Another Bailout – October 2007

October 22, 2007

Dow Jones Average: 13,567
S & P 500 Index: 1,506


Another Bailout

Equity markets around the globe tumbled in August as investors became panicked by the mounting losses on mortgage paper. In June it seemed that the world was awash in liquidity, with endless money available for buyouts, private equity, hedge funds and general business loans. And then in an instant the money dried up, leaving borrowers in a financial desert without a drop of liquidity. The availability of money is driven by human psychology which can change overnight. A strong appetite for risk one moment can turn quickly to risk aversion. The U.S. Federal Reserve Board and other central banks around the world reacted immediately to the credit crunch by pumping about 80 billion dollars into the banking system, in the hopes that this money would restart the lending process. These emergency measures were followed by a September interest rate reduction of ½ of one percent in the United States. The Fed sent a clear message that they will attempt to bailout the risk takers, who made unwise loans backed by real estate, even if such a bailout leads to a decline in the U.S. Dollar and potentially higher inflation.

Investors took solace from the Fed’s actions and poured back into stocks in late September and early October. The rally may turn out to be brief, as concerns have been reignited by Citigroup’s recent announcement of a 100 billion dollar bailout fund being put together by a consortium of banks. The banks need buyers for the messy sub-prime mortgage paper that was issued so liberally in recent years. The Fed’s actions alone did not create buyers, so the banks felt a need to set up a fund designed to step in and buy paper that had lost its marketability. The banks are willing to put up more of their capital to essentially avoid a fire sale of current loans on their books. The analogy would be an investor having bought a stock at 30 per share, riding it to 10 dollars per share, and then setting up a special account with additional money that would buy the stock for 30 again. It’s an expensive way to create the illusion that a loss has not been incurred, when in fact the free market no longer supports the higher price. With trillions of dollars of new mortgage paper issued over the past few years, investors are left to wonder whether the action of the Fed and the banks will be enough to salvage the situation. As most bank stocks crumble to new 52 week lows, it is clear that investors have their doubts.

The Federal Reserve Board has been complicit in short-circuiting the working of free market capitalism. Over the past twenty years the Fed has consistently bailed out those who have employed excessively high risk strategies, while punishing lower risk investors and ordinary savers. Dropping interest rates to one percent, in an attempt to salvage the markets after the meltdown, led directly to the real estate speculation and the high yield, mortgage backed bonds that are now defaulting. One bailout plan just creates a need for the next. The Fed has been unwilling to simply let the economy and the markets take a natural course of flushing out those who have taken foolish risks while increasing the buying power of those who have been more prudent with their capital. It is no wonder that we have a market dominated by high risk takers as the Fed is always providing a safety net for them in case of a fall. One could argue about who pays for the safety net. It seems to us that a lower U.S. Dollar, higher inflation, the real estate bubble, and the historically large wealth gap are all related to the cost of providing the safety net. At this time it is difficult to determine the eventual cost or benefit of the current bailout attempt.

Current Strategy

We are skeptical of a stock market that is flirting with recovery highs while the financial sector is plumbing new lows. The financial stocks represent the heart of the U.S. economy and are the largest component of the broadly based, stock market indices, such as the S&P 500 index. The decline in the financial stocks has been offset by a rise in energy shares, some big technology names, and the basic materials group. We do not think that this situation is sustainable if credit problems persist and the economy weakens noticeably. The U.S. economy may already be in a recession or on the verge of recessionary conditions. The stock market has a long history of doing poorly as recessions unfold.

We would expect the economically sensitive sectors such as energy and basic materials to follow the financial stocks lower. Some investors believe that growth in emerging markets will buoy the energy and raw materials industries even if the U.S. sinks into recession. While this is a plausible scenario, it is also possible that a recession in the U.S. could undermine growth rates across the globe, creating a cascading decline in demand. The heightened market volatility in 2007 has made it possible for us to employ a cautious, yet productive strategy. We have purchased new positions after each of the sharp declines that have occurred this year, and have taken substantial gains at the top of the rallies. We feel that a cautious, nimble approach is called for, given the potential for a dramatic economic shift over the next twelve months.

The fixed income side of the portfolios we manage continues to reflect our concerns about inflation. We purchased more TIPS (inflation protected treasuries) for accounts about a year ago, which was good timing in retrospect. We also bought straight (non inflation protected) treasuries and municipal bonds when the rates seemed high enough to more than cover potential inflation. The recent ½ percent decline in the Fed Funds Rate has pushed up the carrying value of all bonds in our clients’ accounts, but has created a dilemma with respect to new U.S. bond purchases at the current, lower interest rate levels. We are contemplating the wisdom of buying foreign bonds with some of the cash position, and holding the rest in reserve for potential equity purchases.

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