Year in Review: Even Positive Change Causes Some Regression

What a year. Some say we are facing the greatest economic crisis in a century, but the situation is so complex, no one can really be sure. Some predict another Great Depression. Others warn of the potential for hyperinflation as the Federal Reserve’s printing presses shift into overdrive. Layoffs and bankruptcies make the front pages every week and no end appears in sight. Most economists assure us that the situation will get worse before it gets better.

But as you should know by now, we are contrarians. And we are diligent students. The economy has experienced dramatic downturns and lengthy recessions before. Often, the greatest surprise is how quickly we recover. As Warren Buffett noted in his October 16, 2008 New York Times editorial:

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Like Buffett, we have confidence that America’s traditions of innovation and entrepreneurialism will prevail. Here are some of the topics we addressed in our newsletter and newspaper columns in 2008:

January: Do Investors Have the Stomach for Post-Modern Volatility?

We began the year warning of steadily increasing volatility in the stock market, noting that repeal of an obscure short-selling regulation intensified volatility:

But as soon as the rule was repealed, vigilant investors noticed that the market, always a harsh mistress, was now viciously punishing stocks based on the flimsiest of pretenses. By August, bits of news that previously cost a stock two percent of its value could lop off eight percent, based not on the value of the company but on the gamesmanship of the short-sellers. As former Chicago Board Options Exchange Chairman Gary Lahey told the Wall Street Journal, “You’re going to get more volatility because it’s easier to whack a stock.” Other systems and regulations may help avert market crashes, but it stands to reason that repealing a rule designed to reduce volatility will likely lead to increased volatility.

March: The Wealth of Nations, Version 2.0

When we explained how Sovereign Wealth Funds were propping up under-capitalized American banks, we had no way of knowing our government would be allocating hundreds of billions of dollars for the same purpose within months:

Sovereign Wealth Funds (SWFs) are government-controlled pools of capital, often in emerging countries with massive oil wealth, or in the case of Asia, rapidly growing economies. Such countries find themselves with considerable assets available for investment, even after accounting for generous cash reserves. Stephen Jen, an economist at Morgan Stanley, follows 29 SWFs and estimates their current holdings at almost $3 trillion. Thanks to the magic of compounding and the funds’ newfound appreciation for equity investing, Jen projects SWFs will control up to $12 trillion by 2015. Anything that significantly boosts the price of oil could make Jen’s estimates quite low.

On the other hand, a significant decline in the price of oil, such as we’ve seen these past months, could diminish these funds in the future.

April: Two Shades of Green

At the time, the leading presidential candidates all claimed environmentalist credentials and the price of oil was soaring, so we wrote about the potential investment opportunities:

Environmentalism has been a national issue for over 40 years, and conservation and sustainability issues predate the founding of our country. But something is different today. With global warming gaining credence as a genuine threat and oil topping $108 per barrel, green now begets green: there is economic opportunity in energy efficient, Earth-friendly products and services. And where there is economic opportunity, there is innovation and entrepreneurial problem solving. And there is money to be made by entrepreneurial investors!

Now oil and gasoline prices are dropping fast. But lower gasoline prices may come at a very steep price to our future, because the economics driving innovation in alternative energy just turned upside down.

As long as the price of oil was streaking upwards toward $200 per barrel, investors were pouring money into wind, solar, biofuel, electric cars, and the infrastructure to support a paradigm shift in energy production and consumption. Now investment has slowed. If gasoline settles at the two-dollar level for a while, how will we behave? Will SUV sales increase again? Will people drive more just because it is cheaper?  Will we waste resources simply because we can afford to do so? Or will we have learned something about the long-term economics of energy?

July: The Pros, Cons and Paradoxes of Dividends

Seeing one too many press generalizations about dividends pushed us over the edge, so we used the July issue to explain the truth about dividends:

Cash is king, and the truth about dividends is that they are merely one optional use of cash flow. Share buybacks make great sense when the stock is cheap, but a regimented recurring distribution of dividends reduces a company’s ability to invest opportunistically. Instead of making blanket statements about the superiority of dividends or share buybacks, investors should understand the context of each decision, and companies should consider eliminating recurring dividends in favor of situational, opportunistic cash flow decisions. A dividend is an investment, and like any other investor, the company and its shareholders must ask, “Is this the best use of our money right now?”

September: Knee Jerk Regulation’s Unintended Consequences

As the financial crisis picked up steam over the summer, regulators took unprecedented steps, such as banning the short selling of a select group of handpicked companies. We wondered whether the ad hoc regulations crossed the line from market maintenance to market manipulation:

The moral hazard of interventionist regulation is that people will take ever-greater risks when they believe that the government will swoop in and rescue them at the last minute. As mentioned above, such rescues assure the “survival of the unfittest.”

Do we outlaw the forward pass because we don’t like the football score at halftime? Certainly not. Nor do we eliminate helmets just because no one has suffered a concussion in the first half. The rules exist for the good of the game and the safety of the players, not to influence the outcome. The same should be true in our public markets. 

October: A Permanent or Temporary Loss of Capital?

As the stock market suffered a series of record losses, we advised investors to avoid turning temporary losses into permanent losses by selling quality companies that got dragged down with the rest of the market:

Permanent loss of capital is no trivial matter, as Lehman Brothers shareholders know well. When a public company fails, the value disappears and the owners’ losses cannot be recouped.  But thousands of perfectly healthy companies also lost value on September 15, and it’s important to understand that most of those losses are temporary. Under duress, many investors simply pull their money from “the market” without consideration of the individual companies that make up the market.

November: Some Days You Eat the Bear…

Finally, just last month, we reminded readers that a bear market is not the end of the world. On the contrary, bear markets provide opportunities to buy good companies at a discount to their intrinsic value:

The success of capitalism is assured not because of its efficaciousness as an economic system, but its accuracy as a description of human nature. We aspire to build, to create. We work tirelessly to make something new in the world, share it with humanity and enjoy the fruits of our labors. This is not a result of economic theory; it is simply who we are. That is why disasters and tragedies great and small have done little to impede mankind’s progress. Watching the current panic on Wall Street, we remember that even the Great Depression did not defeat the United States and our vision of capitalism. William Faulkner, who lived through WWI, the Depression and WWII, expressed the sentiment in his Nobel Prize acceptance speech: “I believe that man will not merely endure: he will prevail.” Recognizing that the cycle of bear and bull markets is a natural phenomenon of public stock exchanges, entrepreneurial investors know that today we endure so that tomorrow we may prevail.

Comments

[phillybull:]

Extremely weak commentary - nothing new here. WCAM is in the hole, and it wants all it clients to hold tight. Sounds reasonable, until you realize WCAM has gone from stock picking to buying index funds! Talk about a red flag.

2008 Nov 24 11:40 AM

[sleepless_o...:]

I have to disagree with phillybull in one respect: Going to investing in index funds when the market is down 50% is a classic contrarian move. There will be plenty of time to pick individual stocks after the bottom is well defined and the economic picture is clearer.

2008 Nov 24 12:01 PM

[phillybull:]

An asset manager shouldn't get paid to do something I can do myself with no research - pick a mutual fund. Not to mention the double fees involved. The wheels are coming off at West Coast Asset Management.

2008 Nov 26 08:09 PM