Investment Perspective – Market Commentary

August 5, 2009

Over the past 24 months, we’ve seen dramatic developments in the economy and the financial markets. The first hint of trouble occurred in late 2007 when Bear Stearns, the now defunct investment bank, admitted that two of their hedge funds concentrated in subprime loan securities were worthless. Since then the biggest banks in the world have revealed extensive losses from terrible decision-making and have been the recipients of an enormous government bailout.

Almost a year ago when the bailout was being voted upon (first voted down and then approved), financial markets that had been slowly weakening fell apart and the economy rapidly came to a halt. Stock markets worldwide fell 20% in October, 2007 alone, the worst month within the 45% freefall which reached a bottom in early March of this year. Since that October, high unemployment emerged, Barack Obama was elected President, huge fiscal stimulus programs were enacted globally, the Fed kept interest rates low, GM declared and then emerged from bankruptcy, healthcare reform was raised and then called into question, and hope-for bipartisanship in our government is now a fading prospect.


Since early March, however, the stock markets have recovered quite well. There are hopeful signs from the economy and corporate earnings to suggest that we’re turning a corner. The economy isn’t improving yet but as I heard someone say recently, before it gets better it has to stop getting worse so fast J. And so the rate of newly unemployed is declining, the housing markets may be bottoming and the stock market is attempting to predict a recovery late in the year. Still there is reason to be skeptical due to the ranks of the unemployed continuing to increase albeit at a slower rate, home foreclosure rates increasing, worries about government budget deficits and whether our banks truly are as sound now as many wish to believe.
 

How have we invested during these markets?

 

Soon after news broke that the Bear Stearns subprime funds were worthless, we sold all individual bank stocks in our portfolios. This paid off very well through 2008 having little exposure to financial stocks. Once the markets and the economy began to melt down, we engaged in unprecedented sales between the end of September and mid-October, saving portfolios half of the worst month’s losses and those occurring in November and December. This ended up being the only successful stock investment strategy late last year, to simply be out of or underinvested in the market.

Beginning in January, we began to methodically buy back into the market from dramatically reduced stock allocations. January and February were difficult months for the market but those investments have begun to pay off. The investment themes that we’ve acted upon are as follows:

    • Obama Investments – after a slow start to his administration, President Obama articulated his agenda in his 5-year budget projection and incorporated it into his stimulus plan: infrastructure, healthcare, education and green jobs. Prominent stocks in portfolios following these themes are ABB (Swiss “GE” – infrastructure), Cerner (medical records technology) and Teva (generic drugs) for healthcare, and Eaton (truck engines and office power systems) is the consummate green company for the long run.

    • Technology – this industry has led the recovery and Microsoft has been a big player

    • “New Consumer” – we will likely be more frugal as a nation for some time now and companies that cater to the “new consumers” should do well: McDonald’s, Campbell’s Soup, Walmart, Family Dollar and Verizon (due to on-demand movies)

    • High Dividends – some of the first stocks we purchased in rebuilding portfolios due to great companies becoming high-dividend payers overnight, these are good defensive investments during recessions. In particular, natural gas pipeline stocks (KinderMorgan, Oneok) pay very high dividends and have business models with stable revenues not impacted by the swings in natural gas prices.

       

      What can we expect going forward and how should we position investments?


      I think we’re beginning the recovery but that it will be hard to characterize. In many ways it will be a slow recovery, a jobless recovery where many extra dollars will be used to pay down debt rather than buy goods which is what fuels typical recoveries. On the other hand, the depths of the economic slide are just now being realized and the progress we’ve made thus far is being noticed as well. It is quite possible that the economy we have later this year will be thought of as the “Obama economic miracle” – that a disaster that was inherited is turning around and that stimulus measures are finally taking hold.

      There are still big risks ahead. We’re all witnesses to a struggling commercial real estate market and this could be another blow to banks who likely will have to realize further losses as commercial loans come due. The health of banks in itself is hard to assess as recent earnings are the result of government zero-interest loans. Unemployment has rocketed upwards faster than expected and we may reach the important 10% mark soon – as with many elements of this recession however where all has happened so quickly, it’s possible corporations laid workers off so fast that most of the unemployment we’ll see has already occurred. Foreclosure rates are still climbing putting a damper on housing.

      Economic growth in this and the next quarter may increase. Businesses reported earnings for the 2nd quarter that exceeded expectations, mostly due to cost cutting – read “job cuts.” At the same time, inventories are very low. Think of supermarkets with not a lot of products on the shelves and customers that don’t have the job security they used to have. On the one hand, businesses will be placing orders and buying input goods to “stock their shelves” – that will mean economic activity. But if the consumer isn’t wealthy enough to buy the end goods, it’s not clear what that means to the lasting health of the economy.

      We intend to continue to invest in industries that will do well with Obama’s agenda. Looking further out, investments will be made to capitalize on the weaker dollar (international), economic recovery and emerging markets (US multinationals) and inflation (commodities). We will continue to buy on the dips in the market and hope that the stimulus package takes effect mindful of the risks we outlined above.

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