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April – September 2008

Last update on: Sep 27 2019

September 30, 2008 10:30 a.m. The Shadow Bank Run

Well, so much for the notion that short sellers were driving stock prices down. You know how much stocks declined yesterday, and they fell that far without anyone being allowed to sell short 900 or so stocks.

I don’t know if the rescue plan that was defeated yesterday would have worked, but I had some doubts. A major plan from the government is needed, but the rescue plan was probably only one of several needed actions. Financial companies need to build their balance sheets. They will do that by deleveraging, which means selling assets. They also need to attract fresh capital. There are few buyers at the prices institutions want to sell. That is where the rescue plan came in. The government would be a major buyer, establishing a market and prices for assets.

Attracting investors would be more problematic. Those who invested early in the crisis have been burned. Some lost all their investments in Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia, and others.

Pessimism and fear are high. As usual, most people are looking in the wrong place after yesterday. Stocks did indeed decline significantly. But corporate bonds fell even more. The Investment Grade Corporate Bond ETF (ticker: LQD) fell about 10%. That is a fund of investment grade bonds, not junk. That shows investors are not willing to take any risk now. All they want to own are short-term treasury securities.

There also are runs on banks. We don’t see the bank runs because so many of today’s transactions are electronic. But reports are that the major banks were sold recently because they were losing deposits. All the data from the credit markets indicate that credit is very tight. Traditional lenders are not lending, and investors are not participating in the commercial paper and money markets. The crisis has spread outside the U.S. now, with major financial institutions failing in Europe and problems in Russia.

A comprehensive plan from the government must happen. The private sector is unable and unwilling to buy the assets that are coming to market. Foreign investors who have financed U.S. activities for so long are losing confidence.

First we need some kind of market mechanism to establish a value and a floor for the mortgage securities and other debt instruments. The rescue plan would have done that by having the government buy the securities. So might organizing an exchange for the assets. Establishing the prices of the securities would let companies establish their capital levels and give investors some confidence. Altering the mark to market accounting rules so that firms are not forced to sell assets might help.

Second, financial services companies need to attract new investors. Some have suggested it would be better for the government to buy preferred stocks in the companies instead of buying the questionable securities. Again, private investors and foreign investors won’t buy until their confidence is restored.

Third, lenders need to begin lending again. Credit has tightened steadily over the last year. If it continues tightening, the economy will take a sharp turn south. Lenders need to have their capital bases restored. Investors need confidence that the worst is over for most companies and financial institutions. The government might need to increase deposit insurance limits and extend them to money market funds.

The question for us as investors is what to do now. We reduced risk some time ago and have increased it a bit this year. We still are conservatively positioned and awaiting a margin of safety.

One option is to decide we don’t want to miss the initial gains off the market bottom and begin investing now that stocks have declined considerably. The potential problem with that approach is that apparent bottoms since the crises began have not held. As I’ve said several times, this cycle is unique. History is not much use as a guide.

The other option is to wait until there are clear signs the crises are being resolved, deleveraging is near an end, and most importantly, pessimism has peaked.

I’m going with the second option. This is a time to preserve capital. The prices of quality assets are declining, but they could decline further. We are in a bear market for most assets. It is better to miss the first gains at the end of a bear market than to buy before the bear market is over.

September 24, 2008 04:30 p.m. The Law of Unintended Consequences

If the stakes were not so great, the debate taking place in Washington this week would be comical. A few points came to mind as I listened to and read about the discussions of the market support bill proposed by Treasury Secretary Hank Paulson:

  • Paulson and Ben Bernanke are smart guys, but they have been consistently wrong about the crisis. They didn’t see it coming, insisted it was contained at each stage, and took over a year to come up with a comprehensive plan. That record doesn’t give much confidence that the plan is a good one.
  • Some in Congress want limits on executive compensation. It was the $1 million limit on cash compensation imposed by Congress in the 1990s that led to today’s excessive pay from stock options and other incentives. It also led to the stock manipulation, earnings management, and other shenanigans that characterized the last stages of the 1990s bull market and resumed after 2003.
  • Falling housing prices are not the cause or main problem in the crisis. Excess leverage is. The plan doesn’t do much to address the leverage. It gives firms another chance to ramp up the leverage again.
  • Some in Washington are saying that the $700 billion amount is too high. If you think the problem is isolated to mortgages that probably is true. But also on tap are corporate bonds (especially high yield bonds), credit card debt, auto loans, and bank loans. For all these assets, I’ve seen studies indicating $700 billion might be a few hundred million short.
  • There also are calls that the crisis means we need more regulation and that the markets and free economy failed. Actually, all the failed institutions were heavily regulated. The regulations and regulators were wrong. They continued to follow the model developed after the 1930s. Congress never initiated changes despite calls that the regulatory structured needed to be revised. It is largely government interference in the markets, especially incentives for home ownership, that were instrumental in creating the crisis. The least regulated institutions in the capital markets-hedge funds and private equity funds-caused the least problems. The ones that made mistakes quietly liquidated and disappeared.
  • Perhaps worst of all, the plan continues creating moral hazards as all the prior bailouts did. There is an incentive for managers to maximize leverage and risk to maximize short-term returns.The most important points are how the package and other developments will affect our investments. It seems to me that the future is likely to hold the following, and these principles will inform our investing:
  • Returns from equities and real estate are likely to be lower for at least the next five years than in the past.
  • Income is likely to be a more important component of investment returns. Until sometime in the 1950s, dividend yields on stocks exceed bond yields. The combination of aging Baby Boomers and the pessimism generated by the crisis make investors more likely to seek income as an important component of returns.
  • Deleveraging is deflationary, and we are likely to be in a deflationary phase for a few more years.
  • The high level of debt and spending by the government is likely to be inflationary, but the inflation probably is a few years away.
  • There likely is money to be made in distressed debt at some point. The crisis is causing extreme pessimism regarding credit instruments, and that will drive prices too low. The government is likely to make a profit on debt it acquires under the plan.
  • Counterintuitively, mergers and acquisitions are likely to increase in the near term. Many corporate balance sheets are in good shape. Strategic mergers with weak competitors or those whose stock prices were beaten down by the market will be more frequent. The large private equity funds raised a lot of money they have not put to work yet. They won’t be able to leverage the deals as in the past, but they do have a lot of buying power.
  • Hedge funds and private equity funds are likely to assume some of the roles played by the investment banks in the past.

As I have said before, opportunities are being created and quality is on sale. But those who purchased early have been burned. In a secular bear market, it is better to miss the first real bounce off the bottom than to buy early in hopes of catching the bottom. The risks of further declines are high. It still is time to preserve capital to be deployed in the future.

September 19, 2008 11:30 a.m. Some Good News

I was set to write this entry before the dramatic government actions of the last day. As the markets were sinking yesterday morning, I thought there were some positive points that were being overlooked.

In the movie Apollo 13, at one point Ed Harris, playing flight controller Gene Kranz, asks something like, “What’s good about the spacecraft? Does anyone have anything good?” The only answer was “We’ll have to get back to you, Gene.”

The government actions, especially the move to create a fund to acquire the toxic assets and take it off the balance sheets of companies, should have occurred months ago. Though the details are not known and the fund is some time away from being operating, its announcement is a positive development.

The panic of the last week is the sort of extreme pessimism that drives prices to low levels and sets the stage for future gains. The prices of the last week will look very cheap in a few years.

Some of the price declines and bankruptcies of the last year were necessary cleansings. Businesses that were not fundamentally sound and existed only on the debt fueled expansion after 2002 are now out of existence.

One action that went unnoticed in the panics of the last few weeks is that companies are buying other companies, especially in the financial industry. That means there are companies with healthy balance sheets and managers who see a bright light at the end of the tunnel.

The data all indicate that this is a financial crisis, not an economic one. Most of the economy is only affected to the extent companies are not able to obtain debt financing. The government had to act because the financial crisis was starting to bleed into the broader economy. But corporate balance sheets generally are in good shape and have been able to make it through the financial crisis.

Even the sharp recent stock index drops that made headlines did not make it into the top 10 one day percentage losses, according to Investor’s Business Daily. The decline in October 1987 was 25%. The recent declines were a fraction of that.

Housing starts are low. That means very few new homes are being built. Few new homes makes it easier to work off the excess inventory of homes and restore stability to home prices.

None of this means it is time to jump back into the markets. It will take a while to stabilize the housing market and reverse course in the financial industry. The rally in the markets yesterday and today to a large extent probably is short sellers covering their positions. The deleveraging in the economy will continue. Consumers and financial firms will continue to need to sell assets or otherwise reduce their debt levels. There are a number of firms that borrowed short-term and will have to refinance that debt in the coming year. We’ll have to see if the credit markets have been restored enough that they are able to refinance their debts.

Things are looking better. We have a few positions in the portfolios that will benefit from a sharp turnaround. I’ll be watching developments closely to see if it I safe to reduce our hedged positions and cash to take on more risk.

Septmber 11, 2008 11:30 a.m. Behind the Headlines

The media this week had a number of interesting stories. A number of them are interesting more for what is behind the headlines than the main stories. Here are some that struck me:

  • Putting Fannie Mae and Freddie Mac into conservatorship leaves many problems unsolved. The only problem is really solved is that investors, especially foreign investors, no longer are avoiding new investments in bonds of the entities. It doesn’t do much to reduce the excess housing inventory or the credit crunch. It also does not prevent the effects of the credit crunch and housing recession from spreading into the rest of the economy. In short, this bailout does not indicate a bottom any more than the previous bailouts.
  • The government seems to be trying to put a floor under the markets, call it the Paulson-Bernanke put. Since the credit crisis first emerged in 2007, each low in the stock indexes has been met with a dramatic move from either the Treasury or the Federal Reserve. In 2008, the market indexes have been in a trading range with clear bottoms in January, March, July, and last week. Each time the indexes re-approached the lows, the government took action. This week it was the conservatorship of Fannie and Freddie. Each time, the surge in stocks following the action has been shorter and weaker. This has to be a warning for investors in assets with risk.
  • The most serious risks to investors are not in the markets. The greatest risks are outside the markets. Factors such as oil prices, credit availability, global politics and wars, regulations, and others matter more than market factors. That is why each investment should have a margin of safety. These outside factors can move the markets quickly.
  • These outside factors are why people who follow the old investment rules and models are hurting the most. They consistently anticipated premature ends to the market and economic declines. We have to adapt to the new structure of the economy and markets.
  • The government is being asked to bail out billionaires. The folks at PIMCO bought a lot of debt issued by Fannie Mae and Freddie Mac and were part of a public effort to encourage the government to take over the entities. When that happened, the prices of their debt soared.You might have noticed the campaign by T. Boone Pickens to encourage government policies favoring the use of wind to generate electricity and natural gas for cars. A few years ago Pickens made large investments in wind and natural gas. Now he is investing in a media campaign to encourage massive government subsidies and tax credit for wider use of wind and natural gas. He even has a book out which spends most of its content making the case for his subsidy plan.
  • Many investors who poured money into hedge funds the last few years are realizing unexpected losses and withdrawing their funds. These investors jumped on the latest trend and did not carefully choose their hedge funds. They also did not fully understand hedge funds. Too many of the hedge funds used leverage instead of skill to earn high returns during the good years and attract investors. Now that leverage is amplifying losses instead of gains. The old adage used to be, “Don’t mistake brains for a bull market.” The adage for hedge fund investors is, “Don’t mistake leverage for a bull market.”
  • There were a couple of interesting articles in this week’s Barron’s. One is an interview with the manager of American Century’s life cycle or target date funds, the LiveStrong funds. These funds are doing better than most of their competitors. The main advantage the funds have is that the manager does not use historic data and the traditional asset allocation model to determine the allocation in the funds. Instead, he looks for value and a margin of safety. He follows the same philosophy we do in Retirement Watch.

The other article is an interview with Charles Maxwell, a well-regarded oil analyst. Maxwell believes the current decline in oil prices is due to recession and other declines in demand. Extreme optimism also is a factor. But Maxwell believes the decline is temporary. The long-term trend for oil prices is up, because there is not enough supply and demand is increasing. There will be ups and downs caused by short-term factors, but the long-term trend is up until a substitute for oil is developed.

September 4, 2008 11:00 a.m. Forget the Fundamentals

Believers in efficient markets and modern investment theory are puzzled by the recent volatility of markets. That is because the theories do not account for the factors driving today’s markets: forced cash flows, mistakes, and extremes in optimism and pessimism.

Regular readers know my view that markets are prone to extreme highs and lows because investors change their outlooks from extreme optimism to extreme pessimism and back. A major reason investors change their outlooks is that they make mistakes. Not only do individual investors make mistakes, but investors collectively can make mistakes. The process of making mistakes and correcting them is a major cause of bull and bear markets. A more detailed explanation of the process is in my book, Invest Like a Fox…Not Like a Hedgehog.

The swings are more rapid these days because of the size of hedge funds and other leveraged investors. These investors try to earn sizeable profits by using debt and other means to leverage their investment positions. Unfortunately, many of them have made poor bets over the last year. When investments turn against them, they are forced to sell for two reasons. One reason is that they receive margin calls or their equivalent. They have to sell investments to reduce their leverage. A second reason they have to sell is that investors in hedge funds expect to see only profits. When returns are negative, they ask to withdraw their investments. The funds must sell assets to meet the redemptions.

Early this year I reported on a study that indicated the major swings in the stock indexes likely were due to forced sales by hedge funds and other leveraged investors. This pattern now appears to have shifted to other assets.

Oil and other commodities soared in price over the last year, and declined rapidly beginning in August. We sat out the price rise, because there appeared to be little fundamental reason for it. There was a lot of talk about growth in the emerging markets, but it did not seem the growth was high enough to explain the sudden surge in prices. There is a long-term case for a steady rise in commodity prices, but not the sharp rise we saw in the last year.

It now appears there were few fundamentals backing the rise. Instead, leveraged investors were pouring money into commodities. There were no few investors to push up the prices, and economic data made the case that demand was likely to fall because of declining economic growth. The first brief price decline caused a severe downturn because the leveraged investors were forced to sell to meet margin calls and investor redemptions.

The evidence of this is the reported closing of the Ospraie Fund hedge fund. The fund bet big on rising energy prices and was caught when those prices declined in August. The forced selling by this fund and others helped push prices down further. The fund lost 27% in August.

This case presents two profitable lessons for us. One lesson is to avoid momentum investing. Invest only with a margin of safety, not because an asset’s price keeps rising. The second lesson is that leveraged investors and forced selling create market disruptions and disequilibrium. Buying opportunities for the patient investor are created when others are panicking or are forced to sell. We primarily are preserving capital now and investing when these other forces create buying opportunities with a margin of safety.

August 28, 2008 02:00 p.m. When and Why Experts Are Wrong

Spend some time with the September 1, 2008 issue of Forbes magazine. You will have what Sherlock Holmes would refer to as an instructive and enlightening time.

In the back of each issue are columns by several investment columnists who are active money managers. In this issue, the three columnists confess to having been wrong for much of the past year.

Ken Fisher, an excellent thinker whose writings I rarely miss, was in a confessional mode. He stated that in 24 years of being a Forbes columnist, the recent bear market was the first he has not anticipated. He went on with made an admission that matches one I have heard from many other money managers and analysts: “I also admit confusion. In my 36 years as a professional investor I have not seen a period like this.”

Fixed income investor Richard Lehmann wrote, “At this point I must confess to being too sanguine in the past about our big financial institutions. The Fannie [Mae} and Freddie [Mac} preferreds I recommended in my June 2 column have been disasters, having fallen 20% to 46% in price.”

Ariel Investments founder John Rogers, whose firm announced lay offs for the first time after the issue went to press, wrote, “It’s one of the toughest years I’ve seen in a quarter-century of investing.”

My point is not to signal out these investors for criticism or steer you away from them. In fact, each has been successful for some time and probably will be successful for some time. Their comments and recent experience, however, are consistent with several themes in my book, Invest Like a Fox…Not Like a Hedgehog. Here are some key lessons to remember:

  • All markets are prone to wide swings in value that can be at variance with underlying fundamentals, as investors swing from extreme optimism to extreme pessimism and back.
  • Markets change. Economic data are not followed by the same market behavior forever. Patterns change as investors and the structure of markets change.
  • Data can tell us only so much. Because investors are human, they learn and respond differently. They also make mistakes.
  • In periods of extreme optimism, asset prices tend to be far higher than justified by fundamentals. In periods of extreme pessimism, prices fall much lower than they should based on fundamentals. In other words, markets can seem irrational at times.

One point I have made in Retirement Watch over the last year is that investors and analysts who rely on past rules and patterns will be disappointed. Globalization, new investment vehicles, and changes in market structure make obsolete many past patterns and relationships. As Ken Fisher wrote, this is an unusual bear market/recession. It was not precipitated by rising interest rates. In fact, the Federal Reserve cut rates substantially before the economy and stock market turned down. Also, the global economy and sectors of the U.S. economy are doing far better than stocks markets indicate.

Unfortunately, most investors are hedgehogs. They learn only one big thing and stick with it. A long-term successful investor must think like a fox. That means learning a number of things and adapting as circumstances change. Otherwise, you are likely to be caught in an uncomfortable situation when markets change.

August 21, 2008 09:30 a.m. Tug of War

There is a tug of war taking place in the economy and markets today.

One the one side is inflation. Prices in the U.S. and many other countries have been rising at a faster rate than they have in some time. The factors causing higher prices are no secret. Rapid money supply growth after the deflation scare of the early 2000s is a prime factor. Also, some disinflationary forces of the 1980s and 1990s are reversing course. Labor costs are rising in places such as China. Technological innovation is not increasing productivity as much as it was. Higher productivity allows businesses to produce more goods at lower cost without hurting their profit margins.

The growth in the developing economies is creating larger middle classes. This new wealth is creating demand for everyday goods, especially food and energy. The decline in the value of the dollar in recent years raises prices in the U.S. and in other countries whose currencies are pegged to the dollar.

On the other side is deflation. The major force of deflation is the deleveraging being conducted by both consumers and businesses. Debt is being reduced. That hinders economic growth and also reduces demand for goods and services.

Some analysts say the recent decline in oil and other commodity prices means inflation is about to peak, but don’t accept that argument quickly. If central banks continue to increase the money supply, the money that was used to pay higher prices for commodities likely will shift to push up prices of other goods and services.

Central banks want to raise interest rates and reduce the money supply to keep inflation under control. That is occurring outside the U.S., but the Federal Reserve is afraid raising rates would accelerate the deflationary trends.

I think the deflationary forces will remain strong. Consumers are saving more, reducing spending, and taking on less debt. Lenders have tightened lending standards and reduced the amount of money available to lend.

The balance sheets of financial institutions are the most important deflationary forces. The institutions can only lend or invest based on the strength of their balance sheets. Their capital first was reduced by the large write downs of asset values, especially mortgages and other loans. Some of that capital was replaced by new investors. But investors are less eager to invest in the institutions now, and the institutions continue to write down assets. Now we see the financial institutions selling valuable and profitable assets, such as their money management subsidiaries. This gives them cash to offset asset write downs. But it also hinders the long-term cash flow and income of the firms. It also makes clear that sophisticated, institutional investors do not want to invest in financial services firms any more.

Until the write downs, asset sales, and other deleveraging actions cease, the forces of deflation and reduced economic growth will be strong. That is why we are maintaining fairly conservative positions to preserve our capital and wait for a better time to invest more aggressively.

August 15, 2008 08:30 a.m. Why Oil Crashed

Just as most analysts forecast that the upward climb of oil was unstoppable and the price soon would reach $150 and higher, the price of oil on world markets fell. It fell sharply, from a high of over $140 to around $110 in a few weeks.

Investigations and studies are under way to explain this, but they aren’t necessary. We saw this process played out in the technology stock bubble and housing bubble in the last few years and many other times in the past. It is explained in detail in my book, Invest Like a Fox…Not Like a Hedgehog.

Contrary to modern investment theory, markets are not perfectly efficient and are not good pricing mechanisms over any short period. Most of the time markets are relatively efficient and prices are close to fundamental values. But markets are made of individuals making decisions. Sometimes those decisions are wrong. Sometimes instead of holding diverse opinions, most of the investors in a market hold the same opinion and push prices in the same direction.

At times investors collectively are extremely optimistic. Other times they are extremely pessimistic. During these phases, the prices are unsustainable because most investors are wrong. Their emotions and other non-rational qualifies override logic.

It is hard to have an idea in advance what will cause the collective opinion to reverse course. But it will happen. At first a few people will realize the price is too high or they just want to secure their profits. So they sell. At that time, there are very few people willing or able to buy more of the asset. The price begins to fall. It usually does not fall in a straight line. Those who still are optimistic or who missed the surge want to buy on the early price declines, believing they are temporary.

Over time the price action is weak enough that more and more investors turn pessimistic. The process can take months or years, depending on the asset. But it explains secular bull and bear markets, something that is not explained by contemporary investment theory.

Some markets have indicators that measure to some extent the optimism and pessimism of investors. Yet, even those are not very reliable at indicating turning points. At Retirement Watch, we examine the fundamentals and market trends. We invest only when there is a margin of safety and the prospect of reasonable appreciation. We are glad to miss the last surge caused by extreme optimism, because it is how we avoid the losses incurred from the sudden, sharp changes in sentiment-such as those experienced by those who bought oil as the hype reached its extremes.

August 8, 2008 11:45 a.m. Follow the Cash

Let’s start with an optimistic note. The U.S. economy is remarkably resilient. A few years ago if someone forecast the credit crunch, housing collapse, mortgage defaults, rise in the price of oil and other commodities, the conclusion would have been that the economy would be mired in a deep depression. Instead, while the economy is slow and still slowing, many sectors are healthy and official growth has not turned negative.

I pointed out a few times in the past that recessions have been shallower each time, and a deep decline is less likely. The economy is more diversified than in the past and is more service-oriented than manufacturing-based. Those factors make it more resilient. Yet, the credit fuels the economy, and problems in the credit markets hurt most of the economy.

The past year has been great for traders but bad for investors. Market movements are not following the fundamentals. Instead, changes in cash flow and sentiment moving the markets. The movements are strong and change direction, because sentiment changes regularly.

Tuesday’s surge of more than 300 points in the Dow combined with the recent recovery in financial stocks increased the number of people declaring that the bear market hit a bottom. We still remain cautious. While recent weeks might turn out to be the bottom, do not expect a sharp upward recovery. Instead, any bottom is likely to be revisited one or more times, resulting in a long bottoming process. Here are some key fundamental points to consider before getting wrapped up in the latest sentiment:

  • The leading indicators on employment are down and getting worse. Employers are reducing hours and wages. Eventually they will cut jobs, boosting unemployment.

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