Assets Prices Fall Across the Board: Cash is King for Now
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I’m sure you’ve been watching the headlines. The news is horrific. Fannie Mae and Freddie Mac, which hold the majority of residential mortgage paper in the United States, had to be rescued and put under conservatorship of the U.S. Treasury. Lehman Brothers, one of the largest U.S. investment banks filed for bankruptcy. The New York Branch of the Federal Reserve extended an emergency $85 billion loan to the nation’s largest insurance company (AIG) to avert a bankruptcy and a worldwide financial meltdown. In other notable news, Merrill Lynch sold to Bank of America to avoid collapse and Washington Mutual is teetering on failure.
Asset prices have been falling across the board including stocks, bonds (except for U.S. Treasuries), commodities, and real estate. The S&P 500 is -27% since its peak on October 11, 2007 and -21% in year-to-date. Until recently, energy was the only industry sector in the S&P 500 posting a gain, but is now -17% for the year after falling 27% since July. The market is now pitching a perfect no hitter to all industry sectors.
On a side note, Catamount clients can sleep soundly knowing that the managed portfolios have held steady. It will be Monday before more precise performance numbers can be reported, but the portfolios are up slightly in 2008 (in the +1-2% range). Catamount portfolios have outperformed the S&P 500 by more than 30% on a trailing 12 month basis.
The conventional wisdom has fervently argued that the emerging markets and other developed international markets would decouple from the problems in the U.S. and continue to fuel global growth and overseas investment opportunities. In my February 2, 2008 comments, I issued a warning to the contrary, stating that the world markets would catch cold if the U.S. economy sneezes. That prediction has come to pass. The broad international stock index, (MSCI EAFE) is -28%, and the emerging market (MSCI EMIF) index is -36% YTD. This is proof positive that the world is extremely interdependent and inextricably linked. The more frightening fact is that the globe is still, for now, exceedingly dependent on the American consumer to import their products. Unfortunately, U.S. consumers, having pursued the illusion of prosperity (aka. “credit”), have buckled under the weight of their debt. The rest of the world is finally beginning to feel the pinch.
Of course, the credit bubble was aided and abetted by the loose credit standards of our banking and financial system. It was compounded by the massive proliferation of credit derivatives that were invented by crack investment bankers to circumvent traditional lending standards and regulations. The unfettered creation of derivatives allowed our financial system to become so over leveraged that it’s difficult to fathom, much less quantify the risks. Under the circumstances, it doesn’t take too many loan defaults to create an avalanche and there are more than enough delinquent loans to go around. Residential foreclosure rates are at record levels and will surely worsen because the problems are not confined to the subprime market. The problems span the entire credit spectrum from subprime to prime, from residential to commercial, and from real estate to industry. Incidentally, much of this bad paper was sold to foreign investors. Now, a full scale deleveraging of the world economy and financial markets is underway.
Many economist and experts are becoming increasingly concerned about inflationary pressures. In my opinion, they’ve missed their bus stop. This inflationary cycle has been in motion since 2003 and is either complete or very near its end. The only remnants of the inflationary cycle have been high commodity prices. Although I’m a believer that the structural bull market in commodities is still intact, it comes as no surprise that commodity prices have succumbed to gravitational pull of a slowing world economy. Oil, natural gas, industrial metals, precious metals, and agricultural commodities have corrected severely and could continue to tumble in coming weeks. These price drops will translate into lower inflation readings in a month or two.
In reality, the forces currently in play appear very ‘D’eflationary. Of particular relevance, the Banks are tightening credit in an attempt to remain solvent. Already more than 100 banks crowd the FDIC’s watch list and some respected experts predict 1,000 banks will close their doors. Any liquidity that the Federal Reserve has bestowed on the banks has been horded to shore up balance sheets and write down non-performing loans. Therefore, the money supply is not being pushed through to businesses and consumers who are credit worthy. A contracting money supply portends deflation in the near term. By the time the deflationary cycle ends , the Federal Reserve will have pumped so many greenbacks into our economy that the next inflationary cycle will begin again in earnest. (Beware future tax payers!) Until then, these undercurrents may be destructive to all asset values.
After the precipitous sell-off in the stock market, I anticipate a respite soon. But any rally should be used to lighten your stock holdings. This is not your garden variety bear market. It will likely get much worse when it resumes. In addition to other absolute return vehicles, Catamount Capital views a larger cash position as a key element of our immediate investment strategy. Individuals and businesses that have stockpiled cash, maintained low debt burdens, and reduced exposure to illiquid assets (i.e. real estate, cyclical businesses, facilities & equipment) have seen their wealth grow as asset prices and consumer prices deflate. In a deflationary cycle, cash gains real purchasing power even if portfolios do not increase in nominal dollar terms. Increasing purchasing power is the essence of wealth creation. When the time is right, we intend to buy assets and businesses at bargain prices - but not yet.
Keep your powder dry and be sure to park cash with a healthy financial institution.
