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Navigating Through the Storm
Written by Wade Slome Navigating Through the Storm, written by Wade W. Slome, CFA, CFP, is an article reviewing the financial markets as of June 30, 2008. Valuable insights into where investors have been and what to expect in the future make this article a compelling read. |
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Navigating Through the Storm By Wade W. Slome, CFA, CFP
Stay faithful, all is not doomed. In fact, the volatility and uncertainty that has recently dragged the market down is an environment craved by most skilled investors. Volatility attracts opportunity. Good companies with solid growth prospects do not disappear in bear markets – they just become more attractively valued. Remember, the goal of investing is to “buy low and sell high,” or if you have the flexibility to short securities as the Slome Sidoxia Fund does, then “sell high, and buy low!” Current thinking has the energy Armageddon forcing us to ride our bicycles to the unemployment line. And because of soaring food prices, we will be harvesting wheat and milking cows in our personal farms to make ends meet. We obviously are not completely out of the woods in regards to the housing crisis given the previously sloppy banking credit standards coupled with the aggressive sales practices in an industry with lax regulatory oversight. The $4 trillion decline in home equity values from the $23 trillion peak in 2006, means the houses that we previously used as ATM machines with cash-out refinancings and home equity lines of credit will now perhaps need to be replaced with actual savings…hmmm, what a novel concept?! Treasury Secretary Hank Paulson and his governmental counterparts are scrambling to manage the delicate balance between propping up duped mortgage owners while not bailing out irresponsible owners and speculators with subsidized taxpayer dollars. Despite the doomsday headlines, unemployment remains at a relatively low level at 5.5% versus upwards of 25% during the 1930-1939 Great Depression and greater than 10% in the early 1980s recession. Although a lagging indicator, economic activity has not completely fallen off a cliff either, as 1st quarter Gross Domestic Product (GDP) registered at a positive level of 1% growth. The weaker U.S. dollar and healthy global economy are also providing an offset to deteriorating conditions domestically. Not only are foreigners purchasing more of our goods and services, they are also scooping up our companies – evidenced by the bold and active participation of $2.5 trillion in Sovereign Wealth Funds (SWF) and international corporations like Belgian brewer InBev making an unsolicited bid for national icon Anheuser-Busch. Higher energy prices are forcing private companies and governmental agencies to invest in and contemplate alternative energy resources (i.e. solar, wind, nuclear, clean-coal, etc.) to free the U.S. from its addiction to oil that is supplied in large part by less stable regions around the world. With the government only spending $3 billion on alternative energy resources versus $30 billion spent on the NIH (National Institute of Health), there is still room to increase funding for new energy sources.
Interest rates remain relatively low despite frenzied discussions about inflation. Let us not forget that, although painful, the current 4% inflation rates are dwarfed by the double digit rates of inflation we experienced in the1970s and early 1980s. The same analysis applies to long-term interest rates. The 10-year treasury yield has settled in the 4% range, a far cry from the 15% peak in rates experienced in 1981. These lower rates unfortunately led to irresponsible growth in debt/leverage. Leverage is a beautiful thing when asset values are rising, but can be lethal as our 7,000 laid-off friends at Bear Stearns know first-hand. Just as equity can evaporate quickly from a home purchased with a high LTV (Loan-to-Value) loan in a down market, so too can the equity disappear for a heavily leveraged bank when asset prices move unexpectedly. According to analysts at UBS bank, brokerage bank gross leverage -- assets divided by equity -- surged from an average of 21 in 2003 among the largest brokers to 30 at yearend 2007.
The pain has not been limited to the investment banks and global mega-banks that have created these toxic subprime mortgage pie slices, but even plain-vanilla regional banks such as Fifth Third Bancorp (Cincinnati, OH) have joined into the money losing fun. Fifth Third Bancorp (FITB) became the latest regional bank to cut its dividend, raise capital and, worse, warn that its loan losses will be greater in 2009 than the already sky-high losses of this year.
Where We Are Going
The rapid spread of globalization is affording the struggling 3 billion humans that earn less than $2/day on this planet the opportunity to improve their standards of living and join the 21st century with their chins held high. The productivity gains reaped from the technology revolution have propelled the global economy to double in size over the last 15 years despite the more than tripling of oil prices since the beginning of this decade. Fareed Zakaria, Newsweek journalist, captures the essence of globalization phenomenally well in his article “The Rise of the Rest” (sidoxia.com/files/The%20Rise%20of%20the%20Rest.pdf).
The unsustainable price spikes in commodities and flow of “black gold” to whom New York Times columnist Tom Friedman calls the “petro-dictators,” temporarily slows or pauses this mass poverty migration, but does not halt the march. U.K.-based natural resource giant Rio Tinto recently passed through 80-97% price increases to its largest Chinese iron ore customers. If it makes you feel any better, we spend about $25/gallon for Starbucks coffee and over $15/gallon for Fiji spring water, which makes gasoline at $4.50/gallon seem like a steal (Europeans are spending north of $11/gallon on gasoline). Fundamental economic principles maintain that these upward price movements cannot continue at this pace. But let’s be clear however, although price increases can’t increase at this pace forever, our globe is not home to infinite amounts of natural resources. Despite soaring oil prices in the past five years, crude output from nations outside the Organization for Petroleum Exporting Countries has remained essentially flat since 2005. Exxon Mobil, the $450 billion “Super Major” behemoth is also running on a treadmill attempting to stay in place. Although capital expenditures are forecasted to increase by approximately $5-10 billion per year on a $21 billion current annual budget, Exxon still expects oil production to be relatively flat through 2012. Similar supply issues are being found across the globe with respect to other important commodities such as wheat, rice, and corn. Petroleum, which is a building block for fertilizers and pesticides, is not relieving food prices either. Food inventories are at their lowest levels in 60 years according to renowned investor Jim Rogers.
Countering these inflationary, economic headwinds is the Technology Revolution, which is operating as a virtual freight train that cannot be stopped. Everything from microwave ovens, to broadband access, iPods, Tivo, Blackberries, Google, WiFi (Wireless Fidelity), and GPS services (Global Positioning Systems) have completely transformed the way we live today. Billions of other emerging market participants will add these productivity devices/services to their technological tool-belts in the coming years at much cheaper prices and with improved capabilities. However today, pessimism reigns supreme. It is always darkest before dawn and many parallels exist between the Savings and Loan (S&L) crisis experienced in the early 1990s and the banking debacle today. The U.S. economy has survived through wars, assassinations, banking crises, SARs, natural disasters, terrorist attacks, bird flu, mad cow, and yes, recessions! The market is impatient and will anticipate recoveries before they actually happen. Starting in 1991, as earnings deteriorated, the overall market began its incredible 10-year bull market advance.
Will 2008 be the beginning of the next advance? One can never be sure on the short-term direction of the market; however it is always beneficial to have a disciplined plan in hand. So what should one do in these stormy markets?
At Sidoxia, we are not sitting on our hands and watching these global changes fly by. Rather we are taking advantage of these developments by positioning portfolios in areas that will participate in these mega-trends. Just remember, the storm clouds will eventually dissipate and the sunshine will reemerge. We have survived through many storms before and we are confident that this case in point will be no different.
Plan. Invest. Prosper.
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