We again want to keep our clients and friends up to date during these periods of uncertainty.

There was extreme volatility again today, but stocks ended up sharply higher. The Dow touched a low of 10,600 but closed up 460 points to 11,240 an intra-day swing of 640 points.

The S&P 500 followed a similar path. At one point it was down 17 points but closed up a whopping 53 points to close at 1173 – an increase of 4.73% which erased a good chunk of yesterday’s wipe out.

Financials rocketed higher leading the rally.
Gold was up again, but down sharply from its intra-day high.

Did we learn anything new today? Have we really learned anything new in the last week? Not really. Today we learned the Fed is going to keep rates low for a long time, but in this release they actually quantified “an extended period of time” which they identified as 2013. The Fed can always pull this back if the economy does better than expected. There were no new “gimmicks” announced like a QE3. I think stocks sold off after they realized there was to be no additional ‘monetary sugar highs’ but then stabilized and moved much higher.

I’ve said for some time now that trying to micro manage every turn of the cycle lends itself to policy errors and unintended consequences. So perhaps letting the economy stand on its own and not reacting to every single data point will promote genuine recovery.

Interest rates fell sharply again today. The 10 year treasury now yields only 2.50%. This is amazing as a few months ago almost EVERYONE (except us) argued for much higher interest rates. We’ve had a deflationary bias in our equity and bond portfolios for some time now. Many high quality dividend paying stocks now have dividend yields nicely higher than treasuries, which is usually a good time to buy them.

So once again we see a market trading on high emotion and really very little new fundamental data – which is an environment an opportunistic investor with any reasonable horizon should try to exploit.

I can be reached with questions at 570 825 2600
Gerry Mihalick, CFA

Important Disclosure: Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

We are writing to you to update you on recent market volatility. We are keenly aware how unsettling it can be witnessing losses, even if they are temporary. As professional investors, we have a ring side seat to what’s happening in the market. In no way are we trying to call an absolute bottom, but to try to lend the proper perspective and let you know we understand what you are going through. We’re investors in the same strategy you are. We sympathize.

What happened?
On Friday a major rating agency, Standard and Poors, downgraded the LONG TERM creditworthiness of the United States to AA+ from AAA. This has sent tremors throughout many world stock markets. HOWEVER it is important to keep in mind a few very important points:

1. The actual downgrade by S&P really took no one by surprise.
2. The report revealed absolutely no new insights into the fiscal condition of the United States.
3. Importantly the technical downgrade does not “trigger” any financial event. There is not going to be forced selling of US treasuries because they are “not AAA anymore”, banks are not going to have to raise more capital, or the Chinese are not going to be forced to sell as a result of the downgrade.
4. S&P is the same company who rated exotic securities based on sub-prime mortgages AAA. Our personal opinion is that S&P is trying to build image of a “tough cop on the beat.” After the reputational hit they took in 2008, they are not immune to biases in their opinion to serve a particular business aim.
5. The White House correctly challenged S&P’s math and found a $2 TRILLION dollar mistake.
6. Many have called this a “Sputnik-type” moment, or a clarion call to our country to taking the real steps to recovery. Perhaps now our country will be willing to take meaningful long term steps.
7. While stocks have gotten slammed today, investors have POURED MONEY INTO TREASURIES. The market categorically rejects S&P’s assessment. Interest rates went sharply LOWER today which in many ways does the Fed’s job for it.
8. What is real is that it spreads and amplifies the gloom that is surrounding our economy. Today’s market action is more emotional than technical. The negative emotion driving down stock prices today IS REAL, but it can be exploited.
9. Unlike parts of Europe, the US has PLENTY of financial ability to “fix this”. Rates are low, and is plenty of “low hanging fruit” expense wise be made without affecting the very attractive long term growth profile of this country.

What is The Appropriate Response?
Stocks were not expensive a month ago and are still attractive even as some of the indicators have turned weaker. Could the economy slip back into a period where GDP growth turns negative again? Of course but does not need to be a catastrophe. Capital ratios at banks are much higher and unlike 2008, everyone is on high alert.

Bonds are substantially less attractive today and offer little in the way of current return, standard of living increases or inflation fighting protection. Can we call a bottom? Of course not. But today sure feels like a selling climax where many investors have totally thrown in the towel after a couple of brutal weeks.

Selling into the panic rarely is an effective strategy and isn’t likely to be a good choice today. Whether its lack of nerve or lack of funds, there are many who HAVE to sell today. So where risk tolerance and financial circumstances allow, we believe that investors should be adding to stocks at these levels.

Call us with questions

Greece: Total outstanding debt is about $400 billion and its now trading at 40-60 cents on the dollar. That’s a very manageable number relative to the world’s total debt outstanding. German banks are the largest holders of this debt with about $26 billion in exposure. To put that in context, Deutche Banks balance sheet alone is over $2.5 trillion.

Is this, as many say “ A Lehman Style Moment?”. Probably not. First, Lehman’s balance sheet dwarfed the size of Greece’s. But what did in the system with Lehman’s default was not so much the debt default (although painful), but how the default triggered the credit default swap payments/collateral postings from the counter parties.

And in the subprime mess, the amount of outstanding swaps throughout the system was much greater than the value of the outstanding bonds. So there was rampant, “naked” swap trading by entities that had no insurable interest or legitimate hedges in the underlying debt. That’s part of the reason why it was so hard to predict ‘who would fall next.’ According to a Citigroup analyst, there is only $10 billion in outstanding CDS on Greek debt so that part of the contagion many fear would also have limited impact.

Where the system would run into problems is if a Greek default triggers sky rocketing interest costs to other larger sovereign countries like Portugal, Spain and Ireland. Spain and Ireland at least have been more successful in recent bond auctions and have economies that are much more vibrant, and better political systems. Another risk is if the entire European Union falls apart and the uncertainty that would bring.

The market so far today is shrugging off a jobs number that missed expectations by a mile.  You can rationalize a poor jobs number if average hourly earnings hours worked is increasing, but this is not the case with today’s report. It is weak.

 Banks, homebuilders, and industrials have lead to a strong advance in US stocks of late.  The S&P 500 is now approaching double digit percentage gains for the year.

 The appreciation potential of banks remains strong, as most investors are still highly skeptical given all the headline risk. The “once burned twice shy” attitude presents opportunity for this sector in my opinion. It’s rare you get to buy high quality banking franchises at or below tangible book value.

A broader view of recent economic data is more encouraging:

• Initial jobless claims receding
• Retail sales rising sharply
• US productivity improving
• Private sector hiring (ADP report) encouraging
• Auto sales brisk
• Corporate profits increasing
• Export economies like Germany and China are performing nicely
• Spreads on PIIG debt coming in (although the European issue remains a wild card)
• ISM Manufacturing reading of 56+ is consistent with US GDP growth around 3.5%

 3.5% GDP growth  is still below average growth compared with other early stage recoveries. It is tough for a world economy to grow briskly as the world deleverages and takes credit out of the system at rapid rates. That’s just a fact.

 However, the fundamental scenario need not be perfect with prices at these very reasonable levels. Even muted, plodding growth  can still provide attractive equity market returns when P/E’s  are as low as they are and dividend yields are at near or above than 10 year bond rates.

Important Disclosure: Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Friday’s GDP Report:

GDP took center stage last week, and generally the report  met expectations.

Remember this was only an advance number and the trend has been for some pretty noteworthy downward revisions down the road. 

Emerging Markets Euphoria?

This is the chart of the week for sure. The chart is pretty self explanatory – there is a lot of enthusiasm for this asset class as investors pour money into this asset class. 

In some ways, it is perfectly understandable. The ultra loose monetary ZIRP (“ZERO INTEREST RATE POLICY”) and fiscal largesse at large developed sovereigns has investors seeking stronger currencies and better sovereign balance sheets. Most of the emerging markets balance sheets are in much better shape. Some weeks ago, I put forth comparative debt to GDP levels which demonstrated this.

What no one seems to be asking how these balance sheets in the emerging world got so good. In much of South East Asia you could make the case that the successful austerity measures following the Asian Debt Crisis are behind the improvement. But it is also quite possible the improved fortunes are a direct result of the US credit boom.  Loose policies in the United States helped fuel a global boom and high commodity prices creating a very large wind fall for many emerging markets tied to the commodity cycle. And yes, that includes China (and countries whose economies depend on it) where the major commodity is labor.

 The problem of course is that investors are potentially yield chasing as spreads compress. Historically, this is a toxic combination. Balance sheets are much better, but spreads have gotten much, coming in from nearly 1100 over Treasuries during the credit crisis to inside 300 basis points. They are not back to their bubble lows of 2007 however.   

Recommended Commentary:

Here is a Halloween Special compliments of Jeremy Grantham: “Night of the Living Fed” it is available at the following link. As usual, Mr. Grantham is highly insightful. Registration required. www.gmo.com

 The Effects of Extreme Monetary Policy:

Here are some thoughts about the ultra low rate policy we are pursuing.  As the financial system was melting down, aggressive action was required. But now the system is indeed much more stable. Credit markets are obviously functioning again – maybe too well – There is more than adequate issuance of emerging market debt, performance of high yield bonds etc, even some LBO’s are coming to market.

Sure US GDP growth is not where most would like it and unemployment is stubbornly high. But how much more accommodating do we need to be? We’ve gone beyond “ZIRP” and into “QE 2” and the dollar has gotten crushed. So what this is now amounting to is a big tax on savers.  The Fed of course is trying to help, but exactly who is this policy helping? The millions of Americans who live off the interest of their accumulated assets? The scores of pensions who are making assumptions based on 8% returns? Meanwhile the dollar is getting torched and all of the real stuff that these individuals need to live on (you know like gas, food, clothes) are skyrocketing because commodities are purchased in dollars. Below is a chart of the Jeffries CRB Index.

  Election Week:

I am frequently asked how I think the elections will affect the markets. By now it is generally expected the Republicans will win the House and the Democrats will retain the Senate. You can look at www.intrade.com to see the odds of each win. This site has been pretty uncanny at predicting outcomes of events like this. Bettors have surmised a 95% chance of a Republican victory for the House and a 55% chance that the Democrats retain control of the Senate. My take, I think the market would be surprised by a Republican Senate Victory (market probably rallies) or Democrats holding the House (market probably sells off). The outcome I can guarantee? Vitriol and rancor will stay abundant!

Important Disclosure: Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.