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Market Commentary — 3rd Quarter 2009The rally that began early this spring in the world equity markets continued almost unabated during the third quarter, with most equity markets around the globe finishing the quarter near their highs for the year. The broad-based S&P 500 index recorded a gain of 15%, its best quarterly performance since 1998, and its 18th best quarter since Q4 1928. The strength and sharpness of the upward move is even more impressive considering it came on the heels of a nearly 16% gain in the prior quarter. Cumulatively, this most recent 6-month period marks the biggest back-to-back quarterly performance for the S&P 500 since 1975. The dramatic rebound in the markets – seven consecutive months of gains and a 56% move off the 12-year low in March – has come in the face of myriad concerns, ranging from the ongoing weakness in the domestic economy, increasing unemployment, a significant contraction in the availability of consumer credit and a massive increase in the federal deficit. After the huge run-up, the broad equity markets at current levels are arguably fairly priced, and attractively priced individual companies are certainly not as plentiful; however, we are still finding value. We view the current environment as an opportunity to reduce risk – trimming or completely liquidating positions that have done extremely well and are beginning to look stretched on a valuation basis – by shifting client monies into solid companies that have yet to fully participate in the rally as well as preferred shares of financial companies, which are attractive on a risk/reward basis. While skepticism of the huge upward move in the world equity indices is in many respects not entirely unfounded in light of the multitude of issues both here and abroad, it’s important to remember that despite the run-up, the S&P 500 is up only 17% for the year and is still 32% off the October 2007 highs. The markets are just one year removed from the tumultuous sequence of events that nearly brought the entire global financial system to the brink of collapse. The ensuing panic, which lasted almost six months and saw a near 50% decrease in the value of the major equity indices, caused, among other things, forced liquidations by mutual funds attempting to meet redemption requests and margin calls on leveraged investors. During the process, a herd-like mentality took hold among a large group of investors with indiscriminate selling of both equities and fixed income securities at irrational fire sale prices. Viewed in this contextual framework, the recent upward move in both the debt and equity markets is one toward equilibrium in both prices and investor behavior. Although the markets have bounced back, with the worst likely having passed, the domestic economy has only begun to stabilize with no real signs of recovery; this despite significant fiscal and arguably unprecedented government intervention. A read of the most recent economic data is uninspiring at best. For example, while monthly job losses have been in a downward trend since December, the most recent data on the labor markets – the September non-farm payroll report – showed job losses of 263,000, which was well above the 175,000 consensus estimate of economists. Unemployment currently stands at 9.8%, which is the highest level in 26 years, courtesy of an economy that has shed jobs for 22 consecutive months dating back to December 2007. While unemployment is a lagging indicator, in an economy in which over 70% of GDP is derived from the consumer, the current level of unemployment coupled with the lack of foreseeable job growth is cause for concern. Housing, a topic that has been discussed ad nauseam over the past few years, continues to be problematic. Although the most recent year-over-year numbers in the July S&P/Case-Schiller index offered a ray of sunshine with a moderation in the pace of price declines in all 20 cities, delving deeper into the data indicates most markets have yet to bottom. The number of homes entering foreclosure continued at a monthly pace of at least 300,000 for the sixth straight month and was up 18% over the prior year. Moreover, a vast inventory of bank-owned homes has not yet hit the market and a significant number of jumbo borrowers with adjustable rate mortgages are coming up on a reset with limited refinancing options, both of these issues will put downward pressure on prices. Against this backdrop, the $8,000 tax credit for new home buyers, which was set to expire on November 30th, will likely be extended by Congress and possibly expanded. In addition, the Federal Reserve should remain accommodative – rates on conforming mortgages have dipped back to 4.75% – in an effort to provide affordable rates for those looking to buy a home or refinance an existing mortgage. The extension of the tax credit coupled with conforming rates below 5% bodes well for homes at the entry level, which should help to absorb both foreclosed properties and inventory from builders focused on starter homes. While we don’t want to spend too much time on real estate, it’s worth mentioning that commercial real estate is likely the next shoe to drop. It is anyone’s guess how long it will take, but one thing is absolutely clear: many deals from the 2005-2007 vintages were underwritten with assumptions that have completely collapsed in the current environment. Much like the situation at the time for residential real estate, commercial buyers had access to cheap money from lenders who were tripping over one another to offer money at unbelievably easy terms. Now, three to five years later, vacancies are up, rents are down and cap rates are back to reasonable levels making refinancing near impossible. Somewhat related is the problem unfolding in the high-end hotel arena where delinquencies and defaults are starting to surface. Not surprisingly, a lot of the problem loans are on relatively new properties that were underwritten at terms that allowed for little to no margin for error. Aside from the ongoing issues in the labor and real estate markets, another area we are monitoring is consumer credit, which has been contracting at a dramatic rate since early this summer. How much further consumer credit will contract is debatable; however, there is no disputing the positive impact the availability of credit has on consumer spending and economic growth.
One issue that has not been discussed much is the unintended consequences of the government’s massive efforts to revive the economy, specifically inflation. While we have written in the past that we believe low factory utilization rates and the absence of upward pressure on wages will likely keep inflation at bay for the foreseeable future, long-term we are concerned that the extremely high levels of deficit spending could be inflationary. This concern is certainly one of the reasons commodities and gold have had such a strong move of late. Although we are not fully convinced inflation will be a problem, it does play into our investment strategy. For example, with respect to fixed income securities we have avoided Treasuries as we believe they are severely overvalued, and we have limited our investment in corporate debt to shorter maturities. After the huge run-up, the broad equity markets at current levels are arguably fairly priced, and attractively priced individual companies are certainly not as plentiful; however, we are still finding value. We view the current environment as an opportunity to reduce risk – trimming or completely liquidating positions that have done extremely well and are beginning to look stretched on a valuation basis – by shifting client monies into solid companies that have yet to fully participate in the rally as well as preferred shares of financial companies, which are attractive on a risk/reward basis. On a separate note, we have recently launched a couple of new strategies. The first is a pure fixed income product, which attempts to identify missed-priced credits in the investment grade and near investment grade arena. This strategy seeks to preserve capital and generate income. The second is a focused equity product with 12 to 15 positions in the portfolio, which we have been incubating for nearly five years. If you have an interest in learning more about these strategies, please do not hesitate to call us. Market Commentary 3rd Quarter 2011Market Commentary 2nd Quarter 2011Market Commentary 1st Quarter 2011Market Commentary 4th Quarter 2010 |
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