Jimmy Dean said “I can’t change the direction of the wind, but I can adjust my sails to always reach my destination”. Investing is like sailing – we can’t control the stock market but we can anticipate the future direction and gradually adjust our strategy before the gale forces descend on us. Those who navigated their clients to safe harbors (trimmed stocks) last fall avoided the full impact of the hurricane winds – the financial crisis and market decline – and are in good shape to set sail again. The storm won’t last forever.
The Financial Crisis
Financial services businesses are everywhere. Harley Davidson’s financial unit contributes a surprising 15% to profits and Target reported 13% of their profits from credit cards. According to the Wall Street Journal, 92% of GE’s profits in 1980 resulted from manufacturing. Today GE’s financial businesses generate 56% of profits. GE is a proxy for the US economy – we have become a financial services driven economy. Over 50,000 job cuts in this sector have been announced! This resembles the job losses in the 1980’s in the manufacturing sector – jobs that were never restored. Will today’s finance industry go the way of manufacturing, i.e. decades later no sign of revenues or earnings that match the levels seen in recent years?
The banks and brokerage houses reported staggering write offs – over $300 billion since the crisis began. New capital of about $175 billion has been raised. The bulk of the losses from mortgage loans and derivatives could be behind us, if there is little left to write off. However, credit card charges may be the next shoe to fall and bear watching.
The real challenge for the banks and other finance companies will be to find ways to replace the lost revenue from investment activities and risky lending practices. As with all financial crises, the pendulum has swung too far. Will the banks any time soon be willing to lend again, even to their strongest customers? Even these clients find their banks unwilling to extend credit in the aftermath of the recent mortgage problems. Investment banking fees are also down as are many of the revenues tied to the creation and sale of creative financial instruments
Bear Stearns was an unexploded bomb – one the Fed dealt with to avoid a massive run on financial institutions. We came dangerously close to a global meltdown. History will document this as yet another example of excessive greed. Risk was ignored and high returns were the result of low interest rates for a long period of time.
We seem to have a financial crisis each decade or so. This time the stakes were even higher as markets around the globe participated and now share some of the pain. We will come through this and the result may be, at least for a time, an awareness of risk on the part of investors and lenders alike. If the pain stays on Wall Street and doesn’t spread to Main Street then a deep recession might be avoided. It is clear there will be increased oversight by regulators.
The Dollar’s Decline
The US dollar’s steep decline is a reflection of our changing fortunes. The Federal Reserve recently lowered interest rates to ward off an even greater calamity which in turn put pressure on an already weak dollar. Some argue the price of oil would be $65 a barrel if the dollar were trading at more typical levels versus other currencies. It is clear that imported goods like oil cost us more when our dollar is weak.
The end of the Fed rate cuts is near. There isn’t much room left to ease interest rates. Those of us who were around in the 1970’s remember stagflation – high inflation in a stagnant or slow growing economy. It is the worst of all worlds! The dollar decline increases the likelihood of higher inflation and the only way to combat it is by raising interest rates to make our currency more attractive. The Fed is faced with a dilemma – raise rates and depress domestic activity or ignore inflation.
The Good News
We mentioned in our last report that US companies with a high percentage of revenues outside the US would fare the best. This has proven true. In fact, the majority of first quarter 2008 earnings have been reported. So far, year over year earnings for the S & P 500 companies are down substantially but without the financial services sector earnings have grown about 8%. This is still below expectations, but not bad given the headlines and weak economy. The emerging middle classes and higher living standards around the world increase demand for our goods and services. Investment results mirror this trend; stocks of companies that derive a high percentage of revenues from overseas, except finance companies, generally performed better since the peak in stock prices in late 2007.
This global prosperity may mean the US recession, if we have one, will be short and shallow. Growth from exports and continued strength in certain industries and some areas of the US could limit a spike in the unemployment rate. The consumer confidence numbers recently reported were the worst in over 25 years but spending has not yet fallen off a cliff. If the unemployment rate stays at or below 5% we might skate through this with a mild slowdown. Loan delinquencies are high and rising which bears watching, especially for credit cards.
There are risks beyond financial services. The UK economy is weak. It is likely the emerging market economies will slow. Inflation is high and governments will raise interest rates to avoid runaway prices. Hopefully, US demand will pick up about the time this happens. Otherwise, sales and profits could decline, even for the most global US companies. This is also an election year. If the Democrats win the election investors will worry about the potential for an increase in capital gains and dividend tax rates. This could dampen market enthusiasm.
Commodities and Bubbles
Commodity prices are headline news. A recent newspaper article said copper prices are so high that thieves in the Midwest stole copper plumbing from under houses. Prices are high at the gas pump and the grocery store, leaving less to spend on other consumer products. Global demand for corn, wheat, oil, copper, gold and aluminum has resulted in higher prices as concerns of shortages grow. These inflated commodity prices may also reduce corporate profit margins as production costs increase. If commodity prices stay high the only alternative would be for companies to pass along these added costs in the form of higher prices to the consumer. This is inflationary.
Commodity prices are up 10% on top of a 30% increase in 2007.This bull market in commodities looks a great deal like the commodity price increases that occurred in the 1970’s. (as the chart below indicates.) If prices fall, as they could, then commodity oriented stocks would fall as well.
Commodities are easier to trade today. Speculators can own commodity derivatives without touching the metal itself. This increases speculative investment and produces the potential for another asset bubble, like we saw in internet stock prices and most recently real estate prices. Higher prices encourage greed and excessive risk taking. This warrants watching. Investment in the new commodity trading vehicles is tempting but very risky.
Oil prices will only fall when demand drops more than supply. Californians have reduced gasoline consumption an unprecedented 8% as a result of the rise in prices at the pump, but this is hardly noticeable in the world oil market where prices are still rising. Oil prices are at $120 a barrel and could go higher. Only if global demand declines will the price of oil fall. Times have changed. The US demand for oil does not influence prices as it once did. We can be in a weak US economy and still have higher energy costs – the worst of all worlds! Oil prices will come down when supply increases beyond global demand and it will take slowed growth in the emerging economies for this to happen.
Sailing requires skill at every turn. In calm waters the experienced sailor takes advantage of even the most unfavorable wind. Investing, like sailing, takes skill, discipline and a keen knowledge of the markets. Knowledgeable investors who take advantage of today’s fear and uncertainty profit just like the becalmed sailor. There are plenty of issues to worry about but it may be time to selectively add to stock holdings, even if this isn’t the absolute bottom of the market. Prices are considerably better than they were last fall.
The stock market has been in a trading range for some time now following a significant 9% plus drop in the first quarter. We may finally be at the point where good news is rewarded and bad news is taken in stride. Fear and panic have replaced greed and expectations are now more reasonable. Merger and acquisition activity may pick up as companies flush with cash bid for their competitors.
There is no question the lower dollar helped support and generate earnings for multinational companies. This may change as the dollar recovers and foreign exchange gains are reduced. Investors will then shift away from global companies and instead focus on the quality and growth of earnings. This could make small and mid-cap stocks more attractive. Now more than ever investors need to investigate what is behind the reported numbers. Subprime research will lead to subprime results!
The Bond Market & Asset Allocation
As the market dropped, investors moved out of stocks and into high quality bonds, especially US Treasury and agency issues. This could reverse if confidence in the stock market is restored and there are no significant earnings losses or surprises ahead of us. A sharp spike in reported inflation would be negative for most investments, but bonds would be the least attractive. Stocks offer potential for dividend increases – a hedge against rising prices. Bonds are not inflation hedges. Tax free bonds are not as overpriced and may fare better for technical and tax reasons.
Asset allocation should now begin to shift in favor of stocks as cash on the sidelines, together with bond sales, prove positive catalysts, especially if the economy does not end up in a deep recession. Asset allocation is the most important element of a good investment program. Investors who trimmed stocks to a target weight (rebalanced) in the fall of 2007 are feeling less pain today. Market timing does not work. What does work is selectively trimming assets that have exceeded reasonable valuation levels and adding to them when selling is overdone.
The Stock Market
The flight to quality in the equity market has been dramatic. Investors have not been focused on value or growth or large versus small. There has not been a great deal of performance difference between the various styles. What has mattered is earnings predictability and the particular economic market sector. For example, global companies like Procter & Gamble and Pepsi have held up well. Energy and materials stocks, such as Exxon and Monsanto, have risen with the price of oil and global demand for commodities. Companies with problems, such as retailers and banks, have been punished severely. Managers that saw this coming and reduced their holdings in these areas did well. We are happy to report we are in this camp.
Investors today track a benchmark and success is measured in relative performance. Those entrusted with family fortunes at the turn of the century were’ prudent men” who safeguarded their clients’ money and avoided risk at all cost. It’s a rare manager today who focuses on risk and takes the initiative to exit bubbles before they burst (underweight internet stocks in 1998 or bank stocks in 2007) to preserve value. It is very difficult to go against the herd and risk being wrong. That is exactly what should happen when valuations are over extended and stocks are priced to perfection.
The sector performance divergence during this market decline is the most dramatic in years and began to reverse in April. Investors moved to rotate out of safe havens in anticipation of a stronger US economy and recovery in the financial sector. This rotation, if it continues, could be dramatic, given today’s herd mentality and the drive to beat a benchmark, which is 17% invested in bank and finance stocks. However, any market advance will only be sustained when earnings quality is good and expectations reflect reality. This won’t happen if inflation persists and our economy is weak.
Timing the exact top or bottom of any market cycle, like trimming sails in the midst of a storm, is very difficult. Now is the time to begin adding to the quality holdings that have moved down in tandem with the problem companies. If near term performance is what matters rather than building wealth over time then it is easy to miss opportunities while waiting to be proven right by the herd. Investors who “wait it out” are like ships that get buffeted in the wind. The skilled investor reaches his destination by navigating the storm with intelligence and patience.