Well, Steve Jobs is taking a leave of absence from Apple for health reasons, again. The last time he did this, the whole affair was cloaked in mystery for a couple of months before the company finally admitted that Jobs wasn’t in the office every day running the company. This time, Jobs himself reported that he was going to take another sabbatical to work on his health. The difference tells us a lot about Apple and Jobs.
When Jobs left to fight liver failure and ultimately get a liver transplant, the company wasn’t the power it is today. Jobs’ functioned as both the public face of Apple and the primary product driver. But now, with the iPhone and iPad in big-time production and the company the second largest market cap on Wall Street, Jobs’ functions don’t have the same do-or-die meaning for Apple. Also, the day to day operations of the company didn’t falter under Chief Operating Officer Tim Cook the last time and probably won’t this time.
There is hardly another company in America with the possible exception of Berkshire Hathaway that is more wrapped-up in its CEO than Apple. This is not a healthy situation for either Apple or Jobs. According to a recent company profile, there are 49,000 employees at Apple. That is a lot of people depending on one man to lead them. For investors, the question really ought to be: what are investing in, Steve Jobs or a company that makes gadgets?
The gadget company is doing fine. As the recent earnings release attests, Apple is selling more gadgets for more money than ever before. Earnings almost doubled while revenues rose 70%. They beat Wall Street’s forecasts on both counts, earnings by about 20%, revenues by 10%. Of course the company spoon-feeds the analysts these numbers. So the company focuses on how tough it will be to get to say $6 and how $5 something is more likely. The analysts go back and rejigger their spreadsheets to come up with a number of $5 something. Then the company hits them with over $6 in earnings and everybody goes WOW. It’s a silly game, but Apple is good at it.
Apple spent more time on their latest analysts call talking about supply-chain issues than they did about development, or Jobs. That is just lowering the bar so they can get over it come April. Apple is becoming more of a seasonal company. Its gadgets sell heavily at Christmas, so each year their fiscal first quarter is getting more and more important. Were it not for the introduction of the iPad this past year, the December quarter would have been their biggest of the year. This year, the odds are even greater that the peak will be this past quarter. Watch out for that as the year progresses.
<strong><span style=”text-decoration: underline;”>Issue of the Week</span></strong>
Whenever municipal finance is in the headlines, it can’t be a good thing. When was the last time you heard that everything was going smoothly in Indiana? (Well it is.) Not only are municipal finance issues confusing but they are also prone to demagoguery. Out of power politicians will try to make hay while their competitors are under the unfavorable light of having to cut services or raise revenues. This is a tried and true recipe for misleading rhetoric. This occasion is no different.
We all have needs for services which would be almost impossible for any but the richest of us to afford without the benefit of living in a larger community of people. Think of simple things, like roads (and don’t all the engineers send me a note telling me how complicated roads can be). To build a road between point A and point B takes money. Money is needed to procure a right of way. Money is needed to pay design, for labor and materials and equipment to build the road. Even the best roads take a lot of wear and tear from use and from the weather, so regular maintenance must be paid for. Where do we get the money?
In times mostly gone by, the money came from toll road companies which built roads and then charged for their use. Toll roads are still fairly common in the Eastern third of the US and in parts of Europe. But, for most areas, the road is built by the city, the county or the state and use is free to all once the road is built. We agree to tax ourselves, either through consumption taxes (like the gasoline tax), or through property tax, income tax or some other method to raise the money to build and maintain the roads.
The benefit to all of us is enough to justify the tax, or we wouldn’t do it. This same model works for all sorts of services like water, sewer, electricity and others. We all benefit from living in communities that share the burden of building and maintaining these services. Our tiny little share of the cost of building a sewer system dwarfs the expense of each of us trying to build our own.
Today’s crisis in municipal finance is largely due to revenue shortfalls or over-commitments made in more benign times. We all want the services, but are unwilling to suffer higher taxes to pay for them. Essentially, one of two things will happen: we will suffer reduced services; or we will suffer higher taxes. There will be enough suffering to go around.
The new wrinkle this time around has to do with municipal employee retirement obligations. Since the late 19<sup>th</sup> century, civil service laws have largely protected government employees from political pressures. Since the 1950s public employee unions have improved the pay and benefits of public employees. Today, the often generous retirement benefits are leaving a gaping hole in municipal finance. Much of this hole was created by overly optimistic assumptions on what investments would earn over the past decade, part from the recent market breakdown. This hole will be filled somehow. Either public employees with accept lower benefits than now promised, or other services will be curtailed to meet this obligation, or taxpayers will pay, probably a bit of each.
Note that in this description we have not contemplated municipal bankruptcy as a viable option. The big difference between corporate bankruptcy and municipal bankruptcy is that municipalities seldom go away. The debts are seldom cured by bankruptcy, the services go on, and taxes continue to be paid. Generally, municipal bankruptcies don’t change anything. So, it is seldom the answer that it is in corporate or personal bankruptcy. With no winners and lots of losers, there is no reason to play the game.
Despite this ‘sanguine’ outlook, we will admit that there will be many municipal bankruptcies in our collective future. A lot of service districts will go broke. A lot of small cities will go broke. But, the services will continue, the cities will continue. What we may see is a wave of privatizations, combinations and other solutions to these problems. Prior to the Great Depression, there were many more small electric utilities, water companies and toll road operators in America. When these service providers went broke, they were often taken over by municipalities so that services would be continued. We may see the opposite now. We will see a lot of arenas, airports and parking garages sold to raise revenues. We will see hospitals privatized. During times of stress, solutions that may not seem all that likely during benign times become very appealing. This may be one of these times.
So, what does this mean for municipal bondholders? This will not be a pleasant time for bondholders, but that doesn’t mean it won’t be rewarding. We will see increased volatility, headline risk so to speak, in munis now. But, the vast majority of bonds will pay their required interest on time and in full. Almost all municipal bonds will pay-off at maturity. The few bankruptcies will cause periodic hiccups in the market price for munis, but it will be transitory. For the few bondholders who get stuck with these bonds, the losses will be real, but for the market as a whole it will not be material. We are getting well compensated for taking these risks today. After tax yields on municipal bonds are actually quite attractive. We do not like accepting the duration risk of buying long-dated bonds of any stripe, but intermediate term and shorter-term bonds also have fat spreads to Treasuries and plenty of excess return to reward the patient investor for taking the known and unknown risks. Keep your quality high and don’t stretch for yield. That extra 0.25% in yield will cost you a lot more in anxiety. When muni yields get back in line with Treasuries and the headlines have largely gone away, that will be the time to sell.
<strong><span style=”text-decoration: underline;”>Economic News </span></strong>
<strong>Housing starts</strong> were weak again in December, falling 4.3% to an annual rate of 529,000 according to the National Association of Home Builders. The rate was only worse in October of 2009. We should keep in mind that these rates of building are not sustainable forever. Each year, the US creates between 1.5 million and 2 million new households. Those folks have to live somewhere. The existing stock of homes has largely absorbed these new households over the last few years and may for a while yet. But, someday this will change. We got something of a hint of this in the building permits data that was released at the same time as housing starts. Permits jumped by 16.7% from November’s level. This may be a one-off due to stricter building codes in several major states that went into effect January 1.
<strong>Existing home sales</strong> rose pretty markedly in December. This is probably a case of many potential buyers jumping at the chance to finance near record low interest rates after rates began to rise. Haggling over a couple thousand dollars on the price or the terms suddenly didn’t seem all that important when the mortgage rate started rising from 4.5% toward 5%. Houses sold at an annual rate of 5.28 million in December (the actual number of homes sold in December was 404,000). That is a huge increase from November. The price of the median home sold in December was $168,800, down from $170,200 in November. Distressed homes, largely those in foreclosure, were 36% of total sales for the month.
<strong>Leading Economic Indicators</strong> gained for the umpteenth month in a row. It is too late to worry about this indicator, but we watch it none the less. The most recent gain of 1% for December was much stronger than expected. Forecasters have ramped-up the pace at which they expect to see the economy expand from 2.0-2.5% to 3.0-3.5% due to the continued strength in many parts of the economy. The manufacturing side of the economy, though small, is improving and there are several manufacturing elements to the LEI. Monetary policy continues to be very accommodative and that helps, too.
<strong><span style=”text-decoration: underline;”>Weekly Stuff</span></strong>
Last week gives us a great illustration of market dynamics. If you look at the Weekly Review piece, you will see that the Dow Industrials were up some 70 basis points on the week. Over that same week, the S&P 500 was down 75 basis points, the NASDAQ was off over 2% and the Russell was down over 4%. Uh? That’s right sports fans, what we have here is a very prominent divergence. It is far easier to explain than you might think, except for the Russell. The Dow was up because of General Electric and Boeing and IBM. All of these stocks are heavily weighted in the Dow and all had good news. All are also in the S&P 500, but not in the NASDAQ.
Apple Computer is in the S&P 500, the NASDAQ but not in the Dow. While GE was up some 6%, IBM 4% and Boeing 2%, Apple was down 6%. Apple also has a much bigger weight in the S&P 500 than GE, IBM or Boeing. That sums up the change pretty well.
There were a lot more stocks that fell last week than rose. This probably explains why the Russell 2000 was down so far. But, a lot of companies in the small caps are very sensitive to the action of larger companies that move the industry groups. Again, Apple’s decline hurt all the technology players and caused sales of ETFs attached to these micro groups.
We would be hard pressed to explain to some of our older colleagues how the company that made the Apple IIC was more important in today’s world than the maker of the 747, but that is the world we live in now.
With the US markets shaken by company specific news, foreign markets tended to be driven by macro topics. It was an interesting week in currency markets with the US dollar dropping by over 1% against the leading developed market currencies but far more against the developing markets. Currency explains the difference between the local currency market movements noted in the Weekly Review and the MSCI returns data. As an example, Brazil’s market was down some 2.5% on the week, but the Real was up over 4% against the dollar. Part of the drop in the market was attributable to the rise in the currency.
Bond markets around the world are still reeling from the renewed specter of inflation and growth. This could be just a scare, but it feels more like a belated recognition that growth especially in the emerging markets is real, is ongoing and is powerful. Treasuries down in the intermediate and long segments of the yield curve. High grade corporates and mortgages followed suit but high yield advanced for the week.
Real estate markets were confused by the crosscurrents in the markets. The financials fell hard last week and that would usually lead the REITs to follow. And, commodities were generally lower on the week, and that would usually argue that hard assets shouldn’t do well as well. But, real estate securities were about unchanged, with actual strength in the foreign markets. Go figure.
As mentioned, commodities were generally lower last week. That is particularly true of energy prices, precious metals and copper. The ag-complex was mixed. A better economy was recognized in the last few weeks as prices soared on many commodities. But, with the acknowledgement by governments and central banks that inflation was back, commodity markets seemed to strike a note of caution about what that meant. There seems to be a trend toward higher prices, but that is exactly what most people expect. “Most people” are frequently disappointed when their expectations don’t get realized.
We had hoped to get some sort of Jobs and jobs theme for this missive, but it just didn’t work out. Why couldn’t Jobs have started his leave the same week that the Employment Report came out? Oh well, we did what we could with what we had.
Have a great week.
Karl Schroeder RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.