So far, the stock market correction we have witnessed in the past month appears to be normal in scope. In contrast to the “sky is falling!” mentality that prevailed one year ago, signs that our banking system would survive began last spring an overly ebullient reaction by a significant number of investors. Now that Optimists must deal with evidence of a very slow recovery, and economic ignorance on the part of many politicos, a negative reaction has set in, with the flow of new money into equities more than offset by profit taking. It appears to me that the Recovery appears to be playing out along the lines suggested by most economists, including those in government: slow, with fits and starts. 

So far, the stock market correction we have witnessed in the past month appears to be normal in scope. In contrast to the “sky is falling!” mentality that prevailed one year ago, signs that our banking system would survive ignited, last spring, an overly ebullient reaction by a significant number of investors. Now that Optimists must deal with evidence of a very slow recovery, and economic ignorance on the part of many politicos, a negative reaction has set in, with the flow of new money into equities more than offset by profit taking. It appears to me that the Recovery appears to be playing out along the lines suggested by most economists, including those in government: slow, with fits and starts. 

It is, never the less, a recovery. Currently those who are bearish about stocks point to the possibility that China, now an important engine of world growth, is taking moves to cool the pace of its torrid economy. In Europe, meanwhile, the Central bank’s role, less accommodative than that of our own Federal Reserve, has exposed cracks in the economies of Greece, Spain and Portugal. At home, the plight of the States’ two weakest links, California and New York lie iceberg-like with possible disaster just below the surface. Statistics have been mixed, and the joy generated by a surprisingly large rise in US GDP in the fourth quarter, 5.7%, was short lived. Much of the growth was due to extreme Federal pump priming, such as the new home buyer tax credits. Further, initial GDP reports are notoriously subject to revision. Employment appears to have stopped spiraling downward, a major positive, but many fret that the jobs being created or rather, saved, are non-productive occupations of government workers, teachers, policemen and national security apparatus.1 Still, part time employment has been rising, usually a sign of improved full employment to come. Most economists believe that when employment levels turn up, the recovery will gain momentum, possibly leading to a boom. Today Home Depot reported surprising good earnings, which may result from rising home sales and the resultant improvements often made by new home owners.

I suspect that current equity market weakness is not too damaging for many individual investors, since so many became defensive in 2008 and never turned more than lukewarm, at best, with regard to stock investments. This was reflected in sentiment indexes such as that published by the American Association of Individual Investors, which has not risen above 50% since the recovery began. Rather,  the stock market rally that has run from March 2009 until mid January 2010 has largely been a function of institutional activity. Institutions probably bought and bought again because safe alternatives such as Treasury bonds and bills have offered such penurious yields. As the market rally gathered momentum, the fear of missing the train by underperforming peer money managers likely fed the bullish appetite for stocks, driving them to fully valued levels and in some cases beyond.

Speaking for myself, I long ago learned to ignore the race to beat the indexes. Our clients are informed at the outset of their relationship with TFA that we seek to capture 80% of the US stock market’s upside but with half of its volatility, or less. To say this another way, we expect, over a long period of time, to offer returns somewhat below those available from a 100% investment in stocks, but with a lot less terror. Had we done only this well over the past 8+ years of our existence, our clients would have lost a lot of money. As reported to clients recently, we have instead soundly out-performed US stock indexes over an eight year-plus period of time, producing mid single digit total returns after fees and expenses. Stock market index investors have simply lost money over the same period of time. Since our first priority is to protect against a loss of capital, the sub-par stock market environment of the past eight years makes our approach look pretty darned good. During this period, I’ve done my best to pluck opportunities as they flower in what has otherwise been a garden suffering from a series of droughts and plagues. Given extensive experience in the bond market during the 1980’s and early ’90’s I recognized that good quality debt instruments were being priced as if their issuers would fail (i.e. offering junk bond type yields) last year. We scooped up fixed income bargains while other money managers were hiding under their desks convinced that “this time it’s different”. One reason for my willingness to buy bonds was my belief that the Federal government was committed to saving the banking system, and has the tools to do so. Now that the Fix is in, Monday morning quarterbacking has begun in earnest, with ignorant or unprincipled politicians of both parties gladly blaming hapless appointees from Hank Paulsen to Tim Geithner to Ben Bernanke for the problems of the recent past. “Burn down the Banks”may be good press for someone seeking re-election, but does nothing for confidence among investors. Thus, fearful thinking has begun to return, and with it, a few good opportunities to pluck some more blooming “flowers”.

Tax Free Bonds
What of tax free fixed income opportunities? I was asked recently by a client to offer assurances about California munipical. While I believe we are in recovery, this may not be evenly shared throughout the USA. Recently, California – based issuers’ bond prices have been falling again with yields rising. The state is a poster child for bad governance, much of it due to an out-of control Proposition system, a populist legacy that permits voters to ignore fiscal responsibility while approving many well intended but unfunded mandates. The primary saving feature for California homeowners is the effect of 1978’s Proposition 13 that has controlled the rise in property taxes for home owners, while forcing local governments and school systems to operate more efficiently. Prop 13 also prevents increases in state income tax rates unless a 2/3 majority of the legislature approves, yet the state has some of the highest income tax rates in the nation. In order to support initiatives mandated by Propositions and a rapidly rising population of state employees,soaring medical costs for welfare recipients and an aging prison population, California has borrowed heavily through debt issuance. As the real estate transaction industry has imploded, and industry has fled the state, a revenue shortfall of enormous proportion has resulted. The State faces a $20BB shortfall this year, a gap that cannot be filled without help from the Federal government and/or significant tax increases. The Wall Street Journal discusses a coming wave of sales taxes to be imposed upon service providers2, who might include clients of financial advisors.

Does this mean that purchase of California- based bonds is to be avoided? Well, I’m not comfortable with state General Obligation bonds. However, many smaller public entities receive their income from providing essential services: water and sewer, medical care, and schooling. Others have dedicated sources of revenue from the private sector such as electricity generation or parking fees. Those we purchase for clients generally must maintain significant cash reserves, with debt service payment receiving the highest priority for use of income. Before purchasing a bond for a client, I usually research the economic situation in the locality where money will be spent and income generated to repay the borrowing. If there is a school or hospital bond offering, I often read the offering circular, then review minutes of recent Board meetings for those entrusted with investing the money raised. Still, holding the bonds of any California based issuer may prove to be a nerve-wracking proposition: expect plenty of headlines reporting on funding cuts, personnel reductions, facility closures and rising fees. A gubernatorial election in 2010 will result in even greater hyperbole than normal. The state’s budget gap is so large that it appears inevitable that taxes and fees will rise significantly. But default? I doubt it. For one thing, California’s congressional delegation, largest in the nation, is likely too powerful to accept “no” when asking for help for the state. Federal largesse, splashed around to bankers, auto workers and home buyers will, in my opinion, find its way to the Golden State, but only after a well-reported game of Chicken takes place between the Federal government and a reluctant state legislature that is largely in the pocket of public employee unions.

If serious structural changes at the State constitutional level are not put in place, the long range outlook for California is rather dim. Such wrenching changes as we are likely to see will no doubt reflect on the ability of some residents to pay taxes and fees and to live and shop in California, an environment that may result in a shrinking middle class.  So, through corollary effects, even bonds that enjoy dedicated revenue streams may well suffer ratings downgrades and even possible default. Still, I happen to believe that the essential services provided by issuers of bonds held by our clients must and will continue to be provided, and that our selections are of good quality.  Still, my pencil is being sharpened even more than in the past, before placing additional California- based paper into client portfolios.

footnotes
1. The word “non-productive” is not intended to disparage the importance of these occupations, but to indicate that they do not result in more goods being produced , and are less likely to produce collateral job growth than such occupations as manufacturing, mining, and energy production.
2. Wall Street journal on line edition February78, 2010 “States Try to Tax More Service as Coffers Deflate”.