An eNews Update to our Quarterly Newsletter May 2009
Zig-Zagging Against the Wind
“It is possible to reach any destination directly upwind by zig-zagging against the wind” – Sailing Basics
The Storm
Separating panic or exuberance from reality is essential to investing success. During periods of either extreme market duress or market euphoria, making such separation is more important and more difficult than ever.
We believe that helping clients through such times is our single most important mission. Markets have just provided another real life example of why investors should not act on emotional impulses.
Recently, stock markets have been climbing the proverbial “wall of worry”. As of the date of this column, the S&P 500 rose a dramatic 36%* from its March lows. The previously decimated Financial sector led the rally. A ”run-on-the bank” on a global scale, was successfully foiled.
The government’s intervention in the current financial crisis proved to be a net success thus far. The financial system will survive, thanks in no small part, to the government’s infusions of capital and unprecedented aggressive actions by the Federal Reserve.
Changing Winds Ahead
While we believe the government successfully fulfilled its role of paramedic and emergency room physician, the economy remains far from healthy. The necessary physical therapy phase of healing may shape up to be a challenge.
Recent positive corporate earnings surprises are encouraging. Unfortunately, the earnings surprises were not the result of renewed economic growth. They were either a result of the Fed’s maintaining an ideal profit environment for banks, or as a result of deep corporate cost cutting, including additional layoffs.
Over the last three decades there were three principal economic forces that have served as tailwinds in cyclical recoveries. Those three principal forces are now headwinds:
De-Regulation turning into Re-Regulation
After years of remarkable expansion, the world’s financial system ended up in the ICU. Markets proved incapable to self-regulate. Governments’ ability to provide a level playing field was far outpaced by technological and financial innovation.
As a result, the de-regulation trend that started with the advent of the Reagan / Thatcher revolution has come to a screeching halt. Even stalwarts of free market economics such as Milton Friedman and Alan Greenspan are being second guessed.
By utilizing tax-payers’ IOUs in stabilizing the financial system, politicians gained the upper hand. Government control over essential financial and industrial institutions has already resulted in some dangerous threats to crucial elements of the market system.
Repeated executive compensation scandals have illustrated tremendous pressures to override contracts. In the recent Chrysler negotiations, the government sought to apply the principle of “burden sharing”. Arbitrarily imposing sacrifices on the various stakeholders of a corporation, irrespective to the capital structure, may undermine one of the main pillars of property rights.
Introducing uncertainty into the sanctity of contract law and property rights may have the opposite effect than what the government intends. Such actions may prove counterproductive, as they make investors demand higher risk premiums. Higher risk premiums increase the cost of capital for the very industries the government is looking to jump start.
Globalization turning to protectionism
The fall of the Berlin Wall marks the end of this current chapter of globalization. The subprime meltdown may get to symbolize its conclusion.
As former centrally planned economies embraced free market principles, trade flourished and global growth exploded. For all of its benefits, the free flow of trade and capital was also the conduit for the unstoppable spread of the crisis.
Today, free markets are in retreat. Trade is shrinking and global banks are going home, as host country governments are unwilling to lend them a helping hand. In the aftermath of the crisis, it has become clear that using tax payers’ funds to prop-up anything but domestically domiciled institutions is a political impossibility.
We are beginning to see more and more signs of protectionism and trade barriers. Campaigns such as “Buy American” or “British jobs for British workers” are getting louder around the world. Governments’ are getting behind these trends by pushing support for locally domiciled corporations. Provided such trends go beyond harmless political rhetoric, they will be detrimental to economic growth.
Borrowing money turning into paying-down debt and saving
As trade and global growth accelerated over the last three decades, periods of economic expansion became longer while downturns were shallower and short-lived.
Households and businesses alike began to borrow more and more against the increasing value of their assets. In turn, this fueled more consumption and more business, eventually leading to the euphoric excesses that broke the camel’s back.
The current de-leveraging of households and businesses means the above trends have now reversed. Paying back the debt and saving, will naturally result in less money to consume and less money available for business expansion.
Adapting to the new winds
Understanding these challenges and their implications is essential in positioning investment portfolios in the upcoming months and years.
As economic freedoms were expanding around the world, buying, holding and leveraging risky assets proved to be a successful strategy of building wealth. The financial “hurricane” that followed quickly decimated the wealth of over-extended investors as US Treasuries provided the only true safe harbor during the heights of the crisis.
Since then, we have learned that the “hurricane” has passed and the system will survive. While that’s welcomed news, the economy is not likely to quickly recover to its highest growth levels of the past. The three major tailwinds the economy used to rely upon have turned into headwinds.
Sailboats need to zigzag towards their destination when faced with headwinds. Portfolios may need to do the same, as macro economic winds have changed direction. We continuously optimize clients’ investment portfolios to navigate the changing economic winds. For timely details on investment strategies, please refer to our most recent tactical asset allocation updates or contact your financial advisor.
* As of 3/9/2009 the S&P 500 hit of intra-day low of 666; as of 5/4/2009 closed at 940 (a 36% gain).
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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