| 11 May 2010
Cliff Notes on our Economic and Market Outlook
- US Markets are overvalued
- High Quality, especially US stocks are the most attractive segment
- Overall International is cheaper
- Emerging markets are not cheap, but have the most upside if you assume they will be the next bubble
- Debt is not that attractive, though there are opportunities in distressed
- Risky assets in general are very expensive, especially in the US
- Strategies that can profit from increased volatility are attractive
- Have a healthy dose of alternatives
- Be patient, better opportunities will come
- In the meantime the path of least resistance is likely upward
To that end, I recommend people read the shareholder letter from a local bank here in Louisiana, IberiaBank. It is a relatively short summary that lines up well with our overall take on the economy. Here are the key passages from President and CEO, Daryl Byrd:
Many market pundits have suggested the national economic situation is improving rapidly and recovery is at hand. Unfortunately, we believe we still have a tough road ahead of us. We believe this is a fairly lengthy cycle - probably 6-7 years in duration, into which we may be about three years. Nationally, the "shadow inventory" of foreclosures remains extremely high, but not yet visible. Real estate prices remain under pressure, and many borrowers continue to face severe stress. Nothing has really changed materially at many banks. They carry the same bloated prob-lem loan portfolios that they have been carrying for years at inflated values. Many banks are woefully undercapitalized, and they are rapidly bleeding through their current scarce capital. Lit-tle has been done to correct the underlying problems.
Regional and community banks went astray by over-investing in real estate as an asset class at the peak of the credit cycle, recording unhealthy concentrations of these loans on their balance sheets (geographic, client, asset class, wholesale funding, etc.), and being dramatically under-capitalized for the risks they had assumed. The losses incurred in the banking industry over the last few years clearly indicate the industry lent too much money, in an uncontrolled fashion, to too many unqualified borrowers. For some banks, these poor decisions led to substantial losses, a squeeze on the banks' liquidity and access to capital, which ultimately led to their demise. For many other banks, shareholders continue to pay dearly for these mistakes. We refrained from speculation and reliance on concentrations, while maintaining strong liquidity, core funding, and capital. Simply put, we pursued "the principles of basic banking."
[…]
Sometimes it takes a crisis for people to recognize how challenging the banking industry can be. Banks lend money and clients borrow money, both must decide to do so responsibly. That requires discipline, foresight, and experience. Many banks fell short in all three attributes over the last decade. Unfortunately, employees and shareholders of those banks, and the communities they serve, suffered as a result of those poor decisions and lack of discipline. Banking is unique in many ways. It is one of the few industries where the margin for error between being right 99% of the time versus 97% of the time results in being extremely successful versus going out of business. The incremental difference is critical, particularly over this long, and challenging economic cycle.
Moving beyond Mr. Byrd’s exhortation for responsibility, I believe the outlook is spot on. It shows what we still believe is the base case for how the economy will do. I am not saying that their outlook will turn out “right.” That we, and they, cannot know. However, it is a nice summary of the challenges we face. Therefore, even if things do not turn out as difficult as they foresee it may not be the “right” forecast, but it is a responsible one. That is all one can really ask of anyone with confidence.
I also recommend the thoughts of Regions bank chief economist. Emma James of the Baton Rouge Business Report does a good job of bringing out the key issues moving forward. Once again, it is not our prediction he turns out right, but that this kind of outcome is very possible, and your investment approach should account for it. I am impressed with a very tough question Emma asked:
Q: Looking at the financial reports you have issued previously, you were actually forecasting the slowdown and a lot of problems, even in the real estate market. Why was Regions not able to maneuver itself when you were saying there's an iceberg on the horizon?
Allsbrook: I am ignorant about banking, period, and what goes on in my own bank. I am not in the management structure. I don't know what went into those decisions.
Montelaro: We didn't listen. It's the truth. We all said, there ain't no way it's going to be that bad. We had earnings pressure and we just didn't listen.
I am just as impressed with the answer. The investment advice from Morgan Keegan (owned by Regions) did not reflect anyone listening either. Does admitting that they did not listen make up for it? No, but it is the first step to regaining my trust.
