October 2008 - the month that nearly broke the world financial system


By mid-October 2008, the bankruptcy of Lehman Brothers had morphed into a far more serious crisis.  Bear Stearns was absorbed into JP Morgan in March 2008, Fannie Mae and Freddie Mac were effectively taken over by the US government in September 2008, but the failure of Lehman Brothers over the weekend of September 14th created a crisis of confidence that nearly broke the world financial system.  The US government was forced to take over AIG, an insurance company with a "Financial Products Group" that had created a liability of $85-200 billion as a result of writing "Credit Default Swaps" on Lehman and other bank debt.  Of even greater alarm, failure of Lehman Brothers commercial paper caused institutional and retail investors to doubt the safety of money market funds.  As billions of dollars roared out of money market funds, bedrock US corporations like General Electric and McDonalds feared that they could not fund daily operations.  The US Treasury issued a blanket guarantee of money market funds in late September, and also outlined a "Troubled Asset Relief Program" to restore confidence. Congress initially failed to authorize the $700 billion program on September 29th and passed a slightly revised version on October 3rd.  The 4 day delay kicked away whatever confidence remained.

Bank stocks cratered, with Washington Mutual the largest bank failure in US history and Merrill Lynch, Morgan Stanley, Goldman Sachs, and Wachovia tapped as the next banks likely to fail.  On October 10th, the S&P 500 opened at 902, fell as low as 839, rallied as high as 937 but finished the day virtually unchanged despite a record 11.5 billion shares traded and an intra-day swing of 11.5%.  Stocks swung around 10%/day for the next several days on triple average volume, rallying back above 1000 on the election of Barack Obama before sliding 26% by Thanksgiving and 34% to a decade low of 666 on March 6th.

One year later, all seems eerily calm with the S&P 500 trading at a 52 week high of 1097 (but still 29.9% below the October 2007 record,) intraday moves averaging around 1% (same as September 2007) and daily volume around 4.7 billion (versus 3 billion in September 2007.)  A number of our clients have expressed concern that we are poised for another sickening meltdown, so to address those concerns we have compiled:

30 things to worry about (and why we're staying invested)

Investing success is bottom up (finding companies with the characteristics to be successful) and top-down (recognizing the big trends that boost some companies and economies forward while overwhelming others.)  As we are primarily investors in US stocks and bonds, we pay particular attention to those trends that could aid or harm the United States.  However, as more than 50% of the earnings and revenues of our companies come from non-US operations, we also keep an eye on events around the world.  The topics outlined below represent the top 30 things we worry at present about while investing for our clients.


1.    Iran - 30 years after the Islamic Revolution, President Ahmadinejad of Iran still rails against the "Great Satan," seems hell-bent on acquiring nuclear weapons (and the missiles to deliver them) and seems determined on military conflict with Israel, the United States or both.  Two thirds of the population born since 1979 wearies of the regime's increasingly repressive religious governance, high unemployment and stagnant economy.  The disputed June re-election of Ahmadinejad may one day be remembered as Iran's "Berlin Wall moment," the event that exposed the weakness of East Germany and the entire Soviet bloc.

2.    North Korea - Another country whose entire governance is based on "regime survival."  With a collapsed economy 0.3% the size of the United States and 3.0% the size of South Korea, North Korea none-the-less has managed to tie up the US, China, Japan, Russia and South Korea in years of fruitless discussions to limit North Korea export of nuclear technology.  Probably the most totalitarian police state in the world, North Korea characterized US food aid sent to alleviate famine (perhaps 2.5-3.0 million died 1995-1998) as "tribute."  "Eternal President" Kim Jong-Il is 68 and may have suffered a stroke in the last year.  Kim's 25 year old third born son Kim Jong-Un is the designated dynastic successor.

3.    Israel/Palestine - The area west of the Jordan river, bounded by Lebanon and Syria to the North, Egypt of the South has been disputed territory ever since European Jews immigrated there starting in the 1920's and 30's.  Conflict increased following the 1947 partition into Jewish and Arab territories, and over 700,000 Arabs were displaced into neighboring countries following the first of several wars in 1948-9.  Israel's victory over Egyptian, Jordanian and Syrian forces in the 1967 6-day war was followed by another victory over Egyptian and Syrian forces in October 1973, which led to the first oil embargo by Saudi Arabia and other oil states. 

At this point, Palestinian Arabs are as likely to regain ancestral homes in modern Israel as Israeli Jews are likely to regain ancestral homes in Europe (or for that matter Aboriginals in Australia or New Zealand, or Native Americans in the United States or Canada.)  However, as long as the "peace process" holds out the hope of restitution for Palestinian Arabs, the conflict will remain a thorn in the side of US/Arab world relations. 

Israel is thought to have 75-200 nuclear weapons and has a history of taking out nuclear threats (Iraq in 1981, Syria in 2007.)  The current worry is that Israel will attack Iranian nuclear facilities with or without US support, which could trigger another Arab oil embargo or a broader conflict between Israel, Iran, Syria and the United States.

4.    Iraq/Afghanistan/Pakistan - The United States is trying to extricate itself from Iraq to free up troops to stabilize Afghanistan and go after al-Qaeda leadership in the border region between Afghanistan and Pakistan.  The initial euphoria of the success of the 2003 invasion (6 weeks of combat, 139 US military killed) dissipated amongst the harsh realities of governing a dysfunctional and heavily armed society (over 4,000 US military killed since April 2003.) 

At this point, the United States has turned primary responsibility for security of the country over to the Iraqi government and will reduce current troop strength from 124,000 to 50,000 by 2011.  President Jalal Talabani, by ethnicity a Sunni Muslim Kurd, and Prime-Minister Nouri Al-Maliki, a Shia Muslim Arab, are responsible for governing a country still reeling from internecine conflict among the three major ethnic groups and dozens of tribal associations.  Nearly 1700 suicide bomb attacks have been recorded since 2004.  Though the current levels of violence are reduced, there is still the threat of a complete collapse of order.

The United States currently has about 42,000 troops in Afghanistan and could raise that level to 68,000 by the end of this year.  The Soviet Union failed to pacify Afghanistan with 100,000 troops, despite 15,000 killed (1 million Afghanis killed) over a nine year conflict which ended in 1989.  By 1994, the "Taliban" had taken over the country, eventually giving shelter to Osama bin-Laden and other al-Qaeda leaders.  Driven from power in the December 2001 invasion of Afghanistan by the United States, the Taliban regrouped in the Afghan Pakistani border and now control much of Afghanistan, primarily rural territory in the South and West.  To defeat the Taliban, the United State must double or even triple its commitment of troops and weapons, but at risk of leaving the military woefully over-stretched. 

Pakistan is an arid country about 10% larger than Texas but inhabited by 175 million people (versus 305 million in the United States.)  Like Iran, Pakistan's economy is in shambles, so a vast supply of under-employed or un-employed youth are ready converts to fundamentalist Islam.  The North West Territories are virtually ungovernable by the central government in Islamabad and are believed to be the current hide-out of Osama-bin Laden, Ayman al-Zawahiri and Mullah Omar.  US Special Forces and unmanned aircraft are currently operational in the tribal regions attempting to identify and kill Taliban and al-Qaeda leaders.  While Pakistan has pledged to assist the US in this effort, many analysts feel that the Pakistani Inter-Services Intelligence Agency continues to assist and protect al-Qaeda leadership. 

The ISI is also blamed for promoting attacks against Indian interests in the disputed territory of Kashmir.  Two conventional wars were fought between India and Pakistan and in 1965 and 1971 and the two countries have been at the brink of nuclear war several times since 1998.  Pakistan is thought to have 70-90 nuclear weapons.  India is thought to have 45-95 weapons, but a wider and more sophisticated array of delivery options (missiles, aircraft, and submarines.)  Additionally, analysts worry about Pakistan's nuclear weapons falling into al-Qaeda hands if the civilian government should collapse.

5.    China as exporter and lender - China is currently the world's third largest economy with about $8 trillion in GDP versus the United States at $14.3 trillion and the European Union at $14.9 trillion.  There's some dispute as to how "real" Chinese economic statistics really are.  For example, a 2007 World Bank study concluded that after making adjustments for "purchasing power parity," the Chinese economy was 40% smaller than previous estimates.  Still, with economic growth rates average 8-10%/year over the last three decades, versus 2-3% in the United States over the same time frame, some economists wonder not if but when the economy of China will be bigger than the United States. 

This concern illustrates what we call "the fallacy of straight line projections."  China started its current growth spurt from an exceptionally low base following the stagnation of the Mao Zedong era (1949-75.)  With nearly 20% of the world's population (US is 4.5%,) a land mass equal to the United States, and a history of manufacturing running back several thousand years, it is certainly plausible that China could overtake the US by 2020.  However, as the key driver of Chinese economic growth is exports to the US, there's a limit of how much more exports can drive growth.  About 30% of Chinese GDP is driven by consumer spending versus about 70% in the US.  The Chinese government has taken modest steps to adjust how their economy functions (allowing a 28% appreciation in the Yuan over the last seven years, increasing spending on health, education, social security and infrastructure.)  However, as long as the Communist party retains complete control of the government, China will struggle to develop into a mature economy.

China has accumulated $800 billion of US Treasuries  (Japan is the second largest holder with $724 billion, the United Kingdom third with $220 billion.)  Exporters receive dollars for goods, exchange those dollars for Yuan at the Chinese central bank, which buys Treasury Bonds to obtain a return, but also keeps the Yuan undervalued relative to the dollar.  The alternative would be to allow the Yuan to appreciate and let Chinese consumers and industries import more goods from the US, but China wouldn't be delivering plus 8% growth rates anymore.  China needs those high growth rates to absorb workers flooding into cities from rural areas.  Now China is stuck.  Letting the Yuan appreciate 20% would lop $160 billion off the value of the Treasuries it holds, but not letting the Yuan appreciate continues the imbalances which led to the current situation.  Chinese officials have mused publically about setting up an alternative to the US dollar as a reserve currency (the Euro?) but so far only the US Dollar and US Treasury bonds offer the liquidity and security that central banks crave.


6.    Overpopulation - the world's population reached 1 billion in 1804, 2 billion in 1927, 4 billion in 1974 and is currently estimated at just under 7 billion.  Fortunately, as economies reach a certain level of maturity, populations tend to level off or even shrink.  The populations of Russia, Germany, Italy and Japan are currently shrinking, and the population of the US would be shrinking except for immigration.  Demographers expect total world population to level off at 9.5 billion in 2050-2100.  Even so that would be 37% increase of humans in an already crowded planet.  The worst case scenario is that the populations of rapidly developing China and India (37% of total population) start consuming resources (water, food, energy, materials) at the same level of Americans and Europeans - the world's resources area already stressed enough.

7.    Shrinking and aging populations - As societies develop, families shrink from 3-5 children/mother to 1-2 children.  Meanwhile people are routinely living into their 70's and 80's but retiring much earlier.  When US Social Security was first established in the 1930's, the age to receive benefits matched the average longevity of a US citizen.  In 1950, 16 workers supported 1 retiree.  At present 3 workers support 1 retiree, and within 10 years the ratio could drop to 2:1.  For most people, the bulk of lifetime medical spending occurs in the last 5 years of life.  The United States already spends 1/6 of GDP on healthcare, and this percentage could rise dramatically over the next 25 years.  Japan is in a similar situation, while Russia could lose 20% of its population over the next 40 years.  Most societies borrow from the next generation to support the current generation of retirees, so shrinking and aging populations could disrupt this social safety net.

8.    Pandemics - SARS in 2003-4 and the current strain of H1N1 ("Swine") flu are minor inconveniences compared to the pandemic flu of 1918-19, which killed 50-100 million people worldwide out of a population of 1.5 billion.  Medical knowledge and public healthcare are significantly advanced since the last century, so most disease outbreaks in recent years have had modest economic impact.  However, while the rate of infection and mortality of HIV/AIDS is significantly reduced compared to the 1980's (first case dates to 1969) it is possible that 90-100 million Africans out of a population of 1 billion will die of the disease between now and 2025. 

People tend to react disproportionally to the risk of a pandemic.  For example, last spring American parents yanked their children out of schools and whole school districts closed as confirmed cases in the US exceeded 21,000, including 87 deaths.  By comparison, in 2006 heart disease killed 631,636, respiratory diseases such as bronchitis and emphysema killed 124,583, seasonal flu killed 56,326, car accidents killed 40,189, 33,300 Americans committed suicide and 18,573 were murdered.  Contributing to the above statistics are obesity, which afflicts about 1/3 of Americans and causes the pre-mature death of 280,000, and smoking among 22% of Americans, which causes the pre-mature death of about 190,000.

Commodities and Energy

9.    Rising commodity prices - the Commodities Research Bureau index is at a 52 week, though still 42% below the July 2008 record high.  Rising prices are good, because it means that worldwide economic activity is on the rebound, although part of the gain is in reaction to a falling US Dollar.  Gold is at a record high, which means that some investors are also concerned about an uptick in inflation.  Industrial demand for jewelry is also higher compared to earlier in 2009.

10.  Falling energy prices - Oil is up 26.8% on the year, but natural gas is down 34.7% and coal is down 13.5% YTD.  At $76/barrel, oil is just at the point where alternatives ranging from ethanol to shale extraction to wind, tidal and solar become profitable.  Natural gas prices would have to double before alternatives such as wind power become competitive for energy generation.  While it's nice to have a break at the gas pump, lower energy prices once again postpone the transition to the "post-carbon" economy. 

We believe that while the age of oil is not over yet, the age of cheap oil is over.  Given the rapid declines in the rate of extraction from mature oil fields, we're looking intently at companies that work in the alternative energy space, which we believe will develop rapidly over the next 10 years.  Those companies could include companies that generate energy from renewable sources, companies that are involved in the manufacture of hybrid or all-electric cars, and companies that reduce energy consumption (e.g. manufacturers of LED light bulbs.)

11.  Global warming - while there's plenty of evidence that the planet is warming, it's very hard to distinguish the warming effects of human activity from natural cycles.  For example, from 800-1300 AD, average temperatures were about the same levels as today, followed by the "Little Ice Age" from 1400-1800 AD, during which temperatures were significantly lower.  There's a natural cycle of glaciation occurring every 40-100 thousand years.  Luckily we're in an inter-glacial period, with extension of ice across Europe and North America retreating since 10,000 years ago. 

Natural events can overwhelm anything humans can do.  For example, a volcanic mega-eruption in Indonesia (the "Toba Catastrophe") 70-75 thousand years ago dumped an average 6" of ash over the entire India sub-continent, filled the sky with millions of tons of sulphuric acid, reduced average temperatures by 5 degrees, and reduced the world's entire population of humans to about 15,000.  About 13,000 years ago, scientists speculate that a meteor strike in Canada caused the extinction of all large mammals in North America and wiped out early human inhabitants of North America, identified as "Clovis man."  About 10,000 years ago, northern New Jersey and central New York State were covered 100-200 feet deep by a vast freshwater lake.  The Hudson's current flow to the Atlantic was blocked by a dam of rocks and sand which extended the Long Island "glacial moraine" to New Jersey.  When that dam failed, the entire lake emptied out into the North Atlantic in a matter of days.  The fresh water mixed slowly with salt so the Gulf Stream (which creates a mild climate in Northern Europe) was deflected south for decades, triggering a mini ice-age.

What's clear is that we're performing a giant experiment on the atmosphere and it would be prudent to be conservative in increasing emissions.  As carbon dioxide levels increase in the atmosphere, the carbon dioxide absorbed by the oceans increases, which becomes more acidic as a result, which effects the ability of reefs and shellfish to form their exoskeletons, which reduces the viability of other species and could ultimately lead to a collapse of fisheries worldwide.

Fiscal and Monetary Policy

12.  US dollar - The US dollar hit an all-time peak in 1985 as exceptionally high interest rates attracted money flows from all over the world.  From 1985-95, the dollar was range bound as the factor that effect currencies (relative interest rates, money supply, relative inflation, balance of trade, relative economic growth) were roughly in balance.  From 1995-2002, the dollar gained as investors initially doubted the utility of the Euro and investors sought to participate in the rapidly growing US economy.  The dollar began falling in 2002 as other economies grew faster and the US trade deficit, particularly with China, grew ever larger.  The dollar hit a generational low in summer 2008, saw a big flight to safety rally through fall and winter 2008, then resumed its downward slide in spring 2009. 

Between the trade deficit and the expansion of the money supply to deal with the financial crisis, there's just too many dollars floating around.  A falling dollar has short term benefits - increases the value of non-USD earnings, makes exports more competitive, but also long-term detriments - higher inflation, interest rates must rise to offset currency losses for international investors.  A stable dollar is the best scenario.

13.  US treasury yields - US treasury yields are freakishly stable right now.  The US Treasury has dramatically expanded issuance over the last year to obtain the funds to pay for the programs to rescue the financial system, and as a result, the Federal Reserve's balance sheet sheet more than doubled to $2.3 trillion.  Normally, we would expect a "crowding out effect" - competition for dollars among government and corporate borrowers, to drive rates higher.  However, it seems that the $1.2 trillion increase in government lending was exactly offset by a $1.2 trillion shrinkage in what was, until recently "the shadow banking system."  As inflation remains tame and deflation remains a risk, Federal Reserve policy appears to be a hold on short term rates currently at 0-0.25%.

14.  US budget deficit - The US budget deficit exceeded US GDP by 10% on three previous occasions in US history, the American Civil War, World War I and World II.  The 4thoccasion is right now - $1.4 trillion on GDP of $14 trillion for fiscal year 2010.  With tax revenues way down both at the Federal and State levels, the interest rate burden rising along with increased medical and Social Security spending and continued expense for overseas military, it's very hard to see how this deficit will be closed anytime soon. 

15.  Winding down of direct Federal Reserve involvement in credit markets - The Federal Reserve is already drawing back from direct support of the financial markets.  The guarantee of money markets accounts ended last month, and several but not all banks, have repaid TARP funds and bought back preferred shares issued to the government (at a profit to the Treasury!)  The Federal Reserve has to walk a fine line between extricating itself from the financial markets to restore the market mechanism, but not so quickly as to kill off the recovery.

16.  Inflation - Inflation as measured by the Consumer Price Index is negative for only the second in 50 years (down 1.3% year over year through September 2009).  In the short term, CPI will remain constrained by surplus housing, minimal wage pressure in light of high unemployment and general slack in demand for manufactured goods and services.  Traditionally, high rates of money supply growth create inflation, which many economist fear now.  However, more than offsetting that pressure in the negative wealth effect of $10 trillion lost in housing and investments.  We won't worry too much about inflation until the unemployment rate drops back towards 5% (from current 9.8%) and capacity utilization regains the long term average of 80% (versus 69.95 now.)

17.  Deflation - Between inflation and deflation, deflation can do far more damage to an economic recovery.  In the US right now, everything is on sale - housing, jobs, virtually all manufactured goods (car sales jumped substantially over the summer but only with a $4,500 discount provided by the "Cash for Clunkers" program.)  In a deflationary environment, consumers put off buying today what they know will be cheaper tomorrow.  Also, debts and debt service are not deflated, while incomes decline.  At present, deflation is seen primarily in housing prices and the cost of fuels, while medical care, education, food and clothing costs are still increasing modestly.  Still, the Federal Reserve will likely maintain the exceptionally low interest rate environment for some time to come to stimulate demand and ward off deflation.

Real Estate

18.  Weakness in residential real estate - Housing prices turned modestly higher over the summer, but foreclosures hit record levels in the third quarter.  After a 33% peak to trough decline over the last three years, it's possible that housing prices could resume declining further.  What's particularly worrisome is that an estimated 20-33% of US home owners have negative equity in their houses, and those home owners are much more likely to abandon their properties and rent cheaply.  As foreclosure sales always occur at a discount to market levels, certain markets get trapped in a vicious circle of foreclosure sales driving down values and causing more homeowners to abandon their homes.  We have no expectation that real estate prices will surge anytime soon.  Not only are most American cities ringed by hastily built developments of the last 5 years begging for buyers, but sellers who have been holding back may rush to market on the slightest upticks.

19.  Weakness in commerical real estate - Lending to the US commercial real estate market is about 14% of all real estate lending.  Commerical real estate developers tend to be more conservative than residential developers, but a number of high profile deals of the last few years such as the $5.4 billion purchase of New York's Peter Cooper Village/Stuyvesant Town apartment complex are near or in default.  Also, a number of commercial real estate holders are dependent on medium (1-3 year) financing and may find it impossible to roll those loans over.  By 2010, the outlook for both commerical and residential real estate should be more clear.

Financial System

20.  Deleveraging of the financial system - Leverage (borrowing to enhance returns) reached an extreme level over the last decade.  To illustrate, let's say a straightforward investment will return 10% over the next year.  You can invest a dollar and get back $1.10 at the end of the year.  However, if you can borrow another dollar at 4% and invest both dollars, at the end of the year you'll have $2.20.  Pay back the original dollar plus 4 cents of interest and you'll have $1.14, or a 40% increase in return.  Sounds like a pretty good deal!  Problem is, what if the 10% gain turns into a 10% loss.  At the end of the year, you'd only have $1.80.  Pay back the dollar plus the 4 cents of interest and you have 76 cents left, or a 24% loss (your 10% loss is magnified 2.4 times!). 

Real estate, with a typical 20% down payment or 4:1 leverage ratio, offers even better gains, provided prices keep rising.  As we have already seen, the 33% decline in prices has delivered staggering losses to individual homeowners.  Institutional investors known as "private equity" investors (previously known as "leveraged buy out" investors during the last credit bubble) typically employee 5-6:1 leverage ratios, sometimes as high as 10:1.  This strategy works great in a stable or growing economy.  However, last year's sharp down turn drove a diverse assortment of corporations into bankruptcy including Chrysler, Reader's Digest, Linens 'n Things and Crabtree & Evelyn.  We expect many more failures of firms owned by private equity firms over the next two years, although there is considerable value in the underlying companies.  Many will emerge from bankruptcy with better financials (though total loss to the private equity investors.)

In particular, we worry about hedge funds, who contributed significantly to last fall's meltdown.  The term "hedge fund" is a misnomer - we prefer "aggressively leveraged illiquid non-transparent pools of capital."  Most take a plain vanilla strategy (for example, own corporate bonds) and significantly boost the returns by borrowing additional capital (e.g. short government bonds, use the proceeds to buy the corporate bonds.)  In the face of margin calls, as we saw last fall, these funds must sell not when they want to but because they have to.  About 2100 hedge funds, 20% of the funds registered as of a year ago, closed in the last 12 months.  By comparison, the mortality rate in boring plain vanilla investment advisory firms such as ours is close to 0%.

Overall, as the system deleverages, asset prices fall.  If you can borrow to buy an asset, you're more likely to over-pay.  If you can't borrow, asset prices will keep falling and remain low .

21.  Failure to re-regulate Wall Street - There are about 15 separate initiatives working their way through the regulatory institutions and Congress, ranging from requiring Credit Default Swaps to clear through a central repository, to requiring SEC regulation of all pools of capital including hedge funds, private equity and limited partnerships, to creating a "Consumer Financial Protection Agency."  These initiatives would reverse a 15 year process of dismantling the protections established after the Great Depression (we're solidly for restoring those protections and more!.)  As the sense of crisis dissipates, however, maintaining legislative momentum becomes a challenge.  The SEC at least is on a roll, announcing prosecution of more high profile Ponzi schemes and insider trading in the last 8 months than in the previous 8 years.  The SEC still has a lot of explaining to do on how the commission failed to discover the Madoff scheme for over a decade.

Wall Street employment shrank by over 100,000 jobs since 2007, but Wall Street compensation is expected to beat 2007's record payout of $130 billion.  Average employee (ranging from secretaries to managing directors) compensation at Goldman Sachs is expected to be $743,000 in 2009 versus $364,000 in 2008 and $622,000 in 2007.  As recently the mid-1980's doctors, lawyers and bankers all made about the same pay.  In recent years, bankers pay has grown to a multiple of other professions with similar educational and skill requirements.  On the one hand, regulating pay by specific industry contradicts free market principles.  On the other hand, what exactly are bankers doing these days to justify their compensation levels?

22.  Failure to learn from this crisis - in 1998, the Long Term Capital hedge fund, which was headed up by some of the smartest traders ever produced by the Salomon Brothers bond trading floor AND two Nobel Prize winners in economics, crashed and burned with a leverage ratio of 30:1 (for every dollar in equity, the fund borrowed an additional $29.  As we discussed above, leverage magnifies returns but even more dramatically magnifies losses.) 

Scarcely 6 years later in April 2004, a delegation of investment banks including Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brother and Bear Stearns persuaded the SEC to exempt their firms from regulations regarding how much cash (equity) these banks held relative to investments.  As a result, leverage ratios among these banks rose from an average of 23 times in the 1999-2003 time frame to over 30 times by 2007.  If a much small, nimbler LTCM went out of business in 1998, why was it a surprise that Bear Stearns, Lehman Brothers and Merrill Lynch would suffer the same fate?

23.  Revenues, earnings and valuation - Last month we discussed how the S&P 500 had gone from grossly undervalued in March 2009 to fairly valued as of last month. Earnings of S&P 500 companies are forecast to grow 24% in 2010 versus a decline of 25% in 2008 and expected final decline of 6% in 2009.  We are at the start of the third quarter earnings season and so far upside surprises easily outpace shortfalls.  Companies and analysts are largely increasing revenue and earnings estimates for the quarters to come, which net pushes the stock market back into undervalued territory.  If for some reason the recovery should falter, then current stock market levels might be a short-term peak.

Consumer worries

24.  Explosion of healthcare costs - Americans want Rolls Royce healthcare but want to pay Chevrolet prices.  One of the ironies of American society is the presence on highways of well-maintained, fully insured late model cars driven by overweight drivers who smoke and drink to excess, but don't actually have health insurance.  So much of US medical spending is directed towards remedial rather than preventative healthcare and much additional expense is generated by non-essential tests to ward off prospective mal-practice claims.  By some projections, US healthcare spending, already at 16% of GDP, could double between 2007 and 2018 and currently grows 2.5% faster annually than the overall economy.  This level of spending is won't be affordable either at the individual or government level much longer, but the current healthcare initiatives being discussed in Congress barely scratch the surface of the reforms needed.

25.  Failure to provide universal healthcare - 60% of all bankruptcies and 62% of all home foreclosure are triggered by the burden of uninsured medical bills.  About 70% of Americans, primarily government workers, employees of large companies particularly unionized companies, and Medicare recipients will have most of their medical expenses covered in the event of a major healthcare event.  15% are under insured and would face significant out of pocket expenses, while 15%, primarily young workers and workers in low-pay industries, have no insurance at all.

26.  Rising savings rates - The US Personal Savings rate slid from over 10% in the 1970's, averaged 5% in the 1990's, went negative April 2005, but rebounded sharply in late 2008 as the financial crisis spread, hitting an 11 year high of 5.9% in May 2009 before settling back recently to 3%.  US consumers are shrinking their overall level of indebtedness (credit cars, auto loans, mortgages and home equity) for only the second time in 50 years, which is a positive development. 

27.  Falling consumer spending - Money spent repaying debt is not spent on purchases that support the economy, currently 70% of US GDP.  By comparison, only 30% of China's GDP is spent by the consumer, with the rest spent on infrastructure and manufacturing capacity.  Probably both economies would be healthier with consumer spending in th 60% range.  US consumer holiday spending in 2007 was bad, and spending in 2008 was awful.  Preliminary estimates for holiday spending in 2009 look a bit better.

28.  Persistently high unemployment - The US unemployment rate is at a generational higher, with no more Americans employed now that at the start of the decade.  What's particularly alarming is that construction jobs, one of the few high paying non-exportable manufacturing jobs left, are unlikely to return any time soon.  The unemployment rate, which lags strength in the overall economy, may yet peak over 10% in the next 6 months, with continued negative contribution to foreclosures, bankruptcies and overall spending.

29.  The 24 hour news cycle - Once upon a time, American got their news from the morning paper and a one hour nightly broadcast from Walter Cronkite.  Between three 24 hour/day cable news channels and the Internet, the average American can be swamped with data, but given very little information to make good decisions. We commented during the crisis how unhelpful it was to have the "Dow bug" in the lower right corner of every television in every bar, health club and airport departure lounge in America.  Unhelpful because the Dow Industrials is a poorly constructed index of just 30 companies out of 13,000 in the US stock market and because seeing that number bouncing up and down makes investors feel like "I must do something!"  Generally speaking, reacting to each news blip is a prescription for "buying high and selling low."

We review about 600 pages of company news, trade magazines, economic forecasts and commentary per week, and we imagine we could read 60,000 pages if we had the time.  We know which sources provide the most actionable information.  We spend little or no time watching CNN, CNBC, Fox News etc. as the "signal to noise ratio" is extremely low, particularly when the producers pitch two or more guests into artificial "debates."  No single source provides the answers; rather information from multiple sources combines to create the "big picture," which drives our investment conclusions.

30.  Investors abandon stocks for good - millions of investors, including several of our clients, bailed out of stocks at 13 year lows last March.  That was right before the S&P 500 rallied62.9%.  Those investors will never be able to catch up to market returns for the rest of their lives.  The investors who stayed committed to their strategies will make new highs in 2-3 years.

Several of our clients have said in recent weeks, "I don't trust the market anymore," or "as soon as my account reaches this level, sell all my stocks" or "Can we get out of stocks and come back in when the economy is stronger?"  Most economists paint a dire outlook for the US as it struggles through all the issues we've described above.  Many investments strategists decry "buy and hold" investing and recommend aggressive trading, sector bets and shorting as the only way to make money going forward. 

We're more sanguine that most.  As we noted in last month's commentary, we're at the tail end of a decade of poor returns following two decades of exceptional returns.  We were surprised how reliant on leverage investors had become to juice returns, so we did not anticipate the waves of selling we saw last December-March.  Now that the leverage is gone, the level of risk is way down.  The other principle we've adhered to over the years is that when things look worst, that's the time to invest.  In 1989, the Japanese stock market had a higher value than the US stock market, and Japanese GDP looked ready to overtake the US.  Since 1989, investments in Japanese stocks and real estate declined about 75% over the following 20 years.  The time to invest in Japan was in 1946, when smoke was still rising from the ashes of burnt out Japanese cities.  We stayed true to our strategy of buying good companies with reasonable prospects and were amply rewarded over the last 6 months. 


With 11 weeks to go, the S&P 500 may well settle into a trading range through year end.  Only a gain of 14% by year end (on top of YTD gains of 23.7%) would bring the total return of the S&P 500 into positive territory for the decade!  Despite doom and gloom, companies like Intel, Apple, and JP Morgan are able to surprise investors with much higher than expected earnings.  Of course!  Just because there are problems in the economy doesn't mean that employees and managers give up innovating their products and looking for new opportunities.  Between now and year end, we'll be rebalancing accounts somewhat and taking tax losses if needed, while tracking how the recovery develops.  We'll review possible scenarios for economic expansion in next month's report.