Economic & Market Commentary
October 2008

The current financial market turbulence is a result of an excessive amount of debt in the financial system and a new found risk aversion. Non-financial debt as a percentage of U.S. gross domestic product (GDP) bottomed in the early 1950’s, accelerated in 1981 and again in 2001. The last hurrah was focused on housing and mortgages with Fannie, Freddie and many other financial institutions taking center stage.

Financial institutions expanded their importance to the U.S. economy with ever more creative ways to increase their profitability. We now know that this creativity pushed the limits of ethics, legality, transparency and reason in many cases. Fannie Mae and Freddie Mac, taking advantage of their Government Sponsored Entity (GSE) status, were the most egregious. Their political influence with members of Congress, fraudulent accounting practices and financial leverage levels (that made mere private investment banks blush) make them poster children for today’s financial problems. But have no doubt that today’s debt problems took decades to create and housing was just the last hurrah.

As shown in the previous chart, the financial sector’s importance to the economy as represented by its weighting in the S&P500 index was near 5% in 1975, just below 10% in the early 1990s and peaked at close to 25% in December 2006. The financial sector weighting has fallen sharply since and we believe further contraction will occur as the deleverging process continues. We would not be surprised to see the financial sector as a percentage of the S&P 500 bottom below 10% again.

With the status of the U.S. housing market being central to the fate of financial institutions, a detailed look at this important sector is warranted. The chart below shows that housing prices peaked in 2006.

New home inventory peaked in 2006 as prices peaked, but existing homes and empty homes for sale have continued to climb. Likewise, foreclosures and mortgage delinquencies are still rising.

The home building business has reacted to this excess supply of homes by cutting new home construction sharply. Housing starts as a percentage of total households and residential investment as a percentage of GDP have fallen to a level typical of bottoms. As shown below the correction in the housing business and housing stock is well underway. However, the magnitude of the previous over spending in housing creates the possibility that this correction to lower levels of spending may overshoot on the downside

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The correction process in housing started in 2006. Given that housing is not a liquid asset and the additional psychological elements of home ownership, the housing market historically takes years to adjust; hence, the earliest we should expect a bottom in housing construction activity and prices is 2010.

Housing is highly dependent on credit thus its importance to the financial industry. The downward adjustment in pricing, coupled with the inability to make mortgage payments, has caused the mortgage default and delinquency rates to surge. This depresses the economic value of the associated mortgages and their derivative securities. The uncertainty regarding the trends and eventual peak in defaults has created havoc with the highly levered financial institutions that package, trade and own these mortgages. This uncertainty is heightened due to the fact that some mortgages currently outstanding were offered to subprime borrowers. Under the encouragement of well meaning legislation, the mortgage finance industry offered
more subprime loans to consumers who previously would have been unable to get a mortgage. Starting in 1992, the Federal Government had a policy of encouraging lending to low and moderate income home buyers in order to increase home ownership. As you can see below, it worked and home ownership rates increased.

A full listing of the regulatory and legislative initiatives to increase credit to low income home buyers is beyond the scope of this commentary, but unintended consequences have resulted in an increase in foreclosures as shown in the bottom half of the chart above. The unprecedented level of home ownership and the lower quality of the mortgages makes it difficult for investors, owners or potential owners of mortgages to estimate the ultimate defaults and losses and thus price these mortgages and their related securities.

“I am with the government, and I am here to help.” Okay, that is not a real quote, but Paulson and Bernanke arrived on Capitol Hill with a three page proposal and a $700 billion price tag. The credit markets were freezing up and becoming prohibitively expensive for homeowners, car buyers, students, small businesses, corporations and municipalities.

Without fully explaining the benefits of the program to the American taxpayer and more importantly the voter, Paulson asked for speedy passage of the package and no oversight. After inserting the necessary provisions to improve the bill, playing a dangerous game of political chicken and then passing a porked up special interest revised bill, Congress congratulated itself that it had avoided Armageddon and sent the bill to the President who promptly signed it pork and all.

The key element of the Treasury Plan is designed to bring liquidity back to the mortgage market and reduce fear among financial institutions so that they would start working and trading together again and thus restore normalcy and a functioning credit market for homes, autos, student loans, credit cards, corporation and municipalities. By buying mortgages and the related securities near economic value, the government could jump start the credit market and bring back private investors. This lowers the price and liquidity risks and encourages private enterprise to enter the market and buy most of the securities in order to make a profit.
The government’s role would hopefully be limited to jump starting the process and getting the private players back into the market. Given the favorable pricing the government should be able to buy assets for and its low financing costs, the government will probably make a profit on its capital outlays. However, the government will probably not be allowed by the market to continue indefinitely buying securities at bargain prices, because private investors will most likely outbid the government to pick up incremental returns. So, in our opinion, the full $700 billion is unlikely to be drawn upon and capital that is utilized will probably generate a profit. While government intervention is less than ideal, it is in this case the lesser of two evils, with the greater evil being frozen credit markets and a severe recession or possibly a depression.

The magnitude of this financial sector crisis is only eclipsed by the Great Depression. While many have pondered the similarities of this period and the Great Depression or Japan’s real estate and financial sector bust of 1990s, the differences are many and meaningful. The main difference between now and the Great Depression is the Federal Reserve and the Federal Government are trying to prevent a depression. The Fed has aggressively supplied liquidity by just about every means imaginable and “Helicopter Ben” Bernanke has promised investors as much as required and will resort to non-traditional means of avoiding deflation that could even include “helicopter drops” of money if necessary. As a contingency plan, we advise submitting your home address as a potential target drop area.

Henry Paulson and his associates are also busy devising additional strategies to prevent us from entering an economic abyss. The TARP (Troubled Asset Recovery Program) as revised by Congress and signed by President Bush provides a systematic process for providing massive liquidity to the financial markets, jumpstarting credit and the deteriorating economy. Paulson’s Treasury Department is working hard to distance themselves from the infamous depression era Treasury Secretary Andrew Mellon who is quoted as having said “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from the less competent people.” Ouch, that is some tough love. Needless to say, we should all be thankful that we have the steady and compassionate hands of Paulson and Bernanke at the wheel. The wheel is of course used to roll the printing press, but that is a story for another time. In addition, the depression created institutions to prevent its repeat with the FDIC (Federal Deposit Insurance Corporation) and a more powerful Federal Reserve Bank.

A painful economic adjustment process has begun. A weak dollar has allowed net exports to expand and is now a positive contribution to GDP growth. The U.S. consumer is in painful recognition that his lost twin brother, the U.S. saver and investor, needs some money and is starting the reallocation process. With a more competitive export economy and less imports of consumer goods, the trade deficit (excluding energy) has begun to see some improvement and, as energy prices find a new equilibrium, the total U.S. trade balance should show lower deficits over time.

The economy is, in our view, in a recession that started in earnest in the third quarter and should continue into the first half of next year. Earnings as measured by the S&P 500 should be flat this year and next, with the second half of this year and first half of next showing down year over year comparisons. We have been incorporating weaker economic growth in our earnings forecasts for the companies we follow and making the appropriate adjustments to our estimates of each company’s fair value. Since we use normalized earnings power for each company to estimate its fair value, near-term economic weakness may not have a huge impact on a company’s normalized earnings power and fair value. In most cases, the recent decline in
stock prices has significantly exceeded the reduction in our estimates of fair value.

The U.S. stock market, as measured by the S&P 500, sells at 13 times our estimate of next year’s earnings. At the same time, the S&P 500 dividend yield is currently 2.4%, better than most money market funds are yielding. Measured by dividend yield stocks are very attractively valued (see chart below).

Moreover, investment sentiment is very negative and fearful. Investors have built large cash reserves that are available for investment in the stock market once this fear subsides.

The problems in the financial sector are taking a real toll on consumer discretionary spending and creating a negative feedback loop as unemployment ticks upward putting further pressure on consumer spending. However, as we move into early 2009 we believe investors will begin to focus on 2010 earnings which we expect to be markedly improved as the economy recovers and financial sector write downs are drastically reduced. In our opinion, the expectation of improved 2010 earnings should drive the market higher by the middle of 2009.

The past few weeks have been extremely stressful for investors and highlighted the fact that the overall market is near its 1998 levels. On February 2, 1998, the S&P 500 closed at 1001, and on Tuesday, October 7, 2008, we closed at 996 on the S&P 500. Our clients have been fortunate to have faired far better, but it has been a difficult operating environment. (Please see our audited performance reports for details) Ten years is a long time even for long-term investors, but it does set up the possibility of above average returns over the next few years. Moreover, history shows that after sharp market drops like we just experienced, that the average equity market returns for one, three and six months are 6.8%, 7% and 15% respectively.

We think a repeat of the Great Depression is extremely unlikely. The Great Depression was an unfortunate creation of Government and Federal Reserve explicit policy not benign neglect or inadvertent. Although Mellon and Hoover get most of the blame, the liquidationists were common in academia and government (“Liquidation” Cycles and the Great Depression by J. Bradford De Long, June 1991). The liquidationists espoused the belief that liquidation and failure was an essential part of getting capital and labor properly distributed in a free market economy as the risk of failure kept capital and labor focused on likely profitable opportunities and made the downside of unsuccessful or less optimum choices severe. Potential failure
helped assure optimized utilization of capital and labor.

As investors recognize a depression is not going to happen, the financial markets should stabilize and begin to recover. The Federal Government no longer holds the opinion that a depression is both necessary and beneficial, and even the majority of Congress now believes that government intervention is preferable to a depression. We remain cautious in our sector commitments and continue to underweight the financial and consumer discretionary sectors. Our individual stock selection remains focused on quality companies with strong balance sheets and solid growth prospects that are selling at large discounts to our estimates of their
underlying business value.

(c) Tradition Capital Management

www.traditioncm.com