Dear Friends and Investors -
This July I wrote to you about the de-leveraging of the financial system: "When de-leveraging is over, we will be on the way to recovery. This is a crisis with banks that got too big and too risky, but not a crisis in basic economic activity." 'De-leveraging' is now the buzzword throughout financial media. Painfully though, this October de-leveraging unleashed the worst month in our lifetimes as volatility rose to historic levels. Not I, nor Treasury officials, nor mutual fund managers or corporate CEO’s had imagined that such a month could affect blue chip stocks and bonds to this degree.
It is fortunate that the drop in the market is not due to the pricking of an overheated stock bubble such as in 1929, or even 2000. In contrast, the source is the fall of an international nether world of finance that exploited the high productivity of global growth since 2000, a financial Tower of Babel formed with dizzying financial leverage far removed from the underpinnings of reality. In the past, retrenchment of investment excess usually just hurt the protagonists, but this month, as hedge funds and global financial institutions were forced to liquidate, stocks and bonds have been hurt.
It is clear that global banks and financial institutions - thought to be prudent depositories - were less banks, but reckless hedge funds. Thursday, Alan Greenspan admitted in Congressional testimony this fatal flaw in his beliefs; that financial institutions did not act to reduce risk and protect stakeholders, but instead amplified risk like rogue traders, and as I argue, absorbed risks on a titanic scale without enough thought of the consequences. I do not think it is fair to shift blame to the 'overspending American' for this outcome.
So back to real life... I am impressed of how little this has been affecting our daily lives. Here in Chicago people are out busily just as normal. Michigan Avenue is crowded and people are upbeat! Especially for our highly productive younger generation of workers, all of this really means nothing - for them it is an opportunity as parts of our economy that were too credit dependent move onto a more solid foundation. For example, despite broad fears about auto industry mass layoffs due to tight credit, these fears are old news, and our auto industry has been declining for years. I fact I believe these times will push GM and Ford to emerge from this far stronger than they would have been.
Let’s take a look at UPS, our largest holding, which just released very good earnings and maintained their earnings guidance for the year. This has been typical of many of the stocks we invest in, be it UPS or UTX or IBM or JNJ, their business are ok and they are at the cheapest valuations and best yields anyone has ever seen. But alas, it the denouement of the hedge funds and hedge fund global banks buffeting these good companies.
What crosses my mind to support my case that the stock market represents compelling value is an examination of oil below. If markets price assets such as oil or stocks realistically how could oil go from 65 to 140 to 65! Demand did not double nor did it drop in half! There have been major disconnects between values and reality over the past few years, and just as oil was not right at 140, so I do not believe the true value of stocks is Dow 8500.
In ten years, a lot of money chased the wrong things: Internet stocks, then overpriced houses and repackaged debt, and finally black gold. But recovery underlies these waves of speculation. Recently I listened to an interview of a World Bank economist who estimates that the amazing surge of worldwide development since 2000 doubled global capital. While partly a source of speculation, this capital explosion will also be the source of recovery.
Let me write for you the first chapter in the rebound in our markets. At some point, volatility will finally decline from these historic heights. Hedge funds and overleveraged global banks and investors will have taken their financial losses after dumping everything, stock bonds and loans onto the market. Funny, after spending so many years taking all that risk, they will just have dollars and cash earning about 1%, doing nothing for them or anyone else! They will all be in cash, out of the markets with nothing to do. The decline is over.
Somewhere in California the first of many local investors buys for $150,000 a new home that once was 300k. His local banker earns a solid 6% financing the loan. Overseas, a savvy financier launches the takeover of a Taiwanese manufacturer trading below book value. In the US market, companies trading below book value begin to merge and restructure as capital flows into deals. Reformation and renewed investment in low priced homes and companies creates a burst of value and growth as markets recover.
"The storm clouds will certainly pass and good times will return."
- Ted Weisberg, an old time floor broker on the NYSE, interviewed on Friday. The best and simplest quote I have heard these months as I continue to invest and look to the future. -
Matt Shapiro, MWS Capital
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