Q4 2008 Notes on the Quarter

Q4 2008 Notes on the Quarter

Overview of the Quarter:

  1. The fourth quarter was brutal: October was ugly, as was November; and even though December was up—yes, actually up—the quarter was down over 22%. Citigroup needed rescuing; GM and Chrysler got rescue money along with GMAC. Mr. Madoff’s approximate $50 billion fraud was discovered, and we expect this will lead to fraud indictments of others, more hedge funds closing, and more investors having significantly less than before. The Fed and Treasury’s TARP program has turned into a free-for-all. The building industry is looking for a bail out, and hell, why haven’t you asked for one
  2. On the positive side, the credit markets have slowly—very slowly—started to loosen up. Prices on some paper (primarily financials with government protection) have started to rally, but other debt has not rallied to the same degree.
  3. Consumers are still very leveraged, although they have started to pay down debt for the first time in over twenty years. With consumption slowing and layoffs increasing, we should expect that state governments will soon feel the pinch. We are also just beginning to see problems in commercial real estate.
  4. For 2008: the DJIA was down 33.8%, the worst since 1931. The S&P 500 dropped 38.5%, its worst return since 1937; and the NASDAQ lost 40.5%—its worst year ever. The world markets did even worse: China was down 65.5%, India was down 51.2%, and Brazil was down 41%. Commodities were also down big this year, along with real estate. About the only place that didn’t lose money was U.S. Treasuries.

Portfolio Specifics:

  1. This has been a tough year and not because we had been bullish, but because as bearish as we were, the amount of leverage in the system still caught us by surprise.
  2. What we did well was recover: when stocks hit their lows in November, we did not panic, but started buying. We also bought bonds when no one wanted them, and many of those are already showing nice profits.
  3. Covered call writing helped reduce volatility; call writes were better than straddles as volatility was so high.
  4. Buy and hold strategies will work as long as we continue to keep valuations in mind. Volatility, while down versus earlier in the fourth quarter, is still quite high, and so discretion is still the better part of valor.

Looking Ahead:

The Big Picture

Last year, we were convinced that the economy and the markets would be weaker (see our Notes on the Quarter from last year for more details). To us, it was a reasonably apparent expectation, although we, like most people, were shocked by the economic destruction in 2008. This year, we find it much harder to find direction, which in and of itself gives us guidance. First, however, let’s discuss what is making everything so confusing.

  1. Consensus view appears to be for a rebound in the U.S. markets this year. The reasons vary, but essentially they are based on the fact that the U.S. has pumped in trillions of dollars and will pump in even more over the next few years as Mr. Obama takes office. This capital will work its way through the system and will provide significant economic stimulus.

    What concerns me is that this is like fighting a forest fire by dousing it with gasoline. The problems in the economy come from excessive leverage. Cheap money combined with greed and a lack of controls has gotten us where we are today. The government has used a policy of “too big to fail,” but capitalism is based on “survival of the fittest.” The two do not mesh well. We need to deleverage the economy—the government has simply shifted the leverage from the private sector to the government sector—and the government is actually increasing the leverage. Until there is true deleveraging, I do not believe the economy can or will significantly improve.

  2. Stocks are cheap. On a p/e basis we are down to a 12 multiple from the 20 multiple just eighteen months ago, and on a yield basis, the dividend yield of the S&P 500 is greater than the yield on the 10 year treasury.

    While both of these statements are true, they are very misleading. At the bottom of prior significant market bottoms—1932, 1974 and 1980—the p/e on the S&P 500 was 5.6, 7.9 and 6.6 respectively, well below current levels. On a yield basis, the S&P typically has yielded more than treasuries and for good reason—the typical stock in the S&P 500 does not provide the same capital protection that a treasury note does. In fact, there are only six stocks today in the S&P 500 that even have a AAA rating. A more accurate yield comparison would be between the S&P 500 and Baa rated notes; and 10-year Baa notes are yielding above 8% versus the S&P yield of about 3.5%.

    Moreover, on an inflation-adjusted basis, the market is more expensive than at almost any time in its history (see figure 1). This leads me to remind readers of why we have been cautious on stocks for a number of years now and bullish on commodities.

    Dow Jones Industrial Average (monthly - adjusted for inflation by the CPI - all items), 1949 - 2008

    Markets move in various cycles, and one which has consistently had a long-term impact is inflation. From 1947 until 1967 (20 years) the stock markets were strong. From 1967–1982 (15 years) the stock markets were flat and commodities were strong. From 1982–2000 (18 years) the stock markets were very strong and commodities were flat to down. In each of these cases, the markets started from very low inflation-adjusted levels and peaked at very high adjusted levels. We believe the same must occur again and expect that commodities will continue to re-inflate for another six to 11 years (6 years would be 2014, 11 years would be 2020).

  3. There is no inflation. Without question, deflation is a current concern of the Fed, and until the economy picks up steam, rates will stay low. In order for the economy to pick up, lending activity needs to increase, and to do this the Fed has to make treasuries’ yields unattractive, which is done by keeping rates low. This should make corporates attractive.

    However, at some point, the Fed is going to have to pay the piper. Cheap money is the root cause of this mess, and the Fed is merely pumping even more of it into the system. The only thing protecting us now is that many countries are following the same cheap money policies. The Chinese are amongst the largest lenders to the Fed, but how long can that last? Whether it is for their own protection or as a weapon, at some point the Chinese will sell their treasury holdings. Sooner or later the devaluation of paper currencies will cause inflation of real assets.

  4. Many Asian stocks are cheaper than U.S. stocks. On a yield basis, this is true. Many of the Asian countries are not directly exposed to the colossal leverage either. Asian economies are still heavily dependent on exports, however; and as such, until the world economy stabilizes, Asian stocks will struggle just like everywhere else in the world.

The Bottom Line

This year will not be an easy year; it is unclear in direction because of the conflicting and competing economic factors that will impact results. Therefore, diversification will be the key. Typically, different asset classes have low or negative correlations. Last year, because of the extreme leverage throughout the world economy, these varying asset classes had extremely high correlations. We think that the correlations will start to diminish again, albeit slowly, and a mix will be very helpful for portfolios. But within this mix, here are our favorites.

  1. Short term (the next year or two), deflation will outweigh inflation risks. This, combined with the tremendous amount of economic stimulus being pumped into the system, may lead to a rally in stocks. We would, generally speaking, be sellers into these rallies. We believe that corporate, and to a lesser extent, municipal debt will provide more attractive risk/rewards. We are less sanguine about municipals than corporates because state governments will prove to have huge debt levels as well, although we would not be surprised if the Feds bail out New York and California, and perhaps others.
  2. Longer term, we believe that inflation will be a very big problem. As such, commodities that are hedges against currencies will be attractive. At some point, most commodities will resume their price gains, but it will require economic stability for this to happen. As an example, we believe that oil could hit $25/barrel before it hits $80/barrel.
  3. As commodities become more attractive, so too will Asian stocks. Asian economies still have among the most attractive long term potential for growth, as they have the least amount of debt and should have the strongest currencies.

Finally, let us finish with this thought. There is no question that this past year has been a financial struggle. Out of struggle, however, comes opportunity. We have labored hard this past year to protect you, our clients, from the harshness of the markets and hope to take advantage of opportunities as they present themselves this year. Happy New Year, and may this be a healthy and prosperous new year for us all.

Alan E. Rosenfield
January 12, 2009

Comments are closed.