WELCOME | This is our second newsletter of 2010, we hope that the summer weather is starting to rear its head in your neck of the woods. As always, through this newsletter, we'll take a crack at providing a view from 30,000 feet as to where we’ve been and where we are going with regard to our firm, investment philosophy and the economic/investment climate as a whole. Without further delay here you are...
REAR VIEW MIRROR | Since the first of the year we have reviewed an abundance of articles, newsletters, and analyst reports pertaining to the economy, currency, commodity, equity and bond markets. Through our efforts to derive our own opinions, we've never seen such a wide dispersion of economic views. From the Armagedeon-esque double recession to the "Trees don't grow to the sky, but this stock market rally most certainly will." and everything in between. Castle is never one to sit on the fence of opinion but under current conditions we certainly feel we will be witness to a mix between the Bull and Bear camps. The reality is that investors have next to no confidence in any one economic view and are treating all forecasts with more skepticism than in years past. Fortunately, when we sort through the complexity of forward looking forecasts, the facts clear and concise. Over the past (2) years investors have experienced the bursting of (2) bubbles, real estate and the credit crisis with the collapse of Lehman Brothers. Following the utterly painful consequences of the implosion of wealth the U.S. markets rallied over 75% through April 23rd of this year. Capital is generally is misspent during periods of euphoria. Only during the bust does the extent of the misallocation become apparent. In its April 2010 Global Financial Stability Report, the IMF reduced the estimated bank write downs and loan provision in 2007-2010 to $2.3 trillion from $42.8 trillion in October 2009, citing improving economic and financial market conditions' contributions to higher bank capital positions. Two-thirds or $1.5 trillion of the expected losses had been realized by the end of 2009. The IMF is the International Monetary Fund, the international organization that oversees the global financial system by following the macroeconomic policies of its member countries. The IMF's objective is stabilizing international exchange rates and facilitating development through the enforcement of liberalizing economic policies on other countries as a condition for loans, restructuring or aid.
Since March of 2000 the U.S. equity markets have found themselves in a Secular Bear Market the 5th of its kind since 1900. Secular Bear Markets typically last 15-20 years before the Price to Equity ratios fall below 15 providing fair valuations and allowing markets to enter into a Secular Bull market which on average has last just over 13 years since 1900. As you may know Buy-and-Hold is a long term investment strategy based on the view that in the long run financial markets have a good rate of return despite periods of volatility or decline. Buy-and-Hold strategies dominate traditional investment space and have earned an abysmal total return of around -20% in the S&P 500 over the past decade, while enduring (2) separate instances over the past decade where they have lost about half of their value as part of the ride. This is precisely why Castle Strategies encourages investors to curb the rally born enthusiasm and err on the side of caution through active management which pinpoint absolute returns regardless of market cycle.
ECONOMY | It all can't be bad news right? There's always two sides to a coin. Over the past year economic news is ever improving, in particular profits and corporate liquidity. U.S. non-financial firms seem to be in the best shape in over a decade. The combination of sharply rising productivity and low corporate debt levels should continue to produce positive results. Relatively speaking the economy is still pretty weak and will gravitate towards very sub-par recovery growth of around 2%. This is well below post-recessions of the past. The average spending for upper-income households(those with incomes above $90,000) in February plunged to a new low, down 13% from January. By contrast, spending by middle and lower income households has been more or less for a year. Both are significantly off their May 2008 peaks, down by almost half for both groups. The two (2) large hindrances to growth remain, household deleveraging and a heavy fiscal drag. From a macro view this is not all bad. The fiscal drag should allow profits and productivity to keep rising, hold inflation in check, and allow the Fed to keep rates low and liquidity abundant. This should set up for a slow and steady recovery and resist the creation of new asset bubbles. There do remain skeletons in the closet that could derail this recovery, namely taxes. Historically tax increases typically have a negative impact on GDP threefold. We would also note that the growth over the past year has been largely statistical. Part of this came from inventory replenishment, as warehouse shelves were nearly empty. The data for container shipments, which are reflective of finished products rather than raw materials, started 2010 stronger than 2009 and increased further in March. Not so fast bulls, recently the index of U.S. leading economic indicators unexpectedly declined in April, a sign the inventory replenishment cycle may cool in the second half of the year. Secondly, do we remember a significant portion of the increase in GDP came from the government stimulus? This begins to wane in the second half of the year. With this said, the Fed continues to reiterate that rates will remain exceptionally low for an extended period of time. Through the Feds pointed communication we continue to believe that the central bank will not raise rates before the end of the year as high unemployment rates will persist, closer to 10% than 9%. Currently they sit at 9.9% which is slightly higher than January and barely lower than December. It should be noted that we need around 125,000 new jobs per month to just keep pace with the growth in population. The average unemployment rate for the upper 5th of the income distribution was 25; for the middle 5th, it was 6%; and for the bottom fifth, it was 19%. So there is a great disparity amongst socioeconomic classes.
We put the odds of a second moderately sized sell-off in 2011 at 50-50 although no where as severe as 2008-2009. Which hopefully won't be as painful as the first if investors have learned anything from the last sell-off...move to cash and preserve capital during times of volatility. Active management should continue to garner press until the market exits this Secular Bear market that we've been in since 2000, which could take upwards of 5 years.
STOCK MARKET | Currently the markets are back to square-one for the year. As we write this the S&P 500 has moved back into negative territory for 2010. With the S&P 500 falling back to the levels of November 2009, the traditional Buy-and-Hold investors find themselves in a state of purgatory. We felt strongly that the market was due for a breather as we pointed to in our fall 2009 newsletter. Timing is never an exact science in investments and you can't fault us for being early to the party. Nor can you blame the Perma-Bulls for hoping to recoup the decade of mounting losses. None the less, volatility has subtly crept back into the fold seemingly triggered by troubles across the pond. The Eurozone faces complex issues with sovereign debt in the cleverly nicknamed PIIGS(Portugal, Italy, Ireland, and Spain). This situation could continue to provide pain throughout global stock markets for an extended period of time while issues are worked out. No one is immune to issues overseas, as an example we cite the U.S. credit crisis in the spring of 2008, which brought down markets abroad. Investments whether domestic or foreign in nature are joined at the hip to the economies of the world. Our problems are their problems and vice versa to an extent. This coupled with an unprecedented rally and the "Sell in May and go away" effect, we are most likely in store for continued volatility into August. With regard to the "Sell in May and go away" effect, since 1950, the Dow Jones Industrial Average has produced an average gain of 7.4% from November through April and 0.4% from May through October. This in itself is a quite compelling argument for active management, secular market or not. All-in-all there is no reason to fret we find ourselves in an active manager's playground, whether pain or pleasure opportunity will present itself on one side of the fence. It's never too late to diversify portfolios by becoming a proponent of active management.
During the past year we have seen an unprecedented rally which has bred speculation. As with anything else no one wants boring high quality stocks during times of feverish speculation. When Tickle Me Elmos were the prized holiday gift nobody wanted time tested Legos or Barbies. Within the U.S. large high quality companies are still cheap from a fundamental valuation standpoint. They are unlikely to do very well in a speculative environment, however long it lasts, but should be great in declines and in the end should be victors. We have strong conviction that the Coca Cola's of the world diversified with tech, telecommunications, healthcare, biotech and pharmaceuticals are positioned to outperform in the long term. The fundamental's in the technology sector has remained strong and we believe it is one of the few sectors that were able to digest most of the gains seen in 2009. Tech companies have underinvested capital during the past few years and seem to be opening up their wallets once again. After a long year of ambiguity, there seems to be some confidence in the healthcare sector after the passage of the healthcare reform bill. While the passing of this bill makes us nervous in the long term, it resulted in recent poor performance through oversold conditions. We maintain our view that the healthcare sector is positioned to outperform throughout 2010. With its defensive nature and growth attributes, we think healthcare will attract more investor attention in the current economic environment with little clarity elsewhere. Banks have been able to stockpile reserves more than any time since 1934 and their equity-to-asset ratio at 11% is the highest since 1938. This all despite the headwind of paying back 3/4's of their debt to U.S. taxpayers. With this said we continue to believe sitting on the sidelines by underweighting our holdings in the financial sector is prudent for the time being.
As the economy continues to recover slowly, equity markets should continue to grind higher by year end with some volatility along the way. This view leads us to favor U.S. stocks over other developed nations, especially since the economic recovery in the U.S. has taken root more firmly. Overseas there still remain opportunities in emerging markets although fleeting. The odds point to 2010 as a positive year for equities and other risk based assets. However, equity markets do continue to face risks. While real separation can be realized through active management, Buy-and-Hold investors most likely will be able to realize high single digit returns depending on asset allocation when the curtain falls on 2010.
FIXED INCOME MARKET | The Fed will, albeit gradually, begin to sell some of their mortgage holdings, as they reverse their quantitative easing measures. It doesn't take a Stephen Hawkins to see that this will pressure bond prices. The U.S. government was spending at an unprecedented rate and its money it doesn't have. This means that more and more Treasuries will continuously need to be auctioned off. In order to entice buyers to keep absorbing this supply, yields will very likely need to continue higher, just as they have over the past year. Municipals continue to be attractive to us due to their tax equivalent yield, with favoritism for longer term maturities. Negative headlines continue to dominate the municipal bond space, but for the most part states are proactively cutting expenses, increasingly at the local level, and raising taxes in an effort to reduce their significant budget gaps. Even though the current backup in the intermediate part of the curve may be a near-term buying opportunity, we believe the municipal market will continue to face pressure from negative headlines. In February, 56% of the states surveyed met or exceeded their forecasted sales tax collections, up from 50% in January, and 13% reported positive collections over the year, down from 30% in January. We remain overweight in the state-backed and essential service bonds particularly in Texas and Virginia.
REAL ESTATE | There has been no shortage of real estate headlines. Existing home prices have continued to fall. The Office of the Comptroller of the Currency reports that nearly 60% of modified mortgages re-default within a year. As counter intuitive as it may seem, we actually need more foreclosures to get through this real estate debacle, take a look at places like California, Florida, and Las Vegas, where foreclosure activity has been high and prices have fallen the most. There has been sharp pickup in home sales, which are steadily clearing the away the price-depressing inventory of unsold homes. In other words, market forces are working. We believe that we may experience another 3-6% decrease in prices before bottoming out and rebounding in-line with inflation. With inflation forecasted to remain low home buyers will have an extended period of time to take advantage of the real estate market.
GREENBACK & GOLD | The greenback has strengthened, commodity based countries have weakened and the Euro has weakened due to the issues with Greece and should continue to do so with Portugal, Ireland, Italy and Spain in increasingly dire circumstances with their budget deficit and sovereign debt obligations. We believe the Euro and U.S. Dollar will eventually come back into parity, until then we look to go long on the Dollar and short the Euro. While most applaud the strengthening of the Dollar(ourselves included) it will put pressure on U.S. exports. Gold has begun to once again strengthen. With fear rising in risk based assets and currencies, investors are flocking to the safety of gold. This could result in a potential near-term pull back in the greenback, we will keep a close watch on this developing situation.
ENERGY | In step with the stock market and inventory replenishment cycles, commodities have taken a breather and started to come back down to earth. For the 1st part of 2010 they were out pacing the global economic recovery. This coupled with multiple commodity rich countries(including China, India, Australia, and Canada) looking to remove economic stimulus and tighten monetary policy, we think demand for materials will continue to soften in the coming months.
Natural gas moved downward throughout the year but has found a durable bottom around the $4.00/MMBtu range. Which aptly so is in the range of drilling/production costs. When natural gas futures hit this pricing floor it is no longer profitable for companies to continue to produce and pay for storage of natural gas. Credit Suisse expects natural gas to hit $4.66 this year. new technological developments and massive discoveries of resources have caused supplies to balloon, while the recent economic downturn sapped a significant portion of industrial demand from the market. The ratio of crude oil to natural gas prices had deviated significantly from its historical average. At its current level in the low $70's/barrel, crude oil is about 17 times the price of one million British thermal units. That ratio has fluctuated historically but has generally stayed pretty close to 10. In order to get back to this norm, natural gas prices would need to quadruple, which would still put them well below levels touched only a few years ago. The energy sector has seen a string of acquisitions in recent months that all hint at expectations of an increased interest in natural gas going forward. GCEF ministers(OPEC of Natural Gas) from the world's 11 largest natural gas producers, which in aggregate account for 70% of global production, have agreed to work to index natural gas to oil, saying that such steps are necessary to encourage investments in exploration and production.
CLOSING | Surpises are likely; volatility and uncertainty are almost certainly going to remain throughout 2010. I would not plan to make +15% this year through a "Buy&Hold" approach unless you tip the risk scale greatly against your favor, as a number of structural headwinds will remain consistent through 2010 in Castle's analysis: deleveraging, increased regulation, and the forces of deglobalization. The liquidity environment continues to be positive for risk assets, market prices are likely to remain on an upward trend, mergers and acquisitions will increase and investment funds will continue to seek out good value. We firmly believe the key ingredient to successful investing should continue to be tactical asset allocation while using an active management approach to limit downside capture. Fundamental and technical analysis need to be married to one another in portfolio management. By only focusing on one, portfolios will be open to great risk. Our outlook and processes mitigate the risk of absolute portfolio collapse that many investors felt all too recently. We believe this emphasis on risk management presents the opportunity to generate superior, long-term, risk-adjusted, compounded returns. More detailed information on our investment philosophy or proprietary investment models can be found on our website at www.Castle-Strategies.com. As always if you have any questions or concerns please do not hesitate to contact the Castle Strategies, LLC team. Until our next newsletter, Happy Investing!
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