Watermark Asset Management Inc

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CONSUMERS, CREATORS, LEGISLATORS AND THIEVES The end of the quarter marked the end of a year we found preferable to its predecessor. But, as for the decade of ‘00s, well Y2K and NASDAQ 5000 seem so long ago. The optimism of the new century quickly gave way to the time worn disclaimer that “past performance does not guarantee future results”. Perhaps it would be prudent to ask if the same won’t hold true again. Ten years can be a long time. Even longer if it’s 3,653 days, or a dot.com bubble, recession, recovery, housing bubble and financial system meltdown. But if 2009 had a message, it was that the healing has begun and that our complex economy with its consumers, creators, legislators and thieves is a dynamic entity, driven to right itself no matter the obstacle. Markets around the world continued to rally off the lows of March 2009. The S&P 500 gained 6% for the quarter and more than 26% for the year. The Dow Jones Industrial Average topped 8% for the 4th quarter and 22% for ’09. Bonds were flat while the BarCap US Aggregate Bond Index returned just under 6% for the year. For the decade, the S&P dropped almost 1% per year, the Dow gained 1.3% per year and the bond index averaged 6.33% per year. And what was the top 10-year performer among major indices? It was the JP Morgan Emerging Market Global Bond Index with a 10.5% annual return. Does anyone remember the 1997 Asian financial crisis or the Russian debt crisis of 1998? There’s that past performance disclaimer again. It used to be that a 100 point daily swing in the Dow Jones Industrial Average was a big event. And it was, until 2008. That year, there were 146 “100 point” swings out of 253 trading days. Last year we saw 93 days do the same. There were 78 in 2007 and only 33 in 2006. But, if reduced volatility suggests that fear has subsided it should be noted that “cash on the sidelines” peaked in May of this year at $10 trillion. It has since dropped by several percentage points as investors gained confidence and began the journey back to the investment arena. Could the “tech” of 2000 be the “cash” of 2010? As we begin the New Year, the economic prognosticators are forecasting everything from a V-shaped recovery to runaway inflation and the end of life as we know it. Rarely have we seen such divergence of opinions. Our preference is to pass on the drama, identify the issues and act rather than react. Here’s what we see. THE ECONOMY We’re back from the ledge. Third quarter GDP managed to grow at 2.2% while the fourth quarter number is expected to come in at about 4% with 2.5% attributable to consumer spending and another 1.5% to home building, autos, inventory replenishment and business equipment. On the positive side, pent-up demand for these four sectors, if restored to average spending levels of the past ten years would add an estimated 3.9% to real GDP, a significant boost to growth over the next several years. Will it be sustainable? Have we simply pulled future GDP growth into the current period by stimulating spending which would have happened further down the road? One analyst commented that “the great Keynesian hope for 2010 is that lower rates and bigger deficits will stimulate the animal spirits, which will start a self-sustained recovery”. We’ll know if it works, shortly. JOBS The official unemployment rate may be 10% but the numbers are far worse. “Discouraged” workers (those classified as not in the work force because they are no longer looking for jobs) are estimated at 3.5 million people. Add these to the reported 15.3 million unemployed and it is going to be a very long time before the unemployment rate returns to 5%, a number once considered “full employment”. The November employment report was revised to show a small net gain in jobs. December’s numbers were negative again. However, clearly, the number of jobs lost each month has declined. We’re going to need to see an economy strong enough to generate 250,000 jobs a month over the next five years if we expect to get employment back to pre-recession levels. With the consumer responsible for 70% of GDP, unemployment will be a drag on long-term growth. HOUSING & MORTGAGES Annaly Capital Management, a mortgage REIT manager we follow, noted in its December commentary that “some have suggested that the housing market has staged a small recovery in recent months, but it is mostly the effect of a flurry of government-sponsored activity concentrated in cheaper, existing houses. A rebound in building activity and private residential investment hasn’t materialized, and there remains a stubbornly high shadow inventory of foreclosed homes. Sales of existing houses don’t really do much for economic growth, and despite the small bounce in nationwide home prices, the dramatic decrease in household real estate wealth has not managed to recover much”. The US government has become the de facto lender to the housing market with Fannie Mae and Freddie Mac buying about 75% of new mortgages and the Federal Housing Administration (FHA) picking up the rest. Fannie and Freddie’s retained loan portfolios each total about $770 billion. Previously, these entities had been ordered to reduce the size of their portfolios by 10% per year starting in 2010, while the Treasury had committed to provide up to $200 billion in funding to each institution in order for them to maintain positive net worth. On Christmas Eve, the US Treasury announced that its funding commitment for each company was being raised to $200 billion plus all cumulative losses incurred over the next three years. The order to reduce the size of the portfolio was modified to allow for greater flexibility and time to meet the portfolio reduction requirement. If there’s a positive spin to this activity it’s that it will prevent large scale selling of securities by the Agencies and allow them to be more aggressive in engineering buyouts of their seriously delinquent loans. The housing market is far from well and will likely stay that way until we see a private mortgage market re-emerge. Rising interest rates may also hamper the recovery. DEFICIT SPENDING It was a busy Christmas Eve for the Senate as it voted to raise the government debt ceiling to $12.4 trillion. The $290 billion increase was enough to allow the Treasury Department to fund the government’s operations and programs until mid-February. The 2009 deficit for the year ending in September came in at $1.4 trillion. The 2010 loss is expected to be another $1.5 trillion. Excessive growth in the money supply, or growing government deficits could contribute to an increase in inflation. The argument against that happening today is that we have 30% of U.S. industrial capacity lying idle and five million apartments sitting vacant. Add in 15 million unemployed Americans and there is a considerable amount of slack that has to be soaked up before the economy will feel the pressure of price increases. This scenario is why the Fed is able to maintain an easy money policy, holding short-term interest rates near zero to nurture an economic expansion, re-inflate the housing and equity markets, and help to recapitalize the banking system. Having seen this before, we would beware of asset bubbles and a further slide in the value of the U.S. dollar.

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