In January 2009, the S&P500 index lost 8.6%, the worst January in its history. In February 2009, the S&P500 index lost 11%, the second-worst on record following the 18.4% decline in 1933. On March 1, 2009, the S&P500 lost 4.66%, the worst first day of March in its history. We know it feels like a century ago, but it was just in December 2008, Bloomberg surveyed market strategists for their 2009 S&P 500 price targets. Collectively, strategists were looking for a gain of 21.8% from the index's level then, or for the S&P500 to end 2009 at a price range of 975 to 1300. Call them stupid, but didn’t we all kind of enter 2009 a bit concerned of missing a market rally? After all, the S&P500 climbed 20% to end 2008 at 903.25 from its November 2008 low of 752.44. Although we knew 2009 was going to be a very challenging year, we believed a recovery would happen sooner rather than later.
What has happened? There was certainly very bad news such as steadily rising unemployment, a disheartening GDP decrease of 6.2% in Q4 2008, the fastest pace since 1982, rising foreclosures, falling home sales and prices, rising credit card defaults, and continuing banking troubles. While all that news was bad, it was hardly surprising. The market had been waiting for the government to unveil a logical plan to deal with banks, given the build up for our new Treasury Secretary, and had hoped for a restoration of some fiscal discipline of the federal government. Those hopes turned out to be short lived. Starting with Geithner laying an egg during his first major address to the nation about the banking crisis, things only got worse as the month progressed.
Here are the various plans and proposals from the federal government that have been passed, or will likely be passed in the near future, which are largely responsible for the market slide, in our opinion.
1. (2/13/2009) The “Un” Stimulus package passed. The $787 billion stimulus package was pieced together in 4 weeks and quickly passed in the Senate and House, with the final bill not read by a single House member before its passing. Rather than serving the purpose of stimulating the economy, a big portion of the government spending, which accounts for 2/3 of the bill, is to significantly expand federal power, promising to give billions of dollars in grants to local schools, to replace lost state aid, and to increase the federal share of Medicaid payments. While it is very questionable whether this package creates any sustainable stimulus, the bill represents 2.5% of two years’ US GDP, dwarfing Franklin Roosevelt's New Deal which never increased the deficit by more than 1.5% of the nation's GDP even during its biggest-spending year of 1934.
2. (2/18/2009) The Irresponsible Homeowner Affordability and Stability Plan. This plan aims to provide several forms of assistance to as many as 7-9 million home owners who may be at risk of defaulting on their mortgages. By investing in failure, we worry this will fundamentally change the average American’s views on self reliance and financial responsibility. In addition, because this plan is focused on reducing mortgage rates, and investors/lenders will be forced to cover a portion of the mortgage rate reduction, it will deter private sector investment from entering the mortgage market in the future. In addition to the overall concept, from a capital market perspective there are also some particularly troubling provisions in the bill.
A) To provide an extra incentive for borrowers to keep paying on time, the initiative will provide a monthly balance reduction payment that goes straight towards reducing the principal balance of the mortgage loan. As long as a borrower stays current on his/her loan, he/she can get up to $1,000 each year for five years.
B) It encourages the enactment of legislation allowing bankruptcy judges to alter the terms of certain mortgage loans, a practice that to date has been prohibited by federal law.
C) The program applies for loans made on Jan.1, 2009 or earlier and mortgages for single-family properties that are worth up to $729,750.
The formal endorsement by the President of a bankruptcy provision that allows judges to alter the terms of certain mortgages significantly increases the risk to lenders of all mortgages, which will keep many investors on the sidelines and result in higher risk adjusted returns. We believe this will lead lenders to require additional compensation for making loans, through either larger down payments or higher interest rates, which will deter potential borrowers with good and excellent credit from owning a house. By allowing certain principal reductions through a government subsidy, the plan allows the irresponsible to enjoy the potential upside of property value appreciation in addition to the favorable mortgage rates responsible homeowners cannot obtain. This bailout’s loan origination cut-off date is also deeply troubling. If someone bought a house in 2008, as the real estate slump was widely known and in full force, and is now close to default, we believe the borrower should take the sole responsibility for his/her poor decision and cannot possibly blame anyone or anything else for their troubles.
Lastly but most importantly, the long-term moral hazard issues of rewarding irresponsibility and recklessness by having the 93% of the American people pay for the 7%’s mortgages is really disturbing for a society that has long thrived and relied on common sense and self-reliance. It is true that declining house values negatively affect the 93% and obviously we don’t want to see that continue. However, it is not obvious that keeping people in homes they cannot afford is a good solution to getting the housing market back to a sustainable equilibrium. As Rick Santelli captured on a live on air rant, it seems Americans do not want to pay for our failing neighbors’ mortgages to possibly inflate our house values.
3. (2/26/2009) President Obama’s Ambitious Budget. President Obama unveiled a $3.6 trillion budget for fiscal 2010 (ending Sep 2010), making a major down payment on his priorities and marking a historic shift toward greater government involvement in health care, energy and education, while raising taxes on the wealthiest Americans. The budget was a declaration of hostility toward capitalists across the economy. Every voluntary risk-taker and investor now knows that another tax increase will slam the economy in 2011, even if the current crisis subsides in the year ahead. Based on this budget plan, the projected federal deficit will be $1.75 trillion for 2009, or 12.3% of the GDP, a level not seen since 1942 as the U.S. plunged into World War II. The projected federal deficit will be $1.17 billion or 8% of the projected GDP for 2010. While the projected federal spending that is sending the country towards a nanny state is disturbing, the means the federal government will utilize to achieve this goal, mainly via tax increases, are damaging.
A) Based on the announced budget proposal, taxes will rise for singles earning $200,000 and couples earning $250,000, beginning in 2011, for a total windfall of $656 billion over 10 years. Income tax hikes would raise $339 billion alone. Limits on personal exemptions and itemized deductions would bring in another $180 billion. Higher capital gains rates would bring in $118 billion. The estate tax scheduled to be repealed next year would be preserved, with the value of estates over $3.5 million or $7 million for couple, taxed at 45%.
B) The budget is to reap $210 billion over the next decade by limiting the ability of U.S. based multinational companies to shield overseas profits from taxation. Another $24 billion would come from hedge fund and private equity managers, whose income would be taxed at income tax rates, instead of capital gains rates. Oil and gas companies would suffer most, with the repeal of multiple tax credits and deductions.
C) It also plans to cap the emissions of greenhouse gases, forcing polluters to purchase permits for emissions that would be brought down. The sale of those permits, beginning in 2012, would reap $646 billion through 2019.
We are very leery of the tax revenue assumptions on which this budget is based. When President Reagan cut taxes, the fear was that government revenues would plunge, as a result of static projection models. These models tend to work as follows: If taxes today are 70% and income is $100, the government collects $70. If tax rates are cut to 28%, such models project the government will only collect $28. However, the reality during that time showed that as workers and entrepreneurs were given greater incentives to work and take risks, the economy flourished, and revenues to the government actually increased during the Reagan era. We fear that this new budget raises the price of making investments and taking risk, which will be a long-term losing proposition. As people adjust to new tax realities, they will scale back their work and investment activities, with the result being that real revenues to the government fall short of existing projections, as the economy slows more than expected and fewer Americans secure attractive jobs, or lose them as a result of a slower and smaller economy. The stories we have heard in the past weeks include dentists, doctors, accountants, lawyers, who are ready to work less by laying off clients and workers so they make just $249,999 a year.
Over time we have learned that the hard work of individuals is not enough, if government policies are not set to maximize individual growth potential through a rewarding mechanism. A brick layer will not achieve greater prosperity if his employer doesn’t seek to expand his business. An office worker will not receive raises if his company does not grow and become more profitable. Scientists will not create new inventions if investors don’t supply capital to fund their research and development. As taxes on capital and income increase, the barriers to grow a business will likewise increase, resulting in less business for everyone and less wealth to share around. This works to dampen the lives of all people that are not already wealthy. No one would think of adding weights to Kobe Bryant’s or Lebron James’s ankles before they play a game so the talent disparity with other players on the court can be lessened.
The “rich” are not thieves or robbers. While some may have gotten lucky or been born to the “right” family, most of them have worked their butts off, enduring long hours of study, work, uncomfortable risk, and multiple failures before they get to where they are. The “rich” are not the enemies of average folks. The “rich” create jobs for both themselves and the average folks.
Somehow, in the name of reducing income inequality, it has become fashionable to handicap the deployment of capital and application of labor. While income inequality makes for great headlines and is an easy target to advance wealth redistribution policies, it misses the key focus of a good policy – maximizing the wellbeing and life quality for the average citizen. China had perfect income equality between 1950 and 1980 when the country’s economy was in a slump. It is now the world’s 3rd largest economy, despite a rapidly expanding “wealthy few”.
History has shown wealth is best achieved by implementing policies that promote long-term sustainable growth and innovation in the economy. Ultimately that means working to lower barriers to investing capital and supplying labor. The current policies advanced in the new budget do not meet those ends. More alarming, the attitude taken by the new administration seems to echo the recent history of California, where a ravenous government has created an unrealistic budget problem, and has driven highly skilled individuals out of the state.
It is interesting that these new policies are not at all well defined or agreed or proved effective, but will likely be implemented to a system that has worked amazingly well based on different sets of principles. But here is something to consider when evaluating the risk/return of even small changes to our existing political and economic system. Over a century, the difference between an economy that grows at a 3.5% annual real rate of return versus one that grows at a 1.5% real rate of return is 7-fold. An economy worth $1 that grows at 3.5% over a century is worth $31, while the economy that grows at 1.5% is only worth $4.4. That 7-fold increase in the wealth of the economy translates into a greater living standard for all citizens versus the slower growth alternative. While faster growth will likely lead to greater income disparity, few people would willingly belong to the slower growing, more homogeneous economy.
Let’s end the letter quoting what Buffett wrote in Berkshire Hathaway’s 2008 annual report:
Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.
Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.
We want to emphasize, however, that Americans do not possess a special strand of DNA, or unique wiring or have morphed into a new species. We have overcome all of those obstacles and made the US the most prosperous nation the world has seen through the ages because, and only because, our political and economic system has placed the individuals above the government, and has allowed individuals to freely pursue their dreams, and fulfill their potential. The price of our freedom and prosperity has been the dual taxes of self-responsibility and self-reliance. This country will have better days, but the question is when, and how much pain has to be endured before the right policies are in place to get the US economy’s mighty growth engine roaring again.