Review & Outlook

Our take on the investing, financial, & economic themes of the day

First Quarter

11 April, 2006 by admin in Quarterly Letters

When asked about a hot investment idea, such as a hedge fund tied to energy prices, or a fund tied to foreign markets, I like to respond with a decidedly old-fashion expression: Make sure the game is worth the candle. Roughly translated, it means the hoped-for result should be in proportion to the risk. That is, an investment is not much of an investment if you risk losing half of it for a modest return. The trouble with the expression is that it promptly generates another question, how do you know if the game is worth the candle?

We subscribe to various research services, like Daily Graphs, Baseline, Value Line, Telemet and a host of investment periodicals. All contain useful information and opinion, but it can never take the place of gut feel, which brings me to the subject of a visit we received at our office. A recent college graduate stopped by last week to ask if we had any jobs open that he could apply for. (We don’t.) But having once been in that position myself, and having three sons who may be in it before too long (all three of them philosophy majors no less!), I engaged him in small talk to encourage him in a difficult undertaking. Thus I learned about his house purchase, which brings me to the point of the story. The young man had just purchased a house near our office for which – – and this is the exact point of the story – – he had put not one dollar down. In fact, he realized a $300 “profit” on signing the sales agreement, as the seller of the house had agreed to pay the points on his mortgage, which was the source of the pocketed $300.

Why did the young man choose to purchase a house instead of renting an apartment, which is the way it used to be done? He thought he could sell the house for more than he paid. The weightier question is why did the mortgage company provide 100% financing for the young man? Here the answer would appear to be that the mortgage company also thinks the young man will be able to sell the house for more than he paid.

It is significant that this transaction occurred in Media, PA, which is manifestly not a glitzy destination, like Naples, Florida or the Hamptons on Long Island. Banners draped from street lights proclaim that “Media is everybody’s hometown.” If we take Media at its word, we can assume that the housing market is pretty typical of that in the rest of the nation. As for the mortgage company, it too appears typical. According to research by ISI Group, a Wall Street research and brokerage firm, 43% of all first time homebuyers paid no down payment last year.

The anecdote of our new neighbor is not of course proof of a housing bubble. But there is much of a statistical nature that goes in that direction. The national median house price, the national house price-to-income ratio and the national price-to-rent ratio are in record territory. An economic advisor to the president (Herb Stein) famously remarked some years ago: “If something cannot go on forever, it won’t.”

The other “big issue” roiling the markets is the recent surge in interest rates. Several years ago money market funds paid annual interest of less than 1%, which was no competition for stocks. But recently the Federal Reserve Board has boosted short term rates to slow the economy in order to forestall inflation. Whether or not inflation has been forestalled, indeed, whether or not inflation is even a problem, one result of the Fed’s action has been the rise of money market rates from 1% to the neighborhood of 4.75%. With inflation a tame 2%, the difference, or “spread,” between money market funds and inflation is attractive, which means stiffer competition for stocks.

What do a housing bubble, incipient or otherwise, and upward moving interest rates mean for stock market investors? It is hard to generalize right now. Some stocks look attractive, as I will discuss, whereas other kinds of stocks look accident-prone.

Emerging stock markets around the world are on fire. Hottest of all are small-cap stocks in secondary foreign markets. Returns of 30% a year for the last three years have not been uncommon. But here at home stock market returns have been meager. On April 1, 2000 the Dow Jones Industrial average stood at 10,922. Six years later on April 1, 2006, the Dow stood a paltry 1.7% higher at 11,109. How come the rest of the world is doing so well while the U.S. is just plodding along? A related question: is the rest of the world overvalued and therefore the U.S. stock market a good deal?

The bear stock market in the United States in 2002 left bad scars. The popping of the Internet and high tech bubbles, the 9/11 terrorist attack, the anthrax scare, corporate accounting scandals at WorldCom and Enron, and cheating of clients by mutual fund companies, transformed stock market infatuation (akin to the current love affair with housing) into an aversion to American stocks.

The most apt analogy I can think of is a political campaign. The challenger can promise anything, whereas the incumbent has to run on his record. But just because he has no record, the challenger is not necessarily the better candidate. So it is with the markets right now. It seems that investments that had nothing to do with 2002 bear market (housing, so-called alternative investments like hedge funds, emerging markets) are doing great, even though they are expensive, while the familiar assets that were disgraced in the 2002 bear market bubble are limping along, despite relatively attractive valuations.

Where does that leave us? In regard to housing, alternative investments, hedge funds, commodities, and emerging markets, the game is not worth the candle. Rising interest rates and extravagant expectations render them accident- prone. In regard to big-cap blue chip stocks, we think they still represent value. They have current (not projected) strong earnings and reasonable valuations.

Sincerely,

Mark O’Brien