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Capital Markets Outlook

The world holds its breath as the new Leader of the Free World, Secretary of Treasury Henry Paulson, mobilizes an uncharacteristically bipartisan Congress to rescue the world from systemic fi nancial collapse.

A crisis that started with the fall of subprime mortgage issuers and then Bear Stearns has spread to small and large firms alike. FDIC has seized over a dozen banks; Lehman Brothers and Washington Mutual have declared bankruptcy; and the government bailout out AIG taken over Fannie Mae and Freddie Mac. Credit markets have seized, and loans are scarce even among the creditworthy. A flight to quality has driven Treasury yields to historic lows.

Mr. Paulson is leading an effort to purchase $700 billion of embattled, even toxic, assets among the nation’s banks, insurers, and investment houses. After failing to pass the House of Representatives last week in Mr. Paulson’s simple, three page form, H.R. 1424 has grown to 451 pages with legislative add-ons. The U.S. government and its tax-payers are entering a new era, an expansion of size and powers rivaling perhaps that of the FDR’s New Deal. The U.S. government will run the world’s largest investment fund.

Surely, the bailout has drawn fierce debate. We have strong feelings on the matter but also realize the profound severity and complexity of both the problem and proposed solution are nothing short of intellectually humbling. We will be wrapping our collective heads around this for some time to come.

While helping some financial institutions remain solvent (at least for awhile), the bailout package is no panacea. Consider that many Wall Street houses, and even Fannie Mae and Freddie Mac, levered their capital roughly 40-to-1; meaning for every dollar of equity, they borrowed $40 (mostly at low, near Treasury rates) to invest in mortgages of all shapes and sizes. Companies like AIG not only joined the party and invested in mortgage-related securities; they insured some $440 billion worth of those held by other institutions via credit default swaps (CDSs). The rest of the $62 trillion worth of CDS contracts are held elsewhere and everywhere like a web of trip-wire; more credit defaults could ignite the whole lot. We remain pretty bearish, and not only because of the enormity of the financial crisis that will take time and many victims. As soon as the markets move beyond the issue of our financial system’s solvency, they will realize an era of higher taxes and regulation likely waits. In addition, economies around the world are slipping into recession, and lower corporate profits are likely. Sadly, there’s not a whole lot in which to be optimistic. Fortunately, Treasuries have hedged equities somewhat as investors continue their flight to quality and safety, and we’ve held a good amount of cash that we hope to re-deploy in times of extreme market pessimism and cheap valuations.

Allocation Strategy

We remain defensive with equity exposure, both in amounts and composition. Equity allocations remain domestic and large cap in focus as the financial crisis and slowing growth affect foreign and riskier assets more severely. Our bias to “growth” equities also remain. Growth companies tend to be less cyclical and hold less debt than “value” companies. Financial companies—an area we’d prefer little exposure—comprise a good amount of value indexes. Our skepticism of foreign markets has largely been validated as most foreign indexes have dropped further than U.S. ones. We believe economic and market risks remain higher abroad; our allocations to foreign stocks are minimal.

Increased concerns over solvency of the financial system have tempered our inflation worries and indeed deflation is the market’s current concern. However, we prefer shorter maturity Treasuries due to the uncertain nature of fiscal policy. We have exited inflation-indexed Treasuries and raised cash holdings. Gold remains a small dollar-hedge.

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