February 9, 2009
There is No Substitute for Mortgage Debt Restructuring
On Tuesday, the Treasury will announce how it plans to use the remaining $350 billion in TARP funds. Last week's market advance was largely based on Wall Street's hope that current mark-to-market rules will be abandoned or modified. This is like someone taking huge losses in their investment portfolio, and believing that not looking at the brokerage statement will improve their financial situation. Look, if the underlying assets are likely to regain value over a reasonable amount of time, then it might be appropriate to modify the capital accounting rules so temporary fluctuations don't drive banks into failure. But if you've got securities that are marked down to 20 or 30 cents on the dollar, and the underlying borrowers are likely to default because you haven't changed their payment obligations, failing to mark the portfolio to market simply allows banks to go quietly insolvent without the knowledge of the public. Providing federal insurance for those securities would amount to an open-ended, unlegislated, future bailout. Let's hope that isn't part of the plan.
The heart of this problem continues to be the need to restructure the payment obligations of borrowers. For the better part of a year now, I have repeatedly (and increasingly urgently) advocated the restructuring of mortgage obligations by a variety of methods (collecting the pieces of securitized mortgages through “all or nothing” auctions, writing down principal in return for “property appreciation rights”, etc). Frankly, I had expected more progress on this from both Congress and the Treasury, considering the obvious urgency. But evidently, only perhaps $50 billion of TARP funds will be directed toward foreclosure abatement. On Tuesday, we'll find out to what extent they've got it right.
Undervalued, but still very cautious
Among the factors that kept us from becoming overly constructive as the market lost half its value over the past year is a 1932 quote from Edwin LeFevre, who observed about the Depression-era market plunge: “Reckless fools lost first because they deserved to lose, and careful, wise men lost later because a world-wide earthquake doesn't ask for personal references.”
I have absolutely no expectations relating to short-term market direction. It's quite possible that investors will be comforted by the Treasury's announcement on Tuesday, and that some early improvements in market action (particularly breadth) will extend further. The problem is that if we don't address foreclosure abatement in a major, deliberate way, whatever nascent recovery we might potentially get later this year will be cut short by a fresh round of foreclosures as we enter 2010.
From a valuation standpoint, I do believe that the stock market remains undervalued (though still far from the deep undervaluation we observed in say, 1974 or 1982). Accordingly, I do expect that passive, long-term investors are likely to achieve reasonably good market returns in the area of 10% annual total returns over the next 7-10 years. However, we have to be well aware of the tendency for weak markets to overshoot on the downside, so we continue to be unable to rule out even the 600 level on the S&P 500 as a possible (though not an expected or predicted) outcome during the next year or two.
I don't think one can be a good investor without being willing to increase one's exposure to market risk as valuations become more favorable and the expected return/risk profile of the market improves, so I expect that we will continue our practice of gradually increasing our market exposure on substantial weakness, and cutting it back on advances that fail to generate robust improvements in market internals. Still, it's important to recognize that the failure to address mortgage foreclosures has a cost, and will likely extend the recession and its effects on credit and capital formation. The longer our policy makers attempt to solve a deleveraging crisis by assisting lenders but failing to restructure the obligations of borrowers, the longer we can expect the current crisis to persist.
Most likely, the market will continue to trade in a very wide 25-35% trading range for a prolonged period of time, at the end of which we can probably expect a somewhat frightening but final period of “revulsion.” As always, we'll take our evidence as it arrives. Suffice it to say that I do believe the market is undervalued, but I don't believe that we should expect a quick return to sustained bull market conditions on that basis.
This week's issue of Barron's includes an interview with Ray Dalio, who runs Bridgewater Associates, and also emphasizes the urgency of debt restructuring. It's an extremely good interview with an exceptionally smart guy, and it should not be missed. Here are some excerpts:
“Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too.
“What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured. The reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt.
“If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.
“By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
“You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.
“I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first. Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now.”
As of last week, the Market Climate for stocks was characterized by favorable valuations, unfavorable market action, but a modest, emerging improvement in breadth and other market internals. In the Strategic Growth Fund, we continue to hold a largely hedged investment position which mutes most of the impact of market fluctuations on the portfolio, but we do have about 1% of assets in index call options, to dampen the hedge and allow a more constructive position in the event of sustained market strength.
We've observed a small favorable divergence between the major indices and overall market breadth in recent weeks, as investors have begun to pick the wheat from the chaff. There is no assurance that this process will continue, but the gradual sorting process is helpful to the extent that the primary source of our returns here is the performance of our stock holdings relative to the indices we use to hedge. The concentrated strength in financial stocks on Friday wasn't helpful, of course, since we continue to substantially underweight financial stocks. Overall, however, it's a good sign to observe investors being more discriminating about investment quality, because it allows investment returns on the basis of stock selection, without relying on sustained gains in the overall market.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and moderately favorable yield pressures. We've observed a rebound in Treasury yields from their depths a few weeks ago, which lessens the immediate price risk for Treasury bonds from these levels. I continue to view inflation-protected securities as more appropriate than straight Treasuries as the implied rate of inflation in TIPS continues to be implausibly low (alternatively, one could say that the nominal yield in straight Treasuries appears unsustainably low in relation to TIPS yields). The Strategic Total Return Fund continues to be primarily invested in TIPS, with about 10% of assets in foreign currencies, about 10% in precious metals shares, and about 5% of assets in utility shares. As usual, those positions will change as we observe periodic opportunities to lock in elevated yields, or as the pressures on those yields change.
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