Review & Outlook

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

Fourth Quarter

9 January, 2009 by admin in Quarterly Letters

Long-time readers of these letters will recognize the above schedule, which I have used for years to summarize the price performances of the stock and bond markets. Usually this format explains what happened to the stock and bond markets in an accessible and clear manner. But in 2008 one of the two entries – – that showing a 12.4% price gain for a U.S. Treasury bond – – does not work; it is not descriptive of the bond market last quarter. Moreover, to rely on it would be to miss the investment story of 2008.

What was the investment story of 2008? Not AIG, Lehman Brothers, Merrill Lynch, Bear Stearns (really the death of Wall Street), Circuit City, the auto sector, the Bernie Madoff Ponzi scheme, though they were huge. Rather, I think the investment story of 2008 was the collapse of the bond market. People will study it in business schools for years.

If 1987 is remembered for its great stock market crash, then 2008 will be remember for its even greater bond market crash. Domestic mortgage, corporate, high-yield and municipal bond markets all broke down in 2008. So did foreign bond markets. To be sure stock markets broke down too, and they tend to get all the press attention because they are easier to understand; but the trouble started in the bond market, and got worse, and still may be getting worse. There is a loose end to tie up: If the bond market fell apart at the end of the year, then how do you explain the 12.4% price gain in the Treasury bond? The answer is that investors were so scared that they bought shorter-maturity Treasuries in return for 0% interest. That’s real fear. In fact, it is a bubble of fear that you want to stay clear of, because it could burst at any moment.

There were lots of records in 2008 and none of them the sort you want to remember. The press is full of historical comparisons and metaphors meant to shock and amaze. Suffice it to say that most people feel there must be a better way to save and invest. It is one thing for hedge funds and brokerage firms to lose 40% of their money, or more, even a lot more; they had grown rich and reckless in the good times. When the music stopped maybe it seemed poetic justice for them to lose money, even fail. But careful and responsible people also suffered, often grievously, and they didn’t deserve to. This is the painful part of being in this business, and surveying the wreckage of 2008. One sees the collateral damage, which foots to $10 trillion in American stock values, $30 trillion if one counts foreign markets. The losses exceed human comprehension. One thinks of all the individual worry behind those numbers.

Also discouraging is the failure of leadership. We admire the infantry officer who shares the suffering of his troops, the rabbi who works for a meager stipend, and the doctor who cares for the poor. There was little of that among the captains of finance who were careful to take care of themselves as their banks and insurance companies crumbled beneath them. Nor are we likely to be free of this investment banking ethic anytime soon. I see that the new president’s chief of staff interrupted his political career to work as an investment banker for four years. He earned $18 million in that time, following in the footsteps of the outgoing White House Chief of Staff and Secretary of the Treasury.

Insurance companies are seizing on the public’s reaction to plunging stock and bond prices, and pitching annuities as the solution. They aren’t the solution. Annuities lock in an income level. But incomes aren’t the problem; dividend and interest income continued undiminished in 2008, at least they did in our portfolios. Let me repeat, portfolio incomes are about the same as they were this time last year. The problem, rather, has to do with prices. The problem with prices can be neatly illustrated with this question: If a bond has a certain maturity value of $1000 in one year’s time, but no one will buy the bond today, at any price, is the bond worthless? You and I would say of course not; it’s worth $1000, or close to it. But by modern accounting conventions, it is worthless. Thus did fear snowball into panic in 2008, and trigger a liquidity crisis and asset deflation of historical proportion. Coal, oil, copper, corn, small-cap stocks, large-cap stocks, municipal bonds, junk bonds, corporate bonds, residential real estate, commercial real estate, foreign stocks and bonds all plunged in price. Complicated assets, like mortgage-related securities, fetch no price at all. It may be called a liquidity crisis, but it is really a crisis in confidence.

What’s ahead? The economic news is bleak right now, and may get even worse. But it is important to recognize that the recovery has already started. One sees signs. Yesterday it cost me $30.00 to fill up the gas tank in my car; in July it cost $70.00. With the difference I went to the store feeling I had an extra $40.00 to spend. This is happening everywhere. Another thing: We are the reserve currency to the world. When a foreign bank sets up a rainy-day reserve, it does so with dollars; when a Japanese company buys oil from Saudi Arabia, it pays in dollars. We may not deserve the confidence and trust of the world, but we have it. And in the current crisis, which we had a big hand in starting, the confidence appears to be growing. For instance the Treasury of the United States is presently selling the 2-year note at an interest rate of under 2%, and its 10-year note at an interest rate of under 4%. Consider that other countries, even industrialized nations with high standards of living, cannot sell their debt at any interest rate. American policymakers have the free use of money, courtesy of the world, as they struggle to stabilize the American and world-wide economies.

Let me close with a passage taken from Monday’s Wall Street Journal. Lamenting the fallen state of the economy, a reporter wrote, “Individuals, companies and cities with heavy debt and shrinking revenue know they must reduce spending, tighten their belts, pay-down debt and live within their means.” What’s so bad about that?


Mark O’Brien