Our intern this past summer, a senior at the University of Notre Dame by the name of Ben O’Brien (yes, he is my son – – my youngest – – and what’s more, he is interested in the investment business) prepared a new website for O’Brien Greene & Co. One feature of the new website is a Notes and Commentary Section (accessible from the homepage at either O’BrienGreene.com or investmentcounseling.com). In this section I have started to experiment with a more or less weekly comment on the latest investment stories. There’s been no shortage of material the last six weeks. Following is the posting I made this past Friday, the last trading day of the quarter:
The Dow Jones Industrial Average, the great bellwether of the capital markets, ended the third quarter up 3.6% in price. Recall this was the period when the music stopped for subprime mortgages, virtually all forms of leverage and financial engineering, hedge funds, large brokerage firms and not a few banks; this was the period when the entire financial system appeared to be seizing up, locked in fear about new kinds of financial securities that no one understood, like collateralized loan obligations and artificial securities. That the Dow ended the 3-month period up a respectable 3.6% is nothing short of amazing. I feel as though the airplane I am on, commandeered by team of drunken rugby players, just arrived at the terminal early.
The damage over the last six weeks (and it has been huge) is confined to the most sophisticated of investors, namely, brokerage firms, money-center banks, hedge funds, endowments at elite educational institutions, large pension funds and international investors in Europe and Asia. These enjoyed big asset run-ups; now they are taking multi-billion dollar write-offs. Today I see that Citigroup is writing off $6 billion; yesterday UBS recognized $4 billion in losses. These are publicly-owned institutions and they are facing the music quickly so that they can move on. This is a healthy development. More troubling is what lies hidden from view on balance sheets at Harvard, Yale and Princeton and other private institutions. Failed private equity/ hedge funds will sit on balance sheets at cost while their managers hope for a market rebound. The effect here too is not altogether bad; they will sit in silent restraint to speculative enthusiasm in the quarters and years ahead.
This is not schadenfreude (joy at the sorrows of others). Rather recent market action shows that the financial system is correcting its own excesses. It is supposed to do this. It is working. During the height of the subprime mortgage crisis, I was moved to count the number of crises I have lived and worked through since I graduated from the Wharton Business School in 1975. The exercise took a while. There were a lot of crises (too many to list here), most notably the S&L crisis in the 1980s. Now that was a crisis. But crises would appear to be the mechanism our system relies on for getting back on track. Get used to them; they don’t appear to be going away.
In terms of our portfolios, the high-quality and un-leveraged stocks and bonds we manage turned in excellent results for the quarter, year-to-date, and twelve-month periods. The outlook is for them to continue to do well in the immediate future, as the weak dollar is stimulative, inflation is low, employment is high, and equity valuations are, historically, quite reasonable at 15 to 16 times earnings (they were over 30 times earnings in the late 1990s).
What’s on our worry list?
The economy is exhibiting declining productivity, a housing slump, rising commodity prices and slowing growth. The end of the world? Not really – – maybe the stuff of a garden-variety recession. But add one more ill – – inflation – – and you do have the beginnings of a more serious problem. In the late 1970s and early 1980s, inflation and unemployment were both in double digits in a toxic mix called “stagflation.” It took a long time, and much hardship, to correct. So far inflation is a subdued 2% – – not a problem. Still it is important for the Federal Reserve to keep it that way. In cutting short-term rates an aggressive 50 basis points, the Federal Reserve took a bold step at fighting recession. We hope that it was not at the expense of risking stagflation.