Washington Square Capital Management Blog

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.

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.

1. Who’s Hiring? We expect to see the US unemployment rate peak in 2010 at 11%.  While seeing a peak will certainly be an encouraging sign, we don’t believe this will be followed by a rapid economic recovery creating the millions of jobs necessary to lower the unemployment rate down to pre-recession levels (5%).
2. I’m fine with fixed returns: The credit crisis of ‘08-‘09 saw many individual and institutional investors badly burned by overexposure to riskier assets like stocks, commodities and real estate.  While there has been a strong recovery in many risky assets over the past 10 months, we expect investors will continue to re-allocate towards less volatile investment classes, such as bonds, with a trend towards a classic 50% stock 50% bond allocation.
3. Collecting from sovereigns: 2009 ended with warning signs emerging from Dubai and Greece that there is a potential for default or credit deterioration among sovereigns that have over-extended themselves.  We expect to see a number of credit downgrades for developed nations as their persistent deficits, long-term pension/health-care liabilities and weak growth come into focus.  2010 may well see a sovereign nation default on foreign-currency debt obligations.  We expect the US Dollar and US treasury credit to strengthen in any ensuing flight to safety.
4. Reading tea leaves at the Fed: On December 16, 2008, in an effort to encourage banks to lend and provide liquidity for the financial markets, the Federal Reserve lowered interest rates to effectively 0%.  This rate held throughout the entirety of 2009.  We expect this run to end in 2010 with the Fed raising interest rates in 4th quarter of the year.  We expect the Fed to tighten rates to the 1-2% range and then pause for a few quarters.  This will likely result in the yield curve flattening since long term yields will not rise as quickly.  Unlike many other market commentators, we do not expect high inflation despite large increases in measured money supply.  A sharply lower velocity of money and reduced money-creation via private sector credit will dampen inflation.
5. Pay me my money down: Continuing the trend from 2009, we believe paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order.  This will disrupt a strong recovery in corporate profits, particularly retailers (which rely on consumer spending to drive growth), as some businesses will misjudge the new environment.  However, this is very good for the long term health of the US economy.
6. A cold year for growth: We expect the US economy will see almost negligible growth in 2010.  Margins will continue to contract for US businesses and profit growth will remain slim. The expiration of stimulus programs and slim prospects for their renewal in a mid-term election year will reduce aggregate demand.  Cost cutting and efficiency measures will continue to be necessary to offset top-line deterioration.
7. Arranged Marriages: With margins slimming, interest rates at historic lows, the unemployment rate in double digits and the US consumer cutting spending, we see corporations increasingly turning to mergers and acquisitions in order to grow market share, particularly in the cash rich tech and energy sectors.
8. New kids on the block: Emerging markets proved to be more resilient to the global recession than developed economies.  We expect growth in emerging markets will continue to out-pace growth in developed economies.  But this growth will not be enough to offset the stagnation in developed economies or lead to a robust global recovery.
9. Red alert: We believe there is continued risk for a massive correction in China.  We remain skeptical of the veracity of the economic data released by the government and don’t see how the white-hot level of growth can be sustained when China’s main trading partners (namely the US, Europe, Japan) continue to suffer from the effects of the global credit crisis.
10. Fool’s gold: We believe certain commodities are poised for a sharp sell-off over the next year.  Highest on our list for a correction are gold (which only has value if others think it does) and oil (many Iraqi and South American fields coming online and low growth implies low energy use).

Retailers are in the business of parting consumers from their money and they have been remarkably successful at this over the past several years.  However, we believe this holiday season will turn out to be very tough for most retailers as consumers will continue to maintain tight control over their spending.  Consumer spending levels have been a concern since this recession started.  Most observers predicted consumer spending would fall since households entered this recession with very weak balance sheets, high debt levels and low savings.  Added to this weakness in household finances is the pace and extent of job losses, worse than any we have seen since 1983, with a real possibility that they may be worse than the early eighties.  Consumption usually falls when unemployment rises, because people spend less when they aren’t earning.  However, consumer spending has fallen further during this recession because of something called the wealth effect.  When people feel less wealthy, they tend to spend less.  And as home prices and investment valuations have fallen over the past couple of years, a lot of us (not just those unemployed) have begun to feel less wealthy, and as a result curtail spending.

A key portion of any recovery is the stabilization of consumer spending, and a crucial part of this spending occurs around the holidays.  With this in mind, we have been looking closely at expectations and trends for retail sales over the holiday season.

A recently released ARG/UBS survey polled consumers about their anticipated spending patterns this holiday season is very revealing.  They report that over 50% of survey respondents said they plan to spend less this holiday season on gifts, and most plan to buy fewer gifts for fewer people.  Even children know they have to limit their expectations for Christmas gifts.  ARG estimates sales will be down 2.9% when compared with 2008 (and those were down 2.7% over 2007).

We routinely look for unorthodox sources of economic data to complement traditional sources. One data source we’ve become interested in recently is Google Trends, which provides statistics on what people are searching for on Google.  The Google team has made a number of different “canned queries” available and their research team published a paper earlier in the year examining how Google trends could be used as a measure of activity.  What we found most intriguing were the luxury goods query statistics, which show a year over year decline of over 5%.  Since Google trends measures the proportion of total queries (i.e. it accounts for the fact that the total number of queries on Google is growing) it may simply be that interest in things other than luxury goods has risen, or that more people have found the best online stores and visit them directly.  However, we believe this data may augur poorly for luxury good sales this holiday season, and this view is reinforced by the ARG survey result that consumers are planning to trade down.

So, in our view the prognosis for retail sales this holiday season does not look good.  Where then does that leave us?  The chart below plots retail sales excluding-autos along the red line and retail sales and food services (a much broader measure) along the blue line.  We adjusted for inflation to produce these charts, the nominal numbers look worse since we had some deflation in 2008/2009.  The data is from the census.gov and bls.gov.

Retail sales are declining at a slower pace, but at -3.04% the rate of decline for September’s retail sales (ex autos) remains worse than any other seen over the past 15 years.  The remarkable story though, is in the level of sales, which we plot below.

In real terms, the broadest measure of consumption is in the same range as it was in 2000-2002.  Real retail sales excluding autos and food service are at 2004 levels.  These numbers look far worse on per capita terms since the US population is growing by 2.75 million a year.  What makes this picture even gloomier is that the current levels are being propped up by massive amounts of government support.  Unemployment benefit periods have been extended for the longer-term unemployed, and auto-sales have been propped up with incentives.  We shudder to think where consumption expenditure would be without these supports, yet at some point consumers and businesses will have to confront the reality that this government assistance cannot last indefinitely.

So where does this leave us?  We believe this will be another difficult holiday season for retailers, and the medium-term picture doesn’t look any better.  Consumers have cut back spending to real levels last seen 5-9 years ago, and there is no prospect of a quick rise to pre-recession consumption.  We see a slow, halting recovery over 5-7 years for the following reasons:

• Unemployment is likely to remain over 6% for 5-7 years,
• Chastened consumers are saving to repair their personal balance sheets and pay down debt
• Stimulus spending will have to be withdrawn eventually
• Federal and state deficits will have to be repaired and higher taxes will eat  into consumers discretionary income.

We now know that we had too many mortgage bankers, home construction workers, and investment bankers than natural growth could sustain.  It may well be true that we had too many retail stores and salespeople.  If retail sales do not recover for years, we will have to become accustomed to shuttered stores in many areas.  Many people formerly employed in retail trade will have to look to other industries for employment.  The big structural question confronting us is how US businesses are going to produce productive employment for these workers and resources.  This will require retraining, and it may require the movement of labor across geographies.   It will definitely take time.

The extent of the market’s shrinkage in 1969-70 should have served to dispel an illusion that had been gaining ground during the past two decades.  This was that leading common stocks could be bought at any time and at any price, with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market to new high levels.  That was too good to be true.  At long last the stock market has “returned to normal,” in the sense that both speculators and stock investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of their holdings.  – Ben Graham in “The Intelligent Investor”

For years, investors have been told there is an easy, simple way to invest, requiring very little effort, by using index funds.  Many amongst us have been seduced into believing that we can safely invest in stocks, or stay invested, as long as we have a long enough time horizon.  This claim is generally based on analyzing the unique market trajectory of the United States, where stocks have outperformed other investments over most long-time periods (20 to 30 years).  Of course, over shorter periods (say 5 or 10 years), returns from stocks have been painfully small or even negative, and as Keynes said: “In the long run, we’re all dead.”

In addition to being told that stocks are the best game in town, investors are relentlessly advised to buy large numbers of stocks, via index funds.  Too many have taken this easy way out and bought stocks without any sound analysis and we fear the market has begun to reflect this laziness.

I have a parable for you, or perhaps a fable.  Imagine market participants as a herd of buffalo on the plain.  The herd moves together, often quickly.  In the past, it has never run off a cliff because enough buffalo are looking around for the tell-tale signs of a drop-off and slow it down.  One morning, a buffalo has the bright idea that since the herd has never run off a cliff (at least not in living memory, or as far back as the data is readily available), it would make sense to simply follow the herd and stop looking for signs of cliff-edges.  Once enough buffalo buy into this strategy and become free-riders, the herd itself becomes less aware.  As a result, the herd has fewer and fewer buffalo actively participating in picking direction, alert individuals get pushed into the center of the herd, effectively blinding them.  This blind herd runs willy-nilly all over the plain, and eventually it will run off a cliff.

Sometimes it makes sense to cut oneself out of the herd in the interest of self-preservation and go your own way, so you can see clearly.

I’d be a bum on the street with a tin cup if the markets were always efficient.  — Warren Buffet

We wrote earlier this year about the debate surrounding the Efficient Market Hypothesis (EMH).  The EMH, roughly speaking, claims all relevant information that is presently known is incorporated into market prices.  For some time now, we’ve viewed the EMH with some skepticism.  Two recent editorials, one by Jeremy Siegel in the WSJ, and the other by Martin Wolf in the FT, prompted us to revisit the subject and reiterate our skepticism about the EMH.  We think part of the reason these two camps disagree is that they are not trying to answer the same question.

The EMH camp asks the question “what are stocks going to do tomorrow”, and says (with some justification) that it is difficult to predict tomorrow’s moves because the sum total of all market-moving “information” is reflected in the price.   In our view, this is not a particularly insightful observation, partly because the question itself is largely irrelevant for an investor (as opposed to a trader).

The Value camp (Ben Graham, Warren Buffet, Jeremy Grantham) believe the right question for an investor to ask is “should we buy stocks today”, or “if we buy stocks today, do we stand a reasonably good chance of achieving an acceptable return”.  We believe this is a far more crucial question.  The value camp has developed numerous mechanisms to measure the value and risk of an investment based on expected returns.

By convincing many investors that “the market is always right” and that evaluating investment opportunities for themselves is not worthwhile, the EMH camp has successfully encouraged many market participants to become lazy.  And if these multitudes ARE the market now, the market itself has stopped evaluating investments on their merits.  This is how markets get to be wrong and their self-correcting nature is undermined.

A public-opinion poll is no substitute for thought. — Warren Buffet

In his article, Siegel says the fault for the bubble is not with the EMH, but with market participants (ratings agencies and investors) who failed to do their homework on their investments.  That’s pretty rich coming from someone who has been telling investors that doing homework is futile because the market already incorporates all known information.  The folks who buy into this notion have stopped looking for information and see no value in doing their own analysis.  I am not suggesting that Mr. Siegel and his friends in the EMH camp were the first to promote laziness amongst investors and unknowingly encourage the markets to run off cliffs.  Many others before them have touted the same tactics, see the quote from Graham we started with.  We’re also certain this won’t be the last attempt to lull investors into believing easy gains are possible from investing in stocks, or houses, or any other asset for that matter.  As we’ve seen over the past year, this is the stuff of which tragedies are made.