2011 Third Quarter

Posted by David Tillson 2011 Third Quarter

As we exit the third quarter of 2011, the stock market is within a percentage point or two of officially being in a bear market. Like it or not, Mr. Market is doing what he has always done – allowing people who risk their own money to let their voices be heard and to vote with their feet. People clearly remember the 2008- 09 meltdown and are projecting that scenario into our current times. Maybe they are right, but history would suggest not. As we have said many times before, it is not what you know that gets you in trouble, it is what you do not know, or as Mark Twain said, “It’s what you know for certain that just ain’t true.” The things that people “know” today probably will not turn out to be completely accurate. Four years ago investors either did not see what was coming or more probably, did not ever imagine that financial markets would suffer as much as they did. There was a true under-appreciation of risk and an over-reliance on the belief that higher risk equals higher return. People’s ability to forecast based on what they know is tenuous at best, and we expect that this period’s mismatch is likely to err on the side of not being as bad as expected. 

The world is still a dangerous place. The problems are many and they are serious. We do not underestimate their impact on the stock market if they are not dealt with prudently. Fear has been propelling both stock and bond prices recently as investors have taken the 2010’s “risk on/risk off” trade to a new level. Fears of a US government shutdown were quickly replaced by the Eurozone debt crisis. Investors typically sell stocks and buy bonds when fear rises. However, since too much debt is at the root of today’s problems, we believe that this behavior, while predictable, is also short sighted. Corporations for the most part are in very good financial shape and consumers have pared their debt to realistically prudent levels, but excessive debt still exists in areas of the housing market and with many government entities, including federal, state and local governments in the US and many foreign countries. Interest rates are now so close to zero that the next material move in rates must be up. Although such a rise is not imminent, when it eventually occurs, it will put tremendous pressure on already strained government budgets. 

A further fear for the markets to digest is the possibility of recession. Many economists and market strategists believe that there is nearly a 50% chance that the US will enter a recession soon. Timing of a recession is uncertain, but the fact that we will have one sometime is certain and investors should not be overly fearful of one. The problem today is that investors can really only remember the two that have occurred in the last 20 years – 2001 and 2007-09, and they were humdingers. As can be seen in the chart, the US has experienced 22 recessions in the past 110 years. For the first 90 years, they occurred roughly every four years. The last three recessions have been spaced about eight years apart, which has probably had the effect of making them more severe than if they had occurred with shorter intervals. A further comforting fact (or not, depending on your point of view), is that the US has been in contraction 25% of the time and expansion 75% during the past 110 years.

Recessions, while unpleasant, are commonplace and should be acknowledged as such. If we are about to enter a recession, or if the National Bureau of Economic Research decides that the US is already in one, we do not believe that it will be deep or long lasting. Recessions are like childhood diseases; they strengthen our systems as long as they don’t kill us. They remind everyone that life is cyclical, that good and bad times don’t last forever, and that taking on too much risk has consequences. Recessions are often preceded by bear markets, and as we mentioned earlier, the stock market is close to bear market territory now. So, recession or not, equity investors may have already felt most of the pain. 

We have often spoken of and written about our trust in historical trends. “The more things change, the more they stay the same” has great validity and the past can help guide us through bad times, as well as good times. For the past 30 years, the world has operated in an environment of ever declining interest rates and ever increasing debt loads. Overspending in-the-moment and overpromising future benefits has finally caught up with many consumers and with most developed country governments. As economies shift from consuming to saving, the impact on GDP growth has been severe. Further impacting GDP are governments’ needs to raise revenues at a time of slow/no growth in order to pay for what they have promised. Many of these promises made in the past were not presented truthfully enough so that taxpayers were fully aware of their future obligations. While the US is in much better shape than the Eurozone, the trajectory of both economies is similar. In the near term, more government spending will be needed to prevent panic. Longer term, debt levels must be reduced since once interest rates start to rise, debt service obligations will likely take up too high a portion of budgets. 

What will get us out of current conditions? While the exact road back to prosperity is not clear, we believe it should include a recognition that the developed countries have too much debt. The political discussion has so far revolved around too much spending versus too much debt. In our opinion, this misses the point that investors made bad investment decisions and they now want someone to bail them out. Democrats want to raise taxes on the rich to pay for entitlement programs and Republicans want to keep taxes where they are to spur economic growth. Meanwhile, underwater homeowners and undercapitalized European banks are left in limbo. It is well recognized that Greece will effectively default; otherwise their 1-year debt would not be trading at a 90% interest rate. It is equally well recognized that the housing market needs to address loan value rather than monthly payments. Simply refinancing a mortgage that is much greater than the value of the home does not solve the problem. Only when loans that will never be repaid at 100 cents on the dollar are finally cleared at a rational price, will the markets (financial and housing) begin to operate normally, albeit under a new normal. Recognizing losses and moving on is what banks have always done, and now holders of mortgage backed securities and sovereign debt should do the same. Wealth will be destroyed and some people will benefit unfairly. But, if this reset is done successfully, the world economies will stabilize setting the stage for future growth. 

Finally, what the US needs is confidence and certainty. Decisions are made based on assumptions about the future and given the rancor in Washington, it is little wonder that few decisions are being made. European demonstrations have now moved to the US with the Occupy Wall Street movement. No one seems to know what the demands are, but the fact that it is happening is a measure of the frustration people feel. Some say that it is a reaction or counterforce to the Tea Party. Or it may be the people’s version of the government’s bailout of banks – instead of TARP, it is PART (Program for the Relief of Angry Taxpayers). Like the last decade, the 1970’s were also a time of war, political unrest, recessions and no growth in equity markets. In 1969 President Nixon in a speech said “And so tonight – to you, the great silent majority of my fellow Americans – I ask for your support.” It is time for today’s silent majority to work to restore confidence in America’s future and set us on a path to prosperity based on values that are neither ideologically left or right. Our future is challenged, but it is a far better time to invest when investors are aware of the risks rather than when they are complacent.