2010Feb21 Week In Review

This past week we reduced cash balances with commitments to dividend paying domestic equities that have been defensive during the recent sell-off.

 

Over 79% of S&P 500 companies have reported earnings for Q4 2009. By focusing on 12-month earnings for the S&P500, we can gain some long-term perspective into the current business environment. Earnings declined over 92% from the Q3 2007 peak to the Q1 2009 low. With data back to 1936, that was the largest decline on record. Since its 2009 low, S&P 500 earnings have surged (up over 600%) and are currently at levels that have only been exceeded during the latter years of the dot-com and credit bubbles.

 

The earnings surge confirms what we have previously reported from the Morgan Stanley Business Conditions Index (MSBCI). At least publicly traded businesses are doing better and becoming more optimistic about the year ahead. This provides some foundational support to U.S. equities staying in our Dynamic Asset Allocation while International equities remain out of favor due to sovereign credit problems and a strengthening US dollar.

 

While hiring has been increasing, it is far from shrinking the unemployment roles. Last quarter, the Labor Department reported there were six applicants for every available job. Nationally, the number of available jobs has decreased substantially with many never to return. The skill set of the unemployed does not necessarily match the demand. It is our opinion that high unemployment will be persistent due to permanent down sizing and skill set mismatch.

 

During the recent east coast snow storms, the Federal government had non-essential employees stay home. Among the 240,000 non-essential employees (can you explain why they are on the payroll?) was the Federal Emergency Management Agency! Imagine that!

 

Last year California’s excessive spending was news. Michigan and Illinois are financial basket cases. Similar problems face New Jersey’s new governor who has committed to cut spending since higher taxes have resulted in a migration of wealth out of the state. States are just the tip of an ice berg (that has survived global warming). Cities and other municipalities are facing Chapter 9 bankruptcies as they must inevitably renegotiate both debt and labor contracts. Public employees will be the next addition to unemployment roles. Civil service employment has been artificially supported by Democrat stimulus plans. Any modest improvement in the private sector will likely be offset by inevitable terminations in the public sector.

 

Tax free bonds – long a safe haven for conservative investors – are increasingly at risk of default. Credit worthiness is always an issue with bonds and related instruments. The entity that issues the bond really is important. Throughout our lifetime, the United States Treasury instrument has been the world’s safe haven. However, the Chinese have recently unloaded a goodly portion of their investments in US debt obligations. The Japanese bought the debt from the Chinese replacing China as our largest creditor. China is now number two.

 

Rumor has it that the Chinese are worried about our profligate spending habits. The US could become a “third world credit” facing problems now evident in Greece and other European countries. All of us should be worried about our government’s ability to repay debt. David M. Walker, former US Comptroller warns that “We face a $60 plus trillion dollar financial sinkhole that is growing rapidly.”

 

Undaunted, President Obama committed Congress this week to borrowing another $1.5 billion to assist five states with massive home foreclosures. That is $1.5 billion we do not have. His plan is to give it (in his words) to "too many borrowers [who] acted irresponsibly by taking on mortgages they couldn't afford." Giving them our tax dollars will apparently solve the irresponsibility issue and increase our confidence in Congressional management of the economy.

 

There is never a shortage of items to worry about. The Fed raised the discount rate this week. Was it a test to see what reactions would arise? Well, international markets were in turmoil with the announcement, though our markets all but ignored it. The only firms affected by the discount rate are banks with such severe problems that other banks will not extend credit to them. The discount window is the last resort. If a bank shows up there, the Fed will be at the door the following morning. In this economy, using the Fed’s discount window would virtually be a request to be shut down.

 

The next test will be when the Fed actually raises the Fed Funds rate which remains targeted at 0% to 0.25% or when the Fed begins withdrawing liquidity from the market. Anticipating the Fed’s next step, bond investors have been edging interest rates upward keeping bond values at bay.

 

Of the six major asset classes we review, bonds, cash, currencies, commodities, U.S. and international equities, we do not know in advance which will become the next area favored by global investors. Currently, cash and U.S. equities are the two strongest asset classes in our Dynamic Asset Allocation. The weakening in U.S. equities eased this week. As stated in the beginning, we committed portfolio reserves and will do more if trends are supportive.