August 9 Market Commentary

Since July 21, 2011, the Dow Jones Industrial Average (DJIA) has lost 13%; 5.5%, yesterday alone. Crude oil prices have gone from $99 per barrel to about $81 per barrel in the same time frame. The European FTSE 100 Index1 is down 12% since August 1. Yields on 3-month U.S. Treasury bills went negative last week; (i.e. loan the U.S. government $100+ dollars today, and it will give you back $100 in three months— ouch!). The Bank of New York Mellon announced that it would start charging institutional depositors a fee, (13 basis points), on “excess deposits.” AIG is suing Bank of America for fraud and, of course, last Friday afternoon, Standard & Poor’s downgraded the United States’ credit rating from AAA to AA+.

What in the world is going on?

Let’s talk about that last item first. Standard & Poor’s warned a few weeks ago that if the U.S. didn’t cut on the order of $4 trillion from the budget over the next 10 years, it would downgrade the U.S. rating. Congress didn’t manage to cut $4 trillion, so Standard & Poor’s followed through on its warning. We don’t think investors care much whether U.S. debt is rated AAA or AA+. The U.S. Treasury market is still the largest and deepest market in the world, and the likelihood of getting the promised payments (in nominal terms) remains very high. From an investing perspective, the downgrade is irrelevant. From a political perspective, it may be very significant. Mohamed El-Erian, (CEO of PIMCO), has stated the silver lining of the downgrade is the clear and unambiguous message it sends to policy makers. We hope he is right. What we do know is that yesterday, U.S. Treasury bill interest rates fell dramatically as investors rushed to buy U.S. government debt—not what you’d expect if they were worried about getting paid back.

We think what is driving the sell-off in equity markets and the move into “safer” bonds is concern over European debt problems led by Italy. You’ll recall that, for most of the summer, the European Union was wrestling with the problem of Greece’s debt, and, about three weeks ago, it reached an agreement to expand the authority of the European Fiscal Stability Facility (EFSF)—in both size and authority—to address the problem. The new agreement must now be ratified by European parliaments, which are on vacation until September; (I’m not kidding). While that debate was going on, the market was steadily increasing the cost of lending money to both Spain and Italy, currently charging a bit over 6% for those countries to borrow for 10 years. 6%-7% is about the level where Italy’s debt no longer becomes affordable; the Italians can no longer afford to borrow money to pay old debts and other government expenses, so it’s crunch time.

Last week, Italy’s Prime Minister Berlusconi laid the blame for the high rates on irrational markets. Also last week, Jean-Claude Trichet of the European Central Bank (ECB) stated that the ECB was prepared to start buying Irish and Portuguese bonds again, followed by a statement on Sunday that the ECB would buy Spanish and Italian Bonds on Monday—which it did. Even though Italian and Spanish yields fell yesterday, the equity markets were underwhelmed, assessing (correctly, I believe) that Italy and the ECB underestimate the magnitude of the problem, and are not taking effective actions to prevent Italy from being priced out of the debt markets. The ECB also signaled a looser monetary policy—but not much looser—and, apparently, there was some internal dissent on this issue.

So sovereign debt problems and the possibility of a European-led banking crisis are, once again, the focus of the markets, and investors are pulling back because effective action isn’t being taken. You see this in the velocity of money, which has fallen dramatically, and the move into U.S. Treasury bills, bidding their prices up and creating the negative yield mentioned earlier. Banks are having difficulty making money on depositors’ funds—and must pay FDIC insurance fees on them—so they are passing those costs along to their depositors; (at least, Bank of New York Mellon is). I suspect yesterday’s decline was accelerated by some margin calls on leveraged hedge funds, but the essence of it is that the market is concerned about Europe.

U.S. banking concerns also resurfaced yesterday when AIG filed a $10 billion lawsuit against Bank of America. Bank of America led the rest of the U.S. banking sector in a hard sell-off, as investors were concerned about the solvency of Bank of America, and U.S. bank capital adequacy, in general.

The context in which this is taking place is also important. In the U.S., many economic indicators, from the Purchasing Manager’s Index to unemployment, are weakening; GDP growth is still positive, but 1st and 2nd quarter numbers were revised downward last week. These data points are creating renewed concern that the U.S. is moving into another recession. The recent debate over the U.S. debt ceiling was frankly discouraging and exhausting to watch—whether you liked the outcome or not. Healthcare stocks have been hammered by the threat of automatic Medicare cuts if the government can’t find another $1.5 trillion in cuts over the next six months. Last week, I received a letter from our health insurance company, stating that to provide the same level of coverage next year, (as we had this year), it would cost an additional 20%; so the cost of doing business is going up. I think that all of this has an impact on peoples’ “psychic reserves,” and they are tired of the chaos—fed up—and don’t trust anyone much at the moment. People, in their roles as both consumer and investor, are feeling defensive, and that’s not good.

The outlook for the next month or so isn’t good either. Europe has major problems and the parliaments are all on vacation. If this develops into a full-blown liquidity squeeze or banking crisis, it will get ugly. I expect European leaders will be unable to get ahead of the problem for at least six weeks. I think the problems in Europe will impact the decisions of businesses, consumers, and investors in the U.S., and make a 2 recession more likely in the near term, not less. In the last week to ten days, most of the CEOs we listen to during quarterly earnings calls are very cautious when they talk about the second half of the year; so we’re seeing businesses react already. We see a lot of good companies selling at prices we like, but if investors start selling without regard to price—either because they have to meet margin calls or because they are scared—value won’t matter for a while.

While we have sold down some holdings in the last several weeks, it hasn’t been enough to protect us in the last two weeks as everything went down. Today, (August 9, 2011), the market is being a bit more discriminating as good companies with strong earnings are performing better than weaker companies. If we see signs of indiscriminate selling, we will continue to move to a cash position in order to sidestep the decline; otherwise, we will be looking to invest in companies we think will do well going forward. We suspect the companies that do the best going forward will be different than the ones that outperformed the last few years.

1The FTSE 100 is a share index of the 100 most highly capitalized UK companies listed on the London Stock Exchange.