A Defining Moment
December 31, 2008
Market Summary – 4th Quarter, 2008
This is the “Defining Moment” for our generation. Perhaps like no other time since 1933, when Franklin D. Roosevelt assumed the presidency in the depths of the Great Depression, has our financial landscape been at such a crossroads. FDR laid the groundwork for America’s economic engine that would carry on for decades. Our country may now experience a similar renewal.
The late 1920s and early 1930s marked a period where our country lost its way and confidence in the American form of capitalism eroded. The case could be made that something very similar has happened today. In 2008, we witnessed the fallout from:
- careless lending practices;
- excessive use of leverage by institutional investors;
- the collapse of derivative markets; and
- questionable investment decisions by professionals who should have known better.
All of these trends came to a head at lightning speed in 2008 with a stunning sequence of events that changed the look of America’s financial marketplace:
- Bear Stearns, Lehman Brothers and Merrill Lynch are either gone or are no longer independent entities
- The other two giants of investment banking, Goldman Sachs and Morgan Stanley, were converted into bank holding companies
- The government stepped in to bailout the world’s largest insurer, AIG, the nation’s most storied bank, Citigroup and America’s biggest car manufacturer, GM.
- IndyMac, Wachovia and Washington Mutual needed a takeover either by the government or by selling themselves to other entities
- Fannie Mae and Freddie Mac went from “government-sponsored” to “government-rescued” entities.
- Oil prices collapsed to a low of $33/barrel by December, a 77% drop in price in five months
- Home foreclosures reached record levels as housing values continued to erode and many investors were left holding worthless securitized obligations.
You would expect events this dramatic to occur over a lifetime, not in a nine-month span.
Given all that happened, the results for 2008 did not seem so surprising:
- The 37% decline in the S&P 500 was the worst since 1931, and the index ended the year down about 42% from its peak reached in October 2007.
- 397 stocks in the S&P 500 were down 20% or more, 158 lost 50% or more of their value and only 24 stocks in the index were positive in 2008.
- The Lehman Corporate High Yield Bond Index was down 26.16% for 2008, and its index of investment grade long-term credit lost 4.5%.
- Global markets offered no respite. The MSCI EAFE Index fell 45.1% in 2008.
Fear Strikes Out
Fear has had a lot to do with the market’s reaction to recent events. Yet what we are living through today bears little resemblance to the dire circumstances that gripped the nation in 1933. “The Defining Moment,” a new book by Jonathan Alter about FDR’s first 100 days, paints a picture of the period leading up to his inauguration in 1933 that was far more threatening than what we see in our nation today:
- The Friday before FDR’s inauguration, the New York Stock Exchange suspended trading indefinitely and the Chicago Board of Trade closed its doors.
- 34 of 48 states had closed all banks temporarily to halt rampant withdrawals by panicked account holders fearing they would lose everything (FDIC insurance did not yet exist.)
- Unemployment stood at 25% officially, but was closer to 40% among non-farm workers, and as high as 80% in some urban areas.
- Business investment was down 90% from 1929.
- Per capita real income was lower than it had been three decades earlier.
Without belittling today’s challenges, the streets of America in 2009 look far different than they did in 1933. The media remains committed to telling us that we may be entering the next Great Depression. By all evidence we see today, that is hyperbole.
The economy is still experiencing the effects of free market behavior. Areas such as retailing, banking and automobile production grew way beyond sustainable levels. The self-regulating mechanisms of the market are now cleansing the economy to lay the groundwork for the next period of growth. This process will take time, contrary to our culture of instant gratification. We believe patience rather than capitulation is required.
Watching the tide turn
Bad economic times are difficult, but they are nothing new. We experienced it after 9/11, during the credit crisis of 1973-74 and with the back-to-back recessions of 1980-82. After each of these events, our country was stronger and more resilient than before. If you believe in capitalism, than you must have confidence that the markets will justify your faith going forward. We don’t invest on blind faith alone. Below are a few examples of positive factors at work:
#1 – Bernanke has drawn a line in the sand
Many liken the role of President Obama to that of FDR. We believe the more accurate comparison to Roosevelt’s efforts in the 1930s can be seen in the actions of Federal Reserve Chairman Ben Bernanke. Like FDR, Bernanke seems willing to experiment with different measures to find something that works. He has been implementing steps ranging from a nearly 0% Fed Funds rate to rescue programs for big companies to buying bonds and, yes, printing more money.
Bernanke is not alone. Other central bankers have joined him in working to keep markets liquid. The new Obama administration may be arriving at just the right time. Like FDR and Ronald Reagan, Obama seems to have the capacity to instill confidence back into our nation. If he can do that, investors will begin to look at the markets from an entirely different perspective.
# 2 – Low energy prices and low interest rates
Consumer spending is down as layoffs rise and caution sets in. Fortunately, consumers have caught a couple of breaks lately:
- Declining oil prices have, in effect, generated $350 billion (in energy cost savings) for the American economy. Affordable energy has always been a boon to economic growth.
- Low interest rates are giving many the opportunity to refinance their mortgage or pay less for other loans, potentially leaving more money free for other purposes.
These events should be of benefit to the economy at a time when it is really needed.
#3 – The long-term alternatives to stocks are ????“People who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.” -Warren Buffett
Buffett made this comment in an opinion piece he wrote for The New York Times in mid-October explaining why he was “Buying American” stocks. One reason his piece is so significant is not only his support of stocks, but his reminder that investing is all about protecting purchasing power. You won’t get protection with cash instruments paying little more than 0%. The world’s most respected investor reminds us that with government efforts to stimulate the economy (through increased spending and by printing more money), inflation will be back and erode the real value of cash accounts.
The manic rush to 3-month Treasury bills that essentially drove interest rates to 0% is the ultimate sign that fear has overtaken rational investing, as demonstrated by these rates at the close of 2008.
Buffett stated “equities will almost certainly outperform cash in the next decade, probably by a substantial degree.” That seems likely, especially if you believe in the future of America’s economy.
#4 – Investors are lying in wait, but maybe not much longer
A couple of numbers indicate a possible turnaround is at hand for equity markets. Start with a compelling piece of data compiled by Bloomberg and the Leuthold Group. The amount of money individuals and institutions hold in cash is 74% of the market value of U.S. stocks. That’s the highest ratio of cash-to-equities since 1990. Their research also shows that the last eight times cash peaked compared to the market’s capitalization, the S&P 500 rose an average 24% in six months! At some point, we’re bound to see money return to the markets.
A second important fact – for the first time in 50 years, the yield on the S&P 500 topped that of the 10-year Treasury note. In other words, even with NO capital appreciation, that equity index is generating a greater return than bonds in today’s environment. Investors should eventually recognize the obvious opportunity. It is helpful to have your investments in place before the market turns.
#5 – Markets recover before recessions end
In case you view us as “Pollyannas,” we recognize that many economic indicators we will see in 2009 may not be favorable:
- Layoffs will continue and unemployment will rise
- Housing will remain depressed, with more homeowners facing foreclosure
- The nation’s economy will decline, at least in the first part of the year
- The recession will continue to be felt in most parts of the world.
However, the stock market is a predictive indicator. History tells us that the market anticipates the recovery, and starts to respond favorably several months before the recession ends. Consider what has happened since the early 1970s.
When will the recession end? We don’t know. Even if it muddles through 2009, a different scenario may play out this year. The combination of a severely beaten down market and a sense of renewal created by the change in Washington could help to turn the tide of market psychology earlier than would normally be the case.
Looking for tangible value
One of the natural mechanisms of the market is to eliminate weaker companies that don’t have the financial stability or underlying competitiveness to stay in business. That creates an opportunity for strong companies to grow even stronger. Our focus is not on stocks, but on companies that are positioned to meet the needs of the world. We continue to investigate solid firms with sound financials and the right products and services to meet those needs.
We strive to identify key businesses in secular trends that will help drive a market recovery. Among the themes that continue to make sense:
The recent collapse in oil prices may represent an overreaction to the global recession, but it does not change the long-term prognosis for oil. As the Financial Times summarized in an October, 2008 headline:
World will struggle to meet oil demand
Don’t be fooled by the recent drop in domestic oil demand. By 2010, according to the International Energy Agency (IEA), China will overtake the U.S. as the largest energy consumer. If trends hold, oil demand from developing markets in Asia, the Middle East and Latin America will outstrip usage in developed countries (the U.S., much of Europe, Japan) by 2015. Meeting the demands of developing countries will require, according to the IEA, annual investments of $360 billion. Even with that much money put into development of oil sources, output is projected to decline annually by 6.4%. Hard to imagine oil prices staying at today’s low levels given that projection.
Gold was on a roller coaster ride in 2008. Longer term, we see prices moving in an upward direction. According to the website kitco.com (our thanks to Miles Franklin Ltd. for directing us to this information), it costs a lot more in various currencies to buy an ounce of gold today than it did five years ago:
Historically, individuals are drawn to a store of wealth, namely, gold and other commodities that maintain some tangible value. Our position in gold-related companies has been maintained throughout the year, and we continue to see this as a source of opportunity going forward.
Another re-birth on the horizon?
We are not among the doomsayers who believe America is on the decline. Amar Bhide, a professor of business at Columbia University, provides a perspective that we believe is correct. Bhide was quoted in a recent Business Week profile (Jan. 19, 2009 issue) saying that while the recession will be painful, “most people will come out of it fine.” The reason – innovation. According to Bhide:
- Difficult times can create pain, but it is easy to overstate the impact. In 1999, he predicted the Internet bubble and suggested everything would “blow up.” While things got bad, Bhide admits now that “the overall process of economic growth and economic prosperity stayed in place.”
- A recession often stimulates the adoption of new technologies. Good examples – the 1930s saw the highest productivity growth of any decade, as new technologies were put to use. Similarly, productivity boomed in the 1980s following a recession, as the personal computer revolution took off.
- The good news, says Bhide, is that our society is more innovative today than at any time in history. Smart people look for opportunities that will lead us into the next recovery and economic boom.
We believe that Bhide’s closing thought in the Business Week piece sums it up perfectly – “Anyone who thinks that’s going to happen overnight or without pain is delusional. Anyone who thinks that this (our current economic decline) is a bottomless pit is crazy, too.”
This is a “defining moment” for investors. Those who remain fearful that the economy is stuck in reverse will forego the opportunity to position for the next wave of wealth creation. Those who recognize that there is an upside for real businesses with realistic valuations and a plan to move forward will step outside of today’s conventional wisdom. The talking heads in our media, who just last year were predicting positive forecasts, are now telling you to sell…that indeed the sky is falling. These are very smart people who tend to live in the moment; they extrapolate current trends into forever and fail to look out “over the valley.” Analyzing current data and anticipating future data are two entirely different skill sets. The economy can only be an impediment for so long. Companies with genuine value will recover and create tangible results that will translate into new opportunities.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.