Tuesday, November 11, 2008

The Aftermath

           “When it comes, it bears the grim face of disaster.  Those who had been riding the upward wave decided now is the time to get out.  Those who thought the increase would be forever find their illusion destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell.  Thus the collapse.  And thus the rule, supported by the experience of centuries, the speculative episode always ends not with a whimper but with a bang.  There will be occasion to see the operation of this rule frequently repeated.”

-John Kenneth Galbraith
 A Short History of Financial Euphoria, 1990


So here we are with the bang of the collapse in the housing and debt bubble reverberating throughout the world.  October 2008 was the worst month for the stock market since 1987.  The total economic fallout, while uncertain, predictably worsens as we look to early 2009 with rising unemployment leading the way.  We are seeing the effects of deleveraging after a lengthy speculative episode.   The response has predictably been aggressive policy measures from Government and an increase in the cost of capital as risk premiums soar.  However, there are times, such as we face now, when the reaction is so extreme, the fallout so difficult, and the appetite for risk so diminished that financial memory will impede a return to excessive, leverage-driven speculation for a very long time.  The silver lining here, of course, is that investors are paid to take risk and markets are demanding higher returns.  The key is to find where risk is appropriately rewarded and how the reward is realized.  Sufficient return on capital is paramount and a predictable cash yield is essential.

Globally, governments are now responding in concert with stimulus packages and easier money.  Importantly, however, much of this is surprisingly late.  Gripped with fears of inflation which had already come to pass, and with apparently no attention paid to the effects of deleveraging and the developing recession, the European Central Bank raised interest rates on July 3rd.  The Federal Reserve also “jawboned” several times late in the summer about fighting inflation with higher rates.  These were attempts at instilling confidence and protecting purchasing power, but markets had difficulty adjusting to new expectations of tightening credit not just from investors, but also from central banks.  We believe this realization was critical in tipping us from a significant, productive recession to one much more harmful, driven by fear and panic.  Once the market decline began, it was fast and forceful.  Companies such as Lehman, AIG, and the Royal Bank of Scotland faced a sudden death of insolvency as their assets quickly revalued at much lower levels and funding disappeared.  Markets entered into a destabilizing period of forced liquidation and cash hoarding. 

To see what is happening now, let’s first revisit what we said in our March 2008 piece entitled Bubble Backlash.  “Given that we are unwinding possibly the greatest credit bubble this country has ever seen, the proportionate response from the Federal Reserve and lawmakers may be quite large in absolute terms.”  To illustrate, take a look at the chart below that we have been tracking from data provided by the Federal Reserve. (You can click on it for a larger view.)

The red line depicts the annual percentage change by month in what’s called the monetary base.  It is a measure of all currency and banking reserves in the economy; literally the base off of which our entire capital structure of investment, credit, and consumption is built.  As such, it is the bottom of an inverted pyramid.  The Fed has increased this base by close to 40% from last year’s level because so much money is currently being hoarded by those who have it and absorbed by those who need it to unwind leverage; a race to get those US Dollars at the bottom of the pyramid.   The Fed is injecting money to provide actual dollars needed to keep the credit markets functioning at a basic level.   We have never experienced a monetary injection of this magnitude in the US economy.   Add the $700 billion TARP being used to keep banks solvent and the upcoming stimulus packages, and the policy response is certainly proportionate and large.  As one might assume, while policymakers fight the onset of deflation, investors will keenly search for signs of emerging inflation down the road.

So far these measures avoid a direct hit on the issue at the core of our problems:  the deflating of an over-inflated and over-leveraged housing market.   Most of the previous liquidity measures are attempting to re-liquify the banking system and encourage lending but, in reality, many banks are drowning in available liquidity but hoarding it to protect their balance sheets.  Their biggest problem has been avoiding insolvency as they are loaded with bad mortgage debt.   The TARP has attempted to help this with direct equity injections into the banks.  The worst mortgages, which consisted of low quality two-year ARMs with pay-options and low teaser rates, were issued between 2005 and 2007.  As these mortgages reset at interest rates in the double digits, foreclosure rates have steadily risen.  The largest quantity and lowest quality of these loans were written in late 2006 and early 2007 and those are the loans that are defaulting right now.  By late spring 2009, there will be no more such loans to roll over and we may find the beginning of a housing bottom.  But in today’s credit-starved world, 6-8 months is an eternity.  We expect more aggressive action (i.e. hundreds of billions of dollars) aimed at assisting homeowners and banks to work out many of these remaining troubled mortgages.  Banks may then avoid insolvency and begin using these capital and liquidity injections to begin lending to good credits.

As for the equity and fixed income markets, we look for stability to develop as a result of these measures.  In times of panic and distress, the uncertainty of expected outcomes is magnified as human financial behavior is inherently unpredictable.  The panic we see in markets may be justified by fear, but the existence of permanent fear is unreasonable and historically unsustainable.  At some point, when assets are revalued to provide a sufficient return and excess leverage is squeezed from the system, behavior will likely become more predictable and stable, discounting some form of recovery.    We are left to judge whether the resulting prices offer opportunity for investment.  Some companies that we own are trading well below book value while their balance sheets look healthy.  It would appear that no future growth is being forecast forever and assets are being discounted as significantly impaired.  This indicates that fear still pervades and uncertainty rules the day. 

While stability will no doubt take time to develop, it is important to understand that eventual growth in real GDP is, at a minimum, dependent on productivity gains and the basic needs of a growing global population.  We believe investors will begin to identify companies that are vital in those areas and are largely self-financed by sustainable cash flows from operations.  A cash return on investment will be favored and we will look to capture high dividend yield stocks and investment grade bonds where yields have risen to more appropriate levels.  That is where investors will flock when stability returns. 

We have tried to manage our portfolios to be relatively conservative, focusing on companies that meet our usual return on capital criteria.  While we have been opportunistic in selling when it seemed reasonable, it has been nearly impossible to aggressively to sell enough to avoid the fallout in the stock market for that last 45 days.    Our margin of outperformance over the market has been gained from the relative stability of several core holdings and our cash position during the course of the year.  We believe our holdings that are very depressed (i.e. energy, industrial, and commodity related) are worth holding because of the value of balance sheet assets, eventual inflation of commodities from aggressive monetary policy,  and the longer-term secular growth of emerging economies.  We will be very patient when investing available cash and may look to trim positions that have remained profitable.  We will continue to invest in short to medium-term bonds that offer compelling risk-adjusted returns and are paying us 8-10 percentage points more in current yield than what we receive in the U.S. Treasury Money Fund.  We are also focusing on a few key technology companies (such as Cisco and Microsoft) that are vital to long-run productivity gains of the global economy.  Finally, we will carefully add to depressed core holdings that are associated with basic non-discretionary needs of consumers.

It is probably an understatement to say this is a difficult time.  We expected hard times and difficult choices, but we were not investing for a total crash.  We did so in 2002 and largely avoided a very painful decline.  However, by being in Treasuries we missed the very profitable early stages of recovery in 2003 and remained cautiously invested for the past five years, outperforming the market in four of those years including this one.  Rarely is anyone so fortunate to completely miss a crash.  Planning in earnest for a catastrophic market event can take years, and with it comes increased risk of missing longer periods of prosperity while you wait.  Preservation of capital is always at the top of our list, yet, as investors, we inherently take risks that subject us to volatile times.  If history predicts the fallout from repeated bubbles, then it also clearly predicts the recovery that has repeated every time as well.

 To quote Galbraith once more: “Financial genius is before the fall.”  This sense of genius is fleeting and thrives on hubris.  That was certainly the case.   But that is history.  Everyone needs to learn from experience and look forward.   Collectively our nation has been humbled on many fronts.  A sense of humility combined with our freedom, democracy, and free-market capitalism will lead us back to prosperity.

We welcome your comments.

Peter and Jack Falker

"Note:  At the time of publication, Peter and Jack Falker, and the clients of FalkerInvestments Inc. were long the common stocks of Cisco Systems and Microsoft."

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