Clark Asset Management + Associates, Inc.

December 3, 2009

We view the long-term trend in the equity markets as up. For the year to date, the S&P500 Index is up about 21%, and up more from its extreme low in March. Emerging markets are up about 60+%, followed by other international markets. As usual, the equity markets turned up before the economy, as markets look ahead and process information. The definitive dating of recessions and expansions is done by the National Bureau of Economic Research after careful analysis of many different data time series. Our take is that the economy seems to have clearly begun climbing out of the recession in September. The leading economic indicators have now increased for six months. For now, the economic trend clearly appears to be up, although we do not know how strong or long the expansion will last. And while the trend is up, U.S. valuations are not as attractive as a year ago. There are also causes for concern, which we will note below.

Two dominant trends remain, which partly re-enforce each other:

1. Deleveraging and the attendant deflation of asset prices. This may look like people paying down debt, or the debt just evaporating, through bankruptcy, default, or renegotiation. This occurs as the economy’s capacity to support debt shrinks, while the inclination, capability, and willingness of foreigners to own our debt diminishes. We noted earlier, as did many gurus, that various Debt/GDP and debt/income ratios had reached cyclical or historic highs. Those ratios are now declining.
2. The other major development is the readjustment of the role of consumer spending, and its relation with income. The same amount of personal Income will no longer result in the same (as large as) ratio of Personal Consumption Expenditures (PCE) to Personal Income. It is much less feasible to finance additional consumption with additional debt on personal residences, partly due to the greater difficulty of regularly refinancing home equity and pulling out funds for additional consumption. The Chinese aren’t buying Fannie Mae and Freddie Mac bonds as readily. And with global financing generally less forthcoming, and with the prop of refinancing removed, the force is pushing toward deflation and deleveraging.

Many years ago, I was riding around with “Uncle Louie (“Uncle Louie Tomaso, Investments”)” on his boat in Texas. Uncle Louie asserted that, as long as homebuilding and the automotive industry were growing, things were going to be okay. Recently, home starts have been less than the number that are needed just to replace those that wear out or are demolished (about 1.2 million/year), and the current automotive production is below long-term replacement demand.

The diminished robustness of personal consumption expenditure is likely to have several manifestations. First, discretionary consumer items are likely to encounter increasing difficulty in increasing sales. Total revenue spent at local and regional malls is likely to decrease, and with it, the ability to support associated debt collateralized with retail real estate, as well as bank loans collateralized by real estate. This means that banks and other investors who hold debt or securities collateralized by real estate may see some of their assets evaporate.

Traditionally, as our economy recovered, increases in consumption expenditures were associated with expansion of credit. However, unlike any recent previous recoveries, household debt and total private credit is contracting, even as the economy begins to expand. Debt is either being paid down or liquidated.

From now on, this means that the some of the traditional balancers in the business cycle process will not provide the same boost to recovery. The extreme low levels of inventory/sales ratios, for example, will not provide the same bounce-back momentum. And indeed, total household debt is contracting, even as consumption is increasing. This has not happened in the post-WW II period.

As a result, we view the likely and almost necessary policy initiatives as leading to

• A weaker dollar – already in process of occurring. This will boost exports and dampen imports. It also provides a boost to gold prices
• Less reliance on domestic consumption and the American consumer to drive the economy
• An apparently necessary temporary resort to fiscal stimulus
• A resort to monetary stimulus.

The decline of the dollar is accompanied by the desire of many foreign governments to move away from the dollar was a reserve asset, even as their own currency depreciates. Hence, the case for gold, which is currently in a clear uptrend. However, it has always been more volatile that the overall market. That will continue.

Fiscal stimulus is one controllable way to increase domestic demand.  And an increase in U.S. consumer spending now increases production in China more than it did twenty years ago, and has less impact on Indianapolis and Toledo.  Another way to more controllably stimulate domestic economic activity is to have a war.  On balance, wars have historically provided a healthy boost (unless you were one of the unfortunates who got shot or maimed).  Down the road, continued resort to federal fiscal stimulus and deficit spending will shrink our national options, and create more issues of getting others to finance our debt.  While the U.S. Federal Reserve has increased the monetary base dramatically, the M2 money supply has not increased commensurately.  Some of the increase in federal credit is only offsetting what has evaporated in the private sector. 

I think about unacknowledged “likely unlikely surprises.”  A year ago, I thought it would be Israel attacking Iran with nuclear bombs to slow down the spread of dangerous weapons.  With further study and reading, I have since come to feel that the leaders of both Israel and Iran use the inflammatory rhetoric to help stay in power.  Possibly some U.S. politicians have also done this.

 A looming issue (not fully acknowledged) closely related to and growing out of the above, is the increasing problem with asset quality in America’s banks and asset backed securities.  The easy issues have been well-publicized, are well-known, and have already been dealt with.  The lower tiers are firming up, while the problems are in the middle and upper tiers, and in commercial real estate.   Lenders Processing Services Corp recently reported that the number of mortgages deteriorating in status is three times the number being successfully modified or restructured.  Mortgages are deteriorating at three times the rate that they are improving. Ominously, banks seem to be choosing to sit on some foreclosure inventory, rather than selling all of their REOs.  One out of eight mortgages in the U.S. is a problem (concentrated in Arizona, Nevada, California, and Florida), and an increase in foreclosures appears likely.

Restructuring a mortgage is more of a way to protect an investor, than to help a homeowner.  The homeowner is notably better off if he loses his mortgage (and home), and then goes down the street and purchases a similar home for 40% less.  And he is in a better position to move up later.  With the original principal maintained at a reduced interest rate, he or she becomes an economic zombie if he or she struggles to support an asset that is under water.

Many petroleum issues, which have served our client well over the past few years, seem to be moving into the ranks of average market performers.  Demand for petroleum fell off with the decline in economic activity, and price rebounds are not dramatic.  With time, there will be more substitutes, more alternative sources of supply, and more LNG.  There is a large amount of natural gas in storage in the U.S.  Technology boosted gas from shale, and that may begin to happen in Europe in the coming year.  More of Central Asia’s gas will come to world markets from forthcoming pipelines, and LNG from Qatar will play a significant role in world markets and in England.

So

1. Gold remains in an uptrend, for now. 
2. The dollar is likely to continue to decline, boosting firms with export exposure and international or emerging markets. This could be turned around, and Obama is on the right track.
3. U. S. equity markets are trending up, although valuations are less favorable than a year ago. 
4. The economy is improving, which while supported by massive fiscal and monetary stimulus will probably continue. 
5.  We are anticipating strength in technology and health. 
6. And there are looming issues for financial institutions and certain investors in real estate loans and their valuation. 

Thanks for your continued confidence.  Wishing you best holiday wishes and a great 2010.

Gary N. Clark, CFA


_________________________________________________________________________________________________________________________



September 9, 2009

U.S. and most world equity markets have continued to rebound from the recent unpleasantness. The U.S. S&P500 Index is up about 13% from the beginning of this calendar year. To put this in perspective, the average annual gain is about 11%/year, with considerable variation from year to year.

The past year has seen an extreme example of this “variation.” While a market decline began in 2007, the serious damage was triggered by the collapse of Lehman Brothers in September, 2008. The decline in the S&P500 Index over the whole cycle was slightly over 60%, and there were some great values in there.

We think it is more likely than not, that the long-term trend of U.S. equity markets has changed to up. The leading economic indicators are up, the sequence of developments that occurs toward the end of a recession is unfolding as expected, and likewise for equity markets. Inventory levels are low, although inventory sales levels had not declined as much as might be expected. Federal policy is endeavoring to bring about the next upswing.

Two major underlying trends in the U.S. economy are

1. The trend toward deleveraging, the paying down or evaporation of debt, which tends to depress many asset values, and
2. The same level of aggregate pr personal income will not support the same level of personal consumption expenditures going forward. This has adverse implications for retailers, commercial real estate REITS and mortgages, rents, and certain other areas. It also implies that policies trying to foster an economic rebound by reviving consumer spending are fighting a headwind. And GM won’t ever be the same.

While housing may recover somewhat (and it is recovering in an uneven way), it will not attain the prior level of robustness, at least not driven by U.S. consumers. We wrote last time that we viewed the bank stress tests as largely theatre. We still do. There are a couple of US financial institutions that are viewed as too big to fail, but with time and a steep yield curve managed by the Fed, they will be able to earn their way out of their current hole There is an overhang of homes that cannot easily be refinanced because the debt is significantly greater than market value and this means increasing problems for many banks, especially in California, Nevada, Arizona, and Florida --- which implies or suggests that policymakers will opt for lower interest rates for the next couple of years. Interest rates have dropped another notch over the past couple of months. A more market-constructive approach might be to grind up incorrect valuations in a giant foreclosure mill. It would get rid of zombie borrowers, create a good foundation for future market growth, ultimately improve borrowers’ balance sheets, and create a more robust move-up market. However, banks would be likely to resist this. There is some evidence that they are already resisting market adjustments by warehousing foreclosures. Restructurings of loans that do not adjust principal will not do much for homeowners or the housing market, although they may help banks somewhat. We remain open to all of the relevant anecdotes about bank loan quality that people (such as yourself) are willing to provide to us.

Fears of inflation continue. However, there is a lot of idle capacity and idle workers in the U.S. economy, and a lot of slack in the system. Much of the increase in the money supply was meant to offset some of the destruction of asset values after the Lehman collapse. And it is clear that the Fed and Treasury are thinking about how to withdraw the extra quantity of money when the recovery becomes more robustly self-sustaining.

On Energy and Gold:
The long-term trend in gold prices is still up. Interestingly, it is not being driven so much by inflation per se, as by a desire to acquire a lasting store of value, partly to offset the decline of the dollar as a reserve currency. The current path of least resistance for policy-makers is to allow the exchange value of the dollar to decline, preferably gradually, and this is currently happening.

While the world may have a lot of oil, it does not have a lot of excess immediate production deliverability. U.S. natural gas production increased a lot, and there is still a glut of the stuff in storage. The price of oil has rebounded from the low $40s to $71/bbl. We believe the rebound in the price of petroleum to $70/bbl was caused more by OPEC cutbacks, perhaps Obama’s visit to Saudi Arabia, and perhaps China shifting from US dollars to petroleum, than by a global economic rebound. As a global economic rebound unfolds, petroleum price is one area that can firm quickly. In terms of energy production technology, a lot will happen in the next three years. Natural gas is more readily producible from deep shales (both here and in Canada), more LNG will be on world markets, and there will be more production from alternative energy sources. We also note that if significant domestic alternative energy sources were developed and became operational (perhaps over the next five years), it would have a material impact on our balance of payments, strengthening the exchange value of the dollar.

We will be attending Schwab Institutional’s IMPACT 2009 investment conference in San Diego this month. Thanks for your continued confidence. I know it may have wavered a bit over the past year. We think the coming years will be much better.

Gary N. Clark, CFA


_________________________________________________________________________________________________________________________



June 20, 2009

U.S. Financial markets have rebounded recently, from lows over the past eight months. Increasingly, we view the turbulence of this financial episode as triggered by the collapse of Lehman Brothers, and occurring against an inauspicious backdrop of circumstances. To wit:

1. The nation’s debt/output ratio had increased to peak levels, facilitated partly and and importantly by consumer borrowing against home equity, and exacerbated by use of financial derivatives and synthetic instruments. Unlike some other countries in the world, in the U.S. the largest growth of debt was in the financial sector.
2. Deleveraging - which can either take the form of paying down debt, or of default, bankruptcy, or debt evaporation. And one person’s debt is, or was, another person’s asset. Deleveraging is one of the current operative themes in the U.S. economy.
3. The unnoticed growth of inadequately reserved-for Credit Default Swaps and other derivatives;
4. The collapse of Lehman Brothers in September, 2008, Lehman Brothers was counterparty to many financial derivative contracts.
5. The sharp increase in the price of oil may have contributed (with a lag) to the recession somewhat. Likewise, the subsequent decline in petroleum prices may provide additional stimulus, also with a lag.

Granted, a market decline began in 2007, but the serious damage began as Lehman Brothers collapsed.

One salient and important factor that we mentioned last time is the changed significance of aggregate personal consumption expenditures in Gross Domestic Product. Others have described various aspects of this but I am not sure they are getting the main point. And that is, from a Keynesian perspective, aggregate demand is comprised of consumption expenditures, govt spending, investment, and net exports. In the Econ 201 textbook, it was often written
Y = C + I + G + X.

Going forward, consumption will not be , and cannot be as great a percentage of GDP. Consumers can no longer borrow against their home equity to the same extent, the wind is blowing against consumer credit, and China and other investors are less willing to buy the securities that partly financed our consumption spending. Which means that there will be less retail spending to support malls, mall employees, and mall landlords; less resultant rent from merchants to landlords to pay mortgages on malls and other retail buildings, less revenue to support luxury goods stores, less sales tax revenue for local governments, more problems for bonds collateralized with mortgages on retail space. It implies that policies designed to increase debt and boost consumption expenditures are likely to be ill-conceived.

And it also means that, to get the same level of employment, one of the other components of aggregate demand will have to pick up the slack. The most likely candidates are government spending (G) and net exports (X). Many observers are rooting for China and the Emerging Market economies, which are performing better than ours. It is not yet clear that the U.S. economy is on a path to a self-sustaining recovery, but the intent is there.

While there is some rhetoric about the quantity of money and credit that Hank Paulson and his colleagues and successors have shoveled into the system, it is very likely that not to have done so would have resulted in a more severe contraction in employment and economic activity, which would have been a less preferred outcome and had greater political costs.

The marked increase in the monetary base, and in credit, raises the fear of inflation. This is a real possibility, and one that investors and citizens should protect themselves against. However, it is not yet a certainty. It is not as if all the TV commentators know about the increased likelihood of inflation and Ben Bernanke does not. He and the other economists have read more economic history and spent more time mucking around in the data than the CNN commentators have. And, the long-term trend of the price of gold remains up.

One side effect of the bailout is that there has been a massive shift of debt from the private sector to the public sector. While some animosity may be directed towards Jose and Lupe, they are benefitting minimally. The bailout benefits the securitized debt and bondholders, and many average people, more than Jose and Lupe.

Here’s our take on a couple of other recent events. We view the bank stress tests as largely theatre. A likely interpretation of events is that our largest banks became insolvent, and it would have been politically practical to close them down – they might be too big to fail. So the stress tests, in our view, create the cover for keeping them alive long enough for them to earn their way, with policy support, out of their financial hole. (For background reading, see the article “The Quiet Coup” on our website under the Geopolitical tab.) We remain open to all of the relevant anecdotes about bank loan quality that people (such as yourself) are willing to provide to us.

Sometimes we are intrigued by minor events that may be a good marginal indicator of a change in trend, or a harbinger of a coming trend, a manifestation of a developing trend, sort of like a dead canary in a coal mine. Along these lines, we, and many other people in the financial domain, were intrigued by the recent report of a couple of gentlemen of Japanese ethnicity who were arrested while trying to enter Switzerland from Italy with $134 billion of dollar denominated U.S. government bonds in a suitcase. Which raises some questions:

• Were the bonds real?
  
• Were they an attempt by Japan to diversify away from dollars?
• Was this a staged event by Russia, China, or Brazil to further call into question the U.S. dollar’s role as a reserve currency?
  
• Did they come from Castro, North Korea, or Columbia?
• Where did they get the $134 Billion?

On Energy and Gold:
We view the long-term trend in gold as up. Interestingly, it is not being driven so much by inflation per se, as by a desire to acquire a lasting store of value, partly to offset the decline of the dollar as a reserve currency.

While the world may have a lot of oil, it does not have a lot of excess production deliverability. The recession and decrease in economic activity is the principal factor accounting for the decline in the price of petroleum. The price of oil has rebounded from the low $40s to $71/bbl. We believe this is caused more by OPEC cutbacks, perhaps Obama’s visit to Saudi Arabia, and perhaps China shifting from US dollars to petroleum than a global economic rebound. In terms of energy production technology, a lot will happen in the next three years. Natural gas is more readily producible from deep shales, more LNG will be on world markets, and there will be more production from alternative energy sources. We also note that if significant domestic alternative energy sources were developed and became operational, it would have a material impact on our balance of payments.

If you would like a copy of our Form ADV Part II, we would be happy to provide it to you. Please ask. Thank you for your continued confidence.

Gary N. Clark, CFA

_________________________________________________________________________________________________________________________

 

March 19, 2009

Financial markets have cyclical fluctuations, and this has been in a big one. The percentage decline from the cyclical peak in October 2007 to the recent low was 53%. In other words, if ranked by size, this would be one of the larger ones of all time. The implied conclusion is that we are closer to the end than to the beginning of this decline – and perhaps sooner rather than later.

In other words, many declines, when they have reached this percentage extent, exhaust themselves, turn around, and begin the next process of ascent. However, it is not yet clear that the long-term trend has changed from "down" to "up."

We are very aware that many clients are depending on us to play an important role in achieving their financial goals and maintaining their financial security and the recent decline is a step backwards, or at least a pause. We know you depend on us.

We have spent much time considering the recent and current episode, it causes, its ingredients, and the possible scenarios going forward. While we and many others foresaw some of the ingredients, we did not foresee the timing. Here is how we view it.

Going into this episode,

1. Risk was mispriced. This may sound merely academic, but the implied and implicit price of risk was mispriced, too cheaply, the cumulative result particularly of Greenspan boosting the money supply during Y2K, of increasing the money supply to offset the Internet collapse and, recently, over concern about mortgage defaults.
   • The increase in the money supply didn’t bring about inflation in goods prices due to competition from imports of many things, i.e., from China, etc.
2. Overall debt levels were at historic high levels. Overall debt to GDP was about 350%, and had risen significantly since 2000, and since 1990. Much of this was in the U.S. financial sector. Debt for the U.S. manufacturing sector rose much less.

The debt increase was associated with

1. an increase in consumption and decrease in savings rate partly financed by homeowners borrowing against home equity;
2. a current account deficit,
3. China and Japan (and others) financing our current account deficit by buying more Treasuries and federal agency securities (Fannie Mae, Freddie Mac, etc). The U.S. is now a debtor nation, and shares some of the financing issues of emerging market economies. We benefit from the fact that the dollar is a global reserve currently, and we may be pushing our advantage.

Debt in the financial sector was associated with the growth of Credit Default Swaps (CDS) and associated instruments, which introduced additional risks. I pretty much totally missed the significance of this. I think this area accounts for most of the magnificent losses, rather than sub-prime borrowers – they only add up to about two trillion of debt.

The use of more sophisticated financial instruments as well as communications enabled this to be a more global phenomenon. Credit Default Swaps allowed lesser to quality debt to appear to be higher quality to those in far-off lands, such as Iceland or Indonesia, and they also enabled the creation of similarly behaving synthetic securities. Thus, the recent situation is a manifestation of global systematic risk.

The recent decline seemed like it was almost over at the end of this past September (2008), after which it abruptly gained new force in October and November. When the dust is ultimately settled and analyzed, it may seem that the collapse of Lehman Brothers in September was primary disruptive event, although other institutions (Washington Mutual, Freddie Mac, Merrill Lynch, Bear Stearns, IndyMac Bank, Fannie Mae, and Wachovia) also encountered serious difficulties.

Mr. Obama walks into a situation where economic activity is contracting (a genuine recession), and certain financial institutions are melting down, which is

1. Having a dampening effect on the real economy, and
2. Threatening to foster a snowball effect, where further declines in collateral values threaten the remaining financial institutions.

The Fed and the US Treasury can play a role in rationalization of US financial institutions. They play the main role in increasing the quantity of money, in an effort to prop up nominal asset values and to stop further declines in bank collateral values.

In addition to a monetary policy response, the current situation also cries out for Keynesian fiscal policy response. Washington is responding appropriately with stimulus packages.

George Karahalios, in a recent piece appearing in the Gloom, Boom,& Doom Report, notes the similarity of the current situation to the John Law’s Mississippi River Company in 1720. The similarity is that in both cases, there is a tremendous macro-shift of debt. In 1720, investors traded almost the entire national debt of France for shares in the Mississippi River Company. The debt was shifted from the public to the private sector. (The situation ended poorly for the investors). In the current U.S. situation, we are witnessing a very massive shift of debt from the private to the public sector. After, the dust settles, I suspect that most of the relevant assets will still be in the private sector. This will have social and political impacts that are not yet apparent.

I attended the American Economic Association annual convention in San Francisco in January. There were a several papers presented that were relevant to the current situation. Historical analysis of (generic) past financial crises suggests an “average“ crisis may have a 2.5-3.5 year impact on selected variables, such as unemployment or credit spreads. Thus, we may have a year or so more to go. However, one smart economist noted that we have already corrected 80% of the way. This ‘adjustment’ has been more rapid (and painful) than the historical average.

The Executive Summary:
Many valuations are reasonable, and the major trend is still down. (This is not a prediction that it will continue to decline.)

Additionally,

• The long-term trend of gold remains up.
• While the overall trend is still down, there are pockets of strengthening;
• Current economic policy has the intent and is working to improve this situation, unlike some other periods. (So sooner or later things might get better?)
• Credit default swaps (which are not necessarily bad) are being unwound, as a matter of policy;
• Petroleum prices have fallen dramatically, and they are below the marginal cost of some new sources of production. The growth of alternative energy and efficiency improvements over the next few years will not be enough to preclude petroleum prices from rebounding significantly when economic output recovers. And, it may be taxed more in the future. We think most investors do not appreciate how fast technology is advancing in the area of energy alternatives.
• • China and other nations are moving away from as great a reliance on the dollar as a reserve currency.
• There is often a lot of fear and pessimism at market bottoms, which is a rough description of the current mood. However, the trend is not yet turned up. The rationale for being invested is that the timing of a turn is difficult to predict, and some of the largest gains often occur at the beginning of a change in trend.

Additionally there are four major structural changes or trends that appear very likely to be underway or imminent:

• The deflationary effect of the shrinkage of aggregate debt;
• The shift in debt from the private to the public sector;
• A decrease in the percentage of personal income allocated to personal consumption expenditures – an increase in the savings rate- , and
• The movement away from the dollar as a global reserve currency.

It has been a challenging quarter, in a historic decline. We are in a period when macroeconomic analysis is much more pertinent and relevant than usual.

Gary N. Clark, CFA