Washington Square Capital Management Blog

We hope your summer is going well.

Now that we’ve reached the mid-point of 2010, we thought this would be a good time to look back at our list of Top 10 Themes for 2010 and see how our predictions have fared. We’ve attached this list with an assessment of each of our calls.

Like the recent quarters that have preceded it, the second quarter of 2010 was very eventful.  On April 16^th, the SEC dropped a bombshell when it filed a civil lawsuit against Goldman Sachs charging the firm with fraud over its marketing of a 2007 subprime mortgage product known as ABACUS.  The lawsuit shocked many in the financial services industry as it demonstrated the SEC was getting serious (though many have argued too little too late) about holding the larger firms accountable for questionable business practices that helped accelerate the subprime meltdown.  As a result, Goldman’s reputation has taken a major hit and the firm’s share price has fallen over 30% since the lawsuit was first announced.  The lawsuit helped set the stage for the financial reform bill now working its way through Congress.  And while the White House and Congress have repeatedly denied any knowledge of the SEC’s lawsuit prior to its announcement, the timing of the suit certainly didn’t hurt the bill’s chances of being passed.

On April 20^th, an explosion on the Deep Horizon oil rig in the Gulf of Mexico destroyed the platform, killed 11 workers and ruptured a riser pipe on the ocean floor that continues to leak oil and gas into the Gulf of Mexico as of this writing.  While initial reports downplayed the severity and extent of the leak, the world quickly learned how devastating this disaster would become after several attempts to staunch the flow failed.  The only viable solution now appears to be the two relief wells BP is digging, which are still several weeks from completion.  The spill, which is now the largest ever to originate in US waters, will no doubt have long term environmental and economic consequences for the gulf region.  In the short term, we will likely see the spill become a focal point for the coming energy bill as well as the November mid-term elections.

May 6^th marked the day of the now infamous Flash Crash.  At approximately 2:45 pm, the Dow Jones Industrial Average lost over 700 points in a matter of minutes, only to regain those losses several minutes later.   At one point, the Dow was down 998.5 points, which represented the largest intraday point decline in history and temporarily wiped out over $1 trillion in market value.  The cause of the crash has been vigorously debated, but many agree the central problem was an issue of liquidity (traders willing to buy and sell stock in quantity at the prevailing price).  Today, much of the stock market liquidity is provided by high-frequency traders (HFTs) – computer-driven algorithms used by firms trading at speeds measured in the millionth of a second.  While these HFTs provide liquidity during most normal market conditions, they are not always required to participate in the market (their primary objective is to turn a profit, not to maintain orderly markets). Many critics have suggested that something like the flash crash could occur if a group of these HFTs stop trading simultaneously.  The SEC has since instituted system-wide trading curbs or “circuit breakers” on any S&P 500 stock that rises or falls more than 10% in a five minute period.  It remains to be seen whether or not these measures will prevent another Flash Crash.

In addition to the above the highlights, the quarter also saw a further deterioration in the European sovereign debt crisis, a sustained correction in global equity markets and a some less than stellar economic data from China.

But not all the news is bad!

On a personal note, this past quarter also marked the first year anniversary of Washington Square Capital Management (on May 15^th).  This past year has been memorable (to say the least) and we wanted to thank you again for your commitment to work with us – we recognize that none of this would have been possible without you.

Memorial Day Weekend also marked the marriage of Subir to Molly Barker.  There were two weddings: an Episcopal service held on Friday May 28^th in New York City and a Sikh service held in Glen Cove, NY on Sunday May 30^th.

We look forward to speaking with you during our quarterly review.

1. We expect to see the US unemployment rate to peak at 11% in 2010. We may have been a bit aggressive with this call.  While the US job market remains anemic, the unemployment rate now stands at 9.5% (the lowest all year), partly because of workers who have dropped out of the labor force (stopped looking for jobs).  A falling unemployment rate would normally be encouraging news, but private sector job-creation continues to be very slow, despite the record amount of stimulus that has been pumped into the economy. In addition, the most recent jobs data has been disappointing, so the looming threat of a “double-dip” recession remains high and 11% unemployment later in the year is not out of the question.
2. Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010. This scenario has been playing out as we expected.  According to ICI[1], only $7.82 billion in new money has been invested into equity funds through June 23^rd 2010, while bond funds have seen $154.35 billion of net inflows.  Over the last eight weeks (where we’ve seen equity markets correct), net inflows into stock funds have been -$31.29 billion, while bond funds have seen +$33.98 billion over that same period.  We continue to believe demographic factors in the US and Europe as well as an increasing wariness towards stocks after two major bubbles in 10 years will lead investors to allocate larger portions of their portfolios to fixed income investments with a higher claim on corporate cash-flow than stocks.
3. We expect a number of credit downgrades for developed nations as their persistent deficits come into focus.  The US Dollar will strengthen in any ensuing flight to safety. This prediction has been right.  Since the start of 2010, we’ve seen credit downgrades to Greece, Portugal and Spain, as well as a massive bailout plan for Greece.  The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated.  It reached a level of 1.1875 per Euro on June 6^th and has recently bounced back to the 1.25 range.  We expect continued pressure on the Euro until a workable solution for the sovereign debt crisis has been reached.
4. Interest rates will remain effectively at 0% until the 4^th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range. So far this prediction has been accurate.  The Fed has kept the fed funds rate at historically low levels.  It remains to be seen whether or not the Fed opts to raise rates in the 3^rd or 4^th quarters.  While most commentators believe the latest round of economic statistics have made a hike unlikely until 2011, we still believe there’s a good chance the Fed raises rates to the 1-2% level after the mid-term elections in Q4 2010 and then pauses for an extended period.
5. Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order. This trend appears to be holding up.  In May, the personal savings rate reached 4%, which is the highest level it has been in 8 months and a far cry from the .8% we saw in April 2008.  Outstanding consumer revolving debt also continues to decline.   The most recent data from the Fed (for April) shows revolving debt at $838 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
6. The US economy will see almost negligible growth for 2010. It’s a bit early for this call since we won’t see this year’s GDP data until 2011.  Current GDP estimates are on track for 3% growth in 2010.  The caveat, of course, is that this has been accomplished with record government stimulus.  If the economy is unable to stand on its own without the crutch of stimulus, it’s entirely possible the second-half will be much weaker.
7. Corporations will increasingly turn to mergers and acquisitions to grow market share. This prediction could go either way.  According to the NY Times, the first half of 2010 has seen $810.3 billion in global mergers and acquisitions.  Through the same period in 2009, this number was $814.6 billion.  However, many of the 2009 deals were a result of government activity in the banking sector, whereas 2010 has seen deals taking place across a range of industries.  A recent Ernst & Young study of more than 800 senior executives across the world showed that 57% of businesses surveyed said they are likely to acquire other companies in the next 12 months.  This number was 33% in the last survey (in November of 2009).  Whether or not these executives follow through on this sentiment remains to be seen.
8. Growth in emerging markets will continue to outpace developed economies.  But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery. This trend appears to be holding up in 2010.  After a year of gaudy returns, the global equity rally faded in the second quarter.  As of June 30^th, the MSCI emerging markets index was -7.22% year to date, the MSCI EAFE index (which tracks developed markets in Europe, Australasia and the Far East) was -14.72% year to date and the S&P 500 was -7.57%.  We continue to believe equity market returns across the world will be negative in 2010.
9. We believe there is continued risk for a massive correction in China. While we have not yet seen a “massive” correction in China, the Shanghai composite index is now at a 15 month low and is down over 25% through the end of Q2.  We continue to believe equity and real-estate markets in China are over-valued and there is further to fall.
10. In 2010, certain commodities are poised for a sharp sell-off.  Top of our lists for a correction are gold and oil. This call has produced a mixed result.  Gold is up over 13% through the end of Q2 while oil is down over 14% over the same period.  While gold remains a popular investment alternative to faltering currencies (Euro, USD), we believe its big run-up over the past few years puts it firmly into bubble territory.   We believe oil prices will remain depressed until the global economy is back on its feet.

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[1] The Investment Company Institute, which tracks mutual fund flows

For this letter, we’ve attached a brief summary of the investment highlights for the first quarter along with our analysis.  We hope you find this useful.

Two major economic developments not covered in this attachment we thought worth mentioning are:

Landmark Health Care Legislation. Congress and the Obama administration finally managed to pass the much debated health-care bill.  We believe we will see further attempts to control the costs of health-care in the US, including an emphasis on preventive medicine and result-focused care. These additional efforts and the implementation of various phases of the bill recently passed will impact the health-care system for years to come.  Also important to note is that the successful passage of health care related legislation leaves Congress and the Obama administration free to focus on the equally important issue of financial reform.  On that note, we believe the proposed ‘Volcker rule’ is a good start and is the appropriate equivalent of Glass-Steagall for our age and the infrastructure of modern finance. We would also like to see reformed compensation criteria across the financial industry and large corporations, but that is a corporate governance concern best saved for another letter.

Withdrawal of Economic Stimulus. The other major theme we expect to impact our economy over the rest of the year is the withdrawal of extraordinary fiscal and monetary stimulus programs put in place during the crisis. Various measures by the Fed, European and Asian central banks to provide liquidity support to banks and markets will be withdrawn over the course of the next several months.  Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China.  As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.  We will also keenly track developments in trade agreements since various countries have enacted or are considering trade barriers and currency related moves to protect key industries and exporters.

We look forward to speaking with you during the quarterly review.

2010 Q1 Highlights

Equities. The S&P 500 started the year at 1115 and began a moderate sell-off in mid-January, bottoming out at an intraday low of 1044 on February 8th before rallying to a new 52 week high on March 25th, peaking at an intraday level of 1180.  The stock market rally is now more than a year old and much of the recent gains have occurred on weak volume, indicating a lack of conviction from investors.

Our view: We remain skeptical of this rally and believe stock prices have gotten ahead of themselves and are currently over-valued.  We would like to see stronger underlying economic data emerge (lower unemployment, higher consumer confidence, improved housing numbers, etc) before becoming more bullish on stocks.  For now, we continue to believe a defensively positioned portfolio is prudent.

Interest Rates.  On Feb 18^th, the Federal Reserve raised the discount rate (the rate at which banks pay to borrow money from the central bank) by 25 basis points to .75%.  This was viewed as a relatively positive event, since it meant that the Fed felt confident enough in the economic recovery to start charging banks more to borrow money.  The more widely followed Fed Funds rate (the overnight rate depository institutions charge each other to borrow money in order to meet reserve requirements) remains at historically low levels (effectively 0%).

Our view:  We don’t expect the Fed to raise the Fed Funds rate until the 4^th quarter of 2010 (at the earliest) as the consensus amongst the FOMC will likely want to wait until the economic picture shows stronger signs of a sustained recovery.

Taxable Bonds.  Taxable bonds have continued to perform well, particularly in the high yield (lower quality) space.  The high yield rally has corresponded with the stock market rally as investors continue to feel more comfortable taking on risk.  As a result, many high yield bonds are trading at levels virtually unfathomable a year ago.

Our view:  In anticipation of a likely rate hike coming at some point in the next 6-12 months, we are positioning client portfolios to be on the shorter end of the yield curve (preferring short-term bonds to long term bonds).   For bond funds, we prefer the following categories: short/ultra short duration, international and inflation protected.   For individual bonds, we see the most value in BBB rated manufacturing, energy and consumer goods names.  We also like stepped note bonds/CDs as they provide a hedge against rising interest rates (which are pretty much inevitable given where rates are now, it’s just a question of when).

Municipal Bonds.  On March 16^th, Moody’s announced they will shift to a long anticipated universal ratings scale in an effort to make it easier for investors to compare ratings between corporate and municipal bonds.  This move will likely boost the ratings on many of the municipal bonds they cover.  These higher ratings will not be viewed as an upgrade, but rather a recalibration to the new scale.

Our view: With record federal government deficit levels and the recent passage of the Obama health care bill, we believe federal income taxes will likely be raised in order to offset these costs.  We believe municipal bonds remain attractive due to their tax status (federally tax exempt and occasionally state/local exempt).  We prefer high quality general obligation bonds (bonds backed by the taxing authority of a state or municipality) and essential service revenue bonds (bonds backed by the revenues generated by utilities, universities or water and sewer projects).   We believe default risk (particularly for general obligation bonds) is low given the senior status debt service payments enjoy in most municipal budgets (in California, for example, bond holders are junior only to the public school system in terms of how tax revenues are spent).

Sovereign Debt.  The major story this quarter was Greece and its escalating budget crisis.  A tentative bailout agreement was reached in late March, backed by the European Union and the IMF (International Monetary Fund).  The concern here is that this will set a bad precedent as other countries in the European Monetary Union with debt problems (of which there are many, notably Portugal, Italy, Ireland and Spain) will expect similar assistance from the IMF for debt relief.  Meanwhile, back home, US treasury rates have steadily crept up this quarter as the government continues to issue record amounts of debt and the market requires a higher yield payout to own this debt.

Our view:  We expect treasury rates to continue this upward trend.  We prefer short dated treasuries to intermediate and longer term treasuries.  We believe the situation in Greece has not been fully resolved yet and expect more bailouts/aid packages will be necessary to shore up the debt problems for some of the other Euro zone countries mentioned above.   We believe the European Monetary Union faces a grave crisis since the common currency (the Euro) leaves sovereign states unable to devalue when faced by a budget crisis.  The solution is either greater political and budgetary synchronization, or accepting that EU countries may default and defining a mechanism for them to do so without impacting the surviving members.  The uncertainty and perceived lack of a resilient solution is weighing on the Euro.   We believe the Euro will continue to weaken against the US Dollar until these problems are properly addressed.

We hope you enjoyed a restful holiday season and have had a good start to the New Year.

In this quarterly letter, our aim is to provide a review of Q4 2009 as well as a look ahead at 2010, which we’ve separated into an attachment titled “10 economic themes for 2010”.

In the fourth quarter of 2009, risky assets (stocks, commodities, low-grade bonds) added to mid-year gains, while safe-haven treasuries continued their descent from the panic highs of last year (the ten year yield has gone from 2.06% to 3.84% over the year as investors took on more risk).  Strong government support remained the order of the day against a backdrop of continued economic weakness, as the unemployment level rose above 10% for the first time since 1983.  The Federal Reserve kept short-term rates at 0.00-0.25% (boosting bank earnings) and fiscal stimulus continues (extended unemployment benefits, housing purchase credits, etc). The scale of government support in all forms is remarkable and we believe much of the economic landscape over the next few years will be determined by how this support is withdrawn, and how the long-term debt created by these expenditures is tackled.

Our view remains that high levels of unemployment, household debt-reduction and tighter credit standards will continue to keep growth rates at very moderate levels. We consider stock market valuations to be over-stretched and continue to believe the current stock market rally is unsustainable.  Prior to raising equity allocations, we would like to see a sustained organic recovery (as opposed to one supported by government stimulus spending) or far more attractive values.

We look forward to speaking with you during the quarterly review and wish you the best over the coming year.

We hope you had a pleasant summer and are enjoying the start of autumn.

The third quarter was very eventful, both for us as a firm and for the markets in general.

In the financial markets, the events of 2008 continued to reverberate and color all economic activity. After a precipitous drop-off in trade and consumption in the first half of the year, global economic activity began to rise from extremely low levels. Some of the more dire scenarios that had seemed possible just six months ago now look a little more remote. That said, economic activity in most developed countries continues to be far below recent levels and capacity. Unemployment continues to rise in the US and in many parts of Europe. In addition, the commercial real-estate market is suffering, many retailers are struggling to meet sales forecasts, and concerns remain about the holiday shopping season. Federal incentives have supported automobile and home sales, but we view these as temporary measures and not long-term solutions. We believe that unemployment, deleveraging and high savings rates will continue to keep growth rates at very moderate levels for some time to come. American consumers and industry remain cautious, and most participants have accepted that this recovery will be protracted and slow.

The summer also saw very large moves to the upside in both bond and stock markets, particularly in the high risk segments. Along with increased risk-taking, interest rates for intermediate and long-term treasuries have risen from panic lows, with the 10 year yield moving from 2.06% on December 30^th to 3.29% today. Meanwhile, the Federal Reserve remains committed to keeping short-term rates at very low levels and the 2 year rate remains under 1%. We continue to believe the Fed will refrain from any material tightening until the end of 2010 as inflation is not a concern at the moment. However, we may see a swift rise in intermediate and long-term rates with any tightening, and have begun to position bond portfolios to take advantage of reinvestment opportunities when that happens.

We remain skeptical of the rally currently underway in global stock markets, and would like to see evidence of a sustained organic recovery (as opposed to one supported by stimulus spending) before we commit any additional capital to risk assets. From past experience, banking crises tend to cast a shadow on markets for a number of years, and we do not believe this episode will be different.

Meanwhile, on the local level, we used the summer to finalize our transition to the independent advisor model and launch a discretionary investment strategy called “Global Macro 10” which we have been discussing for some time (September was the first complete month of performance for this portfolio). Late this month Subir also learned that he had been awarded the Certified Financial Planner™ (CFP®) designation (Louis plans to follow Subir’s lead and will begin working towards his own CFP designation).

We look forward to speaking with you soon and wish you the best over the coming months.