February 6, 2009
Yesterday, Today and Tomorrow
| Welcome to 2009 and what a year it has been thus far. In our opinion, we seem to have started the year with the average investor in a dazed and confused state. We are coming off the worst year in the Dow since 19311 and the third-worst in history1. For the past three decades this sort of down market proved to be a great buying opportunity, but for some reason this time it feels a little different. When looking back at 2008, it is easy to understand why the investing public might feel like they are staring down at Humpty Dumpty after he fell off the wall wondering whether or not he can be put back together again. We witnessed the pillars of modern finance; Investment Banking, Leverage and Securitization all crumble before our eyes. Although we can not predict the future, one | thing we are clear about at Excelcia is that it is not going to be smooth sailing from here. With that we feel that we should take some time in this newsletter to go over what we witnessed in 2008, the current state of the financial landscape and the future that we are preparing for. It is pretty remarkable that World War II, Korea, Vietnam, the Cold War, the Oil Embargo and September 11th were not as big a wrench to the stock market as the bursting of the Housing Bubble. The S&P 500 finished down 38.6% for the year1 and every asset class except Treasuries, Gold and the US Dollar finished down2 (See Chart #1). The basis of Modern Portfolio Theory requires that different asset classes zig when others zag to reduce portfolio volatility, but it ended up to be a lemming march |
off a cliff. After the failure of Lehman Brothers, the financial system froze up and lending ceased. LIBOR (London Interbank Offered Rate) rates which measure lending between banks, spiked to unprecedented levels. In response, governments around the world have done everything they can to prop up the global financial system. The US alone has lent, spent or guaranteed in excess of $7 Trillion dollars!3 As a comparison, our total debt load prior to this crisis was $9 Trillion and that took us over 50 years to accumulate4. 2008 also brought the beginning of the deleveraging process. This word is commonly used but most people have underestimated the massive implications of this process. Take for example Goldman Sachs, as of quarter-end 8/29/2008, their shareholders equity was about $45 |
Chart #1
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Billion supporting $1 Trillion in assets5. That is a leverage ratio of 24x, so now that they are a bank holding company lets assume they will bring leverage down to around 15x (Bank of America had a leverage ratio of 11x as of quarter-end 8/30/2008) 6. This means the $45B will only support $675B, a reduction of $400B. This is from just one firm! If you take all other investment banks, hedge funds and leveraged investors around the world and run this calculation, you are potentially looking at trillions of dollars in reduced demand for risky assets. So the true implications moving forward are higher costs for capital across the spectrum which will be discussed further in this newsletter. Today we can see the beginnings of the healing process that has been kick started from the various government and Fed programs3. This healing is seen in the increase in capital levels across the banking system as well as LIBOR spreads coming down from distressed levels. Though the healing has begun the government will, more then likely, have to inject even more capital and continue or expand upon the current lending facilities. Risk of widespread bankruptcies has been diminished, at least the perception of risk, which is extremely important in banking. As a result banks appear to be building stronger balance sheets, but remain hesitant and in some case unwilling to extend loans to the public. Despite the urging by government officials to start lending, banks continue to use the cash to rebuild balance sheet strength. This translates to a conforming 30yr fixed loan around 4.75% and a Jumbo loan around |
6.61%7, because they can offload the conforming loan, but must keep the Jumbo loans on their balance sheets. Therefore, borrowing for consumers has become very difficult and extremely expensive. Of course that leads us to the continuation of deleveraging. As consumers have started to accept that borrowing money will be costly, they have decided to join the deleveraging party and start paying down their debts. Prior to 2000, median home prices were around 3x the median income of their respective areas and at the peak some markets were hovering around the 10x level. Now these households must divert a larger percentage of their income to pay down this debt. This means less overall consumption, as evident in the January 14th Retail Sales report showing that December 2008 sales were down 9.8% from the prior year. Allowing for personal consumption to represent roughly 70% of our Gross Domestic Production (GDP) implies that the drag on GDP should be at least negative 6.8%! That is a truly |
staggering number (See Chart #2). In the near future we anticipate two major themes to persist; deleveraging and deflation. Deleveraging in the past and present were mere reactions to a change in circumstance. Banks had to bring down leverage levels because default rates were higher than expected. Individuals had to start paying down debts since borrowing became difficult. The future of deleveraging involves a see-saw between the real economy (individuals) and the financial system (banks). As banks continue to tighten up on lending to businesses and individuals, the outlook for job security diminishes. With an unstable employment environment, consumers will borrow less and use current cash flow to pay down current debts. With consumers spending less, businesses will continue to have reductions in sales as well as difficulty borrowing based on future sales - so they look to downsize. So you can see how this see-saw effect could go on for a considerable period of time until |
Chart #2
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businesses can forecast and operate at a realistic and fundamental level. The Obama administration looks to shore up employment with a massive stimulus package to try and stop this cycle, but we will undoubtedly face several see-saw cycles before the stimulus makes an impact. Really what this means at the end of the day is increased unemployment (Possibly 10%+), low consumer confidence, more bankruptcies (individuals and businesses) and lower GDP (See Chart #3). The impact of this outcome to the investment world is going to be significant. The perception of investment risk will be changed for at least a few decades in our opinion. If you have not lost your investment capital during the fallout, then this event is actually very positive. The last decade of cheap money meant that there was a lot of competition for risky assets, which made them expensive. As a result the risk premiums were pushed lower meaning that your margin of safety was also pushed lower. Now that risk premiums are increasing, your margin of safety moving forward is getting larger – this is great news for those who have been able to weather the storm. We believe deflation may also be a serious issue in the next few months. We were actually incorrect last year when we believed that we would maintain inflationary pressures through this downturn. We underestimated the magnitude in which deleveraging would destroy wealth. Now that it is evident that the rest of the world will not be able to pick up the slack in terms of consumption as well as monetary policy not transmitting down to the consumer, we are |
starting to see deflation taking hold in many areas of the economy. We expect to see lower wages and lower price of products in the next few months. Some of the forces that will drive down prices are excess inventories and production capacity as well as lower input prices. Countries that export to the US will be actively trying to devalue their currency allowing them to continue selling goods to the US at a lower price. We still hold that the long term concern is inflation because the amount of money being injected into the system by central banks around the world will eventually make its way to the consumer and combined with supply destruction price levels could jump substantially in a very short period of time. This is something we will track closely; however, we do feel that now is not the time to be positioning the portfolio for such an event. Moving forward we will use this outlook as a guide to manage risk in the portfolio as well as trying and take advantage of opportunities. Our main focus is around the fact that the US dollar |
should continue to stay strong relative to other currencies around the world - except Japan. We will look to hedge the portfolio with gold even though the dollar is showing relative strength, fiat currencies in general are weakening8. With this view we still believe that international markets do not offer an attractive investment environment. The Eurozone is segmented and their ability to deal with this crisis will not be as quick and decisive as the programs in the US8. Asia ex Japan, is also showing extreme weakness due to their heavy reliance on exporting goods to the US. The pundits would have liked you to believe that the US was becoming a marginal player in the global economy, but this crisis has really shown that when the US sneezes the rest of the world catches pneumonia. In essence, without a recovery first in the US there most likely will not be recovery elsewhere. This economic environment has been quick to evolve and did so in a violent |
Chart #3
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manner. That is why we will continue to be vigilant and keep the portfolios as nimble as possible. The ability to react to changing market environments or government policies will be imperative in avoiding potentially dangerous areas. Volatility should continue for most, if not all, of 2009 so being able to adapt and adjust will be a critical tool in managing our portfolios. No doubt, you must be asking why invest at all in such a treacherous environment? The reason that it is important is due to the fact that even inside a secular bear market such as in the 30s and 70s, you have massive cyclical rallies that can last months and even years (See Chart #4). Many technical analysts believe that the secular bear market actually began in the dotcom bust9, which is plausible considering that the markets are considerably lower than when we started this decade. So even in this long-term bear market, the rally from 2003 to 2007 was a substantial one that a prudent |
investor should have participated in. That is why we will look to participate, but only with a clear strategy founded on fundamentals void of speculation. Therefore, we will probably only partially participate when markets start a cyclical rally to allow for downside protection - much as we have done in the past. To conclude, we wanted to make sure that we shared our outlook in a meaningful way. That is why this newsletter is considerably longer than our normal quarterly newsletters. This is a very scary environment for most investors so keeping our clients updated is one of our top priorities. We have always promised to protect your money as best we can we worked earnestly through 2008 to try and accomplish this. It is not fun to lose money, but we are trying to help you make gains in relative wealth. We will not stand idle with what we have accomplished in the past and will continue to work diligently to allocate your capital prudently to help achieve your goals. |
We continually try to understand the risks from a macroeconomic standpoint, but most importantly we strive to exploit the unique advantage of being a collective intelligence to gain different perspectives on risk. Transparency, liquidity and risk management help drive investor confidence and if that had been enforced in the securities industry we may not be in this mess. We will look to provide this on a grassroots level and hope that it at least drives your confidence that we will continue to look out for your best interest just as have in the past. If you have any questions our entire team is always just a phone call away. If you have any friends and family that could use a little Excelcia care, we will gladly be here to help them as well.
Thank You, |
Chart #4
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