Market Comment Q4 2008
Year End Review and Outlook 2008
“If you can’t forecast well, forecast often,” goes the old saying. At the moment it would seem the height of folly to attempt a specific near-term forecast of the economy or markets. So much has happened so quickly that it is all one can do simply to keep up, though we can be sure that this cyclical economic downturn will end at some point. The factors exacerbating the onrushing recession are not just financial or economic but psychological as well.
Where to start. In the beginning was the cessation of rising house prices. Housing prices peaked in late 2006 then began what was at first an orderly retreat. But any retreat at all changed the game for borrowers whose only hope for future solvency lay in gaining equity through appreciation. Thus was revealed the extent of ridiculous risk-taking in the justifiably maligned subprime mortgage business and – really even worse – the exaggeration of these risks through the securitization of these mortgages. Exposure of risks in these instruments was especially troubling because it was impossible for market participants to know what organizations held what securities that included what mortgages. In fact, it became very difficult for institutions themselves to understand what they owned and what their risks were. Understandably, trust evaporated and lending diminished drastically – especially interbank lending.
The cart before the horse. Historically, recessions were caused by lack of information. Manufacturers had no early warning about slowing sales across their markets. By the time new orders slowed, they had built inventories on the assumption that good times would continue. To re-balance inventories they slowed or ceased production and laid off workers. The unemployed workers were forced to reduce consumption, which caused problems at additional companies,and so on. Corporate profits suffered, leading to defaulted loan repayments, leading finally to troubles among banks.
This time trouble began among financial institutions. The ratio of inventories to sales among manufacturing enterprises is near an all-time low as the recession unfolds. Modern information technology has to a great degree vaccinated the economy against the old-fashioned kind of recession. The only area of inventory accumulation over the last couple years was unsold houses – now joined by the auto industry.
An unprecedented feedback loop is connecting financial news to the real economy. Breathless media reports about the disintegrating banking system, the lack of trust among institutions, the near- impossibility of obtaining financing quite naturally caused both businesses and individuals to re-think spending plans, reducing economic transactions. Lower spending was historically the result of recession,but this time around it is a major cause.
As financial conservatism among consumers spread, the rate of decline in housing prices accelerated because prospective buyers pulled back. The auto industry has experienced a massive decline in sales, converting the domestic Big Three – already victim to forty years of poor management – into beggars at the government trough. The decline in holiday season retail sales was the worst in forty years.
Financial markets had other problems. Certainly these economic woes are a major factor in the stock market’s sickening slide but not the only factor. Another revelation arising from the unraveling of subprime mortgages was the incredible amount of highly leveraged investing going on among hedge funds and other opaque pools of money. This was possible because of readily available borrowing power at very low interest rates. Here is a simplified version of what happened: The securities created from mortgage pools were sliced into a number of segments,supposedly of varying risk levels. It became popular to build investment structures to buy the lower risk slices, paying with low-cost short-term borrowings. A nice return arose from the difference between the mortgage yield and the cost of funds.
The world learned more than it wanted to know about this game as much as a year ago, and it seemed then to be a problem limited to a handful of edgy financial institutions. As recently as last summer Fed Chair Bernanke was saying that the subprime mortgage mess would be contained,i.e., would not infect the broad economy. What none of us knew was the extent to which leveraged investing had grown like a cancer in other asset classes. If it is okay to borrow cheap short-term money to buy long- term mortgage assets, why not go further? Why not borrow as much as possible to buy stocks, commodities, whatever imagination could create?
As banks consumers and businesses closed their wallets, asset prices fell. As banks teetered on the brink (or fell over), they not only were forced to sell assets themselves but also were less likely to continue loans against others’ assets. Leveraged investors were forced to sell at any price, thus pushing prices lower. As prices fell further, lenders demanded either more collateral or repayment, forcing more sales and still lower prices.
At the same time, investors in hedge funds were not particularly happy either, and there is common belief in Wall Street that many have asked for their money. Most hedge funds limit withdrawals to certain dates with advance notice. One common stipulation calls for notification by September 30 for withdrawals at December 31. By October 1 many hedge funds knew what withdrawals they faced, forcing further sales.
The sharp market decline thus precipitated was certainly noticed by mutual fund investors, and many of them also demanded their money, leading to more forced selling.
This vicious cycle is a large part of the reason prices fell drastically for nearly all assets globally – stocks, bonds, oil, and commodities even including gold. While deepening economic woes have certainly harmed asset prices,the sickening stock market slide since September is very largely caused by forced de-leveraging at atime when potential buyers can only be cajoled by dramatic price concessions. Think of the stock market as having the same problem retailers had this season.
The age of the empty suit. The only highly liquid assets that have not fallen in price this year are direct obligations of strong governments, particularly U.S. Treasuries. Why? Because assuredness of payback has become much more important than rn. Despite its current profligate spending to prop up the economy, the Treasury can borrow all it wants at essentially no cost for three months, about 2% for ten years,and less than 3% for thirty years. These rates surely make it easier to fund the many bailouts.
A great deal of trust has been lost. If Lehman Brothers can disappear, if General Electric must offer amazing terms to attract capital from Warren Buffet, and now if Madoff can dupe so many sophisticated people for so long, why should any corporation be trusted with your money? In her Wall Street Journal column December 20, Peggy Noonan said, “Those who were supposed to be watching things,making the whole edifice run, keeping it up and operating, just somehow weren’t there.” People may not trust governments any more than corporations, but they are willing to believe government has the wherewithal to pay them back
The sun will come out tomorrow. In the same column mentioned above, Peggy Noonan recounted a conversation she had with former Secretary of State George Shultz. She asked his view about our country’s fortunes and future. He said there is “every reason to have confidence”. He told the story of Sumner Slighter, an economics professor at Harvard 50 years ago, saying. “He was not the most admired man in his department, but he’d make pronouncements about the economy that turned out to be right more often than his colleagues’.”After Slichter died, a friend found the start of an autobiography. It said, “I have had a good record in my comments on and expectations of the American economy, and the reason is I’ve always been an optimist. How did I get that way? I was brought up in the West,where the future is more important than the past, in a family of scientists and engineers forever developing new things. I could never buy into the idea that we had crossed our last…frontier.”
Noonan paraphrased Schultz’s conclusions: “The current crisis (is) a gigantic wake-up call. We’ve been living beyond our means, both governmentally and personally. We have to be willing to face up to our problems,but we have a capacity to roll up our sleeves and get down to work together.”
De-leveraging. There is no doubt this will all happen, but, for one of the few times in history, it truly is different this time. Never before has so much financial carnage been visited on so many. So much fancy financial engineering failed so miserably that the memory will last a long time. Lenders of all stripes will be less likely to listen to exotic schemes for many years to come. Venture capital providers will be less likely to find investors as quickly, perhaps inhibiting developments of some great ideas.
A significant portion of the great economic growth since 2001 came from the extension of credit to those who used it recklessly. That portion of potential growth will not exist on the other side of this recession;growth potential will be slower.
Even among the prudent,both lenders and borrowers will be more thoughtful. Subprime lending will scarcely exist. Today, consumers with prime credit can easily get mortgages at very attractive rates, but many are reluctant to buy new homes in today’s environment. Households have learned the hard way that excessive debt is bad, and that investments can turn on them. Old-fashioned savings will likely become more popular. Such restoration of common sense is virtuous, but it may limit economic growth.
Valuation. Ben Graham,one of the past century’s most noted investment thinkers and educators, described the Crash of 1929 this way: “…stocks always sell at unduly low prices after a boom collapses…It happens because those with enterprise haven’t the money, and those with money haven’t the enterprise to buy stocks when they are cheap.”
Stocks are extremely cheap. In the aftermath of the tech bubble’s 2000-02 collapse, stocks never achieved fair value, and this year’s wipeout of the gains that did occur has left prices very attractive no matter what happens in this recession. The valuation model we have used successfully since the inception of the firm is actually derived from Ben Graham’s work. Even if we assume that long-term profit growth is less than historical levels, today’s price of the S&P 500 is forecasting a profit decline in 2009 by more than half, a decline in profit growth long term nearly half, and a yield on the U.S. Treasury five-year maturity more than 4.5% versus less than 1.7% today. Certainly interest rates can rise, but for the foreseeable future inflation is not likely to be a problem. Stocks are this cheap not only because of global economic problems but also because of the market problems cited above.
The world is awash in cash, but investors are unwilling to take risk right now. We argue that at these prices,there is little risk remaining in stocks. At some point, greed will replace fear, and cash will pour into quality investments.