The U.S. economy has continued the recovery that began late in 2009. We expect first quarter 2010 growth to be around 3.5%. The recovery is currently being stimulated by improvements in manufacturing, specifically automobiles, as well as a general rebuilding of inventories throughout the economy. Inventories declined as much as 15% at the trough of the recession. First quarter economic results will be adversely affected by the awful weather conditions that affected the entire northern half of the United States, but we believe the next step in the recovery will be in the housing sector and should occur this spring.

Representing about 10% of the economy, housing is influenced by seasonal economic adjustments that, by reason of the weather, sent confusing signals. Existing home sales are at an annual rate of 5,020,000 units, up from a low of 4,610,000 in the second quarter of 2009. Though still below optimal levels, we remain optimistic, as low mortgage rates (about 5% for a 30-year fixed rate) should continue to stimulate housing demand. In addition, the home buyer’s tax credit, which expires in April, continues to help. Hopefully, the second quarter, which is typically a much stronger quarter for housing, will lead to a growing consensus that the recovery is gaining momentum.

New home starts are at a level of 575,000 per year. This supply of housing compares to the 1,000,000 households that have been historically created each year as a natural result of population growth. Last year, only about 400,000 households were created. Therefore, we have a great number of households that would have been created, but weren’t due to the recession. When the job market gives those people confidence to leave the house, it will have a multiplier effect, where pent-up demand will combine with the normal demand. This should result in a significant rebound in housing. New housing starts and permits will lead this rebound. Indeed, permits are currently ahead of actual starts. Since a higher level of permits indicates that a greater number of houses will be built, they should usher in more improvement to the housing market.

Several other factors give us confidence that the economy will strengthen in the coming months. First, the downsizing of business inventories has ended. Manufacturing production schedules are increasing in virtually every sector. For instance, steel output is projected to be up 75% in the second quarter, and steel capacity utilization is now 70%, up from a low of 40%. Whirlpool, a manufacturer of heavy appliances, now has several products on allocation, implying significant production increases are on the way, and ultimately, the hiring of new workers.

Turning to the stock market, the S&P 500 increased 5.4% in the first quarter. The Dow Jones Industrial Average also increased 4.8%. This represents the 4th consecutive quarterly increase since the market bottom during the first quarter of 2009. Moreover, the stock market is now up 73% since its March 9th low. But is there more upside from here? We think so. The market, even after this move, is trading at just 15 times 2010 and 13 times 2011 consensus earnings estimates.

We remain cautious on the outlook for interest rates. Projected deficit levels are significantly higher than we would like. During the quarter, interest rates on the ten-year treasury rose from 3.79% to 3.83%, resulting in a slight decline in bond prices. While not a sizable increase, we think this trend will continue. For this reason, our bond purchases are primarily short maturity bonds.

Thankfully, we seem to have moved into an up phase in our economy, and it may be time to perform a pathology report on exactly what happened in 2008. To assist in that regard, there are a number of excellent books written on the financial crisis. Bear Stearns failed on March 17, 2008 and was hastily married to JP Morgan Chase. Subsequently, Lehman brothers collapsed on Sept 15, 2008. These events are well-chronicled in three books: “Too Big to Fail” by Andrew Ross Sorkin, “Shut Down” by Charles Gasparino and “A Colossal Failure of Common Sense” by Lawrence McDonald. For more reading ideas, go to our website at www.tuftoncapital.com and click on “Investor Intelligence.”

– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –
It may be time to perform a pathology report on
exactly what happened in 2008.
– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

These volumes recorded how our regulatory safeguards, which protected our economy since the Depression, were relaxed. The true cause of what occurred in 2008 was excessive borrowing on behalf of the brokerage industry. Firms took on unacceptably high levels of financial risk through leverage. It became a game of “Heads I win, tails you (the shareholders) lose.” Financial rewards to investment executives were paid based on short-term results, and when circumstances became unfavorable, firms simply failed.

As this is being written, Christopher Dodd, chairman of the Senate Finance Committee, is exploring measures that would prevent another catastrophe. However, all of the preconditions that led to the near-meltdown in 2008 currently exist. Mr. Dodd’s proposed legislative reform is urgently needed, or we could see a replay of the financial crisis.

One of the cries in our nation is to turn the employment cycle up. It should be noted that employment is a lagging indicator. It is painful to lay people off, and companies are reluctant to rehire until their confidence in the future is strong. We believe that confidence level is on the brink of restoration, and that improvements in employment are close at hand. One of the factors that has hampered the employment situation has been very significant gains in productivity. Put simply, if productivity is increasing at a 6 or 7% rate, as it has been, there is a reluctance to hire additional employees. This situation will change as the economic recovery continues. Companies cannot continue to overwork their existing labor force.

In late March, the US Congress passed the healthcare reform act. The key issue of healthcare coverage for some 32 million uninsured does not kick in until 2014. However, some of the tax increases will take effect in 2011. These increases include a new 3.8% Medicare tax in 2013 on all unearned income and capital gains for couples earning more than $250,000. In addition, the 2003 tax cuts enacted under George W. Bush will expire at the end of 2010. The combination of these two factors should see significant federal revenue increases next year. Given the sharp increases in the federal deficits in 2008 and 2009 due to the banking crisis and the accompanying recession, these added revenues should lower the federal deficit over the next several years.

The critical question is whether these tax increases will affect the economic recovery. We do not think this will happen, and believe we will avoid the “double-dip” recession that has been suggested by some forecasters. Rather, the most likely outcome is that the economy, given the changed tax structure, will track Bill Clinton’s experience of economic growth in 1994-2000. The Clinton Administration experienced the longest uninterrupted economic expansion in our modern history, and taxes were increased during that period.

The current fiscal deficit is above 10% of our gross domestic product, at approximately $1.4 trillion. This is an alarming percentage by historical perspective, and has only occurred during the darkest days of World War II (1942-1945). There is a significant difference in the financing of the two deficits, though. In World War II, consumers, unable to purchase goods and services due to rationing, purchased our war bonds. Our debt, essentially, was owed to ourselves.

– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –
Companies cannot continue to overwork their existing labor force.
– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Today is different. In addition to the fiscal deficit, this country is operating at a significant trade deficit with trading partners around the world. As a consequence, the current fiscal deficits are being funded roughly 70% by American buyers and 30% by foreign purchasers. We are becoming dependent, for purposes of financing our deficits, on our overseas “friends.” Specifically, the Chinese are currently the largest foreign holders of our debt, as well as our largest trade partner. The Chinese currency, the Yuan, is pegged to the United States dollar. When the United states was running significant surpluses in the 1950’s and 60’s, one of the ways to relieve pressure of trade deficits with our partners, mainly in Europe, was to let floating currencies devalue themselves against the US dollar. This strategy preserved the standard of living of those Western European economies that were running trade deficits with the United States. The Chinese refusal to float their currency could potentially put future pressure on our living standard.

With such trade deficits, it may become necessary for the United States to increase interest rates in order to attract the recycling of funds. Some have suggested that these interest rate increases could be significant, as much as two full percentage points above current rates. This obviously would be very negative for bond holders. This is another reason we are cautious on bonds; although current interest rate levels are low in the shorter maturities, we do not advocate extending maturities in our portfolios at this time.

It is with pleasure I report David Stepherson was named Chief Investment Officer of the firm, effective April 1, 2010. For several years, Dave has served as chairman for our investment committee meetings, and this change in title formally recognizes his important contributions to the firm. Dave is a graduate of the University of Texas, and he joined the firm in February of 1999. He is a Chartered Financial Analyst (CFA) and a member of the board of the Baltimore CFA Society. He lives with his family in Howard County. I believe his appointment lends confidence to the “bench strength” of Hardesty Capital Management.

In my visits with clients, this year has certainly been more pleasant than last. I thank you for your patience and continued confidence in our firm. I still believe the best is yet to come.
—Jim Hardesty