Review & Outlook

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

Second Quarter

11 July, 2007 by admin in Quarterly Letters

Let me start with a brief discussion of the developments in the second quarter that are likely to influence the markets in the second half of 2007.

Over the course of the quarter just ended, but especially at the end of it, a very risky kind of bond started to have trouble. This kind of bond goes by a variety of obscure names, including structured derivative, collateralized loan obligation, collateralized debt obligation, synthetic derivative credit swap. I am very happy to report that we do not own any of these risky bonds, nor do we know anyone who owns them. Nonetheless, the development is important, for as much as $1 trillion (Barrons, July 2, 2007 p. 8) has flowed into the sector over the last five or so years. The sector now appears poised to pop, like a bubble.

Big state pension plans, university endowments and hedge funds sought incremental return without much regard to incremental risk. They thought that advances in computer-modeling, when combined with new kinds of bond structures, could reduce traditional forms of market and interest-rate risk. But it turns out that the Wall Street brokerages that invented the securities, and the smart-money clients who bought them, overestimated the ability of computer-modeling to manage predictable problems, like poorly-rated borrowers defaulting on overlarge mortgages.

What does this mean for the rest of 2007? Complexity and open-ended risk will for a time be out of favor, and certainty and predictability of earnings and cash flow will for a time be in favor. In other words, high quality stocks and bonds, which populate our portfolios, are likely to be the new market leaders in the months and quarters ahead.

Could a meltdown in the risky market I described jeopardize our entire financial system? I don’t think so. The savings & loan crisis of the 1980s was much larger and more serious, and we got through that just fine. Rather it happens from time to time that financial leverage and risk are dressed up as scientific innovation. Eventually some mal-occurrence unmasks the pretenders. In the second quarter it was people defaulting on mortgages they never should have had in the first place. In the end the system is served.

But the crisis (loosely labeled as the “sub-prime mortgage derivative” crisis) comes on the heels of a bankrupt auto sector and a struggling housing market. Altogether they have generated a good deal of fear. The New York Times business section (New York Times, June 24, 2007, p. 5) reported that the average stock market newsletter – – there are thousands of them – – is advising readers to put a mere 30% of assets into stocks. Given the overall strength in the economy, which I will discuss in a moment, this is a remarkably bearish. But bearish sentiment is not necessarily a bad thing for stock and bond prices. It is typically not associated with market peaks. Consider the opposite, namely that at the last market top in February 2000, right before one of the worst bear markets in history, stock market newsletters were urging readers to put 80% of assets into stocks. There is an expression in the investment business that bull markets climb a wall of worry. As I often write in this space, the problem you identify is rarely the problem that gets you.

The other development in the second quarter? The economy got a second wind. Most everyone on Wall Street expected profit growth to slow this year; many expected the slowdown to deepen into contraction in the second quarter. But strength in the service and retail sectors, and employment data, indicate that the economy is not slowing at all. The national economy’s growth rate jumped from under 1% in the first quarter to a very strong 4% in the second quarter, and unemployment remained fixed at 4.5%, which is as close to full employment as it gets in America.

Not in fifty years have American corporations had such low taxes, such low interest rates, such low inflation – – and such high earnings. The two most populous nations in the world (India and China) are growing at a startling rate of over 10% a year, pulling the rest of the world along behind. Even bureaucracy-ridden Europe is flourishing. Our economic house appears to be in good order. What is not in good order is, of course, the geopolitical state of the union. In focusing on the strength of the economy, there is the danger we forget about this risk. Hard to quantify, geopolitical risk is no less real to our economic health than ills that can be measured like inflation and unemployment.

Sincerely,

Mark O’Brien