We have been guarded about the U.S. economy and financial markets for the past year, but over the past quarter we have seen a deterioration of fundamentals and an acceleration of this deterioration that has alarmed us.
Now we are seeing major stress in Europe, and a growing concern about growth around the world.
For these reasons, although market valuations declined substantially, we became even more cautious and raised substantial amounts of cash in client portfolios over the past quarter, with significantly reduced exposure to domestic and international equity markets.
We see more economic challenges to come in the coming months and quarters. We also see the potential for additional declines in the equity markets, a result of rapidly deteriorating fundamentals, increased systemic risks, and irrational fear.
For these reasons, we would rather err on the side of caution and seek capital preservation, tilting client portfolios towards areas of longer-term opportunity, taking advantage of any major dislocations to buy good assets on the cheap, but maintaining a large cash reserve.
The Surge, The Splurge, The Purge:
The global economies and financial markets are going through a major traumatic event, brought about by years of easy lending and easy spending, well above sustainable levels and without adequate pricing of risk. Much of this money went to inflate the lifestyle of the American consumer, who borrowed and spent the money on houses and other stuff he couldn’t really afford. Household debt has grown to a whopping 100% of GDP and the personal savings rate is near zero. A lot of the money also went to fuel a wave of mergers and acquisitions, especially those initiated by private equity firms who borrowed capital cheaply to finance a flurry of deals that in retrospect look subprime.
Now global financial institutions are in cardiac arrest, their arteries clogged with questionable debt, and their balance sheets overextended relative to tangible equity.
Time is of the essence. Confidence is as important as the cure. Consumers, businesses and investors need to have confidence in the banking system, as well as central bankers and political leaderships. Banks need to have confidence in other banks and central bankers, need to have confidence in one another.
The Chain of Cause and Effect:
Even under the best of circumstances, we see no way that the current problems won’t create additional stresses and challenges for an economy that is already going through a painful but necessary process of deleveraging.
If General Electric and Goldman Sachs - two of the premiere financial companies in the world - are forced to raise capital under fairly onerous terms from Berkshire Hathaway, one can only imagine how tough conditions are for everyone else.
Businesses, investors, and consumers alike are moving to a much more defensive posture, shoring up their balance sheets, cutting back on discretionary projects, and planning for a more challenging future.
We expect the employment situation to deteriorate significantly as healthy businesses scale back their plans, and unhealthy businesses are forced into more radical downsizing. Many overly leveraged companies, particularly those reliant on access to cheap capital and/or exposed to discretionary consumer spending will likely get sold off on the cheap, need to raise capital on highly dilutive terms to current shareholders, or just go away.
Deteriorating business conditions here and abroad will likely lead to more downward revisions to sales and earnings forecasts, as well as the multiple that the investors are willing to place on those forecasts. The future is murky and “murky” does not command a high multiple.
The future is indeed murky, but it is not hopeless. The process of deleveraging and cleaning up balance sheets is a slow, difficult but necessary process. Just how slow and how difficult, remains to be seen and will be a direct result of how effective government solutions are to deal with the many challenges.
We expect that additional government support will be needed to help restore stability to the credit markets, to help shore up state and municipal governments, and to stimulate the overall economy through additional spending programs.
When this is all over, banks, businesses and individuals will emerge on a much more solid footing. We do worry about the overall health and well-being of the U.S. balance sheet. The United States will likely need to inflate our way out of debt by devaluing the dollar. Our ability to finance two foreign wars, as well as a large military footprint around the world, and address our economic problems at home is unsustainable. As a country, we will need to rethink our priorities.
We are also seeing a major reshaping of the competitive landscape as brokerage firms merge with banks, banks merge with other banks, and the U.S. taxpayer takes significant if not complete ownership positions in companies it bails out.
Beware the Son of Sarbanes Oxley:
Finally, we should expect an environment of increased regulation, designed to “make sure that this will never happen again.” Get ready for the “Son of Sarbanes-Oxley,” a comprehensively cumbersome and confusing set of new laws aimed at regulating the barn now that the horses have all left and the barn has burned down. The likely upshot will be that nobody will ever want to become a banker again, and that no bank will ever want to make a loan to anyone who needs one. (We are exaggerating only slightly). This too will pass, but it will likely make credit even tighter and create a false sense of security while the next bubble starts somewhere else.
The United States may be in better shape than Europe, and the coming months will be a real test for the European Union and the Euro currency. Unlike the U.S. which has one currency backed by one dysfunctional government, Europe and the Euro have one currency backed by 15 dysfunctional member governments and 11 others, each with their own set of sovereign banking and political challenges. This will make it difficult to find common ground and common solutions at a time when clear, coordinated, and decisive leadership is needed.
There are also many countries in better shape than the United States and Europe. If we take the long view, we think that developing economies will continue to develop and attract investment capital. In general, these countries have large cash surpluses and improving balance sheets, in contrast to our own. They have also made major investments in education and infrastructure that create long-term competitive advantage. Over time, global capital will flow to where global GDP is growing.
It remains to be seen in the near-term, how much the problems in the United States and Europe will impact their organic growth. In addition, the developing economy trade, like the energy and commodity trade has been a crowded party for a long time. We will likely continue to see substantial money flows out of developing markets as the investment herd moves toward safer pastures, and until there is a better sense for how much growth these economies can generate internally.
As we mentioned at the outset, we are maintaining a substantial allocation to cash in client portfolios, in conjunction with a reduced allocation to domestic and international equities. This allocation has helped to buffer an otherwise difficult environment for all asset classes including stocks and bonds. Given the current uncertainty and deep anxiety in the markets, as well as our longer-term prognosis of difficult economic conditions to come, we think the prevailing focus for investors should be on capital preservation.
The following are a number of themes and ideas that are guiding our current asset allocation and longer-term strategy.
Cash is king:
Two years ago when cash-rich companies were criticized for not maximizing shareholder value, activists argued that they should buy back their own stock, pay out a dividend, or add more debt to their balance sheet. Today, the world looks different. Cash is king and a strong balance sheet is a competitive weapon. There are many companies today that now regret their share buy-backs. They would be much better positioned for today.
We favor companies that have large reserves of cash, produce recurring free cash flow, and can act as their own bank, or use their cash to make strategic acquisitions at a time that their competitors cannot.
From an investment standpoint, we also view cash as a strategic asset. Each day that the market declines, more values are created. We want to have cash to put to work without having to sell existing holdings.
The strong get much stronger:
In difficult periods, the strong get much stronger. Witness the improved competitive fortunes of J.P. Morgan, Goldman Sachs and Wells Fargo relative to many of their former competitors.
The weak get much weaker:
Conversely, the weak will get much weaker and some will go away. We would avoid highly leveraged, economically sensitive companies. The private equity boom of recent years saddled many once healthy businesses with untenable levels of debt that now leave them in critical condition.
Avoid the U.S. discretionary consumer economy:
The U.S. consumer economy is over-borrowed, overstored and overspent. Easy money has fueled an artificial sense of prosperity and demand over the past few years. Too many stores have been built upon this premise. This is a major trend that needs to unwind. If Starbucks is closing stores – and they sell an addictive product – the going will be rough for others, especially companies that have gone on a recent tear of new store expansion.
The U.S. government and taxpayer are becoming shareholders in major corporations and enterprises (Fannie Mae, Freddie Mac and A.I.G for starters). We also expect a flurry of new regulation (see above) and oversight. There will be lots of oversight.
The developing markets will continue to develop:
Brazil, China, Singapore, India and other developing nations are not going away. It is hard to keep a few billion people down. Growth will slow and the dislocations here will have an impact there, but the inexorable force of progress and innovation will continue.
Real assets have real value:
As the market declines, companies and countries that control vast amounts of real assets – real estate and natural resources - are becoming especially attractive. Even without an imminent recovery, real assets in or on the ground have enormous inherent value and will likely attract capital investment. In addition, real assets provide some hedge against the potential devaluation of the dollar that may occur as we print our way out of our current economic mess.
Challenge conventional wisdom:
One of the lessons that we have learned over our many years of investing is that the future often unfolds differently from expectation. Widely held beliefs tend to get turned upside down. People fail to expect the unexpected, or fail to unexpect the expected.
Consider that a few months ago oil was projected to top $150 a barrel and the consensus expectation was that Brazil, Russia, India and China were immune to what was going on in the United States. Their incremental demand for food, fuel, metals and other commodities were creating an inflationary spiral. Today, all that thinking is out the window and everyone is worried about a global slowdown.
Three months ago there was talk of the Euro supplanting the dollar as the reserve currency of choice, as it reached new highs against the greenback. Today the dollar is again the reserve currency of choice, at least for the time being, as investors horde Treasury Bills. Meanwhile, the Euro and Pound are falling fast, a reflection of the continued economic deterioration in Europe.
And so the moral for us is to be highly skeptical of any widely held set of beliefs, especially when they support rather extreme overbought or oversold conditions in the markets.
Risk is often least where you think it is greatest, and conversely, greatest, where you think it is least. 18 months ago, the risk premium for debt was virtually non-existent. Similarly, during the dot-com bubble, the risk premium of equities was nil. Whenever we see major market moves supported by a risk-free theory of the world, we get very nervous.
Today the reverse is true. Investors are uniformly negative and risk premiums are at an all-time high. We are negative too, but not uniformly or hopelessly so. We are trying to stay balanced and rational and are keeping a close eye on fundamentals and valuation, relative to the risk of additional loss of capital. There is tremendous strength and value in our economy and with effective leadership, we will get through our problems. Capital will flow again, the world economies will recover and grow. Strong companies will get stronger, and the markets will eventually rise to new highs..
As always, we welcome your questions and the ability to be of service.
Jurika, Mills & Keifer,