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Galaxy Family Resources, LLC
Eric Philo, CFA

INVESTMENT COMMENTARY                                                                                              May 28, 2009

The stock markets here and abroad have shown a very sizable recovery in value since the brutal sell off that began at the start of 2009.  That sell off was part of a cascade of market declines that began in October 2007, as the financial system began to melt down.  The government has responded with the Troubled Asset Relief Program (TARP), a $700 billion injection of fresh capital (86% used up), the even larger Term Asset-Backed Securities Loan Facility (TARF; $1 trillion committed), and a large number of other programs that together could amount to up to $10.5 trillion if fully deployed.  In fact, so far, "only" $2.6 trillion has been committed. 

Thus, a wall of money is being directed at the economy's worst downturn since the Great Depression.  We think these efforts are bound to help the economy move out of its torpor, however slowly.  It looks like the deficit in 2009 (over $1.5 trillion) will equal at least 13% of GDP - probably more.
The only other times the deficit met or exceeded 13% of GDP were during wartime, specifically World Wars I and II.  Meanwhile, April tax receipts were down 34% year over year.  This is the worst monthly decline in the data we have, which go back to 1981.

Balance sheets are stretched, too.  For example, as a percent of GDP, financial debt (that is, debt issued by financial entities) is 121%, vs. 77% at the end of the 1990s.  (This does not include credit default swaps and the like, which carry a notional value of at least $60 trillion). Mortgage debt is 98% vs. 65%.  Household debt is 130% of disposable income, vs. 94% at the end of the last decade.

Notwithstanding the fact that issuance of large amounts of government debt (already underway) will be adding to already high debt levels, deficit spending is inherently stimulative.  Normally, a dramatic increase in inflation would be reasonable to expect given the magnitude of the deficits in store, assuming final demand does respond to this unprecedented deficit spending.  However, we think the response may be weak.

The classic leading economic indicator is housing, which, according to the National Association of Realtors, is at its most affordable in 28 years, particularly in the Midwest and South.  The Case-Schiller index of home prices shows that housing prices are off 30%-40%.  The inventory of new and existing homes for sale is dropping currently, but at a slow rate. Nonetheless, this is how the recovery begins, and the federal government is hell-bent on pushing this along.  We are also seeing about 9% year-over-year growth in M-2, a broad measure of money supply.  That's a very healthy growth rate.

On the flip side of the coin, consumers are under financial strain, not only from the specter (or reality) of unemployment, but also simply the relationship between savings and household debt.  The savings rate has climbed from basically zero to 4.2%.  The ratio of household debt to disposable personal income is about 1.3, vs. an average of .87 in the 1990s (and .7 in the 1980s).  While the recent Conference Board measure of consumer confidence showed a jump to 54.9 in May from 40.8 in April, 54.9 is still pretty far off the neutral mark, which is 100.  The measure stood at 105.6 in August of 2007, the time at which the sub prime mortgage defaults began to explode.

Meanwhile, new unemployment claims continue to exceed 600,000 people per week, and the idea of a double-digit unemployment rate seems to be gaining currency.  In past recessions, economists and others have looked at unemployment as a lagging indicator, and the recovery in economic growth, whenever it comes, will probably feature the same phenomenon.  However, the size and quick development of a growing pool of unemployed, and the magnitude of the financial markets turmoil, may, in this cycle, play an important role in restraining consumer spending.  The same is probably true for consumer confidence, long considered an unreliable predictor of consumer behavior.  In this cycle, consumer confidence takes on increased importance.

Home foreclosures are up 32% in April (year-over-year).  And job losses are pushing homeowners into defaults. expects that 60 percent of the mortgage defaults this year will be triggered primarily by unemployment, up from 29 percent last year.  Homes with mortgages 90 days past due, in foreclosure or bank-owned have seen a very large jump among prime loans - from $50 billion in 2007 to roughly $225 billion in 2009, close to the sub prime level of $250 billion.  The number of such prime loans is 1.6 million, virtually matching the sub prime level, and up from less than 400,000 in 2007.

So the picture is mixed.  A huge stimulus package is rolling out.  The funds allotted to greasing the financial skids have helped the country avoid a cataclysm.  But the long-term effect of the programs is hard to discern.  At some point, lending will pick up again, but that has not yet happened, and not only with consumers.  We hear of companies having difficulty meeting working capital requirements.  As customers try to squeeze every dollar out of working capital, they are delaying paying suppliers, creating a problem for the supplier trying to finance everyday expenses required to deliver product.  We have seen deals scotched because of such problems.

Ultimately, consumer demand will have to pick up, and as we stated earlier, the critical variable to watch is housing.  So far the outlook remains bleak.  To add insult to injury, oil prices are rising, even in the face of weak domestic demand.  This rise in oil prices is a tax on the consumer, and further weakens an already dim outlook for consumer spending.  While mild restocking of inventories (after massive liquidation) should help GDP growth, we don't think it will be all that additive.

The following is an excerpt from recent FOMC minutes:  "In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."

Our take on all of the above is that capital preservation should be in the forefront of any discussion about asset allocation.  Any incremental commitment to U.S. equities should be predicated on an improvement in macroeconomic fundamentals, particularly in the housing sector.  As noted above, however, some elements of the housing picture are deteriorating.
While it is possible that the market may jump considerably in anticipation of recovery, or because of oversold conditions, we think predicting and "playing" such jumps is difficult.  It is noteworthy that the improvement in economic indicators that accompanied the recent market rally were small positive surprises in only some variables.  Others, like housing and employment, remained weak.  Given all of this, we believe that a substantial portion of assets should be parked in cash for now.

We also believe that the locus of growth in the coming years will be Asia, and in particular, China, whose balance sheet, current account balance, developing middle class and other factors all point to sustained GDP growth of 5%-10%.  As such, over weighting China and other parts of Asia should be considered for capital growth.

Finally, we favor investments that pay reasonably good dividends or interest.  These investments, if chosen properly, can provide a steady or increasing cash flow regardless of the underlying stock price.  This strategy works particularly well for investors with a long time horizon, utilizing stocks of companies that are relatively recession-resistant. 

© Galaxy Family Resources, LLC. - 2010