White Paper – Volume 1, 2009
Bill Carter, President Carter Financial Management and Carter Advisory Services
“A Once-In-A-Century Year”
2008 – Wasn’t it fun? What a year as the subprime bubble burst having far reaching implications. The subprime problem started to surface in the summer of 2007, and raised its ugly head again early in 2008 with the March 16th forced sale of Bear Stearns to Morgan Stanley. The Federal Reserve orchestrated the sale so as to prevent the failure of a major bank hoping to avoid what could have been “a run on the banks.”
Since Bear Stearns’ rescue, the following is a list, just to name a few, of the downfalls, bailouts, or rescues we have seen:
- September 7, 2008 – Freddie Mac and Fannie Mae taken into conservatorship
- September 14, 2008 – Merrill Lynch sold itself to Bank of America
- September 15, 2008 – Lehman Brothers filed for bankruptcy
- September 16, 2008 – AIG received an $85 billion loan from the Federal Reserve
- September 25, 2008 – Washington Mutual was purchased by JP Morgan Chase
- September 29, 2008 – Wachovia agreed to sell to CitiGroup
- October 3, 2008 – Wells Fargo buys Wachovia
A common comment from professionals in the investment business is, “I never thought I would see the day that Lehman or Merrill would go down, and for sure not see their demise come in the same week.”
I could get more specific with names, dates, bailout dollars and other tidbits, but I think most everyone reading this is aware of most of that information. If you have been reading just the headlines and watching the evening news, you know. However, based on the questions I am getting asked, I am not sure anyone fully understands why October and November produced such volatile times in the markets as we saw record swings, nearly daily, in the equity markets.
Only time will give us a full answer, but I offer you some opinions. After the Federal Reserve and Treasury worked out deals to save several of our larger financial institutions from failure, there was this belief that Washington was saving (bailing out was the term used) Wall Street at the expense of Main Street. The political heat Congress was feeling was intense.
I believe it was because of this “political heat” that the Federal Reserve and Treasury felt they had to let someone fail or that they just could not do any more to help under that political atmosphere; so Lehman goes down over a weekend after being upgraded by two firms the previous week. A major U.S. investment bank declared bankruptcy. Because of all of the counter-party relationships that Lehman had, not only domestically but internationally, the ripple effects were far greater than anyone had anticipated. In addition, most investment managers that I spoke with had been convinced that the government would not let Lehman fail. I think this will go down as one of the great policy mistakes in modern economic history.
Realizing what was happening in the markets and the threat to our banking system, Treasury Secretary Paulson literally “got down on his knees” begging Congress for a $700 billion rescue plan to shore up the financial system. Unfortunately, this rescue plan got billed as a bailout plan for the “fat cats” on Wall Street and that proved to lead to even more problems.
As I have said before, there is an intrinsic belief held by the American public, right or wrong, that if there is a major threat to our economic system, government will step in and save the day. Well, they did that with the Troubled Assets Relief Program (TARP), but Congress was reluctant to pass the bill, especially those in the House of Representatives, who were feeling the “political heat” I referred to earlier. It was an election year, with many Republicans in tight races, and this concept of saving the “fat cats” on Wall Street was not playing well with voters back home.
Now, up to this point, the markets were volatile, but in hindsight, they were relatively calm compared to what was to come.
The initial vote on TARP Monday, September 29th in the House failed. After the Senate passed its own version of TARP, giving cover to the members of the House of Representatives, the TARP bill finally passed the House on Friday, October 3rd.
It was good that the bill passed, but unfortunately the credit markets had already frozen up. Those five days from September 29th to October 3rd were the longest five days I can ever remember in my professional life. I had been talking to bond managers all week, and by Friday, I knew we faced a major financial crisis.
These two events, the failure of Lehman and the failure of TARP to pass on the first vote, set off a series of reactions that caused market volatility that none of us have ever experienced.
To give you an example of the effect that these events had on the market, the Dow Jones Industrial Average was down -12.98% up until September 30, 2008. From September 30 through year-end, the market was down -33.84%. The Chicago Board Options Exchange Volatility Index, or VIX, which measures the implied volatility of S&P 500 index options, hit an all-time high on October 24th when it reached 89.53 and is currently at 49.14. Keep in mind that the average value of VIX between 1990 and October 2008 was 19.04.
Both the Federal Reserve and the Treasury went to work to unplug our frozen credit markets. It took a while, but aggressive actions taken by Fed Chairman Bernanke and Treasury Secretary Paulson finally is working. I will not take time to list everything they did, but they did a lot, and most importantly, it worked. While getting loans is still very difficult and the banks are not functioning as needed, at least the “plumbing” is unclogged and is working again.
We also saw President Bush do his part by providing a bridge loan to the automakers. While I understand the sentiment of those that would have preferred to let the “Big 3” go into bankruptcy, the economic consequences of doing so would have literally brought our economic system down. Make no mistake about that. By letting the big automakers go down at this particular time with our economic system so fragile, we would have experienced a depression probably worse than that experienced by my parents. In addition, the cost and time for our economy to recover from such a devastating blow would be an economic disaster to many, many Americans. I will not take more time in this particular piece to elaborate on this, but for anyone who would really like to get a deeper explanation, please call me and hopefully I will be able to have something on our website entitled The Big 3 Bailout sometime in the first part of the year which will offer a more detailed explanation.
We find ourselves in this position because of the sub-prime debacle, the bubble bursting in housing values, too much debt overall, and several policy mistakes over the years going all the way back to President Carter. As Joe Mattei said in an article in one of our earlier newsletters, there is plenty of blame to go around. An op-ed article in USA Today on Wednesday December 17, 2007, titled Who’s to Blame for (the) Economy?, discusses some of the events that led to this financial crisis. It is an interesting and enlightening article, but let me once again promise that many books will be written detailing exactly how we got into this mess. http://blogs.usatoday.com/oped/2008/12/whos-to-blame-f.html
Where do we go in 2009? I went to eBay, but still could not find that crystal ball I have been looking for 36 years. No crystal ball, but I have learned some things in that 36 years, so here is my best guess. Please keep in mind that this assumes there is not another “shoe to fall.” I have said many times that it is not what I can see that bothers me, but it is that event that comes in from left field that no one anticipated, or for that matter may be impossible to anticipate such as the events of 9-11.
I believe Bernanke and Paulson have made mistakes but overall have made good decisions the majority of the time. The crisis they faced was the greatest crisis since the Great Depression and the speed at which it happened after the Lehman bankruptcy was very, very quick. While they seemed to me to be moving in slow motion, when you compare how fast they acted to how the leaders reacted during the Great Depression, history will give them high marks for their quick actions. And they also did not make the mistakes of raising taxes, trying to balance the budget, and imposing tariffs as policymakers did during the Great Depression. However, they did make a few mistakes; Lehman being one of them, and not having a clear idea of how to use the TARP money initially being another. Secretary Paulson in my opinion ultimately made the right decision, but changing his mind and strategy several times led to an ever-increasing loss of confidence by the investing public.
The important point now is that their actions have set the stage for economic recovery. Much more has to be done. The Fed will continue to take actions as they utilize more of the tools they have at their disposal, and we will get one monster of a stimulus bill.
There will be debate, but when the sun sets, there will be a stimulus bill approaching a trillion dollars. My opinion is that it needs to be that big if it is really going to work. I cannot emphasize enough how important the stimulus package will be to getting the economy moving again.
The challenge for President Obama will be to make it an effective stimulus bill, not one that is filled with “carve outs” or “pork”, but where the dollars that are invested will have a positive long-term effect on economic growth.
If the bill is a good one, I think the recession will be over by the third quarter of 2009. The worst case would be the first quarter of 2010. Now let me be very clear, we still face some very difficult situations. The commercial real estate market is continuing to deteriorate, and I expect it to get far worse before the year is out. I expect personal bankruptcies to continue to increase, and as of yet, we have not seen the stabilization that is necessary in the housing market. There are other sectors in the economy that are weak and getting weaker. In addition, we still have the entire situation with the major automakers that will have to be resolved and unemployment numbers will continue to increase.
So the challenges ahead are great. I think what is most difficult to assess is just how effective the past and future actions of the Treasury and the Federal Reserve combined with this huge stimulus bill will really be. I am hoping very effective.
The markets have settled down, the investor sentiment is somewhat better, and the fear seems to be subsiding. However, I would warn you that we may very well test the market lows of October and November one more time. I think a part of this is that we are somewhat in a state of limbo until President Elect Obama is inaugurated and the effects of the stimulus bill combined with the actions by Treasury and the Federal Reserve really “kick in”. If we do see the lows again, I feel confident that it will be the bottom. My gut tells me though that the bottom of the market actually occurred in October/November 2008.
Depending on whose figures you believe, there is somewhere between $4 - 8 trillion dollars currently sitting on the sideline. Two hedge fund managers, who manage fund-to-fund portfolios, have told me that their managers have built up large cash positions.
On January 5, 2009, Wood Asset Management stated in an email that “Cash is at 18-year High – $8.85 trillion held in cash.”
In a follow-up mailing, Wood Asset Management provided the additional tidbit of information I thought you would find of interest:
“As of 12/31/08, there was enough money sitting in zero maturity (cash) accounts to “buy-out” the entire S&P 500 Index. The ratio of cash on hand to U.S. market capitalization jumped 86 percent in the first 11 months of the year, the biggest increase since the Fed began keeping records in 1959. Generally speaking, a ratio below 1.00 is a signal that the market is meaningfully undervalued.”
“S&P: $7,852 Tril. / MZM: $8,827 Tril. = 0.89…This is the lowest ratio reading since 3/31/90.”
A key question is how long will this cash sit on the sidelines?
Treasuries are currently yielding zero and the spread between the Treasury yield and nearly all other types of bonds is extremely high. What this says is that the markets have priced in the very worst case scenario, if not another depression, then a very, very severe recession. While I think the recession will probably be the worst since the Great Depression, I do not think we will experience another Great Depression. I think that when the dust settles, it will be very similar to the 1973 – 1974 recession. However, with the spreads being extremely high and if you believe in a reversion to the mean, then the logical conclusion would be that there are some outstanding buys in both the fixed income and equity markets.
For accumulators, I have RARELY seen this type of buying opportunity. As always, I must say that past results are not indicative of future performance. However, capital is not going to accept zero returns forever. I do not know when money will start to return to stocks and bonds. I do know from history that markets tend to start their recovery before the recession is over. I would not be surprised if this recovery happened sooner as opposed to later, and is more substantial than most are predicting. Market recoveries tend to surprise me because they tend to start right in the middle of bad news. I have experienced recoveries starting right in the middle of absolute terrible news. History has also taught me that buying when asset prices are low yield far better long-term results than buying when asset prices are expensive. Remember, this is what smart investors do. The American public does just the opposite. They always have and they will do so again during this period of time. Mark my words, most people will sit on the sidelines and will only begin to reallocate to the market when the market has moved far above the current pricing.
As I have said at the Carter Investment Conference, there has been a lot of fuel poured on this particular problem. If you permit me to use the analogy of putting fuel on a wood pile, there has been a tremendous amount of fuel put on this particular wood pile trying to get it to burn, and there is about to be a whole bunch of more fuel added in this new stimulus package. However, the fuel has not caught fire. Unfortunately, the matches that have been used thus far have not been able to light the fire. But when one of these matches does light that fire, it is going to be interesting to see how this recovery proceeds. My prediction is that the stimulus bill could be that match.
It is in my opinion that when history is written, the economic events of 2008 will be considered a once-in-a-century happening. I realize that many of the things that have led up to the events in 2008, as I have said earlier in this letter, go all of the way back to President Carter. Let me also be quick to say that the people who took many of these actions were not bad people doing bad things. In fact, many times it was just the opposite. Many of the actions that were taken were by good people trying to do honorable things, especially in making housing more available to a greater percentage of our population. Unfortunately toward the end of this housing cycle, when derivatives became a major part of the financing, things at some point just got out of control. As I said in my last President’s Letter, I think Wall Street got just a little too smart for itself, not to mention greedy.
As in the case of nearly all bubbles, a lot of the cause can be traced to plain old fashioned greed. On so many occasions, derivatives were a large problem leading up to the bubble, especially credit-default swaps (CDSs), which were off-balance sheet transactions. Many people think credit-default swaps played a major role in contributing to the current economic crisis. As Todd McCallister stated in a white paper from Eagle Asset Management, “mortgage debt consequently tripled from 1995 to 2007, its share of gross domestic product (GDP) doubled from 1995 to 2007 and home prices went up to unsustainable levels.”
Again, Todd McCallister said, “There was another development: off-balance-sheet liabilities called credit-default swaps (CDSs). The particularly scary part of the swaps is that they aren’t subject to bankruptcy laws, which can act as a “time out” to allow troubled companies to sort things out. Paying off the swaps can bleed a company dry, which is what happened to Lehman Brothers. Consequently, markets have grown leery of commercial paper (short-term debt to fund corporations’ operations), which historically had been viewed as nearly sacrosanct. I’m convinced that half of our current mess is due to these swaps.”
The things to be looking for in 2009 are the same things I have been saying for some period of time. The most important thing we need to see happen is stabilization in the housing market. This has to happen. Housing inventories HAVE to start decreasing and housing prices HAVE to stabilize. Once this happens, the credit markets will begin to flow more freely, bank lending will return to a more normal level, and with that, investor confidence will start to grow again. Then hopefully as the economy starts growing, corporate earnings will start improving. Somewhere in this continuum the market will turn around, and as I said earlier, it will probably turn up before most of us expect it.
Even though the stock market will begin to turn up at some point, it will not be on sound economic footing until all of the things I have mentioned have happened. Also, keep in mind that equity capital is not going to stay invested forever earning nearly 0%, and also keep in mind the large amount of cash that I referred to earlier that is sitting on the sideline.
And lastly, let me address the fact that many people are concerned about the tremendous increase in government spending, even President-Elect Obama has warned of a trillion dollar deficit existing for several years. Many people are afraid of the moral hazards that are involved by bailing out companies, in other words, fearing that people will take more risk than they should in the future believing that if another crisis exists, the government will bail them out. Of course, we go back again to the situation with the automakers and many people wishing they would just go into bankruptcy so that they could reorganize in a manner to be competitive with foreign automakers. Many economists are also warning of higher inflation because of the tremendous amount of stimulus put into the economy by the Fed, Treasury and the upcoming stimulus bill. All of those concerns are valid, but as I read in a publication the other day, you do not worry about water damage when your house is on fire.
Just today I received my personal statement from Raymond James, and like many of you, have suffered from what I would call “statement shock”. Clients have witnessed asset values decline precipitously over the last twelve months, especially the last three months, and those declines have been hard to comprehend. It has been and is an extremely painful time. Everyone at CAS and CFM are keenly aware of the pain this period has inflicted upon so many people.
One of the reasons this period has been so volatile and declines so steep is that the problems we are encountering deal with the very base of our financial system. It affects the banks. When we had the tech decline starting in 2000, that primarily affected one sector, the technology sector, and the big declines were primarily in technology stocks and technology funds, and private managers that owned a high percentage of technology stocks which fell under the larger categories of large, mid and small cap growth. As I have mentioned earlier, this period has been different in that all asset classes have declined, even bonds.
I have never attended so many conferences, read so much, watched so many business news broadcasts, or listened to so many conference calls as I have over the last twelve months. I fully realize that everyone wishes there was some type of “magic bullet”, something that would quickly turn the markets around and reestablish their values. I doubt seriously that will happen. I do not think there is a “silver bullet” out there, but I do firmly believe that asset values can be rebuilt over time.
Everyone’s situation is different. We are currently reviewing every individual’s portfolio, and trying to come up with ideas and strategies we can utilize that would enhance client returns. It is important to keep in mind that the basics of investing have not changed. We have been through recessions before; we have been through bear markets before; and we have been through major market declines before. We have recovered from all, even the Great Depression. I do think there will be some changes in the overall approach to investing over the next several years. This is the premise of the white paper I have been working on since mid-summer 08. But again, I want to be very clear that this is an adjustment, not a total change. The basics of investing have not been altered because of this severe bear market.
We will continue to monitor events as they unfold especially the stimulus package and will try to provide our insights as events unfold.
