Washington Square Capital Management Blog

We held our first “webinar” earlier this month on the timely topic of municipal bonds. We have posted the narrated presentation at www.youtube.com/wsqcapital for the benefit of those who were unable to attend. We plan to host three webinars this quarter:

• Thursday, April 21: What Makes an Investment Socially Responsible? (April 22 is Earth Day!)
• Wednesday, May 25: Sudden Wealth: How to Make the Money Last
• Tuesday, June 21: Shopping for Life Insurance: Do’s and Don’ts

To register for any of these webinars, please visit blog.wsqcapital.com. We will continue to add recordings of future presentations to our page on youtube. Feel free to pass along an invitation to anyone in your circle interested in learning more about these topics.

IRA contributions, Roth IRA conversions

Most taxpayers can make IRA contributions for the 2010 tax year up until the individual tax-filing deadline, which is April 18, 2011 this year.

Roth IRA conversion rules have changed and virtually anyone can now convert a traditional IRA into a Roth IRA. Partial conversions of an IRA account are also permitted. Please contact us if you’d like to discuss specific issues surrounding your circumstances.

Interest Rates & QE2

In prior letters, we have discussed the extraordinary measures the Federal Reserve and other central banks around the world have taken to keep interest rates at historic lows. Short-term rates in the US remain below current inflation levels, which means savers are being penalized for holding cash. This is no doubt due to the actions of the Fed which continues to purchase the bulk of newly issued US Treasuries under its Quantitative Easing program. We estimate short and medium-term rates are 1.5% to 2.0% below where they would otherwise be.

Meanwhile, the flames of inflation have begun to flicker. A combination of increased demand and easy money policies has driven up food and commodity prices. If this trend continues, maneuvering through the obstacle course of rising inflation will take a toll on the global recovery. And as is usually the case, the burden will be heaviest for the world’s poorest who spend a higher percentage of their income on necessities. We are beginning to see some policy action and rate hikes in developing markets. Unless inflation levels stabilize quickly, this will begin to impact global trade. We caution bond investors that future returns are likely to be lower than those in recent years past. We continue to recommend high-quality bonds with 3-5 year maturities.

Budgets and Bluster

The issues facing most developed-market governments are remarkably similar whether we are talking about Greece, Ireland and Spain, or the US, California and Illinois. The long-term challenge involves tackling unfavorable demographics and enacting the painful policy reforms required to tackle the cost of social programs. In the short term, the double-whammy of a real-estate/financial crisis requiring an immense expenditure of government support, followed by a great recession driving down tax revenues have created huge deficits. The exact mix differs: in Ireland the cost of a bank bail-out has supercharged the national debt, whereas in Greece the crisis is compounded by a culture of tax-evasion and protectionism. In the US, the core problem is reforming Medicare and a health-care system that takes in more revenue per person and results in lower levels of health than those in other developed countries.

The imminent congressional debates over the federal budget and the national debt ceiling will bring fiscal issues front and center in the US. As the 2012 election campaign kicks off over this summer, we expect fiscal issues will be key in every race. In Europe, meanwhile, the moment of reckoning for Greece, Ireland and Portugal fast approaches. European institutions will either have to come up with a plan for debt-restructuring or direct support to assist struggling governments in the short-term. Meaningful progress towards the longer term demographic and policy challenges will also need to be made.

Nature, Energy and Politics

The March 11 earthquake and tsunami took a terrible toll on the people of Japan. The economic damage is also enormous as a significant percentage of the area’s power generation and distribution capacity has been offline for weeks, impacting businesses and residences across the main island of Honshu. Rolling blackouts have affected many areas, including Tokyo. Two nuclear power generation facilities (Fukushima I and II), with a total of ten operational reactors between them, suffered severe damage. It is now clear that all the reactors at Fukushima I will need to be scrapped. A large amount of fuel from the operating reactors and spent fuel stored at the facility has been damaged and released into the environment. The situation remains critical and the full extent of the crisis is still unknown.

Nuclear power generation requires operational and design expertise far more specialized than other forms of energy production. In general, the industry has recognized this and a great deal of thought and effort has been put into improving design and procedures. We should also not forget that most other forms of energy generation carry their own risks, and often a higher carbon footprint. For instance, the production and burning of coal costs numerous miners their lives every year, and damages the respiratory systems of populations globally. Hydro-electric dams have failed due to design faults or natural disasters causing a large number of casualties. We firmly believe renewable energy must be at the core of any long-term solution to global energy needs. Nevertheless, replacing our current energy infrastructure is a multi-decade project and represents an enormous investment. One step towards that process would be to accurately account for the true health and environmental costs of all forms of energy production. As things currently stand, the conventional energy industry derives numerous economic benefits from tax-breaks, favorable industrial policy and political gridlock in assessing the true environmental cost of greenhouse gas emissions.

With all this in mind, we believe certain modern nuclear plant designs can play a role as a crucial bridge technology. In many fast-growing economies, nuclear power is the only viable alternative to coal and gas for large scale power generation. It is clear though, that the nuclear industry will face tough public scrutiny and a risk re-assessment is underway. We are particularly concerned about the operational safety of nuclear power in countries without a strong tradition of accountability, independent oversight and open public discourse (see China). Some of these concerns are acute for certain developed nations such as Japan, which has few energy resources of its own and relies on nuclear power for 24% of its electricity needs. As a result, we continue to view long-term investments in renewable energy favorably.

Upheaval in the Middle East

Mass protests in the Arab world have captured the world’s imagination since the sudden, largely peaceful overthrow of Ben-Ali in Tunisia. We certainly do not believe every group engaged in protest has benign intentions and recognize that in some countries one repressive regime may be replaced by another. That said, we are hopeful the power of public protest and increasing civic engagement by ordinary citizens will transform the moribund political and economic regimes in the region. For the time being, we expect this part of the world will continue to experience upheaval over the next decade or more. In many of these societies, oil wealth has distorted economies and politics. A demographic bulge is now bringing about rapid change. Investors should remain aware that demographic and political change may cause certain markets to be disrupted over the next decade.

We are positive on emerging markets in the long-term, but advise caution for the present since asset prices have risen very rapidly. Further rises in oil prices could accelerate inflation and lead to a slow-down in global growth, which would impact emerging markets negatively.

Regards,

Louis Berger                                                                                        Subir Grewal

We held a webinar earlier this month on municipal bonds. We provided a basic overview of the municipal bond market and discussed recent events. We’ve now posted a replay on youtube, the links are below:

We always recommend national portfolios when managing a substantial allocation to municipal bonds.  Clients often ask about losing the state tax income benefits by buying out of state municipal bonds. Our answer has always been that we believe it is crucial to control geographic risk and concentration, particularly since these can be idiosyncratic, tail-event type risks.

In past discussions with clients, we’ve focused on how certain states and municipalities can have an over-reliance on one or two industries and be impacted by a cyclical or secular downturn. We’ve also pointed out that certain natural disasters can impact a geographic area so severely that a short-term recovery becomes difficult or even impractical. Many disasters can erode the tax base and asset values to such an extent that creditors may suffer substantial losses in default.

For instance, environmental devastation during the dust-bowl era wreaked immense damage on agricultural production in many states and this impacted state and local finances significantly. The tragic events unfolding at present in Japan should remind investors that natural and environment disasters can devastate communities for extended periods of time. When these disasters come in the form of a dam failure or nuclear accident, they can make a large area inhabitable.

Such events are inherently unpredictable, and highlight the need for geographic diversification in investment portfolios of all types. Humans are fallible creatures, in investing as in many other things. Geographic diversification is a way to limit the impact of that fallibility.

Tax Free Municipal Bonds: Are They The Right Investment For You?

The past few months have been very eventful for the municipal bond market: the Bush era tax cuts have been extended, municipal governments are proposing massive budgets cuts, protests have broken out in states like Wisconsin and certain commentators have predicted widespread default. This uncertainty has provided an opportunity for those investors who know what to look for. In this webinar, we will provide an overview of municipal bonds, address many of the recent news events that have roiled these markets and share our approach to finding opportunities in this space.

This web-based presentation will run from 12:30-1:00 pm on Tuesday March 1st. It will include a 20 minute talk and 10 minutes for Q&A.

Please RSVP if you plan to attend as space is limited.

Presented by: Washington Square Capital Management

Speaker: Subir Grewal, CFA: Co-Founder and Principal

Date: Tuesday, March 1, 2011

Time: 12:30 pm, Eastern Standard Time (New York, GMT-05:00)

Discussion Topics:

• Municipal bond market overview
• The ramifications of recent legislative events
• Our selection process and where we see opportunity

To register, please click here.

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.