Investment Review July 2010

The Quarterly Investment Review prepared by Cleary Wealth Management

Market Summary – June Quarter

The June quarter was notable for the sudden reappearance of volatility across global markets. A notable aspect of the recovery from the GFC was the sharpness of the rebound in markets based on an apparent rebound in economic activity. But now that markets have recovered from their near death experience, there are increasing concerns about the sovereign debt crisis, the sustainability of economic recovery and the impact of the reduction in fiscal and monetary stimuli. Investors were caught between the fear of a double dip recession and the hope of stronger profits as company earnings continued to impress.

Thus, the quarter was rocked with a number of sharply negative trading days following expectations of slower global growth, followed by relief rallies caused by higher earnings expectations. Overall, the negative days overwhelmed the positive. May in particular was a very difficult month as markets were roiled by the European debt issues which were coming to the fore.

The MSCI Global index was down 9.91% in May alone due to extended trading losses with the NZ and Australian markets following the lead of the developed world. Overall, a very tough trading environment for equities with many of our hedge fund managers finding it hard to make money this quarter. Notable in this market is that trash continues to lead the markets forward and back.

The banks in the US are a prime example with Citibank and Bank of America up 50% and 40% respectively for the year to date by mid April. At the end of the quarter they are now trading back to where they were at the start of the year. These are broken businesses with a flawed model and are dependent on extensive Government largesse, not to mention a deliberately skewed monetary environment. We can‟t understand why you would invest capital in these businesses. These sharp movements have increasingly reaffirmed our absolute disdain for sell/side research analysts around the globe. These highly paid „experts‟ produce research for the retail market detailing their opinions on the earnings expectations of the companies they follow. They may be well paid, but it‟s not because of performance as they have had a terrible year.

Firstly, they grossly underestimated the earnings of businesses during the recession. While the global economic crisis certainly impacted profitability, most companies surprised on the upside because, incredibly, management weren‟t idle and aggressively cut costs to match lower revenues. Then in Q1 2010 the analysts finally started to get back into line with reality before they started hearing the chattering classes talking about the impending double dip recession. They proceeded to slash forecasts for Q2 2010 and have been woefully underestimating earnings again. This was due in no small part because the companies they supposedly follow are now reporting revenue gains which flow straight through to the bottom line following increased focus on costs.
The repeated idiocy of these herd followers stems from their focus on “business risk” as opposed to “investment risk”. Analysts basically mirror the market sentiment rather than provide actual expert advice about the companies they supposedly know the best. Hence they are positively misleading if not downright dangerous.

In fact the funniest story we saw this quarter was a contrarian fund which basically assimilates the top ten trade ideas of the global investment banks and then proceeds to bet against those very same trade ideas. The fund is up 42% year to date. QED.

The major story of the quarter was the shock and awe bailout by the European Union and the International Money Fund of EU countries who were nearing default. As Greece found it increasingly difficult to finance its Government debt (yields for ten year notes approached 12% pa!), the two trans-national entities put together an awesome Euro 750 billion package Stabilisation Fund which any Euro nation can call upon over the next three years. Greece has already sipped deeply from this well of monies and other Governments are also likely to tap into it.

While this smoothed the markets in the short term, it simply delays the inevitable. On virtually any scenario, Greece will default on its debt, most likely via what is known as a “haircut”. Under this arrangement, the 10 year bond yielding 6% which you own will be “reappraised” so that it is now a 25 year bond yielding 3%. The hidden story behind the Greek comic tragedy was that this was a bailout of German banks, not Greece. European banks, already shaky with huge write-offs on American mortgage debt, were stuffed to the gills with sovereign debt from the likes of Portugal, Ireland, Spain and Greece – the so-called PIGS - which they held as their regulatory capital. Therefore any default would‟ve basically brought the European banking system to a halt.

Now, the banks have three years to either raise capital, increase earnings, or sell their holdings. Only then will Greece be allowed to fail as it inevitably will.

Politics was also a major story over the quarter. We saw Obama under considerable amounts of stress but responding in a reasonably pragmatic fashion. This contrasts noticeably with Rudd in Australia who responded in a panicky fashion to the very well-founded criticism of his mining profits “super tax” and this ultimately cost him his job in a remarkably quick and efficient coup. Obama did put his signature to two rather large pieces of legislation with the healthcare and financial reform laws (the latter being signed in July).

These two vast swathes of regulations are largely pragmatic compromises which are quite similar in that they make some progress on some minor policy aims, but overall just add cost and complexity to the financial and health care industries in the US. The Dodd-Frank Wall Street Reform and Consumer Protection Act is a gargantuan piece of legislation and as much as anything demonstrates the absurdity of the US political system. Upon signing, the law consisted of no less than 2,319 pages or almost 1/3 longer than the standard text of the King James Bible! The Declaration of Independence, which covered some reasonably important issues, was drafted on one sheet of paper; an example the current Congress would do well to follow.

Yet, given this, it completely ignored the issue of Fannie Mae and Freddie Mac which were at the epicenter of the housing problems at the root of the financial crisis. These two mortgage companies either bought or guaranteed about 90% of the house mortgages in the US last year. The bailout of them has already cost US$160 billion and  this could grow to as much as a trillion US dollars if the housing market continues to deteriorate. It‟s astonishing that these giant problems were kicked down the road as “too hard”. The law does have some useful reforms but fails dramatically in that it does nothing to cure the problem of Too Big to Fail, and if anything, increases the incentives for banking organisations to grow into a size which makes them Too Big To Fail.

The Government still remains the ultimate backstop for risky non-banking related behaviour. As such, the investment banks will continue to wager shareholder money with the rewards going to managers and employees (not shareholders) and the bill for losses to the US taxpayers. Revolutions have started for less.