With major stock indexes reaching 12 month highs, day after day, there is a palpable underlying buzz of excitement returning to investors.  No one is more delighted than Yours Truly to watch our client portfolios chalk up gains surpassing, in most cases their pre-Crash levels.  Still, let us recall how desperate things looked only a year ago.  Reproduced below is an e-mail I send to our clients on October 13, 2008:

“Everything you know is Wrong” was the title of a record album issued in the late 1960’s by the Firesign Theater, a Los Angeles based radio comedy troupe.  This phrase has rattled around in my head of late as I watch gold , oil  and commodity prices following financial company stocks, plummeting like a sky diver who forgot his parachute.  Our usual mix of disparate asset classes, designed to reduce portfolio volatility, has been only partially effective, and investment decisions that seemed reasonable at the beginning of September now may seem questionable.  No corner of the investment world was left unscathed last quarter: even safe haven money market funds were suddenly called into question  and when Fannie Mae and Freddie Mac, Government sponsored entities and widely held in such funds, neared collapse. Uncle Sam’s agreement to guarantee of the debt of these two huge mortgage lenders, has within a month, expanded to include money market funds, certain investment banks, insurance companies and just about anyone else who’s lined up at the D.C. Soup Kitchen. The list of failure among well- established financial institutions (Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, and Wachovia) continues to grow like a Conga line, with foreign banks following their American counterparts in a headlong rush to oblivion.

I was warning that residential real estate was overrated as an investment as far back as August 2004. You may link to our newsletter, Trusted Advisor from that month by double clicking the following link  : https://www.trustedfinancial.com/newsletter/2004/CFP_August_04.pdf

The mainstream media also began warning of overvalued residential properties  by late 2005. Real estate agents, mortgage bankers and investment promoters pooh-poohed those who warned, as was to be expected.  What most of us did not know was how many unsupportable mortgages were written in the latter stages of the Housing Bubble.  These were packaged into bonds and derivatives and are now carried on the books of banks, insurers and investment funds world wide.

Every financial panic has as its root cause excessive borrowing, AKA “leverage”.  The current situation has many precedents.  This panic was enabled and magnified by the use of computerized models and there have been additional exacerbating influences. 1999 saw the dismantling of the Depression era Glass-Stegall Act which  limited speculation by regulated banks.  It was supported by a bi-partisan majority in Congress. They and the President were no doubt lavishly lobbied by the banking industry, anxious to use greater leverage to enhance their profits. The failure in a long chain of players to properly understand and evaluate complex financial instruments derived from “junk” mortgages has been exposed this year by recent accounting law changes, designed to promote greater transparency and honesty.

I, and others, did not at first appreciate the implications of the Lehman Brother’s bankruptcy of September 15.  At first, we were primarily concerned to see if  mutual funds and money market funds owned in client accounts held Lehman paper.  But soon the realization dawned that due to accounting  regulations that went into effect just last year, the value of assets held by a wide swath of banks, insurance companies, mutual funds and hedge funds would likely plummet. According to Financial Accounting Standards Board rulings 157 and 159, a company has the option to value  assets that are not regularly traded using theoretical financial models. Most large financial institutions have already marked down the value of mortgages on their books, perhaps to  80 cents on the invested dollar.  If information becomes available suggesting, for example, that mortgage backed bonds have an actual value that may be lower than the theoretical value, the holder is obliged to adjust downward the asset values on its balance sheet. This also entails an accounting hit to earnings for impaired assets. When Lehman collapsed, it became apparent that in bankruptcy proceedings, forensic accounting would report the value of their mortgage bond holdings at distressed prices.

Only this weekend, some credit default swaps on the books at Lehman were valued at under ten cents to the dollar. This means that even financial institutions once considered sound, might surprise the markets with large write downs.  Without knowing who was going to blow up next (respected names like Goldman Sachs and JP Morgan were mentioned), institutional investors have become less willing to lend to one another. Money market fund managers and corporate cash managers began shunning commercial paper from the private sector after the share price of one prominent fund, a holder of Lehman paper, fell below $1.00, a value implicitly guaranteed by money market funds.  This fund held Lehman Brothers notes.  But even funds without exposure to Lehman took notice, when their clients began pulling money out in vast amounts, and they found it difficult to sell Commercial paper for cash to meet these redemptions.  Commercial paper is essentially a short term bond and  issuance provides day-to- day working capital for corporations and governments world wide.  It is like an ATM machine for institutional borrowers. In the present climate of paranoia and fear,  short term credit markets have largely disappeared.  Things have become so bad that even the State of California fears it will be unable to find buyers for their short term Revenue Anticipation Notes and phoned up the Treasury looking for a $7BB loan.

It was against this background that a number of measures have been taken to repair the damage.  While most eyes were on Congress and it’s wrangling over a Rescue package with a colossal price tag of $700BB, perhaps an equally important measure was implemented by the Securities Exchange Commission: on September 30 the SEC effectively  announced that FAS 157 was going to be temporarily suspended, allowing companies to continue to value subprime loans at artificially inflated values.   Their authority to do so was re-iterated in the “Emergency Economic Stabilization Act of 2008”, signed into law on October 4.  But last week’s continued panic suggests these measures have been insufficient to prevent the Tsunami that began in the USA from washing around the globe, affecting short term credit markets from Iceland to India.  As I write this, finance ministers and their staffs are passing a sleepless weekend searching for solutions.

I wanted to phone you personally to discuss your portfolio but in attempting to react to rapidly changing events, there has been little time and insufficient physical energy on my part to perform the multiple jobs of analyzing and then applying my best judgment to blocking and tackling on your behalf.  By the end of a typical day, there is not much talk left in me.
The crisis is real enough, but having lived through two colossal bear markets, 1974-74 and 1987, I know first hand that in crisis lies opportunity. It is important to remember that many of the companies in your portfolio, whether held directly or inside of mutual funds, have withstood the test of time, and of previous panics, wars, recessions and even the Great Depression. It is also useful to recall that for every stock that is sold, there is a buyer.  It is my belief that the savviest investors on “Wall Street” are now entering the market as buyers.

People who sell out now, after stock prices for the soundest corporations in the world have been marked down 25% to 50%, are doing so for one of the following reasons:

  1. 1They are in desperate need of cash to satisfy other immediate obligations that cannot  be put off.
  2. They invested with borrowed money, on margin, or borrowed too much money elsewhere such as on their homes, and have no other source of liquid cash but the stocks and bonds they hold.
  3. They are receiving poor advice or are being told, too late in the game, to cut and run.
  4. They have been terrified into believing that their nest egg can never recover, that the collapse of many financial companies will spread to cause another prolonged Depression, and that they will be “wiped out”.

I cannot help those in the first two categories.  I may be able to guide those in the third category if they ask for advice. However, for the vast majority of my clients who have not used excessive leverage (we employ no leverage with regard to your accounts under management), the only enemy is your own inner voice.  I am writing this note in part to speak to those who may tend to fall into the trap described in category # 4 above.

So far, few clients have called to express worry.  Of approximately 116 accounts, only two have been closed in fear. Of those who have expressed concern, I notice that in every case, they are suffering setbacks in other areas of their lives, such as tough business conditions and/or personal loss.  I fully understand how events in one area of our world can color our judgment in another. Much of my career has been devoted to mastering the emotional side of investing.   I’ve attempted to construct a blend of high quality investments that allow you to rest at night knowing that  your holdings are in the form of safe, high quality financial instruments.  We raised a good deal of “cash” over the past year, and did not rush to re-invest because there were not a lot of bargains out there.   We have enjoyed  some large profits (Alpine International Real Estate, Devon energy to name two) and some significant losses (American Capital Strategies and VCA Antech come to mind), but as a rough average, clients have given back only about half of what the major stock averages have surrendered since the market’s peak in October 2007.

Those who subscribe to the value investing philosophy appreciate that the large amount of cash we have built on your personal balance sheet not only keeps much of your wealth on high ground, but enables us to swoop in and scoop up bargains.  Odd, when a furniture or clothing store host a major sales event, buyers show up. When Wall Street holds a sale, many run for the exits! As some of you know, we’ve done  a limited amount of buying or “nibbling” in recent days.  We try to be worried when others are overly ebullient, and to move forward when others are terrified.  We will not likely buy “at the bottom”, though. My attitude is like that of a shopper at a mark down sale at Lohmanns or Mervyns.  When I find merchandize priced at below its true worth, I am inclined to buy.  If there are further mark downs in the future, so be it. I’ve gotten what I want at a good price.  Any one who purchased a Plasma television set three years ago, and paid more than they would cost today, understands this approach.
Still, our disciplined approach  is to add  shares and bonds that produce regular income from interest and dividend payments.  Sure, prices may fall further, a bear market may last for years, but we are receiving an attractive cash flow from our investments, while we wait for the markets to recognize the intrinsic worth of our holdings. Thus you have seen and may see again small positions taken in businesses that have strong balance sheets, market dominance and good management.

I deeply appreciate the confidence shown in me through your many supportive e mails and a few calls.  Please know I will continue to be on watch with your best interest foremost in my mind.
Sincerely,

Gary E Miller, CFP