Tuesday, August 5, 2008

A Post Modern Economic Fairy Tale

Fairy tales do not tell children that dragons exist. Children already know that dragons exist. Fairy tales tell children that dragons can be killed. ~G.K. Chesterton

Once upon a time, in a country ever so close, there were a group of peasants whose grandparents had lived through some really difficult times. As a result, throughout their lives, those grandparents (the grands) did quite strange things like save money, eat leftovers, wash and reuse aluminum foil, and mend their own clothes. The grands lived within their means. At the same time, the grands loved their children and grandchildren, and wanted nothing but the best for them – which included sparing their progeny having to endure any lack of material goods. The progeny weren’t really spoiled, they just liked nice things.

Everything in the kingdom clicked along normally for quite some time: the progeny bought what they could for themselves, the grands chipped in when there was even the suspicion of want, and everyone lived a moderately comfortable lifestyle. Then, one day near the turn of the century, everything changed when the dominant industry, technology, found itself locked in the dungeon with a dragon in a fight for its life. At roughly the same time, the kingdom came under siege from terrorists, which desperately frightened the peasants. In order to fight the dual threats of dragon and siege, the kingdom’s Financial Wizard, Uncle Greenspan, decided to flood the kingdom with low interest cash. And the peasants rejoiced.

The rejoicing was contained in the peasantry though, for certain investors did not like it at all. Low interest cash made it difficult for them to earn enough interest income. So the bankers, being creative fellows, decided to package home mortgages for sale to those investors at higher interest rates than Uncle Greenspan was willing to offer. Because they needed a continuous stream of new mortgages in order to create these new investment vehicles, the bankers lent more and more of the peasants money to buy homes… including peasants who had didn’t earn enough barley per year or already had two homes. Home demand grew as rental peasants became home owners, and the average price of a hovel within the kingdom rose significantly. The creative bankers, still hungry for new loans, lent the home owning peasants even more money against the increased value of their hovels.

At first the peasants used the new loans to pay off debts owed, or to add a new porch or a better thatch roof to their hovel. But as the home prices continued to rise and the creative bankers continued to lend, the peasants started looking toward the purchasing habits of the royalty for inspiration on how to spend their new found wealth. The peasants shopped and shopped and shopped, truly enjoying the nicer things of life.

But as in all fairy tales, eventually the Evil Queen must put in her cameo appearance. In this case, the Evil Queen removed the ‘beauty’ spell placed on the investments created by the creative bankers, causing investors to flee the investments with horror. This in turn meant that there were fewer peasants able to buy homes, and soon not only were hovel prices kingdom-wide slipping, but there also was no more almost-free money to buy the nicer things in life. The kingdom’s consumer economy was under siege. Uncle Bernanke (Uncle Greenspan having since retired to the book and lecture circuit) and his friends in the turrets of Capitol Hill issued alms to the peasants in the late spring to reinvigorate their spending and restart the party. But alas, with the fall in hovel prices, the retrenching of the stock market as well as high food and fuel prices, peasants are stretched as if on the rack, despite a fairly decent employment outlook. It appears that the peasants will be recovering from their bout of affluenza for a long time to come. If only they had listened to the lessons of their grandparents. Interestingly, even the royalty seems to be at least slightly cognizant of the higher prices and economic pressures on the peasantry – not one has been heard uttering ‘let them eat cake’ – probably because it’s an election year.

Luckily, the Evil Queen’s spell has had limited affect on other parts of the kingdom’s economy. Gross Domestic Product continues to muddle along at very slightly positive rate, although our firm’s chief wizard/economist believes that the odds of the kingdom experiencing an authentic blessed-by-the-powers-that-be recession now stand at 60-70%. Of course, the peasantry all agree that we’re already in that recession, but what do they know? Interestingly, manufacturing, especially manufacturing for export to other kingdoms, continues to be decent. The net export component added about 0.8% to Q1 GDP, although it was hurt by higher oil imports (higher in dollar terms, not necessarily barrels of oil.)

That being said, medium sized companies are finding it hard to borrow money for their businesses from the not-feeling-so-creative-anymore bankers. The most visible victims of this are being seen in the retail sector, where consumers and bankers have pulled back at the same time. I am keeping a list of retailers who have filed for bankruptcy, and it is getting longer every day.

The good news is that the international kingdoms economies, especially the emerging economies of the BRIC nations (Brazil, Russia, India and China) seem to be holding their own, although slowing a mite from their torrid pace. When selecting stocks over the recent past, we have given a higher preference to companies with overseas exposure. We have also tried to minimize the financial sector exposure, emphasizing instead stocks within the energy complex. We do expect that slowing global growth should relieve some of the pressure on commodities, which should, in turn, lessen the burden on the US consumer.

The best way to survive this siege of the markets is through diversification and patience. All sieges end eventually. And even in environments like this different investment classes and sectors can perform. Case in point is the performance within the S&P 500 sectors for the second quarter. While the financial sector (home of the not-feeling-so-creative-anymore bankers) returned a miserable -18.3% and the peasant consumer discretionary sector lost -7.8%, the energy sector gained 17.3% and the utility sector returned 8.0%. One of the things that we pride ourselves on is our efforts to protect clients’ investments on the downside. We are definitely risk averse and have tried our best to position your portfolio to reflect that.

All fairy tales aside, these are the times in the market that build character. Try to remember that eventually we’ll come to the part where they all lived happily ever after.

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