We’re seeing a pattern.  And, it isn’t very encouraging.  After the initial credit market recovery of ’08/’09, and in an effort to stimulate the economy, the Federal Reserve announced its unprecedented $1.2 trillion dollar mortgage purchase program.  When that ended in 2010, the economy stalled and the stock market sold off 14% through last August. 

It was time to call on the Fed, again.  This time, with a pledge to purchase $600 billion in Treasury bonds through June of 2011.  Chairman Bernanke’s stated goals: lower mortgage rates to boost housing, reduce corporate bond rates to encourage investment and raise stock prices to increase confidence and spending.  Was he successful?  According to the Wall Street Journal:

•Mortgage rates remained near all-time lows but the response of home buyers was muted.
•Corporate borrowing costs shrank, but business spending remains weak.
•Stock prices soared, but consumer confidence saw only a temporary boost.
•Deflation fears abated and core inflation is contained for now, but commodity prices are driving up headline inflation.

These quantitative easing (QE) programs by the Fed resulted in trillions of dollars on bank balance sheets, but little enthusiasm to lend it out to admittedly reluctant borrowers.  Instead, two years after the recession ended, we have unemployment at 9.2% and GDP barely growing at a 1.9% annual rate.  This is not the stuff of strong recoveries.

The benchmark S&P 500 Total Return Index closed out the quarter with a modest gain of 10 basis points (+0.10%) after dropping -2.78% in May and another -1.67% in June.  The index stands at +6.02% with virtually all of the gains coming in the first quarter.  The BarCap Aggregate Bond Index declined -0.29% in June, but gained +2.29% for the quarter and stands at +2.72% for the year-to-date period.  Our concern is that stocks, as measured by the S&P 500 TR Index, continue to respond, or not respond, to government stimulus as investors struggle to determine the true strength of the economy absent government intervention. 

The U.S. economy barely added jobs for the second month in a row in June, and the unemployment rate rose to the highest level this year.  Payroll data was revised down for April and May by a total of 44,000, showing increases of 217,000 in April and only 25,000 jobs in May.  June’s number, at 18,000 for the month, could have been worse if the labor force had not declined by 250,000 people.  Virtually every component of the household employment survey – the labor force participation rate, the number of people reporting themselves to be employed, the number of people “not” in the labor force – moved in the wrong direction.  As David Rosenberg at gluskinsheff.com commented, “The economy is obviously in a very fragile state, which actually is not so atypical considering that the scars from the detonation in credit and asset values during the 2008-09 economic contraction have not completely healed”.

Unfortunately, the housing situation is hardly better.  Robert Schiller, the economist who co-founded the S&P/Case-Schiller index of U.S. home prices, said a further decline in property values of 10% to 25% in the next five years “wouldn’t surprise me at all”. “There’s no precedent for this statistically, so no way to predict,” Schiller said at a conference hosted by Standard & Poor’s in New York. 

CoreLogic, a leading provider of information analytics and business services, released its May Home Price Index on June 30th, showing home prices in the U.S. increased by 0.8% in May 2011 compared to April 2011, the second consecutive month-over-month increase, but declined by 7.4% on a year-over-year basis. 

Mark Fleming, chief economist for CoreLogic commented that “Two consecutive months of month-over-month growth and continued relative strength in the non-distressed market segment are positive seasonal signs in the housing market.  Slowly declining shadow inventory and stabilized negative equity levels are also positive signs.  Nonetheless, the fragile economic recovery is still critical to the long-term recovery in the housing market.” 

CoreLogic further reported that there are 2 million current negative equity loans that are more than 50% or $150,000 “upside down”.  These current but underwater loans have increased risk of entering the shadow inventory if the owners’ ability to pay is impaired while significantly underwater.  Again, according to Fleming “The shadow inventory has declined by nearly one-fifth since it peaked in early 2010, in large part due to a reduced flow of newly delinquent loans in recent months.  However, it will probably take several years for the shadow inventory to be absorbed given the long timelines in processing and completing foreclosures.”

And, let’s not forget that starting October 1st, Fannie Mae and Freddie Mac will adjust the size of mortgages they guarantee in high-priced areas around the nation.  The maximum loan amount these GSE’s insure will drop from $729,750 to $625,500.  After October 1st, buyers in high priced areas will have to come up with larger down payments to secure a government insured loan.

And then there’s the deficit.  As if we didn’t have to enough to be concerned about, Treasury Secretary Geithner projects that the U.S. government will hit its $14.29 trillion borrowing limit on August 2nd.  While Congress and the President debate the solution to this dilemma, investors remain on the sideline waiting for final word on tax increases, program cuts and entitlement spending. 

The accompanying charts highlight the components of the 2011 Federal Budget.  Borrowing 39% of $3.7 trillion in annual spending; something has to change. But, a $1.4 trillion spending cutback would represent a huge hit to our $15 trillion economy. We can only hope that the solutions are long-term and not stop-gap measures ensuring a quick return to the same uncertainty.


The Greeks can’t pay their bills, but why should we care?  No longer able to obtain financing in global markets, the Eurozone finance ministers have agreed to provide Athens with financing to help the government function through the summer.  The ECB holds about $145 billion of Greek debt.  A Greek default with the ECB could lead to the collapse of the Greek banking industry.  That in turn would lead to Greece’s exit from the monetary union and shatter the Eurozone’s solidarity.  But more importantly, a default could set off the payment of credit default swaps which could then create serious Lehman-like ripple effects across the global financial system.  European banks hold a significant amount of Greek (as well as Italian, Irish and Spanish) debt.  U.S. money funds hold approximately 40% of their assets in European bank debt.  Sound familiar?

When Lehman Brothers collapsed in September 2008, the oldest and one of the largest U.S. money funds “broke the buck”.  The Prime Reserve Fund owned a significant amount of Lehman Brothers debt.  Today, there is virtually no difference in yield between corporate debt money funds and government debt money funds.  Investors are not being paid to take on the risk of European bank defaults, as unlikely as they may be.  At Watermark, we have instructed our custodians to hold all money fund assets in U.S. government money funds; FDIC insured bank deposits; or municipal money funds.  Nevertheless, a Greek default has the potential to spark another credit crisis.  We expect the ECB to carry Greece, but the level of uncertainty is quite high.

Strategy
The U.S. economy continues to wrestle with excessive non-corporate debt, excessive housing inventories, excessive reliance on imported oil and excessive labor market supply.  Consequently, our appetite for risk remains extremely low.  Though we probably sound repetitive, we continue to focus on income and capital preservation.

In the second quarter, we added two new structured notes to our portfolios.  The securities, a JP Morgan 13-month note tied to a worldwide stock index, and a Wells Fargo 13-month note tied to the S&P 500 Index are designed to provide downside protection and an upside coupon. We continue to utilize these notes to provide protection against equity market declines.

We are continuing to allocate money into foreign and strategic bond funds in an effort to manage interest rate risk, protect against a declining U.S dollar and to increase yield. 

As asset allocators, our investment strategies are designed to create portfolios with certain risk and return characteristics.  In the “old days” it was reasonable to maintain the allocations until something changed in the marketplace, or for the client.  In today’s investment environment, we believe it is necessary to not only be more “dynamic” with allocations such as adding or removing sectors like technology or commodities, but to also have specific “contingency” plans in the event of severe market disruptions.  We will be developing this topic with you in more detail as the year progresses.

In closing, we want to convey that we believe the economy is likely approaching another inflection point.  Things appear to have slowed significantly, and at a time when our government and others around the world have fewer options at hand to generate economic growth.  While the headlines will reflect a debate between austerity and government spending, we are confident that this isn’t a zero sum game, and that the American economy will eventually return to its proper role as one of the greatest generators of wealth in the world.  In the meantime it would be wise to remain prudent, reduce debt, and save and invest.        

Schwab YieldPlus Fund Settlement
Schwab has settled several shareholder lawsuits regarding the management of its YieldPlus bond funds.  Though we liquidated our client positions early on, you may have been included in the class action settlements.  If so, you will receive or may have already received at least one check from Schwab.  If you are a California resident, you may receive two checks, one for each settlement.  If you wish to redeposit your check in your brokerage account, please give us a call and we will assist.  You are under no requirement to do so.  However, if you receive a settlement check for a retirement account, we would urge you to redeposit those funds in your IRA.  Again, please contact us for assistance.

We’re moving!
After ten years in our present location, we have finally outgrown our space.  We’ll be moving to a much larger building and suite on Crow Canyon Place in San Ramon.  Our move is scheduled for the middle of September, so you’ll be hearing much more about that as the time approaches. 

Mark Miller     Eric Lai     John Wenzel