|
US stocks
rise modestly in December, deliver worst annual return since 1937
It's hard to
overstate how much damage was done to the world's financial systems over
the last 4 months. Major events of
the last two years include:
·
July 2006 - Housing prices peak in US
·
July 2007 - Collapse of two Bear Sterns hedge funds
invested in mortgage backed securities
·
October 2007 - Citigroup, Merrill Lynch, other banks
reveal major losses on mortgage backed securities
·
March 2008 - Bear Sterns collapses, forced to merge with
JP Morgan
·
August 2008 - International financial system appears to
stabilize
·
September 2008 - Fannie Mae, Freddie Mac taken over by US
Treasury, Lehman Brothers collapses, AIG taken over, world credit systems
freeze
·
October 2008 - Treasury TARP program approved on second
attempt
·
November 2008 - Citigroup nearly goes under, US stocks hit
11 year low, commodity prices decline 50-70% from mid-summer highs
·
December 2008 - Auto industry bailout approved, US Federal
Reserve drops rates to a record low between 0-0.25%
Despite over $4
trillion pumped into the US banking system, and trillions more pumped
into European and Asian banking systems, none of the standard
counter-cyclical measures employed by the Federal Reserve have worked so
far. As fast as the Fed supplies liquidity,
liquidity is destroyed even faster as banks continue to write down
investments. The problem is
exacerbated by forced sales of virtually every asset class (US and
international stocks, corporate and municipal bonds, preferred stock,
commodities, securitized debt of any kind) by deleveraging hedge funds
and investors in general. The
value of US financial and real estate assets are down about $14 trillion
since January 2008.
The stock market
correction, which took US stocks down 12% through August 31st, turned
into a full scale rout September through November, exceeding the 1987
stock market crash. Only 25 of 500
stocks in the S&P 500 delivered positive returns in 2008; 161 or a
third declined 50% or more. Only 6
out of 1601 mutual funds delivered positive returns. Only Walmart and McDonalds delivered
positive returns in the Dow Industrials, while Citigroup lost 77% General
Motors lost 85%. For the year, the
S&P 500 declined 37%, which was the worst result for stocks since the
41% decline of 1931. From the
October 2007 peak to the November 2008 trough, US stocks declined 52%,
exceeding the 49% loss of the 2000-2002 bear market. Even after the 20% rally of the last 5
week, US stocks remain 42% below last year's record.
Current
state of the US and world economies
Business and
consumer confidence remained buoyant through July 2007, turned lower by
year end 2007 and utterly collapsed by October 2008. For consumers, a relentless slide in
housing prices, losses in stock investments and a sharp increase in
layoffs and the jobless rate took expectations to historic lows for the
series. Businesses are slashing
investment and hiring and scaling back production to keep inventories
low. Expectations about forward
conditions (the next 6-12 months) are equally pessimistic. The biggest problem is that the banks
that were willing to lend on generous terms through 2006 are now not
willing to lend at all. So net, US
GDP growth should be negative through at least Q2 2009, and possibly
through year end 2009. World GDP,
which grew robustly over the last 5 years, will be flat or negative in
2009.
What will
turn economic activity higher?
Falling housing
prices torpedoed the US economy; stabilizing housing prices, which we
expect some time in 2009, will set the floor for the next expansion. From January 2000 through July 2006,
prices increased 106%. Through
October 2008, prices have fallen 23%, with declines of up to 36% in the
frothiest markets of California, Nevada and Florida. About 10% of home-owners are in
financial distress and foreclosures are at record levels. As foreclosure sales are often made
20-40% below prevailing levels, these sales contribute to the sharp
reduction in average prices.
However, housing starts have plunged, which will keep inventories
from expanding. Mortgage rates are
at a 40 year low. Lastly, compared
to family income and prevailing rents, housing prices are falling back
into line with historic ratios.
Over the last 16
months, US and European banks have written off $1 trillion in securities
tied to mortgages. Further
write-downs may include mortgages tied to commercial property, but with
the Federal Reserve now committed to buying up to $600 billion in agency
debt (securities of Fannie Mae and Freddie Mac issued to fund mortgage
lending) further write-downs will be limited in 2009. As banks feel more confident about
their capital situation, hundreds of billions of dollars currently parked
in Treasury bills at 0.1% interest, or ten year Treasury bonds yielding
2.2%, will be redeployed to commercial lending. Through 2006 banks made aggressive
loans on thin margins (little profit.)
In the current environment, banks won't make conservative loans even
though margins are the widest in years.
As bank lending normalizes, economic activity will turn up.
What will
turn stocks and other investments higher?
After falling 25%
or more September through November, asset prices may already be turning
higher. The consensus of
economists is that we should prepare for a near depression over the next
year. The consensus of investment
managers is that asset valuations are at generational lows, and that we
should take advantage. The S&P
500 eked out a 1.1% gain in December.
However securities with yields gained handsomely in December. Preferred stocks gained 11.7%, REITS
gained 17.8%, investment grade corporates bonds gained 6.9% and high
yield gained 21.4%. A large
component of this rally was simply a cessation of forced selling by the
hedge funds. However, given a
choice between yields of 2.21% or less in Treasuries, or yields of 8-10%
in preferred stock, 6-10% in REITS and 8-25% in corporates, some
investors including ourselves are opting for the riskier securities.
Comments on
Bernard Madoff
As if 2008 wasn't
miserable enough, in mid-December we learned that Bernard Madoff, a
fixture of the securities markets since 1960, had swindled his clients of
as much as $50 billion. We were
astonished to learn that his Ponzi scheme runs back more than two
decades. Bayou Hedge Fund, which
cost its investors $450 million, lasted a couple of years. The SEC did not investigate Madoff's
fund despite multiple warnings because he claimed to have less than 25
investors and so was exempt from registration. In fact, each "investor" was
a fund representing thousands of individuals and corporations. We hope that this experience strips
away once and for all the fiction that investors in hedge funds, limited
partnerships and other trading vehicles are sophisticated enough to do
without SEC regulation of their investment managers. Our firm is registered with the SEC and
subject to exams about once every 5 years (we call it the "six week
colonoscopy.") There's no way
Madoff's firm would have stood up to that level of examination that we
routinely experience. The simplest
safeguard is to require that custody of assets be held separate from the
investment of assets, so that, as our clients know, there's a separate,
independent report of activities and balances from the custodian.
Strategy
It's a sad time
for our nation because the damage done to our economy is entirely
self-inflicted. No one forced our
citizens to take out mortgages they couldn't afford, and no one forced
our banks to invest in them. We
saw risks to the system as early as 2005, but we assumed, incorrectly as
it turned out, that others in the regulatory and banking system
recognized those risks and that the damage would be limited. We also assumed that the risks of
excessive leverage were learned after the 1998 failure of Long Term Capital. Instead, the level of systematic risk
taken on by banks and hedge funds in recent years exceeded the risk of
LTC by a factor of a hundred or more.
Even though we
failed to anticipate the market crash of this fall, we're not on margin
and not forced to sell otherwise sound companies. We sold a handful of stocks earlier
this fall in companies that we thought would not survive the crisis. If the markets continue to stabilize,
we expect to spend the first quarter rebalancing our clients' accounts
back to our core positions.
As always, please
don't hesitate to call with questions and concerns.
Yours sincerely,
David Edwards
President
The Heron Capital Management
client letter is published immediately following month end and when
market conditions require comment. The views expressed in this letter
represent HCMI opinion and strategy as of the date published and can
change at any time upon receipt of new information. Data quoted in this
letter are from sources deemed reliable, but no guarantee of such data is
implied.
|
