Washington Square Capital Management Blog

We hope you enjoyed a restful holiday with your family and are off to a great start to 2012.

We’ve attached two documents to this letter: the first reviews our economic themes for 2011 (evaluating where we were right and where we were wrong) while the second outlines our investment themes for 2012 (topics we think will have the biggest impact on client portfolios in the coming year).

The fourth quarter of 2011 saw US stocks recover sharply from the mid-summer selloff.  The S&P 500 (the broad measure of US stocks), which had ended the third quarter at 1,131.42, finished the year rallying up to 1,257.60, a gain of over 11%.  Despite these gains, the S&P 500 finished 2011 virtually unchanged at -.11% (when dividends are factored in, the return was a positive 2.11%).  The Dow Jones Industrial Average (the index that tracks 30 blue chip US stocks) finished the year up 5.5% (8.38% with dividends), which was in line with our investment thesis of buying large cap dividend paying US stocks.  The Nasdaq (the tech heavy index) finished 2011 lower at -1.8%.

The Nasdaq losses were minor compared to stock returns overseas.  While the losses in the UK were modest (the FTSE 100 finished down only -2.18%) due mainly to the strength of the Pound, countries in the European Union fared far worse.  Germany (DAX) finished the year -14.69% and France (CAC 40) saw a return of -14.28%.   The so-called BRIC countries (Brazil, Russia, India, China) – those emerging market powerhouses that seemingly sidestepped the credit crisis – saw stock returns that lagged Europe.   Brazil (FTSE Brazil) finished the year -21.02%, Russia (FTSE Russia) -20.74%, India (Sensex) -24.64% and China (Shanghai Composite) was -21.7%.  However, the biggest loser of the year was Greece (FTSE Greece) which saw a return of -60.01% for 2011 (this was after a -45.83% return in 2010).

The continued debt crisis in Europe was the main reason for European stock declines (banks especially were clobbered) while BRIC losses can be attributed to the slowing global economy and a hard landing after years of rapid growth.  The stock losses in Greece demonstrate what can happen when a sovereign mismanages its debt levels and capital flees when investors lose confidence in that country’s ability to effectively govern itself.

Commodities were down, overall – the Dow Jones UBS Commodity Index saw a return of -13.32% – although there were a few bright spots.  Despite a late year selloff, gold continued its climb in 2011, ending the year at $1,566.80 per ounce, up 10.2% (this finish was well below its September peak of $1,895 per ounce).  Crude oil was up 8.2% on the year, closing at 107.50 per barrel, while natural gas saw continued losses and finished the year -32%.  Copper and cotton also saw big losses, finishing the year -22.73% and -36.69% respectively.

Once again, bonds performed exceptionally well in 2011.  The Barclays US Aggregate Bond index saw a total return of 7.84% while the Barclays US Government index saw a 9.02% total return.  Not to be outdone, the Barclays Municipal Bond index saw a total return of 10.7%.  Even the Credit Suisse High Yield bond index (the riskiest of the bond space) saw a total return of 5.47% despite a big selloff in junk bonds during the third quarter.

While bond returns post-credit crisis have certainly been gaudy (virtually all client portfolios have some bond component), we can’t, as prudent investors, expect these rates of return to continue in perpetuity.   Part of what has been driving these returns is the 0% interest rate policy the Federal Reserve enacted during the financial crisis.  With rates this low, conservative investors who normally leave money in cash or buy CDs have been forced into the bond market in search of yield.  Another factor contributing to these returns has been the continued lack of confidence in the global economy: when investors (both US and foreign alike) want to limit their risk exposure, they often look to the US bond market as a safe haven.

Eventually, though, interest rates will go up, the global economy will recover and investors will begin moving money out of bonds and into more risky investments.  Our job is to try to make adjustments to client portfolios in anticipation of these market forces.  So, with that in mind, we may recommend moving money out of the bond market towards the end of the year and into dividend paying stocks, inflation protected bonds and other non-correlated investments.

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

Regards,

Subir Grewal                                                                           Louis Berger

The third quarter saw equity markets trade substantially lower from where they began—the S&P 500 index started the quarter at 1,320.64 and ended at 1,131.42, a loss of nearly 15%.  On October 4^th, the S&P 500 saw an intraday low of 1,074.77, which marked a decline of more than 20% from the 2011 high of 1,370.58 reached on May 2.  This level was important both from a technical and psychological standpoint since a 20% major index decline is the metric used to determine whether or not we have entered a bear market.  Equity markets have bounced back over the past several days, but it remains to be seen whether we are entering a longer term bear market in stocks or if we are merely experiencing a “soft patch”.

So what has caused this decline in stocks?  There are several factors at play:

US Economic Data

The US economic picture, which we have long viewed as being fragile and artificially supported by government stimulus, is showing substantial cracks in its façade.  In early August, the US GDP for Q1 was revised down from an initial estimate of 1.9% to .4%, a huge 1.5% move down.  Second quarter GDP came in at 1.3%, well below analyst estimates of 1.9%.

While many market commentators at the time pointed to the Congressional budget standoff and the S&P’s lowering of the US credit rating to AA+ as the reasons for the stock selloff, it’s now apparent that the problems run much deeper.  Over the course of the quarter, as employment, housing, manufacturing and consumer sentiment data rolled in, it became clear that the selloff was a response to a US economy losing its footing rather than a gridlocked Congress (although that certainly didn’t help matters).

Federal Reserve policy

From our perspective, the stock market rally of the past two plus years can largely be attributed to the stimulus policies of the Federal Government and the monetary policies of the Federal Reserve rather than an organic economic recovery.

While government stimulus has largely dried up after Republicans regained control of Congress in the 2010 mid-terms, the Federal Reserve has continued to implement a monetary easing policy with ever more inventive sequels to the original QE.

These measures include: ZIRP (zero interest rate policy), quantitative easing (versions QE1 and QE2) and POMO (permanent open market operations).  While the economy and unemployment rate has seen little in the way of tangible benefits as a result of these strategies (although it could be argued that the Fed’s policies helped stave off a Depression), interest rates remain at rock bottom levels and the stock market has roared back to life. The question on every investor’s mind is whether this is a sustainable burst of energy, or a sugar high that will soon wear off.

If the latter is the case (which we believe) then it appears the stock market has gotten ahead of itself and its bullish trajectory does not accurately reflect the fragility of the economy.  Instead of an organic recovery driving the markets, it seems stocks are being buoyed by the Fed’s policies and can only continue moving upwards if the Fed keeps refilling the punch bowl of liquidity.  But what happens if the Fed decides to end the party and cease its easy monetary policy—will the economy be able to expand on its own?

Increasingly, it looks like this decisive moment has arrived. When the QE2 program expired at the end of June, the Fed elected not to renew it. Instead of entering into another round of buying bonds with cash, as many investors hoped/expected, the Fed went in a different direction.  On August 9^th the Fed announced its expectation that it would extend the ZIRP policy through 2013 in an effort to keep interest rates low and encourage lending.  On September 22^nd, they also announced Operation Twist, an action in bond markets designed to push down long term interest rates on everything from mortgages to business loans, giving consumers an additional incentive to borrow and spend money.  This approach was first used in the 1960’s (originally named after the dance craze that swept the nation).

While both of these measures are intended to help support the economy, they failed to elicit the same level of excitement in stock investors as the first two rounds of quantitative easing. We remain skeptical of these policies since, in our mind, the problem is not high interest rates, but rather the desire and ability of businesses and consumers to borrow. If businesses do not believe expanding their operations will be profitable, they will not borrow to do it. If households do not believe they will earn more in the future, they will not borrow to finance home-purchases and consumption today. And if loan and credit officers across the country do not believe the economy and employment will grow in the next few years, they will not extend credit. The problem is not the supply or price of credit (the interest rate), rather it’s the demand for it.

European Sovereign Debt Crisis

Ah, our dear old friend, the problem that just won’t go away, no matter how many summits are organized to exorcize it.  It seems we always devote some space to this topic every quarter and this letter will be no different.

The problems in Greece and in other European debt-ridden nations, reared its ugly head again this quarter.  However, the focus shifted a bit from the nations themselves to the European banks which hold much of this bad debt on their balance sheets.

The major concern many economists and market participants have is that several of these banks would not survive a Greek default.  So, if Greece were to go down, it could create a cascading, domino-like event, similar to what was narrowly averted during the 2008 credit crisis.  The prevailing view is that the countries and banks are so interconnected that one failure – a European country or a bank – could potentially bring down the entire system.  Of course, nobody knows for sure whether or not this is really the case, but elected officials do not seem interested in testing this hypothesis after witnessing firsthand the economic carnage that was unleashed when Lehman Brothers failed. The trouble, however, is that their constituents do not want to pay for the cost of rescuing Greece or even large pan-European banks.

In our view, this train-wreck will continue to play out in slow-motion for the next several months. The solution has to involve some restructuring of Greek debt, and some mechanism to conclusively stop the damage from spreading to Spain and Italy. We do not hold out high hopes for a speedy resolution though. The outlines of the solution have been known for quite some time, but the relevant political and regulatory actors do not appear to have the will or courage to take decisive action and implement it.

So where does this leave investors?

We think the status quo will continue for the near future: structural headwinds in the US economy will persist and the debt problems in Europe are still a long ways from being resolved.  Barring another massive monetary intervention by the Federal Reserve (QE3), we believe stocks will continue their slide lower. If there is a QE3 announcement too soon, we think there’s a pretty substantial chance it will be seen by the markets as a sign of desperation on the part of the Fed. We believe the chance that Congress manages to enact meaningful tax or budget reform, or additional fiscal stimulus, is negligible as we enter the presidential election cycle.

We have seen a few weeks of remarkable volatility within financial markets. Stock indexes have moved hundreds of points in both directions with some regularity. Interest rates, bonds and the FX markets have also seen very sharp moves in each direction. We believe this period of volatility will continue for the next few months as the European crisis grinds towards its inevitable conclusion and signs of stress in China make themselves apparent.

As a result, we continue to recommend a defensive portfolio for clients, with high quality, short term/intermediate bonds and cash making up the bulk of client holdings.

We think there will be an opportunity to buy high quality stocks on the cheap in the coming weeks/months and have targeted a list of companies using the following criteria:

1. Large cap, US-based companies that have significant exposure overseas, particularly in developing markets
2. Companies that have sustainable, attractive businesses and a history of paying dividends to investors through tough market cycles
3. Preference for defensive/non-cyclical industries like consumer goods and utilities rather than banks or financials

We believe that, longer term, investments in these types of companies will perform well.  In the short term, they will provide cash flow through dividends, so investors will benefit by being paid to hold these stocks in the event the stock market trades in a flat or negative trajectory.

“It’s like deja vu all over again.” — Yogi Berra

Let’s take a look at some economic bullet points, shall we?

* The stock market, after peaking in April, is in the midst of a summer swoon.

* The sovereign debt crisis in Europe is getting progressively worse.

* Unemployment remains stubbornly high and the housing market remains stagnant.

* Gold continues to climb as investors speculate that safe haven currencies like the USD, Euro and Yen will see continued pressure as debt levels mount.

*Quantitative easing from the Federal Reserve has recently expired and Government Stimulus money has run dry.

*Investors wait with baited breath as Fed chairman Ben Bernanke is due to give a highly anticipated speech at the annual Jackson Hole economic summit.

Sound like a good encapsulation of where the financial markets are today?   Perhaps,  but I’m actually describing where things stood last summer on the eve of the Jackson Hole summit.  While a lot has certainly changed in the past twelve months, many of the problems facing the global economy remain the same.

And so here we are, almost exactly a year later, and the markets are waiting/hoping/praying that tomorrow Ben Bernanke can pull a rabbit out of his hat in his Jackson Hole address like he did last August, when it looked as if the stock market rally was sure to falter.

So how did things play out last summer?

As we wrote in our last quarterly letter:

“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.”

Many stock market bulls believe that a third round of quantitative easing will deliver similar results.  While we concede that another round of QE will likely give the stock market a short term boost, we don’t believe it will cure any of the underlying ills that the economy suffers from (high unemployment, anemic housing market, low consumer confidence etc).

But never mind all that negativity, a stock enthusiast might say, will there be a QE3?

It’s hard to predict.  The Fed’s dual mandate is to provide economic growth and boost employment.  While it can be argued that the last two rounds of quantitative easing helped the US economy avert a depression, the main beneficiaries of these market interventions, particularly the last round, seems to have been stock holders — not exactly the constituency most in need of the Fed’s support.   And to compound the problem, two byproducts of these policies have been rising commodity prices and a weakening dollar, which creates a whole host of other issues for consumers.

Given that the Fed’s fiscal policies have come under increasing criticism from all corners of the financial and political world, including from some of the Fed’s own Board of Governors, it seems to us that another QE round would be enacted only as a policy last resort.  It’s also entirely possible that the next fiscal action from the Fed would not be a QE package, per se, but rather something resembling Operation Twist, which was an approach used in the 1960′s.

But if the financial markets continue their move further south, the question becomes: what other entity could possibly intervene to provide support?  Congress has demonstrated, through the debt ceiling fiasco and the rise of Tea Party influence over the Republican party, that a stimulus bill would almost certainly be dead in the water.  And as we get closer to the 2012 elections, it becomes increasingly difficult for our elected leaders (namely Obama) to institute major economic policy decisions without being accused of playing politics, particularly in the toxic partisan environment of Washington.

So, really, that leaves the Fed as perhaps the only game in town when it comes to market intervention.  If things get worse, then there may be increased pressure on the Fed to act since they have the mandate and resources to step in — whether that means tomorrow or at a future date remains to be seen (and regardless what your views are on the Fed’s policies, at least they can reach a decision and act on it in a timely manner — unlike our distinguished members of Congress).

So, has this summer sell-off and rampant speculation of potential Fed action hanged our investments thesis?  Not really.  We remain cautious and reiterate what we said in our last quarterly letter, in July, before the stock sell-off began:

“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.”

Terrific piece from the always insightful Jeremy Grantham of GMO on the state of the financial markets and where things may be headed:

Grantham August

On July 30, 2007 Jeremy Siegel — Wharton professor and author of the popular investment book Stocks For The Long Run — appeared on CNBC to give his take on the stock market.  To put things in perspective, this was before the credit crisis had erupted, at a time when the economy was still considered very strong, although there had been some cracks beginning to show in the facade.  The S&P 500, the broad measure of US equities, closed at 1,473.91 that day.   It was in the midst of a modest summer sell-off, having closed at 1,553.08 just 11 days before on July 19th (nearly the top of the stock market rally).

There were rumblings from certain corners of the investment world that the US housing market was in the midst of a major bubble that had the potential to drive the economy into recession.  However, investors like Mr. Siegel, who preaches buying stocks at pretty much ANY time (without regard to fundamental value) told CNBC viewers that the economy was humming along and there was no reason to panic.  He believed the housing market was a small piece of the economic pie and the global growth story would propel equity markets higher.

While we recognize that hindsight is 20/20, we think it’s important to note that if CNBC viewers had listened to Mr. Siegel and bought an S&P 500 index fund the next day, they would have enjoyed a two month rally into October of 2007, before watching a long and painful decline culminating in the March 2009 lows of 666.79.

And while the S&P 500 did rebound from those lows and post a twenty-six month rally,  peaking at 1,370.58 on May 2, 2011, that level was still 100 points below the price Mr. Siegel felt comfortable telling CNBC viewers to buy back on July 30, 2007 (and even when including reinvested dividends, the investment would still be under water).   Now that we are entering what appears to be another major stock sell-off, those same investors (assuming they held onto their initial purchase) will have to wait even longer to recoup their principal, never mind turning a profit.

Mr. Siegel, as evidenced by the title of his famous book, has built his reputation on an unwavering conviction that stocks will outperform almost any other asset class in the “long run.”   While we certainly agree that stocks can be good investments and have a place in most client portfolios, we also recognize they are amongst the riskiest asset classes available to investors.   For investors with a short time horizon (need access to their money in the near term), stocks, particularly during a market correction, can wreak havoc on a savings strategy.

Unfortunately, a cavalier approach to stock investing seems to be a problem for many investors.  The promise of outsized returns often seduces these investors into taking on far more risk than they should.  The financial services industry, which relies on the fees generated from investors taking on this risk, is often more than happy to encourage speculative behavior from their clients.   Compounding this problem are media outlets like CNBC, which benefit from increased ratings during bull markets, and have a vested interest in promoting a pro-market message to keep viewers tuned in.  After all, as an investor, if all your money was sitting in cash, why would you watch CNBC?

When we encounter a prospective client that needs help managing their investments, more often than not, it’s because they were too heavily invested in stocks (either on their own accord or through the advice of another adviser) and lost much more money than they expected.  Rarely do we encounter a prospective client that hasn’t taken on ENOUGH risk (all their money is in cash and they don’t know what to do with it).  As a result, our preference for downside protection over speculative growth resonates more with investors during market volatility.

While the stock market has experienced a severe sell-off over the past few weeks, it is still trading well above the lows of March 2009.  As I write, the S&P 500 is hovering around 1150.  Since we don’t own a crystal ball here at WSQ Capital, we don’t know for sure where markets are headed from here (we have an educated guess, but we don’t know with certainty). What we do know is that if we see a continued sell-off like we saw in 2008-09, higher risk portfolios with significant exposure to stocks will experience higher losses compared to those portfolios primarily invested in short term, investment grade bonds and cash.

So, when sizing up a volatile market such as the one we’re experiencing now, investors should ask themselves which they value more: downside protection or speculative growth?