February 2008: The Cost of Repricing Risk in the Credit Markets (and who should pay?)
For most investors throughout the world, the year-to-date is off to an inauspicious start. Global credit markets (i.e., the markets for bonds, bank loans, refi-mortgages, and other fixed income contracts, such as securitized credit obligations) are stressed. Banks, brokers and other financial services institutions, which until the beginning of 2007 were greedily recycling central bank-generated excess liquidity, and collecting unconscionably fat fee income, are now paying the piper for their avarice. As these financial services firms (whose stocks in total add up to roughly 30% of U.S. equity market value) attempt to rebuild their balance sheets, if not struggling to avoid bankruptcy, home and common stock owners in the U.S. and abroad are also paying the price. Virtually all asset class valuations are being marked down. The negative ripple-effect has been, is and will for the foreseeable future, continue to be pervasive.
Many derivative-based, securitized, and heretofore marketable, credit obligations no longer trade at anywhere near their new issue prices. Of the nearly $500 billion in distressed sub-prime-related debt destined to be written off, roughly $200 billion has already disappeared into the ether of investment banker spin, CPA jargon and/or annual report footnotes. Sovereign wealth funds, recycling our U.S. petro-dollars, have acquired not insubstantial positions in iconic U.S. banking institutions like Citibank and Merrill Lynch. In this interconnected world of finance, the change in the global outlook has been remarkable.
The headlines are, and will continue to be, bleak. The media churns out obsessively depressing interpretations of what’s hot and what’s not. Consumer and investor psychology has turned decidedly bearish. Recession, now the consensus forecast among braying economic pundits, seems more probable. And there’s certainly more bad news to come in the immediate future. Corporate earnings reports throughout the remainder of 2008 will, no doubt, compare unfavorably against all 2007 quarterly year-over-year benchmarks. Further banking institution bailouts seem possible. The spectre of sovereign wealth funds taking over essential U.S. financial services companies will, if they can avert their attention from the MLB steroids controversy, “require” our politicians to protect the afflicted targets.
What's Ahead? Are Client Portfolios Structured to Withstand More Credit Market Pressures?
As always, we are in unchartered waters. Although few anticipated the extent of these credit market developments, you might be comforted to look back and remember that a number of portfolio realignments for clients in the recent past have reduced overall risk exposure. In balanced and bond-only accounts, average fixed income security maturity and duration continues to remain at less than two years. We hold only the highest quality issuers, credit risk appears minimal. Whereas other bond investors today might be concerned with bond-like hedge fund write-downs and devalued, longer term, lower quality, high yield fixed income positions, our clients need not worry about the quality of their bond holdings. Your cash equivalent short maturity money market funds also hold only high quality issuers. The bond investment strategy pursued these past four or five years has been to forgo higher income yield in favor of capital preservation.
You might also recall that periodically, in balanced accounts we have systematically realigned the stock/bond allocation; in most instances reducing over-valued equities, and building up bond positions with sale proceeds. In the summer of 2005, client equity fund holdings were rebalanced to overweight large companies in both domestic and international segments, thus cushioning, to some extent, the general erosion in equity prices experienced since last summer. Prior to this, meaningful equity fund positions were also taken in the natural resource asset class which, contrary to general weakness in small- and value-oriented strategies since last July, was a very strong performer in 2007. As you are aware, exposure to investment real estate (i.e., REITs) was avoided, as was the case with illiquid hedge funds or funds-of-funds. Often what one doesn’t own is just as important as positions held.
What Should Long-Term Balanced and Equity Account Investors do in Periods Like This?
In a few words, stay with the discipline, look for the next paradigm, and continue to monitor asset class valuations for disconnects. Once a mispriced asset class is identified, find the best representative vehicle to participate.
It has proven to be a bit early, but our build up to market-neutral weight in Japanese equities last spring still seems appropriate. Similarly, a watchful waiting approach to global investment real estate (i.e., global REITs), in our estimation, still holds promise. Small company value funds are off nearly 20% since August of 2007; a chance to once again re-build this position lies ahead. In future months, the more large growth company stocks outperform value, the sooner we will have an opportunity to re-tilt portfolio equity exposure back to our usual value leaning.
In past quarterly letters we have referenced a book (Unconventional Success: A Fundamental Approach to Personal Investment) by David F. Swensen, the very successful manager of Yale’s endowment. The enclosed copy of an article in last Sunday’s New York Times summarizes some of his more useful suggestions. They seem very appropriate in the context of today’s investment environment.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO