The Waiting Game

As you have read, heard, and seen in hundreds of headlines and news clips, it has been a troubling year in the markets thus far. From the viewpoint of the general stock market, it was a tough quarter. The S&P500 lost nearly 10%, and down much more earlier in the quarter – a bad downturn, but we’ve seen worse. If you look at volatility, by one measure this was the most volatile market since 1938 when measured by the number of days in which the market was up or down by at least 1%. But on another level that we cannot quantify, we had many ingredients that could have led to a complete meltdown in the financial system.

As you will read in this update, there were some important counter-forces that prevented this scenario, but the confluence of events is alarming. Fortunately, I think the worst is behind us now.

To summarize:

It all starts with real estate. We are in the midst of the worst housing correction since the 1980s and perhaps far beyond. Housing prices have declined by as much as 30% in some markets, erasing over three years of house price appreciation. While some of the decline is cyclical in nature, the largest driver is the aggressive and sloppy lending practices of the banks originating the loans.

From these sour real estate assets, the global banks have reported losses of roughly $200 billion in just a few months, mainly driven by the subprime lending market. These loans were extended to folks with marginal credit and overvalued houses. To make the payments palatable for the borrower and attractive to the lender, most of these loans were structured with rapidly inflating payments. This structure, combined with the cyclical decline in real estate values, has led to a vicious circle of declining values and defaulted loans.

Exacerbating the situation, the subprime loans were sliced, diced and spun into a wide range of financial products used by institutions around the globe. Because of this financial engineering and sloppy rating practices, a number of these new products were classified as “safe” investments with AAA ratings. They were in fact illiquid and subject to steep losses.

These events led to the collapse of one financial insurance company (ACA Financial) and jeopardized the health of several others. The financial insurance companies were mainly engaged in the business of insuring municipal bonds in the event that a town or municipality defaults. Unfortunately, these same companies also insured some of the new subprime-backed financial instruments. As those instruments start to fail, so goes the capital of these insurance companies. In an overreaction to the situation, the market started to view any municipal bond with insurance as risky, even though municipal bonds are historically very safe and insurance is a recent addition.

The culmination of these circumstances led to the freezing of the credit markets. In short, banks and institutions refuse to trade bonds with each other. Starting with corporate bonds, then municipal bonds, then basically any bond that isn’t a US Treasury Bond, the market eventually said, “no way, not today.” If you’ve got bonds – you are stuck with them. On the other hand, if you willing to buy bonds, there are some great bargains to be found.

A freeze of the credit markets is akin to playing with fire in a refinery. Not a good idea. Fortunately, the Fed had some inkling of what was about to happen, and took a series of aggressive measures to avoid the obvious. They instituted four new lending facilities for banks followed by the purchase of Bear Stearns’ ailing mortgage debt, effectively dousing the entire financial system in a blanket of fire retardant foam. Not a promise of ultimate safety, but as close as we can get to one.

Oh, and did I mention that we’re in a recession? Of all the stuff going on, this is the least worrisome of the issues. Recessions happen – it is a part of the business cycle. Frankly, we’re in a good position to recover in a timely manner. While the economic recovery may not occur as fast as some would like, we will get back to economic expansion.

These events have had a profound effect on the markets. First, the equity market continued a decline that began last fall. Dropping another 9.5%, the market is skirting on bear market territory. While the downside may be limited now, the US equity markets will likely bump along for some time until there is certainty around corporate earnings and economic growth. By lowering our equity exposure last fall and early in the quarter, we have buffered ourselves from much of this volatility.

The larger problem has been the impact of the credit markets on our holdings. Some of you are already aware of these issues, but many of our bonds and preferred stock holdings have been priced at a discount because of illiquid markets and unusual pricing. We have responded in a number of ways. In some instances we have sold out of the highest-grade debt to take advantage of the high prices we can get for such instruments. In other cases, we have purchased debt and preferred stock with steep discounts and high yields. The risk here is the underlying credit – the company’s ability to remain a solid firm – placing emphasis on our analysis of the company and understanding of the debt structure.

For fixed income securities, we have been loading up on discounted bonds and preferred stock that will pay interest or dividends of seven to 14% for anywhere from a few months to 15 years. In all of these cases, we have been purchasing the debt of high quality firms with solid credit ratings and ample ability to cover their obligations. The availability of such high yields when treasury rates are so low is a by-product of the market’s aversion to any form of risk, no matter how slight it may be.

For stocks, we have followed our tried and true approach – buy value-based companies at low prices. Firms such as GE, J&J, CSX, FedEx and United Technologies constitute the core of our equity holdings. Other firms, such as Apple and Alnylam, have gone out and come back into some portfolio as we sold at peaks and bought at valleys. In such a volatile market, these opportunities abound. It is our job to find them.

In this next quarter, we are still in a wait-and-see posture. The first three weeks have been very positive, with some bond markets regaining their equilibrium and US stocks showing respectable gains. We expect the equity markets to slowly move off their bottom with the possibility of additional volatility. As volatility subsides, the perception of risk will also subside leading investors to slowly come back into the debt and equity markets. Combined with the Fed’s monetary actions and the stimulus package, we expect the economy to slowly stabilize as well.

Our research and investment focus will swing towards global commodity prices and the impact it will have on the basics such as food. Furthermore, water is increasingly becoming a scarce resource across the globe, a situation that will factor heavily into food prices. We have already incorporated these views into our portfolio with investments in companies such as GE and baskets of alternative energy stocks. Expect to see further investments of these types in the coming months.

As usual, please call with questions, comments, or the like. Also visit our retooled website with an updated look and new research.

Enjoy the spring,

David