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By Howard Aschwald, CFA The story about 2008 will be retold for many years. Let's begin with what didn't start the avalanche. Unlike bear markets of the past (especially as recent as 2000), market valuations this time were quite reasonable in most every respect. Interest rates were low, corporations had plenty of liquid assets and Price Earnings ratios were in the moderate zone. The root cause was too much artificial liquidity in the system. Credit for consumers and credit for private equity deals (also known as leveraged buyouts and/or junk bond financing) was easy to obtain. There was a credit bubble, which funded too many unworthy investments. When the credit bubble collapsed, so did the investments and the banks that supported them. Unfortunately, this spilled over to the stock market, taking valuations to generational lows, even in areas (like technology) that had little exposure to private equity deals and financial leverage. Confidence in a system of self-regulation evaporated. Regulatory oversight assumed that self-interest was enough to keep financial companies from making too many poor decisions. Many investments were made into things that seemed safe through the use of financially created insurance policies. Buy the insurance and your investments were safe. Sell the insurance to buyers and collect extra profits. However, there was no regulation of these insurance contracts. When events in the sub-prime housing market started to trigger claims upon the insuring entities, it turns out they did not have enough set aside to cover the losses. This problem area spilled over into multiple forms of structured (financially engineered) debt and created the equivalent of a run on the banking system. The collapse of the credit market in the Fall was met with unprecedented government intervention. Emergency funds, bailouts and the increased potential for growth-restricting new regulations became the focus of attention for the months of October and November. We feel that the worst of the contagion is behind us. Government actions have forestalled a global financial collapse. On the other hand, the credit crisis has deepened the recession that officially started December 2007. With real estate, hedge funds, private equity and structured debt products trading at fire sale prices and virtually impossible to sell, investors have transferred money from easily cashable stocks into ultra safe government backed CD's, bonds and mortgages. This selling pressure has created tremendous values in the stock market. Our own metrics show the stock market as being thirty to forty percent undervalued. Furthermore, the dividend yield of the stock market is now well above that of the 10 year US Treasury bond. This has not been seen since the early 1950's. With no inflation in view (the commodity/energy price bubble began deflating in the summer of 2008), government bonds seem to be what many investors want to own. Just as plain vanilla government backed investments have become the favorite flavor of the downturn, investments in relatively simple, transparent and liquid stock strategies will rule the investment climate over the next five years. Private equity, hedge funds and complex structured products will be starved for funding. Many of these investment strategies were only marginal at best when their fees and true risk were factored in. Now that they have proven to be rather illiquid as well, future investors will be much less willing to put significant assets into these areas. Strategies that emphasize stocks of high quality, low debt and real growth in sales and profits will predominate. Cash dividends will matter more than management promises of better times. While money will be made in distressed and speculative companies, most investors will not have an appetite for this type of investing until they feel secure. This means that quality investing will be the first beneficiary as investors leave the safety of government-backed investments to venture into assets that can survive future economic downturns and benefit from the eventual recovery. Our stock market outlook is dependent on economic growth returning in the second half of this year. In returning to basics, private sector investing will become much more productive. Corporations and banks will be careful in how they allocate their assets. They may stay overly cautious for awhile, but with unprecedented government spending on the horizon, we feel that economic growth will resume by mid-year. Under this most likely scenario, a stock market rebound, especially in blue-chip stocks, will see double digit returns by year end. In the medium run, one to three years out, much will depend on the quality of government spending. Projects that increase national productivity (real roads, bridges, power plants, etc.) will pay economic benefits for years to come. Spending that is merely consumption (tax rebates to buy new televisions), will create a short term economic benefit, but not increase future productivity very much. Without a good increase in productivity, the chance for significant future inflation greatly increases. Until the effects of government spending become more obvious, an extra one-half percentage point of interest a year seems a poor trade-off to the potential loss of bond principal in an inflationary world. We expect 2009 to be an excellent year for blue chip stocks and a cautious year for ultra safe government bonds. Back to Top"Economic Forecasting was Invented to Make Weather Forecasters Look Good." By Mat Johnson Economists, politicians, money managers, mortgage brokers and real estate agents are forever speculating about how the economy is going to perform; what GDP will be, how many jobs will be gained or lost, how high or low the market will be, whether interest rates will be higher or lower and what home prices will be. Unfortunately, each of these groups are nearly always wrong. The reality is that most economic forecasts are really only very good at explaining the past, based upon the present. It goes without saying that 2008 was a dismal year for the economy and a punishing one for the stock market. Equities in the U.S. recorded the worst annual decline since the Great Depression. Some of the country's largest financial institutions were wiped out and individual investors pulled more than $200 billion from equity mutual funds in the final six months of 2008, nearly as much as they had invested in the prior 2 years. While the economy was only recently pronounced to be in a recession, its duration has already exceeded the average length of 11 months since World War II. Job losses skyrocketed to 1.3 million in the final three months of last year. In addition to paring payrolls, businesses have been putting new investments on hold, first as a result of the developing credit crunch, then as a result of the sudden slowing in end market demand. As a result, the yet to be reported contraction in fourth quarter GDP is likely to approach -6%, the worst quarter in more than 25 years. As we look ahead to the immediate future and the whole of 2009, we believe there is genuine hope for meaningful improvement. However, we also recognize the economic outlook remains very uncertain, particularly given the current backdrop of repeatedly dismal reports on the recent state of the economy. To focus on these reports now, however, is doing no more than looking out the window in the morning to forecast the coming day's weather. Unlike forecasting the weather, psychology plays a large role in the economic outlook. If there was any factor that was widely overlooked this past year it was psychology. From a forecasters point of view, there is always a concern that psychology will result in self-fulfilling prophecies, hence the reason economists tend to avoid dropping the "R-word." What is less clear, however, is why some periods of economic weakness turn out to be temporary and others develop into deep and prolonged downturns. One thing is generally true of all economic downturns — they are necessary adjustments to past errors. Similarly, from an investment point of view, bear markets are best regarded as a period when capital is returned to its rightful owner. For the economy, the adjustments now underway are being felt through businesses sharply scaling back their operations. Companies have become acutely aware that past spending by consumers was artificially high, owing to their taking on ever more debt to finance spending beyond their income. With all consumers more focused on shoring up their finances, this is forcing businesses to scale back to the new economic realities. For those individuals that seemingly did everything right: saving, investing and avoiding the "cheap credit" temptation, it is unfortunate that they too have been caught up in the market correction. On the other hand, by not having to "cash out" at the market's suddenly depressed levels, they are left poised to reap the rewards of healthier and more profitable businesses in the immediate years ahead. For an improvement in economic and market conditions to materialize, the immediate challenge is in restoring confidence among consumers, businesses, and investors. This is clearly important from an economic standpoint, but probably more so from an investment point of view given the current state of the markets and investor sentiment. For example, today 10-year Treasury bonds yield an unbelievably low 2.3%, being driven to these low levels by investors seeking safety from the market's recent bout with uncertainty and high volatility. By comparison, this is below the stock market's dividend yield of 3.5% and below the recent average annual inflation rate also 3.5%. Measured against inflation alone, this leaves investors susceptible to vast erosion of capital and loss of purchasing power. To highlight how irrational this is, let's think of inflation for what it is — a tax on future purchasing power. While most every investor would balk at a 150% tax on their investments, that is precisely what choosing an investment that yields 2.3% every year for 10-years is, when faced with a the likelihood that inflation will average at least 3.5% over the same period. By contrast, U.S. equities have consistently provided investors with returns on equity of 12% over the years, in both high inflation and low inflation periods. Since equity is what we as shareholders hold, companies adding 12% year after year to our equity value will not go unnoticed by the broader investor community for long, particularly when compared to the paltry yields on bonds. Moreover, at current dividend yields, equity investors are essentially being paid 3.5% a year to hold a diverse portfolio of high quality companies. Despite the relative attractiveness of stocks to bonds, recent market events have led investors to become seekers of 'return-free risk,' flocking to the perceived safety of government bonds, and arguably the next bubble to burst, while shunning the much higher prospective return of company shares. The reality is that the way companies deliver 12% returns on shareholders equity is by doing what they are doing now — adjusting their businesses to the economic realities facing them. Government bonds on the other hand, have no means to increase 'profitability.' As an investor you simply get in the future what you paid for today. And today, that is 2.3% in interest annually for 10-years. This leaves a very high likelihood of inflation forcing these investors to consume their capital just to pay the 'inflation tax' before they even meet their real financial needs. With the market's sharp decline in recent months, investors have not been presented with a more compelling value in the equity market since the years following World War II. In other words, the market is cheaper now than in 1974, 1982 and 1994 — each of which were followed by sizable market advances. Those advances were the result of precisely the readjustment actions that companies are taking today. In these earlier periods, investors were presented with attractive prices in exchange for prospective double-digit returns. While the consensus during these periods was decidedly negative toward equities, the consequence of companies making the same difficult adjustments they are now was that those willing to hold shares wound up substantially better off. A key difference between those earlier correction years and today is that corporate equity returns are much higher relative to government interest rates. In each of those prior years interest rates averaged, 7.6%, 13.0% and 7.1%, respectively. Back then, the relative attractiveness of corporate shares prospective 12% return was reasonably compelling, though compared to today's low 2% yields, investors are presented with a substantial opportunity to accumulate wealth at above average rates in the coming years. Ultimately, the economy will recover as a result of the vast adjustments taking place throughout the corporate sector. In fact, one of the key sources of economic weakness in recent months has been the sharp reduction of business inventories as consumers and businesses alike retrench. Companies cannot cut payrolls and pare inventories to zero and cease investing in their future. Companies will necessarily have to begin rebuilding their businesses as emotions subside and conditions begin to normalize. Meanwhile, the equity market has re-priced companies as if the economy has fallen by half. Clearly it hasn't. Ultimately, the painful process of downsizing, which is already underway, is precisely how economic recoveries begin. Back to TopLessons from Madoff By Howard Aschwald, CFA We want to take the opportunity to talk about the Madoff investment fraud. The fraud has special implications for most investors and also plays upon our theme for 2009 — "Back to Basics." It really comes down to trust. Mr. Madoff got people and institutions (made up of committees of people) to trust him even with obvious warning signs. Mr. Madoff used three key elements in gaining trust: affinity group membership (most of his direct contact victims were from a strong identity group), public reputation from credible sources (former head of the NASD and advisor to the SEC) and a sense of exclusiveness. Unlike Mr. Ponzi 90 years ago, he did not promise investors a fifty percent return in three months. Instead, he claimed he would make between 8 to 12 percent each year no matter what the markets were doing. The promised returns didn't seem greedy and this allowed him to avoid instant suspicion. He appeared to deliver these steady returns with a vaguely complex, but plausible sounding strategy. Like a clever magician, Mr. Madoff was able to direct people's attention away from what he was doing by using the illusion of trust. The illusion was so powerful that it seemingly beguiled people into looking the wrong way. He even managed to fool the regulators by allowing them to look only at the areas he wanted them to see. (Hedge funds for "sophisticated" investors are unregulated by the SEC.) The investor's trust in what they saw blinded them to obvious defects. The first defect was that people gave Mr. Madoff full control of their funds in an entity that Mr. Madoff controlled. Unlike Quantum where investor funds are strictly segregated at a third party brokerage house or trust company, Mr. Madoff could deposit and withdraw at will plus create false confirmations of transactions and statements. Furthermore, Mr. Madoff did not charge a fee for management, but received compensation based upon commissions generated in the account. Since he controlled the buys and sells, he could make as much commission as he wanted. No one complained because he always made a "profit." This is a very obvious fundamental conflict of interest. While ALL brokerage firms have a conflict of interest in the "advice" they provide, the financial consultants/advisors do not have control of the buy and sell decisions. Clients have the last say in what is bought or sold in their accounts. That way they can (somewhat) oversee how much (they think) they are being charged for investment advice and transactions. At Quantum, we charge only a management fee and we work to keep commission costs as low as possible. We do not need advice from financial consultants and are exclusively loyal to our clients. Further, Mr. Madoff did not have an officially compliant track record audited by a reputable third party. Unlike commission-based advisors and even fee-only financial planners/consultants, as a qualified money manager, all of Quantum's track records are officially compliant and audited by an industry-known accounting firm. Last, but not least, many investors got taken indirectly by trusting their funds to a third party consultant. Known as fund of funds, manager of managers or investment management consultants, these entities either approved of Mr. Madoff or hired him to be at least one of the managers for their clients. Investors paid an ongoing fee (sometimes a very high fee) to have these entities do a proper background check and provide continual supervision. These types of entities do not directly manage money themselves. While seemingly more knowledgeable about investing than their clients, their fundamental inability to manage money at the individual security level left them as vulnerable to fraud as their clients. Their due diligence was little more than picking out a good (but fraudulent) historical track record. Their clients could have done that for themselves from any number of inexpensive sources. At Quantum, we select and manage our own portfolios at the individual security level. As a "hands-on" manager, we do not delegate our client's money to other people for management. As a part of the 2009 investment theme: "Back to Basics," we see that the appetite for investment risk taking being greatly diminished. Part of this theme is a great unwinding of exotic investment strategies. It's becoming increasingly obvious that hedge funds (especially after fees) do not offer something for nothing. Extra returns come with extra risk and/or serious lock-ups of money that investors cannot get to when they might need it most. All investments have some sort of risk (CD's lose to inflation and taxes). Delegating responsibility in any area that requires expertise (investment, medical, tax, legal, etc.) is a smart idea, but ultimately an investor has a responsibility to watch out for anything that seems well beyond the norm. It's much better to have an investment policy that if "it sounds too good to be true," it is. Until the appetite for risk taking in the marketplace returns (and it ultimately will), we see transparent and historically proven styles of investing as being where the smart money gravitates. The smartest money invests that way all of the time. Back to TopDiversification and Rebalancing By Stephen Bradley, Jr. Diversification is a key to successful investing. A well-balanced portfolio needs two major components; fixed income for stability, and equities for growth. When equity prices depress, fixed income can help balance these low periods, not only with performance, but also with liquidity. After a bear market (like 2008), it is a good time to rebalance the portfolio and take cash from the fixed income side and move it back into equities. Taking assets from the better performing asset class is a hard decision, but has been proven to be the right decision, historically. The best performing asset class in 2008 was the 30-year Treasury bond. Right now, they are poised to become one of the worst asset classes. They have been bid down to a current yield of 3.02%. This yield is about the same as the historical inflation average of 3%. This means for taxable investors, after tax, they are almost guaranteed to lose purchasing power over the next thirty years if they continue with this asset class. Furthermore, if long term interest rates revert back to their historical norm of 5.5%, the present value of a Treasury bond will discount 40%. The equity markets have already significantly declined, and in 2008 alone, the S&P 500 was down 37%. Global equities and real estate have declined more than 40%. The current bear market has depressed prices to historically low levels, and many companies' market values are now less than the investment put into them. This would suggest that companies do not make money, but will actually destroy wealth in the years ahead. This is quite unlike what has historically been the case. Prudent investment management acknowledges that there is no permanent safe haven, and even treasuries can be risky. Either you are faced with a loss of purchasing power, or you are faced with a loss of opportunity of gaining a higher return elsewhere. When an asset class has outperformed other asset classes for an extended period of time, the valuations for that asset class become out of balance. A good investment strategy is to rebalance, to take advantage of lower valuations in other asset classes. Here at Quantum, we are constantly monitoring these shifts in asset classes, and rebalance without emotion or market timing. We make sure that our clients are always well positioned for the long term, with a well diversified portfolio. |
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