First Quarter Report
Thursday, April 10th, 2008 Major market averages worldwide suffered a painful first quarter. The selloff was remarkably broad-based, cutting internationally across markets, market capitalizations, and investment styles, and sparing few market segments. The S&P 500 index lost 9.9% for the quarter, and each of its ten market sectors registered a negative return. From its recent highs in mid-October 2007 to the end of March, the S&P has shed some 15% of its value.
Given the velocity of the market's decline, and general volatility, both up and down, shell-shocked investors may be wondering what has hit them. Better Living Through BorrowingIn today's often overwrought media culture, "crisis" is a clichıd term. A true crisis, however, long in the forming, has set upon the stock and bond markets, and the economy writ large, from the bugaboo of debt. Put simply, there is too much debt that permeates the financial system, and too much of that paper is in danger of insolvency. The debt takes many forms, but is derived in large part from the consumer sector, namely mortgages, home equity lines, and credit card debt. (Public debt, at all levels of government, is another major systemic plague, but beyond the scope of this discussion.) Our debt bulge has been long in the making. For literally a generation, from the early 1980s, Americans have financed their consumption on a growing amount of debt. The underlying reasons are many, and include societal and demographic factors, but perhaps foremost is the steady fall in interest rates in the aftermath of the punishing 1981-82 recession, which slay the inflation beast of the prior decade. Investors and spenders alike had greater confidence in their outlook for inflation, which remained under increasing control throughout the subsequent two decades. With fits and starts, market investors bid down the cost of money, i.e. interest rates. Consumers responded in kind, first with increased utilization of credit cards and, later, home equity lines. Debt levels steadily grew, as our consumerist culture took deeper root, and outpaced the organic growth of unlevered incomes. Former luxuries passed now for necessities. An entirely non-exhaustive list would include the larger homes, more cars, more (or more exotic) vacations, and electronic gadgets that Americans enthusiastically bought in the era. "Debt apologists" contended through this run-up that offsetting asset growth, first in the stock market, later in residential real estate, supported and justified the expansion of consumer borrowing. And to be sure, the economy of the 80s and 90s was largely a good one. Tax cuts and low interest rates together stimulated economic growth. Business slowdowns were brief, and the stock market crash of 1987 was erased in fifteen months. The blow-off top to consumer indebtedness, ironically, resulted from a stock market crash. In a bid to save the economy from collapse following the bursting of the stock market bubble, the Fed slashed short interest rates, ultimately to a low of 1% in 2003. Investors disillusioned from stock market losses found a new haven, real estate, offering scintillating returns on the back of cheap and easy credit, with little money down. Low interest rates allowed for ample borrowing, and heady home price appreciation, fueling a seeming unending upward spiral of higher home values. In the best of times, homeowners could "cash out" their equity from price appreciation, spend the proceeds on consumption (think the aforementioned vacations, or electronics, or cars), while refinancing their loan at a lower monthly payment; heaven on earth, as it were. The Great Credit UnwindAll bubbles must end. In the case of the housing and mortgage bubble, the end lay, inevitably, in the extension of credit to the undeserving. Easier and easier terms, extended to riskier borrowers, all to keep the credit combine, and Wall Street fee machine, churning, led to bad loans. Bad loans were bundled into bad bonds, and sold throughout the global financial system. Today, mighty global firms have been humbled. UBS, Citigroup, and Merrill Lynch have written off billions in bum debt. The country's fifth-largest investment bank, Bear Stearns, was forced into effective receivership by the Treasury, via a shotgun wedding into the arms of JP Morgan, effectively crushing the equity of Bear while preserving the credit side of its balance sheet, and its trillions (notional value) of derivative contracts undergirding the world's financial apparatus. Today, the US financial system, and by extension the global financial system, lie in crisis; there is too much bad paper (debt, of all sorts), too many interwoven promises (derivative securities), fear, and insufficient systemic liquidity. In the end, the game is one of confidence, and confidence is sorely lacking at present. The Fed has cut rates aggressively, to a current 2.25%, and has introduced other policy measures, to provide liquidity to stressed markets. At this writing, the Fed's efforts appear to be helping. However, myriad bad debts derived from mortgages remain dispersed within the financial system. Our best guess is that, with respect to the present credit crisis, if we are not at the beginning of the end, at least we are at the end of the beginning. The passing of time, and the continuing provision of cheap money by the Fed, will gradually assuage the debt problem. Balance sheets at banks and brokers, and among consumers, will slowly heal. The financial industry will de-lever (borrow less), tighten lending standards, and grow more slowly. In a mirror image, the consumer will do likewise, paying down debt, saving more, spending less. The government will strengthen regulatory oversight. In all likelihood, combined, especially, with the steady graying of the population, and its lessened consumption profile, the domestic economy will be on a slower growth footing. Consumer credit provided a steroidal boost to domestic growth over the last many years. Its slow tightening will, likewise, detract from growth as credit levels get unwound. Strategic's Investment OutlookAt the risk of understatement, the current investment stage is tricky. At Strategic, we had taken to viewing the economy differentially, in terms of the financial economy and the non-financial economy. The financial economy - banks, brokers, credit, and perhaps most important, investor confidence - has been under severe stress since debt problems first surfaced in mid-2007. Until recently, the non-financial economy was in much better shape, helped by continuing global expansion. It appears, however, that trends in the two economies are converging, and pointing toward recessionary conditions, at least domestically. The economic risks, at present, lie to the downside. Signs of a broad slowdown are plainly apparent, led by a pressured consumer. The nation's housing economy continues in a deep recession, prices continue to fall, and increasing numbers of homeowners are unable to afford their homes. Steep fuel and food prices are pressuring as well, increasing our conviction in a consumer-led slowdown. We continue to monitor employment levels, which have weakened in recent months, though not precipitously. A sharp falloff in the jobs market will effectively seal the fate of the current business cycle; we will contract economically, for an unknowable duration and depth. Market risk, paradoxically, may lie to the upside, for a host of reasons. The present business slowdown has probably been the most anticipated, talked about, and written about in history; a mild slowdown is surely "priced in" to equities at present, leaving surprise to the upside. Market valuations are not unreasonable, and there is ample liquidity ready to reenter stocks: $3.5 trillion of investor cash is presently parked in money market funds. Historically, the market had led the economy; the stock market swoon that began in last fall presaged current economic conditions and, likewise, the market should head higher before it is apparent that the economy has left its current funk. The steepest trajectory of growth remains overseas, especially in the developing regions of Asia, Latin America, the Mideast and Africa. An ongoing industrial revolution, and companion consumer revolution, continue, the result of bilateral global trade flows, and sundry reforms within these several economies. We seek continuing exposure, direct and indirect, to these geographies. Equity Investment StrategyWe made mild adjustments to our Quality Core strategy in the quarter. Among our actions, we boosted holdings in select health care stocks whose prospects we favor. Balancing these moves with increased exposure to economically sensitive themes, we purchased an industrial company and an IT networking company. We sold a domestic transport holding, and further trimmed our financial exposure with additional sales in that sector. Consistent with our macroeconomic view, we have below-average exposure to financial and consumer-levered equities. On the quarter, we were net sellers, and presently hold above-average cash levels in the strategy. Actions in our Equity Income strategy were several. Among notable moves, we boosted technology holdings with purchases in two semiconductor companies, and established positions in consumer staples and heath care companies, for defensive growth exposure. Additionally, we made an initial purchase of an industrial company with exposure to electrical grid products. Our belief is that a "grid deficit" in both the developed and developing world will capture the interest of investors later this year or next. We were pleased with the results had from both equity strategies during the quarter. Fixed Income StrategyCredit markets have endured historically stressed conditions for several months running, marked by illiquid trading conditions and broad mistrust of most debt securities other than US Treasury bonds. The bond insurance that once "wrapped" municipal securities has come largely undone, with the current problems plaguing such underwriters as MBIA and Ambac. For a time in March, trading chatter, since debunked, even talked up the prospect of the Treasury walking away from its implicit guarantee of government agency debt. As noted in our last quarter's note, the current fixed income investing climate remains grounded in fear. We have remained buyers of agency and corporate bonds and, for suitable accounts, municipal bonds, with the relative spreads of all at attractive levels given market conditions. Broadly speaking, we are shying from new purchases of corporate debt from financial companies. We are maintaining short maturities with new purchases, as levels of interest rates, and the prospect for them to rise on an eventual inflation scare, are not enticing in the absolute. As a continuing reminder, we limit our purchases of corporate bonds to those rated "A" or better, and we have avoided mortgage-related debt among individual bond holdings, with no plans to change this stance. Riskless US Treasury bonds are very dear at current levels, reflecting investor fear and buy-at-any-cost prices. The 2-year Treasury is currently priced to yield 1.73%, and the 10-year Treasury 3.47%. We do not consider these attractive yields in the least. Scott C. McCartney, CFA President and Chief Investment Officer Strategic Investment Advisors, Inc. Download This Market Report |
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