2010 Second Quarter
"The U.S. is in the midst of major internal and external realignments for which parts of the labor force are unprepared. Internally, the economy is adapting to an environment of lower credit, general deleveraging, higher regulation and future tax increases. Externally, it is adjusting to the impact of emerging economies like China and the fact that certain European countries are facing increasingly unsustainable debts and deficits." - Mohamed A. El-Erian, CEO and Co-CIO of PIMCO.
I thought the opening paragraph was a good summary of the state of the current investment climate. It was these "realignments" that created some significant stock market headwinds during the months of May and June. I will spend some time in this report discussing the Flash Crash that took place on May 6th, 2010 and how similar events might impact our portfolios in the future. After briefly recovering from the Flash Crash, we witnessed a sell-off during the rest of May and June that I believe was a combination of profit taking after a significant stock market rally and the fear that the crisis in Greece could eventually wind up on the shores of the United States. I will discuss these themes in this quarter-end letter.
Before proceeding, I thought it would be appropriate to touch on the fixed income markets. Shortly after I sent the previous quarter-end letter, I began to hear that the leaders of PIMCO, the giant fixed income manager, did not believe the Federal Reserve would raise rates until the year 2011. I also heard that Goldman Sachs thought the Fed would have to wait until 2012 to lift rates. With the continued high unemployment rates and potentially slowing economy, I expect that the Fed will have to keep rates low for at least another six to twelve months. I interpret this to mean that we can keep your intermediate bond exposure right where it is at, if not add a little to this category. I will continue to shy away from longer-term bonds, which tend to be much more volatile than they are worth.
The Flash Crash is a label that the press attached to an event where the Dow Jones Industrials fell nearly 1,000 points in a half hour. No one knows exactly what caused the Flash Crash, but many believe it was a combination of exchange traded funds (ETFs) and the ability to place "stop-losses" on these ETFs and other individual stocks. Stop losses allow the investor to automatically sell a stock or ETF at a certain price during a decline. If hundreds or thousands of sales are placed at a certain price on the same index (several stocks packed into one security), then a catastrophe like the Flash Crash could take place.
No wonder why John Bogle, the father of index funds, chastised the creation of ETFs. He did not like the fact that you could trade in and out of them like a stock or sell them short (borrow the shares from a broker and then sell them in the hopes that the underlying security declines). He still prefers mutual funds which gives the investor the closing day's price when a trade is made.
The Securities and Exchange Commission (SEC) now has rules put in place that will supposedly prevent a Flash Crash event from occurring in the future. I do not want to badmouth ETFs in general - I believe that they can be a wonderful tool for investor portfolios. In fact, many of you already have one or two ETFs and I may add more of them to your portfolios in the future. I view these securities as long-term holds; they are not something I would trade in and out of in five minute intervals. As the rapid trading of ETF indexes becomes more popular, it may present an opportunity in the future for our value fund managers to find deeply discounted stocks due to panicky investors piling on and selling the index containing a particular stock and, in essence, throwing the baby out with the bathwater. In other words, there could be some inefficiencies that a good manager can profit from.
Greece, I am told, is a beautiful country with a rich history. It is known for their exquisite, remote islands where tourists enjoy their warm, sunny beaches. If you were to listen to the bond market these past few months, you would have thought that Greece was located at the North Pole. Greece is the current poster child for countries that spend more than they make. Much like Chrysler and General Motors promised more than they could deliver to retirees' pension plans, the government in Greece promised too much to their government workers. Bond investors became nervous and demanded more yield to compensate for the additional risk in loaning money to Greece. Unable to print more money to finance these growing expenses (they are part of the European Union and thus cannot print more Euros by themselves), Greece had to turn to Germany and other economic leading countries from around the world to help solidify a shaky financial situation.
Once investors saw what was happening to Greece, they asked if it could happen to other countries. Ireland, Spain and Portugal were routinely brought up as risky places to hold bonds. As foreign stock markets suffered, the fear eventually hit the U.S. stock market and quickly moved it into correction (10% declines from the previous peak) territory. Ironically, this also rallied the demand for the U.S. dollar, which was severely ridiculed not so long ago.
With that background, I believe most investors are concerned with the debt the U.S. has taken on in recent years. With social security, Medicare and Medicaid making up the lion's share of this future debt, it will be difficult to pay the debt off without raising taxes and/or reducing Federal spending in other areas. I continue to believe that the best way to take advantages of this uncertainty from an investment perspective is by investing in good, solid value funds where the manager is consistently buying stocks that have deep value characteristics with a nod to strong financial statements and dividend streams.
The S&P 500 was looking very cheap at the beginning of July and I suspect many investors found bargains there the last few days. As second quarter corporate earnings surprise to the upside, optimism is beginning to return to the market. Let's hope we can build on this momentum through the rest of 2010.