HCMI Client Letter - February 27th, 2007

Dear Clients and Friends,

“What was that?” wrote one of our clients earlier this afternoon.

One week ago, the Dow was at all-time highs, the S&P 500 and NASDAQ at six year highs and the S&P 500 was within a few percent of making a new all-time high.  Today, S&P 500 fell 3.47%, down 4.15% from the year’s high and down 1.18% on the year.  The NASDAQ fell 3.86% on the day, 4.64% in the last three days, but remains up 0.31% on the year.  Government bonds rallied in a flight to quality, but corporates fell as credit spreads widened.  The dollar fell as US interest rate returns fell relative to the Euro and Pound. 

The triggers were a 9% fall in the Chinese stock market last night on news that China’s government was looking into blocking illegal margin trading, news that US Vice President Cheney narrowly missed injury from a Taliban suicide bomber, and a worse than expected durable goods report in the US. 

By 11:30 AM, just as we saw in the October 1987 stock market crash, the computers took over, sending wave after wave of sell programs to the exchanges.  Thanks to advances in investment products such as Exchange Traded Funds (ETF’s), and advances such as “algorithmic trading” where computers blindly buy and short stocks based on miniscule fluctuations in valuation, investors can short the market at the click of a mouse.  Unfortunately, there’s no guarantee that someone will take the other side of the trade when massive sales hit the markets.  Stocks “gap down” rather than trade smoothly, which screws up the trading programs.  At 3PM, some sort of NYSE computer glitch caused the Dow to fall 156 points in a minute (the Dow was down nearly 550 points at that point, ultimately settling down 415.)

Was this correction a surprise?  Not really.  From the lows of last summer to last week’s high, the S&P 500 gained 19.9% - not bad for 8 months.  In recent weeks, we’ve had that “skating on thin ice” feeling – stocks have performed too well for too long.  Unfortunately, we never can anticipate exactly when stocks will take their correction (anytime in the last three months would have been a fair guess.)  Our strategy assumes that events like this will occur and we position ourselves accordingly.

·         We do don’t buy stocks on margin (so we’re never forced to sell into margin calls.)

·         We remain leery of investing in “emerging markets.”   Yes, there are fantastic returns as we saw last year (38.55% in the Citigroup BMI Emerging Markets Index), but also the risk of fantastic losses.

·         We invest in companies with real products, real revenues, and real earnings – companies that can ride out financial storms. 

What happens next?  This correction, or mini-crash, or whatever you want to call it, brings to mind both the October 1987 stock market crash in the US and the 1997 “Asian Contagion” financial crisis, which morphed into the Russian crisis of 1998, which resulted in the failure of Long Term Capital, a hedge fund, which threatened the solvency of the US monetary system. 

In 1987, the introduction of computer driven “portfolio insurance” products lulled investors into a false sense of security about their portfolios.  In 2007, the proliferation of ETF’s, derivatives, and swaps has lulled investors into taking ever bigger risks to secure constant levels of returns.  Not only are interest rates low, but the differential in yield between US government bonds, the most secure income vehicle, and other credit products (corporate bonds, mortgage backed securities, emerging market debt, high yield debt) are at record low levels.  Investors who buy these products on margin, for example hedge funds who short the government market and use the proceeds to buy higher yielding bonds, are particularly at risk.  Another financing trick of late is to borrow in markets such as the Japanese yen with particularly low yields, convert the cash into dollars, and use the proceeds to buy higher yielding securities.  If spreads in any of these strategies widen, the investor can be wiped out in days, losing both on the shorted government bonds and the purchased non-government bonds.

In the decade through 1997, Southeast Asia, including Thailand, Malaysia, Indonesia, the Philippines, Singapore and South Korea, experience high rates of capital inflows and high rates of economic growth.  Stock markets in that region soared, but currency relationships came under pressure.  In July 1997, the Thai baht lost half its value, the Thai stock market fell 75% and key Thai financial intermediaries were bankrupted.  Financial support from the International Monetary Fund (IMF) was too little and too late.  Like the flu, the crisis spread to Thailand neighbors, causing a sharp contraction in economic activity and a sharp drop in the value of industrial commodities as demand receded.  By October 1997 worries spread to the United States, causing the Dow to fall 554 points or 7.2%, on October 27^th, the 3^rd largest point drop and the 12^th largest percentage drop in stock market history.  The following day, the stock market regained about 60% of the previous day’s losses.  Still, the crisis was not over.  By 1998, oil prices fell to $8/barrel, severely stressing OPEC nations and Russia.  Defaults on Russian bonds in the summer off 1998 led to the failure of Long Term Capital.

So what are the parallels with today?  Liquidity is the chief factor to watch.  Liquidity means that investors can buy into stock, bond and credit markets when they want to, and can sell when they want to get out.  Liquidity dries up when market makers, which include brokers, stock exchanges, banks, mutual funds, investment companies, and hedge funds, are afraid to participate.  In China right now, market makers are afraid to buy Chinese stocks because they don’t know how aggressively the Chinese government will pursue the current program of reducing speculation.  So investors that need to sell Chinese stocks for whatever reason can’t get out.  So they’re force to sell what they can, which is how the “flu” spreads.  Today, we saw the flu spread through Asia, Europe and the US all within 24 hours.  We reasonably expect Asian markets to fall Wednesday, and European markets in sympathy.  What happens in the US next will be interesting.  We expect US stocks to open lower, but close higher as bargain hunters swarm back into the system.

Strategy

Corrections are a fact of life in stock investing, but trading out now in the hopes of getting back in later is a sure-fire “Sell Low-Buy High” strategy.  We held tight through the last correction (May-July 2006 –peak to trough decline of 8.1% in the S&P 500), were amply rewarded, and we’ll hang tight now.  Want to test your knowledge of stock market history?  What caused last summer’s correction (answer below, email us if you get it right.)