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First Quarter, 2009


From our many discussions with clients this past quarter, we know that fear of continued investment losses has created a strong desire to do nothing, that is, to stay heavily in cash while waiting for more clarity about the outlook for the economy.  At the same time, clients express the frustration of not wanting to be left behind when a stock market recovery takes hold, especially when the early stages of recovery typically generate significant gains.  In our letter to clients dated March 13, we noted that some signs of an economic bottom were beginning to appear.  We also observed that government officials continued to signal a “do whatever it takes” attitude to restore liquidity to frozen financial markets and jumpstart the economy.  Their actions gained traction during the past 6 weeks, and as we previously noted, our strategy decision was to position clients’ equity holdings at approximately the mid-point of their agreed upon equity ranges.


Evidence is beginning to mount that this year’s first quarter may have seen the worst of this dreadful economic decline and may have registered a turning point in the liquidity crisis as well.  It will probably require the remainder of the second quarter as a transition period to determine whether or not this is the case given the mounting losses and ongoing uncertainties in the banking sector.  We continue to monitor a wide variety of indicators as we attempt to glean insights about the future direction of investment trends that will ultimately separate winning strategies from unprofitable ones.  For this quarter’s letter we are going to address three major issues that influence our thinking about portfolio structure, each of which is conflicted by many cross currents of opinion held by the country’s best economists.


  • The Financial Sector Crisis


We have been pleased to observe that during the past month there has been a great deal of improvement in both the flow and cost of credit within various segments of the fixed income market outside the banking system.  (The distinction between liquidity within and outside the banking system is an important one which we will address further down in this report).  Some examples of liquidity improvement:


  • Yields of asset based securities, junk bonds and investment grade corporate bonds have experienced declines in the past 6 weeks, demonstrating that investors are becoming more willing to take risk in the credit markets in pursuit of returns in excess of treasury rates.


  • The corporate bond market has come alive with a very strong calendar of new issues, and even in the junk bond category the flow of new product into the marketplace has resumed.


  • The Libor spread to 3-month treasury bills has shrunk to near pre-crisis levels.  Libor is a key interest rate indicating the price of money loaned on an overnight basis between banks.  The cost of credit to many borrowers in the U.S. and Europe is priced off of Libor rates.


P-PIP: The Public-Private Investment Program


The banks, unfortunately, remain mired in financial difficulties, exacerbated in the case of the 19 systemically important banks by increasing government interference in their operations.  Major problems continue to be: achieving closure on the toxic asset (now called “legacy assets”) issue; increasing losses on other types of loans and, the ongoing need to deleverage their balance sheets while adding additional capital for regulatory purposes.  The latest effort by the Treasury Department to deal with toxic assets held by the 19 systemic banks has been given the acronym, P-PIP.


 P-PIP is supposed to be the final dose of government-sponsored medicine to clean up bank balance sheets.  The idea is to have private investors put up small amounts of capital (around 7-10% of the program total) with the Treasury lending the remaining 90% +/- for the purchase of bank toxic assets.  The FDIC would guarantee most, if not all, of the Treasury loans.  These assets are to be acquired through an auction process among various bidders that will determine “fair value” for the toxic assets.  When the housing market stabilizes, these assets can presumably be resold at a profit by the program syndicators (the same large banks and brokerage firms who contributed so heavily to our current financial mess) with profits being split 50-50 between the federal government and the private investors.


The program is looking like a very tough sell to the banks, even before it is formally launched, casting a pall over it’s hoped for future success. For a variety of reasons the banks are not convinced that P-PIP is in their best interest:


  • There is concern regarding “fairness” of price for the assets they sell.  If the anticipated auction prices for toxic assets are too low, the banks won’t participate.  The realized losses facing the banks would be too large to accept.  If the prices aren’t low enough however, prospective investors will walk. 


  • With conventional mortgage rates now below 5%, refinancing activity has exploded around the country.  Many loans in danger of foreclosure due to anticipated higher reset interest rates this year and next may now be refinanced at more favorable rates, thereby lowering the risk of default and foreclosure.  This of course assumes the property owner can qualify for a new mortgage loan.


  • Accounting rules which were forcing banks to mark down their real estate mortgages and securities, resulting in losses and diminished capital bases, have now been relaxed.  Banks can now use computer models to price illiquid securities under the assumption that these assets will be held to maturity.  The result will be a dramatic improvement in bank reported earnings beginning immediately, relative to what had been expected only a few weeks ago.


P-PIP is slated to begin after the well-publicized bank stress test activities are completed, thereby placing the Fed and the Treasury in the position of forcing this program on the banks if they are otherwise unable to raise additional government-mandated capital to improve their financial soundness.  The entire process to launch and fully implement   P-PIP could extend over the next six months raising the possibility that present bank-related economic concerns may continue to fester resulting in ongoing investor uncertainty.


Even if all toxic assets were to magically disappear from bank balance sheets, there would be additional financial pain to reckon with.  The next problem areas include rising delinquencies and defaults in commercial loans, student education loans, credit card balances and consumer lines of credit, all related to the ongoing recession.  Once again, the overall loss potential from this new group of looming asset write downs is believed to be in excess of $1 trillion.  Banks are significantly under reserved for these anticipated future losses.


Regardless of how many signs of economic improvement begin to emerge, the banks have a long way to go on their road to financial recovery.


  • Is Economic Recovery at Hand?


On a number of fronts an increasing array of key drivers of economic activity are beginning to show signs of improvement.  We believe it’s important to be very clear with our word choice here.  “Signs of improvement” does not mean that areas of the economy are growing again.  This is not happening anywhere yet.  It is simply that the news is getting less bad.  The rate of descent of a variety of indicators is slowing down.  Negative trends are giving indications of bottoming out.  Some examples:


  • The Index of Leading Economic Indicators established a bottom in the fourth quarter of 2008;


  • The Chicago Fed National Activity Index has showed signs of bottoming out;


  • The rate of increase in weekly unemployment claims is declining;


  • Applications for home purchases are increasing as are mortgage applications.  Refinance applications have exploded upward;


  • Single family home starts bottomed out in January, 2009 and have held steady in February and March;


  • Auto sales bottomed out in February, 2009 and the scrap rate of autos exceeds the present rate of new car purchases, so further increases in new car sales should follow in upcoming months.


  • Stockpiles of factory inventories have fallen in January, February and March.


Many additional examples can be found in other economic reports.  As has historically been the case, the stock market begins to anticipate better times 6-9 months in advance of a tangible turn in the economy.  The market’s upward move off of the March low point reflects the slowing rate of deterioration in these and other economic indicators. 


Residential Real Estate


The housing picture has become more complex.  Home prices around the country continue to fall although anecdotal evidence of price stability has emerged in various communities where less excessive development took place in the past few years.  In fact, home prices have declined to the point at which home affordability has greatly improved, resulting in a pickup in the rate of new and existing home sales.   In other words, a new equilibrium is now being established, resulting in a stabilized supply of homes on the market during the past three months despite high ongoing default rates.


The sub-prime default debacle has nearly run its course, but a new and much larger wave of potential defaults is looming with a combination of ALT-A, option adjustable rate and prime loans all facing mortgage interest reset dates commencing later this year and continuing through 2011.  There is not, at this time, any government-sponsored meaningful and fair solution on the economic radar screen for dealing with the ongoing homeowner default issue.  In the end, markets may just have to work through this problem in their own way via the process of default, foreclosure and eventual resale.


The only ray of sunshine in this ongoing housing mess is today’s conventional mortgage interest rates being offered below the threshold five percent level.  As noted elsewhere in this letter, refinance applications have skyrocketed and this may greatly reduce the otherwise negative effect of mortgage reset rates.  To summarize, the housing picture is as murky as ever.


  • Inflation or Deflation Ahead?


We believe it would be foolish, reckless even, to bet your portfolio on the assumption at this moment than either inflation or deflation will be the predominate economic theme for the next few years.  The cost of choosing incorrectly is too high.  Therefore your assets are presently allocated in a manner that will derive certain benefits under either scenario.  Economic evidence at this point in time continues to illustrate that we have entered into a deflationary mode.  The CPI, for example, has had its first 12 month decline (through March 31) since 1955.  Rising unemployment, increasing spare manufacturing capacity, declining real estate values and deleveraging on the part of consumers and financial institutions all mean that inflation continues to be a non-issue right now, in spite of the Fed exhibiting hyperactive reflationary behavior.


Stock and bond markets are both being severely buffeted by conflicting views about the future direction of the economy.  At the same time that Congress and the Administration are ratcheting up pressure on the corporate sector with greater regulation and anticipated tax increases, fear is widespread that many banks may be nationalized.  Sitting in cash on the sidelines while this scene plays out is of no economic benefit as short-term interest rates have been pushed down to 1% or less by the Fed thus forcing investors to assume greater investment risk for modest future returns.


On the basis of 1) reasonable stock valuations, 2) increasing liquidity in previously frozen financial markets, 3) a modest improvement in the technical behavior of the stock market, and 4) the government’s position of continuing monetary and fiscal stimulus, we have moved client equity allocations up to around the midpoint of their allowable ranges.  However, we are not comfortable chasing the stock market rally at this point.  In addition, we have recently been increasing the fixed income component of client portfolios while decreasing cash holdings.  From a strategy standpoint, our present thinking is that we want client portfolios to benefit from the approaching wave of global public sector spending and we want to be appropriately positioned for the possibility of a continuation of the current deflationary trend gripping the country.


Presented below are portfolio returns for the quarter ending March 31, 2020 which are proxies for client assets:


Money Market Fund Proxy                                               .1%

S&P 500 Index                                                             -11.0%

Russell 3000 Index (U.S. Stocks)                                -10.8%

MSCI EAFE Index (Non-U.S. Stocks)                       -13.9%

MSCI Emerging Market Index                                         .9%

Lehman Aggregate Bond Market Index Fund              -2.0%

MSCI REIT Index (Real-Estate Trusts)                      -32.7%

Gold (Commodity)                                                          4.2%

Philadelphia Gold/Silver Index (Mining cos.)                 8.7%

CPI Inflation 12 months                                                  -.4 %


Portfolio Performance


After two consecutive negative months in the quarter, the bear market for stocks, real estate and most commodities hit a new low during the first few days of March.  Only emerging country markets experienced positive stock returns during the first quarter.  Emerging markets have been primarily affected by the global recession, not by the financial crises faced by the developed nations.  As the world moves towards an economic recovery, we believe emerging markets will continue to exhibit significant strength.  Since then, stock prices have moved sharply higher on the belief that recessionary economic conditions are bottoming out.  


Fixed income markets were negatively affected by rising interest rates on intermediate and longer term bonds.  Treasury securities have performed much more poorly than corporate bonds, setting up an interesting contrast.  A recovering economy should continue to favor corporate bonds over treasuries.  The reason is corporate yield spreads have been contracting since early March, demonstrating an increased investor appetite for risk.  Corporate spread contractions have offset the price decline from rising interest rates resulting in rising corporate bond prices at the same time that treasury prices have been falling.


The Fed has indicated that they may attempt to force down longer term rates if they believe an economic recovery will be hindered by a continuation of the current rising interest rate trend. 





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