2008 4th Quarter Report

(Download printable .pdf version here.)

Baffled? Frustrated? Worn out? Most of us have to answer yes to these questions. After over thirty years of investment management, I still try to stand up to my own sinking feelings and act as professionally and unemotionally as possible. Our value discipline forces us to take notice, to recognize opportunity and to capture value. Courage is in exceptionally short supply especially among newer clients who have never seen panics or bear markets but even among seasoned investors who have never experienced such volatility.

Many years ago, I was unfortunate enough to be in the path of a Class Five hurricane which bore down on us in a resort on the Mexican Riviera. Resort guests were evacuated in the back of an Army dump truck which headed up to Cancun in the rain. We made a brief stop to drop our luggage at a hotel which we learned was destroyed later that night by the waves churned by the storm. Fortunately for us, we were brought inland to a rural school which provided shelter for 500 terrified souls during the worst of the tempest. About one fifth of the school collapsed in the winds, almost all of the windows were blown out, but thank goodness, we all survived. In the depths, most of us were convinced that panic conditions would persist, especially as walls caved in. This sentiment was self-perpetuating and created a downward spiral of pessimism that was difficult for anyone not to feel.

The fourth quarter panic in the capital markets was an emotional ride for most of us not unlike going through that storm. Like survivors of any calamity, we will look back with some exhilaration inherent in emerging alive though wounded, shell-shocked and weary from such a painful event.

To provide some historical context to this experience, let’s look at the volatility of the S&P 500 which though launched in 1957, has historical data that goes back to 1950. In six decades of trading prior to August 2008, there had been only 24 days where gains exceeded 4% and only 18 days where losses exceeded 4%. However, markets have made history since September. In the last four months of 2008 we saw 13 4+% up days and 15 4+% down days! We experienced the second, third, and fourth largest down days ever with 9.0%, 8.9%, and 8.8% losses. We also experience the first, second, fourth, and fifth biggest up days ever as well with 11.6%, 10.8%, 6.9%, and 6.5% gains. An index which draws from the 500 biggest public companies in the U.S. began to reflect a typical year’s worth of returns in a single day.

Keep in mind that such volatility and anomalous behavior has never before been witnessed- because of its extremeness, it is highly unlikely to be repeated. Such surreal action spawned tremendous anxiety and panic and spilled into every asset class. The volatility bubble infected large and small cap stocks, every sector, every international market, and most commodities and currencies. Though the New Year’s markets have not galvanized courage into a head rush yet, we believe that the extreme choppiness should be behind us.

The flight to cash is a hallmark of any financial panic. Investors seek exits, dump stocks, and are too scared to buy anything with the proceeds. In the financial markets today, cash is really money-market funds backed by short-term Treasuries. The mass liquidation of stocks has driven a gigantic dollar rally and a collapse in government bond yields. As capital market volatility fades, we believe that investors will recognize that the opportunity cost of sitting in cash at a 0% yield will far outweigh the perceived threat of more stock and commodity market downside. The nervous capital parked in money market funds will ultimately go bargain hunting.

What will heal the stock market? The only cure is time. Fear will dissipate, psychology will improve, and coordinated central bank activity will bear fruit… with time. In early December, European central banks slashed rates to some of the lowest levels ever seen. In the U.S. the FOMC slashed rates to a target range of between zero and 0.25%. The Fed has no further rate cut ammunition - beyond moral suasion the Fed’s most effective remaining tool is direct purchase of Treasuries, agency mortgagebacked debt, and potentially, other riskier instruments. Central banks are throwing trillions into a banking system in an all-out effort to thaw frozen credit markets.

One interesting Federal Reserve statistic that we watch is the monetary base, which includes currency as well as all commercial bank reserves deposited with the Fed. Essentially it represents the volume of money in the economy used to purchase real goods and services. In the last half a century, it has averaged about 6% annual growth. In order to avoid a deflationary shock, the Fed has pulled out all stops in growing the monetary base. In September, we witnessed almost 10% growth in the monetary base. By November, this had accelerated to a year-over-year growth rate of 73%, more than four times the highest growth on record. With governments and central banks expanding the availability of money at rates and magnitudes never before witnessed, it seems to us that deflation is about the last thing any of us need to worry about over the intermediate- to long-term. A looming concern for us is that higher price levels and inflation, is the inevitable outcome of excessive monetary growth.

Massive new U.S. Treasury debt issuance lies ahead, Moreover, because the country has been funding itself for the most part at the short end of the yield curve, despite very low nominal longer term yields, there is a large amount of short term Treasury debt that needs to be rolled over in 2009. All this hits at the very time that new issuance for “stimulus” and “bailout” will be coming. At a zero yield, investors are accepting a deflationary economic environment as well as appeasing their fears. Yet, the Fed, and just about every major central bank in the world has clearly stated that they are attempting to stop the threat of deflation. Early in my career, I was admonished never to “fight the Fed” in my investment stance – a Wall Street truism that is worth paying attention to most of the time. It seems that purchasing long U.S. Treasuries is tantamount to committing that investment sin. Our fixed income strategy in US Treasuries is to keep durations short and to keep Treasury exposure limited. We would far rather employ corporate bonds or preferred securities at current yields and decent spreads.

We find it mildly encouraging that so far in 2009, the Fed has already purchased over $70 Billion in agency mortgage-backed securities but despite that, after what was a huge spike in credit extended to the banking system post-Lehman, the support has actually dropped off by a “slight” $200 Billion in the last two weeks. This is mostly due to the recent declines in loans to depository institutions and support to money market funds holding asset-backed commercial paper. While the asset-backed securities market is far from “business as usual,” the run from non-Treasury money market funds that followed the Lehman bankruptcy has already run its course. Because of this, it is no surprise to see the Fed winding down this facility. Moreover, as banks obtain funding from the TARP and as the Fed Funds/LIBOR market eased further, it also made sense for the Fed to wind down loans to depository institutions.

Most US-based investors are somewhat complacent in the belief that Treasuries are the ultimate safe haven, believing that the US will always and everywhere have ease of access to funding. Global investors have historically been quite tolerant of profligate spending and deteriorating balances. Practically speaking, as the world’s preferred reserve currency, the ubiquity of the dollar has created its own demand for Treasury securities by foreign investors. We are concerned about the need for foreign governments to support and stimulate their own domestic economies at this time and the consequent impact on their propensity to purchase US Treasuries. Since 2002, foreign buyers have collectively purchased about $2 Trillion in Treasuries. Foreign buyers have been very obliging by being on the other side of the US trade deficit. As recipients of US trade dollars, they have historically recycled those dollars back into US Treasuries, agency and corporate debt. Trade deficit outflows from the US are contracting - energy prices have fallen and consumer impacted imports into the States have also dropped. In short, the foreign contingent will have fewer US dollars to allocate back into Treasuries. Secondly, these large global buyers have their own domestic economic, banking, and financial market crises with which to contend. Ben Bernanke has indicated that the Fed will buy Treasury debt if need be. Given the current weakness, the Fed cannot allow nominal Treasury yields to move up too far. Therefore, the only financial market relief valve, by default in our view, is the value of the US dollar. For now, the US-dollar has strengthened against most major currencies - the major exception being the yen, partly seen as a risk aversion currency, but perhaps, now more clearly recognized as the beneficiary of a sharply shrinking UStrade deficit. Perhaps one of the corrective elements of a recession is that the deeper the US-economy falters, the weaker the US-demand for foreign goods and services, - thus, the long awaited correction of the huge external balances between the world’s biggest consumer and the exporter nations is at hand.

What are we looking for from equities in 2009? The negatives are well known. Investor sentiment has been terrible, an anticipated reaction to the new administration was muted if at all discernible, and the initial reaction to the stimulus package has been less than stimulating. With consumers experiencing significant strain, it is difficult to see this sector provide much impetus for growth as it de-leverages its balance sheet. Even Obama’s inaugural speech reminded us of painful realities. He spoke not of sunny skies and amber waves but of “gathering clouds and raging storms.” The aftermath of the credit crisis will leave many banks as zombies, their life and value torn out of them by an accumulation of bad assets and bad decisions.

Yet, despite the grim news, we believe that there are many opportunities in this marketplace. In more normal times, sales growth is leveraged through a company’s corporate structure and drives earnings. We believe that companies that can exhibit sales growth in these times will be prized. For most companies, earnings and cash flow growth will be largely predicated by improvements in expenses. Declining raw materials costs as a function of near-term deflation can provide a boost to earnings despite a decline in sales volumes. Though the credit crisis has been front page news, credit conditions have been improving. LIBOR which rose to about 4.25% in October now finds itself at about 1.20%. Hence, businesses with leveraged balance sheets but stable cash flows could perform well as credit conditions ease. In the interim, we are very careful about companies facing uncertainty in their refinancing of credit or debt maturities and are avoiding companies that have significant financing maturities in 2009 or 2010.

We are encouraged by the many companies that have conservative balance sheets and focus on cash flow rather than earnings. When credit is difficult or expensive to obtain, companies with free cash flow generation (that is cash flow generation beyond the company’s needs) can obviously survive. Low capital expenditure needs, and low working capital needs keep both commercial bankers and investment bankers from knocking at the door. The ability to self-fund is golden in these times.

Remember that the economy and the stock market have a remarkable ability to rebound from crises, whether the October 87 Black Monday crash, the bailout of Long-Term Capital, 9/11, or the Tech bubble. Three years after these each of these crises, the market was up - an average of 37 percent in fact. As a leading indicator, the market will recover before the economy does, and well before the media shifts into positive news. In fact, most stock market recoveries take place in the midst of a recession.

Finally, there is plenty of money on the sidelines. With cash, bank deposits and money market funds approaching about $9 Trillion domestically, cash and cash equivalents are equal to about 74% of the total value of the US stock market, an 18 year high (according to Eric Martin and Michael Tsang-Bloomberg.com Dec 29, 2008).

None of us knows exactly when the market or individual stocks will rise or fall. However, using some fundamental disciplines will improve the odds of success. Fundamental ideas are often in sharp contrast to popular ideas. Remember a year ago, many investors clamored for BRIC investments, that is, Brazil, Russia, India and China as growth engines. These markets fell 50%, 67%, 66%, and 52% respectively. Some investors point to weak earnings and potential disappointments relative to expectations for US companies. Wake up! According to the US Bureau of Economic Analysis, corporate profits have fallen for seven consecutive quarters, one of the longest streaks on record. As the late John Templeton said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die of euphoria”. We hope to take advantage of the pessimistic backdrop.

As always, we appreciate your trust and confidence in us. We welcome your questions and comments.

Richard H Konrad, CFA, CFP®