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HERON CAPITAL
MANAGEMENT
FINANCIAL MARKETS
COMMENTARY
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The S&P
500 is up 8.5% YTD and matching the level last seen September 15th, 2008,
the date that Lehman Brother filed for bankruptcy. With US stocks
up an incredible 79.5% from the March 9th, 2009 low, a pause or even a
pullback is to be expected. Our forecast for the S&P 500 for
all of 2010 is only 8%, so reason enough to be cautious 4 ½ months into
the year.
The
critical question is whether current stock market valuations are
justified given gradual improvement in the US economic situation, or in
fact are we setting ourselves up for a sucker punch as the economy slips
back into recession?
Single dip
or double dip recession? Facts favor the first scenario
A "double dip recession" is defined as a second
period of economic contraction followed by a brief expansion."
This can occur because the expansion is not substantial enough to bring
enough unemployed workers back into the economy despite, for example,
inventory rebuilding, and can also be caused by an exogenous event (the
brief downturn in the US economy in 2000 was extended to 2002 by the
aftershocks of the 9/11 attacks.
It's not
unreasonable to fear a "double dip recession" in the current
circumstances. Unemployment remains high at 9.7% even as job growth
exceeded 100,000/month for only the first time since Fall 2007.
Measures of consumer confidence remain deeply depressed. US housing
has leveled off near the levels of 2003. We are telling our clients
to expect NO appreciation in real estate for about the next ten
years. Credit to consumers and small business remain constrained,
with consumer debt levels falling for the first time ever. Still
the ratio of consumer debt payments to disposable income is only slightly
below the record established Q1 2008. Consumers can't spend when a
high portion of their income goes to service mortgages, credit cards, and
car payments.
As a
result, Q1 2010 GDP growth is expected to decelerate sharply to 2.9%
compared to Q4 2009 growth of 5.6%. However growth is expected to
remain positive for all of 2010 and into 2011 in the 2.8% year over year
range. In that scenario, unemployment is expected to remain high in
the 9% range for the next two years. Previously we had calculated
that it would take about 15 million new jobs to take unemployment back to
the sub 5% level last seen in the 2005-2007 range, and we have no idea
where those jobs will come from.
This graph
shows recession peaks in 1974, 1982, 1992 and 2003. The worrisome
issue is gains in jobs are much slower after the more recent recessions
(the so-called "jobless recoveries.")
Bottom line the indicator we're watching the most closely for the rest of
the year is jobs growth.
Despite all
these bearish factors, we're ever more confident that the current modest
expansion is sustainable. In particular, statistics on temp workers
and over-time hours tell us there's not more output employers can extract
from current employees. Further demand can only be met by hiring
permanent workers. Among the employed, spending is up as bargains
are to be had everywhere. We have often remarked that one of the
greatest strengths and weaknesses of the American economy is that the
American consumer has no memory what so ever, so the horrible gloom that
prevailed this time a year ago has already dissipated. Here in New
York City, ground zero of the financial panic, quite a few stores are
vacant, but new restaurants are packed on opening, and the streets are
filled with domestic and foreign tourists. Don't underestimate the "wealth
effect" of the stock market rise - anyone who bought stocks in the
last 52 weeks is sitting on a healthy profit!
Reiterating
the point we've made several times in the last 6 months, this recession
was not caused by the usual constriction of money supply and rise in
interest rates by the Federal Reserve to stifle inflation, but by the
financial system completely shutting down following the Lehman
bankruptcy. As we have seen after similar "credit" crises
including the 1987 Stock Market Crash and the 1998 Long Term Capital
Crisis, the "real" economy tends to rebound quickly and with it
the stock market.
The
Red/Yellow/Green Light Macro Model
The fantasy of all economists is to build the perfect macro model which,
to 8 decimal places, can calculate the probability of economic rise and
fall. The reality is the underlying data is too late, too sloppy,
too inaccurate to ever deliver that level of precision. Instead, we
have developed a simple visual model based on traffic lights. The
more green on the screen, the more positive we feel. At present we
feel that the trend in economic reports, the recent gains in the dollar
versus other industrial currencies, Federal Reserve policy, and overall
technical factors, are bullish/neutral for stocks. Yield curves in
the bond markets are shifting higher and the curves are also steepening
which is bearish, but rates overall are still low, so net
neutral/bearish. Commodity prices have stabilized at modestly high
levels, so neutral. The political situation in Washington is
ridiculous, so neutral bearish.
Add that
all together and the net effect is bullish/neutral for stocks. The
factor that concerns us the most about stocks right is over-all
valuations. Stocks are priced for really good earnings reports not
only for the cycle that started last week, but also for the cycle that
starts July 2010.
As this model from Morningstar indicates, the easy gains have already
been made:
SEC and
Goldman Sachs - return to the "worst trade of all time"
Back in February, we wrote, "What really kills
investor's trust in markets is the creation of what we call
"negative sum" products - an innovation where some trader
profits, but others take a disproportionate loss. John Paulson was
the principal of the relatively modest "Paulson & Co" hedge
fund. Like many, he recognized the bubble in housing from 2005
on. Unlike most, as documented in Gregory Zuckerman's The Greatest
Trade Ever, he figured out a way to profit from the eventual bursting of
the bubble.
Junk
mortgages written against junk properties were packaged into junk
securities called collateralized debt obligations (CDO's).
Unfortunately, as no one could remember a time when mortgages were not
good collateral, these securities were rated AA or AAA by the ratings
agencies and sold to pension plans all over the country. As fast as
the CDO's were sold, underwriters of these securities were also selling
Credit Default Swaps (CDS) on the same securities. A CDS agreement
says that in the event that the issuer (the CDO) defaults, the owner of the
CDS has the right to sell (put) the bond back to the issuer at par (same
price as issue price.)
Paulson
didn't own the CDO's but bought mountains of CDS. He actually went
to Goldman Sachs and pleaded (colluded?) with them to issue more CDO's so
he could buy more CDS. When the bonds collapsed in value in 2007
and 2008, Paulson's company made $20 billion and he personally made $4
billion. Good fun for all except that the pension plans,
representing the hopes and dreams of millions of ordinary Americans, lost
about $1 trillion. $20 billion gain offset by a $1 trillion
loss? Sound to us like the Worst Trade of All Time! Here's
the value question: can we afford to live in a system where such trades
are legal?"
We were
highly skeptical that regulators would ever attempt to bring justice to
bear on these trades, so we were pleasantly surprised Friday morning when
the SEC filed a civil complaint against Goldman Sachs alleging
"Goldman Sachs & Co. sold mortgage investments without telling
the buyers that the securities were crafted with input from a client who
was betting on them to fail." Paulson was not named in the
suit - yet.
The history
of Wall Street firms which face SEC scrutiny bodes poorly for Goldman
Sachs. Other firms include Salomon Brothers, First Boston, Bear
Stearns, and Merrill Lynch, none of which exist today other than as a
name-plate. Credit and credibility derive from the same Latin root
credo - "I believe." Without credibility, you can't get
credit. Obviously Goldman Sachs is not going out of business
tomorrow. But in hindsight, we understand why Goldman Sachs was not
selected as the lead underwriter to sell the US Government's 27% stake in
Citigroup - the Treasury knew this indictment was coming. Multiply
that reaction across all of Goldman Sachs' business lines and obviously
the bank is going to have a tough time, even if the SEC fails to prove
its case (as occurred in their suit against Frank Quatrone of First
Boston over destruction of documents related to junky IPO's, and against
Ralph Cioffi and Mathew Tanning, who ran a collapsed hedge fund at Bear
Stearns.)
We held a
small position in Goldman Sachs among our clients' accounts, which will
be sold Monday morning. Bigger picture financial stocks in
particular and the stock market in general may sell off over the next
couple of days as investors digest a clearly more aggressive regulatory
stance. No matter, our system needs this.
Strategy
Our forecast for 2010 was about 8% for the S&P 500, and markets have
already surpassed that level. Interest rates are rising as we
expected and we're not harmed as we've deliberately kept duration of bond
investments short to intermediate. There are plenty of companies
delivering outstanding earnings reports, Google, Intel and JP Morgan are
examples. We continue to invest our clients' funds in the markets,
just reminding them to lower their expectations of gains for the rest of
the year.
As always,
please don't hesitate to call with questions and concerns.
Yours sincerely,
David
Edwards
President
The Heron Capital Management client letter is published
immediately following month end and when market conditions require
comment. The views expressed in this letter represent HCMI opinion and
strategy as of the date published and can change at any time upon receipt
of new information. Data quoted in this letter are from sources deemed
reliable, but no guarantee of such data is implied.
Heron Capital Management, Inc., is affiliated with Heron Financial
Group, LLC, an SEC registered investment
advisor providing fully managed investment and wealth management services
to individuals, families, trusts, defined benefit plans and
corporations.
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HERON CAPITAL
MANAGEMENT
www.HeronCapital.com
(800) 99-HERON
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