What the heck is going on out there!
From a near record close on October 31st, the S&P 500 plunged 6.1% QTD, mostly in the last 24 hours. Hardest hit are the financial service stocks, with notables such as Citigroup down 29.5% QTD, Merrill Lynch down 25.1%, Freddie Mac down 23.9% and two of our long time favorites AMBAC down 60.8% and MGIC Investment Corp down 42.2% QTD.
The declines are all related to the "credit crisis" which, to recap, started with junk mortgages issued to unqualified borrowers, which were then packaged into Mortgage Backed Securities, which were then sliced into Collateralized Debt Obligations (CDO's) which were then stamped with investment grade ratings and sold to hedge funds, who purchased them with borrowed money to capture the spread. Every participant in this process made money right up until this summer, when investors discovered - Surprise! - that the underlying mortgages were no good.
As this whole system unwinds, investors who have nothing to do with CDO's are none the less getting rocked by the more aggressive ones. The analogy that we like employ in times like these is as follows:
An ocean liner has sunk and the survivors are in a lifeboat. .. Half of the passengers are sitting in their seats, pulling on the oars and bailing if necessary. The other half are frightened by the waves and are frantically throwing themselves from port to starboard. With each iteration, some water splashes in and occasionally a passenger falls out. Over the horizon is land; if the passengers keep cool, they'll get to safety.
How does this apply to the stock market? The US Stock Market, through crisis after crisis (World War's I and II, the Great Depression, the Kennedy Assassination, the 9/11 attacks) grew at an 8% annual rate from 1900 to the present, and 10%/year from 1945 to the present. We reasonably project the stock market to average 8% annual gains for the indefinite future. Our firm, and firms that run straightforward long only portfolios, separate accounts and mutual funds, are like the passengers pulling on the oars. If we do our job buying reasonably priced stocks in companies we expect to grow at reasonable rates for at least 5 years on average, and if we spread our investments around by industry sector and stock market capitalization, we should be able to deliver those historic returns for our clients (and get to land.)
Meanwhile, the aggressive investors, the hedge funds that are both long and short stocks, or who have bought stocks on margin, or who are running the "quantitative" strategies that blindly buy and sell stocks based on minute fluctuations in value (and currently account for 80-90% of the daily trading volume of the NYSE) are like the panicking passengers. In a year during which we forecast that the S&P 500 would rise 8-10%, the "quants" are driving the markets to price swings of 3%/week or even 3%/day. Even so, this frantic trading does not seem to have accrued much benefit to hedge fund investors as a dozen or so major funds (and an unknown number of smaller funds) have gone bankrupt in 2007 (those are the passengers that fell overboard.)
Structural changes in the organization of US stock markets have increased volatility. As recently as 15 years ago, specialists at the NYSE and NASDAQ market makers stood by with capital buying stocks when the preponderance of investors wanted to sell, and selling when the preponderance of investors wanted to buy. The spread captured on each trade delivered a reasonable rate of return to the market makers. However, markets have become ever more "liquid" and spreads became ever more narrow and therefore less profitable, so specialists have withdrawn from market making. Furthermore, alternate trading mechanisms have removed much trading from the exchange floors. On the NYSE, trades of up to 10,000 shares are settled electronically through SUPER-DOT (a computerized matching service run by the NYSE,) while blocks of 50,000 shares and more are generally traded off the exchange in crossing networks. Only 3% of NYSE trading volume actually occurs at the NYSE anymore, which is why the trading floor looks spookily empty these days.
Other structural changes include the elimination of the "down tick" rule. Until July 2007, if an investor wanted to short a stock, the trade could only be executed on an even or up tick in the price from the previous trade. This rule dated from the 1930's after the Stock Market crash, when speculators could drive down a stock by piling on the sales. Lastly, a short seller is supposed to borrow the underlying shares to deliver on a short sale, which historically limited the amount of selling pressure on a company (can't borrow the stock, can't sell it short.) However, the ability to short futures or short ETF's, which represent baskets of underlying stock, has enabled investors to get around this limitation, essentially enabling them to short more stock than is actually in circulation.
So now we have a situation where a little "friction" in the system, as opposed to perfect "liquidity," might be a good thing. If bad news comes out about a company, for example, Citigroup's recent write down of $6 billion in assets, with the potential for another $11 billion later, a reasonable amount of selling is warranted (earnings will be reduced, and it's possible that the dividend, currently at 6.6%, will have to be cut.) The patient investor might make the observation that Citigroup, with 275,000 employees spread across 107 countries managing $2.2 trillion in assets, and with nearly 200 years of operating history, is not going out of business tomorrow. But you wouldn't know that from this week's price action, where everyone seems to be selling into a vacuum. The selling in Citigroup will exhaust itself eventually, and then the stock will rise to something reasonable. The CEO has already been asked to step down, and there's talk of unleashing value by splitting the company into more manageable components. That's a relatively bullish story compared to General Motors (which took a huge writedown this week and seems to be trending ever closer to bankruptcy.)
What we're focused on:
- Q3 earnings once again surprised to the upside, 11.2% versus expectations of 8.0
Q3 GDP also surprised to the upside, gaining 3.9%. Exports surged on weak dollar
Employment still strong, still near the lowest levels of the last 40 years
Disconnect between performance of financial firms, carmakers and homebuilders (awful) and rest of the US economy
But:
- Fed cuts in interest rates causing dollar decline which feeds into rapidly rising commodity prices, particularly oil
Structural changes in the operation of US markets exacerbate swings both to the upside and downside.
Investors completely unable to perform rational analysis, dumping stocks without regard for valuation.
Strategy
Bottom line: if this was 2000 all over again with stock market valuations double fair value, we'd probably be selling stock right now. But with the stock market currently estimated at 13-17% BELOW fair value, we're looking to buy as soon as we get any sense that the market has stabilized.
As always please don't hesitate to call with concerns.
Yours sincerely,
David Edwards
President