Financial System Regulation
Congress passed the Dodd-Frank Financial reform bill last week. The following articles provide a good synopsis of what is included in the final bill:
2010 Q2 client letter
We hope your summer is going well.
Now that we’ve reached the mid-point of 2010, we thought this would be a good time to look back at our list of Top 10 Themes for 2010 and see how our predictions have fared. We’ve attached this list with an assessment of each of our calls.
Like the recent quarters that have preceded it, the second quarter of 2010 was very eventful. On April 16th, the SEC dropped a bombshell when it filed a civil lawsuit against Goldman Sachs charging the firm with fraud over its marketing of a 2007 subprime mortgage product known as ABACUS. The lawsuit shocked many in the financial services industry as it demonstrated the SEC was getting serious (though many have argued too little too late) about holding the larger firms accountable for questionable business practices that helped accelerate the subprime meltdown. As a result, Goldman’s reputation has taken a major hit and the firm’s share price has fallen over 30% since the lawsuit was first announced. The lawsuit helped set the stage for the financial reform bill now working its way through Congress. And while the White House and Congress have repeatedly denied any knowledge of the SEC’s lawsuit prior to its announcement, the timing of the suit certainly didn’t hurt the bill’s chances of being passed.
On April 20th, an explosion on the Deep Horizon oil rig in the Gulf of Mexico destroyed the platform, killed 11 workers and ruptured a riser pipe on the ocean floor that continues to leak oil and gas into the Gulf of Mexico as of this writing. While initial reports downplayed the severity and extent of the leak, the world quickly learned how devastating this disaster would become after several attempts to staunch the flow failed. The only viable solution now appears to be the two relief wells BP is digging, which are still several weeks from completion. The spill, which is now the largest ever to originate in US waters, will no doubt have long term environmental and economic consequences for the gulf region. In the short term, we will likely see the spill become a focal point for the coming energy bill as well as the November mid-term elections.
May 6th marked the day of the now infamous Flash Crash. At approximately 2:45 pm, the Dow Jones Industrial Average lost over 700 points in a matter of minutes, only to regain those losses several minutes later. At one point, the Dow was down 998.5 points, which represented the largest intraday point decline in history and temporarily wiped out over $1 trillion in market value. The cause of the crash has been vigorously debated, but many agree the central problem was an issue of liquidity (traders willing to buy and sell stock in quantity at the prevailing price). Today, much of the stock market liquidity is provided by high-frequency traders (HFTs) – computer-driven algorithms used by firms trading at speeds measured in the millionth of a second. While these HFTs provide liquidity during most normal market conditions, they are not always required to participate in the market (their primary objective is to turn a profit, not to maintain orderly markets). Many critics have suggested that something like the flash crash could occur if a group of these HFTs stop trading simultaneously. The SEC has since instituted system-wide trading curbs or “circuit breakers” on any S&P 500 stock that rises or falls more than 10% in a five minute period. It remains to be seen whether or not these measures will prevent another Flash Crash.
In addition to the above the highlights, the quarter also saw a further deterioration in the European sovereign debt crisis, a sustained correction in global equity markets and a some less than stellar economic data from China.
But not all the news is bad!
On a personal note, this past quarter also marked the first year anniversary of Washington Square Capital Management (on May 15th). This past year has been memorable (to say the least) and we wanted to thank you again for your commitment to work with us – we recognize that none of this would have been possible without you.
Memorial Day Weekend also marked the marriage of Subir to Molly Barker. There were two weddings: an Episcopal service held on Friday May 28th in New York City and a Sikh service held in Glen Cove, NY on Sunday May 30th.
We look forward to speaking with you during our quarterly review.
10 Economic Themes for 2010: Mid-Year Review
Mid-year review of our 10 themes for ’10
- We expect to see the US unemployment rate to peak at 11% in 2010. We may have been a bit aggressive with this call. While the US job market remains anemic, the unemployment rate now stands at 9.5% (the lowest all year), partly because of workers who have dropped out of the labor force (stopped looking for jobs). A falling unemployment rate would normally be encouraging news, but private sector job-creation continues to be very slow, despite the record amount of stimulus that has been pumped into the economy. In addition, the most recent jobs data has been disappointing, so the looming threat of a “double-dip” recession remains high and 11% unemployment later in the year is not out of the question.
- Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010. This scenario has been playing out as we expected. According to ICI[1], only $7.82 billion in new money has been invested into equity funds through June 23rd 2010, while bond funds have seen $154.35 billion of net inflows. Over the last eight weeks (where we’ve seen equity markets correct), net inflows into stock funds have been -$31.29 billion, while bond funds have seen +$33.98 billion over that same period. We continue to believe demographic factors in the US and Europe as well as an increasing wariness towards stocks after two major bubbles in 10 years will lead investors to allocate larger portions of their portfolios to fixed income investments with a higher claim on corporate cash-flow than stocks.
- We expect a number of credit downgrades for developed nations as their persistent deficits come into focus. The US Dollar will strengthen in any ensuing flight to safety. This prediction has been right. Since the start of 2010, we’ve seen credit downgrades to Greece, Portugal and Spain, as well as a massive bailout plan for Greece. The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated. It reached a level of 1.1875 per Euro on June 6th and has recently bounced back to the 1.25 range. We expect continued pressure on the Euro until a workable solution for the sovereign debt crisis has been reached.
- Interest rates will remain effectively at 0% until the 4th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range. So far this prediction has been accurate. The Fed has kept the fed funds rate at historically low levels. It remains to be seen whether or not the Fed opts to raise rates in the 3rd or 4th quarters. While most commentators believe the latest round of economic statistics have made a hike unlikely until 2011, we still believe there’s a good chance the Fed raises rates to the 1-2% level after the mid-term elections in Q4 2010 and then pauses for an extended period.
- Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order. This trend appears to be holding up. In May, the personal savings rate reached 4%, which is the highest level it has been in 8 months and a far cry from the .8% we saw in April 2008. Outstanding consumer revolving debt also continues to decline. The most recent data from the Fed (for April) shows revolving debt at $838 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
- The US economy will see almost negligible growth for 2010. It’s a bit early for this call since we won’t see this year’s GDP data until 2011. Current GDP estimates are on track for 3% growth in 2010. The caveat, of course, is that this has been accomplished with record government stimulus. If the economy is unable to stand on its own without the crutch of stimulus, it’s entirely possible the second-half will be much weaker.
- Corporations will increasingly turn to mergers and acquisitions to grow market share. This prediction could go either way. According to the NY Times, the first half of 2010 has seen $810.3 billion in global mergers and acquisitions. Through the same period in 2009, this number was $814.6 billion. However, many of the 2009 deals were a result of government activity in the banking sector, whereas 2010 has seen deals taking place across a range of industries. A recent Ernst & Young study of more than 800 senior executives across the world showed that 57% of businesses surveyed said they are likely to acquire other companies in the next 12 months. This number was 33% in the last survey (in November of 2009). Whether or not these executives follow through on this sentiment remains to be seen.
- Growth in emerging markets will continue to outpace developed economies. But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery. This trend appears to be holding up in 2010. After a year of gaudy returns, the global equity rally faded in the second quarter. As of June 30th, the MSCI emerging markets index was -7.22% year to date, the MSCI EAFE index (which tracks developed markets in Europe, Australasia and the Far East) was -14.72% year to date and the S&P 500 was -7.57%. We continue to believe equity market returns across the world will be negative in 2010.
- We believe there is continued risk for a massive correction in China. While we have not yet seen a “massive” correction in China, the Shanghai composite index is now at a 15 month low and is down over 25% through the end of Q2. We continue to believe equity and real-estate markets in China are over-valued and there is further to fall.
- In 2010, certain commodities are poised for a sharp sell-off. Top of our lists for a correction are gold and oil. This call has produced a mixed result. Gold is up over 13% through the end of Q2 while oil is down over 14% over the same period. While gold remains a popular investment alternative to faltering currencies (Euro, USD), we believe its big run-up over the past few years puts it firmly into bubble territory. We believe oil prices will remain depressed until the global economy is back on its feet.
[1] The Investment Company Institute, which tracks mutual fund flows
Coming to a head…
In our last few letters, we have discussed the extraordinary measures undertaken by governments across the world to support aggregate demand, and the extensive borrowing required to do this. Over the past three months, both of these issues have been thrown into stark relief by events.
The dramatic and extremely sudden deterioration of Greek sovereign credit in the marketplace forced the European Central Bank (ECB) into a rapid about-face. Germany’s elected representatives blinked and committed to a vast fund to support Mediterranean nations. Very few people expected to see the IMF lead a rescue package for European Monetary Union member-states in their life-times. Eroding confidence in the ECB and EMU led to a deterioration in the value of the Euro as talk of this currency supplanting the US Dollar as the new global reserve currency did a sharp 180 degree turn and even sober commentators began to talk of a break-up of the European monetary union and the Euro’s death. Meanwhile, bond-holders have turned their sights on the increasingly precarious state of sovereign balance sheets in most of the developed world. Shocked by the speed with which Greek bonds lost value, most bond buyers are thinking seriously about sovereign credit risk in the developed world, awakening from a period that lasted two generations during which these risks were largely ignored. Meanwhile, treasury officials the world over review the results of their bond auctions nervously, wary of any sign of demand slacking. In many cases, their own central banks are becoming the most reliable buyers or financiers of new debt.
Three months ago, we wrote in an earlier post:
Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China. As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.
We believe this process has begun and the initial signs do not augur well for the global economy. We have seen a debate re-kindled recently about whether the withdrawal of stimulus at this juncture is a repeat of “errors” made in the 1930s, when stimulus spending was reduced to control deficits. However, with aggregate debt levels in the developed world as high as they are, we see few alternatives to a steady reduction of the extraordinary fiscal and monetary measures undertaken to control the crisis.
We also feel it’s necessary to discuss the “Flash Crash” of May 6th. In our blog post the next day, we wrote that:
Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop. But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery. It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009. …
Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets. …
The major conclusions we draw from the trading action of the past week is that:
- Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
- The Euro-zone crisis will continue to roil markets until it is properly addressed.
- There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.
Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.
All three major indices, Dow Jones Industrials, S&P 500 and Nasdaq composite closed out this quarter below the intraday lows reached that day. The ten-year treasury is now below 3%, and no amount of commentary on US federal and municipal debt-levels appear to impact the decline. Meanwhile, the Baltic Dry Index has dipped below 2500 again (amidst talk of expanding fleets and falling Chinese imports). Speaking of China, we see more commentators openly questioning the solvency of Chinese banks and the reasons behind big IPOs. All of this underpinned by the fact that unemployment and underemployment rates in western countries remain stubbornly high.
Not only is it increasingly difficult to write off the events of May 6th as a mere technicality, we believe that sudden decline has lead to deep distrust and uncertainty amongst investors. Investors were already wary of fundamental economic and market conditions, the flash crash gave them reason to cast suspicion on the technical organization of the market. This coupled with the SEC’s indictment of the premier US Bank, Goldman Sachs on charges of fraud, has fueled suspicion of large player’s motives and methods. Many individual investors now believe the market is rigged against them, for the benefit of the largest trading firms and their most senior traders. In our view, it was always thus. Professional traders, whether they be electronic market-makers or specialists on the trading floor have always enjoyed a privileged position, which is completely appropriate given their role as liquidity providers and their responsibility to maintain orderly markets. What we find difficult to accept is the extension of these privileges new players, without them being asked to shoulder the same responsibilities.
We do not see many silver linings amidst a climate of mutual suspicion and bad news.
EU’s version of shock and awe for bond vigilantes.
A series of measures were announced today to provide support for troubled Euro-zone states. The broad outline of the plan is that the European Union (EU) and the International Monetary Fund (IMF) are committing almost $1 trillion to support bond issues by Euro-zone states. We see three reasons to question the initial market euphoria surrounding this announcement:
- The immediate issue is that this measure, and its cost, will likely need be voted on by all member-state legislative bodies. There is a good chance it faces stiff opposition in at least one Euro-zone nation, potentially setting the stage for a political standoff reminiscent of the US congress’s initial vote on the TARP plan in September 2008. The entire process will be controlled by member-states and the EU institutions have been largely bypassed. The EU leadership has decided they want to sell this deal in 27 member-states simultaneously, with the markets breathing down their neck. It is hard for us to believe they will find buyers in every member-state’s legislature. Imagine if TARP had to be voted on by every US state legislature. The UK government (after last week’s election, we aren’t sure who that is) has already decided it wants no part of the 440 billion euro loan guarantee program, others may follow upon reconsideration. In any case, we suspect member-state legislators will not be as easy to corral as finance and prime ministers.
- This announcement undermines the fiscal soundness of all European Union countries, especially if austerity measures are still resisted by the member states who are in very weak fiscal positions. David Roche writes in the FT that “this deal is a form of contagion by official action”.
- The German provincial election in Rhineland this past weekend did not go well for the Christian Democratic Union (CDU). German voters handed Angela Merkel’s party an effective loss based on her support for a much smaller bail-out of Greece. We do not believe German voters, or the constitutional court will be pleased about this announcement and the European Central Bank’s plan to purchase member-state debt.
A number of the fundamental issues raised as our generation’s financial crisis runs its course are summarized in an excellent Statfor piece titled The Global Crisis of Legitimacy.
In other news, Moody’s announced they may downgrade Greece to junk-bond status (S&P already has). The European Central Bank (ECB) has announced they will buy these junk-rated bonds and the prevailing mood in Europe is to blame the rating agencies and banks for the debt woes of profligate member nations. The ECB’s reputation for monetary stability and responsibility has been deeply compromised by this weekend’s announcement, and we fear it will be impossible to regain in the short-term.
The sovereign credit crisis in Europe is not over yet, and the questions surrounding the Euro have not been laid to rest.
Further reading:
- Europe agrees rescue package
- In a must-read analysis titled It’s not the way to solve Eurozone debt crisis, David Roche writes in the FT: “Initially, markets may be wowed by the size of the package. But the size just means that more debt has been added to a problem that is about too much debt! EU governments and the European Central Bank are now obliged to guarantee or buy the sovereign debt of other members as a solution to the Eurozone’s debt crisis. But the solution to a hangover is not more alcohol.”
Revisiting 2:45pm with Art Cashin
One of the financial commentators we follow (for his trader’s eye view from the NYSE) is Art Cashin. Art wrote today about the brief free-fall in stocks last Thursday afternoon. To quote:
Nothing Sold For A Penny On The NYSE
There was a lot of discussion on the floor Friday about the huge air pocket that stocks hit on Thursday afternoon.
As the day wore on, skepticism began to grow about the “trader error” (fat finger) rumors that circulated late Thursday. There didn’t seem to be a telltale brief volume spike. Traders began to speculate that the trigger might have been a sudden spike in the Japanese yen which may have briefly panicked carry traders.
The other item was the finger-pointing among trading venues. Some competitors claimed the designed safety speed bumps in the NYSE hybrid system caused the air pocket. I may be a bit prejudiced but that borders on the ridiculous.
No $40 stocks traded at a penny on the NYSE. One trading venue, the Nasdaq canceled trades in 281 securities. David Kotok points out that 193 of them were ETFs. There are no ETFs listed on the NYSE floor. Therefore, they could not have been impacted by speed bumps. Further the NYSE canceled no trades.
It would appear that some trading venues may not be as deep and liquid as their marketing brochures imply.
To us this goes to show that investors must be aware of technical factors and market mechanics, since these sometimes create opportunity. More importantly, however, understanding the mechanics of the market for our investments allows us to correctly analyse price action in a stress environment and avoid making bad decisions.
The collapse of 2:45pm and it’s broader implications.
Like most market participants, we watched the market moves yesterday afternoon with a certain degree of amazement. Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop. But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery. It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009.
While there have been some theories put forth to explain what happened yesterday, we do not have a definitive explanation for the rapid decline and subsequent recovery. That said, we would like to share a few observations about yesterday’s trading and its broader implications:
- Equity markets were already down substantially (on the order of 3-4%) before the sudden drop occurred between 2:30 and 3:00pm. During their (brief) lows, the broad indexes were down over 9% before recovering. We closed the day down 3-4% across the major indices.
- The sudden decline took us through multiple significant technical support levels. Volume was steady through the morning, picked up around noon and rocketed after 2:30. Yesterday was the second highest-volume day on record.
- There were various (as yet unsubstantiated) rumors of “trader error” causing the decline. There have also been reports that many high-frequency trading operators stopped trading entirely since they hit internal limits which kick in under extreme conditions.
- Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets.
The last point is the most significant for investors. There is a reasonable suspicion is that yesterday’s activity in the currency markets was part of an unwinding of the carry trade. Carry-traders are very sensitive to risk since they run large, leveraged positions which can be quickly wiped out. If this is correct, the events of this week were broadly similar to moves that occurred in August 2007, which affected quantitative hedge funds mostly, and marked the beginning of the declines of 2008 and 2009. See Andrew Lo’s paper, What happened to the quants in August 2007.
The technical reasons for the stock market decline are what have received the most scrutiny in the press. In our view, the steady surrender of volume and responsibility from trading floors (where participants meet market-makers face to face) to electronic exchanges with liquidity provided by automated high-frequency trading systems certainly exacerbated the sudden acceleration of the decline, but did not cause it.
Not-withstanding purely technical reasons affecting the speed and steepness of a 15 minute decline, the underlying reasons for increased risk-aversion are real. We also believe it betrays extremely short-term memory to claim that such sudden declines do not occur in a specialist managed market. We only need to point to Black Monday (October 19, 1987), when the market dropped 22% over the course of the day. In 1987, most stock was traded via specialists on the physical floor of the NYSE. In that instance, automated selling by “portfolio insurance” providers accelerated the decline. Yesterday, the NYSE maintained a relatively orderly market, the extremely low-priced trades appear to have occurred on secondary exchanges with low liquidity where numerous market sell or stop loss orders may have encountered a limited number of bids and shallow order books. In and of itself, this is not unusual, stocks always decline suddenly when there are a lot of sellers and no buyers.
This is an interesting debate, but in our view is largely irrelevant for investors. One market commentator remarked:
For starters, let’s all keep in mind that these things don’t happen in a healthy tape. The jitters from Greek rioting and possible contagion were the necessary preconditions for a crash like that.
The major conclusions we draw from the trading action of the past week is that:
- Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
- The Euro-zone crisis will continue to roil markets until it is properly addressed.
- There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.
Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.
Further reading:
Felix Salomon’s initial take: How a market crashes
Felix after taking a deep breath: Deconstructing the crash
Bloomberg’s Nina Mehta and Craig Nagi: Market fragmentation may get review after stock drop
The Euro-zone is like…
For the past several months, we have been thinking about the broader Euro-zone’s economic malaise. In the course of conversations, we sometimes use analogies, and we thought we’d share this one with our readers.
As part of the aim to integrate Europe and limit the future likelihood of war, European countries have sought to develop deep political links (by joining the European Union) and integrate their financial markets (by joining the shared currency regime). As a result of this process, large, developed, stable economies in Europe (Germany, France etc.) have lashed themselves to smaller, relatively under-developed, unstable economies (Greece, Portugal, etc.).
Imagine each of these countries as boats on the open ocean. Some of them are large, modern vessels carrying many passengers, while others are smaller, rickety affairs. In creating the European Monetary Union, these countries sought to create a larger water-craft by roping together many different boats. There are definitely advantages to doing this. Passengers on the boats (citizens) can now easily trade and transact with those on other boats.
However, it takes generations for all passengers to develop a sense of common destiny and values. The Eurozone has not had that much time, yet finds itself in the middle of a large storm. The big problem is that there is no mechanism defined to detach the larger unit from a vessel that has begun to sink in a storm.
Passengers on the sound, stable sea-craft (German burghers) do not want to put themselves at risk by stepping onto the sinking ships to help bail water, yet their captains are calling for them to do so. Meanwhile, the combined craft made of many mis-matched boats continues to tilt and take on more water.
To compound the problem, we saw a riot on one of the sinking boats yesterday. Some passengers (Greek nationals) on that boat tried to set it (literally) on fire. The rest of the world does not expect such things to happen in developed economies and looks on in disbelief.
What we find remarkable, is the speed with which assumptions have changed. Nine short months ago, virtually everyone was calling the demise of the US dollar and the rise of the Euro as the new global reserve currency. Now we are at a point where the dissolution of the Euro is being openly debated. Greek citizens riot in the streets because their elected representatives have chosen to call a halt to profligate policies and crack down on pervasive tax-dodging and fudging of statistics. The rest of the world stares aghast. Meanwhiles, the rats (speculators) are deserting the ship.
For a less metaphorical take on the crisis, please read Edward Chancellor’s FT Opinion piece Greece a bad omen for others in debt.
Bond Buyer: Moody’s Lifts Up 34 states
The Bond Buyer reports that:
Moody’s Investors Service kicked off a wide-scale “upward shift” in municipal credit ratings yesterday, assigning stronger grades to 34 states and Puerto Rico.
the article contains a complete list of ratings for all US states Moody’s assigns ratings for. The new ratings are comparable to ratings for other entities. Prior to the recalibration, US municipal issuers was rated on a different scale from all other credit ratings. California’s credit rating was upgraded from Baa1 to A1.
WSQ Capital Quarterly Letter: 2010 Q1
For this letter, we’ve attached a brief summary of the investment highlights for the first quarter along with our analysis. We hope you find this useful.
Two major economic developments not covered in this attachment we thought worth mentioning are:
Landmark Health Care Legislation. Congress and the Obama administration finally managed to pass the much debated health-care bill. We believe we will see further attempts to control the costs of health-care in the US, including an emphasis on preventive medicine and result-focused care. These additional efforts and the implementation of various phases of the bill recently passed will impact the health-care system for years to come. Also important to note is that the successful passage of health care related legislation leaves Congress and the Obama administration free to focus on the equally important issue of financial reform. On that note, we believe the proposed ‘Volcker rule’ is a good start and is the appropriate equivalent of Glass-Steagall for our age and the infrastructure of modern finance. We would also like to see reformed compensation criteria across the financial industry and large corporations, but that is a corporate governance concern best saved for another letter.
Withdrawal of Economic Stimulus. The other major theme we expect to impact our economy over the rest of the year is the withdrawal of extraordinary fiscal and monetary stimulus programs put in place during the crisis. Various measures by the Fed, European and Asian central banks to provide liquidity support to banks and markets will be withdrawn over the course of the next several months. Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China. As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been. We will also keenly track developments in trade agreements since various countries have enacted or are considering trade barriers and currency related moves to protect key industries and exporters.
We look forward to speaking with you during the quarterly review.
2010 Q1 Highlights
Equities. The S&P 500 started the year at 1115 and began a moderate sell-off in mid-January, bottoming out at an intraday low of 1044 on February 8th before rallying to a new 52 week high on March 25th, peaking at an intraday level of 1180. The stock market rally is now more than a year old and much of the recent gains have occurred on weak volume, indicating a lack of conviction from investors.
Our view: We remain skeptical of this rally and believe stock prices have gotten ahead of themselves and are currently over-valued. We would like to see stronger underlying economic data emerge (lower unemployment, higher consumer confidence, improved housing numbers, etc) before becoming more bullish on stocks. For now, we continue to believe a defensively positioned portfolio is prudent.
Interest Rates. On Feb 18th, the Federal Reserve raised the discount rate (the rate at which banks pay to borrow money from the central bank) by 25 basis points to .75%. This was viewed as a relatively positive event, since it meant that the Fed felt confident enough in the economic recovery to start charging banks more to borrow money. The more widely followed Fed Funds rate (the overnight rate depository institutions charge each other to borrow money in order to meet reserve requirements) remains at historically low levels (effectively 0%).
Our view: We don’t expect the Fed to raise the Fed Funds rate until the 4th quarter of 2010 (at the earliest) as the consensus amongst the FOMC will likely want to wait until the economic picture shows stronger signs of a sustained recovery.
Taxable Bonds. Taxable bonds have continued to perform well, particularly in the high yield (lower quality) space. The high yield rally has corresponded with the stock market rally as investors continue to feel more comfortable taking on risk. As a result, many high yield bonds are trading at levels virtually unfathomable a year ago.
Our view: In anticipation of a likely rate hike coming at some point in the next 6-12 months, we are positioning client portfolios to be on the shorter end of the yield curve (preferring short-term bonds to long term bonds). For bond funds, we prefer the following categories: short/ultra short duration, international and inflation protected. For individual bonds, we see the most value in BBB rated manufacturing, energy and consumer goods names. We also like stepped note bonds/CDs as they provide a hedge against rising interest rates (which are pretty much inevitable given where rates are now, it’s just a question of when).
Municipal Bonds. On March 16th, Moody’s announced they will shift to a long anticipated universal ratings scale in an effort to make it easier for investors to compare ratings between corporate and municipal bonds. This move will likely boost the ratings on many of the municipal bonds they cover. These higher ratings will not be viewed as an upgrade, but rather a recalibration to the new scale.
Our view: With record federal government deficit levels and the recent passage of the Obama health care bill, we believe federal income taxes will likely be raised in order to offset these costs. We believe municipal bonds remain attractive due to their tax status (federally tax exempt and occasionally state/local exempt). We prefer high quality general obligation bonds (bonds backed by the taxing authority of a state or municipality) and essential service revenue bonds (bonds backed by the revenues generated by utilities, universities or water and sewer projects). We believe default risk (particularly for general obligation bonds) is low given the senior status debt service payments enjoy in most municipal budgets (in California, for example, bond holders are junior only to the public school system in terms of how tax revenues are spent).
Sovereign Debt. The major story this quarter was Greece and its escalating budget crisis. A tentative bailout agreement was reached in late March, backed by the European Union and the IMF (International Monetary Fund). The concern here is that this will set a bad precedent as other countries in the European Monetary Union with debt problems (of which there are many, notably Portugal, Italy, Ireland and Spain) will expect similar assistance from the IMF for debt relief. Meanwhile, back home, US treasury rates have steadily crept up this quarter as the government continues to issue record amounts of debt and the market requires a higher yield payout to own this debt.
Our view: We expect treasury rates to continue this upward trend. We prefer short dated treasuries to intermediate and longer term treasuries. We believe the situation in Greece has not been fully resolved yet and expect more bailouts/aid packages will be necessary to shore up the debt problems for some of the other Euro zone countries mentioned above. We believe the European Monetary Union faces a grave crisis since the common currency (the Euro) leaves sovereign states unable to devalue when faced by a budget crisis. The solution is either greater political and budgetary synchronization, or accepting that EU countries may default and defining a mechanism for them to do so without impacting the surviving members. The uncertainty and perceived lack of a resilient solution is weighing on the Euro. We believe the Euro will continue to weaken against the US Dollar until these problems are properly addressed.
Greece, the Euro and currency union.
We’ve been following the revelations of prior administrations fudging budget numbers in Greece with some interest and thought we’d pick out a couple of the more interesting articles we’ve read on the subject.
- Wolfgang Schauble writes in the FT on the cross-roads the European currency union has reached.
- Stratfor provides the geo-political take on what this new stance means for Germany and Europe.
- If you’re wondering who Wolfgang Schauble is, the FT has a profile.
- The Economist on “half-baked” ideas to prevent future scares.
- The Economix blog at the NYT has a post titled, Greece, the latest and greatest bubble that is worth reading.
WSJ: Shiller v. Siegel
The Journal’s E. S. Browning has an interesting piece contrasting the views of Robert Shiller and Jeremy Siegel, with some added commentary from Ben Inker at GMO.
No real sign of structural reform – FT
John Dizard writes in the FT about the reforms needed in the securitisations market.
Stratfor on Germany and the future of European currency union
A lot of ink has been spilled recently on the weakness of a currency union without a federal political system (i.e. the Euro). The most interesting background article we’ve seen on this topic is Stratfor’s Germany’s Choice which takes the long view and is well worth a read.
Simply put, Europe faces a financial meltdown.
The crisis is rooted in Europe’s greatest success: the Maastricht Treaty and the monetary union the treaty spawned epitomized by the euro. Everyone participating in the euro won by merging their currencies. Germany received full, direct and currency-risk-free access to the markets of all its euro partners. In the years since, Germany’s brutal efficiency has permitted its exports to increase steadily both as a share of total European consumption and as a share of European exports to the wider world. Conversely, the eurozone’s smaller and/or poorer members gained access to Germany’s low interest rates and high credit rating.
And the last bit is what spawned the current problem.
Deep dive into the BLS model
Bloomberg is running a report on pending amendments to the BLS labor statistics which may result in sharply higher unemployment statistics in 2008/2009. The reasoning is that the BLS model’s mechanism to account for newly-created and recently-closed businesses does not consider the sharply higher number of closures over that time period. More recent data will not be revised till next February. The article is well worth a read.