February Market Review and Outlook

It is said January sets the tone for the year, and if that is the case, it looks like 2010 will not arrive soon enough. In January 2009, the S&P500 index lost 8.6%, the worst January in its history. The US lost nearly 520,000 jobs, matching the jobs lost in the last four months of 2008. For benchmark purposes, 2008 set a record for the most jobs lost in a year since the end of WWII. GDP in Q4 2008 dropped at a 3.8% annual rate, the lowest pace since Q1 1982, when GDP contracted 6.4%. In the month, there was the continued saga of Citigroup, which reported its 5th straight quarterly loss and its decisions to break up into two parts, a good bank – Citicorp, and a bad bank – Citi Holdings. There was also Bank of America, which reported its first quarterly loss since bearing the BOA name, and in the process revealed its acceptance of an additional $20 billion of government capital and $118 billion in toxic asset protection in order to complete its Merrill Lynch acquisition.

It is clear the U.S. banking crisis is deepening, and policymakers have been busy formulating new and ever intrusive solutions. The likely ideas to emerge include forming a bad "aggregator bank" to take bad assets off banks’ balance sheets, further government capital injections, government guarantees of bad assets, or an outright nationalization of banks. In the short term, the capital markets will probably cheer any solutions coming from Washington, short of nationalization. As we wrote before, markets are acting like a crack addict needing a hit. Sadly the markets have become so accustomed to government intervention to ease the pain of new problems facing financial firms, that every new round of government money creates a momentary euphoria that quickly wears off as the markets wander aimlessly waiting for another hit. This leads the markets to freeze up whenever a rumor of a new handout emerges, as market players determine who will win and lose from the latest handout. The seemly insatiable appetite for significant government actions becomes a self-fulfilling prophecy as the markets demand new government funds, and the stooges in Congress are only happy to expand government’s power to preside over the economy. Given the ongoing budget situations found in state governments across the country, and the massive debt amassed by the federal government, trusting our elected officials from either party to effectively manage our financial system is a case of allowing the patients to run an asylum.

We have already heard the President label the $18.4 billion in bonuses paid on Wall Street for 2008 as “shameful” since these firms received government aid. While certainly some individuals performed poorly, assuming every worker in those institutions underperformed at their jobs is silly and unfair. Such misguided comments should be carefully considered before our new President paints himself into a political corner and finds that he is defending the government determining private sector compensation policies, based on populist rantings. This has encouraged congressmen to chime in for the media, chiding, mocking, and scoffing at banks for their need to get help, while no longer making crazy loans like they did in the “good old days”. They seek to paint finance professionals as a group of greedy, unethical thieves looking to pillage the American people. But ultimately, Wall Street never held a gun to consumers’ head making them add debt and buy more cars, boats, and houses. While Wall Street is one of many guilty parties in this mess, it is not a symbol of evil. After all, for decades, Wall Street has enabled the time shifting of capital to facilitate more optimal savings, consumptions, and investments. This in turn has allowed millions of individuals to retire much more comfortably, and funded the thousands of companies that have enabled the United States to enjoy prosperity unrivaled in the world’s history. Ultimately Wall Street has been a very positive and important contributor to the success of corporate America and in turn “Main Street”.

While it is politically expedient to make Wall Street the scapegoat, lets not forget, the chorus of the housing boom was sung by a large choir, including problematic regulations, government policies, and consumers. It is true that Wall Street became overly exuberant, but so did consumers. Is it a coincidence that during this period Coach bags whose prices average $300 became household items and Starbucks selling $3 lattes found a home at every corner of the country? We all should learn a good lesson: whether it is an individual, a family, a corporation, or a government, we should never live beyond our means and exuberance cannot be irrational. We all abused the abundant availability of money, a luxury earned over decades from the US’ unique position as the safest place to invest in the world. This success resulted from our long lasting prosperity, most advanced capitalist system, and a very strong and just legal system to protect property rights.

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We are all paying and will continue to pay a huge price for this mistake. Our tax dollars are being directed to save financial institutions many of which deserve to fail and are very costly to save. We are saving them, however, as we try to prevent wide spread bank failures, which will likely result in a rash of defaults and bankruptcies by businesses and households, like what we experienced in the Great Depression. While sound regulations and requirements are needed to ensure tax dollars are used effectively in the hands of those financial institutions, the last thing we need is for the bureaucrats in Washington to micro manage these firms through directives such as compensation and lending practices. Again, which Representative or Senator is really wiser and more competent than the market? If that person exists, why are governments at the federal and many states levels in such a mess? Though we abused our success last time, let us not forget it was the market process that gave rise to that success in the first place. It is very doubtful that a series of laws and decrees created in the womb of special interests and political motivations will lead back to our prior success. If we are to return our financial institutions to the greatness they once possessed, it will only come by maintaining and strengthening our market driven, individual motivated system.

While Bailout is the buzz word for 2008, Stimulus is going to be the word of 2009. We are told the economy needs a drastic injection of oxygen to preserve or create 3 million jobs, and under that premise, the House of Representatives approved an $819 billion stimulus bill by a 244-188 vote, with zero republican support. Too much pork in the bill has been lampooned but the more alarming fact is the bill is exorbitantly expensive and extraordinarily incapable of fulfilling its premise – to stimulate the economy.

First, a big portion of the bill is a spending spree to expand federal power: $140 billion given to the Department of Education to give grants to local schools and replace lost state aid; $90 billion to increase the federal share of Medicaid payments; $140 billion to give tax credits of $500 per worker, $1,000 per couple for two years, which are geared towards lower income people and gradually phase out at certain income levels. We believe phasing out the tax cuts is a mistake. Essentially it reduces the incentive for people to earn more, by imposing a higher effective tax rate on their earnings. After all, if earning an extra dollar of income loses you ten cents of government programs, the marginal tax burden on your additional income has just increased by 10%, regardless of the statutory tax rates.

Secondly, according to the nonpartisan Congressional Budget Office, for the theoretically job creating $355 billion that House Democrats want to spend on highways, bridges and other investments, more than half will not be used before the end of fiscal 2010, but rather spent over the next several years, after the recession is projected to end. This is not surprising given infrastruture projects are long term in nature, which take time to define, plan, and carry out. Congress and government officials cannot and shouldn’t speed up spending by not thinking through details just for the sake of fostering job creation.

If it is so urgent to stimulate the economy, why cannot we implement a stimulus plan that can take off right away? We have always advocated motivating individuals and the private sector as the best way to stimulate economy and sustain economic growth in the long run. In this particular economic malaise when the American people are reducing their spending, deleveraging, and increasing their savings, handing out temporary tax rebates is not going to stimulate long-term, sustainable consumption activity. Bush’s rebate stimulus program had a limited short term boost for Wal-Mart but nothing sustainable, and this one will likely be similar. The American people need to feel job security from their economically sound employers and expect sustainable income growth either from a permanent personal tax cut or wage growth, before they are likely to feel comfortable about spending again. This can only happen with the increased productivity that comes from voluntary business investment to spur job creation and increase the value of existing jobs.

Therefore, it is crucial to stimulate GDP by rejuvenating private investment growth, which will in turn create jobs, provide income growth, job security, and hopefuly get consumers comfortable spending again. We believe the particularly effective measure is to encourage private investment by reducing corporate tax rates, and temporarily eliminating capital gains taxes on new investments made during the next 2-4 years. During the Great Depression, private investment accounted for an average of 8% of GDP from 1930-1938, compared to a median ratio of 15% from 1929 to now. The ratio was as low as 2.2% in 1932. That period was accompanied by the highest unemployment in the US contemporary history, which averaged 18.3% each year. In Q408, we saw real nonresidential fixed investment decreased 19.1%, compared with a decrease of 1.7% in Q308. Real residential fixed investment decreased 23.6%, vs. a decrease of 16% in Q308. The sharpest decline of nonresidential fixed investment is in equipment and software, which decreased 27.8%, compared with a decrease of 7.5% in Q308. Corporations clearly have accelerated their deleveraging and reduced capital expenditures across the board. While the Fed actions have helped to inject liquidity, and in the process improved the commercial paper market and corporate bond market, it is about time for corporate tax cuts to be implemented to help companies invest, grow, and encourage risk taking again.

The deficit spending plan passed by the congress democrats is going to saddle the country with nearly $1 trillion of additional debt, pushing the federal debt toward levels not seen since the WWII. While President Obama repeatedly promised that his administration would go line by line over its budgets with a focus on fiscal responsibility even though he seeks huge amounts of money to stimulate the U.S. economy, we only hear about spending, and nothing of cutting. It is actually more important than ever for the government to restrain federal spending to limit the budget deficit; and utilize the stimulus power to motivate corporations and individuals through tax incentives.

The American people are deeply disturbed by the failures of Wall Street, the regulators, and the government. We are amid a crisis of confidence and prevalent distrust. However, like anywhere and anytime in the history of mankind, it is always the people who make history, and in the case of the USA, with its government as a tool not its leader. We hope we have the long-term wisdom to say “thanks but no thanks” to a government that seeks to promise an economic Shangri-La through massive entitlement programs and control of the economy. Such plans historically have failed to generate the sustainable wealth derived from America’s system based on individual responsibility and liberty. Adding a bigger, more controlling, and intrusive government into our lives for short-term help is a very bad long-term decision. Ultimately, “we” as individuals will have to bail ourselves out, and sustainable wealth only results from the actions, efforts, and sacrifices of us the individuals.

From Dec.31, 2008 to Jan.30, 2009, the returns (equal weighted) are the following:

Although we had the worst January on record for the S&P500, it is worth noting the index is traded around 830, much greater than the scary 750 we visited briefly in November 2008. In addition, continuing the trend since Mid-November, selecting stocks on the basis of their intrinsic value has resulted in superior performance in January, relative to price and earnings momentum strategies. We continue to view this as a positive development if the market is returning to its long-term tradition of recognizing undervalued companies and rewarding investors that invest in those firms. This is not to say that undervalued stocks cannot go lower, but for value conscious, long term oriented investors, the market is currently offering some great companies at prices that make them great investments.

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