Great Depression? Not!

Here is why we don't think we are looking at the next Great Depression

The government is throwing everything at this problem, unlike what happened in the 1930s or even in Japan during the 1990s. Even though the credit markets have been slow to thaw, the policy initiatives that have been put forth have been massive, synchronized globally and unprecedented in nature starting with central banks slashing rates. In the early 1990s, Japan initially raised rates and then waited more than two years before they cut rates. The U.S. did the same thing in the 1930s. This time, however, the U.S. immediately cut rates when the credit crisis started.

The Fed's direct capital injections into the banking system as well as their direct involvement in the commercial paper market, opening the discount window to non-bank broker dealers and all but nationalizing Freddie and Fannie have been major steps in the right direction to attempt to fix the systemic problems.

The money supply in the 1930s shrunk by a 33%. Today, it is up by 40% year over year. During the Great Depression, we did not have economic stabilizers. Today, we have unemployment insurance and the FDIC. Both came into existence just after the Great Depression. That doesn't mean things can't get worse from here. At this point, we believe this is a "wicked bear market" brought on by financial panic.
Emotions you might be feeling

"You don't understand - it's different this time."
It is very common to feel that the crisis you are in right now is the biggest crisis ever. But whenever we hear the phrase "it's different this time," however bad things were in the past, they tend to mellow with time, thereby heightening the magnitude of the current crisis. Remember the oil embargo of the 1970s, "Black Monday" in the 1980s, the Savings & Loan, Long-Term Capital Management, the Asian/Russian collapses of the 1990s, the bursting of the tech and telecom bubbles in the early 2000s. Remember the markets response to 9/11. Things often look very bad when you are in the middle of them.

"I will get out now and come back in once it's safe."
Behavioral Finance is the study of why generally rational investors so frequently make seemingly irrational decisions about their money. One concept is known as the "gambler's fallacy". Think of someone playing blackjack in Las Vegas. How frequently might you overhear them say, "I'll know when it's time to get out"? And how frequently will they be wrong? It is natural human behavior to possess this "gambler's fallacy" - to have an exaggerated perceived ability to identify trends and predict turning points in those trends. Statistical investment facts indicate otherwise. Investors tend to pile into the stock market just prior to a significant downturn, and pile out of the market just prior to an upswing; a complete inverse relationship.

"I've reached my point of capitulation - just get me out!"
It is quite common, when markets get especially tough, for many investors to simply throw in the towel all together. Nothing like storing your money in nice safe, insured, bank CDs and Treasury bonds, right? Unfortunately, no! While burying your money in a coffee can in the backyard feels safe, it ignores the menacing effect of inflation. The fact is that earning less on your money than the rate of inflation is the economic equivalent of incurring a loss in the stock market. The result is the same - your money will purchase less in the future than it does today. An inflation rate of 4% per year will cut your purchasing power in half in only 15 years. No investor would accept a 50% loss on their stock portfolio over the same time frame, but somehow having inflation eat away at their money feels "safer" to many investors.

The other aspect to consider when investors feel the urge to capitulate is that it usually occurs at the absolute worst possible time - right at the point of locking in maximum loss. Once again, we can look in our Behavioral Finance textbook and find an explanation for this behavior. The concept of "Prospect Theory" (a theory which earned it a Nobel Prize in Economics) says that humans dislike "pain" more than they enjoy "pleasure". In investment terms, investors have an asymmetrical view of risk. They hate downside risk more than they enjoy upside reward. It is a highly understandable response to want to take flight and put your money in "safe" investments. But it is critical to remember that "risk" takes many forms. It is not simply the volatility of the stock market. Selling out at the bottom, missing part of any recovery from that bottom, and the loss of purchasing power because of inflation are also forms of risk that must be considered.

Do the above arguments dictate that investors simply "hang in there" and wait for things to get better? Not at all! They illustrate that decisions should be made in a rational manner with the long-term in mind.

Prudent ideas for this market

Portfolios are depressingly down. It is completely appropriate to rethink your actual tolerance for risk and adjust your portfolios accordingly. Let's face it: a discipline to follow traditional investment principles is very difficult in the current chaotic market.

Here are some ideas that are prudent in this market:
1. Reevaluate your personal tolerance for risk. Now that they are experiencing the downside part of the equation is quite different (and quite lower) than they believed. If your time horizon or blood pressure does not allow you to endure volatile markets, then reallocate to a more conservative portfolio. Keep in mind that your portfolio needs to beat inflation to be successful over the long-term.
2. Improve your portfolio's "time diversification". If there is a certain amount of money you know you will need over the next 2-3 years, or which you simply cannot tolerate losing, then by all means move that money to a shorter-term, more liquid, more conservative sub-portfolio.
3. Take advantage of the market downturn to rebalance your portfolio. While most investors would rather have gains and owe taxes, this is now a good time to make any portfolio moves you were holding back on because of the associated tax hit. Harvest any tax losses within the portfolio that you can use later to offset gains.
4. Think opportunistically. Many smart investors (e.g., Warren Buffett) believe this current market environment has created some unbelievable opportunities. No one is predicting when or where the bottom will be, but if you are comfortable watching your investments go down in the short-medium term, you may be well rewarded in the long term.
5. Don't panic, stay disciplined and think long-term. Cliché advice. It is a cliché because it is true. Whatever portfolio moves you decide to take, take them with the long-term in mind and in accordance with a well-thought-out investment strategy and objective.
6. Be very wary of anyone offering simple or one-off answers. Traders and stockbrokers love this market. Fear sells. They are making a fortune on commissions. You need to look at your entire picture.
7. Don't buy high and sell low.

Difficult Times

These are difficult times. One can never underestimate how fear can affect the market place. The entire stock market has reacted. So far, this crisis has mainly been concentrated on housing and a few financial firms. Now it is starting to spill over to other parts of the economy. Can it get worse? Yes! Will it get worse? We don't know, but we do not believe it will.
Recession talk can be a self-fulfilling prophecy. However, strong productivity and corporate balance sheets have enabled the economy to remain quite solid. Consumer confidence is starting to rebound. The IBD/TIPP gauge of Economic Optimism shot up over 24% in November. Falling gas prices, economic rescue plans and the presidential election have lifted confidence. Unfortunately, no one has told the media and politicians.

The Federal Reserve has created a dramatic increase in the monetary base. Unprecedented! It will take time, but it's setting the stage for the next expansion. Big implosions often lead to big expansions.

In our opinion, the Federal Reserve has acted wisely. We are lucky to have Ben Bernanke. In addition to an Ivory League education, he has written three textbooks on macroeconomics and one on microeconomics. Oddly enough, Bernanke's hobby is studying the economic and political causes of the Great Depression. He has written extensively on this subject. We are in good hands.

The Fed's first move was to apply triage to the banking crisis. In a short period of time, the government has taken over Fannie Mae, Freddie Mac and AIG. They orchestrated accelerated mergers of Merrill Lynch, Bear Stearns, Washington Mutual and Country Wide. Their final dose of "antibiotics" (the bailout) are just starting to take affect.

How bad is the banking system? The FDIC reports only 13 bank failures from January 2007 through mid September 2008. By comparison, there were 15 in 1999 and another 15 in 2000. The Savings & Loan crisis produced failures in the thousands. Since the Great Depression, the average annual number of bank failures has been 94. Stats can be misleading, but we are way below that level.

How bad is this mortgage meltdown? Mortgage Bankers Association reports that 6.4% of mortgages are delinquent, that's delinquent, not in foreclosure. Only 2.75% of all mortgages are in foreclosure. During the Great Depression the foreclosure rate was around 50%. Today, the majority of foreclosures are concentrated to the sub-prime market. Sub-prime mortgages account for 12% of all mortgages, but make up 52% of all foreclosures.

Across the board, home values are starting to stabilize. The National Association of Realtors reports median price of an existing homes are starting to increase. They report median prices are actually up 8.5% from the low of February 2008. Supplementary data supplied by the U.S. Census Bureau reports a 1.3 increase since December 2007. While some geographic pockets may be experiencing declines, aggregately, declines in U.S. housing prices have slowed.

How's the overall economy? The US economy grew at a rate of 3.35 in second quarter. The average growth rate since the Great Depression has been 3.4%. We have had 11 recessions since the Great Depression; right now we are nowhere near the 12th. In fact, export growth and non-defense capital goods orders are running at levels that indicate expansion. The Institute for Supply Management Manufacturing Index (Manufacturing ISM) is running at tolerable levels. Other than employment (which is a lagging indicator), it is difficult to find indicators running at recessionary levels.

We have never seen a surge in the monetary base like we are witnessing today. On October 29, the Federal Open Market Committee lowered the Fed Funds Rate to 1%. This process created a title wave of liquidity. It's the equivalent of a rich relative dumping buckets of money at your doorstep, with a sign attached that says "Help Yourself". Year over year, the monetary supply is up by 48%. Unprecedented.

Money is used in most economic transactions. Increased money supply works by lowering interest rates, and putting more money in the hands of consumers. It creates investment. It makes consumers feel wealthier, which increases spending. It doesn't happen overnight. But as it unfolds businesses will respond to their increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. Stock market prices will eventually begin to rise.

Over the last 82 years, the market has had positive returns 72% of the time. It has been down greater than 20% only 5 times. Markets typically post a 25% return in the 12 months following a correction.

From December 31, 1997 until December 31, 2007 the S&P 500 realized a cumulative return of 77.56%. But, if you were out of the market the results would be different.

If you missed the 10 best days of the market your annualized returned would have been: 1.12%
If you missed the 20 best days of the market your annualized returned would have been: (2.55%)
If you missed the 30 best days of the market your annualized returned would have been: (5.72%)
Stay the course!

Capitulation

Stocks trade on three things:

1. Fundamentals (earnings)
2. Technical (charts)
3. Market psychology (fear and greed)

This market represents fear.

The massive deleveraging of financial firms and market repricing is hopefully nearing an end. Let's hope today is "capitulation". In the stock market, capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.

After capitulation selling, it is thought that there are great bargains to be had. The belief is that everyone who wants to get out of a stock, for any reason (including forced selling due to margin calls), has sold. The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that true capitulation is the sign of a bottom.

Here's the good news. On average, earnings have been good. You can go to CNBC's website and look at the earnings surprises. They have been overwhelmingly positive. However, companies are starting to guide that next quarter's outlook is not looking so rosy. Based on the economic data available to us today, we do not see a slow down lasting a long time.

We have low interest rates, low inflation, and relatively low unemployment. Now, we are starting to see improvement in the credit markets. Policy actions are just starting to come on-line with more to come. The Fed should act very decisively next week when its commercial paper market facility kicks in. The Federal Reserve announced back on October 7th that it was creating a special purpose vehicle to purchase 90-day commercial paper directly from eligible issuers. This creates liquidity for big US companies.

A few years from now, investors sitting on cash, will look back on these days as the greatest lost opportunity. Over the long haul, long-term stocks have done better than any other asset class. While this may not be the absolute bottom, equities are on sale, and today, they may be heading for the "clearance rack".

We still advise you to stay the course. If you have cash on the sidelines, you may want to consider making some buys.

Proverb

"Just when the caterpillar thought the world was over it became a butterfly."

Let's hope this proverb applies to our stock market! 

September Market Commentary

History is repeating itself!

Lehman was the largest bankruptcy in our country's history. It was larger than the previous nine largest combined; it was just a few weeks ago, now it's a passing thought.

The news keeps coming out faster than Wall Street can digest it. Wall Street doesn't like uncertainty. We are feeling the effects of that now.

Back in the late 80s and early 90s there was plenty of scandalous news. You might remember some of these stories.

• The crisis of the Savings and Loans (S&L) industry.
• Ivan Boesky-prosecuted for insider trading.
• Salomon Brothers-caught submitting false bids to the U.S. Treasury. Their story is documented in Michael Lewis' book-Liar's Poker.
• Drexel Burnham Lambert-driven into bankruptcy in the 1980s by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken.
• Michel Milken a.k.a. "Junk Bond King"-Drexel employee who was sent to prison on finance-related charges.

These stories dominated the crisis of that day. This current mess is a re-occurring nightmare from the past. The names might have changed, but the greed hasn't.

From 1986 to 1995, the number of US federally insured S&L in the United States declined from 3,234 to 1,645-a 50% decline. Ironically, it was due to unsound real estate lending. Many other banks failed for other reasons.

Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance.

During the S&L crisis, the government created the Resolution Trust Corp. Now, they want to form the "Resolution Trust Bank". A structure that will buy illiquid assets, mainly mortgage related, to create liquidity within the system.

We are fortunate to have Ben Bernanke, a scholar of the 1930s and the Great Depression, as well as Henry Paulson, one of Wall Street's most respected leaders, at the helm of this crisis. Even though the politics of the day voted down yesterday's plan, we'll eventually see a workable plan.

Even through all of this, our nation, economy and capital markets have survived. Even thrived!

We have seen a breakdown of this magnitude before. We will get through this one.

Tips to Thrive During Economic Turmoil

Tips to Thrive During Economic Turmoil

Now would be a good time to use your yoga breathing.

We are in the middle of turmoil in the financial market. It’s not fun.

At times like these it’s important to have some perspective.

The stock market is still over 10,000.  In 2002, it was at 7,500.  In the early 80s, it was at 750.

Nationally, unemployment is at 6.1% today.  In the early 80s, it was 11%.  During the Great Depression of the 1930s, it was over 20%.

Core inflation has been ranging between 2-3%.  In the 70s, it was double-digit inflation.  It was dramatic, and it was dubbed "hyperinflation".

Depending upon where you live, home prices have declined by 10-20+%.  They are 50% higher than they were at the start of the decade. Plus, the 30-year mortgage rate today is about 7% in the early 80s it was as high as 18%.

Okay, here are some ways to take positive action.

·      Turn off the TV! It’s not healthy to watch channels like CNBC 24/7. Journalists, like markets, suffer from the herd mentality.  They very rarely report on the good things but rather the news that increases their ratings or sells more papers.

·      Check that your bank accounts are federally insured. The Federal Deposit Insurance Corporation insures $100,000 per account holder at one institution.

·      The National Credit Union Administration (NCUA) is the federal agency that administers the National Credit Union Share Insurance Fund (NCUSIF). Which, is a federal insurance fund backed by the U.S. Government. They insure $100,000 per account holder at one institution.

·      Make sure your brokerage account is SIPC guaranteed. Securities Investor Protection Corp. protects up to $500,000, including $100,000 in cash. Most brokerage houses offer additional supplemental insurance as well.

·      Tighten your belt. Remember, it’s not what you make but what you keep. Now is the time to examine your budget and cut out any non-essential expenses. Stop worrying about the Jones! They are not doing as well as you might think.

·      Create a rainy day fund. It’s important to have a savings account that is equivalent to three to six months of living expenses.  This money should never be invested in the stock market. It should be kept in a place where you can have immediate access to it.

·      If you need your money in the next 1-2 years—it should be in a bank product like a CD that’s insured, not in the market. This is a rule to follow all the time.

·      If you are a long-term investor, stocks are on sale. It’s not a time to speculate however it might be time to dollar cross average into the market or purchase some high quality individual stocks.

·      Take some losses and put then in the bank. If you own really good companies it may makes sense to hold on to them; however if you own stocks or mutual funds where the underlying fundamentals are not longer strong or a match for your investment plan. Sell. Do not wait for them to recover. That money will work for you better in another investment opportunity.

Making money decisions under panic is never smart. The key is to remain calm.

It is likely we will continue to experience a bumpy ride for the foreseeable future. Make sure to stay vigilant about your own personal situation.

Discovering Value off the Beaten Path

I sent a last minute call to a good friend and great wholesaler Bob Leahy to see if I could meet two of the asset managers he represents.

Bill: “Bob, sorry for the last minute call. I’m going to be in Kentucky tomorrow. Can you arrange meetings with Andrew Beck from River Road and Tony Weber from Veredus?”

Bob: “Let me see what I can do”.

Bill: “I know Tony Weber / Veredus story. I want to make sure he’s sticking to his process in this miserable market.”

Bob: “Veredus has an open door policy; you’ll be more than welcome”.

Bill: “I’ve been watching River Road from a far. They’re numbers are great. I need to know their story.”

Bob: “Let me see what I can do.”

As always, Bob came through.

As I drove around downtown Louisville looking for River Road Asset Management, I wondered how many other advisors fly around the country looking for value. Couldn’t I just do a conference call like most advisors?

I showed up at their offices with a set of prepared questions. Like a reporter looking for a flaw in their story, I’d find out for sure if this was a boutique money manger.

As I sat in reception, River Road had posted in big letters on the wall, “Discovering Value, Off the Beaten Path”. Great tag line, I’ll need to borrow that one from time to time.

I got the tour of their office and was pleasantly surprised by two things. A board room table that was easily converted to a billiards table (I guess I want one of those for my office) and all employees were from the Kentucky area, even the CFAs and portfolio managers (Kentucky accent is hard to miss). I was expecting Wall Street types and ivory leaguers that were transplanted to Louisville. I was told that you had to be from the area to work at River Road. They want long term employees. I guess the typical blue-blood Yankee types don’t last long in Louisville. Interesting culture, hidden value possibly?

I received thorough presentation by Andrew Beck. Impressive, boutique to the core! Identifiable edge, structured sell discipline, unique story. River Road is able to find value in undiscovered, under-followed, and misunderstood companies via an absolute value strategy. If I were fishing for boutique money managers, I just caught another one.

Time was running short. I needed to get on the highway, head north, visit Veredus, and find time to procure some fine bottles of bourbon (another value quest) before heading back to Boston.

Not being from Louisville, the directions I had for Veredus was hard to follow. Had they told me of their proximity Ruth Chris Steak House, I would have found it instinctively, oh well.

I’ve been a fan and a client of Veredus for quite some time. I know their story, and have always been impressed with Tony Weber. I have had many meetings with the Todd Patterson (Director of Marketing) from Veredus, but had never met the master fund manager of Veredus Aggressive Growth and Veredus Select Equity.

Over lunch, I was schooled on theory earnings momentum. I probed for weakness in the theory, especially in this current volatile environment. “I been doing this successfully since 1980, I’m not changing my strategy”, stated Tony. Upon completion of presentation, I was more than convinced

The conversation quickly switched to bourbon (by me of course). The quest for bourbon began. Tony sent me to a secret location. I was to ask for John Smith (name changed to protect the innocent). Tell him, “Tony sent you”. Jackpot! 8 bottles of the finest, single barrel bourbons made their way back to Boston. Unfortunately, I need to check my luggage. Smuggled 8 bottles home, 7 made it all the way. One crashed and we had many unhappy pieces of luggage smelling like bourbon. Oh well!