November 24, 2008
The Cornerstone of Capitalism
A Note on Economic Stabilization:
Fundamentally, the current mortgage crisis is about present value. We could ease the crisis in the mortgage market tomorrow if distressed homeowners were allowed to get a reduction of current mortgage principal in return for giving away an equal claim to future price appreciation of the home. The cash flows required to service the mortgage would be greatly reduced, but the present value of the payment obligations would be about the same. As a result, the value of the mortgage securities on the books of financial institutions would also stabilize.
The two most important actions that government can take to address this crisis are: 1) continue to provide capital directly to the banks, rather than purchasing troubled assets, and 2) reduce the mortgage principal of distressed homeowners in return for a claim on future price appreciation.
The best use of the TARP is to do exactly that. It would be a dangerous mistake for the Treasury to arbitrarily pay down various distressed mortgages receiving without an equivalent property appreciation right (what might be called a "PAR") from the homeowner. To do so would create an immediate incentive for every homeowner in the nation to go delinquent in hopes of receiving free money, and would provoke a rash of additional foreclosures.
In contrast, lowering principal in return for a PAR would allow homeowners to stay in their homes without any major government “giveaway.” The PAR obligation would be paid down at the time the home (or subsequent property) was sold, and if unpaid, would be a claim on the homeowners' estate just like any other debt. The risk of “adverse selection” (where only the worst properties and credit risks get funded) could be reduced by requiring the reduced principal to be refinanced either by the existing mortgage lender or a new one. Properties and homeowners that could not obtain refinancing even after principal reduction from the TARP would not be eligible at all. No "equity extraction" would be allowed except to pay down the PAR obligation.
As for providing capital to the banks, the Treasury was absolutely correct to abandon the awful idea of buying up distressed assets directly from the banks. As I noted in September (9/29/08 – You Can't Rescue the Financial System if You Can't Read a Balance Sheet), if you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side. The only way buying questionable assets would increase capital (particularly “Tier 1” capital, which is what gives depositors confidence) would be for the Treasury to overpay for those assets.
Secretary Paulson has repeatedly said that the Treasury abandoned the plan to buy distressed assets because “the facts changed.” The only fact that changed is that the Treasury realized that this was a really bad idea. In contrast, banking conditions, particularly LIBOR spreads and interbank credit, immediately improved once the Treasury provided capital directly by purchasing newly-issued preferred stock. This is still the best approach. It would be ideal if the capital could be provided by way of a “super-bond,” which would be subordinate to depositor claims, but would come ahead of the claims of the bank's bondholders if the bank failed. Still, preferred stock is good enough in most cases, particularly for the large money-center banks.
Beyond following through with policy changes discussed in the Presidential campaign, I don't believe that the U.S. economy needs any massive “stimulus” targeted toward consumers. The force of this economic downturn is coming from mortgage losses, and the interventions we require must be targeted at 1) bank capital and 2) mortgage principal reductions in return for property appreciation rights. Mortgage related losses have impaired the asset side of bank balance sheets because of the requirement for those assets to be “marked to market” at their going liquidation value (which is heavily affected by short-term sentiment). The decline on the asset side is reflected in a lower total of “Tier 1” capital on the liability side, which frightens customers and depositors into withdrawing funds, and causes available credit to shrink. Boost bank capital and restructure the payment obligations of distressed mortgages, and credit, confidence and consumption will quickly be restored.
Long-term and Gradual
The cornerstone of finance is also present value. During panics, as we are in now, the intense focus of investors on short-term outcomes can blind them to the fact that the vast majority of the value of any long-term asset lies in the “tail” of the stream of cash flows beyond the first few years. The notable exception is when debt levels and short-term obligations are so high that the company has to file bankruptcy and in effect sell itself to its creditors. Balance sheets are more important than income statements at present. A year of earnings, or two, or even three, mean very little to the long-term fundamental value of a security.
For the majority of U.S. companies, balance sheets are sufficiently sound that the risk of an “early termination” is not significant, yet investors have priced the market as if the entire U.S. economy and U.S. corporations will never grow again – even on the basis of normalized earnings. There are a number of good economists who continue to expect economic deterioration, as we do, but many of these economists have never managed a portfolio, and appear to overlook how much earnings and unemployment have continued to deteriorate even a year into new bull markets. For some perspective on this, Bill Hester has a nice research piece this week: Bad News Bulls (additional link at the bottom of this comment).
There is certainly no joy in having the Strategic Growth Fund down -14.27% (adjusted for distributions) since the S&P 500 peaked on October 9, 2007 (the S&P 500 is down by -47.58% over the same period). The Fund is down -17.10% from its own record high set earlier this year. For standardized performance reporting purposes, the 1-year, 3-year and 5-year average annual total returns of the Fund as of the 9/30/08 quarter-end were 4.18%, 3.63%, and 6.12% respectively, with an average annual total return of 10.76% since the Fund's inception on 7/24/2000. Performance information as of the most recent month-end is regularly updated on The Funds page of the website.
The math of compound returns is important to remember. It takes a 25% gain to recover a 20% loss, but it takes a 100% gain to recover a 50% loss, and a 150% gain to recover a 60% loss. It's the really deep losses that we care about, much more than the transient ones that are easily recoverable very early into a new market cycle. So though the continued losses in the market do cause us some discomfort, they are frankly a welcome event. They provide investors (at least the ones who were prudently defensive when the market was overvalued) an opportunity to gradually establish long-term investment positions at increasingly high levels of long-term expected return.
The emphasis is on “long-term” and “gradual.” As I've repeatedly noted, I am not “calling a bottom,” nor am I “bullish” here. Any belief to the contrary would be a misreading of these weekly comments. As of last week, the Strategic Growth Fund continues to have about 65% of its stock positions hedged, primarily with deep in-the-money put options. Still, we are gradually reducing the extent of our hedges on market weakness, while the remainder of our hedge will “soften” in the event that the market advances substantially. A measurable improvement in the quality of market action would prompt us to lower our strike prices and reduce the extent of our hedges more quickly, but presently we don't have enough evidence to do so.
Below is an update of our 10-year total return projections for the S&P 500 Index (standard methodology ). The heavy line tracks actual 10-year total returns (that line ends a decade ago for obvious reasons). The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings.
I trust that investors no longer shrug off data prior to 1950 as outdated evidence that ignores the “New Economy,” so I've included data points back to 1925.
Note that in the Great Depression, valuations did not reach present levels until late-1931. The market would ultimately decline until mid-1932, so in the unlikely event of a second Great Depression, we would experience more weakness still (probably not without a few powerful “bear market rallies” of 20-40% even in that event). Investors should also note that actual total returns in the decade following the 1932 low were reasonable, but on the lower end of expectations because valuations also plunged in the early 1940's as World War II unfolded. It's interesting that even an investor who went “all-in” well before the bottom, at triple the level of the ultimate 1932 low, would still have earned positive total returns over the next decade (mid single-digits, outperforming both long-term bonds and Treasury bills).
In overvalued markets, risk-management is generous in the sense that avoiding risk costs very little (or nothing) in terms of foregone long-term returns. In undervalued markets, favorable valuation is generous in that it forgives even the most abominable timing of purchases, regardless of what happens over the short-term.
Risk avoidance is generally uncomfortable when the markets are hitting speculative highs, and value-conscious investing is equally uncomfortable when the market is declining. Moving gradually and analyzing the quality of market action are helpful, but long-term investors who entirely ignore valuation are simply not investors at all. Value-conscious investing is both rewarding and forgiving over time. What the markets don't forgive is accepting risk in extremely overvalued markets and abandoning risk in undervalued ones. To do that more than once or twice in one's lifetime is to destroy any prospect of financial security.
Investment returns aren't “free money.” Over the long-term, they are compensation for providing scarce, useful resources – liquidity, information, and risk-bearing – to other market participants. No useful services are provided to the market by a speculator who follows the crowd and chases glamour stocks higher late in an extended bull market run. People who take enormous risks in overvalued securities and compete with other speculators to accumulate scarce stock at high prices do three things: they accept risk when the expected long-term return for risk taking is extremely low, they absorb liquidity when liquidity is scarce, and they distort the information content of market prices by pushing overvalued stocks to even more extreme levels. These speculators lose because they deserve to lose – they have bargained to lose, because they have spent their wealth in a way that makes the market less efficient. This is why the Nasdaq has lost 80% from its speculative peak 8 years ago. Valuations have plunged from ridiculous elevations in 2000 to similarly extreme lows at present.
In contrast, the market compensates investors – not over the short-term, but predictably over the long-term – for the willingness to bear risk when other investors are unwilling; for the willingness to provide liquidity by holding out bids (gradually and at depressed prices) to panicked holders stampeding to get out; and for improving the information content of market prices by reducing the pressure for undervalued stocks to become even more distorted in relation to their probable cash slows. Long-term returns in a market economy are always compensation for providing scarce, useful resources to other participants in that market. If the activity is not scarce, and is not useful to others, there is no reason to expect it to to be profitable.
It is certainly not comfortable to scale into any investment exposure at all during a market plunge, but we are doing so very gradually. My guess is that when we look back on this period using monthly or quarterly charts, today will look like a very favorable point to have invested. On a weekly or daily chart, it may look premature or unfortunate – but that's why you move gradually in response to improving valuations. Valuation provides investment merit, which relates to long-term returns. Market action provides speculative merit, which relates to shorter-term outcomes. Because we attend to both, we are most probably scaling in slower than “pure” investors like Warren Buffett, who noted a good month ago that “if prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.” Regardless of short-term prospects, I doubt he will have any regrets.
As of last week, the Market Climate for stocks was characterized by favorable valuations and unfavorable market action. From the standpoint of the general approach described in the Strategic Growth Fund's Prospectus, this places us in the “moderate” yellow box. The appropriate investment strategy is to increase market exposure gradually on substantial price weakness, which is exactly what we are doing here. While it's difficult to imagine a sustained improvement in market action and the appetite of investors for risk, it would be relatively easy for the market to recruit enough improvement in internals to allow a much more extended rebound than we've seen in recent months. A fresh improvement in the quality of market action would allow us to lower our strike prices and reduce the extent of our hedging somewhat more, but we'll take that evidence as it arrives. For now, about 65% of the Fund's stock holdings remain hedged, primarily with in-the-money index put options.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and yield pressures. The Strategic Total Return Fund continues to have most of its assets in U.S. Treasury Inflation Protected Securities, which reflect real yields of nearly 4% even on issues trading near par value (the ones that trade at substantial premiums have more price risk in the event of outright deflation, but even in that event, they do not mature at less than par). Our holdings in this area do not reflect any expectation of significant inflation – indeed, no inflation expectations are priced into these securities for several years to come. Rather, the real yields are quite high even considering the economic risks, and are likely to look particularly attractive in hindsight if the economy does not, in fact, experience a deflationary depression. A similar argument holds for precious metals shares here, which are unusually depressed relative to the metal itself, and would likely enjoy particular strength on any moderation or weakness in the U.S. dollar.
New from Bill Hester: Bad News Bulls
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