Assumptions Going Forward
June 22, 2009
Good morning. First real down week for the market in a while, with the SPY down from 95.08 to 92.04, or 3.2% on the week. A lot of the down move was caused by a correction in the price of commodities, most notably oil. Oil was down over 3% on Friday, and the oil part of the SPY (XLE) was down 8% on the week, from 53.51 to 49.21. An awful lot of oil industry fundamentalists have been saying for a while that the recent steep run up on oil prices was not justified by the supply/demand situation, and was more a function of hope that the world economy would turn around soon. Maybe they are right. In any case, the supply of oil and natural gas seems high and prices seem to be easing. The VIX was down slightly on the week, from 28.14 to 27.98, as even though the market was down it was a very slow week in terms of trade (despite being options expiration). So far this morning the market is down sharply.
My theme this week was going to be the role of governmental regulation and its effectiveness, surely a timely topic since it appears every thing you do will now be regulated (George Orwell where are you, maybe you were just like a trader, a little bit early). It makes no difference that virtually all regulation to date has been something between ineffective and unnecessary to a total fiasco, we need more. Maybe if we do it right for every person working and making something we will have five idiots watching, grading, or telling him to hurry up. While we are at it let’s have another five writing procedures dealing with what the one worker is doing, how he is doing it, and how to check what he produced. Everyone thinks I am this liberal guy who would welcome all this government intervention, but I think virtually all regulation of this sort has been ineffective. In the unusual situation that the Fed, for instance, has noticed huge problems, like in 1928-29, late 70’s, 2000-01, and the last few years they have totally lacked the will or power to raid the party. It is not like they did not see it. Even in 1929, while the Fed has been historically lambasted for their lack of action (before the crash), they in fact knew there was a massive problem developing and were vilified and stopped by Congress and others every time they tried even small corrective actions. Anyway, I leave this topic until next week.
The topic I do want to address this week is one of assumptions going forward. When I say assumptions I mean that in any type of analysis or plan there needs to be some starting point and some idea on how the future will generally play out. For instance, you may ask, “Assume that the population will grow 2% per year for the next 20 years. At our current rate of 45% of the widget industry (also assume we maintain our market share or increase it to 46 or 47%) how much will we have to increase capacity in the next 20 years? At our optimal plant capacity of X how many new plants will we need, and at what rate should we start buying land and building them?” This is a very standard type business school and real life type of problem for financial analysts (I know, I used to be one and maybe still am). Does anyone find anything wrong with the problem? No, because this is America. The view going forward is always positive, the country will grow, our firm will grow, our products will keep pace, 20 years from now this country, city, company, will be bigger and stronger than it is today. Granted your timing could be wrong, you could borrow too much at the wrong time, someone could invent a product better than yours, your company could fail, but not because your long term view of the world is fundamentally flawed.
What do I mean by flawed? We had a seminar last Saturday, as usual a great group of people on the first nice Sat. in a while. When I asked what their view of the world going forward was, really no one could say anything positive. Questions like “Do you think the market will be appreciably higher than here 10 years from now?” and “Do you think the average worker wages will keep pace with inflation in the next few years?” were met with very tepid responses. The one that was a unanimous was “Do you think that the leadership of the average large firm, while owned by shareholders, could care less about those shareholders?” No one thought that they were any part of the CEO thought process. If correct the new analysis might read “Assume population stays flat or goes down as immigration not only slows but people flee back because of lack of work. Also assume that we can’t maintain our widget market share and 20 years from now we will have 30% market share vs. 45% now. How many people will we have to lay off per year and how many plants have to close? Would it be better to just decrease wages by 5% per year so people get disgusted and quit rather than have to pay any lay-off packages?” Is this really the new reality? If so it sure is a lot different than we, and generations before us, have become used to.
I can only imagine how this country would look if this rather bleak view had always been in place. Picture your parents in the late 50’s or early 60’s seeing a house they like and trying to get a mortgage. Dad has a job (maybe Mom as well), they have the 20% down payment, it will be tight but the job looks good, the company is growing, promotions (and raises that go with them) are in the near future, etc. I suspect they got the loan, but what if the loan officer were to say “Sorry, but based on my assumptions housing prices will drop 30% in the next year, you will probably not be promoted, and actually will probably be laid off, leaving us holding the bag on this ratty bungalow.” Sounds like Mr. Potter in “It’s a Wonderful Life.” Are we really going to start thinking that way? Remember that the lions share of those people with bad mortgages are just regular people that bought a house where it was priced, only to find out that the price has dropped 30-40% and that their job is probably in jeopardy, never mind the raise or promotion. The timing was surely bad for them, but it does not make most criminals. Some of the flippers and bad loan people yes, but the regular homeowners, no. The question remains, are we as a people going to need to undergo a fundamental change in assumptions like what eventually happened in the 30”s, that you should assume nothing good for a real long time.
Maybe there is a connection between assumptions going forward and the new rush to governmental regulation. I think we need more people making things, like a new and more varied energy landscape, more efficient transportation of all types, etc. There is plenty of stuff to do, plenty of real needs that should be addressed by real people making a decent wage. We need to have a regulatory framework that allows that to happen and regulates with solid principles of growth, not one that causes 5 people to support the one person working. That one person cannot pay enough taxes to support the 5 idiots watching him work or telling him how to work. The group last Saturday, real bright people with a dim view of the future, has me real nervous. They could be right.
What about investing in this climate? My Grandfather told me once “Tom, anyone can break his back and make a buck, the smart man know how to have his money work for him, not his back.” How about today? In that last ten years the market is down, worse for you if you had a company that disappeared and you were left with nothing. Returns for just use of your money by banks and government returns next to nothing, and the relative safety of corporate bonds and preferred stocks is in jeopardy. What to do? I refuse to believe the long-term future is that bleak, and I think you need to have something going for you in case things are a little brighter. Having said that I think you need to be very concerned about protection in case the market does some kind of double dip. I also think we need to be relatively aggressive selling covered calls, the idea being that we will try to remain protected and positive until we get a chance at a real buying opportunity. If the market makes some violent short-term moves there may be an opportunity for some trading opportunities. I expect a struggle and difficult market, but as our track record indicates we will be up to the task and will prevail.