November 17, 2008
Greetings,
The News from Lake Woe Be Gone (Will They or Won't They?)
At the moment, all eyes are on the congressional auto company bailout struggle in Washington. Absent the politics, the solution is probably self-evident, and has been for years. But the equation's variables are mired in chits, paybacks, markers, earmarks, and partisanship. The outcome will be a messy, inconclusive compromise. In today's world of "no-one-should-be-seen-as-loser," sad to say . . . the taxpayer will be disadvantaged yet again. Although today this drama commands the headlines, it's a sideshow compared to all the other issues confronting global investment markets.
"Be fearful when others are greedy, greedy when others are fearful." (Warren Buffett, Chairman, Berkshire Hathaway)
An old-fashioned value investor, Buffett's maxim is worth repeating at times like this. He is, of course, referring to the tendency of investors to allow their emotions to guide their investment decisions, to run with the crowd and not think independently in their own best interest. Practicing what he preaches, Buffett has recently been purchasing not insignificant equity and preferred stock positions in a number of financial services companies (e.g., 10% of Goldman Sachs for $5.0 billion; $3.0 billion stake in General Electric).
The urge to attempt to time these investment markets is universal, but the average investor's experience and long-term results reveal a frustrating under-performance. When compared to remaining fully invested throughout a complete market cycle against a representative broad market benchmark such as the S&P 500, trying to time the markets is counter-productive to say the least (see "The Danger of Trying to Time the Market (PDF)").
Crucible for Hedge Funds?
In the end, stock prices are a function of future corporate earnings, but just as importantly the direction of investor cash flows. These movements of capital into, or out of, financial market sectors drive the markets' asset class and security relative valuation framework. The velocity, volume and short-term nature of these capital flows around the world today have changed the markets' volatility characteristics almost overnight. Since the start of this decade, a primary driver behind these massive flows has been leveraged hedge funds which hold in excess of $1.5 trillion of investor capital, roughly 20% of today's total U.S. stock market capitalization.
Stock market prices (and, therefore, the total market value of each company) are by definition determined each day by the trading of a marginal amount of each company's outstanding capitalization. Hedge funds, today often leveraged 2-3 times their investors' capital and account for 35-40% of daily, average equity market trading volume. Primarily executing their tactical trades through computer models, often referred to as programmed trading, these unregulated players have had a pernicious effect on the world's bond and stock markets.
Most hedge funds today are faced with calendar year-end investor withdrawal windows requiring 45-day advanced notice of intent to redeem (i.e., the fund must be notified at least 45 days prior to the year's final trading date). Having just passed the November 15th mark, many hedge funds are faced with substantial withdrawal liquidity requirements. Most have had advanced notice of participant intentions and have already been raising cash during the fall months.
However, recently many large endowments and pension funds (both major hedge fund investors) have also indicated publically a need to liquidate portions of their alternative investment holdings to cover current operating cash flow requirements. Normally, institutional investors like these do not put such liquidation pressure on hedge funds. This immediate cash need, another unexpected consequence of this fall's credit market meltdown, indicates yet another source of selling pressure the markets must endure as the year winds down.
Are the Global Stock Markets Selling at Reasonable Valuations?
Although these past few months investors' attention has been centered on the viability of the global credit and equity markets, absent future such extreme emotional swings, in the last analysis prospective corporate earnings dictate individual company stock prices. Depending on their assumptions about the depth and length of the recession, at the moment analysts' earnings estimates for 2009 and 2010 vary widely. The variables (e.g., strength of the U.S. dollar, U.S. and international GDP growth patterns, inflation/deflation expectations, consumer behavior, export sales, etc.) more than is usual make predictions hazardous at this time. As worries about the credit market collapse recede, more attention by the media will be paid to the earnings outlook. In our next market update, a more detailed review of this important metric will be undertaken.
Currently, and probably for the next few months, the news and media drumbeat will continue discouraging. However, for the equity markets to find a bottom, the headlines don't need to turn optimistic, they just have to be less bearish than the prevailing wisdom.
As always, your thoughts, comments and questions are most welcome. Please contact us via email at tfc@tfcfinancial.com or call us at 617-210-6700.
Sincerely,
James L. Joslin
Chairman & CEO