Fagan Associates Archive for July, 2010

This past week President Barack Obama signed into law sweeping changes meant to provide the framework believed required to regulate the financial services industry and prevent the potential for a systemic collapse of the economy, a collapse that we came precariously close to during the Autumn of 2008.  In addition to the regulatory authority, several bodies have been created that will oversee the application of the law.

Recalling the causes for the near collapse, during the early 2000’s, after the repeal of the Glass-Steagall Act, a bill signed into law during the Great Depression and meant to provide regulation and oversight to the financial industry, banks and other financial organizations began to securitize mortgages in an effort to collect fees, maximize profits and make home loans available to more Americans.  Unfortunately, this process of securitization led to lax underwriting procedures for mortgages by regulated entities such as FannieMae, and FreddiMac and banks as well as unregulated entities including Bear Stearns, Lehman Brothers and AIG.  A bubble and subsequent collapse occurred in the housing market.  The rest is history.

Enter financial reform.

For consumers, the federal government has established the Consumer Financial Protection Bureau within the Federal Reserve that will oversee banks and credit unions with more than $10 billion in assets as well as all mortgage related businesses.  Furthermore, the law also permanently lifts Federal Deposit Insurance (FDIC) to $250,000 and establishes minimum underwriting standards for mortgages.  Regarding mortgages, the law now requires verification of income, job status and credit history.

The law also attempts to address the issue of “too big to fail,” one which led the U.S. Treasury to bail-out AIG and Citigroup, but let Bear Stearns and Lehman Brothers go by providing authority to the Treasury, FDIC and the Federal Reserve to seize, regulate and perhaps even liquidate struggling companies, regardless of whether or not they can be defined as a bank in the strictest terms or not, if their collapse would pose a systemic risk to the U.S. Economy.  In order to provide adequate oversight, the government would assess charges on firms with more than $50 billion in assets.

The assumption of excess risk, a contributor to the meltdown, is also intended to be regulated by the law through a limit on proprietary trading by financial firms.  In addition, the law also raises capital requirements.

The securitization of mortgages noted above as well as the usage of derivatives, intended to maximize profits from the potential increase in market value of the underlying real estate also contributed to the deep recession when real estate prices tumbled.  Furthermore, given the fact that much of this risk was taken by unregulated firms, the Government was slow to respond.  The Financial Reform Bill, officially known as the Wall Street and Consumer Protection Act, begins to regulate the over-the-counter derivatives market by requiring transactions to be completed over an exchange, thereby increasing transparency.

Finally, the law also establishes a Financial Services Oversight Council, chaired by the Secretary of the U.S. Treasury, and charged with identifying potential issues or companies that pose systemic risk to the global economy.

THE BOTTOM LINE – No legislation is ever perfect.  However, we believe that this is certainly a step in the right direction as it will hopefully provide early warning signs, thereby preventing a similar near-death economic collapse like the one we experienced during the latter stages of 2008 and early 2009 and from which we continue to recover.

According to a recent Economic Letter from the Federal Reserve Bank of San Francisco, “U.S. household leverage, as measured by the ratio of debt to personable disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s.  Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007.  That dramatic rise in debt was accompanied by a steady decline in the personal savings rate.  The combination of higher debt and lower saving enabled personal consumption expenditures to grow faster than disposable income, providing a significant boost to U.S. economic growth over the period.”

Furthermore, according to Haver Analytics, “annualized, credit growth averaged 8% during the fifteen years ended 2007.  Over an even longer time period that increase does not loom particularly large.  However, against an average 5% growth in disposable income during those years, it precipitated a rise in the ratio to disposable income to 24% from a longer term norm of 17%.”

Taking into consideration both of these statistics noted above, the meat of the issue and the main cause of our current economic predicament is illustrated by the next statement contained within the aforementioned Economic Letter.  “In the long-run, however, consumption cannot grow faster than income because there is an upper limit to how much debt households can service, based on their incomes.”

This past month the Federal Reserve also released data that showed revolving (credit card) debt has fallen 9.6% over the past year while non-revolving (automobile and consumer durables) has risen only fractionally.  This combination has helped push the U.S. Savings Rate above four percent, a multi-decade high.  We consider this contraction of consumer debt, either voluntarily due to a lack of demand or involuntarily as a result of a lack of availability, to be a permanent change in the spending patterns of American consumers that will negatively impact the strength of the current economic recovery.  We believe the recovery, unlike past economic rebounds, will not be led by the housing or the automobile industry, purchases that results in debt accumulation.  Unfortunately, thus far it has been led by government spending that will, hopefully, eventually give way to the private sector.  Specifically, we find attractive for investment those sectors that export their goods and services to the emerging economies of the world; those industries that provide materials and services for the infrastructure build-out both here and abroad; and finally, those industries that provide goods that consumers can purchase without breaking the bank, namely those items under $500 (see Apple).

THE BOTTOM LINE – From its peak in 1989, Japanese Automakers are selling approximately fifty percent of that amount, locally.  Automobile sales in the United States peaked at around seventeen million during 2007.  We do not believe that U.S. automakers will suffer the same fate as those of their Japanese counterparts.  However, we do not think it likely that we will see sales in the U.S. move back toward their old highs anytime soon.  In addition to the sectors noted above, investors would be wise to look at companies such as Nike, McDonalds Corp and Pepsi or other companies that have a strong presence in the United States as well as growing sales abroad.

During volatile markets like the one we have witnessed over the first half of 2010, we often go back to the basics, focusing on some of the tenets of legends in the investment business.  Two individuals that come to mind are Warren Buffett, CEO of Berkshire Hathaway and the individual who wrote the book on value investing, Benjamin Graham.  As you read through these quotes, try to determine of you are heeding their advice or are you like a rudderless boat being tossed about by the wind that is the day-to-day noise of the stock market.

“I don’t want to buy any stock where if they close the New York Stock Exchange tomorrow for five years I won’t be happy owning it.  I buy a farm and I don’t get a quote on it for five years and I’m happy if the farm does ok.  I buy an apartment house, don’t get a quote o it for five years – I’m happy if the apartment house produces the returns that I expect.  But people buy a stock and they look at the price the next morning and they decide if they’re doing well or not doing well.” ~ Warren Buffett

“What you’re looking for is some way to get one good idea a year, and then ride it to its full potential.  And that’s very hard to do in an environment where people are shouting prices back and forth every five minutes.” ~ Warren Buffett

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information.  What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” ~ Warren Buffett.  We ask you, when you are investing, are you deciding to buy or sell with your heart or your head?

“Individuals who cannot master their emotions are ill-suited to profit from the investment process.  The investor’s chief problem – and even his worst enemy – is likely to be himself.” ~ Benjamin Graham

“Most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse.  The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time.” ~ Benjamin Graham

“Basically, price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.  At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” ~ Benjamin Graham

Finally, our favorite, “the market, like the Lord, helps those who help themselves.  But unlike the Lord, the market does not forgive those who know not what they do.” ~ Warren Buffet

THE BOTTOM LINE – Be rational when investing.  Keep emotions out of it.  Spend some time learning how do invest and if you can’t or won’t spend the time or are ill-suited to invest by yourself, contact a professional.  We’d like to apply for that job.