Austerity Measures – July 2010

July 22, 2010

Dow Jones Average: 10,323
S & P 500 Index: 1,094


Austerity Measures

Economic conditions have improved modestly in the U.S. and in other nations, since the severe recession of 2007-2009. While conditions have improved, particularly for technology companies, the overall pace of recovery has been tepid when compared to typical economic rebounds. The somewhat muted pace of recovery should not be surprising, given the unprecedented decline in real estate prices and the financial industry meltdown that triggered the worst recession since the 1930’s. Unemployment is likely to remain high as many jobs in home building, finance, and auto related industries are gone and will not return.

The slow pace of recovery has frustrated the public, giving rise to movements such as the Tea Partiers. People would like a quick return to the salad days of 2006 when real estate prices were soaring, the stock market was scaling new heights, credit was flowing freely to anyone with a pulse, and companies were hiring. That is not going to happen. The debt-induced financial euphoria has given way to a much more sobering reality.

A vigorous debate has been joined over the perceived success or failure of government stimulus programs. President Obama and the Democratic Congress believe that the stimulus program, combined with Federal Reserve Board actions, saved the economy from another Great Depression. It is a hard case to make, because there is no way to go back in time and prove that a depression would have happened in the absence of such moves. The Republican Party and Tea Party members think that the government stimulus programs have failed, because they have not restored the economy to its pre-crash condition. They point to high unemployment as proof that things are not getting better for the average person.

While financial legends, such as Warren Buffett and George Soros, believe that a deeper recession or depression surely would have occurred without government action to restore confidence in the economic system, the average citizen is far less certain when figuring financial odds and outcomes. There is a general sense, though, that the debt obligations of society (government debt) are rising fast, while economic conditions are improving slowly at best.

According to public opinion polls, the momentum is with those who favor austerity measures and deficit reduction. Taking a position against government debt (as Ross Perot did in the 1990’s) is usually popular with independent, swing voters. It is easy to make the theoretical case that debt is inherently bad, burdens future generations, limits financial flexibility, and causes economic crises. It is much more difficult to assess the practical impact of deficit reduction during a period of extreme economic turmoil. The austerity hawks do not discuss the deficit implications of the depression that might have occurred in the absence of government stimulus. Deficits explode during depressions as tax receipts shrink while spending on programs such as Social Security and Medicare remains high. For political challengers, discussing the consequences of what might have happened in the absence of government stimulus is not politically convenient.

Stock markets throughout the world stumbled in recent months when it became clear that austerity measures would be imposed on some countries and embraced by others. Most investors are not advocates of runaway debt accumulation. They know that too much debt will eventually sink a nation, as is the case in Greece, Iceland, and other countries on the brink of insolvency. But investors also know that applying the economic austerity brakes at this point would almost certainly break the fragile economic recovery, and undermine stock market gains that followed passage of the stimulus package.

Current Strategy

Stock markets throughout the world fell sharply during the second quarter of 2010. It was the worst loss for stocks since the meltdown in the fall of 2008. As investors grew increasingly worried about the sustainability of the worldwide economic recovery, they ignored positive business results from numerous companies. While rays of sunshine came through the dark skies and illuminated extremely good results from leading companies, investors chose to focus on the menacing thunderheads still rolling in from the distance. The consensus among investors was that good results were perhaps temporary, driven by inventory rebuilding and stimulus programs that might be replaced by austerity measures.

When the S&P 500 broke above 1200 in April we felt that investors had become too optimistic and ebullient about the economic recovery. After a fall of almost 20% during May and June the mood changed suddenly to one of despair and negativity toward stocks. We sold a number of positions at excellent prices last winter and early spring when other investors were still in an aggressive buying mode. We bought back some of those positions, and added a number of new holdings to accounts, after the sharp price declines that occurred in the May-June period. Clients who have been with us for years are familiar with our pattern of selling during periods of extreme optimism, and buying when most investors have become disgusted by poor stock performance. In a low return world, good timing on both the buy and sell side is essential if one hopes to make a positive return.


On the fixed income side of the portfolio we have followed through on intentions mentioned in past strategy updates. We have purchased foreign bonds (Canada and Australia) which yield much more than U.S. bonds, at currency exchange rates that were favorable in our opinion. We waited patiently for the currencies to reach acceptable levels and then made our move. Foreign bonds now make up about ten percent of client accounts. While we are comfortable with the exposure to foreign paper, we may take some profits if the currency exchange rate continues to move strongly in favor of our position.

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