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
information for asset classes is for total return assuming reinvestment
of interest and dividends. It excludes management fees, transaction
costs and expenses.
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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."
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.
Looking 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
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.
- Supported by temporary US Government programs-
the largest is to conclude in March
- Prices have returned to earth but are still
- 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.
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.
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).
Unemployment rate often a lagging indicator of
- Even broader measures of employment have not yet
- Political risks associated with high
unemployment could threaten financial markets
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
What we think this
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
- 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
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
was recently interviewed by the Wall Street Journal on the effects of
regulation on client communication. You can see the article here.
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.