Centre Street Cambridge Corporation

Private Investment Counsel


January 2005

We find it remarkable that so many people still seem traumatized by negative experiences in the financial markets during the first years of the decade—this, despite one outstanding, and a second very good, year in the world’s stock markets, and strong returns within the fixed income arena. Perhaps it shouldn’t be so surprising: after gains of 26% and 9% in 2003 and 2004 respectively (excluding dividends), the S&P 500 stock index remains 21% below its all time high set in March, 2000. The NASDAQ likewise is 57% below its March 2000 highs, after gaining 50% and 8.6% during the past two years. Progress is being made, but apparently not rapidly enough, or, perhaps the experience of three consecutive years of losses in 2000-2002 was so benumbing that people have forgotten that stocks actually do go up.

The mood of hesitation—even fear—evident among some private individuals was nowhere to be found in the markets last year, however, as participants fell over themselves in a clamor after risk. For proof, one need only look to where the biggest gains were scored, or where the most money rushed in. Foreign markets, for example, advanced 18% overall during the year, with the riskier “emerging” markets, up 23%, attracting the most interest. Commodities, long the backwater of the investment world, have suddenly become a legitimate “asset class,” ripe for exploitation by big institutions. Now we learn that basic materials have produced returns better than stocks since the early 1970s. Not mentioned, of course, is that most of that result is due to the speculative run-up in commodity prices during the last two years, or that the size of the market is minuscule compared to debt and equities.

Some of the most striking action has been in fixed income, where “reaching for yield” has created a situation in some respects not unlike the dot-com era of the previous decade. In an environment reminiscent of the 1980s in the U.S., when falling yields drove income seekers to lower quality, high-risk paper, historically low yields in the established markets and high-grade sectors launched a world-wide movement of money to areas offering the possibility, but hardly the certainty, of higher income. As with stocks, the interest has tended to focus on emerging areas. The strength of demand has drastically reduced the cost of credit to those emerging markets, and new issuers have appeared which had previously not had access to international capital. High-yield or “junk” corporate bonds also continued to attract lots of interest after a very strong 2003. Absolute yields in the 7-8% range on average are historically low (comparable to what treasury securities offered not so many years ago), and their “risk premium,” or yield advantage over comparable high-grade paper, has likewise narrowed to record lows under 3%. By comparison, the yield premium of junk bonds historically has been in the 6-7% area, and sometimes much higher. Credit markets are not offering much reward for taking on risk.

Finally, the current run-amok financial excess—hedge funds (another new “asset class”)—continues, in spite of lackluster results. Thrill-seeking wealthy individuals (and late-comer institutional types) are flocking to these devices for extracting high fees, hoping to get better results than those offered by simply owning stocks and bonds (they obviously haven’t been paying much attention to the latter markets lately). Anecdotal evidence indicates there is also some sort of “cachet” factor involved in having one’s own hedge fund manager. Such funds (now numbering 6000) control $1 trillion in assets—up 1000 funds and $200 billion during the year. Presumably the individuals and institutions who insist on shoveling their money into these operations find the entertainment and prestige value of hedge funds to be worth the expense.

We wish these risk-takers luck—and they may need it. In finance it is generally not a good idea to do what everyone else is doing, whether it be hedge funds, stocks, or even treasury bills. The consequences of following fads on Wall Street are much more dire than those in fashion. The risks are usually substantial, and the rewards are iffy. Judging by the low measures of market volatility (the so-called “fear index”), participants do not view the current investment climate as being particularly hazardous—this is in itself reason enough to be concerned.

Stay Short, Stay Out of Debt, and Don’t Buy Property

It has always been our firm policy never to make specific investment recommendations in a public forum, for several reasons—we make mistakes, some ideas are not appropriate for all investors, etc. We do not intend to change that rule now; however, we have received queries lately that justify a general response, given the seriousness of the issues involved. Fears of an impending “economic Armageddon,” as one Wall Street strategist put it, seem to have put some people on edge, and they wonder what can be done to protect themselves financially. Chief among the concerns being raised are the high level of indebtedness, budget and trade deficits, and a possible collapse of the world’s primary currency—the U.S. dollar.

Before people rush to stuff cash in mattresses, however, it is worthwhile to note that only the speculation about potential calamity is “new news,” while the allegedly dire trends associated with the predictions of difficult times have been with us for a while (and even doomsday fears surface once in a while). Let’s review what has happened already. The U.S. dollar has fallen significantly versus some major currencies. From a trough of 82.28 cents in October, 2000, the euro climbed 65% to $1.357 at year’s end. The Japanese Yen likewise has risen 24% against the dollar from a recent low of 134.79 to the dollar in January, 2002, to 102.68 at the end of December. Budget and trade deficits are also not new phenomena, although the steep deterioration in these measures of late has pushed them to record or near record rates, both in absolute terms and relative to GDP. Indebtedness, too, has been a longstanding area of concern, but as it now stands at record levels in relation to GDP and income, worries have grown. We do not mean to downplay these concerns or suggest that the trends alluded to cannot worsen and have an evil impact on our economy and the financial markets. In fact, we share the concerns, but differ from others concerning how one should deal with them. To begin with, it is important to keep in mind that markets tend to “discount” anticipated events, and, given the extent of the publicity surrounding these problems, one has to wonder to what extent the discounting has already taken place.

Let’s consider for a moment a few of the possible ways that one might protect wealth against financial calamity issuing from one of the sources that have been alluded to, in which our currency collapses in value, and large numbers of people and businesses descend into bankruptcy. Some very sophisticated operators have entered into forward currency contracts to take advantage of an anticipated dollar collapse. Such a strategy requires very deep pockets and the patience to accept a string of potentially big losses before seeing the expected profits—not for everyone. Furthermore, as we have seen, some foreign currencies have already strengthened significantly. Another route might be the ownership of foreign assets, such as stocks and bonds. Once again, as we have noted, foreign stocks rose smartly in 2004, and bond prices are now very attractive to issuers—buyers beware. In short, none of these alternatives are slam-dunk, and entail significant risks—especially for non-professional individuals.

It will be more appropriate for most people to look closer to home to protect their financial health in the event of an “Armageddon,” because broader economic upheavals would have an impact on areas more directly under an individual’s control. We have identified three such areas where individuals can take concrete steps to avoid trouble: fixed-income investments; borrowing; and real estate transactions. All three are related in that the potential problems associated with them have been exacerbated by the low interest rate policies of recent years. Likewise, all three would be impacted by a disaster involving a currency collapse, loss of confidence in the U.S. as a place to invest, and loss of capital flows into the U.S. (which has helped maintain low U.S. interest rates).

Never is the rule “never a long-term lender be” more appropriate than during those times when the temptation to “reach for yield” is greatest—when bond prices are high, interest rates low, and buyers are desperate for income, but are not being compensated for the risk of owning long-term obligations. Rising interest rates are a threat to capital tied up in long-term paper. Protection of capital during such times requires confining oneself to short maturities, and using a little capital if necessary in order to fund the purchase of necessities. Reaching for yield can also be accomplished by lowering one’s quality standards with the purchase of low-grade, but higher-yielding “junk” bonds. This may work in individual cases; unfortunately, as we noted earlier, the current “spread” between high and low quality yields is historically low—there is insufficient reward for taking on this kind of risk. We have heard stories of fixed-income-dependent senior citizens purchasing junk bonds to enhance their income—not a wise course of action since rising rates and/or economic difficulties could mean a severe contraction of low quality bond values.

Indebtedness—public and private—has reached such a point that maintaining the current economic calm has become a real priority. A period of deflation could make paying those obligations very difficult for borrowers. Inflation, accompanied by higher interest rates, could make life difficult especially for those with adjustable and floating-rate debts. It may be well worth remembering that in the past, debt binges of similar magnitude have usually been followed by periods of “correction,” as Wall Streeters say, when weak borrowers collapse and assets backing loans pass to “stronger hands.”

Little need be said about conditions in the property markets—every homeowner knows how property has appreciated in recent years, especially in the coastal regions and the Northeast, and everyone else regrets having missed out on the boom. The rate of price increases has been unprecedented (doubling, or more, in five years in some cases) and property valuations in relation to income are at records. Disturbing, too, are indications of speculation in the property markets by non-professionals—buying properties with credit and “flipping” them, for example. Also noteworthy are the attempts by lenders and borrowers to make property ownership “affordable” through the use of adjustable mortgages or arrangements that defer payment on principal for a number of years. It is interesting to see that authorities in the U.K. have taken steps to reign in a similarly overheated housing market there. In the U.S., authorities and analysts are still debating whether or not a “bubble” really exists. It is worthwhile remembering that in the late 1990s a few of these same authorities didn’t know if there was a stock market bubble, either.

To summarize, our observations lead us to emphasize three broad cautionary themes at the present time: avoid overpriced property and the mountain of debt that goes with it (if you must buy a house, plan to stay there for a very long time); avoid debt in general; do not buy long-dated fixed-income paper, even if it means meagre returns on holding short-term obligations. By all means, avoid owning low-grade debt instruments.  Finally, although we have not mentioned stocks, “investing with an eye to calamity,” as always, remains the rule when dealing with equities.

In closing it is important to stress that we do not predict difficult times; in fact, we have no idea what the future will bring. On Wall Street much time and effort are given to forecasting how long trends such as the ones we have been discussing will continue—all with the objective of determining the proper timing of investment operations that will maximize profits, “beat the market,” or avoid downturns. These are questions that the investor cannot answer with certainty. Indeed, it is not the proper aim of the investor to make such forecasts and to gamble based on them. Investing aims to protect against whatever the future brings by acting consistently in accordance with the basic teachings of investment theory and experience. Based on our assessment of the current situation—particularly in regard to asset valuations—we believe the diligence, patience, and consistency demanded by these basic principles is especially prudent.


Dennis Butler, MBA, CFA