Washington Square Capital Management Blog

Before we begin our quarterly market commentary, we wanted to give you a few quick updates.  Louis was recently profiled in the Wall Street Journal online where he discussed the mobile budgeting app we are developing.  The genesis for the idea came from speaking to both clients and non-clients who have expressed a need for on-the-go assistance in tracking their spending habits.  We’ll keep you posted on the app’s progress and let you know when it’s in beta.

Over at the WSQ Capital blog, Subir wrote a blog post examining the fundamental differences between Google and Yahoo in how they approach the internet.  He wrote a second piece where he sites Pandora as a case study for how entrepreneurs can run into trouble if they sell too much equity to outside investors. And to complete the tech trifecta, he wrote a third piece looking at Facebook’s growth prospects just as the hype machine for the company’s IPO grinds into high gear. Meanwhile, Louis wrote a post that provides a primer for investors interested in learning what makes an investment socially responsible.

We look forward to speaking with you over course of the summer.

This has been an eventful quarter in the global markets. We now know that the UK has slipped into a double-dip recession with negative growth in the past two consecutive quarters. The jury is still out on whether this was driven by the relatively austere economic policies adopted by the Tory government and the Bank of England or the general weakness in broader Europe. Looking out east, we see a carefully choreographed political transition in China becoming unexpectedly messy. A very senior official, who was expected to join the nine-member Standing Committee of the Communist Party has been removed from his position in the Politburo and remains under house arrest amidst allegations of wire-tapping and murder. Meanwhile, the housing bubble in China continues to deflate.

Against this background, US stocks continued their upward trajectory. The S&P 500 index (a broad measure of large-cap US stocks) finished the quarter up over 150 points, closing at 1,408.47 – cracking the 1400 point threshold for the first time since 2008. This represented a quarterly gain of 12.59% (which, if annualized, would be 50.36%). These are gaudy returns and we don’t think it’s realistic for investors to expect stocks to continue performing at these levels for the remainder of 2012. So what’s been driving this rally? There has been a confluence of factors:

1. The primary explanation is extraordinary stimulus provided by the Federal Reserve over the past few years in an effort to stabilize the US economy. In addition to its 0% interest rate policy – intended to drive down mortgage rates, boost lending and encourage both investors and savers to flee cash and take on more risk – the Fed has played a direct, directional role in the bond markets via quantitative easing. So far, there have been two major rounds of quantitative easing (QE1 in 2008/09 & QE2 in 2010/11). Both rounds helped prop up equity markets as investors expected the Fed to be ready with its safety net protecting them against catastrophic losses.

In a variation on this theme, the Fed announced “Operation Twist” on Sept 21, 2011. It would sell $400 billion in short-term Treasuries to buy longer-dated bonds, driving down long-term rates. The policy took effect in October and is set to expire in June, 2012. At the time of its announcement, the stock market was mired in a summer slump with investors increasingly jittery about muted economic data and continued problems with the European debt crisis. Once Operation Twist took effect on Oct 1st, the US stock market began its renewed run upward to where we are today.

We recognize that these stimulus policies have been implemented to support the fragile US economy as it slowly emerges from the Great Recession. The catch, however, is that risk-taking investors have come to rely on the Fed’s intervention in the markets. Like clockwork, once these policies are set to expire, equity markets (and other risk assets) have sold off until a new iteration of the policy is announced. This is a dangerous precedent for the Fed to set. A constant cycle of interventionist policies skews market prices and encourages the type of herd-driven speculative behavior that caused the crisis in the first place.

2. In addition to continued Fed stimulus, the stock market has benefited from improving economic data (albeit from very low levels). Unemployment – while still stubbornly high – has continued to drift lower with recent monthly numbers beating expectations. Corporate earnings have beenstrong, especially for large-cap US conglomerates, which have continued to benefit from a weak dollar. Several of these companies have cut costs by reducing head-count and used the savings for share buy-backs and dividend distributions. With interest rates at historic lows, blue chip stocks with dependable dividends are attractive to conservative investors in search of income.

3. The equity rally has also been strengthened by the threat of inflation. The Fed’s policies have brought trillions of dollars of liquidity into the markets over the past few years. This liquidity has weakened the US dollar and driven up commodity prices. The consumer price index (CPI) – which measures changes in the price level of set basket of consumer goods and services purchased by households – has steadily crept upwards over the first three months of 2012. This trend suggests inflation could be closer on the horizon than expected, despite continued high unemployment levels and a stalled housing recovery. Since companies can adapt their strategy and pricing to changed conditions, stocks tend to be a better hedge against inflation than fixed income.

4. As the economy emerges from recession, an overheated economy becomes a very real concern. A majority of the board of governors in the Federal Reserve have stated that they expect interest rates to remain historically low through the end of 2014. However, this is not written in stone. If the economy does rebound and inflation picks up, the Federal Reserve will need to raise interest rates before 2014. Since the Fed can’t lower interest rates any further than where they are now, they will go up at some point. The question, of course is when. Once interest rates do start to rise, stocks will outperform bonds.

As the second quarter is now underway, we have seen a few of these drivers fading (which, not surprisingly, coincided with a selloff in stocks). The Federal Reserve has given no indication that another round of quantitative easing is imminent once Operation Twist expires in June. Corporate earnings continue to be strong, but US economic data, which was strong during the first quarter, has started to flag. If the macro-economy weakens materially, both inflation and the potential for an interest rate hike prior to 2014 become less of a concern and the Fed’s attention will turn back to unemployment. The monetary quiver though, is virtually empty, and there is not much we feel the Fed can do beyond keeping rates low.

So what does this mean for investors?

While we still view equities on the whole as over-valued, there are pockets of value in certain industries, and in individual stocks. We prefer large cap, blue chip stocks with strong balance sheets and dependable dividends. We favor short term, high quality bonds, with a preference for inflation protected or stepped coupon/variable rate securities. We continue to think that there will be an opportunity to buy stocks at an attractive level in the near future.

Louis Berger                                                                   Subir Grewal

Lou was profiled in the Wall Street Journal yesterday where he discussed the mobile budgeting app we are developing.

If you’re new to investing and thinking about putting your money to work using an approach that incorporates social or ethical criteria, it’s important to know what types of strategies are available to you and how to differentiate between them.

When we consider the socially responsible investment (SRI) universe, there are five main strategies most often used by investment managers.  SRI investors will usually incorporate some combination of these five when picking their investments.

1.  Positive Screening.  With positive screening, the investor looks for profitable companies that integrate corporate social responsibility (CSR) into their business practices and operations.  Typically, this investor wants to see the company actively engaged in the following issues: environmental conservation, human rights, labor rights, fair trade and indigenous rights.  This investor may also consider companies whose products or services directly address CSR issues, like a solar power company or an organic food manufacturer.  However, it’s important to note that just because a company is engaged in a sustainable business, doesn’t necessarily mean they are exempt from other CSR considerations.

2.  Negative Screening.  With negative screening, the investor excludes certain companies that do not place a high value on CSR within their business practices.  Often times, this approach means eliminating entire industries, like tobacco companies or defense contractors.  Like positive screening, negative screening can be subjective, as each SRI investor has his or her own idea of what does or does not constitute an ethical company.  For example, an investor who uses religious screening criteria may want to avoid a medical devices company that manufactures products used in abortion procedures.  However, a pro-choice investor will likely not take issue with this company, and rather, may actually consider it as a candidate for a positive screen.

3.  Best-in-Class.  With best-in-class, the investor often targets a progressive company within an industry likely to have a poor CSR track record.  An example would be an oil company that’s an industry leader in environmental conservation.  While the type of business (oil drilling) may not be considered socially responsible, the way the company conducts their operations (making environmental protection a priority) is the chief criteria.  In a way, this investor seeks to encourage and reward good corporate behavior with their investment dollars.   It’s important to note, however, that this approach can be susceptible to greenwashing, as a company may market themselves as being an upstanding corporate citizen, but in reality, may not live up to that image.  A prime example of this would be BP, which was once a top pick for best-in-class SRI investors prior to the Deep Horizon disaster.

4.  Activist Investing.  With activist investing, the investor targets those companies with poor CSR track records in the interest of changing the company’s business practices.  This approach uses proxy votes and shareholder resolutions to pressure management to alter corporate behavior.  This approach is most effective when used by large institutional investors (mutual funds, pension funds or foundations) or a coalition of smaller investors.  The activist investor, while a bit unorthodox in their approach, can achieve significant long term CSR victories when successfully petitioning large corporations to change their business practices.

5.  Community Investing.  With community investing, the investor is less concerned about the financial returns of their investment then they are about the greater social impact.  The main goal with this approach is to deploy investor capital to individuals, organizations or geographic areas that have historically been denied access to capital by traditional financial institutions.  Often times, this style of investment is done by larger institutions.  Individuals can also take part in this approach through microfinancing, for example.

In addition to considering the social and ethical approaches discussed above, it’s also important to make sure that an investment is a good fit for you, especially in terms of risk tolerance (how much risk you are comfortable taking – some investments can be riskier than others) and time horizon (when you will need access to your money – investors with short time horizons generally should stick to less risky investments).

As always, if you need help finding a socially responsible investment that’s a good fit for you, let us know and we’d be happy to schedule an introductory phone call.

Image Credit: Tom Magilery

Here are our top 10 investment themes for 2012.  These are the topics we think will have the biggest impact on client portfolios in the coming year…

1.  Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election. With the ongoing crisis in Europe, the Fed would normally be engaging in further monetary easing, but there is nowhere to go below the current 0.00% target overnight rate. In most presidential election years, the Fed is hesitant to make large moves in either direction, to avoid appearing politically biased. That instinct is especially heightened in an election cycle where Fed policy action and arcane monetary policy debates have unexpectedly become contentious, emotional political issues.

2.  Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors.

3.  Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis.  Though it has been over a decade in the making, things have finally come to a head. All the dominoes (Greece, Portugal, Spain, Italy) are lined up, and we wait to see which the two players (France and Germany) will allow to fall before they stop the carnage. We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value.

4.  Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. We would not be surprised if the Euro approached parity with the dollar over the course of the year. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed.

5.  Blue States/Red States: The US presidential election cycle should be the major story in the US in 2012. US and individual state debt burdens will be the most important topic of debate, as the European sovereign debt crisis plays out in the background. American politicians will have to negotiate some cut in benefits for the charmed baby-boomer generation to ensure the financial burden of these programs in coming years does not doom the economic prospects of their children and grandchildren. This negotiation of a new social compact between the generations is the most important issue of our times.

6.  Chinese Math: At the 18^th Communist party congress to be held this year, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required as China moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, GDP growth is slowing as labor costs rise, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels.

7.  Revolutionary Times: We were surprised to see the speed at which the political structure of the Middle East has been transformed in a remarkable series of revolutions. Though we have been aware of the demographic pressures that created the basis for these changes, their rapidity has astounded us. As events unfold in the Arab world, something perhaps even more remarkable has begun to happen in Russia. A previously apathetic Russian electorate seems to be flexing its muscle in opposition to a renewed Putin presidency.  We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year.

8.  Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources. And while we’re talking about oil, we would like to reiterate our skeptical view of gold prices, which we believe would be well under $1,000 an ounce if the political and economic future were not as muddy.

9.  Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance). The larger story will continue to be the steady march of the internet into every device and living room, placing a strain on core Internet infrastructure. We heard relatively little about a seminal event that took place in 2011, the last large block of addresses (IPv4 numbers) was assigned and there is no address space on the current infrastructure to accommodate another few hundred million devices. The public discussion has centered around the addition of new top level domain names (like .com, .org), but the addresses that sit behind these are the real concern. A new addressing scheme (IPv6) has been built into most devices for years, but adoption is minimal. We expect this will have to change in 2012, with a few hiccups along the way.

10.  Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis.  We believe there is still too much supply available and US consumers as a whole will be reluctant to financially over-commit themselves given job security concerns and how many were burned by homeownership in the past few years, despite record low mortgage rates.

Since we’ve now closed the chapter on 2011, we’d like to review our “11 Economic Themes For 2011” from last January, to see how well our ideas performed.

1.   No.   Raise ‘em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members. We were flat out wrong on this one. The Fed kept rates steady at the lowest possible level of 0-0.25% throughout the year. A blip in US economic data mid-year and continuing concerns about Europe held back even the most hawkish voting board-members from recommending a raise.

2.   Not exactly.  Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25 , prices are at the upper end of historical range. We were right to think that 2011 would be a year where market participants would lower risk, but we focused on US Equities. In fact, US Equities became a relative safe-haven as investors fled the Emerging Markets and Europe.

3.    Yes.  United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe. We have been discussing this theme for years, but it did come into its own in 2011. If anything, the conversation about potential outcomes has moved much faster than we would have expected. A year ago, who would have thought the markets (and even some in European political circles) would be discussing Greek default, and the break-up of the European currency union. The conclusion of the extraordinary events in Europe is still unclear and this will be a theme for 2012 as well.

4.    Yes.  Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion. We expect certain weaker revenue and real-estate projects linked bonds to default… large scale defaults by major issuers (state GOs, water/sewer) are very unlikely. Municipal and State finances have continued to be in the news all year. We saw a very high-profile bankruptcy in Jefferson County, Alabama. We expect the role that financial intermediaries played in that case, and others, to receive attention over the course of 2012. As we anticipated, defaults in the municipal space were limited and the muni-market did quite well in 2011. However, the longer-term challenges remain in place. State revenues improved in 2011, but the fate of state-guaranteed pension funds and health benefits is still uncertain and remains a huge future liability for most US state and local government.

5.   Yes.   Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011. It is now clear to most participants that China is at an inflection point. The Chinese equity market has been in an unbroken bear market since reaching an all-time high in 2007. We believe other asset bubbles in China are at the point of bursting as well, and that this could well lead to large-scale social and political change in China.

6.   Yes.   Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages. Deleveraging continued as US consumers reduced debt wherever possible. Debt service and financial obligation ratios fell over the course of the year as rates remained at all time lows. Total outstanding consumer credit rose by 2%. Consumer sentiment returned to where it was at the tail end of 2010, after spending much of the year at depressed levels.

7.   Yes.   Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year. We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%. Though headline unemployment took a large drop towards 8.5% in December, it had spent most of the year around or above 9%. And if the political discussion is an accurate measure, the country as a whole remains concerned about jobs. As we anticipated, U-6 stayed over 15%, suggesting almost one in every seven workers is under-employed in some way.

8.    Yes.   Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course. Though the full-year numbers are not available as yet, growth in the first three quarters in the US was estimated at an annualized rate of 0.4%, 1.3% and 1.8%. Unless the fourth quarter growth rates were truly remarkable, we will be well under 2% for the year. The story in Europe was, if anything, worse, with full year growth rates for the 27 member EU estimated at 1.6% and growth-forecasts for 2012 at 0.6%.

9.   Yes.   Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent. We started 2012 with the news that a number of companies expect to offer solutions to sequence a person’s entire genome for about $1,000. We believe the rapid commercialization of this technology will change health-care and many other realms of human activity.

10.  Not exactly.  Feast and Famine: We expect 2011 to be a very volatile year for commodity prices. We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well. We were partially right here. Commodities remained volatile in 2011, with the DJ-UBS commodities indices down over 13%. However, the two commodities we highlighted, gold and oil, remained relatively strong though gold did see a selloff during the second half of the year.

11.  Yes.  Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform. The Congressional debt ceiling crisis and the subsequent downgrade of US treasuries by S&P this past summer brought this topic to the fore. As with everyone else, we wait to see what reform proposals the tax discussion will bring to the 2012 political season.

The final score is 8 out of 11, which is not bad.