March 2010 Market Update

As I stated in my last missive, two main themes to watch in 2010 that affect our portfolios are:

  1. Withdrawal of the economic stimulus
  2. Financial reform; particularly derivative regulation.

Withdrawal of Economic Stimulus

The ability of the government to stop printing money and pumping it into the economy to replace what normally would come from bank loans is an important indicator of how strong the economy is on its own. So how has that gone now that we are nearing the end of the first quarter of the year?

Answer; instead of withdrawing stimulus money we are actually adding to it in the form of a $15 billion bill to give tax breaks and subsidies to businesses that hire new employees and $20 billion for highway construction.In other words, the government has little faith in the ability of the economy to survive without artificial support.

However, the Federal Reserve will cease buying loans from Freddie Mac and Fannie Mae at the end of March. This means the banking industry will have to support the housing industry on its own.This should be interesting.

The economy is currently 12 million jobs shy of full employment.It is likely to take 5 to 10 years to get back to the pre-recession ratio of employment to population. This is a signal that deflation will be the primary theme for some time to come.

Why? Loss of wages means there is less money for purchases which drives down the price of goods. This means your dollar is actually worth MORE. What is the best investment to be in during deflationary times? BONDS! The interest payments you receive and the eventual return of principal are worth more and more as the dollar increases in purchasing power. This and concerns about safety is why the masses continue to shift from stocks to bonds. Bond funds took in another whopping $9 billion the week before last (up from 4.1 billion the week prior) compared to $2 billion net inflow into stock funds.So, once again we are positioned as intelligently as possible.

“For all the concern about a federal budget deficit and the rising Treasury debt; U.S. bonds are the place to be in 2010 with returns topping equities and commodities” said Cordell Evings in the March 8th edition of Bloomberg.com.

Financial Reform

FINALLY! We are starting to get some momentum to take on the really serious business of financial reform.European leaders are ratcheting up the pressure for global regulation of derivatives amid the Greek fiscal crisis in which derivatives played a major role.

“Europe and America must say ‘enough is enough’ to those speculators who place value on immediate returns with utter disregard for the consequences on the larger economic system and threaten a new global financial crisis”, said Greek Prime Minister George Papandreou in a speech in Washington on March 9th.

The European Union’s top regulatory official said the bloc will consider banning “purely speculative” credit default swaps as German Chancellor Angela Merkel called for “a crackdown on derivative trading” to prevent a rerun of the Greek crisis.

In this country, Democratic Senator Dodd, Chairman of the Senate Banking Committee introduced a tough financial reform bill recently; however it is weak on regulating derivatives. Like the House bill, Dodd’s bill calls for trading derivatives over central exchanges as President Obama’s initial proposal recommended.The problem however is that the bill excludes the biggest players from having to comply!! Could this have anything to do with the enormous amounts of money being thrown at Congress by the banking industry to influence their votes?

This won’t be over soon but at least the issue is on the table.When entire countries (Greece, Italy and Spain) and regions (European Economic Community) are brought to their knees by derivative speculators, you would think our leaders would lead!

Next Shoe to Drop

Lastly, the value of residential real estate has proven to be a huge source of volatility over the last two years because so much is connected to home values. As you know, I am positioning your portfolio not only to protect your principal but also to shelter it from the extreme volatility that is built into our market system presently.

My sense is that most people are aware that the commercial real estate market is in trouble but have no idea how much its problems and their effects dwarf the residential crisis.

Let us look at a typical commercial real estate transaction.A real estate developer wants to build a small shopping center.The projected cost of the development with the land and buildings would be approximately $1,000,000.The bank will allow the developer to borrow 70% of the cost, in this example the developer would borrow $700,000 and put a down payment of $300,000.The developer begins making interest payments on the loan and starts the project and soon spends most of the $700,000.After about 4 or 5 years the developer needs to renew the loan to complete the project (commercial real estate loans only have a 4 or 5 year term, not like residential loans that lock in a fixed rate for 30 years).However, with the collapse of real estate values the property is now only worth $500,000.The bank will now only allow the developer to borrow $350,000 (70% of the cost) to complete the project.Since the developer still owes the $700,000 his total outstanding debt will be 1,050,000 on a property worth $500,000.

The current estimate of commercial loan values coming up for renewal in the next several years is $3.5 trillion. Remember, if these loans are not repaid or renewed trillions of dollars simply go up in smoke and are removed from the economy for good.

I came across this recently and felt it was a good aid to conceptualizing a trillion dollars:

1 million seconds = 12 days

1 billion seconds = 328 days

1 trillion seconds = 328 centuries

So what is the big picture?Are we in a recovery or are the doors still flying off the hinges as the crash continues?Because we are a member of an international economy we cannot answer that relative to the U. S. alone.While there is clearly no one correct answer there does appear to be a consensus in regard to a few things;

1. The worldwide government stimuli, despite widespread misunderstanding, did indeed save the world from financial collapse in 2008.The stimuli bought us time to figure out what happened and try to fix it.

2. As business staggers back toward profitability it will be an uphill battle to convince the consumer to keep spending instead of paying off the enormous overhang of debt we have accumulated in the western world.Growth will be choppy at best.

3. Significant sustainable growth will not occur until banks start lending money and again they won’t until they digest huge plates of toxic loans.

4. Even if we were at full employment and had no debt, or if you wanted to invest in emerging markets, the derivative markets still cast a very dark shadow over the stability of the stock and bond market.Hopefully that shadow may eventually lift.

Happy Spring and remember to call if you have any questions.

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