Monthly Archives: April 2009

Not About the Swine Flu!

Whew! You can really tell when a story hits the media at a time when nothing else important is going on. With words like “pandemic” and “crisis” being thrown around like cowboys at a rodeo, it’s hard not to panic a little bit. If there is any good news in all of this, it seems that this flu strain is responsive to treatment by existing medicine, which seems to be available in ample supply. We hope for the best for all involved.
What I really wanted to talk about today is the housing market. Remember that problem? Every once and a while, we will hear something about how many homeowners are “upside down” (have mortgages bigger than the value of their house), how many homeowners or behind on their payments or how many foreclosures there were last month, but generally the news flow about the housing market has been rather light lately. When swine flu, automaker bankruptcies and/or banking industries do not dominate the airwaves, we might reasonably expect the media to recycle the apparent bad news about the housing market.

Recall that the baseline problems which led to the current recession and bear market were housing related. Recall that many experts consider the bursting of the housing bubble a key factor in all the economy’s current struggles. Recall that the US government is trying to lower mortgage rates in an attempt to help homeowners keep their houses. Amid of all this, it’s easy to ask “When Will Housing Recover?”
Well, in the latest issue of the Financial Analysts Journal, two finance professors, Eli Beracha and Mark Hirschey, attempt to answer that very question. They point out that in the 25-year period from 1982 to 2007 the annual rate of house price appreciation in the U.S. was 1.65% per year, and that over this period nominal house price never fell. This makes the experience in 2008, where nominal prices fell, so unusual – something not seen since the Great Depression. Yet, they emphasize, that despite stunning declines in several states (California, Nevada, Arizona, Florida and Virginia), the housing market remains moderately strong (or at least not horribly weak) through most of the country. The real trouble exists in those markets which had been the strongest.

This may sound pretty obvious to many of us, but it was a bit of good news to me – that the real estate problem was not the wide-spread “pandemic” we might think it is, just listening to the nightly news. After many pages of data and commentary, the authors were able to offer this conclusion – “…if typical per capita income growth continues for only 1.49 years [note the academic penchant for precision without accuracy! – ed.] with flat housing prices and continued low interest rates… the nationwide housing ‘crisis’ will be on the road to recovery by the second quarter of 2010.” In other words, they can see the housing market recover by the middle of next year, IF incomes rise and housing prices stabilize. Perhaps those two assumptions are overly optimistic, but they are based on reasonably assumptions spelled out in detail in the essay. IF this were true, we could expect the stock market to begin discounting this good news sometime later this year.

I am sometimes accused of being too optimistic. Well, if this is a fault, then label me “guilty.” My optimism is not congenital; is has been acquired through many years of analyzing great companies and seeing how much motivated, creative and hard work goes on behind the scenes. The economy is not one thing. It is not a monolith controlled by some all-knowing entity. Rather, it is the amalgamation of millions of actions by millions of people all trying to make products, provide services and make some money along the way. The fact that this is the driver of our economy makes me optimistic. Better news about the housing market will make me even more so.

The Susan Boyle Rally

By now I suspect that most of the world’s population which is connected to the Internet knows about Susan Boyle. She is the unassuming-looking, late-40s woman from Scotland who amazed the judges (and the world) in her audition for the television talent show “Britain’s Got Talent.” Within a week of being placed on YouTube, her rendition of “I Dreamed a Dream” has been seen and heard by over 12 million people. In an industry that so highly favors looks and image, it’s inspiring to many to see Susan Boyle receive so much praise and notice. As John Rash, an advertising columnist put it, “[her video] encapsulates the power of everyday people becoming overnight sensations.” Bravo, Susan, Bravo.

I think the stock market rally we’ve been experiencing since early March has much in common with Susan Boyle. At the beginning, there was much skepticism. Economic data was clearly drab and uninspiring. Most of the “experts” were not looking at the markets favorably. I suspect many of them expected the market to disappoint or even fall on its face.

Just as Susan’s clear and melodic tones stunned the judges, the market’s rise began to sway sentiment. As the rally progressed, grumpy skeptics, who before only saw gloom and doom, began to see “glimmers” of favorable economic activity. With the market now over 20% above the March low, many more investors are seriously discussing the market’s potential? Is this the big turn? Can it be sustained? Can this market become a “big star?”

We hope the best for Susan Boyle and her budding singing career. We can’t predict whether or not she’ll be a big success, but we hope she will be. Similarly, we hope the current rally will be sustainable and even become the next bull market, but we can’t really predict this. Yet, we are encouraged by the market’s tone and responsiveness to new information (bad or good).

In our view, the fundamentals that matter to the capital markets are always a mix of positives and negatives. The direction of the market is not so much determined by the difference between these two extremes, but rather by which part of the spectrum captures investors’ attention.

Here is a partial list of positive fundamental factors as we see them now:

• High Cash Levels. We see $9 trillion in money market accounts. These funds had been in stocks and bonds and now just sit there waiting for the “all clear” signal to get back in.
• Sentiment. High bearish sentiment (we saw historically high levels in early March) often accompanies the bottom of the market.
• Interest Rates. The Federal Reserve is determined to keep short rates low (which helps a large number of borrowers) and has also begun a tactic aimed at lowering longer-term rates, especially mortgage rates. This could stabilize the housing industry and via refinancing, put more cash into households.
• Lower Energy Prices. The dramatic decline in energy prices from last summer is another stimulus to the American household budget.
• Government Action. The new administration is determined to do as much as it possibly can to jump start the economy and return confidence to the system.

Despite the above, we continue to see significant negatives which may impact the establishment of a new bull market:

• Unemployment. As layoffs continue, many may worry about the impact this has on consumer sentiment, spending and saving. The fact that employment is a lagging indicator may not matter to the average citizen watching the nightly news.
• Earnings. First quarter results have just started to trickle out and despite good news from Wells Fargo, it’s hard to imagine that all companies will report better-than-expected earnings in a quarter where GDP is expected to fall 6%.
• “Expert” Opinions. The handful of economists and academics credited with “predicting” this recession are mostly staying with their pessimistic forecasts. Unless they are particularly nimble (and different from past prophets of doom), they will miss the upside of a new bull market. Yet, the combination of their new-found fame and continued gloomy opinions may sway investor sentiment and stifle the rally.
• Bailouts. Major U.S. industries (banks, real estate, insurance, banking, etc.) may yet require a great deal of government assistance and/or dramatic changes before the “all clear” signal can be sounded. Regardless of the skill of the decision makers involved, these industries’ status is highly uncertain and fraught with risk.
• The Other Shoe. In the back of everyone’s mind seems to lurk the fear that something else, unexpected and dire, is just around the corner, and could bring us right back to the pain and losses seen last year. This fear is particularly worrisome because it’s impossible to prove the absence of something. To the extent that this fear inhibits action, it could dampen the recovery.

Over the last few weeks, the market has clearly been focused on the ““glimmers of hope” and not the “worst economy in 50 years.” Will this continue? Hard to say. I think the time to be defensive is long past. In my view, cash is the most expensive and “risky” asset, especially for those investors with longer time horizons and important financial goals yet unmet. Time will tell.

Happy Birthday Mr. Jefferson

Thomas Jefferson was born on this day 266 years ago. The power of his words still reverberate throughout the nation.

“We, too, shall encounter follies; but if great, they will be short, if long, they will be light; and the vigor of our country will get the better of them.” –Thomas Jefferson to Thomas Digges, 1806

Fortune Cookie Investing

After a very satisfying meal at my favorite Asian fusion restaurant, I opened up my fortune cookie with the usual mix of hope and skepticism that dominates my life. Many years on Wall Street has taught me to be skeptical about most things. Being an optimist, so they say, is the key to a long, happy life. Maybe a fortune cookie could bring good luck. Maybe being a hopeful skeptic (oxymoron?), is a good way to cope with the ups and downs of the capital markets.

Despite my penchant for the scientific method and math proofs (I didn’t say I was normal!), I will also occasionally peek at my horoscope in the local newspaper. Generally, I place more weight on things measurable and discernable, but sometimes things just don’t work out like the formulas suggest. I am not suggesting that I ever I select stocks based on fortune cookies, the phase of the moon or tea leaves, but I am willing to consider all reasonable sources for inspiration, motivation and knowledge.

So, what did my fortune cookie say? Thus spake the ancient sage, “The problems of today will be buried by the sand of time.” Is this hopeful or fatalistic? My time in Japan taught me that fatalism is not necessarily negative or hopeless. Often it’s just a broader perspective on the issues at hand.

I think this simple saying contains a grain of important truth. Investors right now are questioning everything they’ve learned over the last few decades. The Wall Street Journal today suggests that many investors are abandoning the “buy and hold” strategy. Many are suggesting that the stock market may never again offer its historical rates of return. According to many, the massive rush into cash marks the end of an era; the stock market will never again attract the average individual investor.

To all this, I say “bah.” Buy and hold never works in a bear market. But it is arguably the best strategy for a bull market. Every time we enter a recession or a bear market, it always 1) feels unique, 2) feels worse the previous one, 3) feels like it will never end and 4) is marked by “experts” telling us that the old ways will never return. I have seen this pattern over and over again in my career.
I recall a research report from the early 1990s by a professional “expert” analyst who stated that the New England commercial real estate market was so over built that no new buildings would be needed for the next 37 years! Of course the late 1990s tech boom made that prediction totally wrong. I suspect that most of the predictions we are hearing now about the U.S. economy and stock market will likely be proven wrong within a few quarters.

What I do know is that there are still many very wonderful companies out there trying to compete and thrive in this challenging environment. The stock prices of many of these wonderful companies appear to be very cheap compared to where they could be in a more normal market and economy. I cannot predict with any accuracy when these stock prices will reflect my measure of intrinsic value, but I truly believe that the potential rewards are well worth the wait. The worse place to be right now is cash. The best place to be (if you have an investment horizon longer than a year or so) is in those stocks I feel are massively undervalued.

And, I don’t think we will have to wait all that long before the sands of time will bury our current batch of problems.