstrated at least that over the past 10 years of negative returns. What is interesting and perhaps more rewarding is to look at the realities of today, not just the expectations and perceptions the markets have of tomorrow. Today there are some important potential inflection points that may reverse trends that have been at work for several decades. The typical Pavlovian response in markets to take risk in the presence of easy money, big government spending, and a declining dollar might be, at the very least, somewhat premature.

It is really astounding that our economy is hardly motivated with interest rates at all time lows. Indeed on many fronts it is not “rates” that are important. Instead, it is the “levels”. The levels of debt are so high and onerous that even historically low interest rates can’t seem to induce further borrowing and consumption. The level of capacity in the economy may be too great to provide significant rates of return on marginal capital investment. The potential rate of growth in GDP is too weak to impact the level of employment. Yes, the recent GDP report showed annualized growth of 3.5% in the 3^rd quarter. However, nearly half of that growth came from auto sales. Will auto sales be sustainable, post Cash for Clunkers, or without government backing for GMAC and Ford Credit to provide auto financing? Another 16% of recent GDP growth came from residential construction, which is only 3% of our overall economy these days. Will the first- time homebuyer tax credit result in sustainable housing construction? If the levels in the economy are misaligned, then the rates of change and return may prove illusory.

The U.S. economy has been expanding for many years, certainly creating wealth along the way, but also propelling our growth with artificially low interest rates and increased leverage when times got tough. It has worked, and the expectation is that it will work again. Many fear it may only work too well and create runaway inflation and unfunded fiscal deficits. But it’s the status quo. Yet, there is an opposite force starting to assert itself, which might give us an indication of the returns we can expect on our investments in the years ahead.

Figure 1. (Click the chart for a larger image.)

An object in motion tends to stay in motion unless acted upon by an opposite force.

This paraphrases what most of us remember from high school physics of Newton’s First Law of Motion, which is also known as Newton’s Law of Inertia, and it actually applies to what we might expect from the economy and asset values for years to come. As the chart above indicates, we may begin to see it in the relationship of increased savings and ownership of risk-free U.S. Treasury bonds. According to Federal Reserve data, the household and non-financial business sectors combined are on track in 2009 to see a reduction in year-end debt levels for the first time since data from the Federal Reserve started in 1946. The average rate of growth in debt levels over that period of time is close to 10% annually. This marks an historic change in behavior. Furthermore, the savings rate has broken a 35 year downtrend that reached a low near 0% in 2005. From the late 1940s to the early 1990s the savings rate was between 6% and 12%, consistently averaging just above 8%. By the middle of this year, for the first time in the past 10 years, the savings rate increased to 5%. If we continue this trend reversal, it is certainly possible an 8% or even 12% savings rate can be achieved. So, what does this mean?

Consider for a moment that credit is tight, the household sector is at record levels of indebtedness at 180% of GDP, and real unemployment (including those who have given up looking for jobs and those reduced to part-time) is frighteningly high at around 17%. Of course people are saving. They need to save in order to protect their personal balance sheets, amid job insecurity, stifling debt levels and the specter of higher taxes. The same goes for corporations and banks, where funding and returns on capital have become more uncertain. Again, given the levels of debt, not the rates, people have little choice but to save and sit on cash. Hence, there is an underlying demand for U.S. dollars and safe, liquid U.S. dollar assets. Only dollars can repay dollar-denominated debt, of which there is 30 times more than actual dollars available. That’s why the dollar appreciated over 25% when the initial and most violent wave of deleveraging occurred in late 2008 and early 2009. It’s also why the Federal Reserve continues to be so aggressive. They understand how scarce dollars are, relative to the amount of debt in the system and the potential for further deleveraging.

Bear with me and consider the numbers to see how this is playing out. It could mark a material change in how we, as a nation, save and invest.

The U.S. has aggregate borrowings of close to $55 Trillion. U.S. Treasury debt owned by the public is just over $7.1 Trillion (and there is another $4.4 Trillion of intergovernmental holdings owned by agencies such as Social Security). In the first quarter of 2009 alone, household ownership of U.S. Treasury bonds increased by an astounding 140%. This represents an increase of $336 billion. We have never seen a quarter-to-quarter increase greater than 30% (occurred in 2004) going back to 1951, as far back as this data goes from the Federal Reserve. Add to this that during the first two quarters of 2009, money- market mutual funds, which many households have ownership in through 401ks or brokerage accounts and is not included in the household data, increased Treasury holdings by almost $400 Billion, an increase of 324%. Certainly much of this results from general risk-aversion. Very similarly, FalkerInvestments transferred client money market assets into a U.S. Treasury money market fund, in late 2007, to avoid risks we could see developing in the asset-backed commercial paper market. When taken together, there is over $700 Billion of additional funds that have been invested in Treasury bonds from these sources over the last two years. They have absorbed 30% of additional publicly held Treasury issues since 2007, yet only account for a combined 15% of all Treasury ownership. Further, consider that the household sector alone only accounts for 8% of all publicly held Treasury debt today, having hit a low of 4% at the end of 2008. As recently as the year 2000, the household sector owned 21% of publicly held Treasury debt and was consistently between 20-30% going back to 1951. At the 20% level today, the household sector would own roughly $1.4 Trillion of the $7.1 trillion of Treasury bonds outstanding. Indeed, we may see those ownership levels again. With disposable personal income today at $10.9 Trillion, if the savings rate reached 12% there would be at least $1.3 Trillion available for investment annually, without considering growth in income. That is almost $1 Trillion more than we are saving today. Certainly, the savings will be spread around, but as households continue feeling the pressure of debt and unemployment, it is very likely that Treasury debt will see a significant continued source of demand, as it is the only legitimate risk-free investment available. You can debate that in the long-run, but for now the U.S. is a long way from any risk of default. When people save against the financial pressures that are mounting, they invest for more certain return and do not speculate. Given the data, we could well be in the early stages of a trend reversal.

Taking a quick tangent from this, everyone seems to be worried about China selling Treasury holdings and their continued willingness to fund our deficits. Mainland China and Hong Kong combined represent the largest foreign investor in U.S. debt with $921 billion of publicly held Treasuries. But also understand that they have their currency pegged to the U.S. dollar, so they have to keep buying dollar assets, favoring Treasuries because they are risk-free. If they don’t keep buying, the Chinese yuan will appreciate, making their exports more expensive and threaten all the capacity they are adding through their own massive stimulus measures. With our trade deficit shrinking, as consumers revert to saving instead of spending money, China’s trade surplus will also shrink, leaving them fewer dollars with which to buy Treasuries. Yet, when considering the numbers from above, it is distinctly possible we don’t need China to buy more of our debt. We could fund our own budget deficits with domestic savings. The whole China concern of today may well be flawed and it is really they who face the more difficult adjustment. If we aren’t willing to underwrite Chinese trade surpluses, as we have for so many years with debt-fueled consumption, they are left with fewer resources to keep their currency and exports cheap, and will have to seek other ways to keep their 1.3 Billion people happy.

Many people would dismiss all this as conjecture, especially those counting on runaway inflation and skyrocketing interest rates, but there is a message here. It is hard to imagine a world so different from what we have become used to. The imbalances in the global economy have been building for a long time and we have now experienced an awakening, with two collapses of asset prices in seven years. It is entirely possible that the opposing force of over-indebtedness will reverse the economic course of the last several decades. It is showing up in the numbers, while the markets, aside from the Treasury market, might not see it yet.

As this relates to our investment strategy, we may have to be willing to accept investment returns over the next several years that are potentially lower than the long-term average. Certainly, the last 10 years have already been well below average. In the midst of deleveraging and increased savings, risk-taking may not be well rewarded and, indeed, risk-aversion will continue to be the surprising beneficiary. Using the changing character of household savings and Treasury ownership as an indication of risk tolerance going forward, we can infer that high-quality investments with a greater certainty for return, both on and of principle, will likely be favored over investments that offer potentially higher rates of return. This is called saving and investing, not borrowing and speculating.

We don’t see such developments as disastrous or necessarily portending another crash. One could argue that it sows the seeds of more balance and stability in the absence of any significant geo-economic or geo-political interference (i.e. trade protectionism and global terrorism, two destabilizing forces that make life all the more uncertain). Economic growth will slow considerably, in part due to Keynes’ paradox of thrift. The Fed’s position on interest rates and monetary policy is likely a symptom of what ails us, not necessarily a catalyst for further imbalances. We would rather see growth in equity prices moderate and have interest rates remain stable. If stocks continue to fly upward, it may likely be on the back of speculation, not on sound value investing. If interest rates begin to move higher as more people are convinced of future inflation and unfunded deficits, then the indebted household and real estate sectors may likely crumple under the pressure.

We need to see moderation and we are investing along those lines. We are not interested in the risk trade or one that assumes the status quo. We are not willing to chase the stock market higher by adding high-beta, speculative growth stocks to our portfolios. We are looking for consistent, more predictable, returns from the stocks and bonds of high-quality companies, and favor a portfolio profile that outperforms markets by being risk-averse, which is characteristic of our past returns.

As always, we own only companies that demonstrate consistent internal rates of return that exceed the cost of capital. That is an irrefutable measure of quality. We are increasingly focused on those companies with the stocks and bonds that offer strong cash flow yields to the investor. Before the markets reached the bottom this year, we allocated up to 25% of our model portfolios to investment-grade bonds with an average annual yield to maturity of 7.5%. We have trimmed several equity positions as they have recovered and started to add more concentration to stocks with dividends in excess of 3%. Our stock holdings represent close to 60% in our model portfolios with any remaining cash immune from market risk and awaiting opportunity in the U.S. Treasury Money Market Fund. For our clients with dedicated bond portfolios, we continue to invest at the best investment-grade bond rates available on the yield curve, favoring maturities under 5 years. If we see long-term rates rise, we will slide our maturities out further on the curve

Again, no one knows what the future holds. The markets, however, seem on the verge of certainty about the future. I would agree that things are better today; we did not go completely over the edge. The market rise is fairly well justified to this point and, frankly, a relief to those of us with stock investments. This may not be “the” moment and maybe the lesson has yet to be learned. But with households losing almost $12 Trillion in financial and housing asset values in two years, representing the biggest percentage drop since the Great Depression, I’m not sure the system can withstand a more obvious lesson. With such deep losses in assets dear to the American household, the widespread public outcry over bailouts, deficits and taxes, combined with the changing nature of savings and investment, there is good reason to believe we are finally changing course.

As always, we welcome your questions and comments. So we can respond directly to anything you might want to offer or ask, rather than sending a comment through this blog, please send an email to Peter@FalkerInvestments.com .

Peter J. Falker, CFA

November 4, 2009

The Big Picture

It’s time for a little economics review. While this risks putting you to sleep, it’s essential that we keep a level and clear perspective on where we are today. We think this is pretty important stuff and we want our clients and interested followers to know how these things affect our current investment strategy.

It’s no secret that the major catalyst for this “Great Recession” was the highly leveraged consumer who mortgaged their future with cheap credit on the back of inflated housing prices. That may risk oversimplifying the problems we are facing and, indeed, the ensuing collapse of credit markets and the dismantling of the banking system created much greater threats to our economy. The general population may never understand how perilously close we were to a calamity worse than the Great Depression, due to a widespread failure of the banking system. As it is, the only evidence of support for the U.S. economy today is coming from massive infusions of liquidity by the Federal Reserve and the supposed ability of the U.S. Government to finance a growing budget deficit; both very controversial actions. The markets have responded to this support and are currently trying to discount an uncertain future. Right now you can find equally compelling arguments for an extremely wide array of potential outcomes. We seem to be riding on a “razor’s edge” of confidence that keeps us on guard and focused on capital preservation and balance in the portfolios. We are much better off than just a few months ago and that alone can inspire markets to move higher if risk appetite increases. However, we still need to keep a grip on reality and weigh the fundamentals.

From a macro-economic perspective, there are three areas that are of particular importance when reading the roadmap to recovery.

1.) The housing market

2.) The health of the largest component of U.S. GDP – the consumer

3.) The prospect for inflation.

While we look at each individual investment in our portfolios based on its own merit, our asset allocation and willingness to take risk largely rests on these big picture factors.

Housing

Figure 1. (Click on chart to enlarge)

Figure 2. (Click on chart to enlarge)

These charts point to some very important progress in the housing market. The first thing to recognize is the improvement in housing supply. Figure 2 shows a massive contraction in building activity represented by building permits, while figure 1 shows a recent downtick in housing inventory (the green line). This is tremendous progress towards flushing out extra supply. If you look very closely at the last data point on each chart you will even see microscopic improvements in demand. Housing permits just moved slightly higher and houses sold (the blue bars in figure 1) have recently moved up. So the housing market may well be improving and that has very significant implications for stability in the banking system. That is undeniably the market at work and certainly a good sign.

Natural rates of supply and demand are highly correlated to population growth but they were most recently skewed by the proliferation of cheap mortgage credit. Since 1960, average building permits have run close to 1.5 million per year. In the period from February 2003 to August 2006, the heart of the housing bubble, average annual permits were running just over 2 million units. In 2005, permits were running close to a 2.2 million annualized rate every month. Given the below average numbers of the last 2 years, the average annual permit rate from February 2003 until now is just over 1.6 million, signaling a reversion to the mean and a more normal environment.

Lingering concerns remain from foreclosure rates that are resulting from what may be the highest rate of unemployment we’ve seen in the last 30 years (currently at 9.5% and rising). The Mortgage Bankers Association recently reported that 1 in 8 of the nation’s home mortgages were behind on their payments in the 1^st quarter. This is the highest rate in 37 years and largely the result of too much debt. When combined with tight credit conditions, the data portends a much slower rebound in housing than has occurred after past recessions, but improvements in supply and demand do indicate that prices may stop going down.

The Consumer

The state of the housing market provides a good lead-in to discussing the state of the consumer. First, let’s take a look at mortgage debt relative to household real estate values.

Figure 3. (Click on chart to enlarge)

What’s important in figure 3 is the skyrocketing loan-to-value ratio (the red line) over the last 3 years. Home mortgage debt has remained close to $10.4 Trillion while housing values have plummeted almost $4 Trillion since 2006. The only ways for loan-to-value to improve is for debt levels to go down or housing values to move up. Even though supply/demand has improved, a meaningful rise in the value of real estate is very limited in the near term, given tight credit and unemployment. Debt levels can only effectively be reduced by asset liquidation or aggressive savings toward future debt reduction. Neither of these support rising real estate values and are likely be dilutive to future household income and equity. Certainly it is helpful that mortgage debt has stopped growing. Refinancing has been very strong as rates are managed lower by the Federal Reserve and lending is subsidized by the government through Fannie Mae and Freddie Mac. We are clearly fighting fire with fire as such policies significantly contributed to the housing bubble in the first place.

Figure 4. (Click on chart to enlarge)

Figure 5. (Click on chart to enlarge)

That leads us to household income statements and the ability of consumers to continue driving the economy higher. As identified in figure 4, U.S. households are well on their way to a higher savings rate. In an environment of high unemployment, record levels of household debt service (18% of personal disposable income), and tight credit, there is virtually no choice but to save. While saving has healthy long-term implications, it makes for very difficult economic growth in the near-term. Add to this that average weekly hours worked, as reported by the U.S. Department of Labor, are at the lowest levels since 1964 (when the data was first compiled) and you can understand how personal income statements are pinched. How does this relate to economic growth? Figure 5 shows that consumption is at record levels near 73% of GDP. However, with consumption coming under pressure because of significantly higher savings rates, it’s easy to see the why GDP growth may be limited over the next several years. In other words, increased saving naturally results in lower consumption, which could keep the economy stagnant for years to come.

Important to understand in all this is that there is a level of production the U.S. economy has to maintain in order to meet the basic needs of a productive and growing population. Lower capacity utilization rates and drastic cutbacks in capital spending have reduced manufacturing inventories by almost 10% from year ago levels while sales have decreased 18%. The decline in sales has recently begun to moderate and may support some GDP growth from inventory restocking. As far as predictions go for the recession ending this year, much of it will be tied to this natural process. For example, Intel Corporation recently excited the markets when they claimed higher sales and margins largely due to inventory restocking by their OEM customers. As we hear this from more businesses, it will be received as relatively good news and indicates we are not going over the cliff as we were in the 1^st quarter. But that is about all it indicates at this point.

Our economy still faces a gap in potential growth as it begins to rely less on a “borrow, import, and spend” model and shifts towards one of “invest, innovate, and export”. Important to note, export oriented economies such as China, face almost the exact opposite challenge, as they will encourage less saving and more consumption. As we see aggressive infrastructure spending and stockpiling of industrial commodities by the Chinese, arguably a significant factor in recent global economic stability, we will learn about their economic viability, as their largest customer (the U.S. consumer) embarks on a fundamental shift in saving behavior.

In all, consumers and households have very difficult issues to confront as the excesses of the past 20 years are corrected. We expect this sector to emerge healthier and more resilient after several more years of adjustment. We also need to monitor how significant headwinds from government policy in the private sector and the prospect of higher taxes will affect future rates of unemployment and income.

Inflation

Possibly the most debated issue among economists today is whether we are headed for inflation or deflation. Milton Friedman is famous for declaring that inflation is always and everywhere a monetary phenomenon. This is a simple concept and given the record increases we’ve seen in money supply it would mean we already have inflation.

Figure 6. (Click on chart to enlarge)

The above chart was originally used in a blog piece written back in November 2008 (click on the link to read that post) and depicts what is called the monetary base. It is often referred to as the Federal Reserve’s balance sheet and reveals the magnitude of the increase in the supply of money. Where is all this money going? The Fed has initiated several unprecedented programs to support liquidity and credit in the economy. For the first time in its history, it is literally functioning today as the lender of last resort to the short-term commercial paper and asset-backed lending markets, as well as backstopping money market mutual funds. It is even buying mortgage debt and U.S Government bonds to keep interest rates low. Without this continuing support, we believe that our economy would have collapsed into a serious depression.

Friedman’s theory may have already proven true, as we do have rampant inflation manifesting in the price of U.S. Treasury bonds, where yields are frustratingly low. In fact, Warren Buffet, in his annual letter to shareholders, stated that the Treasury bond bubble may prove to be just as extraordinary as the dot com and housing bubbles. Consider that while the monetary base has increased, it is only acting as life support and has not encouraged meaningful increases in bank lending or private investment. Money has continued to filter down into excess banking reserves held at the Fed, short-term treasuries, and FDIC insured bank accounts, as consumers, businesses, and banks look to hold cash to stabilize balance sheet capital. The Fed is in the money market every day and Fed Chairman Ben Bernanke has expressed confidence that by targeting only what the credit market needs, they can unwind their balance sheet very quickly, if and when private capital comes back to the market. The problem is that large parts of the credit market, such as asset-backed securitizations, have essentially disappeared and banks are still quite risk averse when deploying capital, so it may be quite some time before private capital reappears in sufficient quantities to make a difference.

Unless liquidity provided by the Fed finds its way into the economy and grows via the multiplier effect of bank lending and investment, we will not see any meaningful rate of inflation in consumer goods or wages. With capacity utilization rates low (68% vs. average 80% since 1980) and unemployment rising, there is very little pricing pressure. Also consider that, according to Federal Reserve data, aggregate debt of the U.S. economy is roughly $56 Trillion, which includes approximately $12 Trillion of U.S. Government debt. As you can see in figure 7 below, that is approaching four times the level of U.S. GDP. By way of comparison, that ratio was only 2 to 1 in 1985. If confidence wanes and deleveraging continues, inflation in the general economy will not develop any time soon. This is where the government stimulus is intended to pick up the slack, why its effectiveness is being debated, and an additional stimulus plan seems likely. We need money in the economy to move toward productive investments and expenditures. If it only transfers to social and corporate welfare (bailouts) and then lays idle in bank accounts and Treasury bonds, we lose the efficient allocation of capital. In this way, some inflation in goods and services will be a welcome sign, indicating the movement of money deeper into the economy. It is only after evidence of a significant economic rebound that we can begin to fret about potential runaway inflation in consumer prices.

Figure 7. (Click on chart to enlarge)

Recently, the Fed has slowed the pace of money growth as it tests the resilience of capital markets. We will keep a close eye on this as an indication of confidence coming back to the market. While deflation, by definition, may not occur because of an expanding money supply, waning confidence could result in declines in asset values and consumer prices, while Treasuries (and quite possibly gold) would strengthen. That would not signal economic recovery and at this point is a compelling variant view as the consensus of many analysts and media pundits seems more focused on hyper-inflation. Judging from the bond market (specifically Treasury bonds), heightened inflation expectations have not been priced in at this point, which suggests the markets are not aligned with popular opinion. This issue is possibly the largest wildcard of all when considering the direction our economy takes.

Investment Implications

When considering everything discussed above, it is reasonable to question whether or not the extreme conditions we are witnessing should portend greater challenges ahead.  Are we really at a breaking point that marks a turn in the global economy and the balance of power?  Are we over or underestimating the potential for debt induced price deflation to accelerate?  Is debt at four times GDP unsustainable?  Certainly at two times GDP it may have looked just as troublesome.  Is consumer spending at 73% of GDP necessarily too high?  Couldn't consumption continue to increase as it has in the past?  Are dramatic declines in U.S. equities and housing prices sufficient to provide reasonable future returns?  The list goes on and we continue to ask ourselves these questions when formulating investment decisions.

In all, the state of the housing market and consumer, when combined with inflation expectations, signals that a significant and healthy correction is running its course, while risk aversion remains very high. We believe the markets have discounted many of the economic challenges we face and could potentially move higher if more positive news develops.  At the same time, we do not like the condition our economy is in to handle any external shocks (of course we are talking mainly about ever present geopolitical threats). Households are still over-burdened with debt, government policies are casting a long shadow on consumer and investor confidence, while monetary policy has introduced unprecedented risks.  There is little value in trying to speculate and predict specific outcomes of the Great Recession. There are simply too many variables to allow for bold predictions, and investors shouldn’t feel anxious to chase returns. There is a growing belief that “it’s different this time” and that we are likely to continue feeling the ramifications of “The Great Recession” for a generation to come.

Given this, our focus at FalkerInvestments is on the objectives of our individual clients and the investment returns required to meet current and future financial needs. The majority of our clients are invested in our model portfolio, which achieves what we think is an appropriate balance of risk and return for long-term compound growth. Within that portfolio, our strategy over the next 6-12 months is to remain balanced with EVA-producing, dividend-paying stocks representing 55-65%, investment-grade bonds 20-30%, and the remainder in the US Treasury Money Market Fund.

We also manage dedicated bond portfolios for some of our clients, in which we hold significant investment-grade fixed income holdings that provide relative stability and modest returns to support their lifestyle. We do not encourage them to look for returns in excess of what they need and can reasonably achieve. We are investing those assets across the yield curve while keeping enough liquidity to invest if rates move higher.

Equities have recovered from declines that occurred earlier in the year and have reversed a small percentage of 2008’s decline. On the whole we see our stocks being close to fair value, given the state of earnings projections, while remaining intact to produce solid returns on capital going forward. We have not attempted to “catch bottoms” or take incalculable risks to ride recent momentum in the markets. We have and will continue to take advantage of the current market rebound to trim positions, where warranted, while maintaining an active list of dividend-paying reinvestment opportunities.

Our bond allocation has done very well and we are actively looking for 6-8% long-term returns in investment-grade bonds, as they become available. In our model portfolio, the maturity schedule is currently under three years with an average yield-to maturity around 8%. The short-term nature of our bond holdings provides us with reinvestment opportunities, should rates move higher from rising expectations of inflation.

It is important to note that cash should not burn a hole in our pockets in times like this. Remember that we are only a few short months removed from what was a potentially devastating collapse in the banking system. Investing is dynamic and, while earning any yield seems desirable over no yield, it is important to consider the value of liquidity and stability that a core cash position provides. Just as banks are sitting on excess reserves to protect capital while waiting for better lending opportunities, the access to stable and liquid cash serves as an effective lever for us to quickly respond to investment opportunities. Our portfolios are designed with a cash component in mind , which is factored into our expectations for return. It has served as an extremely useful asset over the last 12 months by providing reassuring stability in difficult times, while also allowing us to move quickly on specific bond investments. Finding meaningfully better short-term yields today requires losing significant flexibility and certainty of return, the two things cash is meant to provide. If we see any very short-term bond opportunities that strike the right balance, we will pursue them with a percentage of cash that we would otherwise expect to hold in treasury funds during that time period.

So that covers how the macro-economic view is influencing our thinking. Hopefully you’ve made it through without too much head-bobbing. As always, we appreciate your comments or questions. We really are fortunate to communicate with a wide array of very intelligent, informed clients and friends, who provide useful inputs to our thinking.

Peter Falker

July 22, 2009

The Nationalization of General Motors

The bankruptcy of General Motors is the tangible result of the capitalist free-enterprise system functioning exactly as it should.  This did not come about because of a slowdown in automobile sales as part of the “Great Recession”; that is just the straw that broke the camel’s back.  It came about because of the long-term destruction of capital investment in this company, both debt and equity, that was provided by investors throughout its history.  GM (as well as Chrysler) has destroyed so much capital that private investment capital is no longer available, thereby necessitating an unprecedented government nationalization of the company, outside of the capitalist system, to save thousands of jobs.

The value of capital is destroyed when a company in which it is invested does not generate an internal rate of return on invested capital (ROIC) to cover the capital’s cost (This is simply net operating profits after tax divided by the total capital invested in the company).  Conversely, when a company generates an ROIC that exceeds its cost of capital, then value is created.  This is called economic value added, or EVA, and is one of the primary considerations in our investment analysis.

The weighted average cost of debt and equity capital (WACC) deployed in the automobile industry has historically been about 10 percent, and no company in the auto industry has consistently generated ROIC that even came close to meeting that cost.  GM’s return on capital (when they had any at all) hovered around 4-5%, so they have always been capital value destroyers.  Ultimately, when capital destruction reaches a crescendo, as it has in the vast losses posted by GM in the last several years, all capital is finally destroyed.  And that’s what just happened.  If anyone has any doubts about the cost of equity capital (some naively believe it has no cost) ask the “former” shareholders of GM what it just cost them.  This, of course, is equally true of Chrysler, whose most recent shareholders, Cerberus and Daimler, have been wiped out over the last several years.

More than three years ago I posted a blog entitled “Generous Motors”, calling for the bankruptcy of GM.  Here is an excerpt:

 I am often asked if I believe GM can avoid bankruptcy. My answer is always: “They shouldn’t”. In my view, Chapter 11 is the only way to save GM from themselves and the union. Like the airlines, management in bankruptcy can eliminate ponderous salary and benefit provisions (and the jobs bank!) once and for all. Also, it presents a once in a lifetime opportunity to bring fresh management thinking to an industry that has always been run by people who grew up in the business; usually in the same company…. People in Detroit really don’t get it about product, and that isn’t something new. So, if the bankruptcy court is wise, they will cede management of a bankrupt GM to outside professionals, who could care less about “how we have always done it around here”. Also, that ultimate old boys club, the dealer network, needs to be changed drastically, but no one in Detroit has ever been strong enough to tackle it…. In the world of the internet, cars should not be sold from vast inventories held by dealers and floor-planned by captive auto finance companies. This is a huge misuse of capital, but very convenient for keeping assembly lines cranking when cars aren’t selling. Cars should be ordered on-line and delivered “just-in-time”, and dealers should be delivery and servicing agents; obviously very different from today and probably only achievable “in extremis” of bankruptcy. By the way, I’m waiting for the Japanese to figure this one out…. Frankly, I have very little hope that much of this is going to happen. I’m pessimistic about Detroit and I do not believe the U.S. auto industry is too big to fail. However, we have no way of knowing when the band-aids will fall off.

If you would like to read the rest of this posting, click on 2006 in the box at the right and scroll down to March 31, 2006.

Unfortunately, the “band-aids” have really fallen off now and I don’t like what I’m seeing.  Things have gotten a lot worse in the last three years than I had imagined.  The usual means of providing financing in a Chapter 11 bankruptcy filing is called “Debtor in Possession” (DIP), which is usually provided by the nation’s largest banks, secured by the restructuring assets of the bankrupt company.  This is how the steel and airline bankruptcies were done in the last several years, with the DIP loans being paid off as the companies emerged from bankruptcy.  However, with the nation’s banks themselves in-extremis and being propped up by the Federal Reserve, they are not candidates to loan GM $50 billion plus in DIP financing, especially since there is no probability of GM paying off these loans anytime in the near future.  So, with the $20 billion already lent by the federal government it would be natural for them to become the lender of last resort for DIP financing.  That, along with guaranteeing warranties, would seem to be the right solution, but that isn’t what’s happening.  The U.S. government is nationalizing GM by taking a 60% ownership/equity position, while Canada will own 12.5%.  This is the exact opposite of what the government did with the banks, because the concept of nationalization is anathema in a capitalist system.  And, as I see it, there is no reasonable probability of the government being taken out by private capital for a very long time to come.  Remember that vast amounts of private debt and equity capital have just been lost by GM investors and no reasonable capitalist is likely to make an equity investment until they can see an ROIC which would meet their opportunity cost.  Since that has never happened in the auto industry, why would anyone believe it will happen anytime soon?  We will no doubt hear about the new GM becoming profitable.  But when will it become profitable enough to provide the ROIC necessary to attract private capital?  Not soon in my opinion, so only taxpayer capital, which has little or no return expectation, will remain.

As the talking heads keep repeating, the “new” GM will emerge from bankruptcy very quickly. And why shouldn’t they?  They are now majority-owned by the U.S. and Canadian governments.  This is historic, because for the first time in our free-enterprise, capitalist system, government is taking ownership of the means of production, primarily to save the jobs of thousands of Americans.  It would be different if private capital was waiting in the wings but it isn’t, for all the reasons mentioned above.  So what we now have is not free enterprise capitalism; it is benign socialism and a giant WPA-like jobs program necessitated by the failure of the automotive industry to provide the investment returns necessary for capital investment to flow.

David Brooks of the New York Times described the effects of government control of GM in a June 1, 2009, op-ed entitled “Quagmire Ahead”:

“The end result is that G.M. will not become more like successful car companies. It will become less like them. The federal merger will not accelerate the company’s viability. It will impede it. We’ve seen this before, albeit in different context: An overconfident government throws itself into a dysfunctional culture it doesn’t really understand. The result is quagmire. The costs escalate. There is no exit strategy.”

 

To read the rest of David Brooks’ op-ed click here:

http://www.nytimes.com/2009/06/02/opinion/02brooks.html?_r=1

The emergence of Chrysler from bankruptcy is potentially even worse, since Fiat, its new minority owner whose own track record is very shaky, is making no financial investment for 20-35% of the company, the UAW gets 55% for its health-care trust, and the federal government is providing all the DIP capital to save the jobs.  This is socialism thinly masquerading as capitalism and, in my opinion, only delays the ultimate Chapter 7 bankruptcy liquidation of Chrysler, which ultimately makes it worse for Detroit and those whose jobs are temporarily saved.

Unfortunately, this is just one of the major problems facing our economic system and we are likely to remain in potentially dangerous financial waters for years to come.  For our part, we continue to focus wholly on equity and fixed income investments in EVA producing companies, which are very unlike the auto industry.  This has always been our investment strategy and we believe it is more important today than ever before.

Let us know what you think.

Jack Falker

June 3, 2009

Bull Market?

On March 9, 2009, the S&P 500 Index bottomed out at $676.53, a decline of 25% from the $903.25 close on December 31, 2008, which in itself represented a decline of 38.5% for the year.  The March 9^th close was the low point in the market since August 1996 and technically represented a support level that, if broached, threatened to take the Index down to 500 or below.

The reason for all of this, of course, is the worst worldwide recession since the “great depression” of the 1930s.  It has aptly been called “the great decession” or the “great recession” and none of us born since the 1930s can remember anything like it, nor did many expect it to be as severe as it has been.  There is no question that, given the severity of the underlying failures in the financial system, it could easily have morphed into a situation rivaling or even surpassing that of the early 1930s, if the U.S. Federal Reserve had not pumped vast amounts of money into the banking system, as well as literally becoming the buyer of last resort in the short-term money markets, a role that few, if any, would have imagined. 

Fortunately, it now appears that the Federal Reserve and the U.S. Treasury have averted the threat of further significant deflation and have effectively placed the nation’s largest banks on life support.  Nevertheless, the banking/credit system is still not functioning properly and virtually every sector of the economy continues to struggle, resulting in increasing unemployment numbers and a distinct reduction in spending both by businesses and consumers.

So, that said, why has the S&P 500 Index rallied 30+ percent from its low in March (which some are now terming a “generational low”) to its current level around 900?  The answer probably is that most people believe a depression scenario has been averted as the “less-bad” character of economic data exposed deep discounts in equity valuations.  A further rally from here implies expectations of significant economic strength.  Indeed, things do look better than they did two months ago, as well they should after massive infusions of capital into the credit markets and the largest fiscal stimulus program in history.

 But keep in mind that we are still not out of the woods.  Virtually every big bank in the country faces massive loan losses in their commercial loan, credit card and mortgage portfolios over the next year. The International Monetary Fund (IMF) has indicated that both European and U.S. banks are well behind the curve in terms of recognizing their credit related losses, expecting at least another $1.5 trillion to come.  The European economic outlook is perhaps more uncertain than the U.S., adding destabilizing pressure on the Euro currency.  Furthermore, almost everyone waits anxiously for signs of inflation and the anticipated headwinds from dramatically rising government deficits. 

 So what has happened since March is almost certainly a classic bear-market rally.  Bear market rallies are not unusual, but they can be very powerful.  They have occurred historically during periods of economic stress, when better than expected economic news is reported.  In April 1930, the DJIA rallied 53% off of the October 1929 market crash.  In all, between 1929 and 1932, the NYSE saw four 20% plus bear market rallies, preceding the actual generational low of the depression in July 1932, which was a whopping 86.4% lower than its high in the April 1930 bear market rally.

Since the current depression scenario now seems to have been averted, leaving us with “just” a severe recession to deal with, we probably have seen the generational market low and won’t see the kind of wild swings experienced in the 1930s.  However, we also believe it is dangerous to draw the conclusion that a new long-term bull market, based on a substantial economic recovery, has begun. The problems are not over yet and it is going to take longer than 18 months to unwind the excesses of the past 25 years.  The current market rally is likely to be corrected, or at least flattened out, with both peaks and valleys to come, as we go through the rest of 2009 and the first half of 2010.

We approach this environment with a cautious outlook and intend to maintain a conservative balance between equities and bonds.  Our model portfolio over the next 12 months (with the exception of client portfolios that require a higher fixed-income component) is roughly targeted to be 55-65% equities, 30-35% bonds, with the remaining cash in the U.S. Treasury Money Market Fund, awaiting opportunities.  While our cash holdings temporarily earn close to zero, we are comfortable being risk-free, as we seek further opportunities for yield in the bond market.  We believe the investment-grade bond market is in the early stages of providing acceptable long-term yields that will give our portfolios consistent underlying compound return.  Our equity holdings have participated nicely in the rally and we have and will continue to trim positions to keep our equity exposure within conservative limits.  However, if the markets and economy continue with signs of stabilization, we do like the value and dividends offered by several EVA-generating companies we follow.

This strategy has outperformed the S&P 500 index to date in 2009, as it did throughout 2008.  Most importantly, we continue to focus on preserving client capital, with a specific view toward generating some consistent compound yield.

 

Jack and Peter Falker

Balancing

With all of the political and economic uncertainty surrounding us every day, we have seen a somewhat artificial breakdown of long-term technical support in the equity markets during the last week.  Accordingly, we have decided, as a precaution, to further reduce our equity market exposure, for the time being.  With these moves, our portfolios, which hold stocks, will be approximately 50% invested in treasury and government securities and medium-term corporate bonds, generating some yield while awaiting better buying opportunities.

 Among several moves, we have sold our last piece of Goldman Sachs (GS), a company which we expect to own again in the future.  Therefore, our only continuing exposure to the financial sector, at this point, will be General Electric (GE), which has been significantly impacted by its GE Capital business, despite the strength of its industrial segment.  Fortunately, we were able to sell our other financial-sector positions at advantageous levels, during 2008. 

We have been building our position in cash and bonds for several months, which has enabled us to stay well ahead of the continued downturn in the equity markets.  We believe this week’s move to an approximately 50/50 balance should serve us well in the next several months, as we await the effects of government stimulus spending and the ultimate outcome of continuing difficulties in world financial markets.  As we watch the markets rally modestly off their technical support, which is encouraging in the short term, we may decide to generate additional cash in order to further protect client capital.  Our strategy, as outlined in our February blog posting “Midwinter Thoughts 2009” continues to be as follows: 

“….It is our intent to find a conservative balance in our portfolios by investing in bonds, government money-market funds and high-quality, value-creating equities.  This balanced approach will provide our portfolios with consistent yield and staying power, while allowing for significant upside potential, as we patiently wait for the inevitable turn in both the United States and world economies.”

  

Jack and Peter Falker

March 4, 2009

 Note:  At the time of writing, Jack and Peter Falker and the clients of FalkerInvestments Inc. were long the bonds of GS and the common stock and bonds of GE.

Midwinter Thoughts 2009

Back in October, when Warren Buffett published his op-ed piece in the New York Times advocating buying American stocks, it was easy to rationalize that this would indeed be the moment to buy “straw hats in the winter”.  Warren made no guarantees about performance in the short-run and is looking five or more years out to be rewarded (the market is about 4.5% lower than it was when he wrote the piece).  We generally agree with his long-term assessment for returns in the stock market, but feel the near-term is too uncertain for us to put more client assets at risk.  While Buffett may have been too early in his call for stocks, given the unprecedented nature of this crisis, we would rather be slightly late and more certain. 

We are all in uncharted waters because of the severity and complexity of the financial problems now being encountered both in the U.S. and worldwide.  As President Obama said in his February 5^th Washington Post Op-Ed: “By now, it's clear to everyone that we have inherited an economic crisis as deep and dire as any since the days of the Great Depression.”

To read President Obama’s entire op-ed piece follow this link:

http://www.washingtonpost.com/wp-dyn/content/article/2009/02/04/AR2009020403174.html?nav=hcmoduletmv

Looking back at recent history, both the S&P 500 and Dow Jones averages are currently trading at levels of nearly 12 years ago, i.e., mid-1997.  This is somewhat reminiscent of the period from 1968 to 1982 when the major averages were virtually unchanged.  These events argue against the time-honored theory of buy and hold long-term investing, but not against holding high-quality, dividend- paying equities with a trading philosophy that takes profits along the way.

Fortunately, we did take many of our profits in 2008; unfortunately, however, we deployed a portion of those funds into holdings that looked very attractive last fall, only to see them decline further.  So, even though we significantly outperformed the market in 2008, we weren’t as immune from the problem as we might have been.  In our fully invested accounts we are currently holding approximately 40 percent of client assets in investment-grade bonds and government money market funds, and 60 percent in high-quality equities.

Given the current “deep and dire” economic situation, it is our intent to find a conservative balance in our portfolios by investing in bonds, government money-market funds and high-quality, value-creating equities.  This balanced approach will provide our portfolios with consistent yield and staying power, while allowing for significant upside potential, as we patiently wait for the inevitable turn in both the United States and world economies.

The operative word here is “patience”.  We believe that our investments are relatively well positioned and that we must see certain initial outcomes of the new stimulus bill, before we act further. There are early indications that the vast deficit spending upon which the United States is embarking will have an inflationary effect, with significantly higher interest rates to follow, once the deflation we are currently experiencing is forestalled.  We believe there is enough time to make carefully reasoned judgments about both bonds and stocks, once more facts are known.

That’s the way we see it in Mid-Winter 2009.  Please let us know what you think.

Jack and Peter Falker