The most dangerous words when it comes to investing are “this time it is different”. There is always uncertainty, bad news and prevailing despair during every Bear Market or we would not have them. Yet with the passage of time, we tend to forget all the fear and uncertainty that ruled at that time. Remember the “tech wreck” that destroyed trillions in wealth followed up with 9/11, SARS and Iraq? The wisdom then was that we would never go into shopping malls or restaurants again for fear of terrorism and infection. Remember 18% interest rates and 12% inflation in 1982? While today’s headlines are lousy, let’s put some perspective on the economic realities.

 

Yes, there is a great deal of uncertainty at the moment. The banking crisis clearly got worse than most could have ever imagined just a couple of months ago. The credit markets absolutely stopped functioning in October, banks stopped lending to everyone (including each other) and investors feared for even the safety of their bank deposits. But as every new fire broke out it was met with quick government intervention. Central governments have shown an understanding of the severity of the problems and a willingness to coordinate an effective response. Trillions of dollars worldwide are being pumped into the system so all the Depression talk is just plain irresponsible journalism. There is no doubt that we will see some ugly economic statistics in coming months as a consequence of the banking malfunction and a recession is likely unavoidable at this juncture. But at one point last month, the major stocks markets were down 45% from their peaks which is absolutely “off the charts” in terms of a reasonable forecast for how bad this recession will get.

 

Markets rarely get it right over the short term and always overshoot fair value due to momentum, fear, greed etc. Oil at $147 a few months ago was clearly mispriced and oil at $70 today is just passing through on its way to either $50 or back to $100. Was Goldcorp priced correctly at $52 last July, $18 last week or $26 today? Bear in mind that the price of Gold in C$ terms has moved less than $150/oz in that time frame. I think markets have forecasted a nastier and longer recession than what will actually materialize because I don’t think markets are that terribly efficient at any given time. The “deleveraging” process as a consequence of the credit crunch and the resulting forced liquidations that occurred in hedge funds last month drove a cheap stock market down to levels that are completely unreasonable and unsustainable. Remember, I said in my last letter, we entered this Bear Market with very reasonable valuations and now, Standard and Poor’s estimates that 40% of the stocks it tracks are trading at less than half of their long-term market valuations and 10% are trading below their current cash holdings. Is this an efficient market trading on fundamentals?

 

So prevalent was the fear last month that on two different occasions, U.S. Treasuries yielded a negative return. Investors bid up the price of short term U.S. Treasuries to the point that they would get back less than they invested! They were willing to lock in a guaranteed loss but they knew the U.S. government would print the money to pay them back most of their capital. So what happened? It seems that with the benefit of hindsight, the U.S. government completely underestimated the consequences of allowing Lehman Brothers to fail on September 15^th. Bear Stearns was transitioned in an orderly fashion to JP Morgan in March and chaos was averted but allowing Lehman to fail strained the system unnecessarily. When it declared bankruptcy, $600 billion of hedge fund assets were frozen and this kicked the deleveraging process into high gear.

 

To put that number into perspective, the total amount estimated to be in hedge funds at the start of the year was just under $2 trillion so a huge chunk of assets were plunged into chaos. Hedge funds almost always employ lots of cheap leverage to magnify returns and to complicate matters, almost overnight the cost of those loans skyrocketed due to the credit deep freeze. The result was one big “margin call” that lead to the forced liquidation of an estimated $350 billion in stocks that were dumped onto a very fearful market and the result was a market plunge of about 23% in N.A. indices over a one week period ending October 19^th. Markets began to steadily climb last week (and are up almost 20% from their lows in just over 5 days) but the TSE and S&P were still down 17% on the month.

 

The unwinding of “inflation trade” that was a very popular Hedge Fund strategy hit Canadian resource stocks particularly hard. This trade had funds owning all things oil, gold, agriculture etc. and going short the U$ and suddenly the strategy was broken on both sides. The deleveraging process paradoxically resulted in the U$ appreciating very rapidly as money flowed back to the U.S. to pay down leverage. Even though the U.S. got us into this mess and is printing $1-2 trillion to inject liquidity into the system, the rush to the U$ was on. And while hedge funds were responsible for almost 30% of all the trading volume on the NYSE, clearly others investors either ran for the sidelines or were pushed there if they were using margin. During all of this, the “VIX Index” (known as the volatility or “fear” index) soared to 89.5 on October 24^th when in prior times of crisis (9/11, the Asian Contagion etc.) it never broke 50 which is where it is down to now.

 

This Bear Market has punished everyone including Warren Buffett who has paper losses of $13.6 billion this year or about 22%. Another billionaire, George Soros reportedly lost $20 million betting that Lehman would survive. Even a Hedge Fund that shorted Lehman when it forecasted it’s bankruptcy is on balance down 25% YTD. Nothing has held up to the Bear and the deleveraging process has led to irrational consequences that confound all. So while things got much worse than we could have ever predicted just 2 months ago, and there remains lots of uncertainty, we think markets have clearly overreacted and are the cheapest that they have been since 1982. The credit crisis seems to be waning, panic is dissipating and we hopefully will see a return to rational pricing over the coming months. I see no reason to sell good companies at fire sale prices when we don’t have to with the one exception being to harvest capital losses where appropriate to get a tax refund in the spring. So speak to your accountant to see if you paid capital gains taxes over the prior 3 years and if so, it may be advisable to “harvest” losses before year end. We will remain invested in similar companies or funds so that we can participate with the markets when they return to fair value.

 

Lastly, I would like to thank everyone who has inquired about my personal well being through this very stressful time. This has difficult for all of us but I know we will all survive this storm if we remain rational and keep our heads!

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