Market Update

There are three problems currently facing the economy and markets. First, too much credit was created for individuals, corporations, and government and it needs to be unwound. Individuals and corporations have begun that process and it will continue for several years. Second, the U.S. economy’s recession began near the start of 2008. Even though government statistics masked its existence, it was evident through common sense observation. Recessions are a natural part of the business cycle and need not be feared. They generally last 12-16 months, causing stock markets returns to be low or slightly negative for a few months and bond prices to rise, offsetting some of the stock market’s return. However, the third factor, the recent credit freeze, has caused a powerful flight from risk pushing virtually all security prices much lower. This, in turn, makes the first two problems worse.

The credit freeze is much like a financial heart attack. It does not matter what other illnesses the patient may have, because they become irrelevant if the heart cannot be restarted. If credit does not flow through the economy’s veins, then business will come to a halt. Every week that conditions were frozen will likely add one month to the patient’s recovery. Thus, we expect that the four weeks from mid-September to mid-October will add four months to our recession, taking us out to mid-2009 before conditions begin to look better. The stock market, however, will anticipate the recovery and begin to move higher before the news media can report improving conditions.

Carpe Annum

As you read the newspaper or listen to the evening news, you hear a litany of reasons explaining our turbulent stock market: the economic recovery has stalled; earnings have disappointed; oil prices are high; deflation seems just around the corner. And to further complicate our nation’s economic situation, the threat of war with Iraq looms on the horizon. It makes a certain amount of sense that the market should be encountering instability as a result of these concerns. But they don’t adequately explain the sharp deterioration in confidence that has gripped not just our nation, but countries around the globe.

It is the combination of all of these factors which has led U.S. investors to what has become a crisis of confidence. Confidence is indeed depressed but the question is why has the result been so unusually harsh? Though our situation seems grim, we must remember that oil prices have been high in the past; the pace of economic growth, while somewhat disappointing, is still positive; deflation is under the control of the Fed; and earnings are up. But upon further inspection, one can see that our market seems to be falling into a cycle. The economy is weak because the market has drained consumer confidence. This crisis of confidence leads to lower market growth and this lower growth means fewer profits. This further drains consumer confidence, the economy weakens further and thus the cycle continues…

There is, however, a light at the end of this tunnel. The cycle can be broken when investors examine the facts and focus on the reality that the U.S. economy, for all the disappointments it’s delivered, is not in bad shape. GDP growth is positive and productivity is rising sharply. The unemployment rate remains near 6%; job growth is positive, if slow; consumer durables and housing are strong; and inflation and interest rates are low. It’s easy for us to lose sight of these fundamental supports when growth doesn’t necessarily meet expectations.

In the short-term, stray factors can influence stock prices and cause valuations to deviate from fair value. Sometimes these deviations can be rather large and last for quite some time, as we saw in the late ‘90s. But eventually the fundamental principles of capitalism will overcome, and the market will reflect a fair price that’s based on real earnings growth. In every market environment, good or bad, there are always opportunities and risks. A good investor will find some of the opportunities and avoid most of the risks. In 2003, most investors will once again be surprised by the market - missing the best opportunities. What will you do?

Published in Westlake Magazine – February 2003

Client Update – January 10, 2003

While the fourth quarter was strong for stocks and high-yield bonds, it was small consolation in a tough year. For the year, every S&P industry sector was down and eight of the ten experienced double-digit loss. It has been sixty years since the market has fallen three straight years, and 2002 was the worst single year since 1974.

In our opinion, there are a number of factors that contributed to the bear market, but without question the biggest was the stock market’s tech bubble. Terrorism and war fears didn’t help, but these only contributed at the margin to the magnitude and length of the bear market. Corporate shenanigans also hurt, but were not the driver—just another outgrowth of the environment of bubble-driven greed.

It is almost a tradition for investment professionals and the media to issue a forecast at the beginning of each year. But in any particular year there are many factors that play out differently than expected (e.g. Enron & Worldcom), and other potential issues that simply can’t be foreseen (e.g. 9/11). This makes accurate forecasting very difficult. Instead, to achieve long-term investment success we believe it is essential that we base our strategies only on analysis that we are highly confident in, not hope or speculation. This necessitates a relatively long-term time horizon, since we have a much higher level of confidence in our ability to assess long-term factors.

As we look out over the next five years we are optimistic and believe financial markets are likely to deliver decent returns relative to inflation. There remains a lot of cash sitting on the sidelines waiting to enter, corporate valuations are moderate, and interest rates and inflation are low. While we won’t be seeing anything like the 1990’s Bull for many years, we don’t expect to be visited by the Bear anytime soon either.