Fourth Quarter, 2008
It was truly a beautiful sight to watch the joy visible in the beaming faces of the million-plus visitors who came to Washington, D.C. to celebrate the inauguration of Barack Obama. Equally stunning was to hear about the celebrations of million of others around the world precipitated simply by the election of one man to the presidency of the United States and the hope of a “new beginning” inspired by that election.
Numerous studies of stock market cycles have revealed that markets turn well ahead of clear signs of an economic turnaround and the catalysts for the rebirth of bull markets are varied. So, many people were hoping that with new leadership, a feel good emotional high and a “Yes We Can” sense of purpose infusing the nation, the transformative power would now be in place to initiate the long awaited beginning of the next bull market advance. But, as if to insure that no one should bask too long in the happiness of that moment, the US stock market delivered the steepest inaugural day decline in the history of our country, and by month-end the stock market had recorded the largest January losses on record. Both stock and credit markets are once again signaling renewed concerns of worsening economic conditions.
The team of Paulson and Bernanke worked with great intensity to initiate a stream of programs designed to restore life to a financial system rapidly approaching a comatose state. Every economy’s lifeblood is its credit system, and the credit system of the US was grinding to a halt as 2008 drew to a close. We credit Paulson and Bernanke for recognizing the seriousness of the problem and for aggressively advocating the need for immediate action. Also significant were their actions associated with convincing Congress to set aside politics and their usual partisanship behavior by quickly allocating funds to approve the first phase of a massive financing program for ailing financial institutions.
Bernanke gave a speech in mid-January in which he outlined three broad programs that have been put in place over the past year. The first program was designed to shore up shaky financial institutions that needed large and immediate infusions of capital to avoid imminent financial collapse and consumer “runs on the banks”. It was hoped that these infusions would restore confidence to the credit markets, however that desired outcome proved elusive as credit markets continued to shut down.
The second program bypassed the banks by providing liquidity directly to the corporate commercial paper market and to money market mutual funds. In effect the Fed agreed to become the “lender of last resort” to US businesses, thereby preventing possible collapse of otherwise financially sound companies which were in desperate need of cash to roll over their short term debt obligations. The Fed’s actions saved the day for many businesses, but once again failed in the larger context of returning credit markets to needed levels of liquidity.
The Fed’s third program, recently initiated, involves purchasing various housing related securities in the open market for the purpose of forcing down mortgage interest rates. Bernanke has made it clear that Treasury and other government-related interest rates will be kept low by whatever means are necessary until normalcy has returned to our financial markets and clear signs of an economic recovery have become evident. Since announcing phase three of this program, the interest rate on 30-year fixed rate mortgages briefly dipped below 5% but has since edged up slightly. The Fed’s ultimate interest rate target for 30-year fixed rate conventional mortgages is in the low to mid 4% range.
Mortgage rates in the 4% range, if the Fed can engineer them, will be extremely attractive to a great many homeowners. In fact, applications to refinance have quintupled during the past few weeks and now the interesting question becomes, how many of these applicants will actually qualify for a new loan? Home appraisal honesty now matters. Financial qualifications of the borrower now matter. A sense of rational risk taking on the part of creditors has been reestablished.
Inflation vs. Deflation
Financial institution and consumer deleveraging can each become significant sources of deflationary pressure. Combine those trends with falling home prices, falling stock and commodity prices, rising unemployment and declining consumer prices and you’ve got all the important components of a deflationary spiral. It would be difficult to argue that the US is not experiencing just such an environment at the present time. History has demonstrated that the forces of deflation tend to feed upon themselves with the passage of time. Rooting these forces out of the financial system is difficult. Asset prices decline, as we have all witnessed. Debt used to acquire assets however remains unchanged. If the value of an asset falls below the amount of debt securing the asset, forced asset sales typically follow. Asset prices continue to decline as the rate of forced sales accelerate eventually causing entire economies to spiral downward.
The Fed, as should be expected, is fighting these deflationary forces with all the resources and creativity it can muster. So far, the deflationary trend is prevailing. Our consumer price index (CPI) and producer price index (PPI) continue to decline and may soon turn negative. There is legitimate concern that the Fed’s deflation fighting efforts will eventually lead to a major inflationary thrust at some later date when signs of economic recovery begin to materialize. This issue is critical to the investment composition of your portfolio as these two opposing economic tides call for quite different asset strategies. For the time being we continue to structure your portfolio with a deflationary preference as described below, simply because inflation is not currently a problem. In the investment world, a problem isn’t a problem until it is a problem. We will begin to restructure your portfolio with an inflation bias when the various indicators we monitor begin flashing inflation alarm signals. The timeframe for this strategic shift is presently indeterminate.
Should we have done a better job at preventing the 4th Quarter decline in the market value of your portfolio?
It’s human nature to look back on a historical event and see with almost perfect clarity the sequence of events and the outcome that should seemingly have been obvious. At the start of the fourth quarter, central banks around the world were aggressively cutting interest rates. Energy prices had already experienced a massive decline, relieving some of the pressure on consumer budgets. Stocks worldwide had declined significantly by the end of September and were already fairly attractively priced in our opinion. Gold was well behaved, indicating that inflation wasn’t a threat. Money was flowing into the US as a safe haven from around the world. Then in early October, a global panic set in resulting in US stock markets falling 26 %, foreign developed markets 30% and emerging markets 42% in an approximate three week period. This panic coincided with the demise of Lehman Brothers, which triggered a perception around the world that the US was behaving in an erratic manner by arranging for the rescue of some major financial institutions but not others. Hedge funds quickly sold tens of billions of dollars of liquid assets of all types exacerbating the decline. The financial investment community (ourselves included) was greatly surprised and quite unprepared for the massive selling that took place in the corporate bond investment sector as well as every other investment sector (with the only exception being treasury securities). SIMI had hedged a portion of your equity exposure with put contracts, but the degree of protection was not sufficient to materially offset the magnitude of overall portfolio declines.
Clients, would most assuredly find it odd if we suggested, 1) selling your home or business when signs of a recession were building and then, 2) starting a new business or purchasing a replacement home when subsequent economic recovery evidence began to mount. Your home and your business are long term assets. As long term investors, we take a similar view with respect to the equities market. A few quarters of bad, or even terrible, earnings aren’t necessarily a reason to sell a stock if its long term fundamentals remain sound. To be sure, staying the course is not easy but the history of markets is certainly on the side of those who retain their stock market exposure as valuations become increasingly attractive.
Before markets crashed in October, valuations had fallen to reasonable levels for our portfolio holdings, and thus when the vertical descent began, we felt little need to further reduce our overall client equity allocations.
The good news, according to a variety of valuation measures we monitor, is that broad US stock markets are currently priced for strong long-term future returns over the next 5-10 years. That’s not to say that stocks can’t get cheaper from today’s levels – because they certainly can. Increasingly grim economic reports from both within the US and around the world continue to batter our confidence and sense of economic well being. But this malaise is already significantly reflected in today’s stock and bond market prices. According to various indicators we review, markets are within 20-30% of all time valuation lows. In other words, a 20% or more additional decline in the broad stock market indices from today’s levels would result in the lowest valuations on record.
Therefore, further market declines, should they occur, will cause us to increase client equity allocations and reduce our hedge protection strategy. There is no way to predict when Mr. Market will undergo a mood change towards increasing optimism. All we can do is set our longer term strategies based upon our assessments of trends and valuations, collect stock dividends and bond interest in the interim, and wait for the economy and/or market sentiment to improve.
Presented below are various market proxies which illustrate the areas of our investment exposure. All figures represent results for the 12 months ending December 31, 2020.
Money Market Fund Proxy 2.1%
S&P 500 Index -37.0%
Russell 3000 Index (U.S. Stocks) -37.3%
MSCI EAFE Index (Non-U.S. Stocks) -43.4%
MSCI Emerging Market Index -53.3%
Lehman Aggregate Bond Market Index Fund 7.9%
MSCI REIT Index (Real-Estate Trusts) -38.0%
Gold (Commodity) 5.8%
Philadelphia Gold/Silver Index (Mining cos.) -27.7%
CPI Inflation 12 months .1%
Stock market total returns for the full year were the worst since 1931 (Dow Jones Average). As bad as the numbers were for US markets, they were even worse for foreign markets as evidenced by the EAFE (Europe, Asia, Far East) and emerging market indices presented above. Client portfolios typically contain a combination of domestic and foreign based equities, and therefore our equity returns represents a blend of the results from these three areas of the world. Today, US equity markets represent between 30-40% of global equity markets and thus we believe a meaningful foreign component in client portfolios is warranted. Furthermore, emerging markets, in spite of being the worst performing area for the year, have been generally immune to the global banking malaise. Emerging market issues are mainly global trade related. When world markets begin to recover, emerging markets may outperform other equity areas as that is where the strongest future growth will be found.
The fixed income portion of client portfolios generated unexpectedly poor results due to the credit freeze which caused substantial price declines in some of our bond fund holdings. In effect some of our bond fund investments experienced price declines commensurate with stock market-type declines during the third and fourth quarters. With yields on some of these investments in the mid-to-high teens, we have concluded that it makes more sense to keep the securities while waiting for normalcy to return to security valuations.
The REIT industry experienced a virtual collapse in equity prices during the fourth quarter, causing the results for the year to be strongly negative. REITs are typically highly leveraged and our deflationary environment has played havoc with these investments. We reduced our REIT exposure in client portfolios throughout the year. There are now indications that the REIT industry is lobbying Congress and the Fed for funding which has been necessitated by banks’ unwillingness to roll over maturing debt of companies within that sector.
Gold held its own for the year in spite of collapsing prices in most other commodities. Gold has always held a unique place in peoples’ minds as a means of protection against the inflationary tendencies of governments as well as a form of protection against depreciating currencies. During the fourth quarter the value of our primary gold mining company stock (Goldcorp) experienced a sharp price decline causing it to become very cheap relative to the price of gold. As a result we increased our position in Goldcorp relative to our investment in the SPDR Gold Trust.
Dollar strength during the third and fourth quarters caused us to close out all of our foreign currency positions. The dollar has rallied as global market volatility increased and investors around the world sought the relative safety of our currency over most others in spite of short term government yields falling to zero. When global market stability begins to reestablish itself, the dollar may once again resume its long term slide vis a vis other currencies.
Finally there is inflation, or actually the lack of it, as illustrated by the 12 month Consumer Price Index change of .1%. Evidence thus continues to mount that we have headed into a deflationary environment in spite of all the massive reflationary efforts to date by the federal government.
Summarizing our present investment thinking in this uncertain environment, we believe we are in the midst of a deflationary, bear market environment until such time as the various indicators we follow indicate otherwise. Offsetting the negativity of this situation are attractive stock market valuations and the possibility of a bull market rise when sentiment becomes positive.
We believe the current environment calls for moderate equity exposure, a degree of put protection, an increased exposure to the bond market and continued ownership of gold and gold mining shares. Within the equity portion of client portfolios, we have temporarily reduced our international exposure until evidence begins to mount that the global recession is beginning to subside. Any further meaningful declines in the stock market would compel us to increase our equity exposure, taking into consideration our knowledge of each client’s personal situation, while we wait for an eventual economic recovery.
Ponzi schemes
When you think that there couldn’t possibly be anything else in the financial world to go wrong, it’s learned that money manager Bernard Madoff has lost as much as $50 billion of investor money in a classic Ponzi scheme. Madoff used money from a constant flow of new investors to pay unrealistically attractive returns to his existing investors. The scheme collapsed when significant numbers of existing investors requested a return of their money as the current bear market gained intensity. What is so unusual about the Madoff scam is its time frame and magnitude.
Since the Madoff scam was revealed, a number of other similar ponzi schemes have been described in the financial press. The common threads in all of these frauds are: 1) investment returns that seem too good to be true, and 2) physical access on the part of the manager to the client’s assets. Also, typically the manager generated the only financial statements sent to the client. Thus with physical control over the assets and the ability to generate misleading statements, the fraud can continue until too many people demand a return of their capital at the same time.
Madoff and other fraudulent operators are easily distinguishable from the vast majority of ethical and hardworking investment advisory firms around the country and the world. SIMI’s physical relationship to client assets is fairly typical: we do not have physical access to client assets. Instead, client assets are held at unrelated, independent custodians.
Clients are protected by virtue of the services performed by these custodians, including holding the assets, collecting dividends and interest, issuing periodic statements directly to the account owner and presenting appropriate tax information on an annual basis. This separation of account management from custody and reporting protects clients from the types of crimes that Madoff and a small handful of other rogues perpetrate on their victims.