Is There Good News in This Market?

by: Larry Swedroe

Consider All the Bad News We Have Had

Home prices have fallen 15% and in some markets about 30%. And expectations for further declines as supply at about 11 months and about 5 indicates stable markets.

Oil went to almost $150 per barrel and gold to almost $1,000 per ounce. The Dollar collapsed as the Euro hit about 1.60. The auction-rate securities market, hundreds of billions, seized up.

Countrywide (the nation’s largest mortgage lender) had to be rescued, and Indy Mac (one of largest and a large bank) did fail. FNMA ((FNM) and FHLMC (FRE) had their equity basically wiped out in bailout.

Lehman (LEH) had the largest to-date bankruptcy in history at $168b. AIG (NYSE:AIG) needs a government bailout and was put into conservatorship. Credit spreads widened dramatically, and many people were cut off from credit.

We saw huge hedge fund losses, with their worst year in perhaps 15 and maybe worst ever. We've already seen 134 LBOs go bust. Many more are likely to follow.

The Democratic nominee wants to raise taxes on capital.

Those who knew all this before the year started might have thought market would be down at least 40-50% if not more (as it was from 73-4 and 2000-02).

Anatomy of a Crisis: Mistakes Made by Investment Banks

They took more risk than they were able to take. If they lost the bet, the company goes bust. Never bet more than you can afford to lose.

They had too many eggs in one basket or a few baskets that were highly correlated (in Lehman’s case, commercial and residential securities or investments). Also, these banks invested in other risky investments whose correlations tend to rise during crisis.

They had way too much leverage for the amount of risk taken. Highly leveraged institutions have to be right 100% of time, because while they might be right in the long term, they may not weather a short-term storm. An example of this would be the downfall of hedge fund Long-Term Capital Management in 1998. Banks leverage between 10:1 and 12:1, but Lehman Brothers and Bear Stearns were more than 30:1 with just assets. This doesn’t include off-balance-sheet risks, so the real risk of leverage might have been as high as 100:1. Who knows? In other words, these investment banks had evolved into highly leveraged hedge funds, just like LTCM. The lack of transparency is one reason why there were no buyers at the end, as it was difficult to value assets and put bids in.

They treated the unlikely as impossible (housing prices don’t go down) and forgot that just because something had not happened does not mean it cannot or will not.

They did not understand that liquidity can be an illusion. It is there when you don’t need it but “gone with the wind” when you do.

In my opinion, the result is we will see several, if not many more of these forced mergers of failures as the crisis of confidence leads to liquidity “failures” of firms (possibly even Morgan Stanley (NYSE:MS), Goldman (NYSE:GS) and WAMU (NYSE:WM)). They will want to avoid the Lehman outcome, preferring the Merrill outcome.

Been There, Done That

One of my favorite sayings is “The only thing you don’t know about investing is the investment history you don’t know.” The following are four examples of very similar crisis in just the last 30 years. A longer look would provide many more examples.

In the 1980s, banks recycled Petrodollars to the third world, developing nations, which led to a major crisis with Continental Illinois failing and Citicorp coming very close.

In 1989, the Resolution Trust Company was set up as a rescue for savings and loan associations with hundreds failing and costing hundreds of billions. We had a similar drop in housing prices (especially in the oil belt as oil fell from $40 per barrel to $8 per barrel) and similar banking crises due to junk bonds and similar bad investments (remember Milken).

In 1990, the Nikkei hit 40,000, and Japan was at the top of the world. And the land under the Imperial Palace was worth more than all the land in California. They had a deflationary problem, banks had to deleverage, and the Nikkei is still at only about 11-12,000 almost 20 years later, down about 70%. It serves as a reminder that stocks are risky, no matter how long the horizon.

In 1998, Long-Term Capital Management goes bust in what was at the time the largest hedge fund failure in history. The Asian contagion led to a global financial crisis that threatened the banking system. The Fed forced banks to put together a “bailout” package to prevent systemic damage.

Risks in the System

This is the worst financial crisis since the Great Depression. Risks are great. The reason is that liquidity crises are the worst kind as they feed on themselves, creating a vicious cycle or death spiral (see Lehman).

In general, banks and financial institutions are likely to lose at least $1 trillion and perhaps even $2 trillion if housing prices fall another 10-15%. They raised perhaps $500 billion of new capital, so let’s say there will be a net loss of about $0.5 trillion to $1.5 trillion. Even with leverage of only 10:1, that means balance sheets must shrink by $5 trillion to $15 trillion. That is why credit spreads widen and credit becomes tough to get: Liquidity is simply not available. Even if banks want to lend, they need to restore their capital ratios.

We are seeing a massive deleveraging as banks must now shrink balance sheets.

Capital becomes scarce and expensive, with only the best credits having access.

Thus even if the Fed lowers rates, the cost of capital may rise as spreads widen more than the Fed lowers rates.

Consumers and businesses a have tough time borrowing, and they will be forced to deleverage.

Banks and hedge funds are forced to sell assets, which makes prices fall, losses grow and more deleveraging take place. Many hedge funds are being forced to return capital and thus must sell assets, or are forced to sell to meet margin calls. The downward spiral continues.

State and local governments will have budget crises and have to cut spending. Some might even experience bankruptcies as income, real estate and sales taxes fall or fall well below projections.

Deflation is tough to break, as there is a “liquidity trap” since rates cannot fall below zero. And with deflation, even very low borrowing costs become high real costs in nominal terms. Also, people delay buying some goods when prices are falling as they can buy cheaper tomorrow (such as what is currently happening in the housing market), so prices fall more. Even if people want to borrow at low rates, they may not have access to capital as banks cannot lend what they don’t have.

So What’s The Good News? (Where’s the Pony in the Pile of Manure?)

Everything above is already known by the market and should already be built into prices. It is important, therefore, not to confuse this information with information you can exploit. You can only profit from information that no one else has.

Commodity prices are collapsing, which is the good side of deflation/deleveraging. That will act the same as a massive tax cut

Inflation will slow dramatically, if not turn negative. That will provide the Fed cover to lower interest rates if need be.

The trade deficits will also be lower as we pay less for the oil and other imports as dollar has risen.

There will almost certainly be counteractions to help resolve the problem, which is something those that panic fail to account for. The Fed is already providing massive amounts of liquidity to offset the reductions by the banking system. Other central banks around the world doing the same, and they will do more if needed (including cutting rates). I would be surprised if they are not already coordinating efforts to prevent a true global contagion like the Great Depression.

Almost all the losses are in just two sectors: housing/construction and autos. Together they make up very small percent of GNP. But they are in depression, falling 20%. The rest of the economy has actually been growing at very healthy rates of 3-4% (though they too cannot escape the impacts of the deleveraging). This is not Europe after WWII when their physical capital was destroyed. Our capacity of labor and physical capital is fundamentally sound.

There are risks that one need not worry about. Insured bank CDs are safe. Treasury instruments are safe. It is likely that all high investment grade municipal bonds (AAA/AA) are safe. Brokerage accounts are safe as separate accounts. Insurance company investments also likely safe, as they are well regulated and separate assets, even at AIG.

Lessons Investors Should Learn

Investment banks (and active managers in general, such as hedge funds) cannot protect you from bear markets. They could not even protect themselves. Their crystal balls are just as cloudy as all crystal balls. Which is why Warren Buffett long ago concluded that “The only value of stock forecasters is to make fortune tellers look good.” If they could protect you, why did firms like Lehman Brothers and Bear Stearns go belly up and firms like Merrill Lynch have to run into the arms of Bank of America to prevent the same fate? You don’t need to pay them big fees that are only likely to make them rich, not you. In other words, their best skill is separating capital from owners.

Active mutual fund managers cannot protect you. Consider the following: The hardest hit sector has been financials, which comprise a significant portion of the asset class of large-cap value stocks. Dimensional Fund Advisors’ Large Cap Value Fund is passively managed (no stock picking or market timing). Through 9/15, it was down 17%. The following is a list of the returns of mutual funds with superstar value managers, five of whom were named by Morningstar in June as the stars, their recommendations. (Those are noted with *.)

  • Legg Mason Value Trust (Bill Miller fame) - 36.4%
  • *Dodge & Cox - 22.9%
  • Dreman Concentrated Value - 31.7%
  • *Weitz Value - 20.4%
  • *Schneider Value - 31.1%
  • * Sound Shore - 32.2%
  • *Columbia Value and Restructuring - 20.2%

Of course there are some active managers who have outperformed, but how would you have known ahead of time which ones they would be? Thus only use passively managed funds.

Never take more risk than you have the ability, willingness or need to take. And diversify broadly, avoiding concentrating bets. If you do so, you can be extremely wrong, yet survive. On the other hand, you can be only slightly wrong and go bust if you concentrate your holdings.

Don’t concentrate your labor capital and your financial assets. We can only wonder how many employees of these companies have lost not only their jobs but so much of their financial assets — including stock, options and 401k plan investments — because they tied their labor and financial assets together.

For fixed income assets, stick only with government bonds and the highest investment grade bonds as anything else (such as junk bonds and preferred stocks) can have the risks show up at the wrong time, despite seemingly attractive characteristics. So instead of anchoring your portfolio in the storm, they create further losses because they tend to perform poorly at the worst time. For example, junk bonds have lost money this year while Treasury bonds are generating capital gains as well as income. Other non investment grade bonds (and even low investment grade bonds and preferred stocks) have gotten hit hard too.

Bottom Line

It is most important to understand that we live in a world of uncertainty (where we cannot measure the odds of events occurring) not a world of risk (where you can measure the odds). The best we can do is estimate odds.

Never treat the unlikely as impossible or the likely as certain.

Just because something has not yet happened doesn’t mean it cannot or will not.

Make sure your investment plan incorporates really bad crises so that you don’t take more risk than you have the ability, willingness or need to take. Recognize that these events can happen and happen unpredictably. The only way to avoid them is to not take risk, which means you must accept Treasury bill returns that may not be likely to allow you to achieve your goals. Forewarned is forearmed.

Stocks are risky no matter the investment horizon. Even if the investment horizon is very long, you must accept the fact that stocks are risky (see Japan).

Build a portfolio that is globally diversified.

While bear markets are painful, there is no good alternative to buy and hold except to avoid risk. Timing the market is a mug’s game. As Warren Buffett said: “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” He also said: “We continue to make more money when snoring than when active.” And Peter Lynch said: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.” And a study on 100 pension plans that hired the “best managers” around to engage in tactical asset allocation (fancy word for market timing) found that not a single one benefitted from the efforts.

The key to successful investing is to get the plan right and then stick to it. This means acting just like the lowly postage stamp that does one thing but does it well. It sticks to its letter until it reaches its destination. The investors’ job is to stick to their well thought out plan (if they have one) until they reach their destination. And if they don’t have a plan, write one immediately.