Market Outlook November 2009

With the market rising since March, but investors almost unanimously stating “I don’t see the fundamentals to support this rise”, I can’t help but think the market is skeptically optimistic if that makes any sense at all. The market has risen due to increasing profits and reduction of fear. The question is whether or not we will see that illusive pullback or next leg up. I believe, for several reasons, we will continue to have an up trending market for the next 2 or 3 quarters. I will present some challenges to overcome as well as reasons to be somewhat optimistic, not the least of which is the Fed. Monetary policy continues to be very accommodative.

The dollar is likely to stay weak, which drives exports and foreign tourism, and the government is playing a much larger role in our economy. Just 2 years ago the government was responsible for 1/3 of the spending in the U.S. Now it is responsible for over 1/2 and is rapidly approaching 2/3 of total GDP (Gross Domestic Product). I am not saying all these things are good things, particularly over the long run, I am merely stating what I believe to be fact and what I believe to be driving the economy and market in the next year. The real issues are; how and when do we return to normal market forces, and what type of medicine must we endure in order to recover? I fear the unresolved structural deficits create substantial risks for future years. For now and for the next few quarters I believe the economy and the market will continue to improve.

Trivia: From what country did the most visitors
arrive in the U.S. for vacation in 2009?
Answer: Brazil

Commercial Real Estate
Collateralized Mortgage Backed Security (CMBS) maturities will be about 20 billion per year for the next 5 years, and then there is a spike to 54 Billion dollars in 2015. Since the Wall Street gurus that created these types of loans are no longer in business or at least no longer able to “creatively” structure a new product to get folks out of this mess. Can you say, “toast”? (to the tune of $211 Billion dollars).

At the same time, Banks are being forced to reduce their exposure to real estate by as much as 50%. There simply aren’t any new developments that are creating a lending mechanism to solve this problem. There will be vultures, err….folks that do have cash that will be able to take advantage of this situation and purchase commercial properties for a good value. My good friend Bill Chapman always says, “A smart investor buys his straw hats in the winter and his felt hats in summer”. Those folks with the ability to purchase or finance will be in the driver’s seat. Since we are seeing little new development, buying properties now should show increasing rental rates and occupancies in the coming years which will reap investors’ big dividends in 3 to 5 years
Residential Real Estate: The recent extension of the homebuyer’s credit should continue to buoy home sales. This helps on two fronts; first time buyers and longtime owners may be induced to buy, while those who don’t qualify may be able to sell their existing home to those who do.

Health Care
There are several plans floating around. There are a couple key objectives of each of these plans on how to reform the healthcare system. One of the key objectives is to cover more of the uninsured. At issue is how to pay for that. Current estimates for the healthcare reform bills are in estimates of $1 Trillion (with a T) over the next 10 years. One plan calls for some offset here because the current system typically covers anyone that comes in through the emergency room. If everyone has healthcare, this $150 billion dollar expense would not exist. There is also language to increase Medicaid rebates by 15 or 20 percent which is about $20 billion over the next 10 years. There is also talk of drug companies to allow 50% discounts on drugs once a person is “in the donut hole”. The donut hole is when reimbursements run out and patients must pick up 100% of the tab on their medications. For my dad this usually happens just about the time the holidays start. I have had clients tell me they begin to take only half their medication s in an effort to regulate costs. There are also proposals where everyone would be required to purchase healthcare much like the requirements to purchase auto insurance but with substantial subsidies for those that do not have the financial means to pay for the insurance. The bottom line is that there are many plans floating around, with tremendous cost, and the issue is; how we pay for this? The managed care industry is probably most at risk as there is a bigger range of outcomes possible. Generic companies that actually benefit from lower cost drugs would clearly be least at risk from healthcare reform. Also companies with drugs that have no substitute or therapy that is life saving is unlikely to be impacted.

The economic woes continue. Don’t be mislead by the numbers being touted such as productivity gain. Managers and owners laid off workers in large numbers but have been dragging their feet as the economy picks up. The growth rate will lose a bit of steam if the hiring rate does not increase. In the mean time this will translate into big corporate profits. Let’s also not forget the stimulus bill that was passed last year. There is quite a bit of money that is due to be released in January and February that does not require another congressional vote, it has already been approved. In recent quarterly reports 80% of companies beat the street’s expectations in earnings while 58% beat the street’s expectation of top-line revenue. With updated projections the forward P.E. of the S&P is 14.5. Most of the prognosticators I have read are calling for a year end close of the S&P somewhere in the 1200 range.
Interestingly enough the consumer is shifting to purchasing on line.

This is due to a couple of reasons; workers that have jobs are strapped for time as they are being asked to do more, generation X and Y are in their prime earning years and are the folks that utilize the internet. With this comes a need for more protection against internet fraud. I recently spoke with a company that facilitates credit card payments for several banks. They said that 10 years ago they spent very little money on internet safety, now they spend 1 million dollars a month in trying to detect and prevent hackers who attempt to steal consumer identity. Additionally consumers tend to use services that allow the seller to “bill me later”. This is due to several factors all of which are driven by the desire to not pay the entire balance upon purchase. This leads to a new growth industry with players such as; Revolution Money and Bill Me Later carving out a niche vs. PayPal and the like.
There is some noise about an impending bubble in the municipal market due to lower tax revenue. The states most in danger are: Arizona, Virginia, Kentucky, New Mexico, Maryland, Colorado, Kansas, Mississippi, Alabama, New York, California, and Florida.

In short I believe the market and economy will continue to recover for 2 or 3 more quarters. One of the most difficult things to gauge as an investor is what expectations are reflected in security prices. It is, after all, the unexpected changes in economic and corporate data that move markets. There is a enough stimulus still out there, there are a lot of efficiencies that have been achieved, and there is enough skepticism that I don’t believe the market has become a crowded trade. If the data is better than expected, positive ripple effects may do more to create a sustainable economic recovery than is currently projected. This does not mean clear skies ahead. As the San Antonio Spur’s coach Greg Popovich says: “with enough confidence and a sufficient amount of fear the players respect the game”. I believe that the players in this case are investors and there is enough confidence to continue to drive the market and a sufficient amount of fear that; investors, government officials, and corporations will continue to work through the problems that exist and America will recover from this terrible sickness we call; deep recession. Sitting on the sidelines will continue to cause pain so in spite of their fear, I believe more and more investors will continue to enter the market.

We at Alamo Asset Advisors wish everyone a safe and happy Thanksgiving!