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| Second Quarter - 2009 The Sun Peeks Through the Clouds  After reading William Cohan’s book “House of Cards,” I was taken aback by the level of greed that has tarnished respected financial institutions. Greed turned them into financial casinos where executive compensation levels became an overriding corporate objective. This excess is wrong and, just as the excesses of Drexel Burnham in the late 1980’s were corrected, today’s unwarranted and unnecessary compensation levels will eventually return to some form of sanity and normalcy.Greed was not restricted to the corporate suites of managements across the country. Unfortunately, more financial thievery was exposed this quarter as the public confidence in the U. S. financial markets had to withstand another indictment. Just as the Madoff case came to an end with a 150 year sentence, Mr. R. Allen Stanford, a Houston based financier, who operated significant offshore tax havens, was indicted. To our delight, the sheriff is here, and hopefully those that have abused the financial structure of our economy will be awarded a full measure of the prison sentences and fines they deserve. This is a precondition for restoring investor confidence, which should result in more normal equity valuations. “Normalcy” could equate to more than 50% above current stock prices. (See the Schopf Stop for more on this.) With some investor confidence returning, and after six consecutive quarters of declining share prices, equities finally scored a respectable gain for the quarter ended June 30, 2009. The S&P 500 rose 15.2%, the NASDAQ increased 11.0% and the Dow Jones Industrial Average was up 11.9% for the quarter. This brought gains from the March lows to 35.9% for the S&P 500 and 44.6% for the NASDAQ. Year-to-date, the S&P is now up 1.8% and the NASDAQ is up 16.4%. Although interest rates were volatile during the quarter, the bond markets were stable. The federal funds rate was unchanged in the quarter (maintaining the range of 0% - 0.25%), resulting in little movement in short-term rates. Long-term Treasury rates rose along the curve from two to thirty year maturities. A steep yield curve can be viewed as a good sign the economy is coming back to life. More importantly, spreads between government and corporate yields improved significantly, as credit fears that gripped corporate issuers eased materially in the quarter. Although far from normal, the improvement in credit spreads is encouraging, as it shows the credit crisis is moderating. As the credit crisis moderates, there is some evidence of improvement in several key, leading economic indicators. The aforementioned interest rate spread between 10-year Treasury bonds and the federal funds rate is a healthy sign. Also, an increase in the money supply bodes well for future growth. Orders for durable goods posted their second straight monthly improvement in May. Finally, the sharp increase in stock prices from the March lows suggest that an expansion could be ahead. But although there are burgeoning signs of future growth, much of the economic data is still gloomy. The real Gross Domestic Product fell at a 5.5% rate in the first quarter of 2009. We anticipate a somewhat smaller decline in the second quarter. The unemployment rate, a lagging indicator, advanced to a twenty-year high of 9.5%. We expect further bad news on this front. In addition, auto, home and retail sales continue to struggle. We do expect some improvement in these areas as the year progresses. The automobile industry has gone through some amazing changes this quarter. Although unthinkable a year ago, Chrysler and General Motors both filed for bankruptcy on April 30 and June 1, respectively. The two bankruptcies together represent the largest business failures in history. Operating under broad executive powers, the Obama administration effectively wiped out shareholders, as well as the secured creditors. Labor unions and the U.S. government are now in control of two of the big three American car manufacturers. Vehicle output remained weak at under ten million units annualized, down more than 40% from peak levels. Output levels now trail scrappage rates by more than three million units annually. Dealer inventories were further reduced in the quarter, setting the stage for a recovery in demand for automobiles during the first half of 2010. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - The sharp increase in stock prices from the March lows suggest that an expansion could be ahead. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Although thirty-year fixed-rate mortgages increased 75 basis points to 5.5%, the housing affordability index, which measures the ability of the average family to afford a median priced home, was at its highest level since data was collected (1971). This is a strong positive for housing demand. Of note, California, one of the hardest-hit housing markets, reported a 4.2% uptick in median house prices in May. This is possibly the first indication that housing prices in one of the more important markets may have bottomed, signaling that a recovery in other parts of the country could be in its early stages. Jim Cramer, a widely followed stock market commentator, declared flatly on his television show on June 16th that the housing decline was over. As one would expect, the consumer, frightened by reports of a worsening financial and economic situation, began to sharply increase savings. Consumer savings jumped from 0% of income earned one year ago to an annual rate of 6.9% in May, the highest savings rate in over 15 years. As consumers saved their money, they effectively withdrew $800 billion in spending in our economy, which helped deepen the recession. Known as the Paradox of Thrift, these savings represent a deferral of consumer purchases, which means less income for business owners. Over the long term, though, higher savings allow for a stronger consumer when confidence returns. In the meantime, government stimulus programs have been enacted to provide support for the economy.
Though the financial and economic news has been grim since the beginning of 2008, the real difference in this cycle has been the turmoil in the financial markets, triggered by an excess in housing spending. This exposed the dangers of many derivative and credit insurance vehicles, which were related to the housing market and had never been subjected to a serious financial downturn. Extraordinary steps were taken by the U.S. Treasury and world central bankers to avoid a financial catastrophe, and they demonstrated that the imaginative use of fiscal and monetary policies could maintain financial order during extremely challenging times. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - It is possible our current situation may bounce back more sharply than any current economic forecasters anticipate. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - It is possible our current situation may bounce back more sharply than any current economic forecasters anticipate. In essence, we could replay the 1957-58 recovery. The Federal Reserve has flooded the U.S. financial system with ample liquidity, capable of fueling a strong recovery. In addition to an expanding monetary base, there also will be large fiscal deficits associated with the lower-than-anticipated tax receipts and higher federal spending for safety-net programs. The combination of stimulative fiscal and monetary policy could provide the conditions of a perfect storm, triggering a surprisingly strong upturn in 2010 economic activity. The risk in this forecast of a stronger recovery could unleash a secular increase in inflation levels. As noted in past issues of Hardesty Horizons, inflation is the mortal enemy of financial assets. Therefore, if government spending is not tempered as the economy’s recovery gains momentum, higher inflation levels could ensue, complicating both the economic recovery and valuation of financial assets. We plan to monitor economic developments closely in the coming quarters. Do not overlook the fact that, despite the terrible valuation declines in financial and housing values, we are still a very wealthy country. Our economic strengths are formidable and we remain a very innovative economy that has always recovered after past economic difficulties. The question is not “if” the economy recovers, but “when.” The challenges, of course, remain, but we think the sun may have just peeked through the clouds. The second half of 2009 could prove a surprise on the upside. —Jim Hardesty --------------------------------------------- Company Spotlight  Hudson City Bancorp (HCBK), the largest savings bank in the United States, is a healthy, growing bank that currently operates 130 branches in the New York metropolitan area, in upscale parts of New Jersey, New York, and Connecticut. They have a strong presence in nine of the wealthiest counties in the U.S. The bank focuses on being the low-cost jumbo mortgage provider to prime borrowers. Asset quality is maintained by requirements for at least a 20% down payment and up to 40% down on the highest value properties. And, unlike many other lenders, they hold all of the mortgages they originate. HCBK is the nation’s lowest cost provider, making it the most efficient bank in the country. Their ability to control costs better than any other large U.S. bank is a competitive advantage, enabling Hudson City to deliver higher deposit yields, lower fees, competitive mortgage rates, and a straightforward, streamlined loan process to their customers. Their management team is excellent.
—Scott Schluederberg --------------------------------------------- The Schopf Stop  The sentencing of Bernard Madoff brings the Securities and Exchange Commission one step closer to closing the book on one of the largest Ponzi schemes ever perpetrated. While Madoff has garnered most of the headlines, numerous other fraudulent schemes of various magnitudes have come to light over the past six months.The common thread between many of these schemes is quite simple. The criminal serves dual roles as investment manger and qualified custodian of the same assets. As investment manager, funds are accumulated, often under the guise of guaranteed high investment returns. Once in possession of the money, funds are transferred between accounts in order to meet withdrawal requirements. As custodian, fake account statements with bogus information are provided in order to create the illusion of a legitimate operation. If the money inflow from new clients offsets the outflow from withdrawals, the fraud may be perpetrated for a long time. Hardesty Capital does not take custody of client assets. Independent third-party qualified custodians, such as banks and broker-dealers, are utilized for the vital function. Qualified custodians are subject to extensive regulation and oversight. Included in the oversight is a daily reconciliation conducted by our firm to assure the accuracy of custodial records. In response to the financial schemes, the SEC has modified their registered investment adviser examination process. They will now perform a valid verification of assets by requesting independent confirmation of investor assets from various third parties, including custodians and advised clients. The SEC exam staff may ask clients to confirm that their account balances as of a specific date were consistent with their own records and that the contribution and withdrawals from their account were authorized. —Eric Schopf --------------------------------------------- If you would like more information about Hardesty Capital Management, please visit our website at www.hardestycap.com or call 800-791-7738. Visit our newsletter archive to download the print version of our newsletter and see old issues of Hardesty Horizons. |
Table of Contents: The Sun Peeks Through the Clouds Company Spotlight: Hudson City Bancorp The Schopf Stop Find out more about: Hardesty Capital Management Horizons Newsletter Archive Our Executive Staff Our Television Appearances Complimentary Portfolio Evaluation: Contact Us |
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