All of the economic uncertainty makes it a tough time for all of us, but Hepburn Capital’s managed account clients are doing all right. Looking at the 24% drop in value for the stock market** this year , and the 2-3% loss we’ve seen in our model accounts* is not bad at all. This is the protection you pay me for.
Still, one client told me he felt like the homeowner with the only house left standing after the tornado had flattened the rest of the town. He was grateful to have just lost a few shingles, but found it hard to be happy with all the misery being experienced by the other folks around him.
Please read on for more thoughts on the drama. 
In a Time B.C.
The looming financial crisis that is holding everyone’s attention these days is rooted in the most basic element of our economy—the money supply.
The invention of money allowed value to be stored for the first time in history. Before Cash (B.C.), when you had something of value, like food, that you could not use– you had it to barter for whatever your neighbor had to offer. But if you did not want what your neighbor had, old worn-out skins perhaps, what were your options? None. Your food might rot before you could trade it for anything of value.
However, if your neighbor instead had cash, you now had a way to store the value of your food for a few weeks and easily transport it as you traveled to the next village where you could use your cash to buy those trendy snow-shoes you were wanting.
Money creates a tremendous efficiency in an economy. And the banking crisis is eroding the government’s ability to put cash into the economy where it is needed. The term liquidity refers to money’s ability to flow to where it is most wanted. The liquidity in our system is declining as financial institutions fail and those channels in the money supply close up.
Our media is daily raising the specter of sliding into another Great Depression. The reason for this comparison is that one of the two main reasons the 1930’s were so tough, economically, was that 10,000 banks failed and all the money they held went “poof”. Gone. And the banks were the primary mechanism for getting money into the economy. Without money, mechanics could not be paid for their work unless they bartered. Shopkeepers could not sell their goods, only trade with them. The economy ground to a halt due to the inefficiency of trying to deal without money. Prices for everything plummeted as owners of goods competed to attract what little cash was left in the economy.
Deflation 101: Too many goods chasing too few dollars.
The alternatives back then were few. The government resorted to putting money into people’s hands one paycheck at a time through programs like the CCC and WPA and the recovery took more than a decade.
The reason the government is bailing out certain financial institutions right now is that they are critical to the channels of money creation in our country. If those institutions fail, recovering from this problem could be as drawn out as the Great Depression.
I’m rooting for the government on this issue.
The Blame Game
Who is really to blame for all of the financial mess our country is in? Everyone and no one, that’s who. Well, a few people will go to jail for being excessively entrepreneurial, but they will be the poster children for the rest of us who enjoyed the prosperity of the last 25 years without questioning it deeply enough.
You see, the solutions of one problem often bear the seeds of the next problem. This particular problem was created by fixing earlier ones.
Forty years ago, all mortgages were 30-year fixed-rate loans. When interest rates began to rise in the 1970s, banks found themselves in a squeeze. They had to pay higher interest to keep depositors happy, but their income from mortgages was fixed at lower rates. This profit squeeze put a lot of banks out of business. The solution to that round of bank failures was a new era of flexibility in lending. Adjustable rates, the selling and reselling of loans, and much more began in the era of the 1970s.
This new flexibility is what allowed the current lending problems to get so out of hand.
Bottom Line? No one 25 years ago could foresee the end-game that we are in now. The few that said “Hey this is becoming a problem” were dismissed as the lunatic fringe, because all the evidence pointed to prosperity and success rather than problems. Until recently. And by then it was too late to avert the crisis.
Junk bonds were the first bit of excess to come out of the solution and junk brought on the Savings and Loan crisis of 1990.
The stock market declined in 2000-02 as the air went out of the late 1990’s technology bubble, convincing many investors to never invest like that again and to stick to something solid like real estate. That surge of interest led to over-participation in real estate and a new variety of speculation typified by the term “condo flipping”. We are now seeing the unwinding of that bubble.
A spin-off of the real estate bubble were mortgages that were sliced and diced into many complex investments that derived their value from parts of the underlying mortgages – you may recall hearing the term derivative investments. These dressed up bits of mortgages have recently been impossible to resell as new investors begin to suspect that perhaps the Emperor really has no clothes after all.
When something can’t be sold for its original value is it just worth less or is it worthless? Sometimes there is a fine line.
How Low Can Interest Rates Go?
When discussing interest rates, have you ever heard the saying “Interest rates can’t go to zero”? I have. I have even used it on occasion.
But I was wrong.
On Wednesday, September 17th, the rates someone would earn for Treasury-Bills actually dipped into negative territory during the middle of the day. By the end of the day, rates had risen a bit so that T-Bills closed that day at .03% annual rate of interest. You read that right, three one-hundredths of a percent!! But at least it was a positive rate of interest.
Buying earlier that day at negative rates would have guaranteed a tiny loss. Apparently that was OK with a lot of folks if the rest of the investment was guaranteed to not go away.
As Will Rogers said, “I’m more concerned about the return of my money than the return on my money”. Many investors agree with him right now.
Treasuries of all forms are backed by the government printing presses. There is no politics involved such as we will soon see when FDIC or other government agencies run out of money and have to beg Congress for more. How safe do you feel when political posturing can affect your savings? Treasuries are the only US investment to avoid this problem.
Actually, negative interest rates are not without precedent. In the 1930’s companies could pay the federal government a fee for holding their money when banks were dropping like flies. Isn’t a fee really negative interest? You bet.
How Bad Can This Get?
Are there similarities between our current financial crisis and events triggering the great depression? Sure. But will life in America dip to dust bowl levels? No.
The Great Depression was one of the Federal Reserve’s earliest crises, and they had not yet learned what worked and what did not. They did not know how to react. Today they do.
It is not often I compliment the government, but the creativity shown by the Federal Reserve in dealing with our crumbling financial structure has greatly impressed me. From 1929-33, 10,000 banks failed in the US and the money supply in the country dropped by 25%. (source: The Econ Review.com) Without money in circulation, trade grinds to a halt unless you can barter. With 10,000 banks gone, the mechanism to get money back into circulation was gone. This is why the Fed now goes to great lengths to bail out financial institutions. They are the infrastructure of our money supply. Without them, everything could grind to a halt like it did in 1932.
Back then the Fed had not yet discovered how much power it had. In the 1930s it did not even have the statistics to know how much money was disappearing from the system due to bank failures. Now they have many tools available to them and the skill to use the tools, too.
Some say that a stock market crash like we saw in 1929 can’t happen again. Wrong! It can, and it already has.
If a price chart of the Nasdaq stock index from 1992 to present was overlaid onto the Dow Jones Industrial Average from 1922-1938, the pricing patterns are eerily similar. A quadrupling of values followed by a minus 89% decline for the Dow in the 30’s and a minus 78% for the Nasdaq in 2000-02. A close enough match.
A 1929-magnitude stock crash? Been there. Done that. Did you survive it? Good! And you’ll survive the next one, too, thanks to the creative genius at work at the Fed. It is a testament to the skill of our Federal Reserve is the fact that the country kept rolling right along 6-7 years ago. And they seem to be making the right moves again these days.
We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” ~ Warren E. Buffett
Market Outlook
The market is traditionally in its weakest period of the year, and September is living up to its reputation as the worst month of the year to be invested.
Investors often associate October with stock market problems. Black Monday in 1987, Black Friday in 1929, the stock market declines associated with Saddam Hussein’s 1990 Kuwait invasion hitting bear-market depths, and the shock of Russian bond defaults in 1998 all occurred in October. Those are events to avoid, for sure, but to me they signal the greatest of opportunities in investing. A bottom in the market.
I may not be a market timer, but I love bottoms when they occur.
Remember, banks are not the markets. The Fed is not the markets. The markets are merely the balance of the numbers of buyer and sellers.
A bottom in the stock market occurs when all of the investors who were going to sell have sold. When we run out of sellers, it only takes a few buyers to shift that balance of buyers and sellers, which is what drives the market upward. These “wash-out” bottoms are the sweet spot of investing – low-risk market entry points.
Current market activity is suggesting we are close to just such a market bottom and low-risk market entry point. It is possible that the market low we will see in the next few days will be the low for a while. If so this can create a great buying opportunity in the near future. It may be several weeks away yet – I’m not even close to buying right now – but this is shaping up to be one of the greatest low-risk buying opportunities in many years.
What can we expect if the stock market bottom is truly behind us? Even if this bottom turns out to be a temporary bottom and the decline continues in 2009 or 2010, markets often bounce up halfway back to the previous highs before declining further. Considering the Dow Jones Industrial Average** has dropped 3,500 points from its highs above 14,000 since last year, a 50% retracement of the loss from last October, or a 1,750 point rise in this Index may be in the cards before the rally runs out of gas. That is a 16% gain. Enough to get my attention.
Account updates
The unprecedented activity in both the stock and bond markets had some effect on both our Flexible Income* and Careful Growth models* on which most of our managed accounts are based. The investments we held successfully for the past month or more stopped performing two weeks ago, and as you would expect I sold them off during the past week as the change became apparent.
This market activity caused both strategies to drop from having small gains for the year to having small losses, generally in the -2% for Flexible Income to -3% range for Careful Growth. Considering the stock market is down 24% for the year and 28% from last October, you are doing well despite the dip into negative territory.
Most importantly, both our growth and income strategies are currently 100% in the cozy comfort of a 100% all-Treasury money market fund so that neither you nor I have to worry about the market getting more negative over bailouts and bailout politics.
And in my opinion, an all-Treasury money market is the safest investment there is. Safer even than FDIC insured bank deposits as I mentioned in earlier in this newsletter. Tell your friends.
Watch your mailbox.
The paperwork mentioned in past newsletters has been mailed to all clients in just the past day or two.
If you already had managed accounts with us, your change involves getting new accounts numbers assigned at the custodian, National Financial, due to a change in service providers. For previously commissioned clients, the change involves moving away from commissions to fees for services performed.
The details are in the packet of paperwork sent to you in the past few days. Please look for it and return it to us immediately to avoid any interruption in our service.
1. *The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
2. **The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
Information in this newsletter is derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitutes a solicitation for the purchase or sale of any security. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
