2009 Year End Review“Insanity: doing the same thing over and over again and expecting different results.” Financial markets staged a remarkable recovery in 2009, bouncing back from the brink of disaster, thanks to an unprecedented unilateral rescue effort by global government banks. Year 2010 and beyond will reveal how domestic and international markets respond when various stimulus and zero borrowing cost for banks are removed. LCM Capital Management has often stated that volatility is the new norm, and 2009 reconfirmed this. After plunging more than 25% in the first 3 months of the year, the Dow Jones Industrial Average staged a massive recovery to finish the year up almost 19%. The S&P 500 rose over 23%, the Russell 2000 (small cap) index climbed over 25% while the EAFE International index jumped 28% and the NASDAQ soared over 43%. These performances were amazing but minor compared to the riskiest asset classes and emerging markets. The U.S. junk bond market, for example, was up over 57% and markets such as Russia exploded by 129%. India, China and Brazil all gained over 80%. The safest of investments, the U.S. intermediate-term Treasury index, dropped by 1.4% while the long term government bond index lost almost 13%. Although 2009 ended on a positive note, the decade will go into the record books as the second worst ten year performance since the 1930’s. Corporate earnings were much stronger than expected, which can be largely attributed to aggressive cost cutting. The market benefited from the Federal Reserve’s pledge to keep interest rates low for an “extended period” and federal government stimulus dollars that continued to pour into our economy. The challenge going into 2010 and beyond is how to manage the cost associated with massive deficit spending while keeping interest rates at zero for an indefinite period of time. LCM Capital Management indicated over a year ago that Ben Bernanke and the Federal Reserve have been backed into a corner. That corner has never been smaller. The U.S. government sold a record-breaking $2.1 trillion of new debt into the marketplace to fund its programs and budget deficit. Eventually, inflation will flare up as rates will have been kept too low for too long. Accordingly, high yield (junk) securities, emerging markets (sovereign and equity debt), highly leveraged equities (over 50% debt to equity ratio), lower investment grade corporate debt, preferreds and long maturity treasuries should be avoided in an environment of rising interest rates. As Einstein noted many years ago, doing the same thing over and over again, leads to an exercise in futility (recall Greenspan’s 1% for federal funds rate from 2002 through 6/2004). The insanity here is that the banks and financial institutions that took on the largest risks and performed worse (through 2007) were rewarded with almost one trillion in taxpayer dollars and billions in executive bonuses, allowing them to survive and compete with their better-managed peers (i.e., LCM Capital Management). Another area we continue to be skeptical of is real estate, both residential and commercial. The Fed has bought more than 70%, that’s $1.25 trillion, of all mortgage-backed securities, backed by loans from Fannie Mae and Freddie Mac. This government sponsored program is expected to draw to a close in March of 2010. What will happen to mortgage rates when the buyer of 70% of them disappears? While these government programs have been instituted in order to stabilize and support the residential market, the number of struggling homeowners is steadily rising. At the end of September 2009, one in seven households with mortgages was either in foreclosure or delinquent on payments, according to the Mortgage Bankers Association. On the commercial side, the market is faced with huge amounts of unoccupied space and a deluge of defaults and foreclosures that are putting new stresses on banks and other financial institutions already on life support. One only needs to look at midtown Manhattan, the most expensive and presumably most valuable office space in the U.S., to gauge the market. According to C.B. Richard Ellis, roughly the equivalent of sixteen 40-story office towers are vacant. Asking prices are down more than 30% since November 2008. Nationally, only $42 billion in commercial real estate had been purchased through November 2009, compared to almost $700 billion purchased in 2007 and 2008. Sky high prices and monstrous loans were justified on the assumption that rents and occupancy rates would keep rising. Instead, both have plummeted. Something must give over the next few years. The acceleration of power from Wall Street to Washington D.C. is reflected in commercial rates where it now costs more to rent in D.C. (home to our country’s largest employer) than Manhattan, an historical first. While the fix to this sequel is pathetically simple-- stop excessive building across the country and significantly reduce leverage at financial institutions-- it will not happen for the foreseeable future. The silver lining is that LCM Capital Management continues to believe we will benefit tremendously from these lessons and our economy will find stable footing with gradual growth over time. While we envision the recovery to be a jobless one, corporations will be more profitable, due to lower overhead. Consumers will reacquaint themselves with the benefits of saving, and the markets will eventually return to gradual growth. This is why controlling your investment cost is imperative. Interest rates will head higher in the coming years (since federal funds cannot go below zero), and inflation most likely will follow. LCM Capital Management is preparing our clients for this by buying inflation protected CDs and TIPS for a portion of our fixed income holdings. While the near term will be a choppy environment, we are very optimistic long-term. Out of this period will emerge powerhouse entities (the late 70’s produced companies like FedEx, Microsoft, Cisco, Schwab, etc.) that will change the landscape of the future similar to what LCM Capital Management has done to private asset management. Our clients will continue to have exposure to equities with lower debt ratios, as credit will remain tight for some time. Given the high jobless rate, high-end home oversupply, and expensive jumbo mortgage rates, one can understand why real estate is still overextended and is no longer an inflation hedge. High quality tax-free municipals are still attractive even as rates rise, because income tax hikes will more than offset principal declines. We have a changing of the guard on the horizon. If you hold accounts away or know of someone who needs help with their investments, please inform us or your advisor. Thank you for your continued trust, business and referrals as we build the most transparent, low-cost, fiduciary-focused money management firm in the country. As always, should you have any questions please call us at (312) 705-3013 or email lcm@lcmcapital.com. LCM Capital Management The view expressed reflects those of the authors as of the date of this commentary. Any such views are subject to change at any time based on market or other conditions, and LCM Capital Management (LCMCM) disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for LCMCM are based on numerous factors, may not be relied upon as an indication of trading intent on behalf of LCMCM. Thoughts about investing, the direction of the market, and individual securities are based on the author's own analysis and are not representative of actual future performance. Investing involves risk including the possible loss of principal. |