Tuesday, June 24, 2008

Drinking Their Own Kool-Aid

We’re back where we started. The major equity indexes are down to the low levels of January and March of earlier this year after a valiant attempt to break the downward trend. In 2000 a number of strategists and investors I admire were opining on the investment course for the new decade and that we had a decade of, at best, modest returns ahead. Today, nine and half years later, the Dow Industrial Average is exactly the same. In January 2000 the Dow hit 11,720 and today it touched 11,727. Seven points in nine years and now in the middle of a financial industry shake-out the likes of which few of us have seen before.
Historically the market has advanced in spurts for underlying structural reasons and then gone into hibernation and turmoil for about fifteen years. The good news is that we are significantly through, at least historically, the painful lull. The bad news is there are reasons to believe the next advance will not come any sooner than usual.
The seeds of opportunity are found in crisis. Conversely it seems the seeds of crisis are found in opportunity. As interest rates fell to levels that were unpalatable to pension funds in particular, the search for higher yields began in earnest. The product that rose to the surface, driven by demand and profitable fees was the securitization of mortgages. So profitable in fact was this business that the reek of risk was masked by the perfume of profit.
Even the highest and mightiest misunderstood what happened. Alan Greenspan admits he miscalculated the risk because of the assumption that the bundles of risky investments had been widely dispersed to institutions able to withstand such risk. Unfortunately much of this risk was not spread throughout the system and instead remained unrecognized and unaccounted for within the entities that created it, the banking system. The value of residential property was seen as so stable, the government encouraged all to buy with easy money and the industry paid little attention to the verification of ability to pay. Some mortgages which were written had not a single payment made before going into default. Mortgages were made at 110% of dubious valuations and income documentation was passe’. Those were heady times.
Today the headline news is that the real estate gains of the past four years are gone nationally. In the previously hot markets, the decrease in valuation in the past year alone has been breathtaking; Las Vegas -26.8%, Miami -26.7%, Phoenix -25%. Add a soft employment market and the effect is catastrophic.
The banking system is crying for capital investment and the sources are balking. The sovereign wealth funds from China, Dubai and similar are no longer willing participants in the collapse and have stepped back until the fog clears. Until the valuations of the impaired assets are marked to market instead of marked to myth the market will not clear. Investors know if the assets are accurately valued on balance sheets some of the companies will have no value. There is no guarantee that names long associated with the term, “sound as a dollar,” will continue to exist. National City stock has fallen from near 40 to 5, Citibank from 60 to 18, Countrywide Mortgage from 45 to 4.
For a nation which runs on credit these are difficult times indeed. However this too will pass in time and investors who use the time to clean up their own “balance sheets”, preserve capital and rebalance opportunistically will come through bruised but intact. The debates of inflation v deflation, global delinkage and commodity endless boom or impending bust, continue vigorously. Beware of hype and hope. Regulatory agencies and central banks will continue offer lifelines when they must and investors would do well to buy despair ahead of the fixes and sell euphoria as crisis and solution ebb and flow. Keep a clear head and a cold heart with investment portfolios.

john barnyak