April 2008 - From Client Review Letters

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There is an ancient Chinese proverb that says “may you live in interesting times”.  These are indeed very interesting times.  Between economic events and the upcoming presidential election there is no shortage of interesting news almost daily.  We always categorize the stock market as constantly being in transition between euphoria and despair.  The same might be said about the U.S. economy in our democratic free enterprise system.  Things seem to go too far in either direction until things become overdone and reason is restored.

Bear Stearns, whose hedge fund collapse last summer coincided with the start of the current credit market turmoil, was forced into a fire-sale buyout by J.P. Morgan due to liquidity issues.  J.P. Morgan, despite being forced to quintuple its original $2 per share bid for Bear Stearns, still appears to have received a tremendous value.  This is especially true given the Federal guarantee on some of Bear Stearns’ risky holdings.  The entire deal was controversial but was needed to stave off a broader and deeper financial problem had Bear Stearns failed and defaulted on many of its financial obligations.

The Federal Reserve cut interest rates three times during the first quarter of 2008 totaling 2%.  The Fed Funds target rate now stands at 2.25% down from 5.25% last summer.  The Fed has also committed to provide liquidity to troubled financial institutions through a program under which Treasuries will be loaned in exchange for various forms of collateral including out of favor mortgage-backed securities.  Securities dealers will also be allowed to borrow directly from the Federal Reserve’s discount window for the first time.  This lending facility was previously available only to commercial banks and will likely lead to an expansion of the Fed’s regulatory authority over securities dealers.  The problems we currently face are leading to a complete reexamination of regulatory oversight in the financial sector.  That could be years in the making, however.

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The U.S. housing market has continued to decline in 2008.  Home prices fell more than 10% year over year through January according to the Case-Shiller index.  Nineteen of the twenty metropolitan areas measured in the index registered annual declines (Charlotte was the exception).  New and existing home sales declined more than 20% year over year in February and the ratio of inventory to sales increased over the same period.  Home prices will need to decline further in order to bring prices more in line with personal income.  Building permits and housing starts have declined dramatically which should help to bring inventory levels back in line over time.  Foreclosures and tighter lending standards (more money down, higher credit scores, etc.) will continue to put pressure on the housing market.

The U.S. dollar continued its decline and ended the first quarter down approximately 15% year over year against both the Euro and the Yen.  While this decline has benefited U.S. trade by making our goods cheaper abroad, it also poses many potential negatives including the inflationary pressures brought on by higher import prices as well as the prospect of capital flight from the U.S. in search of higher returns.

Oil prices have recently reached all-time highs (both nominal and real) and are currently trading around $115 per barrel.  AAA reported that the national average price of unleaded gasoline reached a record high of $3.29 per gallon on March 31.  This represents a 23% increase over year ago prices and the price has continued to go up.

Gross Domestic Product (GDP) slowed markedly in the fourth quarter registering a 0.6% annualized gain.  The U.S. consumer, which accounts for approximately two-thirds of GDP, is being squeezed by higher oil and food prices, the weak housing market and rising unemployment.  Consumer confidence has also declined in recent months to levels consistent with past recessions.  Many forecasters expect additional softness, if not outright declines in GDP over the next couple of quarters.

On a positive note (finally), one trend that has been in place for well over a decade is the strengthening of corporate balance sheets.  Since the early 1990’s, corporate debt has decreased from around 50% of capital to less than 40% currently.  We tend to favor companies with even less debt in the portfolios we manage.  Over this same period cash on corporate balance sheets has doubled to nearly 10% of total capital.  Earnings quality as measured by Standard & Poors has also improved dramatically since the accounting scandals of the early 2000’s.

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In contrast to the market’s previous peak and subsequent decline from March, 2000 through October, 2002, current valuations are reasonable by historical standards.  Our Fair Value Channel indicates that the stock market is currently trading near the low end of the fair value range.  This is likely the result of a market advance (2002-2007) having occurred during a period of PE contraction.  In other words, earnings were the primary contributor to the market’s increase from its lows rather than the expansion of PE ratios. 

Another potentially bullish signal could be the recent increase in volatility in the stock market which is the highest it’s been since 2002.  Historically, a rise in volatility has often coincided with market bottoms as investors become fearful rather than complacent.  Still, U.S. stocks were much less volatile than most major markets around the world in the first quarter.

If the U.S. economy is heading into recession, it is important to remember that recessions are a normal part of the business cycle and that the U.S. free enterprise system is a self-correcting mechanism.  Economic expansion can often lead to over-extension which is inevitably followed by some sort of correction.  Difficult times allow the economy to wring out its excesses and lay the groundwork for further expansion.  For good or bad, that is how the capitalistic system works.  The former Soviet Union’s planned economy never really worked at all.  One should also keep in mind that current economic issues are not unique to the U.S.  Most of the world, including China, is experiencing some degree of economic turbulence. 

Everyone is no doubt aware of events in the presidential campaign.  Similar to the economy, politicians also tend to overreach.  The populist message of higher taxes on dividends and capital gains and greater restrictions on free trade is unlikely to yield positive results for the economy.  However, the perfect candidate is difficult to discern given that the rhetoric of the campaign trail is often followed by a more moderate approach to governing.  Certainly, key issues will be healthcare, views on the war/terrorism and the economy.  The candidates are a mixed bag on these issues and it will be interesting to see how things play out between now and November.

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