Review & Outlook

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

Third Quarter

8 October, 2008 by admin in Quarterly Letters

In my entire career I cannot remember a more difficult time for investors than the present time, except perhaps the blowing-up of the Internet / high tech bubble at the end of the last decade. That time was difficult too, and I think maybe even more dangerous for investors, though for different reasons that I need not go into now. Suffice it to say that a market-based economy such as ours is both creative and destructive, and to survive the one so as to enjoy the other requires vigilance, perspective and understanding. To those ends, in the words that follow, let me say what I think has happened in recent weeks, what it means, and what we intend to do next.

The huge story last quarter is the destruction of Wall Street. Lehman Brothers, Morgan Stanley, Merrill Lynch, Goldman Sachs, Bear Stearns – – all the investment banks – – are gone. What happened to them? In five words, they ate their own cooking. In earlier years Wall Street sold stocks and bonds to investors (clients ate their cooking), but the deregulation of brokerage commissions in the 1970s, 1980s and 1990s took the profit out of that business. So Wall Street transformed itself in recent years from broker to investor, and that’s when the trouble started. Executives at these firms believed various kinds of experts when they said they knew how to take the risk out of debt. (Others believed them as well, including regulators at the SEC and the Federal Reserve.) In a short time the great Wall Street firms gorged on an addictive brew of high-tech debt called derivative securities. It was not the first time clever people underestimated debt, nor will it be the last.

Does it matter that the great Wall Street firms are gone? I do not think so. In the wake of recent banking legislation, they had ceased to perform a unique function. Emerging from the rubble of their collapse is a banking oligopoly along the lines of the European financial system. Where there used to be investment banks, loosely regulated by the SEC, now Citigroup, Bank of America, JP Morgan, Wells Fargo and a few other commercial banks, more tightly regulated by the Federal Reserve, will perform underwriting and capital-allocating functions.

The destruction of the great Wall Street investment houses would appear to leave a vacuum of risk-takers, which could be a problem. A financial system needs risk –takers. These innovators are like the one kid on the basketball team who shoots too much, and in so doing gets the others to shoot too. But hedge funds and private equity funds will probably step in the space left by the Wall Street firms, supplying innovation and creative energy to the capital markets.

So much for the big picture. What about individual investors? Yes, the purging of Wall Street excesses, while maybe healthy for the system as a whole, has not been healthy for individual investors. They committed no excesses in the first place that needed to be corrected, but they are suffering from the panic. It is hardly fair. For these investors (among whom we count our clients), the question is how to keep the collateral damage to a minimum.

For starters we would make sure you have enough liquidity to live on for the next year or two. (We have made sure our portfolios provide this.) Any more liquidity than that is not necessary. As for those investors who are selling all assets with market risk (stocks, bonds and money market funds) and putting the proceeds into cash and insured CD accounts, these investors are setting themselves up for additional, and unnecessary, collateral damage. The rebound will be unannounced, and it will be quick, and they will not be there. Moreover, they will be chewing up principal, since so-called riskless assets, like Treasury bills, pay close to zero percent interest, and are subject to inflation.

But will there be a rebound? There always has been, through 100 years and more of wars and depressions far more serious than this. The markets tend to look 6 months to a year in advance. The fact that vehicle sales, manufacturing activity, constructing spending are cratering at this moment means less to stock prices than what these sectors will be doing a year from now. Bear in mind that the world economy is 70% larger today than it was in 2000. Emerging markets like India and China, representing the most populous nations in the world, are industrializing. These countries need American products and services. The demise of Wall Street firms shrinks in significance to the demands of a globalized world economy.

We may be seeing some signs of a turning point. The so-called $700-billion bailout plan, passed last Friday to mixed reviews, is an important step in restoring confidence. It will isolate the toxic debt in the federal government’s hands, and get it off private balance sheets where it is subject to the vicious downward spiral of “mark to market” accounting. Once stabilized, the debt should be available for sale at a profit. As I write commercial banks Wells Fargo and Citigroup compete to acquire Wachovia, a sign that fear is beginning to give way to good old fashion profit-seeking (AKA greed).

I want this to be a short letter, so it won’t a burden to read. Let me say, then, in closing that we are watching the situation daily, and we are taking a long-term perspective because we think it is the most effective way to preserve assets and make them grow. I would like to think we are staying on top of the situation so you don’t have to. But we know how difficult this time is, and if we can help by talking, we are always available.


Mark O’Brien