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

The Aftermath

           “When it comes, it bears the grim face of disaster.  Those who had been riding the upward wave decided now is the time to get out.  Those who thought the increase would be forever find their illusion destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell.  Thus the collapse.  And thus the rule, supported by the experience of centuries, the speculative episode always ends not with a whimper but with a bang.  There will be occasion to see the operation of this rule frequently repeated.”

-John Kenneth Galbraith

 A Short History of Financial Euphoria, 1990

 

So here we are with the bang of the collapse in the housing and debt bubble reverberating throughout the world.  October 2008 was the worst month for the stock market since 1987.  The total economic fallout, while uncertain, predictably worsens as we look to early 2009 with rising unemployment leading the way.  We are seeing the effects of deleveraging after a lengthy speculative episode.   The response has predictably been aggressive policy measures from Government and an increase in the cost of capital as risk premiums soar.  However, there are times, such as we face now, when the reaction is so extreme, the fallout so difficult, and the appetite for risk so diminished that financial memory will impede a return to excessive, leverage-driven speculation for a very long time.  The silver lining here, of course, is that investors are paid to take risk and markets are demanding higher returns.  The key is to find where risk is appropriately rewarded and how the reward is realized.  Sufficient return on capital is paramount and a predictable cash yield is essential.

Globally, governments are now responding in concert with stimulus packages and easier money.  Importantly, however, much of this is surprisingly late.  Gripped with fears of inflation which had already come to pass, and with apparently no attention paid to the effects of deleveraging and the developing recession, the European Central Bank raised interest rates on July 3^rd.  The Federal Reserve also “jawboned” several times late in the summer about fighting inflation with higher rates.  These were attempts at instilling confidence and protecting purchasing power, but markets had difficulty adjusting to new expectations of tightening credit not just from investors, but also from central banks.  We believe this realization was critical in tipping us from a significant, productive recession to one much more harmful, driven by fear and panic.  Once the market decline began, it was fast and forceful.  Companies such as Lehman, AIG, and the Royal Bank of Scotland faced a sudden death of insolvency as their assets quickly revalued at much lower levels and funding disappeared.  Markets entered into a destabilizing period of forced liquidation and cash hoarding. 

To see what is happening now, let’s first revisit what we said in our March 2008 piece entitled Bubble Backlash.  “Given that we are unwinding possibly the greatest credit bubble this country has ever seen, the proportionate response from the Federal Reserve and lawmakers may be quite large in absolute terms.”  To illustrate, take a look at the chart below that we have been tracking from data provided by the Federal Reserve. (You can click on it for a larger view.)

The red line depicts the annual percentage change by month in what’s called the monetary base.  It is a measure of all currency and banking reserves in the economy; literally the base off of which our entire capital structure of investment, credit, and consumption is built.  As such, it is the bottom of an inverted pyramid.  The Fed has increased this base by close to 40% from last year’s level because so much money is currently being hoarded by those who have it and absorbed by those who need it to unwind leverage; a race to get those US Dollars at the bottom of the pyramid.   The Fed is injecting money to provide actual dollars needed to keep the credit markets functioning at a basic level.   We have never experienced a monetary injection of this magnitude in the US economy.   Add the $700 billion TARP being used to keep banks solvent and the upcoming stimulus packages, and the policy response is certainly proportionate and large.  As one might assume, while policymakers fight the onset of deflation, investors will keenly search for signs of emerging inflation down the road.

So far these measures avoid a direct hit on the issue at the core of our problems:  the deflating of an over-inflated and over-leveraged housing market.   Most of the previous liquidity measures are attempting to re-liquify the banking system and encourage lending but, in reality, many banks are drowning in available liquidity but hoarding it to protect their balance sheets.  Their biggest problem has been avoiding insolvency as they are loaded with bad mortgage debt.   The TARP has attempted to help this with direct equity injections into the banks.  The worst mortgages, which consisted of low quality two-year ARMs with pay-options and low teaser rates, were issued between 2005 and 2007.  As these mortgages reset at interest rates in the double digits, foreclosure rates have steadily risen.  The largest quantity and lowest quality of these loans were written in late 2006 and early 2007 and those are the loans that are defaulting right now.  By late spring 2009, there will be no more such loans to roll over and we may find the beginning of a housing bottom.  But in today’s credit-starved world, 6-8 months is an eternity.  We expect more aggressive action (i.e. hundreds of billions of dollars) aimed at assisting homeowners and banks to work out many of these remaining troubled mortgages.  Banks may then avoid insolvency and begin using these capital and liquidity injections to begin lending to good credits.

As for the equity and fixed income markets, we look for stability to develop as a result of these measures.  In times of panic and distress, the uncertainty of expected outcomes is magnified as human financial behavior is inherently unpredictable.  The panic we see in markets may be justified by fear, but the existence of permanent fear is unreasonable and historically unsustainable.  At some point, when assets are revalued to provide a sufficient return and excess leverage is squeezed from the system, behavior will likely become more predictable and stable, discounting some form of recovery.    We are left to judge whether the resulting prices offer opportunity for investment.  Some companies that we own are trading well below book value while their balance sheets look healthy.  It would appear that no future growth is being forecast forever and assets are being discounted as significantly impaired.  This indicates that fear still pervades and uncertainty rules the day. 

While stability will no doubt take time to develop, it is important to understand that eventual growth in real GDP is, at a minimum, dependent on productivity gains and the basic needs of a growing global population.  We believe investors will begin to identify companies that are vital in those areas and are largely self-financed by sustainable cash flows from operations.  A cash return on investment will be favored and we will look to capture high dividend yield stocks and investment grade bonds where yields have risen to more appropriate levels.  That is where investors will flock when stability returns. 

We have tried to manage our portfolios to be relatively conservative, focusing on companies that meet our usual return on capital criteria.  While we have been opportunistic in selling when it seemed reasonable, it has been nearly impossible to aggressively to sell enough to avoid the fallout in the stock market for that last 45 days.    Our margin of outperformance over the market has been gained from the relative stability of several core holdings and our cash position during the course of the year.  We believe our holdings that are very depressed (i.e. energy, industrial, and commodity related) are worth holding because of the value of balance sheet assets, eventual inflation of commodities from aggressive monetary policy,  and the longer-term secular growth of emerging economies.  We will be very patient when investing available cash and may look to trim positions that have remained profitable.  We will continue to invest in short to medium-term bonds that offer compelling risk-adjusted returns and are paying us 8-10 percentage points more in current yield than what we receive in the U.S. Treasury Money Fund.  We are also focusing on a few key technology companies (such as Cisco and Microsoft) that are vital to long-run productivity gains of the global economy.  Finally, we will carefully add to depressed core holdings that are associated with basic non-discretionary needs of consumers.

It is probably an understatement to say this is a difficult time.  We expected hard times and difficult choices, but we were not investing for a total crash.  We did so in 2002 and largely avoided a very painful decline.  However, by being in Treasuries we missed the very profitable early stages of recovery in 2003 and remained cautiously invested for the past five years, outperforming the market in four of those years including this one.  Rarely is anyone so fortunate to completely miss a crash.  Planning in earnest for a catastrophic market event can take years, and with it comes increased risk of missing longer periods of prosperity while you wait.  Preservation of capital is always at the top of our list, yet, as investors, we inherently take risks that subject us to volatile times.  If history predicts the fallout from repeated bubbles, then it also clearly predicts the recovery that has repeated every time as well.

 To quote Galbraith once more: “Financial genius is before the fall.”  This sense of genius is fleeting and thrives on hubris.  That was certainly the case.   But that is history.  Everyone needs to learn from experience and look forward.   Collectively our nation has been humbled on many fronts.  A sense of humility combined with our freedom, democracy, and free-market capitalism will lead us back to prosperity.

We welcome your comments.

Peter and Jack Falker

"Note:  At the time of publication, Peter and Jack Falker, and the clients of FalkerInvestments Inc. were long the common stocks of Cisco Systems and Microsoft."

What’s Happening and What We’re Doing

Given the state of the markets and economy, we would like to update everyone with our strategy and outlook. Over the past four weeks we’ve had some success trimming back and selling certain profitable long-term holdings that had not yet suffered from the broad-based selling of the last two weeks. These were gains that we had planned on taking under normal conditions that have helped build a significant cash position to buffer the portfolios during this downturn. Focusing on our bank stock exposure, we eliminated our US Bancorp position, near all time highs, and reduced our Goldman Sachs stock holding by taking advantage of dramatic short-term market swings. Given the uncertainty in financial stock valuations due to the need to raise capital, we decided to “move up the balance sheet" with senior bonds in Goldman and GE Capital that were trading at seemingly distressed levels. We have seen yields to maturity of 9% on Goldman and 7.5% on GE for bonds that mature anywhere from 2 to 4 years. At this point, those are the only purchases we are willing to make until we see signs of stability in the markets.

The rest of our positions likely represent extraordinary opportunities for long-term investment. Unfortunately, because of the massive credit freeze, a disorderly unwind of leverage and a race to cash for those in distress, particularly hedge funds with significant energy and commodity holdings, has heaped enormous pressure on the entire stock market. This process is having a definite impact on economic fundamentals, which affect overall equity valuation in the market. The problem for investors is discovering when the liquidation of assets has run its course. This unwind is happening very fast and when it ends we can assess the collateral damage to the economy.

We expect markets to stabilize with the assistance of an unprecedented amount of money being made available from the Federal Reserve and Treasury. While somewhat controversial and by no means a panacea, these efforts must be done efficiently and quickly to provide needed capital and lending facilities where credit markets are dysfunctional. In a way, this injected money can be considered a surrogate for the capital that investors and institutions are hoarding. It essentially buys time for good credits until confidence and clarity return. The risks of inflation are low because the money already in the system is unwilling to be invested and will not, in the short term, result in the classic “too much money chasing too few goods” scenario. However, there is likely to be a period down the road when inflation risks will run higher, as the Federal Reserve attempts to drain the excess money supply from the system.

Our investment strategy remains the same. We continue to look only at companies with strong cash flow and limited needs for credit. Companies with significant cash flow and steady returns on capital will be rewarded with premium valuations in years to come. We will continue to look for companies with stocks and bonds that pay steady and sustainable dividends and interest. As we have maintained for several years, returns on most assets will be subdued. Quality and consistency will be rewarded over time.

Let us know of your thoughts and questions.

Peter and Jack Falker

"Note:  At the time of publication, Peter and Jack Falker, and the clients of FalkerInvestments Inc. were long both the common stock and bonds of Goldman Sachs and General Electric."