It's hard to overstate how much damage was done to the world's financial systems over the last 4 months. Major events of the last two years include: July 2006 - Housing prices peak in US; July 2007 - Collapse of two Bear Sterns hedge funds invested in mortgage backed securities; October 2007 - Citigroup, Merrill Lynch, other banks reveal major losses on mortgage backed securities; March 2008 - Bear Sterns collapses, forced to merge with JP Morgan; August 2008 - International financial system appears to stabilize; September 2008 - Fannie Mae, Freddie Mac taken over by US Treasury, Lehman Brothers collapses, AIG taken over, world credit systems freeze; October 2008 - Treasury TARP program approved on second attempt; November 2008 - Citigroup nearly goes under, US stocks hit 11 year low, commodity prices decline 50-70% from mid-summer highs; December 2008 - Auto industry bailout approved, US Federal Reserve drops rates to a record low between 0-0.25%.
Despite over $4 trillion pumped into the US banking system, and trillions more pumped into European and Asian banking systems, none of the standard counter-cyclical measures employed by the Federal Reserve have worked so far. As fast as the Fed supplies liquidity, liquidity is destroyed even faster as banks continue to write down investments. The problem is exacerbated by forced sales of virtually every asset class (US and international stocks, corporate and municipal bonds, preferred stock, commodities, securitized debt of any kind) by deleveraging hedge funds and investors in general. The value of US financial and real estate assets are down about $14 trillion since January 2008.
The stock market correction, which took US stocks down 12% through August 31st, turned into a full scale rout September through November, exceeding the 1987 stock market crash. Only 25 of 500 stocks in the S&P 500 delivered positive returns in 2008; 161 or a third declined 50% or more. Only 6 out of 1601 mutual funds delivered positive returns. Only Walmart and McDonalds delivered positive returns in the Dow Industrials, while Citigroup lost 77% General Motors lost 85%. For the year, the S&P 500 declined 37%, which was the worst result for stocks since the 41% decline of 1931. From the October 2007 peak to the November 2008 trough, US stocks declined 52%, exceeding the 49% loss of the 2000-2002 bear market. Even after the 20% rally of the last 5 week, US stocks remain 42% below last year's record.
Current state of the US and world economies
Business and consumer confidence remained buoyant through July 2007, turned lower by year end 2007 and utterly collapsed by October 2008. For consumers, a relentless slide in housing prices, losses in stock investments and a sharp increase in layoffs and the jobless rate took expectations to historic lows for the series. Businesses are slashing investment and hiring and scaling back production to keep inventories low. Expectations about forward conditions (the next 6-12 months) are equally pessimistic. The biggest problem is that the banks that were willing to lend on generous terms through 2006 are now not willing to lend at all. So net, US GDP growth should be negative through at least Q2 2009, and possibly through year end 2009. World GDP, which grew robustly over the last 5 years, will be flat or negative in 2009.
What will turn economic activity higher?
Falling housing prices torpedoed the US economy; stabilizing housing prices, which we expect some time in 2009, will set the floor for the next expansion. From January 2000 through July 2006, prices increased 106%. Through October 2008, prices have fallen 23%, with declines of up to 36% in the frothiest markets of California, Nevada and Florida. About 10% of home-owners are in financial distress and foreclosures are at record levels. As foreclosure sales are often made 20-40% below prevailing levels, these sales contribute to the sharp reduction in average prices. However, housing starts have plunged, which will keep inventories from expanding. Mortgage rates are at a 40 year low. Lastly, compared to family income and prevailing rents, housing prices are falling back into line with historic ratios.
Over the last 16 months, US and European banks have written off $1 trillion in securities tied to mortgages. Further write-downs may include mortgages tied to commercial property, but with the Federal Reserve now committed to buying up to $600 billion in agency debt (securities of Fannie Mae and Freddie Mac issued to fund mortgage lending) further write-downs will be limited in 2009. As banks feel more confident about their capital situation, hundreds of billions of dollars currently parked in Treasury bills at 0.1% interest, or ten year Treasury bonds yielding 2.2%, will be redeployed to commercial lending. Through 2006 banks made aggressive loans on thin margins (little profit.) In the current environment, banks won't make conservative loans even though margins are the widest in years. As bank lending normalizes, economic activity will turn up.
What will turn stocks and other investments higher?
After falling 25% or more September through November, asset prices may already be turning higher. The consensus of economists is that we should prepare for a near depression over the next year. The consensus of investment managers is that asset valuations are at generational lows, and that we should take advantage. The S&P 500 eked out a 1.1% gain in December. However securities with yields gained handsomely in December. Preferred stocks gained 11.7%, REITS gained 17.8%, investment grade corporates bonds gained 6.9% and high yield gained 21.4%. A large component of this rally was simply a cessation of forced selling by the hedge funds. However, given a choice between yields of 2.21% or less in Treasuries, or yields of 8-10% in preferred stock, 6-10% in REITS and 8-25% in corporates, some investors including ourselves are opting for the riskier securities.
Comments on Bernard Madoff
As if 2008 wasn't miserable enough, in mid-December we learned that Bernard Madoff, a fixture of the securities markets since 1960, had swindled his clients of as much as $50 billion. We were astonished to learn that his Ponzi scheme runs back more than two decades. Bayou Hedge Fund, which cost its investors $450 million, lasted a couple of years. The SEC did not investigate Madoff's fund despite multiple warnings because he claimed to have less than 25 investors and so was exempt from registration. In fact, each "investor" was a fund representing thousands of individuals and corporations. We hope that this experience strips away once and for all the fiction that investors in hedge funds, limited partnerships and other trading vehicles are sophisticated enough to do without SEC regulation of their investment managers. Our firm is registered with the SEC and subject to exams about once every 5 years (we call it the "six week colonoscopy.") There's no way Madoff's firm would have stood up to that level of examination that we routinely experience. The simplest safeguard is to require that custody of assets be held separate from the investment of assets, so that, as our clients know, there's a separate, independent report of activities and balances from the custodian.
It's a sad time for our nation because the damage done to our economy is entirely self-inflicted. No one forced our citizens to take out mortgages they couldn't afford, and no one forced our banks to invest in them. We saw risks to the system as early as 2005, but we assumed, incorrectly as it turned out, that others in the regulatory and banking system recognized those risks and that the damage would be limited. We also assumed that the risks of excessive leverage were learned after the 1998 failure of Long Term Capital. Instead, the level of systematic risk taken on by banks and hedge funds in recent years exceeded the risk of LTC by a factor of a hundred or more.
Even though we failed to anticipate the market crash of this fall, we're not on margin and not forced to sell otherwise sound companies. We sold a handful of stocks earlier this fall in companies that we thought would not survive the crisis. If the markets continue to stabilize, we expect to spend the first quarter rebalancing our clients' accounts back to our core positions.