Who We Are - President Letters - Mr. Bernanke, In What States is The Recession Over

November 19, 2009

Dear Clients and Friends,

MR. BERNANKE, IN WHAT STATES IS THE RECESSION OVER?

Commercial Real Estate
In our last letter, we opined that Commercial Real Estate will be the next shoe to drop. Sam Zell had an article to that effect in the November 16th issue of Barron’s. He is legendary in his home town of Chicago for buying commercial real estate in the depths of recession, giving him the nick name of “The Grave Dancer.” In the interview he indicated that he “wasn’t ready to play yet.” He went on to say that he believes we will see another 30% drop before he will participate. Thirty cities including Las Vegas and New York are currently saddled by $1billion in commercial loans that are not performing.

Why should we care about office buildings and apartment houses? Because banks own a large portion of the debt of these properties and if commercial real estate loans fail, then more banks will fail. That is a large part of why 115 banks have failed this year…with the number of bank failures each month accelerating since January 2009.

Housing
As long as we are talking about real estate, I do not believe we have seen the bottom of the housing market. Even with government programs providing up to an $8,000 credit towards the purchase, historically low mortgage rates and government loans requiring less than 5% down, no one is buying! Perhaps the issue is that consumers have found more sense in conserving their money then taking on a large mortgage obligation in the midst of extreme unemployment, regardless of the government’s efforts to the contrary.

“The sharp downturn in housing markets across the country, which undermined the solvency of major financial institutions and severely disrupted the functioning of financial markets, has led the United States into a recession that will probably be the longest and the deepest since World War II.” -2009 Budget and Economic Outlook, Congressional Budget Office, March 2009.

Unemployment
The jobs market is not improving, just getting less bad each month. We are all grateful that monthly job losses have declined from 500,000 jobs lost per month to 200,000; however, we still are deep in a hole and have not stopped digging.

Since the 90’s, small businesses have accounted for 64% of the new jobs in the US. Due to lasting effects from the banking crisis and failures of firms offering credit to small companies, small business job creation has been almost non-existent. It is imperative that whatever additional stimulus the politicians implement, it should have small businesses as its main focus.

States Budgets
How bad are the states budgets? States are using stimulus to fund up to 40% of their budgets. Nine states are considered to be in fiscal distress, with California, Michigan, Arizona and Florida topping the list. Michigan is instituting 20% budget cuts for 2010. California’s budget gap is still estimated at $7 billion for 2009 and $14 billion for 2010 after spending cuts. Mr. Bernanke, in what states is the recession over?

The Stock Market
If we were on our way to an economic recovery, the Federal Reserve (FED) would not have interest rates at the unprecedented historically low rate of ZERO! The stock market, by all traditional measures, is way over priced. The price to earnings ratio, the most closely followed, is over 100, which is traditionally in the 15 to 25 range! The only thing keeping the markets afloat is the low cost of money. Michael Farr, CEO of Farr, Miller & Washington, said “a non-stop supply of monetary opiates could keep a dead elephant jogging for miles.”

A lot of money has been made in the stock market over the past couple of months. I believe this “irrational exuberance” will not end well. When, you ask? Before the end of the first quarter of 2010. Hmmmm…why then? It all goes back to housing. When one buys a house, they almost always get a mortgage. Where does the money come from? These days, it is the government that makes the loan. It works this way….a mortgage broker initiates the mortgage. They sell it to Fannie Mae or Freddie Mac, who then ‘sells’ it to the FED. In short, the FED is, de facto, making the mortgage. No secret…and it is working well. There is, however, a however. The FED has announced that they will stop buying those mortgages effective March, 31, 2010. How will that affect the mortgage market? We don’t know, and quite frankly, we do not like not knowing.

“In the end, I have no idea how high the flames of this market surge may be fanned. I know that when the music stops, many will be desperate for a chair. The FED officials are holding out hope for a fairy-tale ending that consumer demand will return at a steadily increasing pace so they are able to withdraw the artificial liquidity at a steadily decreasing pace. The hope is that the economy will continue to grow modestly without any significant inflation and without disruption to the equity markets [stock markets]. We hope so too, but our investment discipline requires a more substantial architecture than hope” -Michael Farr

Our Conclusion
We believe market risks are substantial at this time. The marketplace is only beginning to sense the reemergence of the economic crisis on the horizon. At this juncture, we prefer the risk of lost opportunity and not the risk of lost capital.

Sincerely,
Barry Cliff
President
Barry@AFCAssetManagement.com

Jim Young
Vice President
Jim@AFCAssetManagement.com

AFC Asset Management Services, Inc.
18310 Montgomery Village Avenue, Suite 440
Gaithersburg, MD 20879
301-588-5000
www.afcassetmanagement.com