October
2008 - the month that nearly broke the world financial system
By mid-October 2008, the bankruptcy of Lehman Brothers had
morphed into a far more serious crisis.
Bear Stearns was absorbed into JP Morgan in March 2008, Fannie Mae
and Freddie Mac were effectively taken over by the US government in
September 2008, but the failure of Lehman Brothers over the weekend of
September 14th created a crisis of confidence that nearly
broke the world financial system.
The US government was forced to take over AIG, an insurance
company with a "Financial Products Group" that had created a
liability of $85-200 billion as a result of writing "Credit Default
Swaps" on Lehman and other bank debt. Of even greater alarm, failure of
Lehman Brothers commercial paper caused institutional and retail
investors to doubt the safety of money market funds. As billions of dollars roared out of
money market funds, bedrock US corporations like General Electric and
McDonalds feared that they could not fund daily operations. The US Treasury issued a blanket
guarantee of money market funds in late September, and also outlined a
"Troubled Asset Relief Program" to restore confidence. Congress
initially failed to authorize the $700 billion program on September 29th
by passed a slightly revised version on October 3rd. The 4 day delay kicked away whatever confidence
remained.
Bank stocks cratered, with Washington Mutual the largest
bank failure in US history and Merrill Lynch, Morgan Stanley, Goldman
Sachs, and Wachovia tapped as the next banks likely to fail. On October 10th, the S&P
500 opened at 902, fell as low as 839, rallied as high as 937 but
finished the day virtually unchanged despite a record 11.5 billion shares
traded and an intra-day swing of 11.5%.
Stocks swung around 10%/day for the next several days on triple
average volume, rallying back above 1000 on the election of Barack Obama
before sliding 26% by Thanksgiving and 34% to a decade low of 666 on
March 6th.
One year later, all seems eerily calm with the S&P 500
trading at a 52 week high of 1097 (but still 29.9% below the October 2007
record,) intraday moves averaging around 1% (same as September 2007) and
daily volume around 4.7 billion (versus 3 billion in September
2007.) A number of our clients
have expressed concern that we are poised for another sickening meltdown,
so to address those concerns we have compiled:
30 things to worry about (and why we're staying invested)
Investing success is bottom up (finding companies with the
characteristics to be successful) and top-down (recognizing the big
trends that boost some companies and economies forward while overwhelming
others.) As we are primarily
investors in US stocks and bonds, we pay particular attention to those
trends that could aid or harm the United States. However, as more than 50% of the
earnings and revenues of our companies come from non-US operations, we
also keep an eye on events around the world. The topics outlined below represent the
top 30 things we worry at present about while investing for our clients.
Geopolitics
1. Iran - 30 years after the Islamic
Revolution, President Ahmadinejad of Iran still rails against the
"Great Satan," seems hell-bent on acquiring nuclear weapons
(and the missiles to deliver them) and seems determined on military
conflict with Israel, the United States or both. Two thirds of the population born since
1979 wearies of the regime's increasingly repressive religious
governance, high unemployment and stagnant economy. The disputed June re-election of
Ahmadinejad may one day be remembered as Iran's "Berlin Wall
moment," the event that exposed the weakness of East Germany and the
entire Soviet bloc.
2. North Korea - Another country whose
entire governance is based on "regime survival." With a collapsed economy 0.3% the size
of the United States and 3.0% the size of South Korea, North Korea
none-the-less has managed to tie up the US, China, Japan, Russia and
South Korea in years of fruitless discussions to limit North Korea export
of nuclear technology. Probably
the most totalitarian police state in the world, North Korea
characterized US food aid sent to alleviate famine (perhaps 2.5-3.0
million died 1995-1998) as "tribute." "Eternal President" Kim
Jong-Il is 68 and may have suffered a stroke in the last year. Kim's 25 year old third born son Kim
Jong-Un is the designated dynastic successor.
3. Israel/Palestine - The area west of
the Jordan river, bounded by Lebanon and Syria to the North, Egypt of the
South has been disputed territory ever since European Jews immigrated
there starting in the 1920's and 30's.
Conflict increased following the 1947 partition into Jewish and
Arab territories, and over 700,000 Arabs were displaced into neighboring
countries following the first of several wars in 1948-9. Israel's victory over Egyptian, Jordanian
and Syrian forces in the 1967 6-day war was followed by another victory
over Egyptian and Syrian forces in October 1973, which led to the first
oil embargo by Saudi Arabia and other oil states.
At this point,
Palestinian Arabs are as likely to regain ancestral homes in modern
Israel as Israeli Jews are likely to regain ancestral homes in Europe (or
for that matter Aboriginals in Australia or New Zealand, or Native
Americans in the United States or Canada.) However, as long as the "peace
process" holds out the hope of restitution for Palestinian Arabs,
the conflict will remain a thorn in the side of US/Arab world
relations.
Israel is thought
to have 75-200 nuclear weapons and has a history of taking out nuclear
threats (Iraq in 1981, Syria in 2007.)
The current worry is that Israel will attack Iranian nuclear
facilities with or without US support, which could trigger another Arab
oil embargo or a broader conflict between Israel, Iran, Syria and the
United States.
4. Iraq/Afghanistan/Pakistan - The
United States is trying to extricate itself from Iraq to free up troops
to stabilize Afghanistan and go after al-Qaeda leadership in the border
region between Afghanistan and Pakistan.
The initial euphoria of the success of the 2003 invasion (6 weeks
of combat, 139 US military killed) dissipated amongst the harsh realities
of governing a dysfunctional and heavily armed society (over 4,000 US
military killed since April 2003.)
At this point, the
United States has turned primary responsibility for security of the
country over to the Iraqi government and will reduce current troop
strength from 124,000 to 50,000 by 2011.
President Jalal Talabani, by ethnicity a Sunni Muslim Kurd, and
Prime-Minister Nouri Al-Maliki, a Shia Muslim Arab, are responsible for
governing a country still reeling from internecine conflict among the
three major ethnic groups and dozens of tribal associations. Nearly 1700 suicide bomb attacks have
been recorded since 2004. Though
the current levels of violence are reduced, there is still the threat of
a complete collapse of order.
The United States
currently has about 42,000 troops in Afghanistan and could raise that
level to 68,000 by the end of this year.
The Soviet Union failed to pacify Afghanistan with 100,000 troops,
despite 15,000 killed (1 million Afghanis killed) over a nine year
conflict which ended in 1989. By
1994, the "Taliban" had taken over the country, eventually
giving shelter to Osama bin-Laden and other al-Qaeda leaders. Driven from power in the December 2001
invasion of Afghanistan by the United States, the Taliban regrouped in
the Afghan Pakistani border and now control much of Afghanistan, primarily
rural territory in the South and West.
To defeat the Taliban, the United State must double or even triple
its commitment of troops and weapons, but at risk of leaving the military
woefully over-stretched.
Pakistan is an
arid country about 10% larger than Texas but inhabited by 175 million
people (versus 305 million in the United States.) Like Iran, Pakistan's economy is in
shambles, so a vast supply of under-employed or un-employed youth are
ready converts to fundamentalist Islam.
The North West Territories are virtually ungovernable by the
central government in Islamabad and are believed to be the current
hide-out of Osama-bin Laden, Ayman al-Zawahiri and Mullah Omar. US Special Forces and unmanned aircraft
are currently operational in the tribal regions attempting to identify
and kill Taliban and al-Qaeda leaders.
While Pakistan has pledged to assist the US in this effort, many
analysts feel that the Pakistani Inter-Services Intelligence Agency
continues to assist and protect al-Qaeda leadership.
The ISI is also
blamed for promoting attacks against Indian interests in the disputed
territory of Kashmir. Two
conventional wars were fought between India and Pakistan and in 1965 and
1971 and the two countries have been at the brink of nuclear war several
times since 1998. Pakistan is
thought to have 70-90 nuclear weapons.
India is thought to have 45-95 weapons, but a wider and more
sophisticated array of delivery options (missiles, aircraft, and
submarines.) Additionally,
analysts worry about Pakistan's nuclear weapons falling into al-Qaeda
hands if the civilian government should collapse.
5. China as exporter and lender - China
is currently the world's third largest economy with about $8 trillion in
GDP versus the United States at $14.3 trillion and the European Union at
$14.9 trillion. There's some
dispute as to how "real" Chinese economic statistics really
are. For example, a 2007 World
Bank study concluded that after making adjustments for "purchasing
power parity," the Chinese economy was 40% smaller than
previous estimates. Still, with
economic growth rates average 8-10%/year over the last three decades,
versus 2-3% in the United States over the same time frame, some
economists wonder not if but when the economy of China will be bigger
than the United States.
This concern
illustrates what we call "the fallacy of straight line
projections." China started
its current growth spurt from an exceptionally low base following the
stagnation of the Mao Zedong era (1949-75.) With nearly 20% of the world's
population (US is 4.5%,) a land mass equal to the United States, and a
history of manufacturing running back several thousand years, it is
certainly plausible that China could overtake the US by 2020. However, as the key driver of Chinese
economic growth is exports to the US, there's a limit of how much more
exports can drive growth. About
30% of Chinese GDP is driven by consumer spending versus about 70% in the
US. The Chinese government has taken
modest steps to adjust how their economy functions (allowing a 28%
appreciation in the Yuan over the last seven years, increasing spending
on health, education, social security and infrastructure.) However, as long as the Communist party
retains complete control of the government, China will struggle to
develop into a mature economy.
China has
accumulated $800 billion of US Treasuries
(Japan is the second largest holder with $724 billion, the United
Kingdom third with $220 billion.)
Exporters receive dollars for goods, exchange those dollars for
Yuan at the Chinese central bank, which buys Treasury Bonds to obtain a
return, but also keeps the Yuan undervalued relative to the dollar. The alternative would be to allow the
Yuan to appreciate and let Chinese consumers and industries import more
goods from the US, but China wouldn't be delivering plus 8% growth rates
anymore. China needs those high
growth rates to absorb workers flooding into cities from rural
areas. Now China is stuck. Letting the Yuan appreciate 20% would
lop $160 billion off the value of the Treasuries it holds, but not
letting the Yuan appreciate continues the imbalances which led to the
current situation. Chinese
officials have mused publically about setting up an alternative to the US
dollar as a reserve currency (the Euro?) but so far only the US Dollar and
US Treasury bonds offer the liquidity and security that central banks
crave.
Demographics
6. Overpopulation - the world's
population reached 1 billion in 1804, 2 billion in 1927, 4 billion in
1974 and is currently estimated at just under 7 billion. Fortunately, as economies reach a
certain level of maturity, populations tend to level off or even
shrink. The populations of Russia,
Germany, Italy and Japan are currently shrinking, and the population of
the US would be shrinking except for immigration. Demographers expect total world
population to level off at 9.5 billion in 2050-2100. Even so that would be 37% increase of
humans in an already crowded planet.
The worst case scenario is that the populations of rapidly
developing China and India (37% of total population) start consuming
resources (water, food, energy, materials) at the same level of Americans
and Europeans - the world's resources area already stressed enough.
7. Shrinking and aging populations - As
societies develop, families shrink from 3-5 children/mother to 1-2
children. Meanwhile people are
routinely living into their 70's and 80's but retiring much earlier. When US Social Security was first
established in the 1930's, the age to receive benefits matched the
average longevity of a US citizen.
In 1950, 16 workers supported 1 retiree. At present 3 workers support 1 retiree,
and within 10 years the ratio could drop to 2:1. For most people, the bulk of lifetime
medical spending occurs in the last 5 years of life. The United States already spends 1/6 of
GDP on healthcare, and this percentage could rise dramatically over the
next 25 years. Japan is in a
similar situation, while Russia could lose 20% of its population over the
next 40 years. Most societies
borrow from the next generation to support the current generation of
retirees, so shrinking and aging populations could disrupt this social
safety net.
8. Pandemics - SARS in 2003-4 and the
current strain of H1N1 ("Swine") flu are minor inconveniences
compared to the pandemic flu of 1918-19, which killed 50-100 million
people worldwide out of a population of 1.5 billion. Medical knowledge and public healthcare
are significantly advanced since the last century, so most disease
outbreaks in recent years have had modest economic impact. However, while the rate of infection
and mortality of HIV/AIDS is significantly reduced compared to the 1980's
(first case dates to 1969) it is possible that 90-100 million Africans
out of a population of 1 billion will die of the disease between now and
2025.
People tend to
react disproportionally to the risk of a pandemic. For example, last spring American
parents yanked their children out of schools and whole school districts
closed as confirmed cases in the US exceeded 21,000, including 87
deaths. By comparison, in 2006
heart disease killed 631,636, respiratory diseases such as bronchitis and
emphysema killed 124,583, seasonal flu killed 56,326, car accidents
killed 40,189, 33,300 Americans committed suicide and 18,573 were
murdered. Contributing to the
above statistics are obesity, which afflicts about 1/3 of Americans and
causes the pre-mature death of 280,000, and smoking among 22% of
Americans, which causes the pre-mature death of about 190,000.
Commodities and Energy
9. Rising commodity prices - the
Commodities Research Bureau index is at a 52 week, though still 42% below
the July 2008 record high. Rising
prices are good, because it means that worldwide economic activity is on
the rebound, although part of the gain is in reaction to a falling US
Dollar. Gold is at a record high,
which means that some investors are also concerned about an uptick in
inflation. Industrial demand for
jewelry is also higher compared to earlier in 2009.
10. Falling
energy prices - Oil is up 26.8% on the year, but natural gas is down
34.7% and coal is down 13.5% YTD.
At $76/barrel, oil is just at the point where alternatives ranging
from ethanol to shale extraction to wind, tidal and solar become profitable. Natural gas prices would have to double
before alternatives such as wind power become competitive for energy
generation. While it's nice to
have a break at the gas pump, lower energy prices once again postpone the
transition to the "post-carbon" economy.
We believe that
while the age of oil is not over yet, the age of cheap oil is
over. Given the rapid declines in
the rate of extraction from mature oil fields, we're looking intently at
companies that work in the alternative energy space, which we believe
will develop rapidly over the next 10 years. Those companies could include companies
that generate energy from renewable sources, companies that are involved
in the manufacture of hybrid or all-electric cars, and companies that
reduce energy consumption (e.g. manufacturers of LED light bulbs.)
11. Global
warming - while there's plenty of evidence that the planet is warming,
it's very hard to distinguish the warming effects of human activity from
natural cycles. For example, from
800-1300 AD, average temperatures were about the same levels as today,
followed by the "Little Ice Age" from 1400-1800 AD, during
which temperatures were significantly lower. There's a natural cycle of glaciation
occurring every 40-100 thousand years.
Luckily we're in an inter-glacial period, with extension of ice
across Europe and North America retreating since 10,000 years ago.
Natural events can
overwhelm anything humans can do.
For example, a volcanic mega-eruption in Indonesia (the "Toba
Catastrophe") 70-75 thousand years ago dumped an average 6" of
ash over the entire India sub-continent, filled the sky with millions of
tons of sulphuric acid, reduced average temperatures by 5 degrees, and
reduced the world's entire population of humans to about 15,000. About 13,000 years ago, scientists
speculate that a meteor strike in Canada caused the extinction of all
large mammals in North America and wiped out early human inhabitants of
North America, identified as "Clovis man." About 10,000 years ago, northern New
Jersey and central New York State were covered 100-200 feet deep by a
vast freshwater lake. The Hudson's
current flow to the Atlantic was blocked by a dam of rocks and sand which
extended the Long Island "glacial moraine" to New Jersey. When that dam failed, the entire lake
emptied out into the North Atlantic in a matter of days. The fresh water mixed slowly with salt
so the Gulf Stream (which creates a mild climate in Northern Europe) was
deflected south for decades, triggering a mini ice-age.
What's clear is
that we're performing a giant experiment on the atmosphere and it would
be prudent to be conservative in increasing emissions. As carbon dioxide levels increase in
the atmosphere, the carbon dioxide absorbed by the oceans increases,
which becomes more acidic as a result, which effects the ability of reefs
and shellfish to form their exoskeletons, which reduces the viability of
other species and could ultimately lead to a collapse of fisheries
worldwide.
Fiscal and Monetary Policy
12. US
dollar - The US dollar hit an all-time peak in 1985 as exceptionally high
interest rates attracted money flows from all over the world. From 1985-95, the dollar was range
bound as the factor that effect currencies (relative interest rates,
money supply, relative inflation, balance of trade, relative economic
growth) were roughly in balance.
From 1995-2002, the dollar gained as investors initially doubted
the utility of the Euro and investors sought to participate in the
rapidly growing US economy. The
dollar began falling in 2002 as other economies grew faster and the US
trade deficit, particularly with China, grew ever larger. The dollar hit a generational low in
summer 2008, saw a big flight to safety rally through fall and winter
2008, then resumed its downward slide in spring 2009.
Between the trade
deficit and the expansion of the money supply to deal with the financial
crisis, there's just too many dollars floating around. A falling dollar has short term
benefits - increases the value of non-USD earnings, makes exports more
competitive, but also long-term detriments - higher inflation, interest
rates must rise to offset currency losses for international
investors. A stable dollar is the
best scenario.
13. US
treasury yields - US treasury yields are freakishly stable right
now. The US Treasury has
dramatically expanded issuance over the last year to obtain the funds to
pay for the programs to rescue the financial system, and as a result, the
Federal Reserve's balance sheet sheet more than doubled to $2.3 trillion. Normally, we would expect a
"crowding out effect" - competition for dollars among
government and corporate borrowers, to drive rates higher. However, it seems that the $1.2
trillion increase in government lending was exactly offset by a $1.2
trillion shrinkage in what was, until recently "the shadow banking
system." As inflation remains
tame and deflation remains a risk, Federal Reserve policy appears to be a
hold on short term rates currently at 0-0.25%.
14. US
budget deficit - The US budget deficit exceeded US GDP by 10% on three
previous occasions in US history, the American Civil War, World War I and
World II. The 4th
occasion is right now - $1.4 trillion on GDP of $14 trillion for fiscal
year 2010. With tax revenues way
down both at the Federal and State levels, the interest rate burden
rising along with increased medical and Social Security spending and
continued expense for overseas military, it's very hard to see how this
deficit will be closed anytime soon.
15. Winding
down of direct Federal Reserve involvement in credit markets - The
Federal Reserve is already drawing back from direct support of the
financial markets. The guarantee
of money markets accounts ended last month, and several but not all
banks, have repaid TARP funds and bought back preferred shares issued to
the government (at a profit to the Treasury!) The Federal Reserve has to walk a fine
line between extricating itself from the financial markets to restore the
market mechanism, but not so quickly as to kill off the recovery.
16. Inflation
- Inflation as measured by the Consumer Price Index is negative for only
the second in 50 years (down 1.3% year over year through September
2009). In the short term, CPI will
remain constrained by surplus housing, minimal wage pressure in light of
high unemployment and general slack in demand for manufactured goods and
services. Traditionally, high
rates of money supply growth create inflation, which many economist fear
now. However, more than offsetting
that pressure in the negative wealth effect of $10 trillion lost in
housing and investments. We won't
worry too much about inflation until the unemployment rate drops back
towards 5% (from current 9.8%) and capacity utilization regains the long
term average of 80% (versus 69.95 now.)
17. Deflation
- Between inflation and deflation, deflation can do far more damage to an
economic recovery. In the US right
now, everything is on sale - housing, jobs, virtually all manufactured
goods (car sales jumped substantially over the summer but only with a
$4,500 discount provided by the "Cash for Clunkers"
program.) In a deflationary
environment, consumers put off buying today what they know will be
cheaper tomorrow. Also, debts and
debt service are not deflated, while incomes decline. At present, deflation is seen primarily
in housing prices and the cost of fuels, while medical care, education,
food and clothing costs are still increasing modestly. Still, the Federal Reserve will likely
maintain the exceptionally low interest rate environment for some time to
come to stimulate demand and ward off deflation.
Real Estate
18. Weakness
in residential real estate - Housing prices turned modestly higher over
the summer, but foreclosures hit record levels in the third quarter. After a 33% peak to trough decline over
the last three years, it's possible that housing prices could resume declining
further. What's particularly worrisome
is that an estimated 20-33% of US home owners have negative equity in
their houses, and those home owners are much more likely to abandon their
properties and rent cheaply. As
foreclosure sales always occur at a discount to market levels, certain markets
get trapped in a vicious circle of foreclosure sales driving down values
and causing more homeowners to abandon their homes. We have no expectation that real estate
prices will surge anytime soon.
Not only are most American cities ringed by hastily built
developments of the last 5 years begging for buyers, but sellers who have
been holding back may rush to market on the slightest upticks.
19. Weakness
in commerical real estate - Lending to the US commercial real estate
market is about 14% of all real estate lending. Commerical real estate developers tend
to be more conservative than residential developers, but a number of high
profile deals of the last few years such as the $5.4 billion purchase of
New York's Peter Cooper Village/Stuyvesant Town apartment complex are
near or in default. Also, a number
of commercial real estate holders are dependent on medium (1-3 year)
financing and may find it impossible to roll those loans over. By 2010, the outlook for both
commerical and residential real estate should be more clear.
Financial System
20. Deleveraging
of the financial system - Leverage (borrowing to enhance returns) reached
an extreme level over the last decade.
To illustrate, let's say a straightforward investment will return
10% over the next year. You can
invest a dollar and get back $1.10 at the end of the year. However, if you can borrow another
dollar at 4% and invest both dollars, at the end of the year you'll have
$2.20. Pay back the original
dollar plus 4 cents of interest and you'll have $1.14, or a 40% increase
in return. Sounds like a pretty
good deal! Problem is, what if the
10% gain turns into a 10% loss. At
the end of the year, you'd only have $1.80. Pay back the dollar plus the 4 cents of
interest and you have 76 cents left, or a 24% loss (your 10% loss is
magnified 2.4 times!).
Real estate, with
a typical 20% down payment or 4:1 leverage ratio, offers even better
gains, provided prices keep rising.
As we have already seen, the 33% decline in prices has delivered staggering
losses to individual homeowners.
Institutional investors known as "private equity"
investors (previously known as "leveraged buy out" investors
during the last credit bubble) typically employee 5-6:1 leverage ratios,
sometimes as high as 10:1. This
strategy works great in a stable or growing economy. However, last year's sharp down turn
drove a diverse assortment of corporations into bankruptcy including
Chrysler, Reader's Digest, Linens 'n Things and Crabtree &
Evelyn. We expect many more failures
of firms owned by private equity firms over the next two years, although
there is considerable value in the underlying companies. Many will emerge from bankruptcy with
better financials (though total loss to the private equity investors.)
In particular, we
worry about hedge funds, who contributed significantly to last fall's
meltdown. The term "hedge
fund" is a misnomer - we prefer "aggressively leveraged
illiquid non-transparent pools of capital." Most take a plain vanilla strategy (for
example, own corporate bonds) and significantly boost the returns by
borrowing additional capital (e.g. short government bonds, use the
proceeds to buy the corporate bonds.)
In the face of margin calls, as we saw last fall, these funds must
sell not when they want to but because they have to. About 2100 hedge funds, 20% of the
funds registered as of a year ago, closed in the last 12 months. By comparison, the mortality rate in
boring plain vanilla investment advisory firms such as ours is close to
0%.
Overall, as the
system deleverages, asset prices fall.
If you can borrow to buy an asset, you're more likely to
over-pay. If you can't borrow,
asset prices will keep falling and remain low .
21. Failure
to re-regulate Wall Street - There are about 15 separate initiatives
working their way through the regulatory institutions and Congress,
ranging from requiring Credit Default Swaps to clear through a central
repository, to requiring SEC regulation of all pools of capital including
hedge funds, private equity and limited partnerships, to creating a
"Consumer Financial Protection Agency." These initiatives would reverse a 15
year process of dismantling the protections established after the Great
Depression (we're solidly for restoring those protections and more!.) As the sense of crisis dissipates,
however, maintaining legislative momentum becomes a challenge. The SEC at least is on a roll,
announcing prosecution of more high profile Ponzi schemes and insider
trading in the last 8 months than in the previous 8 years. The SEC still has a lot of explaining
to do on how the commission failed to discover the Madoff scheme for over
a decade.
Wall Street
employment shrank by over 100,000 jobs since 2007, but Wall Street
compensation is expected to beat 2007's record payout of $130
billion. Average employee (ranging
from secretaries to managing directors) compensation at Goldman Sachs is
expected to be $743,000 in 2009 versus $364,000 in 2008 and $622,000 in
2007. As recently the mid-1980's
doctors, lawyers and bankers all made about the same pay. In recent years, bankers pay has grown
to a multiple of other professions with similar educational and skill
requirements. On the one hand,
regulating pay by specific industry contradicts free market
principles. On the other hand,
what exactly are bankers doing these days to justify their compensation
levels?
22. Failure
to learn from this crisis - in 1998, the Long Term Capital hedge fund,
which was headed up by some of the smartest traders ever produced by the
Salomon Brothers bond trading floor AND two Nobel Prize winners in
economics, crashed and burned with a leverage ratio of 30:1 (for every
dollar in equity, the fund borrowed an additional $29. As we discussed above, leverage
magnifies returns but even more dramatically magnifies losses.)
Scarcely 6 years
later in April 2004, a delegation of investment banks including Goldman
Sachs, Morgan Stanley, Merrill Lynch, Lehman Brother and Bear Stearns
persuaded the SEC to exempt their firms from regulations regarding how
much cash (equity) these banks held relative to investments. As a result, leverage ratios among
these banks rose from an average of 23 times in the 1999-2003 time frame
to over 30 times by 2007. If a
much small, nimbler LTCM went out of business in 1998, why was it a
surprise that Bear Stearns, Lehman Brothers and Merrill Lynch would suffer
the same fate?
23. Revenues,
earnings and valuation - Last month we discussed how the S&P 500 had
gone from grossly undervalued in March 2009 to fairly valued as of last
month. Earnings of S&P 500 companies are forecast to grow 24% in 2010
versus a decline of 25% in 2008 and expected final decline of 6% in
2009. We are at the start of the
third quarter earnings season and so far upside surprises easily outpace
shortfalls. Companies and analysts
are largely increasing revenue and earnings estimates for the quarters to
come, which net pushes the stock market back into undervalued
territory. If for some reason the
recovery should falter, then current stock market levels might be a
short-term peak.
Consumer worries
24. Explosion
of healthcare costs - Americans want Rolls Royce healthcare but want to
pay Chevrolet prices. One of the
ironies of American society is the presence on highways of
well-maintained, fully insured late model cars driven by overweight
drivers who smoke and drink to excess, but don't actually have health
insurance. So much of US medical
spending is directed towards remedial rather than preventative healthcare
and much additional expense is generated by non-essential tests to ward
off prospective mal-practice claims.
By some projections, US healthcare spending, already at 16% of
GDP, could double between 2007 and 2018 and currently grows 2.5% faster
annually than the overall economy.
This level of spending is won't be affordable either at the
individual or government level much longer, but the current healthcare
initiatives being discussed in Congress barely scratch the surface of the
reforms needed.
25. Failure
to provide universal healthcare - 60% of all bankruptcies and 62% of all
home foreclosure are triggered by the burden of uninsured medical
bills. About 70% of Americans,
primarily government workers, employees of large companies particularly
unionized companies, and Medicare recipients will have most of their
medical expenses covered in the event of a major healthcare event. 15% are under insured and would face
significant out of pocket expenses, while 15%, primarily young workers
and workers in low-pay industries, have no insurance at all.
26. Rising
savings rates - The US Personal Savings rate slid from over 10% in the
1970's, averaged 5% in the 1990's, went negative April 2005, but
rebounded sharply in late 2008 as the financial crisis spread, hitting an
11 year high of 5.9% in May 2009 before settling back recently to
3%. US consumers are shrinking
their overall level of indebtedness (credit cars, auto loans, mortgages
and home equity) for only the second time in 50 years, which is a
positive development.
27. Falling
consumer spending - Money spent repaying debt is not spent on purchases
that support the economy, currently 70% of US GDP. By comparison, only 30% of China's GDP
is spent by the consumer, with the rest spent on infrastructure and
manufacturing capacity. Probably
both economies would be healthier with consumer spending in th 60% range. US consumer holiday spending in 2007
was bad, and spending in 2008 was awful.
Preliminary estimates for holiday spending in 2009 look a bit
better.
28. Persistently
high unemployment - The US unemployment rate is at a generational higher,
with no more Americans employed now that at the start of the decade. What's particularly alarming is that
construction jobs, one of the few high paying non-exportable
manufacturing jobs left, are unlikely to return any time soon. The unemployment rate, which lags
strength in the overall economy, may yet peak over 10% in the next 6
months, with continued negative contribution to foreclosures,
bankruptcies and overall spending.
29. The
24 hour news cycle - Once upon a time, American got their news from the
morning paper and a one hour nightly broadcast from Walter Cronkite. Between three 24 hour/day cable news
channels and the Internet, the average American can be swamped with data,
but given very little information to make good decisions. We commented
during the crisis how unhelpful it was to have the "Dow bug" in
the lower right corner of every television in every bar, health club and
airport departure lounge in America.
Unhelpful because the Dow Industrials is a poorly constructed
index of just 30 companies out of 13,000 in the US stock market and
because seeing that number bouncing up and down makes investors feel like
"I must do something!"
Generally speaking, reacting to each news blip is a prescription
for "buying high and selling low."
We review about
600 pages of company news, trade magazines, economic forecasts and
commentary per week, and we imagine we could read 60,000 pages if we had
the time. We know which sources
provide the most actionable information.
We spend little or no time watching CNN, CNBC, Fox News etc. as
the "signal to noise ratio" is extremely low, particularly when
the producers pitch two or more guests into artificial
"debates." No single
source provides the answers; rather information from multiple sources
combines to create the "big picture," which drives our
investment conclusions.
30. Investors
abandon stocks for good - millions of investors, including several of our
clients, bailed out of stocks at 13 year lows last March. That was right before the S&P 500
rallied62.9%. Those investors will
never be able to catch up to market returns for the rest of their
lives. The investors who stayed
committed to their strategies will make new highs in 2-3 years.
Several of our
clients have said in recent weeks, "I don't trust the market
anymore," or "as soon as my account reaches this level, sell
all my stocks" or "Can we get out of stocks and come back in
when the economy is stronger?"
Most economists paint a dire outlook for the US as it struggles
through all the issues we've described above. Many investments strategists decry
"buy and hold" investing and recommend aggressive trading,
sector bets and shorting as the only way to make money going
forward.
We're more
sanguine that most. As we noted in
last month's commentary, we're at the tail end of a decade of poor
returns following two decades of exceptional returns. We were surprised how reliant on
leverage investors had become to juice returns, so we did not anticipate
the waves of selling we saw last December-March. Now that the leverage is gone, the
level of risk is way down. The
other principle we've adhered to over the years is that when things look
worst, that's the time to invest.
In 1989, the Japanese stock market had a higher value than the US
stock market, and Japanese GDP looked ready to overtake the US. Since 1989, investments in Japanese
stocks and real estate declined about 75% over the following 20 years. The time to invest in Japan was in
1946, when smoke was still rising from the ashes of burnt out Japanese
cities. We stayed true to our
strategy of buying good companies with reasonable prospects and were
amply rewarded over the last 6 months.
Strategy
With 11 weeks to go, the S&P 500 may well settle into
a trading range through year end.
Only a gain of 14% by year end (on top of YTD gains of 23.7%)
would bring the total return of the S&P 500 into positive territory
for the decade! Despite doom and
gloom, companies like Intel, Apple, and JP Morgan are able to surprise
investors with much higher than expected earnings. Of course! Just because there are problems in the
economy doesn't mean that employees and managers give up innovating their
products and looking for new opportunities. Between now and year end, we'll be
rebalancing accounts somewhat and taking tax losses if needed, while
tracking how the recovery develops.
We'll review possible scenarios for economic expansion in next
month's report.
As always, please don't hesitate to call with questions
and concerns.
Yours sincerely,
David Edwards
President
