Third Quarter 2008 – Crisis Update

“These are the times that try men’s souls,” – Thomas Paine
“The best way out is always through,” – Robert Frost

In Greek and Roman mythology, Apollo, in our logo in the upper right-hand corner of this page, was said to be the god of truth and prophecy, among other things. He was said to be the source of prophecies that emanated from the Oracle of Delphi. We prefer to think of him as the god of wisdom, and that makes for a better introduction to this quarter’s update anyway. Suffice it to say that after the events of the past fifteen months, thus far culminating in the events of last week, we need some wisdom on Wall Street.

These are extraordinary times, and hyperbole is virtually impossible. It is doubtful that any investment manager alive has seen anything like this. What any seasoned investor is familiar with, however, is the pendulum that swings between fear and greed. For the moment, at least, the pendulum seems firmly stuck to the fear side. The future seems very dark, like staring in to an abyss. But take cheer, gentle reader: it always looks that way at a time of crisis. We have a dynamic and resilient economy and will get through this time, too. Also, the Chinese word for crisisis instructive in that it’s comprised of two traditional Chinese characters, the first meaning danger; the second meaning opportunity. So it is with our current crisis: it presents danger and opportunity.

According to Wikipedia, there are four laws of Yin-yang, embodied in the symbol to the left. One of them seems particularly relevant to the situation at end, and that is that there is a transition between two polar-opposite effects; the one leads to the other. In our case, fear will eventually transition to greed. Stock and bond prices will rise again.

We want to take this space to 1) give you a brief recap of what has brought us to this point; 2) share our thoughts on how it might be resolved; and 3) provide our counsel on dealing with it personally.

How we got to this point

Last week’s events, and the follow-on ripples of this week, are only the present culmination of a process that began in the bursting of the internet bubble. That’s when the Fed began its very easy monetary policy, as evidenced by the very low Federal Funds rate, and foreign central banks increased their buying of U.S. Government bonds; in short, interest rates were very low. Once the internet bubble had completely burst, we also entered a period of very low volatility, in the economy and otherwise. That gave investors, using the term loosely, increased confidence to take risks.

This led to another bubble, one in housing, and what a perfect bubble it was, fulfilling the American dream of home ownership, aided and abetted by the masters of unintended consequences, Congress. The mortgage-banking industry pitched in by coming up with novel ways to finance home purchases. Keeping up with the Joneses became much easier, and the home buyer was lured in, forgetting the caveat emptor, buyer beware, mantra. Wall Street did its part by creating securities out of mortgages, something it has done for a long time, in the form of collateralized mortgage obligations (CMOs) and mortgage pass-throughs. This time, though, it engaged in a little financial alchemy, turning financial lead (sub-prime mortgages) into gold (AAA-rated securities) by creating Collateralized Debt Obligations (CDOs). One could substitute Derivative for Debt, and derivatives aren’t always well behaved.

These securities were embraced by investors, again the term is used loosely, of all stripes, from the traditional smart money, hedge funds, to all types of banks, from regional banks to investment banks. Near the end of the salad days of this period, investment banks were not able to foist all of the CDOs off on others and were forced to keep some on the books. Everything was fine until, in mid-2006, when housing affordability was at its lowest since 1991, house prices began to decline, and this is critical, on a nationwide basis, something the creators of CDOs had never envisioned. They hadn’t modeled the tremendous price declines, either.

What should be done?

Many would say that nothing should be done, that the bitter pill should be taken. This draconian approach might, indeed, be the best way to completely cleanse the system, to bring back the quaint notion of saving, and to instill new discipline at the corporate chieftain level. That outcome is not, however, tolerable to the 535 elected congressmen in Washington, and, thus, we are looking at a bailout, one with a price tag that could be as high as $700 billion if Treasury Secretary Henry Paulson has his way.

  • The Paulson plan would, in short, purchase troubled assets, such as the aforementioned mortgage-backed securities.
  • There is also a plan that New York Senator Chuck Schumer has proposed. It would, according to BCA Research, resemble the “depression-era Reconstruction Finance Corporation,” and includes refinancing troubled mortgages, requiring banks to record possibly substantial losses, but offsetting those losses through capital injections back into the banks.

The Schumer plan appears to better address the problems at both the consumer and corporate levels. It would allow homeowners to remain in their homes, while shoring up a critical pillar of the country, the banking system. Both plans seem lacking in not meting out consequences to any of the parties, however.

What should you do?

There are at least two things one should not do. First, one should not let emotions override rational thinking. From personal experience and reflecting on the experiences of others, decisions based on emotions rarely work out as expected. Second, one should not pretend to be an ostrich, burying one’s head in the sand.

One thing that should be done is to use this time of scary headlines as an opportunity to reassess one’s risk tolerance. If your investment policy, your asset allocation, includes an investment to stocks, consider this: this won’t be the last time that stocks decline precipitously. Is this too gut-wrenching? Are you having a difficult time sleeping? If so, it’s probably time to contemplate a lower allocation to stocks, while recognizing that over time, stocks have proven to be the source of highest return among the traditional categories of stocks, bonds, and cash.

Indeed, there are a number of reasons to sit tight at the present time, to see some light at the end of the tunnel. They are these:

  • Stock and bond markets last week, especially on Wednesday and Thursday, had the feel of sell-at-any-price, run for the exits. In the vernacular of investing, those periods are often called capitulations or climax selling. Those two days had most of the hallmarks of distressed selling, although a few classic indicators were missing.
  • Historically, more bear markets have ended in September and October than in any other two months of the year. That possibly puts us within a few weeks of having a pretty solid low, from which point stocks could rebound considerably.
  • From peak (10/11/07) to trough (9/18/08), the S & P 500 has fallen by 28.08%. The average bear market since 1929 has fallen by 29.5%; the median (i.e. middle value) has been 27.0%. So, we’ve experienced an average bear market. To be fair, though, averages are made up by a distribution of data above and below the average, so average is no guarantee of no further declines.
  • Similarly, the current bear market has played out over 343 days. The average bear market lasts 356 days; the median, 273.
  • There are a host of technical indicators that argue for a low being at hand, perhaps even past.
  • The CBOE VIX index, a measure of fear derived from option prices, spiked to 42 last Thursday, before closing lower. In the past 12 months, in spite of the Bear Stearns bailunder and related crises, the fear index had never breached the 40 level, which it did several times at the market’s bottom in October 2002.
  • Investor sentiment, as confirmed by various surveys and other, more esoteric readings, is at very depressed levels.
  • Treasury Bills were, for a while, during the week of September 15 sporting negative yields for the first time since World War II. There was fear of losses on money market balances, such that investors were willing to pay the government to use their cash.
  • Popular magazines can often be important contrary indicators, the most famous being BusinessWeek*rs s, “The Death of Equities” (see below, left), which marked almost perfectly the market’s ’80s low. This week’s issue of The Economist featured a gloomy cover page, “What’s Next?“ (see below, right).

It’s not safe to say, however, that we are out of the woods; the coast is not yet clear. The reason to remain invested and focused on the longer term, however, is that when the coast is clear, stocks will be 20% or more higher. The news is always gloomiest at the bottom. We are not above market timing, but doing so requires two heroic leaps. The first is that one gets out at the right time; the second is having the courage to buy back in, hopefully at lower prices, when the news is almost by definition bound to be worse.

Tower Private Advisors Investment Management


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