March, 2009
The
long-term delivery of the truth is a must, even when the truth is not so rosy.
America is getting back to the fundamentals, unfortunately much so by force, not
by choice. What has worked for 233 years will continue through basic financial
fundamentals, in part which is consistency in operating through good markets and
bad.
The stock
market is down substantially from its peak - in relationship to current
quarterly earnings, in relationship to book value, and in relationship to
perception of the future. We need a component of optimism, to remain being a
holder of companies that create new value. We've got be optimistic the future
will be better than the past. Based on
current research, the present value of the U.S. economy over the next 75 years
is worth well over $750 trillion today (that’s 750,000 billion dollars),
with the majority of the profit and economic value being realized in the average
investor's lifetime. Activity and growth is not going to stop.
The
household savings rate of 5.0% is at a 14-year high, jumping from near zero or
negative for five years and down from 11.1% in 1985.
Stocks are trading at their lowest prices relative to earnings since
1985. The employment rate is 91.9%, the prime lending rate is 3.5%, core
inflation is less than 1.0%, mortgage rates are less than 5.25%, and
the housing affordability index is the best it's been in more than 40
years. Organizations and individuals, from sub-prime to the high-end, are
de-leveraging for the greater good as excess debt becomes less permissive. This
is having a fluctuating effect on the economy and the financial markets.
The biggest
concern by far over the long-term is not short-term fluctuations in the
financial markets - it is
inflation risk. Core inflation will
not remain low – we will see inflation spikes of 10% or more again. With
long-term historical 5% compounded annual inflation,
the cost of living will double in 14
years (100% increase), triple in 22 years (200% increase),
quadruple in 28 years (300% increase), and
quintuple in 33 years (400% increase). Anyone less than 70 years old
should count on seeing all four flips. Many costs will increase up to 10 times
today's levels. For example, health care cost increases over the past 45 years
compared to gasoline would cost $15 per gallon today. Holding bonds and cash
long term after taxes are guaranteed to erode up to 75% of your buying power.
The majority of stock’s gains in the future will be due to inflation, earnings
appreciation and dividend reinvestment.
We are
nowhere close to 'The Great Depression'. Even the name condones negativity -
what was so great about it, anyway? Economic output (GDP) dropped 34.5%, an
equivalent to a $5 trillion annual output decrease today, back to 1999 levels.
Unemployment was 25%, wages for those fortunate enough to keep their jobs fell
42%, home foreclosure rates topped 50% and the stock market dropped 89%. An
astounding 3,636 banks (not branches, entire institutions) would have to fail
today to match bank failures then.
As of today
there are 8,283 FDIC insured banks and savings institutions in America, with
over 75,000 branches and 2.1 million full-time employees, and with
$13.8 trillion in assets and
$1.3 trillion in Tier 1 capital. Ten
new banks have started and 17 banks have failed so far in 2009. From 2000 and
2008 a combined 52 banks failed and most merged into a well-capitalized bank.
The reality is 99.8% of banks (8,283
banks) are functioning with 5,625 of the banks reporting a profit last
quarter. The banks collectively are well capitalized enough to weather a
downturn much, much greater. Banks are $472 billion in write-downs away from
being considered “not well capitalized”, and $750 billion in write-downs from
being “not adequately capitalized”. As you can clearly see, nationalizing
(Government owning) all banks would be like Pluto becoming the sun.
Let’s
pretend the 8,283 FDIC insured banks received $235 billion additional cash
in exchange for issuing $235 billion of common stock (Tier 1 capital).
Banks could then lend anywhere from $2.4 trillion to $5.8 trillion in
additional loans based on that extra $235 billion. Banks (big ones included)
could have easily issued their own common stock over the past few years on their
own and dodged this bullet.
The Troubled
Asset Relief Program (TARP) has currently provided $235 billion of capital
(mostly to the largest banks) in exchange for preferred stock (rather than
common stock) which requires 5% interest payments and going to 9% in five years.
The banks used this $235 billion to shore
up their balance sheets rather than lend, and not by choice. The preferred
stock isn't really even considered Tier 1 capital since it's a form of a loan
(backed by the U.S. Treasury). Additional long-term lending with this short-term
funding is truly not an option for these banks. Without TARP, dozens of larger
banks and/or more leveraged banks would have risked eclipsing their required
capital ratios (minimum 4% to 6%) over the short-term.
Over the
last 10 years the 8000+ banks collectively were earning about $25 billion to $35
billion per quarter with 90% being profitable. In December, 2008 they booked a
collective $26 billion loss (mostly from a handful of big banks), a 2% loss of
overall Tier 1 capital. Realistically it appears that $150 billion to $250
billion more losses are in the pipeline for a total of 10% to 20% loss of
capital. TARP provided about 20% additional capital to the banks.
Most likely
a hundred or more banks will be taken over by the FDIC and/or merged into better
banks. The other 8,000+ banks will move
forward and earn their way out of this recession. There will still be $1.0
to $1.2 trillion of capital left and banks will go back to profiting over $100
billion per year, which will go to shareholder dividends and new Tier 1 capital.
They can then leverage and underwrite new, better loans from their future
earnings. Moving forward positively with the banks will be the biggest step
toward an economic solution.
Banks are
currently lending 53% less than last year. Because of the lack of credit,
negative perception and other economic factors,
the investment world has moved from underpricing risk to overpricing
risk, causing this temporary pullback. Fear is causing less economic
activity, leading to more fear.
The American
Recovery and Reinvestment Act of 2009 in part will slightly improve this
economic downturn. However, much of this borrowing and ‘spending our way out’
will occur well after the current recession is over. The Government is trying to
fix what should have never been broken, which are basic economic fundamentals
and time-tested financial rules and regulations.
Every stock,
bond or other security, investment index and/or asset class is traded by
vote in the short term and by weight over
time. Right now stocks are being put on the scale. These inexact balances of
supply and demand are causing unrest in the markets - however these same
elements, much like wind and rain, are our friends over the long term.
This is a
time to be holding stocks and indeed buying.
There's no question stocks will have a greater return vs. bonds in the
near term and most certainly the long term. Since 1971 there have been seven
major market corrections, and even through all the turmoil, the Large Cap Index
have managed gains of 11.2% annually, the Small Cap Index 12.9%, Emerging
Markets over 15%, and the European Index 13.4%. Time decreases annual variance
from the average - it will as we move forward.
In two to
five years you will look back with a sigh of relief. The fundamentals hold true
- if you are redeeming less than 5% to 7% of your assets adjusted for inflation,
you will be fine over the long term. As always Form ADV Part II is available for
review at any time.
Thank you
for your business in these trying times; we will get through this.
Sincerely,
Les Jepsen,
MBA
Jepsen Consulting
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