Washington Square Capital Management Blog

The second quarter of 2011 saw equity markets close down slightly over the last quarter – the S&P 500 began the quarter at 1,325.83 and ended at 1,320.64.  Losses were on track to be far more substantial until the last week of June when the S&P 500 rallied over 50 points in the final 4 trading days after news of the Greek bailout and some encouraging US economic data.

Commodities, after experiencing an impressive two year long run-up, fell sharply in the second quarter.  Crude oil, which touched $115.52 per barrel on May 2^nd, sold off to $89.61 by June 27^th as economic indicators pointed towards a slowing global economy.  Mirroring the equity market rally, crude oil (and commodities as a whole) rebounded a bit in the last week of the quarter, closing at $95.08 on June 30^th.

Perhaps the biggest news this quarter was the highly anticipated end of the Federal Reserve’s second quantitative easing program.  QE2, as it has come to be known, saw the Fed invest $600 billion into US treasuries in an effort to keep interest rates low, promote economic growth and stave off any signs of deflation.  It is debatable whether or not this program resulted in any long-term benefit for the US economy, but it certainly did provide monetary rocket-fuel for the rally in stocks and commodities.

When Ben Bernanke announced the QE2 plan on August 27^th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23^rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.

Now that the second round has expired, and the possibility of a third round looks ever less likely, market participants may wonder whether equity markets can continue to move higher without that monetary stimulus.  We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.

Greek Debt. Another summer and another quarterly letter with a section devoted to the debt problems in Europe. And despite the passage of the latest round of bailout/austerity measures in Greece, we don’t believe this problem is going away anytime soon. Most observers expect Greece to restructure its debt over the next few years. As with the Russian default of 1998, any restructuring or default, though widely anticipated, will shock the markets. We expect concern will move rapidly to other countries in peripheral Europe as Portugal, Ireland, Spain and Italy will likely be the next group to find themselves sitting in the debt crisis crosshairs. As with most crises of confidence, European authorities will have to decide where best to build a firewall. Tough decisions will be made and in its exhaustion, Europe will likely realize that not every troubled sovereign can or should be saved. We believe neither Spain nor Italy can be abandoned, and we do not believe Ireland deserves to be. But as with many things that spur strong emotions, these events may take on a life of their own and force elected representatives to act in a knowingly destructive manner, simply to deflect virulent public opinion.

Debt ceiling debate. Meanwhile back on our side of the pond, a similar dynamic is playing out. With their 2010 reclamation of the House still fresh, Republicans appear determined to use their voting power to force budget cuts before approving a raise in the debt ceiling. Democrats, meanwhile, strongly prefer reducing corporate tax breaks and other revenue raising measures as a solution. Both sides are still far apart, but we expect they will find a workable solution before the August 2^nd deadline.  In our view, a workable long-term solution must involve both revenue raising measures and cost-savings in major programs, especially Medicare/Medicaid. We agree with many market commentators that a default on US debt would be catastrophic and hope cooler heads will prevail ending this game of debt/budget chicken sooner rather than later.

Regards,

Louis Berger                                                                                        Subir Grewal

The sharp drop in silver last week made us think of price-support in different markets and how that depends on the constitution of market participants. When a significant percentage of a market is composed of financial buyers and speculators, many of them leveraged, it is prone to sharp, steep drops. It doesn’t matter whether the underlying object is “safe as houses” or “worth their weight in gold”. When a speculator buys an asset with borrowed money, the lender (typically a bank or brokerage) will seek additional security if the asset’s market price moves in the wrong direction (a margin call), and when the speculator can’t provide additional security to hold on to the position, the lender will move to sell the asset. If a significant number of buyers are speculating with borrowed money, or on margin, small downward moves snowball as waves of margin calls  trigger liquidation, which trigger further margin calls.

This is a lesson that was dearly learned during the crash of ’29 and led to the simple and strict margin limits in the US equities markets. The lesson was unlearned over time. High loan-to-value mortgages were used by large numbers of people seduced by stories of millionaire flippers to speculate in real-estate. High levels of leverage are what trigger quick unwinds in the carry-trade as well. IN 2008-2009, all this frenzied activity triggered the recent real-estate bubble and ensuing crisis.

What a lot of US-based “investors” in commodities fail to understand is that the financial markets for commodities operate with a degree of leverage that is simply unattainable for the average investor in equities (the market people are most familiar with). To take an initial position in a 5,000 oz. silver future on the CME (worth about $187,500) requires posting $18,900 in margin. That’s 10:1 leverage, or 10% down, and this is after the exchange recently raised the margin requirement. A 10% move can wipe out the margin posted, and a 2% move can require the speculator to post additional margin. Seasoned participants in commodities know this, but we fear the vast masses who have been drawn to investment products linked to gold, silver, copper etc. do not appreciate how much borrowed money fuels the market they’ve recently entered.

2011 Themes: These Go To Eleven

1. 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 expect rates to end the year in the 1% to 2% range. We think it is likely that the Fed raises rates to the 2% range this year because moves during the 2012 presidential election year would be politically toxic.  A rise in the short-term rate will result in a flatter yield curve (compared to the extremely steep levels today) and reduce bank earnings.
2. Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25[1], prices are at the upper end of historical range.  Governments across the world have provided immense demand support and a low rate environment over the past couple of years.  We also believe investor wariness and demographic changes (a large cohort of new retirees who will begin drawing down on savings) suggest much support for asset prices is weakening. We believe investors will continue to focus on fixed income investments, and rightfully should.
3. 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.  This will doubtless further strain the Euro and all European establishments.  We believe the stresses created by the currency union existing outside of a strong federal structure will be resolved with a more federal Europe.  The alternate solution where certain states opt to leave the currency union is less likely, but not outside the realm of possibility.  In general, we believe European sovereigns will begin to be treated more like US states (which do not have the power to issue currency either) by the markets. Over time, we expect a move towards additional bond issuance at the European Union level, with each state having access to a certain amount of borrowing against the EU federal credit in exchange for heightened oversight and restrictions.
4. 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 project linked bonds to default, we also expect acrimonious budget debates on benefits for public sector employees and pensions in many states.  We think large scale defaults by major issuers (state GOs, water/sewer) are very unlikely, but investors will continue to discriminate between strong and weak credits and heavily discount informal support expectations and bond insurance.
5. 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.  Overbuilding and overinvestment in physical infrastructure during the past few years has left a glut of underutilized buildings and this could lead to a sharp downturn in Chinese property prices and construction activity.  Any such downturn would also impact Chinese banks, and potentially have a wider impact in the region, affecting commodity-driven economies like Australia and Canada.
6. Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages.  This will make for a more difficult general retail environment and generally depress big-ticket discretionary spending.  The real-estate bubble has altered an entire generation’s perspective on housing, and we expect households and financial institutions both to be skeptical of high mortgage indebtedness and expectations of large capital gains in residential real-estate.  We expect similar deleveraging to occur in commodity-boom fueled economies like Australia and Canada. We do not believe US residential housing prices will rise in 2011, and may indeed fall further.
7. 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%.
8. 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.
9. 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.
10. 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.  Such a correction would be far more likely if China has a hard landing from the withdrawal of extreme stimulative fiscal policy and over-building over the past few years. We expect food prices to become a focus of attention in many parts of the developing world (as they were in 2008), and that governments will be forced to respond in whatever manner they can.  In the developed world we expect a resurgence of interest in agricultural and timber land investment.
11. 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.  Corporate and higher-income tax-payer earnings will be the center of discussion and there is an off chance that the byzantine US tax code is simplified. In particular, trial balloons have been floated to withdraw the deductibility of mortgage interest, and tax life insurance benefits and municipal bond interest income.  Similarly, we have seen increasing discussion of doing away with the estate tax and replacing it with an income tax on proceeds received by heirs. Each of these deductions is supported by sizable vested interests and we think it is unlikely that they would all be swept aside and the tax code completely over-hauled.  Nevertheless, the possibility exists with a president and congress who are both eager to demonstrate their independence and fiscal sobriety to an irate electorate.

The Mojave desert boasts some of the largest utility-scale solar power facilities in the world and it will soon get another one.  This week, the California Energy Commission approved the licenses required to begin construction on the Blythe solar power project.  When the facility’s four phases are online, it will generate 1,000 MW making it the 15th largest power plant in California.  The facility will produce roughly the same amount of power as a large-sized coal or gas facility and would be capable of powering 800,000 homes.

The size of the project is definitely attracting attention, and will go a long way towards California’s stated objective of meeting 33% of its power needs from renewable sources by 2020.  The Energy commission is currently reviewing a number of other solar thermal power projects which would add another 3,300 MW in total power generation capacity.

If built, the Blythe plant would be one of the largest solar power projects in the world, but still a drop in the bucket for US power consumption which averaged 420,000 MW per hour in 2009.

Lest we forget, solar projects do have an environmental impact, just as hydro-electric projects do.  This particular project would cover 7,000 acres of flat desert.   The New York Times Green Blog covered the story as well.