March 9, 2009
I suspect that the markets are about to get volatile, possibly to an extent beyond what we observed in October and November. As long-term shareholders know, we don't invest on forecasts, but on the basis of observable measures of valuation and market action. Not surprisingly, we are positioned in a way that can accommodate a strong advance as well as profound weakness. Overall, however, our investment stance has to be characterized as defensive.
As always, we have the ability to accept risk by holding a portfolio of stocks having a different composition than the indices we use to hedge. The difference in performance between our stocks and those indices has been the primary driver of the returns in the Strategic Growth Fund since its inception. We can certainly accept those risks that we expect to be compensated over time, while still hedging against general market fluctuations. As for the stock market as a whole, I continue to view the market as undervalued, but not deeply undervalued. So over the course of a 7-10 year holding period, I do expect passive buy-and-hold investors in the S&P 500 to achieve total returns somewhat above 10% annually. Shorter-term, however, investors may demand much higher prospective long-term returns in order to accept risk, and that's a problem, because the only way to price stocks to deliver higher long-term returns is to drive prices lower.
While the stock market is extremely compressed, which invites the typical "fast, furious, prone-to-failure" rallies to clear this condition, my larger concern is that market action and credit spreads are demonstrating very little investor confidence, risk-tolerance or commitment to stocks. Value investors know that stocks have been much cheaper at the end of lesser crises, and traders are still sellers on advances. My impression is that only prices that allow no room for error (what Ben Graham used to call a "margin of safety") will be sufficient to prompt robust, committed buying from value investors. This will be a fine thing for investors who keep their heads, are already defensive, and have the capacity to add to their investment exposure on price weakness, but other investors are likely to be shaken out of long-term investments at awful prices. This need not happen in one fell swoop, and we need not observe the "final lows" anytime soon. The problem is that even to get a sustainable "bear market rally," somebody has to be convinced that stocks are desirable holdings for more than a quick bounce.
When I was working down at the Chicago Board of Trade as an options mathematician in the late 1980's, I learned that the best approach to volatility is to "widen your spread and lower your size." For a trader, that means keeping a wide bid-ask spread so you get more "edge" for putting on a trade, and holding the number of contracts you trade to a small number so that your capital can tolerate a whole succession of moves against your position. As investors, the same advice amounts to establishing exposure to market fluctuations only very gradually, and on significant price weakness.
I've been asked when we are likely to move to a significantly constructive investment position. We do have some out-of-the-money call options (about 1% of assets) to slightly anti-hedge our otherwise strongly defensive position, but conditions have deteriorated significantly from even a few months ago. Late last year, I was far more optimistic that our leaders would respond correctly than I am now. Unfortunately, the growing revulsion of investors is palpable. Presently, we don't observe any "favorable divergences" from market action that would suggest that the under-structure of the market is holding up. Such divergences would be a sign that investors are becoming less risk averse. We just don't see it here. Moreover, we've lost the opportunity to address this problem without significant "add on" effects in the form of job losses and economic contraction.
Probably the most important long-term risk to perceived valuations here is that the deleveraging pressure we're observing is increasingly likely to cap future return-to-equity at a much lower level than was possible with extremely high levels of debt. This will make historical norms of price-to-book value and price-to-revenues increasingly relevant, while the recent history of peak-earnings (and perhaps even dividends) may be misleading because the recent peak in profit margins will be far more difficult to recover compared with past cycles. Again, I believe that stocks are undervalued, but not extremely so. Passive, long-term investors in the S&P 500 can reasonably expect average total returns moderately higher than 10% annually over the next say, 7-10 years, but there is a good chance that even these prospective returns are not high enough for value investors to make a firm stand.
The misguided policy response from Washington has focused almost exclusively on squandering public money and burdening our children with indebtedness in order to defend the bondholders of mismanaged financial institutions (blame Paulson and Geithner - I've got a lot of respect for our President, but he's been sold a load of garbage by banking insiders). Meanwhile, I suspect that the little tapes in Bernanke's head playing "we let the banks fail in the Great Depression" and "we let Lehman fail and look what happened" are so loud that he is making no distinction about the form of those failures. Simply letting an institution unravel is quite different from taking receivership, protecting the customers, keeping the institution intact, replacing management, properly taking the losses out of stockholder and bondholder capital, and issuing it back into private ownership at a later date. This is what it would mean for these banks to "fail." Nobody is advocating an uncontrolled unraveling of major financial institutions or permanent nationalization as if we've suddenly become Venezuela.
Make no mistake. Buying up "troubled assets" will not materially ease this crisis, nor will it even improve the capital position of financial institutions (see You Can't Rescue the Financial System if You Can't Read a Balance Sheet). Homeowners will continue to default because their payment obligations have not been restructured to any meaningful extent. We are simply protecting the bondholders of mismanaged financial institutions, even though that bondholder capital is more than sufficient to cover the losses without harm to customers. Institutions that cannot survive without continual provision of public funds should be taken into receivership, their assets should be restructured to better ensure repayment, their stockholders should be wiped out, bondholders should take a major haircut, customer assets should (and will) be fully protected, and these institutions should be re-issued to the markets when the economy stabilizes.
The course of defending the bondholders of insolvent institutions is not sustainable. Do the math. The collateral behind private market debt is being marked down by easily 20-30%. That debt represents about 3.5 times GDP. That implies collateral losses on the order of 70-100% of GDP, which itself is $14 trillion. This estimate would include not only bank mortgage losses, but also loan losses to insurance companies, pension funds and other institutions that own private debt. Unless Congress is actually willing to commit that amount of public funds to defend the bondholders of mismanaged financials so they can avoid any loss, this crisis simply cannot be addressed through bailouts. Bondholders have to take losses. Debt has to be restructured (and can be restructured in ways that largely preserve the present value of the obligations). There is no other option - but the markets are going to suffer interminably until our leaders figure that out.
Nearly 5 years ago, in Freight Trains and Steep Curves, I wrote "The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses, and the U.S. itself (via its record current account deficit) have accumulated... much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam." Was this really so difficult for Wall Street and our leaders to recognize at the time? Is it not clear that if we issue trillions in additional debt to foreigners in order to defend bondholders, it will act as a claim against the future output of the nation, at exactly the time that an aging population will be most dependent on that production?
For our part, the Strategic Growth Fund is tightly hedged, with a small "anti-hedge (about 1% of assets) in call options simply to allow for the potential for a recovery. I am increasingly concerned that investor confidence in the U.S. dollar is unjustified, as we are on a track of both long-term monetization and expanding current account deficits. Aside from credit spreads, the behavior of the U.S. dollar here is of great importance, as a weakening in the dollar may portend a further loss of confidence in the markets more generally.
I would love to set a more optimistic tone, but it is difficult to believe that our policy makers are willing to send America into fiscal chaos in order to protect corporate bondholders. Yes, some pension funds, insurance companies, mutual funds, and other investors who hold the corporate bonds of mismanaged financial institutions will take a haircut on those investments. As they should. But if we ignore the need to restructure debt obligations, we risk allowing this downturn to move aggressively into 2010.
As of last week, the Market Climate for stocks was characterized by favorable valuations and unfavorable market action. We presently don't observe anything to convey an easing of risk-aversion. Generally speaking, market troughs are marked by fresh lows in some major indices but with other indices and internals failing to confirm those lows. In contrast, when the markets break support with broad uniformity and few divergences, it suggests that risk aversion is - if anything - becoming more pointed. Along with credit spreads and the exchange value of the U.S. dollar, the CBOE volatility index (VIX) is worth watching, as a push above about 55 may signal another "cascade" to the downside as we saw in October and November (as would a burst of say, 700 or more daily new lows on the NYSE).
In the Strategic Growth Fund, over 90% of our stock holdings are hedged with offsetting short sales in the S&P 500, Russell 2000, and Nasdaq 100 indices. Again, the Fund does have about 1% of assets in call options essentially to "soften" our hedge in the event of a strong market rebound, but that "anti-hedge" is more like insurance than expectation.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and modestly favorable yield pressures. The Strategic Total Return Fund continues to be primarily invested in TIPS, with about 30% of assets allocated across precious metals shares, foreign currencies, and a modest exposure to utility shares.
The Wall Street Journal featured an article about Strategic Growth last Monday, which I thought was nicely done (apart from an underestimation of how much our stock selection approach has contributed to the Fund's returns, which is detailed in our latest Semi-Annual Report, along with relevant performance figures). I'm not sure what to do with "Its manager is a quirky, voluble academic who maintains mild cult status among investing geeks," except that it's probably true. Undoubtedly quirky, and probably voluble too ("talking easily and at length; marked by a ready flow of speech"). The dot drawing was a bonus.
And just to let you know, I couldn't be writing and investing for a nicer bunch of geeks...
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