Washington Square Capital Management Blog

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.

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.

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

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