What Leads the Recovery?

It looks like the the stock market found a bottom. The massive capital injections, loan guarantees, and rate cuts seem to have stemmed the crisis. The price of a barrel of oil is in the manageable range, and credit is slowly starting to flow. What's important to remember is that Main Street is not in trouble; Wall Street is.

On Main Street, we are in a recession, but not a 40% decline that was reflected in the stock market. In the past the market was a rough reflection of the future economy, that connection is broken – perhaps forever. A recessionary market should have reflected losses of no more than 15%.

Where will we see the recovery? Last week I wrote that we wouldn't see supply side growth for at least two years. I regret that statement. I usually look for the positive and opportunities prevalent in all situations. I allowed myself to get caught up in the panic I was watching on CNBC. The fact is; there are supply side drivers developing to push increases in productivity and efficiencies in technology and energy.

The technology driver is loosely termed cloud computing. Cloud computing as a concept is not really new. When I learned programming in college, I learned on a terminal attached to a central processor. Cloud computing is the use of Internet- based applications that incorporates software as a service (SaaS). We all use the early cloud computing applications – mapping services, gmail, and yahoo mail for example. Google has fielded Google Aps, which include applications that compete with Microsoft's Office package. Although still buggy, the productivity and efficiencies offered by SaaS are apparent. As an example, there are studies that show for every dollar spent on Microsoft products there is up to seventy three dollars spent in support of those products. Cloud computing will not eliminate those costs, but will greatly reduce those costs. In terms of bottom line dollars, that's a large productivity impact, as some of those dollars are redistributed to revenue generating use.

Additionally, anything that has access to the cloud – wireless devices – have access to Internet-based applications. Admittedly, many of those applications still have a way to go, but most of us have the ability to receive and send email on the road, review documents, and complete simple tasks like get directions, get news and information, or get that all important Southwest Airlines A boarding pass while on the road. Our ability to complete these tasks from almost anywhere with a wireless device make us productive 24 hours a day and essentially triples the work day. Our efficiencies will increase as more robust applications are fielded for wireless devices using SaaS.

On the energy side, the global increase in demand for fossil fuels and the corresponding increase in the cost of those fuels have driven the refinement of alternative energy technologies – solar, wind, and geothermal. Wind for example, as per the Department of Energy, can supply up to 20% of America's electricity needs by the year 2030. Wind currently supplies 1% of America's electricity. Extracting oil from the ground is becoming increasingly more expensive, this with the continued global increase in demand for fossil fuels causes a drag on productivity. Putting the positive environmental impact aside of alternative energy, harvesting alternative energy is now becoming less expensive than harvesting fossil fuels. Two things will happen based on this fact: 1. employment and wealth is created as the industry and wealth shifts to the development of alternative energy, and 2. as energy harvesting costs decrease, some of those monies are shifted to revenue producing uses spurring further macro-economic growth.

These are two prominent growth opportunities in the near term, this doesn't include the growth provided by the peripheral markets that will get created by enterprising entrepreneurs around these industries. I'm looking forward to see what ingenious markets are created as result of the shifts in technology and energy.

For my part, I plan on continuing to look for the economic opportunities of the future, and ignore the “CNBC” effect. As I continue to say, there is always opportunity in every situation, we just need to look harder sometimes.

The Bail Out Passed. What Next?

What a dramatic week for investors.  Correction, what a dramatic week for Americans.  We hear a lot about Wall Street and Main Street, and how this bill was necessary for both.  Time will tell who benefits more - Main Street or Wall Street.

There are some key provisions in this bill which will have immediate impact on Main Street and Wall Street.  FDIC deposit insurance is increased from $100,000.00 to $250,000.00.  More importantly this bill suspended mark-to-market accounting rules.  What that means is that financial institutions can subjectively value their asset base instead of valuing assets at what the current market will bring for the asset.  Bank balance sheets will improve immediately, and this alone should "unfreeze" the credit markets.  Increasing the value of assets reduces the need for banks to raise capital by selling those assets to the Government.  In fact, the need to sell those assets to the Government is decreased.  What the $700,000,000,000.00 bail out does is recapitalize the banking system through a vehicle other than the Fed.

What does all this mean to Main Street?  What it should mean over the next quarter is that credit worthy borrowers should get access to capital at reasonable rates.  Remember the Federal Funds target rate is still 2%, as credit tensions ease within the financial system lower rates should flow to consumers - although expect banks to take advantage of the tight market and maximize the spread between what they pay for money, and what they charge consumers for money.

A rapid recovery from this recession is unlikely.  Sub prime mortgage holders did not get any relief, and the housing market still needs to work through excess inventory.  From a demand side, consumers have little impetus to spend.  Asset values are down, and will take several quarters to recover - in Main Street terms, your house is worth less, your portfolio is worth less, and your business has less value.  Slow consumer spending adversely affects manufacturing, wholesale, and retail, which in turn continues to put downward pressure on asset values.  

On the positive side, the price of oil is continuing to decrease, and may very well drop to $70.00 per bbl before recovering.   More than driving down prices at the pump, oil is a basic manufacturing ingredient, its continuing price decrease leads to decreases in production costs.  The recovery effect of lower prices should become evident in the 2nd quarter of 2009.

Also, the next administration whether Democratic or Republican will probably enact an economic stimulus package.  This will contribute to a demand side - consumer - economic recovery.

On the supply side, the most immediate positive impact is the relative low price of raw materials. This allows manufacturing costs to stay down, and should contribute to an increase in production - more jobs.  However, inventories will grow slowly in response to demand.  In the short and medium term, out to two years, there is little to spur supply side growth.  Productivity is steady, and there is little in immediate technology to contribute to supply side economic expansion.

Assuming a slow recovery and slow, steady growth over the next year, where should investors put their money?  As in previous posts I'll stick to my mantra, think long.  Good assets are on sale now.  

If you're a stock investor, bet on Buffet.  Look where he put his money, and follow suit.  His track record speaks for itself.  Your probability of success is even greater when you take the time to study and learn how much control Warren Buffet has on both his investments and the investment environment.  When betting Buffet as an individual investor, remember, he has more staying power than you do.  Be careful if your portfolio is sensitive to volatility or you'll need short term liquidity. 

In terms of hard assets, specifically Real Estate, now is the time to look at land.  If you have some staying power, you can find some incredible bargains - in real terms, land prices haven't been this low in a generation.  Look for good land, study growth patterns, study community development plans, study infrastructure plans, buy some dirt and hold it.  If you don't like land, buy investment properties.  If you work with sellers, you can get into properties for 10% to 20% down.  If you finance your purchase through a bank, expect to have at least a 30% equity requirement.

In short, now is the time to get back in.  The full impact of the bail out will take up to ten years to play out, and that's the subject of another post.  The most immediate impact of the bail out is that it has probably defined the bottom of this recession.  There are some good deals on the market, take advantage.

So Where do Investors put Their Money Now?

These are exciting times, some call them scary. For investors, remember the foundations of fortunes are built during bust cycles. The U.S. Senate just passed the Emergency Economic Stabilization Act, more commonly referred to as the Bail Out Bill. I was against the bill, but as I've always maintained, I can't influence policy so I adjust and see how I can best profit from policy.

This past Monday, the U.S. House of Representatives rejected the Bail Out Bill, the market dropped over 700 points. The following day the market rebounded 450 points.

A review of the current financial climate shows the following. There is a credit crunch. The Federal Funds Rate is 5%, the Fed's target for that rate is 2%. The yield on the three month Treasury bill is at .65% - in a normal environment it should also be close to the Federal Funds Rate. The Libor, which is the European equivalent to the Federal Funds Rate, is also at 5%. All of these indicate the unwillingness of banks to lend to each other, thus the premium. Assuming the U.S. House passes the Emergency Economic Stabilization Act on Friday, these rates will start to go down. Banks currently won't lend to each other because many are carrying the toxic assets that the the Stabilization Act will buy up. As these toxic assets come off the banks balance sheets, and the banks are recapitalized, credit markets will ease.

What can investors expect to see? There are published studies that show that the length and depth of economic contraction is inversely related to state intervention. In other words, the more the Government spends to buy itself out of a recession the shorter and less severe is the recession. We are in a recession. Investors can expect the recession to continue. Even as credit markets ease up, there is little guarantee that the banks will pass down to consumers the ease in credit. In fact, this being a Capitalist society, banks will probably take the opportunity to profit from the increased spreads.

Home building is down, commercial construction is down, and manufacturing has contracted. As mentioned earlier, the long term effects of the bail out are inflationary. Wages haven't kept up with inflation, and assuming consumer credit remains tight, investors can expect a continued demand side contraction. The effect is to drive down asset prices.

In terms of stocks, investors need to buy strong balance sheets. You want companies that have the ability to do well in a long recession. Buy long, and look at the winners. In financials those include JP Morgan, Bank of America, and Goldman Sachs. Look at discounters. People don't have the disposable incomes they had during the boom periods, but they need essentials, and they want to pay discount prices for those essentials.

The question for many investors is where is the bottom? The short answer is if you buy quality and buy long, finding the bottom is less important. However, if your looking for a bottom, there are some indicators. One is the Volatility Index or VIX, the VIX is currently at 46.72. The last time the VIX was this high was the last time market hit bottom in 2000. Another indicator is commodities, when raw material pricing starts to climb, manufacturing is increasing, this signals an end to the bust cycle.

A good friend of mine has chosen to take a wait and see approach. He will put his money in money market funds, which as of September are guaranteed by the U.S. Treasury. When he feels the market has bottomed, he'll invest. His rationale is that even though he'll lose some return to inflation while the money sits in a money market fund, he'll more than make up the difference on the upside when the economy comes back.

Personally, I'm a hard asset guy. I like investments in which I have some control. Just ask Lehman and Wachovia investors how much control they had. If you are looking at Real Estate understand that appreciation is slow or non-existent in the current environment. Focus on investment properties, that is properties that throw off income streams. Focus on maximizing the return on your cash investment in the property. Look at diversifying your tenant base. In this environment be wary of single tenant investments. If you lose that tenant, you've lost your income stream.

If you have staying power, now is a good time to land bank, even if you are not a developer. There are many fully entitled projects on the market at fire-sale prices. The entitlements don't have a lot of value right now, but will become increasingly valuable when the economy returns. At that point you can sell, take out the appreciation in the dirt, and profit from the entitlements. I've over simplified the process, but if you know what your doing, or hire someone that knows the process you can make some great investments in this environment.

In short, these are are exciting times and offer incredible opportunities. Don't panic, study the environment and take advantage of the situation.

For information contact Chris at christofer.pacheco@gmail.com .