“It is never going to get better, it just keeps getting worser!”
Carter Lahey, age 4 after an injury.
Four year olds (or at least mine) are prone to exaggeration. They live in the moment and whatever they are experiencing in that moment appears to be their reality that stretches as far into the future as they can imagine. Human beings in general suffer from that same sort of myopic outlook when it comes to investing. We tend to think in a linear fashion and whatever has happened most recently will continue to happen for the foreseeable future. If the market is going up, it will keep going up and if it is going down, it will just keep going down.
Investing is what I have labeled, “an emotionally strenuous” activity and many investors let fear and greed destroy their chances for a successful long-term return. Most investors are way too accepting of risk at market tops and way too risk adverse at market bottoms. The most celebrated investor of our time, Warren Buffett, said that most are greedy when they should be fearful and fearful when they should be greedy. (By the way, Warren has made the news lately by investing billions into Goldman Sachs and GE so I guess we know how he is feeling these days.) In reality, stocks are the only “things” that most individuals feel compelled (by fear of further losses and of the “unknown”) to sell after they have dropped by 25-50%. We don’t do this with our homes or our other assets but we seem compelled by our primitive “fight or flight instincts” to do such with our ownership in companies. Actually, perhaps we would behave similarly if there was a market that told us what our homes were worth every business day and all that was involved in selling it was a few key strokes with no need to pack and move!
As you know, we are currently experiencing a vicious Bear Market downturn. The selling pressure in September was unrelenting with the TSE losing about 15% of its value in 4 weeks. From its June peak, the TSE is down 29% in just 3 months which is absolutely stunning. The S&P500 (representing the largest 500 companies in the US) is down about the same but its slump from its peak took 15 months. All global stock indexes are down at least this much but many are down much more. While our commodity heavy TSE shielded us better than most markets, widespread fears of a global recession have gripped the markets in recent weeks. Where just a few weeks back there was more demand than supply for all things commodities, now it has shifted into weaker demand and ample supply for those very commodities (oil, copper, fertilizer etc.). Just a few months back we faced a global food and energy shortage, and now, not so much. Fears of global inflation a few weeks ago have been replaced with fears of global deflation, resulting in a dramatic re-pricing of commodity stocks. Alternatively the massive unwinding of leverage has given the “appearance” of commodity deflation and only time will tell which is correct (I still think it is the latter by the way).
These past 2 weeks have been extremely volatile and I know it is getting to all of us. There have been 3 different 800+ point day moves on the TSE (2 down and one up) based on what is happening in Washington. Not since the Congressional hearings on the Worldcom and Enron bankruptcies has the world paid so much attention to the US political process and it makes our collective stomachs queasy. We watch President Bush on live television tell the world that Congress needs to approve the Bailout Package to avert certain disaster. And then in a stunning development that could only happen in Washington, Congress voted down the Bailout, leaving us all to contemplate for a few days of certain disaster.
Then to throw more gas on the fire, we saw a US Senator go on live television and incite panic by talking about how he has inside information about a major insurance company on the brink of failure if this Bailout does not get through Congress. Shakespeare could not have done a better job of writing the tragedy that unfolded in Washington over the last few weeks.
So what happened after the Bailout Package was finally approved on Friday? With the backdrop of incredible fear mongering that had taken place over the prior 2 weeks, is it any surprise that it was met with more of the same fear and despair that the political process helped to create? Many were expecting a relief rally on its approval and quite frankly I think we would likely have had one the first time around but after 5 more days it was just met with pure skepticism. As I have said several times, markets bottom either with selling climaxes or with widespread despair (“it is never going to get better, it just keeps getting worser!”). Well, we have had several selling climaxes that could certainly be considered capitulation, and we now have widespread, universal despair. Take your pick.
We all know that the Bailout Package is not going to be “the silver bullet” that magically fixes everything. However, it should help to restore orderly markets and boost confidence ever so slightly. It was needed because banks literally stopped lending to each other, much less to individuals and businesses. Bank capital is tied up in illiquid securities that are very difficult to accurately value and they were being forced to write down the value of these investments to the lowest bid in a very illiquid market.
What would happen if the same process occurred at the same speed in your own neighborhood? Let’s imagine that your neighbors’ mortgage does not get renewed by their bank and they have to find a buyer with a one month closing. Would they get a fair value for their home under these circumstances? Of course not but let’s carry it a step further. What happens when your house and all the houses in your neighborhood are marked down in value to that one forced sale price? If your outstanding mortgage is more than that “reference price” and everything is happening as fast as it is in the capital markets these days, you get kicked to the curb within days.
This is essentially what was happening in the banking system over that last few months. It has contributed to the overnight bankruptcies and forced sales of such Wall Street stalwarts as Lehman, AIG, Merrill Lynch, Washington Mutual, and Wachovia (and has begun to spread to Europe). So now the US government is stepping in to swap cash for illiquid assets which should help to grease the gears once again and enable banks to start lending that cash to their customers at a profit. This model was used successfully during the last banking crisis 20 years ago (the Savings and Loan Crisis) and there is every reason to believe it will work again given time. It is entirely possible that the US government and taxpayer will actually make money over the next couple of years on these asset purchases (just like the buyer of the forced sale on your street!).
The bill also raises the deposit insurance in the US from $100k to $250k which should help to reduce the fear in the marketplace that deposits are at risk. Washington Mutual and Wachovia both experienced “runs” where clients pulled their deposits making the death spiral inevitable. Once a bank loses its deposits it is all over. Happily, the Canadian banking model is much stronger as we have fewer, less competitive, better capitalized banks that have been vindicated as some of the most conservatively run banks in the world. When the dust settles, that is what the US banking landscape will likely resemble. There will be fewer, better capitalized banks that will absorb the weak. In fact, in an overlooked bit of positive news this past Friday, Wells Fargo stepped into the fray and offered a competing bid for Wachovia with no government support requested. So now Wells Fargo and Citigroup are exhibiting “rationale greed”.
So where do we go from here? Well after seeing the VIX Index (literally known as the Fear Index) spike over the last 2 weeks to levels not seen since the bottom of the last bear market (and prior to then, the 9/11 terrorist attacks), there is a very good chance that we may have seen the worst of this mess. And unlike prior bear markets that began with rich valuations, (like the “tech wreck”) market valuations were very reasonable heading into this downturn. We actually need a very painful and prolonged global recession to justify what has been priced in already!
Of course, the media has skipped over the recession talk and is now predicting a Depression which entails a drop of 30% in GDP and 20% unemployment. That sure sells papers and airtime!
Another indication that we are getting close to the bottom is that analysts are now rushing to be the first to downgrade their stock recommendations when just a few months ago they were pounding the table on why their stocks would hold up the best. When analysts capitulate and tell you to sell (like the Merrill Lynch analyst did this week to the fertilizer stocks after they were already down 50% in 3 months) you know we are getting close.
Our strategy committee recently crunched some numbers that examined all the bear markets since 1956. On average, it takes 13 months to find the bottom and that bottom is 28% from the peak. Twelve months after the bottom has been found, the market is up 30% and within 19 months from the bottom, we are back to all time highs. This downturn began in July of 2007 and as mentioned, most markets are down 28%+ from their peaks so if it were to end right now, we would satisfy both the duration and the damage of the average bear market over the last 50 years. While this downturn feels worse than the ones before it, that is only because we are in the thick of it at the moment. In every downturn, seemingly unique and insolvable crises (remember 9/11?) present themselves and then fade from memory as the expansion resumes. By the way, our Chief Investment Officer, Dan Chornous thinks stocks are as cheap now as they were at the bottom of the last bear market.
There is over $3.5 Trillion in cash that has accumulated on the sidelines with much of that earmarked for equities for when the bottom can be determined. That is more cash as a percentage of the stock market than there was at the last bear market low. If confidence creeps back into the markets, we could have an absolute buying panic. Smith Barney’s John Manley once said that the shortest interval of time measurable by man is between the moment when it is too soon to add to stocks and the moment when it is too late. I am looking for that moment but in the meantime, selling into this pessimism just does not seem reasonable to me.
We usually define a Bear Market as a drop in index value of 20% or more. I recently came across another definition of what a Bear Market is and I suspect Warren Buffett operates under this interpretation:
“A Bear Market is a period of time during which common stocks are returned to their rightful owners”.
I know this has been and continues to be a very stressful time and I hope my updates help. I take the time to write my own updates because I think you want to hear my thoughts. But in the interest of disclosure, they are not just my thoughts. I am spending many hours each week on conference calls and in presentations, drawing from some of the best investment minds in the business and it is somewhat reassuring that nobody has all the answers. Professionals with 50+ years of investment experience are feeling humbled and are being challenged just like we are.
I used to say, if you are losing sleep over your investments then we need to talk but I think we are all losing a bit of sleep these days. That being said, if you think you not sleeping as much as most, please give me a call and we can discuss everything further.