The Federal Reserve last week surprised everyone by extending its “exceptionally” low interest rate environment until late 2014. This is almost a year later than its previous forecast for interest rates. With many economists saying the economy was improving over the last few months, we have to wonder why the Federal Reserve made this announcement. At THOR, we think there are two reasons for this decision. First, the economy is not as rosy as it appears. Yesterday, the consumer confidence index fell and home prices slipped another 1.3% in November. The economy also grew less than 2% last year which is well below the average growth rate for an economy rebounding from a recession. Second, the Federal Reserve is keenly aware of what is happening in Europe. We believe that the Fed is keeping rates low in order to assist Europe in keeping its rates low – it isn’t helping Portugal whose 5-year rates are now over 20%! In a worst case scenario in Europe, if Greece and Portugal start a chain reaction that brings down the Euro, the US dollar will become the defacto currency for Europe. One big question this announcement leaves in our minds is “Does the Federal Reserve know more about an upcoming crisis than they are telling us?” In our opinion, the Federal Reserve is telling us that our economy has two more years before it starts to turn around. Not the best sign for our economy.
Time to buy a home?
It was just a few years ago that investors in rental real estate were suffering because people were buying homes instead of renting. People did this because of the ease in getting a mortgage. Today, the opposite is true as the only real construction going on is in multi-family units – apartments. Below is a chart that shows it is now cheaper to buy a home than to rent one. We still believe that the fall in the housing market has a few months to run. However, if you or your children are renting, you may want to consider buying a home. We believe it could be a worthwhile investment over the next five to ten years.
There is much information suggesting that the stock market will have a great year because of the upcoming Presidential election. One of the reasons for this position is that the President – and to a lesser extent Congress – will do everything in their power to have the stock market rise so that they can be re-elected. This cycle – known as the Presidential cycle – became a phenomenon in 1994. That is when Adam White drafted a piece showing that excess returns were actually achieved by being fully invested the two years before a Presidential election while avoiding the first two years after an election. These are the results Adam presented for the Presidential cycles from 1912-1992:
Dow Jones Industrial Average
Post-election Year: +4.7%
Mid-term Year: +2.3%
Pre-election Year: +11.0%
Election Year: +7.0%
The results seem compelling. However, our most recent Presidential cycle did not follow this trend.
Dow Jones Industrial Average
Post-Election Year (2009): +18.82%
Mid-term Year (2010): +11.02%
Pre-election Year (2011): +5.53%
Election Year (2008): -33.84%
The results are opposite of what the Presidential election cycle would suggest would happen. In fact, an investor would have generated a -30.1% return over the past 4 years if they only invested in the stock market during the pre-election and election year and stayed in cash for the final two years. This is why we believe it is important to use more than one indicator when making investment decisions. Keep in mind that the Dow was up 5% in 2011 when most stocks were down last year – the equally weighted Value Line Composite Index of over 1,700 stocks was down 11%. The Dow is not necessarily a good indicator of the return for the overall market because it is weighted based on the share price of the stocks in the index. This causes the return to be skewed towards the stocks with the highest share price. IBM, with a share price of $179, has the largest weighting in the index of greater than 10%, while Bank of America’s weighting in the index is .40%.
EUROPE FOLLOW-UP
Last Friday, more European countries had their credit rating downgraded. This caused the Euro to reach 16 month lows. The situation in Europe has not improved from last year. There is still significant risk to the global economy. China is especially vulnerable since Europe is their largest trading partner. The human tragedy that is now hitting Greece, will likely hit the other PIIG countries if Europe does not figure out a way to balance trade between countries. The Euro is not just a financial crisis, but a social one as well.
Throughout the past couple of months, we have heard from analysts and experts that “despite the headwinds from Europe, the U.S. economy is doing well.” We have also heard “if it weren’t for the economic problems in Europe, the U.S. markets would be stronger.” We know there are major problems in Europe that have yet to be solved, but we are not sold that our own market is thriving. The U.S economy recently received some positive economic news. Jobless claims dropped to 366,000 – the lowest level since May 2008. The Empire State Index is a survey of 175 manufacturing executives that gauge the sentiment of the current and 6-month outlook on the manufacturing sector. The index in December jumped from .6 to 9.5 – the highest level it has been at in 7 months. The majority of this increase came from a rise in new manufacturing orders.
On the other hand, there is some bad news out there. The industrial sector declined by .2% in November. Our job market continues to grow slowly. This is a concern for the Federal Reserve and an issue it has been struggling with for a while now. To help combat this problem, the Federal Reserve announced plans this past week to keep interest rates low at least through mid-2013. Federal Reserve Chairman Ben Bernanke has also told the Senate that he has no plans to bail out Europe. It is easy to have a mixed reaction to that statement. On one hand, we should be satisfied that Bernanke does not want to entangle us in Europe’s problems. On the other hand, it is uneasy to hear this believing that if Europe “unravels,” our economy will be affected as well.
Many experts believe that the euro-area economy will fall into a recession. Despite the EU leaders agreement last week to implement stricter controls over government spending and taxation and their pledge to hasten the start of the 500 billion euro bailout plan, substantial risk remains. These moves temporally have eased the European credit markets. The risk is still elevated as a large amount of refinancing of government debt still needs to take place in 2012.
Recession fears are not just coming as a result of policy issues, but from economic data as well. The Purchasing Manufactures Index (“PMI”) is an index that measures whether a country is headed for a recession or an expansion. If the index is below 50, then a country is believed to be moving toward a recession. If the index is above 50, then a country is believed to be moving toward an expansion. The most recent PMI reading for Germany was 48.1, for the euro-zone it was 47.9 and for China it was 49.
What does this all mean? To us it means uncertainty. We have some economic data in the U.S. that is positive, but our job and real estate markets are not doing well. We have Europe that does not seem to be tackling the real issues needed to solve their mess. We believe that if Europe falls into a recession, our economy will be affected.
Where does that leave us? It gives us further comfort that the defensive position we have taken in your portfolio was the right decision. What about the strength of the U.S.? With the cash in your portfolios, we have the ability to take advantage of undervalued investments when we think the time is right.
The market today feels like a tale of two worlds. In the United States, the holiday shopping season is off to a robust start. The Chicago Purchasing Managers Index came in at 62% – above 50% means the economy is expanding – and ADP reported 206,000 new private sector jobs in November. In Europe, things are deteriorating more rapidly than many expected. Today’s action by the Federal Reserve – and other global central banks – was done to provide liquidity. As the risk of the collapse of the Euro has intensified over the past few days, European banks have been scrambling to acquire dollars. The problem is the cost to get dollars has started to become very expensive as there are not enough dollars in the system to handle European bank demands. Banks in Europe are struggling to survive as depositors drain accounts, as United States money market funds stop buying European commercial paper and lending to European banks stops. In addition, European Companies are looking to protect themselves from a collapse of the Euro by diversifying away from the Euro. The Federal Reserve is trying to unclog the European financial system.
The Federal Reserve’s action is its attempt to assist in stopping the runs on European banks and European money market funds. It took similar action in the United States in the fall of 2008. In September of 2008, the Federal Reserve created the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility. This facility provided funding to allow financial institutions to purchase asset-backed commercial paper from money market funds to prevent the money market funds from defaulting as a result of investors’ redemptions. This action helped to halt runs on money market funds in the United States. The markets reacted positively to this action in the short-term as the stock market rose over 6% on September 19th. Over the next six trading days, however, the market fell more than 11%. We believe the market reacted this way because the Federal Reserve’s action treated the symptoms and not the disease. In fact, the stock market continued to fall another 30% from mid-September through March of 2009. The market finally turned the corner once the problem with the financial stress was finally addressed.
Like the Federal Reserve’s actions in September of 2008, we believe central banks around the world are treating the symptoms of the disease and not the disease itself. We believe the disease needs to be fixed by political action. A large part of the solution to the United States financial crisis was changing the mark-to-market accounting rule. This rule, if you recall, forced financial companies to price assets well below their true market value. The rule change occurred within a week of the stock market’s bottom in March of 2009.
The crisis in Europe is more extensive and more complicated than our financial crisis. To fix the problem, in our opinion, there are basically two options: complete fiscal integration – United States of Europe – or a disbanding of the Euro. Other measures that have been taken to date have not been effective in solving the sovereign debt crisis. The first option would mean a loss of sovereignty and political power, likely create social unrest and require new treaties. The second option likely would cause major financial disruptions around the globe – including United States markets. Either solution adds risk to the financial markets. That is why, even with encouraging economic numbers in the United States, we believe it is prudent to continue to have a defensive weighting to your portfolios.
Sincerely,
Your THOR Team
Note: Please click on the two hyeprlinks in the above update to read a corresponding article addressing our point.
The European train is hitting Italy and is spreading to other European countries such as Belgium, Hungary, Spain and France. Things have not gotten better since our last update and, if anything, have gotten worse. We have attached a flowchart we created internally to assist us in determining the potential ramifications of the events currently taking place in Europe. Whether the Euro stays or goes, we foresee the following as the most likely scenarios:
Recession in Europe:
Interest rates in Spain, Italy and France are up anywhere from 1% to 2% in just the past few weeks. These economies are on pace to grow slower than the United States. Imagine the impact on the US economy if mortgage rates rose 1% to 2%. We think this will slow economic activity further and drive these countries into a recession.
In August and September, Italian depositors withdrew E80 billion from Italian banks. This was done before Italian interest rates started to spike up significantly. We can only imagine what the withdrawal rate has been since the end of September. If banks lose depositors, they can’t lend money – remember “It’s A Wonderful Life.”
Industrial production in the European Zone dropped 2% in October.
South Korea announced today that exports to the European Zone had its sharpest drop since 2009 – sliding 20.3% from a year earlier.
Fall of the Euro:
A weak economy, political unrest and fear among people in Europe will cause the Euro to fall further versus other world currencies.
Gold and Commodities:
A recession in Europe will slow growth in the US and around the world. Recessions are deflationary and cause commodity prices to fall as demand for goods falls. Commodities are priced in US dollars. If the Dollar increases in value versus the Euro, commodity prices will fall in US dollar terms.
It is very difficult to find a safe deposit box in Europe at this time. We believe that is one sign that many people in Europe have begun to hoard cash, gold and silver to protect them from financial catastrophe. Der Spiegel, the German newspaper, reported that Greeks have already moved over E280 billion to Swiss bank accounts. If the Euro dissolves, we believe gold may rise leading up to its dissolution, but will fall as people sell gold to convert to the “new” currency to live on. In other words, a busting of the Euro bubble will cause gold to fall as Europeans sell gold. On the other hand, if Europe is able to stave off dissolution for a few years, gold may increase in value as more Europeans buy gold for protection.
When analyzing an investment vehicle, there are different ways to determine value. Two of the most basic ways are: (1) determining the price at which assets can be sold in the current market and subtracting from that price liabilities; and (2) determining value based on projected future growth. The first method works in any market. The second method is more complicated.
In our opinion, the stock market performed well during the political landscape of the early 80’s when President Reagan was in office and mid to late 90’s when President Clinton was serving for a number of reasons. One of the biggest reasons was the certainty that surrounded policy making and its effect on business. Business people felt that the rules affecting their operations would not drastically change in a negative way. One of the biggest problems that pervades the United States and the global economy today is the rapid rate of change in the political landscape and its impact on future policies that affect business. Because of this, market analysts have trouble forecasting how companies will adapt and what impact it will have on future growth. As such, projections of future profitability get lowered and, consequently, stock prices fall. In the United States, uncertainties about our federal debt and the corrective measures needed to address it – regulations, taxes, etc. – have also hurt stock prices. The monthly bailouts in Europe have created uncertainty around the globe as markets speculate which policy initiatives will be enacted to help the global economy.
When analyzing investments today, the political uncertainties have to be accounted for. That is the reason why most of our recent market updates have addressed these issues.
Another point of view
A few market updates ago we talked about government worker pay. We addressed this issue in the context of how it affects the investment world. We do not have the resources to analyze the data ourselves, but rely on third party sources for the information we present. A long-time client expressed some concerns about our portrayal of this issue and provided us with links to two articles that contain a different point of view. Here are those links.
We wanted to share these links with all of you because we believe the articles make some good points. We know there is a lot of information out there and we do our best to provide full and accurate information, but on occasion we may miss something. If any of you have thoughts different than those that we express, please feel free to share them with us. Our intention is to address issues that we believe may have an impact on your portfolios.
August was the fourth consecutive down month for the stock market. It looks like September has a number of events that could significantly impact the market. We believe the next few weeks in the market could be volatile because of these events.
September 7 – Germany’s high court is expected to rule on whether the 440 billion Euro European rescue fund created by the European Central Bank breaches the European Union’s treaty which states that no member nation shall bail out another member nation and on whether the rescue fund undermines German fiscal sovereignty. This ruling will have a major impact on stock markets around the world.
September 11 – Marks the 10th anniversary of the terrorist attacks on our nation. Evidence gathered from the raid on Bin Laden’s compound earlier this year indicates that Bin Laden was very interested in attacking America on this day. If there is an attack, it would certainly jostle the markets.
September 29 – Assuming the European rescue fund is upheld by Germany’s high court, Germany’s lower parliamentary branch – the Bundestag – will vote on expanding the European rescue fund as well as expanding its own powers. There is significant political opposition with respect to this vote growing both in Chancellor Merkel’s own party and within the people of Germany. If Merkel has to rely on opposing party members to get the bill passed, it will weaken her leadership. Germany is currently the glue holding the European Union together – any weakness by its government will bring more uncertainty to the European Union and, likely, the world financial markets.
The outcome of these events, of course, is out of our control. However, having some “powder dry” to take advantage of any market dislocation is appropriate. Those of you who were with us in 1998 saw us raise our international equity exposure significantly, up to more than 40% exposure, after the Asian markets collapsed. Our worst performing international fund was up 55% in 1999 while our best international fund was up over 100%. We believe patience will be rewarded in the months ahead.
We hope you and your family have an enjoyable Labor Day weekend!
News out of Europe yesterday included a proposed plan by France and Germany to solve the EU debt problems. This plan called for the creation of a “collective government” run by the EU President and a tax on every financial transaction. Both of these ideas are significant and, we believe, unworkable.
By setting up a “collective government,” Germany and its people will continue to transfer wealth to weaker countries in the EU. Part of setting up the collective government is that countries would no longer issue their own bonds, but would issue Eurobonds backed by the EU as a whole. In doing so, interest rates would fall in the PIIGS, but would rise in Germany. In other words, it would hurt Germany because it would pay higher interest rates and take on the risks of all the countries in the EU. Politically, German Chancellor Merkel is dead on this issue as her popularity has sunk to its lowest level in nearly five years. In December of 2010, a poll by ZDF television of 1,421 Germans found that 62% opposed greater aid to the PIIGS. That was eight months ago. Recent polls now show a majority of Germans now want to dump the Euro and go back to the Deutschmark. We don’t believe Germany wants to be the piggy bank for the rest of the EU countries and lose its sovereignty to the President of the EU.
A tax on every financial transaction makes no sense. European banks are in bad shape. This tax is the equivalent to the adage “kick‘em while they’re down.” When I was in Italy a month ago, many vendors did not accept credit cards. Our guide in Rome said they did this to get around having to pay taxes. This new tax will only serve to drive transactions further underground. We believe it will also drive deposits out of banks.
This is a last gasp effort to save the Euro. It might buy a little time, but Merkel cannot continue to act against the wishes of her people. Eventually, we believe the German people will win out and the EU will collapse under its own weight. The uncertainty surrounding the EU debt crisis will continue to weigh on stock markets around the world. We believe it is still prudent to play some “defense” at this time.
When we mentioned that the market would be volatile last week, we didn’t know that Standard and Poor’s would downgrade US Treasuries late Friday night. The downgrade is having a ripple effect across global equity markets today. What is interesting is the yield on US Treasury Bonds has fallen dramatically today. That is the complete opposite of what one would expect after a downgrade. What normally happens is that yields shoot up. The drop in yields is setting the stage for an economic recovery a few months down the road.
I received a call from a client today and was asked, “Do you see anything good out there?” My response was something along the lines of “right now, not much.” But, we are encouraged by the bond market rally, the drop in oil prices and the drop in commodities (except gold). This is exactly what happened in late 2008, early 2009. If oil prices and commodity prices fall, the price paid for goods and services will fall and consumers will have more money to spend. With interest rates dropping, the cost of borrowing will fall. Anyone with a mortgage should refinance now (if you need assistance, please call us). Refinancing will either lower payments or reduce the time to pay off your house, both good for the consumer.
Another silver lining from the downgrade is that it will force our government to confront the debt in a more meaningful way. However, we think that with the economy wavering, the government should take the opposite approach of the typical playbook and cut spending first, and then raise taxes. Even the most recent cuts occur years into the future with no assurances that a future Congress wouldn’t reinstate the spending. The government needs to cut spending in a more meaningful way including the level of compensation for federal workers. (See video below)
If you have facts or figures that dispute the video, please forward them on to us. We are only interested in the truth.
All those pundits that said we need to get a debt deal in order to “stabilize” the markets are certainly eating their words. The last few days have been horrendous for the stock market and today is no exception, with the market being down over 450 points so far. As we stated in our last update, the debt ceiling was a minor consideration compared to what is happening in Europe. As you might recall from our March newsletter, we detailed our concerns about Europe. The contagion from Greece has not been contained and is spreading faster than the flu. We expect more volatility in the days ahead.
Although some clients may be more nervous than others, a key point for all to keep in mind is that the time to prepare for winter is during the fall harvest, not during a winter blizzard. We did our harvesting a few months back by reducing your exposure to the stock market. At some point, the ice will start to melt away and it will be time to move money back into the stock market. Every stock market downturn has different causes, but one thing is constant – human emotion. That emotion is showing up in these current downswings in the market.
Most of your portfolios have what we believe is a substantial amount of “dry powder”. In the past couple of months, our decisions were based on the amount of risk and reward we saw in the market, with more risk than reward. Our decisions going forward will be based upon that same principal, and however hard, we are confident the right decisions will come through with our disciplined approach. Although we do not hope for a major fall in the equity markets, we will be sure to take advantage of our cash position and capitalize on unique opportunities when the time is right. A lesson we learned many years ago still remains intact: When the market is going up, any cash is too much cash. When the market is going down, you never have enough cash.
At times like this, we may be more accessible after work hours due to other client calls, investment meetings and conference calls with analysts on the street. Please don’t hesitate to call us here at THOR or on our cell phones at any time if you need to talk with us.
