Mid-Year 2009 Outlook
Economy-wise, there has not been a significant amount of positive change since we wrote our last quarterly letter in April. Still, we have seen bankruptcies continue, led by two of The Big Three auto producers Chrysler and GM. We continue to see real estate prices decline (both residential and commercial), loan losses and credit card losses by banks surging, and unemployment inching upward. Oddly enough, the stock markets have ignored the negatives and are discounting something much more promising. We've witnessed a continuance in the market's bounce off the March lows, the end result being the first positive return quarter in more than 18 months and the largest quarterly increase in stock indexes since 1998.
So what gives? Are we out of the storm? Could the combination of record-low interest rates, record-high fiscal stimulus, and unprecedented government bailouts of public companies, be finally showing enough signs of promise that everybody all of a sudden wants back into the game? This unprecedented move off of a huge trough poses many questions, most of which will not be answered until we are well beyond this extended period of uncertainty. What we do know is this: the equity markets are forward-looking and typically move in advance of much of today's economic news. We need to continue to follow the economy to get a better gauge of where we might actually be heading, but we can't ignore what the markets are trying to tell us. An examination of the knowns is worthy of consideration, but first let's evaluate where we've gone thus far.
Second Quarter Performance Review
There is no better way to describe second-quarter equity returns than "eye-popping". We have previously admitted that last year's debacle was unlike any decline we've experienced in our careers. We will expand that statement to include the rebound this year. Equity returns from the March lows have been astounding, and for the most part, unending. While we know this tree will not grow to the sky, we are duly impressed with its resiliency. History has shown that the steeper the recession, the stronger the recovery, so it makes sense that we are experiencing such a huge rebound after entering the worst economic decline since the Great Depression. What doesn't make as much sense to us is that the move has been so quick and so one-directional. We'll take whatever positive moves the markets want to give us, but we still remain leery that this straight-up bounce will not have the life that we'd hope for.
Regardless, we've just witnessed one of the largest and sharpest rallies that the markets have ever seen. Domestically, NASDAQ was the biggest winner in the quarter, up 20%. The S&P 500 and the DJIA weren't far behind, producing returns of 16% and 11%, respectively. NASDAQ is up solidly YTD at 16.4%, yet the S&P 500 is only up 3% and the DJIA is still in negative territory, down 3.8%. International markets shared the strongest quarter with Japan up 23%, developed International (MSCI EAFE) up 26%, and emerging markets (MSCI EM) up a whopping 35%! These are all impressive quarterly returns, but they are coming off of extreme bottoms, so investors still have a long way to go before seeing previous highs. On the fixed income front, the recovery in lesser credit bonds helped boost general bond indexes up 1.9% for the quarter, yet YTD returns are still barely above zero.
St. Nicholas' equity performance continues to shine, even in spite of the fact that we were carrying heavier cash positions in the second quarter. Our short-term and long-term equity performance numbers continue to stay well ahead of the S&P 500, and total account returns are even better due to the higher-than-average cash positions we carried throughout the fourth quarter of 2008. We continue to cautiously reduce cash reserves and the few stocks that we've added have done extremely well, but have not let the recent run-up cause us to chase in haste. However, we absolutely like the promise of the markets longer-term, and expect to be fully invested at some point in the second half of 2009.
Another Word on the Banks
We have not pulled any punches on the banking and brokerage industry in any of our recent letters, and we still do not like where many of them are left after near collapse last year. However, we also recognize that the survivors will eventually have to turn the corner and will begin to make progress toward re-establishing themselves as viable and attractive business entities. Financials have a long way to go before they can reach that point, and many may never earn their solid reputations back. However, we've seen enough on the earnings front that leads us to believe that we may have at least hit the bottom of the banking cycle. This is in no way intended to indicate that we think the banks are now healthy, but it does give us some relief that the worst is behind us.
Profit growth in the industry has a very long way to go before any of the bailed-out bunch will be able to pay back their TARP loans, and we're still not out of this recessionary economy where losses continue to loom. We were certainly encouraged to see Goldman Sachs repay their government bailout, but we knew from the beginning that they were a survivor and were among the healthiest of the investment banks. We expect that others will follow, but don't see the big money center banks making repayment moves anytime soon. Still, even the worst industries can become attractive investments once they get cheap enough, and we have started to dip out toe into the sector to take advantage of a recovery from doomsday lows. The jury's still out on what the industry will look like (both business-model-wise and regulatory-wise), but we are happy to at least be able to start breathing a little easier.
Who's paying for all this?
Any bottom in the banking cycle is certainly welcome news. Indeed, as transparent as they may be, even minute signs of recovery are laudable. However, as one Fed Governor puts it, "The panic's hasty retreat should not be confused with a robust recovery. The rather indiscriminate bounce off the bottom - across virtually all assets and geographies - may be more indicative of a one-time reset, which may or may not be complete." The Fed has put itself in the extremely precarious position of being the master engineer of both fiscal and monetary stimulus. They need the ability to measure and define economic process in a very precise manner. Their ultimate goal is to find that perfect balance of economic recovery with only moderate inflation.
This may be easier said than done. The first and most obvious goal is to guide the economy toward recovery. Once we have achieved a satisfactory level of growth, it's going to be time to pay the piper. The inflationary implications of $3 trillion in stimulus and deficit spending are probably unavoidable. The government needs to be able to keep an open checkbook, yet the damage to the value of the dollar from the flood of new money looms. Indeed, Chairman Bernanke has already stated that the need for a highly accommodative monetary stance will be necessary for an extended period. The balancing act comes, however, when it is time to tighten the purse strings and allow higher rates in order to combat the impending inflation. This is the tricky part. The Fed believes that it can withdraw these extraordinary policy measures in a smooth and timely fashion, thus avoiding the undesirable inflationary effects. Students of the Great Depression will point to the fact that the Fed's contractionary monetary policy was too much and too soon, and was a primary reason for the protracted fall into further economic demise. Can Bernanke's Fed engineer the perfect recovery? Will the Fed have the precise timing and magnitude of monetary policy to stave off inflation, or will they repeat the errors of 80 years ago and choke off growth before it reaches optimum levels? Stay tuned...
Speaking of mistakes of the past, isn't it ironic that the answer to the real estate crisis (which blossomed as a result of easy money, overextension by incapable borrowers, and the debt inflation of equity from rising home values) is low rates, automatic qualification of troubled loans, and refinancing limits as high as 125% loan-to-value? We understand the desire to keep borrowers afloat and we accept that low rates are a necessity to help spur economic activity. However, we can't help but scratch our heads and wonder whether more credit extension will solve the real estate crisis, or just delay the inevitable and remain uncorrected unless or until the excess has been cleared.
And, while it is not necessarily the same type of argument, we find some irony as well in the GM crisis relative to the current administration's healthcare proposals. Admittedly, the auto industry had many problems, and healthcare costs are a burden to any company. However, the union-bargained health care benefits created an enormous financial liability that helped drag down the car companies and was a big factor in the forced bankruptcies of both Chrysler and GM. The United States, similarly, already faces a fiscal day of reckoning when it comes to its own healthcare liabilities. An aging population and an unchecked growth in costs will result in a doubling of relative GDP outlays for healthcare in the next twenty years. This increase considers only Medicare and Medicaid as they are currently structured...what's to become of this fiscal train wreck if we nationalize healthcare altogether?
We will not take a political stance here and support or oppose a national healthcare plan. However, as investment managers, we will consider the economic and financial implications of such sweeping reform. We accept that fiscal support was necessary in the extreme environment of the past twelve months, and that this support has created a sentiment shift away from capitalism. However, history has proven that the US has continually walked the ideological plank between capitalism and socialism. Many historians will argue that FDR acted as a socialist dictator and single-handedly instituted many plans whose roots were pure socialism. Still, these programs were necessary to keep a depressed economy from complete collapse, and most morphed into something less socialistic as the need for them changed. Capitalism in its purest form probably reached a peak in the Reagan/Bush (H) years, and most capitalistic peaks can be defined by periods of excess just before collapse like we saw in the last Bush (W) administration. Regardless, even these extreme peaks of capitalistic eras contained strong elements of socialistic approaches.
This is not the end of capitalism as we know it. The US has the strongest and most resilient economy in the world, and will continue to be the bastion of capitalism that we always have been. It's just that we're a little sick right now, and the answer to economic sickness has almost always included some form of socialistic inoculation. We need to monitor these programs and forecast their impacts. First, they have to be paid for. Expect tax increases folks - not necessarily across the board, but you can count on increases for the highest income earners as well as anticipate an upward revision in corporate tax rates. When Wall Street Execs and Corporate CEOs headline the blame for this crisis, it will be easy to garner voter sentiment to hit them harder in the pocketbook. Should your tax rate be higher than Warren Buffet, the billionaire next door? Even he will tell you he's never felt that he's paid his fair share. An increase in the capital gains tax rate is also a given, but we're not as concerned here. Capital gains tax rates are at 50-year lows, so we think there is room for a nominal increase of 5% or so that is big enough to generate measurable revenue, but small enough so as to not discourage investment capital. The real concern with these spending programs is the amount of debt that they will eventually create for future generations to repay. Just maintaining entitlement programs at current cost levels will diminish other growth, and will increase real rates that will ultimately drag on economic growth and could eventually cause a permanent lowering of our standard of living.
The Stock Markets
So, does all of this sobering news put a damper on our previous optimistic forecast for the next five years? Absolutely not. We made the capitalism versus socialism argument to prove the point that the US economy has and always will have elements of both; that ideological categorizations do not necessarily define investment opportunities. China is a great example. Here's a country that, 20 years ago, was as far away from capitalism as you could imagine - and they are still decades away from any material shift to a capitalistic economy, if ever. Yet, the Chinese economy and the companies that lead it present some of the most attractive investment opportunities in the world today. As we've said previously, China's early and powerful fiscal stimulus (many times greater than the US's own stimulus programs, relative to GDP), have already produced measurable signs of accelerating growth. Many other emerging economies have also begun functioning better as a result of massive global stimulus. St. Nicholas clients should expect to see increases in the level of global and emerging markets exposure in the coming years.
None of this means that we ignore the US markets either. Even without venturing beyond our own exchanges, we can't help but gain international exposure - 40% of the revenues of the S&P 500 come from other countries, and, barring any suicidal dip into protectionist trade practices, that number will only get higher. US companies also have valuation metrics that continue to make them attractive longer-term. Obviously, unless we experience a double-dip in economic activity (still a possibility), most US companies have passed their trough in earnings meaning that the next growth cycle should be setting up nicely, even with a less-than-stellar recovery. This earnings growth is coming off of extremely depressed values, so we could experience magnified rebounds. These companies also have the ability to leverage their recovery due to low interest rates, although credit markets still need to re-liquefy before this can happen on any large scale. Even though the consumer may not be ready yet - that may not happen until unemployment peaks well into the low teens sometime near the end of 2010 - there is still residual demand that needs to be met. This means that manufacturers will eventually have to rev-up production since inventories have been depleted to record lows. Finally, and perhaps most importantly, there is still an unprecedented amount of cash on the sidelines. Given that many investors were severely burned in last year's market debacle, there's no guarantee all of that money will move back into stocks, but you can bet that a significant portion of it will.
Looking Ahead
We're still not completely confident that we've seen enough progress on the economic front to warrant the huge run in equities over the past several months. We reiterate that we feel we are beyond the trough in the earnings cycle, so we look forward to improving earnings going forward. However, we are a bit tepid on the economy at this point. It is certainly a good feeling to see most earnings stop decelerating, but this is still a very delicate economy. The party leading up to the collapse was huge, and the economic hangover that was left still persists today. Fiscal stimulus was large, but not necessarily quick - the bulk of the program spending has yet to be started, and most of it will not be fully implemented until well after the anticipated recovery. Monetary policy is about as generous as it can be, but without more aggressive lending by banks (and borrowing by consumers), its impacts are minimal. And, as we have said before, once all of this is in play and working, we're still going to have to start paying for it somehow. We don't think real estate has bottomed, so we think loan losses will continue and credit standards will remain tight. The consumer will also remain the key, and confidence probably wanes until unemployment peaks and jobs are actually being created. We're not sure what the next 12 to 18 months holds, but we don't feel like downside risk is worth giving up the substantially higher levels that we anticipate seeing in the next three to five years. It will continue to be a nervous ride, but we strongly feel that investors with patience and managers with diligence and discipline will reap the greatest rewards.
Thanks for your Confidence and Trust.
"October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February."
- Mark Twain
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Our Latest Market Outlook - Mid-Year 2009
