Thursday, May 22nd, 2008...7:15 am
The Raw Deal
Laguna Beach, California
- The Fed had won the war! Hip! Hip! Hooray! Oh, wait…
- What more than two decades of easy money has done to your dollars,
- The disconcerting “knowns” and the harrowing “unknowns” on Wall Street and more…
Eric Fry, reporting from Laguna Beach, California…
Back on May 6th, the Dow Jones Industrial Average closed above 13,000 – capping a brisk 10% rally from the lows of mid-March. The stock market was recovering nicely from its early-year swoon and financial stocks were leading the recovery. Almost everyone understood that the Fed had rescued the financial system. And almost everyone rejoiced that the worst of the credit crisis had passed.
Finally, we could all get back to the business of buying overpriced stocks and watching them move higher.
But amidst the self-satisfied delight of those early May days, a handful of nervous investors continued to worry that the worst of the crisis might not have passed. And a few of these anxious souls produced some frightening data points to validate their fears. The financial system remained dangerously leveraged, they pointed out. And the credit markets remained dangerously dysfunctional.
But in early May, very few investors cared to heed any words of caution. Optimism held sway. The Fed had won the war! Hip! Hip! Hooray!
Nevertheless, on the morning of May 7th, one skeptical – and very successful – investor offered a dissenting point of view. In a detailed and compelling speech before the attendees of the Value Investing Congress, Steven Romick explained why he remained leery of the U.S. financial sector, and why he had been building a large cash position in the funds he manages. “We are not ashamed to admit that the unknowns in this environment scare us a bit,” Romick said. “Not enough to be disinvested, but enough to make sure that we have enough on the sidelines to survive what the market throws us.”
Even more disconcerting than the “unknowns” however, were a few of the “knowns” that Romick cited, like the incomprehensibly large leverage that still resides on the balance sheets of companies like J.P. Morgan and Lehman Brothers.
In short, Romick’s delivered an extremely persuasive and compelling justification for a defensive investment stance. It was an outstanding speech…So outstanding, in fact, that your editor asked Romick if he would allow us to publish it in the Rude Awakening. He agreed.
Without further ado, therefore, please enjoy the insights of Steven Romick, as presented to the Value Investing Congress on May 7, 2008.
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Steven Romick’s Speech to the Value Investing Congress
Pasadena, CA, May 7, 2008
Then the Gods of the Market tumbled, and their smooth-tongued wizards Withdrew, And the hearts of the Meanest were humbled and began to believe It was true That All is not Gold that Glitters, and Two and Two make Four And the Gods of the Copybook Headings limped up to explain it once more.
- Rudyard Kipling, 1919 - From The Dollar Crisis, Richard Duncan
Thank you Whitney and John for having me here today. I thought I’d speak on a subject that is more macro than we at First Pacific Advisors have historically been accustomed. However, we believe that we live in unprecedented times such that we cannot just look to the recent past and see an easy way out of the issues we have created for ourselves. We recognize that we are not economists, but feel that to not wrestle with these substantive issues of the day would recklessly endanger the capital entrusted to us. To ignore the crisis of confidence in the world today is the same as investing butt-naked – drafty, and potentially embarrassing.
For the last couple of years, my partner Bob Rodriguez and I have communicated our concerns to our investors through shareholder letters, and commentaries. We wanted to make sure they understood why we have let our cash grow to around 40% of our invested assets in our Crescent and Capital funds. Suffice it to say, that what’s currently transpiring is, sadly, not a surprise. As long term investors one might say who cares, because one cannot time the market. We agree in principle, but we have met few claiming to invest for the long-term, who have also proven to have the stomach to handle the downside volatility that brings prices lower than you ever thought possible.
Our cash hoard has not grown because of our top down point of view, but due to our inability to find comfort in the upside versus the downside for the individual investments we analyze. We are not ashamed to admit that the unknowns in this environment scare us a bit – not enough to be disinvested, but enough to make sure that we have enough on the sidelines to survive what the market throws us. We know we lack the skill to pick the bottom, but we sure don’t like the idea of picking the middle.
More than two decades of easy money, combined with a deteriorating savings rate that is now negative, magnified by leverage and lax oversight has created our current predicament – the Housing Bubble and Subprime defaults are just two of the symptoms.
As a result, we now expect a deleveraging across all types of domestic lenders, with many international companies similarly impacted and that a global credit crisis is in its early stages. Less capital and greater regulatory oversight will impact both lenders and borrowers – a combination that can only negatively impact economic growth.
The U.S. Personal Savings rate has declined from the teens just three decades ago, to less than zero today, and that’s with the benefit of historically high employment. Adjusted for inflation, the savings rate has been negative since the late 1990s. When combined with the national price of homes declining for the first time since the 1930s, we fail to see how the consumer will not find themselves more negatively impacted as the credit crisis plays out. Since consumption now represents approximately 70% of our Gross Domestic Product, our economy will likely have a commensurate impact. We act as if it is our birthright to consume more than we produce. We have turned into a nation of spendthrifts.
In order to finance a lifestyle that exceeds our capacity to earn, we obviously need to borrow more. Note how the net international investment position of the United States has turned so deeply negative. We are selling our country piece meal. This means somebody else owns our assets! We still feel rich because we live in a nice country, but each year overseas investors are owning more of the Land of the Free and, as a result, we are effectively forced to pay more rent to live here.
This has not gone unnoticed as the international community has already debased the U.S. dollar. Looking at this chart, the only place you’d want to visit anytime soon is Mexico. Although we do not like the U.S. dollar, we also don’t understand why the Pound and Euro are trading where they are. It’s not like England doesn’t have its share of issues – and the Euro has never been stress tested since its 1999 introduction.
The President, Congress, and the Federal Reserve are well aware of the problems and aredoing what they can. There’s a $150 billion direct injection coming in the form of tax
rebates. But, that’s not such a big number when you look at it in the context of almost $2 trillion that entered consumers’ pockets through home-mortgage refinancing activityfrom 2004 – 2006. We look at this as Red Bull economics – get a quick buzz that doesn’t last and long-term it’s unhealthy.
Meanwhile, the Fed has taken aggressive action in using its balance sheet in an unprecedented fashion, not the least of which was its novel assistance in bailing out Bear Stearns, a non-regulated institution. Many have theorized that the Fed had concern that a Bear Stearns failure could have brought down the U.S. banking system. If that was the case, what does that say about the strength of our system when one medium-sized investment bank could inflict such injury?
And, if Bear was about to go out of business, we fail to see why any value remained for the equity shareholder. If institutions believe that the Fed will come to their rescue, then all sorts of financial evil will be attempted and the U.S. taxpayer will pay the price. That hardly seems fair since the majority of the benefit of the unwarranted risk-taking accrued to the benefit of the cavalier corporate executives. As we pointed out in our 2007 First Quarter letter, almost 60% of gross income accrues to the employees of the investment banks and its disbursement is hardly egalitarian. To continue to socialize risk in this fashion practically guarantees that future attempts will be made by the few to benefit on the backs of the many.
We expect continued aggressive Fed and Government intervention to maintain confidence and liquidity in the banking system, in a desire to keep this economic boat afloat, and out of deflationary fears. They are the only ones with the money, and they can always print more – and likely will.
As you can see, U.S. Government debt has grown at a rate that far outstrips our economic growth. The dark blue line is U.S. Government Debt as a % of GDP and the pink line is total U.S. Government Debt. We expect that this graph will look even less appealing over the next few years, as GDP flattens out or declines, while Treasury Debt continues to increase.
Should unemployment increase measurably, we would not be surprised to see a form of the 1930s government jobs programs. Providing jobs would finally give politicians justification to make sorely needed infrastructure investments.
Eventually though, we will have to repay our debts and the best way to do so is to inflate, that is, use cheaper dollars for repayment. We already believe that inflation is greater than the headline Consumer Price Index number today unless, of course, you don’t drive, eat, or require healthcare – so if you are really skinny, healthy and don’t care about getting out of the house, you’ll be fine. We expect this trend to continue into the immediate future, with higher interest rates as just one potential result…
Please tune in tomorrow for the second half of Steven Romick’s speech.
[Joel’s Note: Steven Romick, Senior Vice-President of First Pacific Advisors, Inc., is the portfolio manager of FPA Crescent Fund, FPA Hawkeye Fund, FPA Multi-Advisor Fund, and various separate accounts. He was previously Chairman of Crescent Management. Click here for more info: http://www.fpafunds.com/mutualfundinvestors.asp
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Rude Endnote: Your editor was en route to the Dubai gold souk to snap up a few more tolas for his modest collection last weekend when we got sidetracked. A call from a friend saw lazing around their pool, sipping a few beers and talking about old times.
Unable to make it down to the markets during the week, your editor has winced and moaned as the precious metal soared from around $860 back up to $935, as of this mailing.
“What ifs” are painful thoughts, Rude reader. When an opportunity presents itself, you have to grab it by the scruff of the neck. Right now, for instance, our colleague and editor of the Gold & Options Trader, Ed Bugos, is offering new subscribers the chance to learn the secret of “Vancouver Leapers”. Ed reckons these leapers can supercharge your returns on gold investments to the tune of 971%, 2,464% and even 3,987%.
If you don’t want to spend the next week whining on the sidelines as your “potential” profits run away, check out his report here.
Until tomorrow…
Cheers,
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