How is everyone out there feeling these days about the economy?  Judging by the 45% rise in the S&P 500 off the March 9th low, it would seem that investors feel pretty good.  But while the “green shoot” mentality has certainly taken root in the stock market, the consumer remains in precarious condition.  The unemployment rate is now 9.5% and is expected to reach over 10% by year end; housing price declines continue in much of the nation as banks resume foreclosures; and banks are restricting access to credit for all but the most qualified applicants.  Why is this important?  Because consumer spending still accounts for over 70% of domestic GDP.  Inventory replenishments and short-term booms in government spending and/or exports can certainly have a dramatically positive impact on GDP growth in any given quarter, but sustained domestic economic growth can only be achieved through a healthy consumer who is willing and able to spend.  It seems that neither the willingness nor the ability are forthcoming.

After a long period of relying on housing appreciation as a nest egg, consumers have finally been spooked into saving nearly 7% of disposable income (for the month of May, 2009) from close to zero percent over the past few years.  The increase in saving is the result of the loss of $15 trillion in net worth through a combination of housing and stock market declines.  While it is tempting to say that the increase in savings is a temporary phenomenon, we believe it represents a much more permanent shift in consumer behavior.  Baby boomers are ill-prepared for retirement, and the loss in wealth sustained over the past couple of years is unlikely to return any time soon.  Therefore, a permanent shift in consumer savings rates is likely to be a major drag on the economy for a prolonged period of time.  However, it should be noted that although a higher savings rate would undoubtedly subtract from economic growth over the next few years, we view this shift towards higher savings as absolutely imperative for longer term economic growth and stability, and it should ultimately lay the foundation for the next bull market.

Notwithstanding the negative economic effects of a higher savings rate, the recent rise in stocks helped spark a rebound in consumer confidence off the February low of 25.3 to a yearly high of 54.8 in May.  Over the past two months, however, the index has pulled back to 46.6 in July.  Digging into the numbers, there were sharp drops in both the “present situation” and “expectations” components of the index over the past two months.  These declines undoubtedly reflect the employment situation.  The percentage of people surveyed in July describing employment as “hard to get” increased to 48.1% from 43.9% in May.  Given the anxiety level over job prospects and a shortage of retirement savings, it does not appear as though the consumer’s willingness to spend will rebound any time soon.

As for the ability to spend, the banks hold the key.  An article in the Wall Street Journal on Monday described a disturbing trend amont the big banks.  According to the article, “The total amount of loans held by 15 large U.S. banks shrank by 2.8% in the second quarter, and more than half of the loan volume in April and May came from refinancing mortgages and renewing credit to businesses, not new loans.”  The actual decline in credit extension is likely much greater as the securitization market remains essentially closed.  The article goes on to say, “The numbers underscore two related trends weighing on the economy.  Financial institutions are clamping down on lending to conserve capital as a cushion against mounting loan losses. And loan demand is falling as companies shelve expansion plans and consumers trim spending to ride out the recession.”  The bottom line is that banks are lending to only the most credit-worthy borrowers, which is likely to continue to constain consumer spending for many quarters to come.

So this might be a good time to ask yourself a few questions.  The answers to these questions may provide useful insight that can be applied to your investment decisions.

• Would you describe your spending habits as more or less cautious than a year ago?
• Are you saving an amount you believe will be required to maintain your lifestyle at retirement?
• Is any shift you have made in your savings a permanent shift or are you likely to save less in the event of an economic recovery?
• Do you feel you have access to the credit you will need over the next 2-3 years?
• Do you feel like your job is secure even in the event of a protracted recession?
• How have your job-related compensation expectations changed over the past year?
• How do you feel about upgrading to a larger house and taking on a bigger mortgage?  Are you planning any other major purchases like a new car?
• Have your expectations regarding investment returns changed in the wake of the market decline?
• How do you feel about committing new dollars to stocks now?

Now that you have contemplated these questions for yourself, put yourself in the shoes of Joe and Jane Sixpack.  Do you feel like your situation is reflective of the challenges facing Middle America?  If not, do you feel your investment decisions are being driven by a perspective that goes beyond your own personal circumstances?
We suggest you use these queries as food for thought.  Emotion is the foe of the long-term investor.  Patience, clear perspective, and listening to your own truth are vital to your success no matter if you are out of step with the herd.

Peace,

Michael

The second quarter earnings season is unfolding better than expected.  However, our well-voiced concerns over revenue shortfalls are proving well-founded. Currency headwinds and a contracting economy are providing a difficult operating environment for many public companies. The good news is that bottom-line earnings are coming in ahead of expectations. While this may initially seem counter-intuitive, the answer is cost cutting and expense reductions.

Management teams finally appear to be grasping the severity of this economic downturn. In prior quarters management teams had flocked to the confession rail, quarter after quarter, to explain why earnings came up short after the economy proved to be surprisingly difficult. It is true that much of the positive 2Q earnings surprises thus far are no doubt the result of sandbagging (ie, dropping the bar so low that it is easy to hurdle). However, that companies have finally started aggressively cutting overhead and headcount strikes us a responsible and healthy.

Companies are getting leaner and meaner, and balance sheets (especially within financials) are actively being fortified to withstand further demand weakness to come. When top-line growth returns, these companies will be superbly positioned to bring maximum dollars to the bottom line. Growth will return; don’t lose faith. Don’t get impatient either; there are an awful lot of things working through the economy.

The investment banks posted very strong underwriting fees for both debt and equity in the second quarter, which reflects the urgent demand to strengthen balance sheets. We expect continued strength in underwriting activity based on higher stock prices and the continued need to fortify balance sheets. Banks that do not have underwriting fees or trading revenues have not fared as well, and we expect this trend to continue. Consumer and commercial loan losses will continue to mount, and most bank appear to be behind the ball with regard to loan loss provisioning.

While we do not believe a strong economic recovery is imminent, we do believe that any incremental recovery in revenue growth could ultimately translate into sharp bottom line increases as a result of all of the cost cutting that has taken place. Moreover, year-over-year comparisons are beginning to represent a low bar for most to easily meet or exceed.

We continue to believe we are in the midst of a protracted period of consumer de-leveraging, which means higher savings rates and less consumer demand. In this environment, companies are likely to remain lean and mean, and any reversal of unemployment rates is likely to be very tepid.

We are actively seeking companies that were early to recognize the severity of the downturn, and have consequently adjusted their businesses to strengthen balance sheets, protect earnings, and take market share in this environment. There are many such companies in our client portfolios that fit this description.

Positive signs are unfolding. They are real. They will build the foundation for the ultimate climb higher and recovery. A recovery will happen but it will take time.

Hang in there!

Peace,

Michael

In our July 1 email blast, we speculated that after a nearly 100% rise in the S&P Financial Index from the March 9, 2009 lows, further strength in the overall market may have to come from a different sector(s).  Well, as of right now, we’re wrong.  As I write, the S&P 500 is now up 1.5% for the third quarter (thanks to today’s rally of about 3%), with Financials performing the best of the ten S&P 500 industry groups.  Financials are up 5% in today’s trading and are now up over 3.5% for the quarter.  It would appear that risk is once again in vogue after a modest 7% pullback in the S&P 500 from mid-June to July 10.

So what’s driving all the renewed euphoria?  The answer is earnings from two very large bellwethers: Goldman Sachs and Intel.  According to some, the positive earnings news doesn’t end with these two behemoths.  From a article by Whitney Kisling of Bloomberg today: “Earnings have topped estimates by an average 20 percent for the 16 companies in the S&P 500 that have released second- quarter results since July 8, according to data compiled by Bloomberg.”  Given that Intel beat the consensus estimate by 125% and Goldman beat by 39%, however, we wonder how much of the buying celebration can be attributed to the smaller, less significant companies that have reported earnings so far in the quarter.  Johnson & Johnson may be an exception, but that company only beat the consensus estimate by 4%.  It’s pretty clear to us that investors are looking at Goldman Sachs and Intel as harbingers of a very positive earnings season.

Are the optimists correct?  We think they may be half right.  Intel’s guidance for higher-than-expected revenue on stronger chip demand may indeed signal that pent-up demand for technology products and services will lead to better corporate earnings in that sector.  However, Goldman Sachs’ blowout quarter should not be viewed as a signal of strength in the Financial sector at large.  Goldman’s blowout quarter was the result of its positioning as the preeminent trading and investment banking firm on Wall Street, operating in a very favorable environment.  Goldman posted quarterly revenue records (which is saying a lot!) in its Fixed Income, Currencies and Commodities (FICC) segment, its equities trading segment, and it equity underwriting segment.  While these results are encouraging (and we own Goldman Sachs stock), we are not sure how sustainable these results may be.  From an article in today’s Wall Street Journal: “Analyst David Trone of Fox-Pitt Kelton Cochran Caronia Waller LLC told clients he expected Goldman’s results to be “far weaker” during the second half of the year due to a smaller deal pipeline, less demand for corporate-debt issuance and the end of the big bank capital raises following the government stress test results this spring.”  We agree that this type of favorable environment won’t last forever for capital markets firms like Goldman.  But perhaps more importantly, Goldman Sachs has virtually no exposure to consumer credit, which continues to rot as the unemployment rate marches toward 10%.

Other banks will most certainly benefit from the current positive trading and investment banking environment.  We are likely to get better-than-expected results from the likes of JP Morgan Chase, Morgan Stanley, Bank of America, and even perhaps Citigroup.  However, the vast majority of “banks” within the S&P 500 Financials index continue to suffer mightily from soaring credit costs, which are likely to spread from consumer mortgages and credit cards to commercial mortgages and other loans.  The cycle is clearly not over, with many analysts speculating that another round of capital raises will ultimately be required.  While it may or may not get as bad as the doomsdayers project, it is pretty clear that the nuts-and-bolts business of making loans is not making money right now.  We’d prefer to see some light at the end of the tunnel before getting on this bandwagon.

Peace,

Michael

After exceptional lows in March, markets rallied in the second quarter.  While the advance was broad-based, the groups that suffered most in the decline bounced most.  Banks and materials led the charge higher with each sector enjoying returns of over 100%!  Investor sentiment improved, and other economic indicators declined at a more moderate pace.  “Green shoots” was the buzz phrase in the press, and determined optimists began to hunt for whatever data they could find to construct a sustainable, positive argument.  Steven Goldberg wrote an interesting book a few years back called When Wish Replaces Thought.  In it he criticizes advanced education for abandoning the honest, open Socratic dialogue which catechizes students using open-ended questions to discern a conclusion.  In its place, Goldberg suggests that modern educators begin with a conclusion they find philosophically appealing and construct supporting logic.

A 15.9% return for the S&P 500 would be a great year, so it was certainly an outstanding quarter.  After reaching a sub-670 level on the S&P 500 in early March, investors wondered if stocks could possibly recover and even if capitalism and corporate America might be doomed.  What a difference 90 days can make!  While the increase in share prices brings relief to frazzled nerves and diminished accounts, there has been scant evidence of sustainable earnings increases.

Perhaps the March decline was overdone (as most major swings are), but this rally’s foundation is more emotional than empirical.  A simple measure of share price is a multiple of earnings: a share of stock trading at $14 with $1 per share in earnings has a multiple of 14.  When share prices increase, either the earnings or the multiple is increasing (or both).  The recent rally from March lows was based on a 6 point increase in the multiple and not an increase in the earnings.

As choruses of insistent, happy voices declare that the worst is over, it seems as if the higher share prices resulting from exuberant multiple expansion have fully discounted a very positive recovery scenario.  A multiple-driven price increase always creates a vacuum.  These vacuums are resolved when either the multiples contract or earnings increase and “catch up.”  Our analysis of the broad market suggests that it will take longer than the consensus expects for earnings to merit the current rate of increase in the average share price of index members.  Stock selection is critical in this environment, and our fundamental, dogged analysis has never been more important.

Don’t Worry.  Be Happy.

“In every life, you have some trouble.  When you worry, you make it double.  Don’t worry.  Be happy.”  Bobby McFerrin would not make it as an investment advisor.  But, you feel better, don’t you?  Remember how you felt in March?  This feels better, right?  Why?  You feel better because prices are up, and your brokerage statement has a larger balance.   The 24-hour business TV crisis has passed (much to the chagrin of business TV executives).  It’s sunny and warm, and “the livin’ is easy.”  “Experts” have scripted an economic recovery for the third quarter and year-end.  That feels good, and all heads are blithely bobbing.

At lunch last week with Jim Bullard, president of the Federal Reserve Bank of St. Louis, the topic was “exit strategies.”  Jim was suggesting plans to gently wind down the current, unprecedented levels of stimulus and recently-established liquidity programs.  The size of the monetary base has doubled in the last two years.  Economists cannot envision how this scale of increase will not transform into inflation at some point.  But, there is another side to this story.

Household net worth has fallen by more than $14 trillion dollars over the past two years; that amount is larger than the entire US Gross Domestic Product (GDP).   De-leveraging investment banks have also removed something over $2 trillion from the asset base.  The dilemma for market participants is attempting to parse the tea leaves of unprecedented increases in the monetary base versus unprecedented decreases in the asset base.  There is a tug-of-war to be sure, but which side will prevail?  Those focused on the monetary base suggest troubling levels of inflation in the not-too-distant future, while those following asset trends fear a deflationary spiral.  Deflation is upon us: housing prices and the prices of other hard assets have fallen.  Basic materials have enjoyed a rebound, but will it last?

The inflation or deflation assessment may be the most critical macroeconomic judgment of the Obama administration’s tenure.  June’s unemployment rate was 9.5%.  We believe that that number will easily exceed 10% and perhaps 11%.  Insecure employees spend less, and they don’t borrow to spend.  This suggests that the consumer, who still represents the lion’s share of GDP, will not be increasing their share of the economic pie.  Jobs and homes represent Joe Six-pack’s two largest assets, and the first is fragile and the second is falling.  Joe is not happy.  Our conclusion is that while recoveries will occur in share prices and in the US Economy, both will take longer than current analysis suggests and much longer than current sentiment demands.  If we have the luxury of choosing, inflation seems preferable when one studies Japan.  They have been unable to break free of their deflationary collapse, and they have been adding stimulus for almost 20 years.

Investing

The inflation or deflation outcomes are each problematic for investors.  White House Economic Advisor Larry Summers uses a refrigerator analogy to explain this paradox. Given a choice between a simple, energy efficient, inexpensive refrigerator and a water-through-the-door, fancy, top-of-the line model, consumers will choose one or the other based on what you tell them about their job security and direction for the economy.  He points out that consumers typically make the right decisions about these sorts of things.  However, if you tell the consumer that both job status and the economy will change dramatically a year from now, but you can’t tell in which direction, no refrigerator will be purchased.  This parable applies to investors too as evidenced by the huge amounts of cash on the sidelines.  As people become more persuaded by the inflation forecast, money is moving into hard assets like gold and rate sensitive assets like Treasury Inflation-Protected Securities (TIPS).

Investing in growing companies with experienced managers and solid balance sheets is the only sensible investment approach.  Trying to guess and trade the volatility will eventually catch you without a chair when the music unexpectedly stops.  Whether inflation or deflation becomes our destiny, a carefully selected and scrutinized portfolio of solid, global corporations provides the best foundation we can imagine.  C.S. Lewis said that certain major decisions would be eternally enjoyed or endured.  While we decline the burdens of eternity, the reality of clear consequence for every decision we make is always at hand.  Near-term consequence may be pleasant or unpleasant, but long-term consequence is supremely important.   We are pleased with the way our clients’ portfolios have endured and enjoyed but in no way believe that the all-clear has sounded.  Rest assured that our approach is ever rife with caution.

Policy Risk

Nancy Wentzler is Chief Economist for the Office of the Comptroller of the Currency and one of the smartest human beings we know.  She is a good friend and is most concerned about “policy risk.”  Policy Risk may be loosely defined as whatever may come out of the government next.  This letter has addressed the doubling of the monetary base.  There has been additional fiscal stimulus, and we fear there will be a good deal more of each.  The Obama Administration is tackling issue after issue with blinding speed and determination.  The deficit is increasing at record pace as is the National Debt.  Healthcare is the current new program that will come with a price tag over $1 trillion.  As new banking regulations are enacted and capital requirements adjusted, Nancy looked up from a recent lunch and asked “Where are they leading us?  What are the goals?”  Many are hollering “follow me,” but they don’t tell us where.  Oddly enough, we follow anyway.

Nancy wonders about government’s desired outcome.   How many banks will be left standing?  How will their efforts be coordinated and regulated to prevent those things that led to the current collapse?  What sort of consequences have already been created by various recent policy decisions that may not become evident for years, and when they do, will it be too late?

Most reasonable strategies come in two parts: this is where we’re going, and this is how.  The current administration, for all that it has done (and a lot of it seemingly quite good), has failed to articulate the “where.”  Our worry is that if they told us where we were being led, we might not want to go.

Sell?

We don’t actually know what the market will do going forward.  We believe that our guesses on this topic are educated to be sure.  Farr Miller & Washington’s investment team is experienced, thoughtful, and skilled.  However, we are smart enough to know that we do not (and no one else does either) know for sure where the market is headed.  After all, if Warren Buffett professes not to know where the economy is headed, how could we possibly say otherwise?  If we start with this basic assumption, which is that we can’t forecast the future with much accuracy consistently over long periods of time, then it would be irresponsible to set up client portfolios to adhere to our potentially faulty macro forecasts.  Instead, we take the view that we don’t know what will happen and, given that we don’t know, which companies are we most comfortable owning over the next five years?  The companies that we are most comfortable owning typically have the following characteristics: 1) a long track record of growing EPS faster, and in a more stable fashion, than the overall market, 2) great balance sheets, 3) high free cash flow generation, 4) high returns on capital, and  5) great management.  If we buy 30-40 companies with these characteristics across a variety of industries at reasonable valuations, then we should have a reasonable chance of generating returns in excess of the S&P500 over long periods of time.  This has been the case since the firm’s inception in 1996, and we obviously hope that this track record (e.g. we are ahead of the S&P 500 over the 1-yr, 3-yr, 5-yr, 7-yr, 10-yr, and 12-yr periods) will continue going forward.

We continue to stick to our discipline.  We buy companies that we believe are attractive long-term investments, and we sell companies that we believe offer our clients sub-par long-term returns.  Our cash levels have built up a little in the past two months as we’ve found more companies to sell than to buy after such a sharp recovery in the market.  Cash is a residual of these buy and sell decisions.  Our client portfolios have recently become even more conservative after this recent 40% run-up.  This has not been a conscious, top-down decision.  Instead, our individual stock picks have left the portfolio more conservative because the riskiest names have bounced the hardest over the past 3 months and have thus become less attractive while the safest stocks have not participated.

Hang in there,

Michael

Now that the second quarter is in the books, we thought we would take a look back at how we arrived at a 1.8% increase in the S&P 500 so far this year.  It was indeed a Tale of Two Quarters.  For the first quarter of the year, we saw heavy selling nearly across the board, with the S&P 500 falling 11.7%.  Information Technology was the only sector to post an increase during the quarter, while financials continued to get hammered (down 29.5%).  Investors had yet to see the “green shoots” of spring that we’ve been hearing so much about lately.

The second quarter, on the other hand, was a completely different story.  The strong and broad-based rally that yielded a 15.2% increase in the S&P 500 for the quarter actually started on March 10 following the S&P 500 low on March 9.  From the S&P 500 peak on October 9, 2007 to the low on March 9, 2009, the S&P 500 had dropped a stunning 57%.  Since that March 9 low, however, the S&P 500 is up over 36%.  We now stand about 41% off the high of October 9, 2007.

Below we show how the S&P 500 performed by industry sector so far this year.

What can glean from the market action so far this year?  One thing is crystal clear to me.  The Financials are driving the overall market.  The S&P 500 Financial sector was down 29.5% in the first quarter before rebounding 35.1% in the second quarter.  The low in the Financials corresponded very closely to the low in the overall market.  Financials bottomed out on March 6, 2007 (compared to March 9 for the S&P 500), after falling 84% from the high in early 2007.  Since the March 9 low for the Financials, the sector has rallied nearly 100%, accounting for a sizable portion of the 36% rebound in the S&P 500 since that time.

I suppose my message is that if you’re cautious on the Financials (like we are), it would stand to reason that the market will need to find new leadership if this rally is to continue.  We believe further markets gains will be achieved only though leadership from high-quality, financially strong companies with the ability to take market share in an environment that will continue to be very difficult.  In other words, the low-hanging fruit has already been harvested.  Investors are not likely to continue embracing the riskiest of securities until and unless corporate profits show a meaningful rebound.  We think we’re still a ways off.

How have Farr, Miller & Washington clients fared so far this year?  Our composite of fully-discretionary accounts continues to solidly outperform the S&P 500 for the year-to-date period.  We have achieved this outperformance while maintaining our defensive posture.  We continue to favor companies with rock solid balance sheets and strong management teams as we navigate through this downturn.

Peace,

Michael