Centre Street Cambridge Corporation

Private Investment Counsel


January 2006

In a lecture given a few years ago, historian David McCullough remarked that “nothing ever happened as it happened. No one ever knows how things will unfold.” That history really is a “story” subject to diverse interpretations is a fact that is perhaps lost on most of us, especially on Wall Street, where history is played out in remarkably graphic fashion: as charts illustrating the progress of the market averages. The danger in such charts lies in their tendency to instill and reinforce the notion that the record therein inscribed was inexorable and that we really can see how things will unfold.

Understanding market history requires more than just a perusal of price charts. Unfortunately, many students of the market seem never to go beyond this step. For example, how many market participants are aware that there has been an underlying strength in the stock market since early 2000, as opposed to weakness in the 1998-2000 period? Looking solely at the index charts, who would guess that most stocks lost value during the earlier period, while most gained in the latter, despite strong index gains in the pre-2000 boom times and rather sharp index declines in 2000 – 2002? The failure to understand the underlying reality of the markets during the last several years has led many people to misinterpret their investment experience and make counterproductive decisions. We are concerned that the relative calm of the last few years may, in a similar fashion, prompt investors to let down their guard at a time when, as one observer put it, “the entire world is overpriced.”

One’s outlook on history is colored by one’s own experience. We currently have a generation that has known only relatively easy credit conditions and whose views of the financial markets has been shaped by unusually bullish conditions, punctuated by some sharp setbacks followed by relatively speedy recoveries. Fewer are those whose outlook has been informed by the experience of less favorable economic and investment circumstances which, at times in the past, appeared seemingly endless to those caught in the middle. It’s best to keep that in mind during this year-end prognostication season and to remember, “no one ever knows how things will unfold.”

Many on Wall Street never seem to learn this lesson, but having discovered long ago that the quickest way to embarrassment in this business lies in the making of forecasts, we will limit our year-end remarks to a brief review of last year’s action. After being in negative territory for much of the year, strength during the last two months of the year (a not uncommon occurrence, as market mavens are wont to remind us) resulted in modest gains for some of the popular averages. Despite headlines proclaiming a small negative result, the Dow Jones Industrial Average returned 1.72% when dividends are included. Likewise, including cash payouts, the S&P 500 and NASDAQ composite indexes returned 4.91% and 2.17% respectively. If you so desire you may slice and dice the markets into segments and find areas of strength, such as energy or precious metals, but by and large results in the U.S. were modest, especially when the energy sector is excluded. Some foreign markets—Asian markets in particular—showed impressive returns, with Japan (up 25%) making a comeback after years of weakness.

In the fixed-income area, short-term interest rates rose due to Federal Reserve policies, but market-determined longer rates remained relatively low and little changed for the year (intermediate term treasury securities returned only 1.56%, corporate bonds about 2.4%). Towards year-end the treasury “yield curve” (a graph showing fixed-income yields plotted against a range of maturities) inverted slightly for the first time since 2000. Since short-term yields are normally lower than those of longer-term securities, yield curves usually slope upward from left to right. An inverted curve occurs when short-term yields are above long-term yields, resulting in a downwardly sloped curve. In the past, yield curve inversions have sometimes portended economic slowdowns. We can’t help but think that the current global liquidity glut (more on this subject in a moment) is at least partly responsible for the odd patterns in the fixed-income markets, but these “speculations” are best left to economists and Wall Street seers.

For those who still insist on seeing some value in prognostications, we would have you recall the near-unanimity of opinion a year ago on the fate of the U.S. currency: the dollar was doomed to decline in 2005, the consensus view maintained. Now that the dollar has routed the other major currencies, we should feel satisfaction in our skepticism of the previous new-year’s consensus (as outlined in our January 2005 letter). In all honesty, however, we were merely trying to evaluate risks and hopefully avoid foolish ones. We didn’t know how the future would unfold any more than anyone else did. In a similar vein, looking at 2006, we think the risks remain high. This is a view now apparently shared by Mr. Greenspan, who recently said “History has not dealt kindly with the aftermath of protracted periods of low risk premiums” (in other words, everything’s overpriced). Our judgement is influenced by our sense of history, and by patience reinforced by the knowledge that circumstances eventually change and opportunities eventually arise. So, in contrast to the frenzied behavior of so many of our competitors, our activity remains minimal. As Daniel Webster once said, “a strong conviction that something must be done is the parent of many bad measures.”

Tranquil Seas

Webster’s teaching may now be more apt and valuable than ever. Future financial historians looking back on this period will probably view it as one characterized by a worldwide sea of liquidity. In financial terms, liquidity refers to the availability of capital—“easy money” or “tight money” are common terms—or, how difficult it is to get hold of cash. Judging by some recent reports and observations of activity in the financial field, there is ample capital and the problem may be that it is a little too easy to get.

The Wall Street Journal ran a series last fall (“Awash In Cash—Cheap Money, Growing Risks”) reviewing the phenomenon of growing piles of cash around the globe, and the equally growing pressure to put it to productive use. It was revealed that pension, insurance, and mutual fund organizations hold about $46 trillion in assets, up by a third over 2000. Central bank reserves represent another $4 trillion of capital, double the 2000 figure. Where did all of this money come from? Oil revenues among exporters of the commodity and large trade surpluses enjoyed by some countries represent a large source. Record corporate profitability is another: high cash flow accompanied by a slowdown in corporate capital spending has left U.S. companies with about $1.3 trillion in liquid assets on their balance sheets. Additional large pools of capital are found in some unexpected places also. For example, Australia’s compulsory savings system (in place since 1992) has made a country of 20 million people one of the biggest sources of investment capital in the world, with an accumulated pool that now stands at about $0.5 trillion.

All of this money has to find a home. As one International Monetary Fund official said in the Journal,  “the search for yield has been the defining factor in financial markets for the last two years.” That search has taken those managing these funds to some interesting places. For example, 5% of the state of Maine exchanged hands in 2004 as timberland traditionally held by paper companies passed to financial buyers. Australian investment groups have been buying up infrastructure projects—highways, tunnels, power generation facilities—around the world. Financial groups have purchased control of an amount of uranium oxide (the fuel for nuclear power plants) equal to 10% of annual mine production. In addition to such investments in real assets, financial assets—stocks and bonds of various types, entire companies, and more exotic financial creations—have been eagerly sought after. Even “blind pools” (in which the investors do not know beforehand how the money will be used) have made a comeback despite a history of scandal and losses. Growing hordes of parasitic organizations, including hedge funds and private equity firms, have become conduits for the enormous sums flowing into these targets.

The impact of these massive capital flows is widespread. Tolls on a highway in Chicago are higher owing to the Australian investments noted above. On the other hand, foreign capital eager to invest in American securities has kept U.S. mortgage rates lower that they otherwise would be, helping to fuel a housing boom and support American spending habits. Countries and companies which heretofore had difficulty raising any external capital at all now find ready buyers for their securities.

The ultimate consequences of the “reach for yield” have yet to be seen. For the moment, there appears to be a calming influence; market volatility (which some associate with risk) is at historic lows. The world financial system has proven quite resilient in the face of potentially disruptive events such as the notable rise in energy prices, war in the Middle East, and expensive natural disasters here in the U.S. The oft commented-on ability of the U.S. to easily fund its various deficits with no ill effect is also due to the vast amounts of money seeking a high, and in this case, safe, yield.

Trends, however, tend to sow the seeds of their own demise, and as the title of the Journal series suggests, there are “growing risks.” The worldwide search for yield has driven down returns and, moreover, compressed them, so that risky investments no longer offer rewards commensurate with their risk. This is a process that feeds upon itself; as yields decline, managers of capital seek greater returns by taking on greater risks, thereby further driving down yields, etc. To quote The Wall Street Journal, “As investors pile into riskier assets and their prices rise, they generate impressive returns for those who own them and attract still more investors. Cautious money managers who play it safe and stay on the sidelines run the risk of showing embarrassing low returns, and losing clients. Most choose to stay in the game.” So, once again the same tired story is playing itself out as it always does in boom times: financial buyers—buyers with interests other than those strictly concerned with investment risk and reward—are attracted by high returns in the recent past, and, dismissive of the risks, muscle their way into businesses far and wide. When this happens, history suggests to us that it is best to “stay on the sidelines.”


Dennis Butler, MBA, CFA