Centre Street Cambridge Corporation

Private Investment Counsel


April 2008

Where are the taxpayers’ yachts? Or, perhaps more appropriately under present circumstances, New York City condominiums? In return for its agreeing to bail out the Chrysler Corporation nearly thirty years ago, the U.S. government received common stock warrants that ultimately proved very valuable compensation for the risk that the public had taken on in rescuing a private corporation from collapse. Now it seems the authorities are intent on endorsing a no-skin-in-the-game business culture which has “privatized gains and socialized losses.” We have seen no evidence of any sort of quid pro quo in the arrangements announced to date. Not only have the managements which brought us the credit and housing crises gotten away with their wealth intact (a small number having to suffer only the indignity of losing their jobs), we fully expect that in a few years time when the financial storm has blown over and memory of the Federal Reserve’s exertions has faded, there will be oversized bonus and stock option awards granted to those corporate leaders who “successfully guided their organizations through difficult times.”

Not that the Fed’s unprecedented intervention in the investment banking industry—underwriting the sale of one big bank and providing liquidity to the rest—doesn’t make sense from a public policy standpoint. Quite the contrary. Financial groups such as Bear Stearns are enmeshed in an earth-spanning web of derivatives contracts, interbank lending, and financial transactions of all kinds—all dependent on trust in a counterparty’s willingness and ability to pay when due. Failure of one of these organizations would have serious repercussions for financial flows, and the real economy. No central banker or politician wants to be associated with a modern-day “Hooverville,” so, when the going gets tough, lots of money is made available, and fast. We are skeptical as to whether the measures currently being undertaken or suggested will prevent future crises or prove anything more than a way to deal with this cycle’s particular challenges. Liquidity injections and new regulations may help solve the problem at hand, which is the need to reduce debt and, more broadly, revalue risk. However, the American bonus culture, with its perverse incentives to take huge risks with other people’s money, will live on. As the old saying goes, banks will always find new ways to lose money, in spite of the success of the old ones. And, apparently, the managerial class will always preach free enterprise while at the same time eagerly embracing ways to profit from the public purse. Already the head of one of the largest banking institutions has said he would welcome the chance to “do a deal” with the Federal Reserve.

Our central bank has been busy, indeed. In addition to bailouts, its policies (which also include enormous injections of funds into the banking system and reductions in key interbank lending rates) helped to reduce the rates on short-term treasury securities to levels not seen in over 50 years. Low rates are also indicative of difficult times in the financial system. Market turmoil encouraged a “flight to quality” from everything that had risk associated with it, and treasury securities are a natural safe harbor when that happens. Curiously, longer term rates, such as those charged for home mortgages, have not been affected as much. Short-term rates in the international lending markets also remain elevated, indicating that tension remains, despite the provision of hundreds of billions of dollars of liquidity by central banks in Europe as well as the U.S.

Difficult times—but not too difficult. Credit-worthy firms sold record amounts of debt securities in January. Some industries (banking in particular) have probably suffered some earning power loss due to the collapse of unsound lending practices that inflated the real estate sector, but average corporate profit margins were already at record levels and a return to more normal profitability has been long overdue. Meanwhile, employment remains relatively healthy overall. Drivers don’t seem to fret too much about paying $3.50 for gas, and Americans have yet to significantly change their spending/saving habits. To be sure, there are signs of an economic slowdown, and for those who chose to engage in unwise financial practices and are not big or wealthy enough for government largesse, there is some suffering. But, talk of the most challenging conditions since the Great Depression seems premature.

As evidenced by the big run-ups that have followed the slightest hint of good news, institutional investors, at least, still love stocks. Some money managers are rejoicing over the fact that prices have suffered the most significant declines in years, and are salivating for an opportunity to buy on a sizable dip. But despite declines in the popular market averages in the seven to fourteen percent range, noticeably absent is the panic and loathing usually associated with depressed stock markets, and also absent are the cheap valuations. Although the market’s volatility has created a few areas of interest, stock values are neither too hot nor too cold, and it would take a much bigger market dislocation to create significant numbers of the kinds of attractive situations we look for. Although we cannot speculate on future market movements, we suspect that the probability of such a negative event is significantly lower than it was several months ago. Actions such as those taken by the Federal Reserve and Congress to inject funds and stimulate credit creation and spending do tend to work over time, and we would not be surprised if the markets eventually react positively. Then again, we are never surprised by what the markets do.

Meeting The Bear Market

Meeting the Bear Market, by Glenn Munn, is a book that was published in January, 1930. In it, the author, a security analyst at one of the major stockbrokerage houses of the time, argued that the Great Crash of 1929 had run its course, and conditions were set for a resumption of the advance in stock values that Americans had become so accustomed to in prior years. Mr. Munn’s timing proved to be poor; within a few months stocks resumed a sickening decline into the summer of 1932 that at their lowest point wiped out fully 85% of the value of the equity market when it was at its peak in 1929. Nothing even close to this disaster has occurred in the intervening years—not in the U.S., at any rate. The experience traumatized at least a generation of investors and even today colors how many people view the stock market.

We read Meeting the Bear Market early in our investment career and have been constitutionally incapable of making market or other forecasts ever since. Munn, and other authors whose writings reflect prior and later periods of market history, illustrate, and—we feel—prove that such predictions are nothing more than speculation, a waste of time, and a poor basis for making investment decisions. From the investor’s standpoint, the future is unknowable, and what you cannot know should be protected against, not wagered on.

Nevertheless, works such as Munn’s are highly instructive; as they provide a perspective on market history they shed a harsh light on the market chatter that always finds a ready audience among those who too often lack a critical eye. Much of current commentary, for example, involves wishful thinking on the part of market participants. Like their counterparts in January, 1930, today’s investors have experienced several months of declines, sometimes jaw-dropping ones, after several years of relatively calm markets and rising prices. Furthermore, as in that earlier period, investors are anxious for the bad news to be over so the party can begin anew. Exhibiting their characteristically bullish bias, today’s market observers see light at the end of the tunnel, or a resumption of advances in the second half of the year, and even new records for the Dow within a year. Who knows? Perhaps they will be proven correct. All of this positive chatter keeps the spirits up and makes for entertaining copy on the nightly business news, but it is thin gruel on which to make concrete investment decisions with real money and real consequences.

Meeting the Bear Market offers another important lesson for investors. In January, 1930 the investment community had experienced several years of robust economic growth and corporate profitability—an experience not dissimilar to what current investors have known for much of this decade, if not longer. As a result of the economic and market booms of the 1920s, it came to be expected that continuing strong growth was a certainty, and therefore, stock prices could never be too high. Today’s expectations are unquestionably more modest, although they are still elevated, owing to the record-breaking corporate profitability of the last few years. The fate of investors, who, in early 1930 relied too heavily on a recent record of strong growth and earnings, should be a lesson for us now. Unusually high profitability has inflated apparent earning power. Profitability, however, is subject to “mean reversion,” meaning it has a tendency over time to return to some long-term average rate. Adjusting for more realistic long-term profitability levels indicates that stock valuations have been and remain higher than generally believed.

The market’s adjustment to lower future profitability is at least partially responsible for the return to more normal (some would say “heightened”) volatility since last summer. Reversion to the mean can be a painful process; excesses in finance and real estate in particular will have to be wrung out. Although encouraged by the deflation of market expectations, in the absence of genuinely attractive valuations based on more normal business conditions, we still find little to be reasonably priced.


Dennis Butler, MBA, CFA