Centre Street Cambridge Corporation

Private Investment Counsel


April 2010

You never want a serious stock market crash to go to waste. Such events provide an opportunity to do things that you normally could not do. Similar sentiments regarding economic crises were expressed in a political context not too long ago, where they quickly caused quite a stir. Moral ambivalence notwithstanding, these views merely reflect the age-old tendency of human beings to overreact to frightening events. Hence, crashes and crises spell opportunity for those who know their history and are prepared to act. Astute investors and business people understand that troubling times are temporary and use them to advantage in many ways, from buying securities at bargain prices to exploiting a competitor’s temporary weakness to gain market share. The history of investment is replete with examples of this: the Great Crash of 1929 and its aftermath depressed stock prices for more than a generation, benefitting long term investors. Warren Buffett laid the foundation for the phenomenal success of Berkshire Hathaway in 1973-1974 during the big declines triggered by the first energy crisis. Depressed conditions in the early 1980s proved profitable to patient investors, as did the sharp stock market rout later in that decade. We believe our recent experience in 2008-2009 will prove to be the generator of fortunes, also.

Such maneuvers seem obvious in hindsight, but that is far from being the case as the events unfold in real time. Underlying the ability of some investors to take positive action under difficult circumstances is the assumption that things will eventually return to status quo, more or less, as market history shows they always have—a brave stance to adopt at a time when game-changing circumstances and talk of  “new paradigms” is in the air. In the midst of a crisis it is a leap of faith few are prepared to take, hence the lessons of history go unheeded except by those few, while the rest stumble on.

The attitudes formed in traumatic times can be long-lasting and ultimately self-defeating, as the post-Great Crash experience illustrates. It was not surprising to see reported in BusinessWeek that since the stock market’s bottom a year ago, fully $369 billion of investor money has embraced the supposed safe haven of bond mutual funds, while a measly $23.4 billion has gone into stock funds (money actually fled U.S. stock funds last year in spite of one of the strongest rebounds in history). Individuals “have absolutely no current enthusiasm for equity investing,” the report concludes. What they are buying is telling (and disconcerting): bonds whose prices are at record highs, corresponding to record low interest rates. An additional $3.2 trillion sits in money market funds earning exactly nothing. In another telling sign, the strong interest in fixed-income has not gone unnoticed by the sellers of such securities. Despite the competition from massive government issuance due to its recession-fighting efforts, corporations have sold record amounts of debt, locking in low rates and refinancing higher-cost debt. Firms saddled with debts from buyout deals are being given a new lease on life, and the healing powers of low interest rates and high market liquidity are helping beleaguered banks repair their balance sheets.

Meanwhile equity markets have been on a tear. In the U.S. the broad averages have gained 70% or more since march 2009. This strong recovery seems inconsistent with the public pessimism about stocks until one remembers that March saw not one, but two notable anniversaries. March 9 was the first anniversary of the market bottom in 2009, a traumatic 12-year low. The very next day marked the bursting of the dotcom bubble in 2000. These events neatly bookended a ten-year span which, for the first time in many such periods, produced negative returns for stocks. This experience seems to have effectively erased the view widely held in the late 1990s that stock markets held the answer to all financial challenges, including retirement, college costs, and so on. A healthy change overall, but not one conducive to enthusiasm for equities.

From a focus on its assets, the public has now turned to facing its liabilities. For the first time in at least sixty years, Americans reduced their household debt in 2009. Much of this reduction was due to people walking away from obligations (mortgages on “underwater” properties, for example) rather than actually paying off creditors, but it is still an important development—healthy, too, if not exactly consistent with a vibrant “equity culture.” Corporations also have been hoarding cash—over $800 billion at the latest count—but corporate thrift has come at the expense of jobs, dividends and buybacks. Once a source of buying power helping to lift stocks, share buybacks have dropped approximately 75% from pre-crisis levels.

The U.S. Federal Reserve Board continues to grapple with a financial crisis at least in part of its own making. It is interesting to note, by way of contrast, that the Chinese are doing what the Fed should have done years ago: acting to reign in speculative stock and property markets by limiting bank lending and other tough measures. Granted that authorities in a “command economy” have more flexibility to act quickly to curb excesses, but ours is not William McChesney Martin’s Federal Reserve either (it was Martin, Fed chairman from 1951 to 1970, who quipped that it was the Fed’s job “to take away the punch bowl just as the party gets going.”). Hobbled by ideology, the modern Fed refused to even acknowledge the existence of rampant speculation in finance and property, much less move decisively to reign it in.

Until recently, another factor contributing to the current financial stress—the “agency problem”—has received scant attention. This term refers to the conflict of interest between a diffuse group of corporate owners (shareholders) and company managements whose intimate knowledge and control of operations has resulted in the creation of incentive structures inimical to the owners’ interests, not to mention the taxpayers’ pocketbooks. Many, including ourselves, argue that these perverse incentives, and absence of disincentives, led banks to take on risks that resulted in the enormous losses that have now been “socialized” throughout the Western world. Warren Buffett recently advocated a simple solution: make corporate officers (and their spouses) personally responsible for failure. Facing wipeout risk for policies which ultimately lead to outcomes such as taxpayer bailouts, managements’ interests would truly be “aligned” with corporate ownership. Unfortunately, there has been little or no discussion of this proposal, possibly because the “agency problem” extends to the political sphere as well.

Despite the lack of interest among the general public, stock markets continued to climb the proverbial “wall of worry” this year, with the averages up 4-5% or so at quarter-end. Small-capitalization gauges did even better, with gains in the 6-8% range. The popular Dow Jones average had its best quarter since 1999 and finished 66% above its year-ago low. The broader S&P 500 index added nearly 5% onto last year’s strong gains, but is still 25% below its October 2007 highwater mark, reflecting the severity of the late 2008-early 2009 collapse. Not surprisingly, so-called “emerging” equity markets, so hot in 2009, have lagged so far this year.

As noted, bonds, especially corporate issues, continued to show strength, but wobbles in the market for government debt in March prompted a former Fed chairman to remark that the uneasiness was akin to a “canary in a coal mine,” foreboding future trouble for bond markets and government financing needs. Although we find it amusing that an official who was blind to bubbles in equities and real estate is suddenly able to see one in bonds, he could be right. Debt markets do seem destined for a comeuppance that could prove very uncomfortable for those who have placed much faith in these supposedly “safer” instruments. When this might happen is, of course, impossible to know.

Nomina Rutrum Rutrum *...

... “to call a spade a spade,” for the Latin-challenged. Everything sounds better in a foreign language, even a dead one. In similar fashion, all of Wall Street’s activities in securities have a more positive ring to them when dubbed “investing.” Buying the stocks of small, unproven enterprises is often called “aggressive growth” investing, for example. Institutions and deep-pocketed individuals putting money in illiquid ventures usually burdened with debt are known as “private equity” investors. Even trading in futures contracts on commodities, at one time held to be little more than gambling, can enhance diversification in “investment” portfolios, it is now claimed. It seems that anyone who ever bought a share of stock or traded a credit default swap is an “investor.”

We have long felt that how we think about securities transactions plays an important role in their ultimate outcome. For example, it may be comforting for those currently putting so much money into bond funds to believe they are “investing” in “safe” instruments, yet the same people who balk at paying a high price for tomatoes at the grocery store are readily buying bonds, including treasury issues, at prices not seen in decades. One of the primary tenets of investing is that it aims to protect capital. The current interest in bonds defies that basic principle. In fact, it strikes us that little of what passes for “investing” on Wall Street—including most of the “creative” financial products whose unpredictable behavior lay at the heart of the financial crisis—really qualifies for that title. A more appropriate designation would be “speculation,” an activity whose outcomes are far less trustworthy than those of true investment. Understanding this distinction truly does make a difference. It may not have prevented the current crisis and market collapse, but it could have helped many avoid significant and permanent losses.

It is the responsibility of those in the securities business—professionals—to engage in this kind of analysis. Had Wall Street done so, and dealt honestly and transparently with its customers, it might still have an ounce of credibility.

*With apologies to Lucy Kellaway of the Financial Times.


Dennis Butler, MBA, CFA