October 2008: From Irrational Exuberance to Unbridled Avarice to Abject Panic: How did we get here from there?
When Tom Wolfe and others complete their fictional versions or historical accounts of how this worldwide convergence of trends (financial as well as psychological) merged to bring us today's credit and equity market meltdown, there will be more than enough blame to share amongst those who prospered from their genesis.
Readers of these past letters will have found indications of our concerns about a global banking system awash in liquidity, Wall Street financial engineers (i.e., investment bankers armed with computers who designed "riskless" securitized obligations bundled in the U.S. and flogged around the world), commercial bankers who ignored conventional mortgage loan application standards, and grasping corporate executives. Add to this group of worthies our politicians who, with little understanding of the regulatory and/or economic consequences of their inaction, set the tone for all this by insisting that everyone should own a home.
Aided and abetted by accommodative central banks around the world which have injected an unsustainable amount of leverage into the system and encouraged investment risk-taking beyond normal standards, investors (professionals, fiduciaries and individuals) knowingly or without realizing it, became speculators.
"Alternative" investments have become the rage; hedge funds being the most visible manifestation. Sophisticated managers of endowments and retirement plan portfolios have parked as much as 40% of funds entrusted into these unmarketable, illiquid, often highly-leveraged vehicles. Their day of reckoning is also at hand. Appraisal values of the contracts and properties making up these strategies will need to be marked-to-market, reflecting the impact of declining real estate values and under-water financial instruments underlying these approaches. Today, hedge fund clients are lined up at the exits with withdrawal in mind, private equity transactions are at a standstill, merger and acquisition activity is on hold, and initial public offerings non-existent.
The romance with alternatives is behind us, the financial markets are undergoing a purge, leverage is being washed out of the system, and a return to fundamentals is underway. This painful realignment process will take time to play out. To date, most of the unwinding has taken place in the financial services and housing sectors which account for roughly one-third of the U.S. economy. On the other hand, as of this writing, our "real" economy is holding up surprisingly well. Manufacturers of products and services providers, particularly exporters, are competing and prospering in world markets. Smaller, regional banks (i.e., those which have carefully managed their loan portfolios and are conservatively capitalized) have money to loan and are looking for economically sound projects. Regardless of the headlines and media talking heads, the "operating" economy continues to function.
Nevertheless, the "R word" cannot be ignored. The spill-over effect from the financial markets malaise most certainly will affect consumer behavior. Job loss figures are beginning to build (but remember there are still 130 million working Americans in our labor force), unemployment is on the rise. However, labor productivity continues to grow and business balance sheets, except for the auto industry, remain strong. Many feel a recession in this country began in the early spring of this year and could last into next summer. Some economists, Martin Feldstein being one, predict this recession could be the deepest and longest since World War II; but economists are paid to opine, very few are managing other people's investments.
Financial Markets in Crisis Mode: Looking for Signs of Changes in Investor Behavior
As has been mentioned in previous letters, and others have pointed out, investment markets are sensitive investment information discounting mechanisms and real-time reflections of investor behavioral patterns (i.e., investor sentiment). Currently, both credit and equity markets are dominated by fear resulting from a lack of information, an inability to determine how to price financial instruments, primarily mortgages and the financially-engineered securitized products held by individuals and institutions throughout the world. The recently enacted Troubled Asset Recovery Program (TARP) is an attempt to provide a government-sponsored market (an oxymoron?) to enable the process of price discovery for subprime loans and under-water mortgages to take place in an environment in which, after due diligence, informed buyers and sellers establish values.
The birth of TARP (think cover-up?) wasn't exactly a flawless production. If regarded more as a work-out rather than bail-out, the program, if properly implemented, might provide taxpayers a reasonable return. The same approach worked with the Resolution Trust Corporation (RTC) S&L "rescue" in the early 1990's, as well as the Chrysler loan and Executive Life Insurance Company take-over by the State of California. The main objective of the TARP legislation is to restore order and calm to the credit markets, a first step toward a more orderly asset price discovery process.
Further steps required to repair our credit markets will include greater transparency in financial investment contract language and fuller disclosure, tighter accounting standards, and more attention to the moral hazard issue always present in dealings between buyers and sellers, as well as politicians and voters. The need for transparency starts at the top. By generally accepted accounting standards today our Federal, and many state governments, are poor credits. For starters, leveling with the electorate about the Federal government entitlement gap (now calculated to be approaching $60 trillion during the next 20 years), would set a more constructive resonance for all parties to work within. If investment and commercial banks, corporations and individuals are all required to mark-to-market the value of their assets and liabilities, accurate accountability should also be the minimum standard for our political class. The time for full disclosure by all parties has arrived!
Facing the Issues: What Should Investors Do Today?
As this letter is being written, equity markets around the world appear to be in free fall. Individual, professional and political behavioral patterns reflect a loss of confidence in established norms. The credit market paralysis has become a concern on Main Street. Presidential election politics and media hype magnify each shift in the markets. Media programming is designed to heighten concern. Emotions are at fever-pitch levels.
Not surprisingly, portfolio values reflected on the September 30th appraisals included with this letter are down considerably. Both the international and natural resource equity segments are off more than the domestic funds as a group. Since the end of September, of course, the sell-off has continued, but coordinated central bank policy shifts may have begun to turn the tide. A few leading indicators in the housing market have begun to at least stabilize, a return to some sense of order in credit markets seems closer at hand.
Counseling clients to remain calm in a storm like this rings a bit hollow, we realize. However, it is just at such times of stress when a review of first principals is in order; a return to the rationale behind established investment policy would be helpful. When we all felt confident we understood how the global markets were operating, we embraced a long-term investment horizon. In this emotionally charged atmosphere, it would strike us as counterproductive to make snap decisions. Stay the course remains our counsel.
Our research at this time continues to focus on shifting asset class relative valuations within the fixed income and equity markets. As you know, our fixed income holdings have always been in the strongest credits (primarily U.S. Government) and very short duration. Within the past few months, even our money market holdings have all been shifted to U.S. Treasury securities funds.
Generally speaking, prior to this summer, in rising global equity markets, the implementation of our periodic portfolio rebalancing programs has meant a systematic and gradual shift of equity money into the fixed segments. As the situation stabilizes, we will begin to move portfolios in the opposite direction. We have also been interviewing active managers of Real Estate Investment Trusts (REITs), emerging market and US small company funds. Some new equity fund names may begin to appear in your portfolios in the months ahead. We may also want to discuss the applicability of tax-loss generating programs in the equity portion of portfolios. In a post-election environment of rising capital gains tax rates, losses taken today and offset against future gains may prove useful.
Firm Business and Operational Matters
TFC now employs 20 individuals (16 at 30 Federal Street; 4 at our Harvard Square office), a dedicated group of professionals, together now with a strong administrative and business management support structure. Financial controls are more than appropriate, banking relationships are in good order, and our compliance procedures have been tested recently by outside auditors. We have just introduced our new website (www.tfcfinancial.com) and soon will open up the client access portal.
We have examined once again the financial status of our client custodian servicing firms. Charles Schwab, being a brokerage firm in the fullest sense (i.e., no affiliated investment banking involvement) appears to be well situated. National Advisors Trust Company passes all the tests, and Fidelity, of course, seems in good financial condition.
As ever, please feel free to call or comment by e-mail; we will be happy to respond.
Sincerely,
James L. Joslin
Chairman, CEO