Third Quarter, 2008
Clients who have worked with us for any period of time have been subject to our nonstop mantra regarding the benefits of diversification. The idea behind this strategy is that different types of investments are impacted in different ways by economic and political events with positives and negatives somewhat neutralizing each other in terms of overall portfolio performance.
In the current global panic however, stocks, many areas of the bond markets and commodities have declined in unison. Diversification has temporarily ceased to provide its usual benefit. Presently, sellers of marketable securities have been depositing sales proceeds in bank deposits, money market accounts and short term treasuries. The first half of October for example, has experienced record investor withdrawals from mutual funds and hedge funds.
Governments will eventually win this marathon against panic simply because governments’ ability to create money is infinite while consumers’ ability to liquidate investments is finite. This panic will subside through the combination of eventual exhaustion and increasingly attractive asset values. Home property values, where ongoing price declines have been at the root of the current crises, will begin to stabilize as soon as prices reach compelling valuation levels in the eyes of prospective purchasers. We are now observing the beginnings of some degree of balance between home sellers and home purchasers in the existing home market as revealed through various industry-wide statistics.
Franklin Roosevelt’s words are as relevant today as they were in 1933 when he said “the only thing we have to fear is fear itself”. We all recognize that Mr. Market has been in the midst of a massive, panic-driven market decline which did not have its origin in broad economic fundamentals. Borrowing from another quote: “We have met the enemy and he is us”. In this current environment the skills needed to manage client portfolios include an understanding of crowd psychology in addition to training in the analysis of company financial statements.
Market comparables for the nine months ending Sept. 30, 2008 are presented below:
Money Market Fund Proxy 1.8%
Russell 3000 Index (U.S. Stocks) -18.8%
MSCI EAFE Index (Non-U.S. Stocks) -29.3%
MSCI Emerging Market Index -35.5%
Lehman Aggregate Bond Market Index Fund .5%
MSCI REIT Index (Real-Estate Trusts) 1.8%
Gold (Commodity) 4.4%
Philadelphia Gold/Silver Index (Mining cos.) -23.8%
US Trade Weighted Dollar Index 3.9%
CPI Inflation 12 months 4.9%
The third quarter was particularly challenging as the ripple effects from the credit freeze and individual and financial institution deleveraging took their toll on virtually all client portfolio holdings. As the third quarter progressed, markets entered an accelerating loop of asset price declines, calls for further institutional and individual deleveraging and, indiscriminate asset sales. And to make matters worse, banks were freezing or reducing access to credit for increasing numbers of their customers. Given the great uncertainties in investment markets and in the economy, we have set aside enough cash to meet the next two years of distributions from client accounts to insure that we won’t be compelled to sell securities prior to a return of a more normal market valuation environment.
There continues to be tremendous diversity among returns in the bond sector. The benchmark section of the report above presents the results for the Lehman Aggregate Bond Market Index Fund ETF (AGG) as a proxy for the overall bond market. Based upon the nine month returns for AGG one might conclude that bond markets have been fairly tame, although not particularly profitable, through September 30. Beneath the surface however, nothing could be further from the truth. The Lehman Index is composed of approximately 77% government and government agency bonds, with the balance being investment grade corporate bonds.
AGG is an unleveraged index fund, meaning that the fund’s managers do not borrow money to purchase bonds for the portfolio in addition to the money invested by the equity shareholders.
Many client portfolios have an allocation to closed-end bond funds that a) primarily contain corporate bonds which have, as a group, declined in market value during this year to a significantly greater degree than government bonds; b) fluctuate in market price around their underlying net asset value to a substantially greater degree than does AGG and c) frequently employ leverage which has the effect of magnifying changes in portfolio market value, relative to unleveraged portfolios. When normalcy returns to the non-government portion of the bond market as the credit freeze thaws, we expect that the severe declines in the price of these securities will reverse.
The benchmark index numbers also reveal a dramatic decline in the price of mining company shares relative to the price of gold. We can only surmise that this dichotomy is illustrative of investors’ mad scramble out of stocks without regard to industry fundamentals causing gold and precious metals mining company shares to be hit hard as of September 30.
During the remaining months of 2008 we will take tax losses on various securities in client taxable portfolios thereby raising portfolio cash levels. We plan to gradually re-enter securities markets at today’s more attractive prices for both bonds and stocks. We continue to marvel not only at valuation levels of many solid companies but also at current yield levels on various non-governmental bonds and closed-end bond funds. Our caution will continue nevertheless as we believe a rather long period of deleveraging is in progress at both the individual consumer level and at financial institutions around the world. Deleveraging implies reduced levels of consumer spending, lower levels of bank credit available to their customers, and slow or negative GDP growth for some period of time.
Future actions taken in client portfolios will depend upon events as they unfold in the market place, both domestically and internationally. Through the fog of this panic we maintain the view that concerted government actions to reinforce the banking system will ultimately prevail. All panics eventually end in exhaustion as security valuations become increasingly compelling. We believe the current panic will end in a similar manner. Our thinking is also influenced by the history of investment market recoveries which in the past have begun approximately 3-6 months ahead of tangible evidence of economic recoveries.
UMB Bank
Some of our clients have inquired regarding the safety of their investment accounts at UMB. We believe your account(s) bear none of the types of risks experienced by many other investors with affiliations at other financial institutions. The principal reason stems from the fact that your portfolio is held in the trust department of the bank and is therefore not subject to the risks associated with UMB’s other banking activities. In other words, your assets do not collateralize any of the bank’s business operations.
Also comforting is the fact that UMB is one of the most conservatively run banks in the country. The have largely sidestepped the spreading tentacles of the subprime mortgage debacle. In recognition of this achievement their stock has appreciated this year through October 20th, a truly remarkable feat!