Asset Class Returns Q4 2009
IHA Quarterly
January, 2010
In This Issue
History Speaks
Reading List
Asset Returns
Main Commentary
What's New
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Commentary from Mike and John
 "Washington finally stopped trying to solve every problem by throwing billions of taxpayer dollars at it and instead started trying to solve every problem by throwing trillions of taxpayer dollars at it."
-           humorist Dave Barry
In 2009 Washington threw trillions at Wall Street which helped lead to a recovery in financial markets as nearly all asset classes, led by the most risky, rose significantly.
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History Speaks

"I see no reason why 1931 should not be an extremely good year."
(1930)- Alfred P. Sloan, Chairman of General Motors
Certainly Mr. Sloan shows the difficulty in forecasting, even for the most knowledgeable and informed participant. He was a pioneer of automotive innovation and would go on to build General Motors into one of the world's largest companies. His prediction for a rebound in sales in 1931 would soon prove to be disastrously wrong as production of vehicles in the United States fell from 5.5 million in 1929 to under 1.4 million in 1932 during the Great Depression. General Motors stock fell nearly 90% in the same period. The only good news for GM and Mr. Sloan was their competitors proved less durable with most folding over the next seven years.

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What We Have Been Reading

 Five recent articles that stood out to us:

Americans Are Finally Saving. How Did That Happen?
How the recession is changing consumption and debt habits.

Housing Animal Spirits to Be Banished by Prime Foreclosures
The foreclosure focus has moved away from subprime.

Timothy Geithner Meets Vladimir Lenin
"failure of financial institutions need not result in customer losses or disorderly unwinding. All it requires is that the bondholders of the institution properly absorb the losses". Obviously John Hussman does not run our Treasury Department.

Bruce Greenwald on Structural Problems in the Economy and Unemployment
An economist with an alternative view on the rise of China and the best solutions to the global recession.

Andy Xie: An Overwhelming "Get Rich Quick" Mentality Dooms China To Endless Bubbles
Maybe that is what we have been exporting to them.

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Asset Class Returns
4th Quarter 2009
Performance information for asset classes is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.

Asset Class Returns Q4 2009

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Commentary from Mike and John

 "Washington finally stopped trying to solve every problem by throwing billions of taxpayer dollars at it and instead started trying to solve every problem by throwing trillions of taxpayer dollars at it."
-           humorist Dave Barry
In 2009 Washington threw trillions at Wall Street which helped lead to a recovery in financial markets as nearly all asset classes, led by the most risky, rose significantly.
MainArtLooking forward in 2010 most Wall Street analysts expect us to continue this upward path. The median forecast from strategists at the large investment banks is for a rise of 12.1% in the S&P 500. Causes for their optimism:

>        The stock market is near its lowest valuation in a generation
>        Historically, the economy rebounds strongly after deep recessions

As housing prices led us into recession and unemployment is the continuing story, we offer our perspective on these two big topics in this edition of the IHA Quarterly.
Housing Market
  • Supported by temporary US Government programs- the largest is to conclude in March
  • Prices have returned to earth but are still relatively expensive
  • The housing bubble was years in the making and still poses a huge threat to banks
While constructing the graph below two points quickly became clear to us - house prices have stopped declining but are still richly valued; and even a stable market is not necessarily good news for banks.

Home Price Graph

We'll explain: That blue line shows the prices of homes from 1987 to today.  (Source: Case-Shiller National Home Price Index, generally regarded as the most accurate housing price indicator.) We removed the effects of inflation to allow an apples-to-apples comparison of prices from various time periods. The straight red lines indicate reasonable growth rates (inflation plus 1%) from the pre-bubble high and low. While they have recently entered within an acceptable range and are no longer historically overvalued, housing prices are still relatively expensive.

Without a significant rebound in prices, the extent of the run-up from 2003 to 2007 leaves millions of homeowners holding mortgages greater than the current value of their homes. So even if the housing market stabilizes here, at the high end of historic valuations, the solvency of many banks is reliant upon homeowners continuing to make payments on losing investments.

The federal government has gone to great lengths to stop the decline in home prices. By directly entering the mortgage market, the Federal Reserve and the Treasury Department have been testing the limits of their legal mandates. The Fed has embarked on a program to purchase $1.25 trillion in agency MBS (mortgage backed securities guaranteed by Freddie Mac, Fannie Mae and Ginnie Mae). Last Christmas Eve, the Treasury Department pledged to stand behind all agency MBS no matter how severe the losses. This effectively turned these agency MBS into obligations of the U.S. government (read: taxpayer).  These actions helped engineer the record low mortgage rates (4.75%) which are the main reason for the recent stabilization in home prices. The Fed is scheduled to shut down the massive MBS purchase program by the end of March. We will be monitoring mortgage rates as this deadline approaches. A significant rise in rates would imply a lack of confidence in the housing market and potentially large losses at banks. It could also mean continued government involvement in the housing market to ensure the solvency of the banking system.

  • Unemployment rate often a lagging indicator of economic recovery
  • Even broader measures of employment have not yet stabilized
  • Political risks associated with high unemployment could threaten financial markets
History shows rash governmental actions to combat the business cycle often do greater harm than good, perhaps best demonstrated by the Smoot-Hawley Tariff Act of 1930 that deepened the severity of the Great Depression.  We believe short-sighted legislation is a significant threat to the resumption of economic growth in this recession. As the often-headlined 10% unemployment rate threatens to take control of the political process, we should examine the utility of this number as an indicator of economic recovery. The unemployment rate has been particularly slow to improve in the last two recessions, not peaking until long after the economy had bottomed and the recovery had begun. This is partly structural as the economy has moved away from manufacturing jobs to a greater service orientation. Employers are able to squeeze more production from these jobs until they are more certain of the economy's direction. Another part is the statistical methods behind how the unemployment rate is measured; it does not count people as they drop completely out of the workforce (because employment prospects are so poor in the depths of a recession) but does start to count them when they reenter (as the economy gets stronger and they feel they have a better shot of landing employment). This means that the economy can be adding jobs even while the unemployment rate remains flat or continues to go up. We believe a better jobs indicator to watch is the Civilian Employment Level from the Current Population Survey (CPS) conducted by the Bureau of Labor Statistics. This is the government's best estimate of the total number of people working in the country. In the two previous recessions the CPS data has bottomed out long before the unemployment rate peaked (see the chart below).
Months Until Decline Unemployment Rate
 The current CPS data has not yet shown any signs of stabilization. Even if the most recent release (December) turns out to be the low it may be months before the unemployment rate starts to go down. The longer the unemployment rate continues to stay above 10%, the greater the chance of damaging government action in the areas of trade, regulation or taxation.

What we think this all means
  • Deleveraging is necessary and beneficial in long term
  • Unusual source of recession means greater risks to recovery
  • Important to consider these risks when developing financial strategy
In the last year we have seen the U.S. savings rate move to its highest level in a decade (above 4%) and banks write off their worst mortgage losses while raising significant capital. This deleveraging phase is a necessary for the U.S. economy. In a typical recession, these developments would set the stage for continued growth in financial markets as the economy recovers.However, the root of this recession was a financial and credit crisis, making it unlike any experienced in the post-WWII period and increasing the possibility of a protracted recovery.

While nobody can predict the future we believe that an informed client stays on shortest path to financial success. Considering the effects of the risks discussed here on the lives of our clients is what we do at InnerHarbor Advisors. As always, if you have any questions or comments, please give us a call.

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What's New With Us

Mike was recently interviewed by the Wall Street Journal on the effects of regulation on client communication. You can see the article here.
We recently prepared a presentation on Emotions and Investing that Mike gave at the Harvard Club. If you would like a copy please send us an email.
A Saturday in the Park. Mike and John both participated in the Brooklyn Duathlon in the Fall of 2009. The next will be on March 20, 2010 in Prospect Park. If you care to join us, you can register here.
InnerHarbor Advisors Team Photo

Contact Info:
InnerHarbor Advisors, LLC
212-949-0494 and

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