General Motors filed for bankruptcy and Chrysler has emerged from bankruptcy. Both hope to become stronger and leaner companies. They may emerge as stronger and leaner, but given today’s automotive market, can they make money?

Both GM and Chrysler can make quality cars. After decades of trailing Japanese standards of quality and efficiency, domestic automakers have largely caught up. GM’s market share even went up in 2007. The Chevy Malibu, Cadillac CTS and Buick Enclave are all extremely popular cars. GM’s hybrid Chevy Bolt (scheduled for a 2010 launch) is supposed to be superior to Toyota’s Prius. Overseas, GM does extremely well, accounting for 65% of its sales. Its Latin American presence is strong and has a leading market share in China at 12%.

The real question is whether GM and Chrysler can make those quality cars at a profit. Many blame GM’s downfall on their contracts with the United Auto Workers. The reality is GM used to have an added cost of $1,400 for each car due to its health-care promises to employees. This was reduced after a 2007 agreement which shifted the liabilities into a union run trust. New hirers also earn wages in line with Toyota and Honda’s US factories. Despite this reduction, GM still fell into bankruptcy.

GM will continue to have liabilities to the union at a rate of $600 million per year in preferred stock dividends. This should be about $300 per car if GM hits its market share goal of 2 million cars domestically. The cost per care is less if it gains more share. And retirees are also being replaced by less expensive labor with compensation to match GM’s competitors.

GM can no longer use its labor structure as an excuse. There still is a brand problem for the companies. Growing up in the 1980s, I learned that Toyotas will last forever while a Chevy will fall apart after a couple years. While the quality gap has been closed, the perception is still there—Toyota cars sell for $3,000 to $10,000 more per similar size car to GM. In addition, consumers are aware that many Toyotas, Hondas and Mercedes are actually manufactured in the South, so the foreign/domestic line is blurred. If a consumer wants to buy American, Ford may be the target anyway as they avoided a bailout.

And while GM and Chrysler go through their restructuring, competitors are taking advantage. Volkswagen is building a new factory to churn out 250,000 cars year and aims to triple its market share from 2% to 6% by 2018. It should be noted that while this is bad for GM and Chrysler, it’s actually good for autoworkers as their expertise will be needed in any new plants opening in the US.

The added competition means GM and Chrysler are going to be in a dogfight for market share. Can they make money in today’s car market? GM’s plan calls for them to breakeven when the domestic market is selling 10 million cars per year (it’s currently at 9.5 million) and their market share is about 18.5% (vs. their current share of 19.5%). This is how the $300 pension liability is calculated as their 18.5% market share translates to about 2 million cars. Some of the estimates might be a little optimistic. The 10 million is high in today’s economic climate. Their market share may fall further as people avoid buying from a company in bankruptcy. And any fall in sales increases their pension liability per car, making it even harder to break even.

GM and Chrysler have other issues. GM’s pension is underfunded by $13 billion. If the companies return to the private sector, as intended, their cost of borrowing will be affected by the bankruptcy. Secured creditors were jumped in line by unsecured creditors (the UAW) during the bankruptcy proceedings, upsetting bankruptcy laws. An Indiana pensions fund representing teachers and police officers challenged this result. The US Supreme Court declined to hear the challenge, but the proceedings will make future lenders warier.

At the end of the day, the real problem is the dichotomy between the world’s annual manufacturing capacity (90 million cars) and the world’s annual car demand (60 million in good times). Long term, the demand for cars will exist as emerging markets grow and citizens’ increase their purchasing power. The IMF forecasts the number of cars worldwide in 2050 will be 3 billion, more than four times the current rate of 700 million. However, in the short term we are clearly making too many cars.

GM and Chrysler recognize this and included cutbacks in factories, workers and dealerships in their bankruptcy plans. This is a necessary step and should be done in the most efficient manner—i.e. closing the most out-dated manufacturing facilities and the least profitable dealerships. The government is already interfering with these needed steps. Senators questioned the closures in their states on June 3^rd; Senator Mel Martinez asked “what rhyme or reason is there to this?” The debates will only slow GM and Chrysler’s recovery.

Of course, even if GM and Chrysler cut capacity, the competition doesn’t have to follow suit. Other governments are supporting their car companies. Germany has already stated its manufacturers will not shutter factories in face of a decline.

At the end of the day, there are too many car manufacturers fighting over too small a pie. This is a fundamental problem for all car manufacturers. GM and Chrysler may be the weakest and therefore the first to face bankruptcy, but at the end of the day capacity must be trimmed.  Until then, making money is going to be hard, especially for GM and Chrysler.

A 42 gallon barrel of oil has the same energy content as roughly 6,000 cubic feet of natural gas. Given this equivalence, one would assume that the market price for these two hydrocarbon resources would be about the same. However, oil is roughly three times as expensive as natural gas now.

Price differences between these commodities could arise for a number of reasons. Oil is literally and figuratively a more liquid commodity. Once pumped out of the ground in Mid-East, Africa or North America, oil can be transported anywhere in the world through a network of pipelines and tankers. Natural gas is a much more local commodity and is mainly transported via pipelines. Natural gas can be converted to a liquid state (liquid natural gas or LNG) and shipped similar to oil; however, there are a number of hurdles to this process including restrictions in this country that limit the building of LNG processing facilities in our coastal areas due to environmental concerns. The fact that oil is easier to transport suggests that it deserves a slight premium to natural gas.

On the other hand, natural gas is a cleaner fuel than oil. Burning natural gas produces less nitrogen and sulfur oxides than oil and is better for the environment since smog is reduced per unit of energy produced.

Over the past 15 years, the price of natural gas has fluctuated between 30% and 200% of the price for oil. During this period, it has averaged about 75% on a monthly basis. Right now, natural gas is very close to an all-time low selling for 35% of the price of oil. The low price of gas relative to oil suggests that either oil is too expensive, natural gas is too cheap or a combination of the two.

Over time, we believe that natural gas will increase in price relative to oil. The main mechanisms by which this will occur are demand substitution of gas for oil at the margins and supply expansions of oil relative to gas. Utilities that use both oil and natural gas have a strong incentive to substitute natural gas for oil since it is much more cost effective. Boone Pickens, energy magnate, is lobbying the government hard to convert cars to natural gas to decrease our reliance on foreign oil. These efforts may tip the balance toward natural gas in the distant future, but are by no means assured. Energy suppliers will focus more on oil production since it garners a much higher price in the marketplace so that the supply of oil should increase at a faster rate than the supply of gas. Regardless of how the change in the intersection between supply and demand occurs, the relationship between oil and gas prices will revert closer to parity.

There has been enough evidence recently to determine that the worst strains in the financial system are behind us. The results from the government's stress tests indicated that the largest banks needed to raise about $75 billion in capital. After a flurry of activity during the past week, those banks have already raised over 75% of that amount including the $13.5 billion stock offering from Bank of America earlier this week. The fact that private investors are risking their own money is a very positive sign that the crisis has passed. Three-month LIBOR rates are down in the 0.6% range from over 2% last year and banks are lending to each other and not fearful that their short-term loans will not be repaid.

Measures of volatility have also decreased markedly. The VIX (a volatility index derived from futures prices) is trading at about 30 which is lower than any time since Lehman Brothers went bankrupt in mid-September 2008. In November of last year, the VIX reached 80 and the index was as high as 50 earlier this year. For reference, the long-term norm is a reading of 20.

Finally, oil prices have almost doubled to about $60 per barrel from their levels earlier in the year. Commodity prices reflect expectations regarding future demand and supply. Assuming supply is flat to slightly higher, the market is indicating that it expects demand to increase as the global recession abates.

We are bullish, but not unreservedly so given continued areas of concern. Even though the rate of increase in unemployment has slowed, high levels of applications for unemployment suggest that the level of joblessness in the population is increasing. These increases will dampen consumer spending and the overall economy. Our trading partners are also in bad shape as depicted graphically on the front page of this morning's Wall Street Journal. Japan and Germany's export driven economies contracted at over 15% and 14% per annum respectively during the 1st quarter of 2009. Crippled by the global recession and the early stages of the H1N1 virus, Mexico's economy contracted at an annual rate of over 21% during this period. These numbers indicate that US exports will slow since our trading partners will not have the resources to purchase goods and services from us.

Even though stocks have rebounded 30% since the lows reached in early March, we expect long-term returns from stocks from their current levels to be superior to the alternatives (cash, bonds, real estate etc.). However, if last year's losses caused too much anxiety indicating that a lower risk profile is more appropriate, then it would be prudent to reduce your equity allocations now. This change would lower risk, but also decrease potential investment returns going forward.

“These," he said gravely, "are unpleasant facts; I know it. But then most historical facts are unpleasant." - Aldous Huxley, Brave New World, Ch. 2

The shockingly rapid retreat of the economy and the stock market continued during the first quarter of the year. While the emotional toll has been wrenching, intellectually, it has been intriguing to watch our financial system and government respond to the shocks.

During the expansion that ended in 2007, credit financing mainly grew through the securitization of debt, especially mortgage debt. Wall Street packaged debt taken on by consumers and businesses and sold securities based on that debt to investors hungry for yields that exceeded what they could obtain from buying traditional bonds. This mechanism of financing for all types of purchases from houses to automobiles and commercial real estate has dried-up completely since mid-September of last year.

Our government has responded extremely aggressively by pumping incomprehensible amounts of money into the system. Aside from the explicit stimulus bill, the Federal Reserve has committed to purchasing $300 billion in Treasury bonds and $1 trillion or more of mortgage-backed securities. The goal is that purchasing the bonds will lower interest rates which will then entice borrowers to spend. The Public-Private Investment Program was also finally introduced after Treasury Secretary Geithner’s failed attempt in February. This program recruits private investment managers to buy depressed securities and loans from the banks using government financing. The basic idea is to create a market for various “toxic assets” that the banks can sell to these private funds and as a result banks will then feel free to expand their lending. The problem with this plan is that the banks may not want to sell the assets unless they receive top dollar.

The second casualty of the credit crisis has been a global demand destruction and recession. Consumers are afraid to spend and prefer to save as much as possible. Businesses are also leery about pursuing expansionary projects while their revenues and earnings are falling.

Given the interconnectedness of our global economy, no region has been spared. Unemployment continues to rise dramatically in the US as businesses race to reduce their costs. Asian exports from Japan and China have decreased about 25% compared to last year. Many developing economies, especially in Eastern Europe, are crumbling since these countries are not able to service their debt in Euros. During this writing, the G-20 is meeting to negotiate a more coordinated stimulus through the International Monetary Fund.

The severity of the imbalances in the financial system and the world economy will take years to heal; however, there are signs that recovery is occurring in certain sectors and that the downward spiral will not last indefinitely.

Housing sales are starting to increase in the hardest hit locales. Orders for durable goods and retail sales appear to have bottomed during the first quarter.

Additionally, merger and acquisition activity has been very robust in the U.S. According to Dealogic, businesses worth $215 billion were acquired during the first quarter which is 39% above last year’s volume. In the pharmaceutical space, Pfizer is buying Wyeth for $68 billion, Merck agreed to acquire Scherring-Plough for $41 billion and Roche is acquiring the piece of Genentech that it does not already own. Other transactions include the recently leaked deal that IBM is buying Sun Microsystems.

Each of these acquisitions was accomplished by payment of significant premiums to the market prices of the stocks when the deals were announced. News of IBM’s acquisition was reported before formal terms were announced, but Sun’s share price has doubled from its level prior to the news. The Wall Street Journal reported that IBM will pay roughly $7 billion which is almost a 100% premium to Sun’s market capitalization two weeks ago. Pfizer is paying a 30% premium to acquire Wyeth in cash and stock. To finance the purchase, Pfizer had to issue $13.5 billion in debt. Similarly, Merck paid a 34% premium for Scherring. While these deals are primarily defensive in nature (the pharmaceutical companies are trying to diversify their offerings and cut redundant costs to boost earnings as top-selling drugs lose patent protection), the acquisitions suggest that savvy managements believe that these combined businesses will profit. The managers are also making a judgment that they feel comfortable issuing debt and expect conditions within their markets to improve.

Similarly, we view the equities in client portfolios as underpriced even given the recent rebound. Capitalism is not dead and patient investors will be rewarded even though we expect continued volatility in the near term.

Mark-to-market accounting has become a point of contention among banks, investors and politicians during the current financial crisis. Banks, with the help of politicians, blame the accounting rules for ruining otherwise healthy institutions. The argument is that banks are forced to write down assets to artificially low prices (because the market for the assets has ceased to function). These write-downs then reduce the bank’s equity and force them to conserve cash and restrict lending. On April 2^nd, the FASB (accounting standards board) passed new accounting rules easing the mark-to-market requirements.

The rules require a company to write down the value of an asset if it becomes “other-than-temporarily-impaired” and recognize the loss on its income statement. In the past, banks could avoid an asset write down if the bank had the ability and intent to hold on to the asset until its value recovered. With the rule change, now the bank only has to intend to hold on to the asset and be more likely than not to do so.

In addition, the bank does not have to recognize losses related to the market conditions, only those related to the underlying creditworthiness. For example, if a bank has mortgage backed securities (MBS) worth $10 million in book value that have a current market value of $6 million they don’t have to recognize the entire $4 million loss. They could state that $3 million of the loss is due to market illiquidity and only $1 million due homeowners’ not paying their mortgages. As a result, they only write down $1 million and their equity is reduced by $1 million.

Basically, the new rules give banks more freedom in determining whether or not they will write down an asset. The arguments in favor of the rule change are focused on the illiquidity of the current market for MBS. Banks are arguing that based on the underlying homeowners’ creditworthiness, these assets are worth near book value because most homeowners are still paying their mortgage. In other words, their cash flow valuation is near par. The only reason the market is giving such a discount is that everyone is afraid to buy these assets due to panic/fear. Of course, the fear is that the homeowners are not going to pay.

Banks are happy with the new rules because they now have more discretion in determining the value of their balance sheet. Banks have an incentive to put an inflated value on their assets which increases their lending ability and maybe even their stock prices. Some investors are not as happy because bank balance sheets are less objective. The investor just wants an accurate valuation. If a bank shows $100 million on its balance sheet, an investor should feel confident the bank could dispose of those assets for $100 million. Asset valuation is very important since the banks themselves borrow so much money. Unfortunately, the banks themselves do not have the ability to also reduce what they owe to their creditors.

One supporter of the rule compared it to an individual’s portfolio getting hit with a paper loss. He stated that if you buy a stock worth $10,000 and expect it to climb to $25,000, if it falls to $6,000 you don’t write off $4,000. You hold the stock and hope it climbs to your predicted $25,000. While this may be true, if you went to borrow money against the stock, no bank is going to assume it’s worth $25,000, or even $10,000. They’ll use $6,000.

Banks, on the other hand, are asking us to assume it’s worth $25,000 and value their stocks accordingly.