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Bob's Journal 
What's this?______________________________________________ NOTE FOR MEMBERS: An expanded and more frequent version of Bob's Journal now appears on the members' site at www.RetirementWatch.com. Check in there for more commentary and insights on all the financial aspects of retirement.
August 27,
2007 11:00 a.m. Investment markets had a good week and seem to be returning to what was normal a couple of months ago. Is the worst of the financial crisis over? What are the signs that it might be over? Last week things looked almost dire when the commercial paper market almost dried up. Financially sound companies drew against bank lines of credit because the yields demanded on their short-term debt suddenly went sky high. Buyers for commercial paper were nonexistent for a while. That situation largely has corrected. Stocks had a strong rise for the week, leading many to speculate that normal times are back. I believe there are more hidden problems. Home Depot announced today that it would reduce the price for the sale of a subsidiary by $2 billion. There probably are such events to take place. Also, investment books are on the hook to place about $3 billion in high yield debt from commitments made before the financial market squeeze. Many hedge funds and other firms have not marked down their prices of mortgage products, high yield bonds, and other investments that were repriced in the last couple of months when investors rediscovered risk. I don’t think the housing and related problems will cause a recession. They will reduce economic growth to a low level. International economic growth will continue and keep the U.S. from drifting into a recession. Financial companies, however, make up about 30% of the S&P 500 and a higher percentage of overall profits in recent years. The earnings of many of them will suffer from the financial markets upheaval. While interest rate spreads no longer are at the record lows of earlier this year, investors still are not paid much for taking risk. The spread between high-yield bonds and treasuries still is below the long-term average. This reflects a forecast by investors of extremely low defaults, which I believe is too optimistic. In some ways the worst is over. We have avoided a complete meltdown of financial markets. But it will not be a smooth road going forward. There will be bumps and surprises. One surprise for many people I think will be the number of overseas entities holding a lot of the risky U.S. mortgages. Some firms are deferring problems, hoping that they can be fixed. They will announce in coming months the problems could not be fixed. Market prices also do not reflect the profit and growth reductions from the recent events, and there still are not fully functioning markets for mortgage products and high yield bonds. There are bargains being created, but there is no need to rush in. We will discuss the opportunities in the next issue of Retirement Watch. One key indicator to watch is the interest rate on treasury bills. In the flight to safety, this rate fell sharply as investors sold everything else to buy treasury bills. The interest rate has increased some, reflecting reduced demand. But the yield still is lower than before the crisis and much lower than the fed funds rate. If the t-bill yield remains stable or, preferably, rises, that will be a sign that investors are attracted to other investments. But if the t-bill yield stays low or falls further, that will be a sign that investors are hoarding cash.
August 22,
2007 01:50 p.m. Is the worst of the credit squeeze over, or is there more bad news to come? The stock and bond markets seemed to hit a climactic bottom last week, and investors are acting less panicky. The stock markets have calmed compared to their wide swings of the past few weeks. The temptation is to come out of our shelters and invest as though the crisis has passed. I recommend continued caution for the following reasons. ? The stock market action has not been bullish on recent days when the indexes rose. Trading volume has been relatively low. There usually are fewer advancing stocks than declining stocks. Few stocks are hitting 52-week highs or new highs. ? The commercial paper market appears to have collapsed for now. Yields on the paper have skyrocketed. Several corporations have reported problems selling commercial paper and have opted for bank loans for their cash needs. ? The carry trade has not fully collapsed. Investors no longer want to borrow in Japanese yen (and a few other currencies) to invest the proceeds in the U.S., Australia, and other countries. The carry trade grew extensively over the last few years, much more than is reflected in the amount of unwinding so far. I think there is more selling to come. ? A floor was under the stock market because of investors purchasing stock with borrowed money. These investors included corporations buying their own stock, corporations acquiring other corporations, hedge funds, and leveraged buyout funds. ? It still is possible that corporate buyouts and acquisitions announced in recent months will not be completed because of an inability to obtain the financing. ? The decline in housing prices and activity will make consumers feel poorer and reduce their spending somewhat. ? The spreads in interest rates and other financial indicators are not at the levels usually achieved in times of crisis or distress. That could mean there is more bad news to come, or it could mean that this will be a slow-motion unwinding. ? I suspect there are more firms and investors that stretched the limits of low-risk, easy credit than have reported problems so far. I think there are more blow ups to come. Many of the subprime mortgages were purchased by overseas investors. Those defaults might be handle more quietly than they if the investors were in the U.S. I don’t expect the unwinding to be a short event. It is more likely to take time. For example, the resets in rates on adjustable rate loans will occur steadily over the next 18 to 24 months. It will take time for homeowners to discover that they cannot afford the new payments or refinaince on more favorable terms. It will take longer for them to default on the loans. Likewise, it will take a while for the effects of reduced credit to impair business activity. Don’t take this as a bearish forecast. I do not expect the catastrophe some are forecasting. It is more likely that the unwinding and readjustment will take an extended period. Economic growth and investment returns will be below their long-term averages for a while. We will earn higher returns than the market indexes with lower risk by locating undervalued assets.
August 16
2007 10:00 a.m. It is fitting that the recent panic in the financial markets coincided with the publication of my latest book, Invest Like a Fox…Not Like a Hedgehog. One facet of the book is the exposure of fallacies that underlie conventional investment strategies and lead to panics, bear markets, and major investment losses. Here are some points from past financial fiascoes that investors seem to forget. An investor must accept that the unlikely and unexpected are likely to occur. The Wall Street Journal recently quoted a quantitative investment strategist as saying that once in a hundred year events happened three days in a row in the credit markets. The statistical models developed by hedge funds and other investors did not expect the recent series of events, believed they could not occur, and were not prepared for them. The markets involve people acting on their beliefs and fears. The unexpected always can happen. That fact can be anticipated, but the actual events and their timing cannot be. For that reason, we try to invest with a margin of safety and place sell signals on our more volatile investments or those that are reaching fair value. The search for patterns depends on the data used and can be misleading. Statistics and models are helpful, but they cannot be relied on absolutely. Markets change. Everything that can happen in the future cannot be found in past data. What many people interpret as patterns involving cause and effect really are just random series of events. That is why we always are conducting research, testing accepted theories, and are willing to change our rules and theories when the evidence warrants. Once a reliable investment rule or strategy is discovered, it soon will stop working. As more investors learn about it, their participation and knowledge changes the markets. In the recent series of events, lenders saw past patterns in the mortgage markets. But when many billions of dollars acted as though those patterns were immutable laws of finance, their actions changed the markets. The patterns changed. Even reliable patterns do not have 100% probability. The investor who was quoted in The Wall Street Journal made two mistakes. One mistake was thinking that because a series of events happened infrequently in the past, it always would occur infrequently. His second mistake was in assuming that a historically rare event would not occur in his investment career. These are common investments mistakes. Correlations change, especially at times of market stress. People thought they had diversified, safe portfolios because they used historic data to develop their portfolios. Unfortunately, correlations are not fixed. To take risks in a portfolio, an investor needs to be sure of good diversification and lack of correlation, such as our pairing of Hussman Strategic Growth and ProFunds Ultra Bull. Factors outside the markets can determine the direction of the markets. People borrow Japanese yen to buy U.S. stocks, so the fate of the yen and Japanese interest rates influence U.S. stocks. A drop in housing prices and shrinking of mortgage capital affects consumer confidence and spending, and that influence stocks and bonds. That is why we avoid certainty and one-way bets in our portfolios. Balance, diversification, and a margin of safety are essential to deal with these possibilities.
August 13,
2007 12:20 p.m. Many people do not understand the origins of the current mortgage crisis. Let’s briefly review the sequence of events. For many years, mortgage lenders have sold those mortgages to investors. The lenders preferred to make their money from fees on the initial loans and servicing the mortgages during their lifetimes (collecting payments and pursuing delinquents). They did not want to take the risk of prepayments and defaults, or deal with the effects of interest rate fluctuations changing the values of the mortgages on their books. To make the mortgages more appealing to investors, many mortgages are packaged into one bundle or security. That way, the investor does not have to evaluate mortgages one at a time, and a diversified portfolio of mortgages can be obtained with one purchase. Rating agencies would rate the mortgage packages just as they give credit ratings to bonds. Computers and statistical wizardry allowed an additional step. Each mortgage could be divided into portion, or tranches. An investor could buy only the interest or only the principal payments. Also, an investor could purchase only the high risk portion of a package of securities, only the prime risks, or some other section. The packagers bragged that they could slice and dice a portfolio of mortgages any way the investor desired. All the sophistication and apparent certainty greatly increased the demand for mortgage securities. Indexes of mortgages as well as options and futures were developed. Hedge funds and other aggressive investors became particularly interested in these products, because there were many possible uses. They could earn higher yields than treasuries and set whatever risk to yield ratio they desired. Returns could be enhanced with leverage. Other strategies and uses are possible. These securities are not traded on exchanges or other organized markets the way stocks are. There are several ways investors determine the value of the securities each do. Some use computer models, based on historic relationships between mortgage prices and other factors. Other funds use outside firms that provide pricing services. Some of those firms use models; others use market prices for whatever mortgages are trading to determine values. This is where the system became vulnerable. The amount of mortgages traded is unique. Also unique over the last couple of years was the percentage of subprime mortgages issued and the extent to which people could borrow with little or no documentation or their income or assets. A final unique feature was the number of people who borrowed 100% or more of the value of their properties. Historic relationships and default ratios did not apply under these circumstances. This year, as default rates and foreclosures began to rise and home prices fell, market participants began to re-evaluate their views of what the securities were worth. They used to believe that only a small percentage of debtors would default, and even if they did there was home equity backing the securities. Those premises were in doubt. Investors started to lose their appetite for the securities. The main trigger to the panic apparently was in May when brokerage firms that were marking the prices of securities held by two Bear Stearns hedge funds substantially reduced the prices of those securities. The funds then had to inform their investments that they had significant losses. Investors began to request the return of their investments. The hedge funds either could not sell the securities or could sell them only at a fraction of their face values. Once the news of these investments was made public, panic entered the markets and spread. The premises behind investments in all other risky investments also were questioned. Interest rates on all these investments rose. Reports were that for many securities there have been few or no buyers for a while. If you want a detailed explanation of how such panics and financial crises can occur, read one of my favorite financial books, When Genius Failed by Roger Lowenstein. It describes the last major financial panic, the failure of the hedge fund Long Term Capital Management in 1998. The details are different, but the basic series of events is the same.
August 8,
2007 12:20 p.m. Many investment managers are using near-apocalyptic terms to describe what has occurred in some of the markets in the last month. They are wrong to use such extreme terms, and I believe such comments are attempts to cover their mistakes. Too many investors entered the markets this summer without historical perspective or risk controls. They tried to maximize returns and yields instead of remembering that markets are not always rational or efficient. Markets tend to have what the statisticians call “fat tails,” and that is why we always try to have a margin of safety and balance in our portfolios. In a normal probability curve, there is a very low probability of extreme events happening. This is known as a normal or thin tail on the edges of the curve. Markets, however, have fat tails. Extreme events, both good and bad, occur with some regularity. That is why we kept our income investments in money market funds and kept the fully hedged Hussman Strategic Growth Fund in our Sector and Balanced Portfolios. We didn’t know when investors would demand to be paid more for the risks they were taking, but we knew it would happen. We also didn’t know what would trigger the change in sentiment, so we knew that investors would not be able to sell their risky investments in time to avoid large losses. As one hedge fund lawyer said in a recent issue of Barron’s, “It’s when the unanticipated happens that you have a problem.” Investors need to anticipate the unanticipated and prepare their portfolios. If more investors had invested with risks in mind, they would not be feeling so overwrought and making unwarranted comments about the state of the markets. When examined in perspective, the recent market upheavals were quite modest. The major stock indexes still have not had a 10% or greater correction since March 2003. The rise in rates on high yield bonds and corporate bonds merely restores their yield spreads with treasuries to a normal level. The spread had been abnormally small. Buyers dried up in those markets for a while, because they weren’t sure how far the spread correction would go. But journeying from an abnormally low yield spread to a normal yield spread is not cataclysmic, unless you invested assuming that markets would not return to normal. Now, we are surveying the markets for opportunities. There will be a time when it pays investors to re-purchase investments such as high yield bonds, mortgage lenders, real estate investment trusts, and others that bore the brunt of the recent upheaval. We’ll be able to make such investments, because our portfolios were positioned to preserve most of our capital in a downturn and to take advantage of bargains when they appear.
August 8,
2007 12:30 p.m. Today the homebuilder stocks are up solidly. They are today’s market leaders. This occurred literally days after many analysts were stating that they saw no bottom in the residential housing market and housing-related investments could be poor investments for years. In contrast, the Second Quarter Commentary from Third Avenue Value Fund (dated April 30, 2007 and delivered in June) stated that Martin Whitman’s fund had purchased positions related to U.S. housing. In the second quarter it bought USG, MDC Holdings, and Home Products International. All three stocks are dependent on the home building business. Whitman didn’t try to find a market bottom or time the recovery. Instead, he looked at for companies selling at substantial discounts to their net asset values. “Obviously, I have no good idea as to how bad the current slump in residential housing will be or how long the depression will last.” Instead, he is a patient, long-term investor who knows a bargain when he sees it. If the stocks decline further, he says, the fund will average down in the stocks. Contrast this approach with the many investors who purchase the investments that have increased the most in recent periods and are surprised when the investments fall sharply. Whitman beats the market indexes long term. He knows that a quality investment eventually be recognized by the markets. He is happy to buy an investment that is down and wait for a long time, sometimes years, for other investors to recognize the value and bid up the price. We strive to be like Whitman in our portfolios.
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The web site and web journal of the editor of Retirement Watch, covering all the financial aspects of retirement and retirement planning, with a few odds and ends thrown in.
E-mail: BCarlson@ Bob's Journal Archives January 2007
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