A Progress Report
September 19, 2008
In an attempt to keep everyone appraised of the events unfolding in the fmancial markets I would like to take this opportunity to summarize where things stand at this point, what our thinking is and what all of this means for your portfolio activity.
It goes without saying that global financial markets, both equity and credit, are under severe pressure at this time. Despite today's rally the markets are fragile and fear is elevated.
The central cause for this stress is the massive de-leveraging taking place primarily in the financial sector.This is without question a hangover following the easy credit years of early this decade when interest rates were held at extremely low levels for an extended period.
The pressure point remains financial institutions that have entered extensively into unsecured credit default swaps and other derivative instruments. Because ofthe decline in market value of these instruments resulting from the sharp increase in mortgage delinquencies and defaults, these institutions are forced to raise capital (cash) to meet contractual obligations with their counter-parties (the second entity holding the derivative contract) to post additional collateral. As the value of these contracts continues to decline and more collateral is required to stay current this in tum forces credit rating agencies to lower ratings on the underlying business leading to even higher margin requirements. This vicious cycle continues until the entity runs out of cash, is acquired, files bankruptcy or is bailed out.
So far the U.S. Government through the combined efforts of the Treasury and Federal Reserve has provided funding for the JP Morgan Chase acquisition of Bear Steams (this took place in March), placed Fannie Mae and Freddie Mac under government conservatorship, decided against supporting Lehman Brothers and orchestrated an emergency loan for AIG. The total incremental capital needed to pull off these actions is not yet know but could be as much as $500 billion and possibly much more. Private sector bidders have emerged for various pieces of Lehman Brothers and AIG which is encouraging and could hopefully serve to preserve jobs and lessen the burden on taxpayers, bondholders and shareholders. Morgan Stanley is reportedly in advanced talks to merge with Wachovia Bank. Rumors surfaced today that Wells Fargo and Washington Mutual have had talks and some private entities have expressed interest in certain WaMu assets such as their 2,300 branch offices.
Market volatility, already at elevated levels through most of the year is pushing to even greater heights reflecting traders' uncertainties of the market's direction.
Credit spreads have widened substantially in recent days as risk premiums return to more normal historic levels after being at unsustainably low levels in recent years. This is presenting challenges for those needing credit but for investors it gives greater incentive to provide new capital.
One money market fund the Primary Reserve Fund (the nations oldest) "broke the buck" meaning the funds assets are no longer equal to $1.00 per share. This is a rare occurrence and was caused in this particular case by exposures to both AIG and Lehman Brothers debt. The fund is being liquidated and cash returned to investors who in this case were primarily pension plans. It is quite conceivable other institutions might also break the buck as well in the next few days as securities are marked-to-market.
Last evening we forwarded a statement from TD Ameritrade Institutional regarding their exposure to the problem institutions and their overall financial health. On both accounts TD Ameritrade is on solid footing.
As a result of intensifying concerns about credit market issues and the spillover effect they could have on future economic growth, stock values have declined significantly this week. Already struggling to regain their footing, the selling earlier this week reached significant levels. Although it is very pre-mature to call a bottom it is important to understand that at the point where trends reverse, particularly at the top of multi-year bull and bear markets, pressures reach a fever pitch then dissipate. In the case of an ending bull market it is known as a "climax run" for bear markets it is a "capitulation." As I said it is pre-mature to think the worst is over however there are numerous signs from a technical perspective that we might be getting close to the capitulation of this down trend. The charts below show two visual examples of these terms in action. The first is the NASDAQ from 1998 through 2001 showing a climax run, the second the capitulation that occurred in mid-2002. There are reasons why these occur and counter-intuitive rationale for why the trend reverses thereafter. However for the sake of time I will avoid those explanations herein.
We do expect the issues in the financial sector to have a spillover effect on Main Street primarily through constrained credit availability for small businesses and consumers. It is likely this constrained lending environment will prolong the recovery in the housing market and U.S. GDP growth. However at present levels of unemployment (6.1 %) remain below those reached during previous growth recessions (7.8%) and that fact combined with record productivity, solid exports and tight inventory management there is reasonable hope for some stability through this period. Overall activity on Main Street continues despite being at subdued levels.
We do believe the financial services industry will be forever changed. Regardless of the winner of the presidential election new regulations will be put in place. We think this can be constructive so long as the regulations don't go too far and address the wrong issues. Specifically penalizing risk-taking rather than putting caps in place on the irresponsible use of leverage by financial market participants namely hedge funds. The new restrictions on naked short selling that took effect yesterday should curtail speculative shorting. We do not have issue nor do we believe short-selling should be disallowed - it performs a critical role in a healthy capital market - we simply want the activity to be conducted in a manner that is not abusive. Furthermore the news over-night of the possible creation of a government trust to purchase and re-market bad credits from financial institutions is possibly a good thing to calm the markets however it may cost taxpayers significantly.
In our view free markets are not broke in fact they seem to be working perfectly to weed out unsustainable economic activity and business models. Yes it is painful during the process and sometimes intervention is required to maintain order but once cleared the foundation is set for more sustainable and real economic progress. Much like how the human body rejects tainted food flushing it form the digestive system the market is now flushing out irresponsible amounts of leverage and economically invalid derivative contracts that were abused for obscene profit.
As far as tactical portfolio activity is concerned, although uncertainties are high and fear is in control history shows that selling at points of emotional stress can be precisely the wrong thing to do. Even if after experiencing the declines that accompany this level ofturmoil you prefer to be less aggressive in your investment strategy it is more beneficial to stay the course before adjusting your target allocations until price levels are more reflective of underlying economic fundamentals and less influenced by indiscriminant panic selling. Taking this approach allows asset values to recover and personal wealth to be restored. Of course each investment in the portfolio must be evaluated on its own merits to determine its quality and overall recovery potential.
Over the next several months we will look to take advantage of the sell-off to revisit your investment objectives, re-balance portfolios, consolidate holdings, and add attractive new positions. Our goals are to position portfolio holdings for the eventual recovery in the market while at the same time harvesting tax losses to shield gains realized to date while assuring the recommended strategy truly reflects your objectives and risk tolerance. Although it may take some time to materialize in earnest what lies ahead is a tremendous buying opportunity not only in equities but also in high-quality credits such as corporate and municipal bonds. Given the sell-off we have experienced this quarter valuations are very attractive even with lowered revenue and earnings growth expectations given the subdued economy.
The global capital markets are likely to remain fragile in the days ahead as the market digests all of the dramatic changes that have occurred in the past two weeks. Keep in mind new surprises should not be ruled out. Realistically it may take several quarters until the extent ofthe damage is fully understood. We'll continue to get comments out as we feel we have thoughts to share. As always if you have any questions or concerns of any kind please do not hesitate to call or email us.
Jack E. Payne, CFA
Chief Investment Officer