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Market Commentary — 4th Quarter 2009After an extremely rocky and uncertain beginning to the year the equity markets bounced back strongly in 2009, going nearly straight up since the low point on March 9th. Since that time investor confidence has slowly returned to the markets, and equity prices have steadily surged with the broad-based S&P 500 registering gains in 9 of the last 10 months of the year. Since the March lows, the Dow Jones Industrial Average gained 59.3%, while the S&P 500 gained 64.8%. For the year, the Dow and S&P finished up 18.8% and 23.5% respectively. The dramatic gains were not limited to equities as evidenced by the snap back in most fixed-income indices. US Treasuries as an asset class were the outlier generally posting negative returns. While the upward move back to current levels in the equity markets is largely justified in our minds, going forward we believe a certain amount of caution is warranted. 2010 will likely not be as easy as 2009 as the broad based equity indices are simply no longer cheap. Moreover, numerous significant economic issues remain unresolved, namely stubbornly high unemployment and the ongoing deteriorating fundamentals in residential and commercial real estate. In addition, we are somewhat concerned with the rapidity in which the animal spirits that Keynes referred to have returned to the markets. The consensus view of extreme caution held less than a year ago has been replaced to a certain degree by complacency and many of the ongoing risks are simply being ignored. As we mentioned in our last letter, we believe the upward move, albeit dramatic, is merely a return toward equilibrium. During the extended period of panic that gripped the markets as the credit crisis unfolded – beginning in late 2008 through early 2009 – asset valuations were driven to unsustainably low levels as the equity and debt of numerous quality companies was liquidated almost indiscriminately, and solid investments were left for dead as many flocked to the safety of US Treasuries despite yields at close to zero. This is not to say there were not significant issues during this period or that the concerns voiced during that time were unwarranted. Clearly the crisis was severe as a number of major financial institutions did not survive, and the entire financial system was believed to be on the precipice necessitating unprecedented steps by the US government, Treasury and Federal Reserve to restore confidence and provide much-needed liquidity and capital. That having been said, the worst appears to have passed and confidence has started to return. Against this backdrop of stabilization in the banking sector, increased confidence, and paltry rates on risk-free assets, investors appeared increasingly willing to wade back into the proverbial water, wholesaling out of low-yielding Treasuries in an attempt to capture returns in both the equity and corporate debt markets. While the upward move back to current levels in the equity markets is largely justified in our minds, going forward we believe a certain amount of caution is warranted. 2010 will likely not be as easy as 2009 as the broad based equity indices are simply no longer cheap. Moreover, numerous significant economic issues remain unresolved, namely stubbornly high unemployment and the ongoing deteriorating fundamentals in residential and commercial real estate. In addition, we are somewhat concerned with the rapidity in which the animal spirits that Keynes referred to have returned to the markets. The consensus view of extreme caution held less than a year ago has been replaced to a certain degree by complacency and many of the ongoing risks are simply being ignored. This is not to say we are bearish on the markets – we are not – we are simply pointing out that the risk-taking behaviors that were commonplace a few years ago appear to be seeping back into the markets as evidenced by the fund flows into commodities and emerging markets. Looking at the macro picture there are a number of things we are keeping under a watchful eye. The banking sector, for example, is somewhat of a mixed bag. Many of the large banks have raised capital via the equity markets and used such capital to repay the TARP funds. As such, the banks are generally speaking in a much healthier position than they were 12-18 months ago; however, delinquency trends on the major consumer loan asset classes (e.g., credit cards and first mortgages) have yet to materially improve, largely due to difficulties related to unemployment. Moreover, banks have arguably become too stringent in their underwriting standards, restricting the much-needed flow of credit. Beyond this, the unintended consequences of the quick decisions made by the Federal Reserve and Treasury during the tumultuous period of late 2007 – and there were many – is that the concentration of assets at the largest banks actually increased significantly, making the “too big to fail” problem even bigger. Equally concerning is the trading activities of many investments banks, which, judging by recent results, suggests they may be back to their old ways in terms of taking on risk. While we are hardly ones to advocate more regulation, a regulatory structure that allowed banks to take on risk to such a point where the entire financial system was brought to the brink of collapse is one that is clearly in need of repair. Unfortunately very little has been done to address the situation (e.g., no reform on the rating agencies), and likely a huge opportunity has been lost. The lack of leadership with regard to the areas in need of reform should come as no surprise; by way of example we have a Chairman of the Federal Reserve who still can’t seem to admit that ultra-low interest rates contributed to the housing bubble. Speaking of housing, in an effort to stimulate the market the Federal Housing Administration (FHA) has engaged in many of the same poor underwriting standards that led to the current mess. FHA will allow borrowers with as little as 3.5% down to obtain a loan. Not surprisingly FHA’s market share of conforming loans has soared, going from less than 3% in 2006 to nearly 23% as of the second quarter of 2009. Such loans are showing relatively poor performance and the agency’s capital reserves are running low. There has been talk of increasing the down payment requirements; however, to date nothing has happened. The picture from a macro perspective in residential real estate is still pretty dismal. Delinquency and foreclosures continue to rise. Moreover, such issues are increasingly associated with prime mortgages. Clearly a lot of this is the result of job losses; however, some of this is what can be termed strategic defaults, which are situations where borrowers could continue to pay their monthly mortgages, but have elected not to because they are so severely underwater with respect to equity. In that vein, the mortgage modification programs that were introduced with much fanfare early last year to stabilize the housing markets and assist worthy but troubled borrowers have simply failed. Although demand from China has in large part fueled the global recovery, it is somewhat concerning that so much of the recovery has become hinged to an economy with such opacity. Furthermore, the effect of Chinese infrastructure demands coupled with the dynamics in the US economy of a falling dollar, budget deficits, and near zero Fed Funds rates may be sowing the seeds for speculation in commodities – much like what crude oil experienced in the run up to $150 a barrel in the spring of 2008. Looking out into this year, we no doubt have some concerns. That having been said, while the opportunities are clearly not as plentiful as what we experienced in the spring of last year, we are still finding some investment ideas in companies with strong balance sheets and solid cash flows trading at attractive levels and will prudently put capital to work. Additionally, Treasuries, which looked rich to us coming into last year, still look rich despite registering negative returns last year. Accordingly, we are looking at opportunities to profit from an eventual rise in rates. Market Commentary 3rd Quarter 2011Market Commentary 2nd Quarter 2011Market Commentary 1st Quarter 2011Market Commentary 4th Quarter 2010 |
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