Saving American Capitalism – January 2009

January 12, 2009

Dow Jones Average: 8,474
S & P 500 Index: 870


Saving American Capitalism

Proponents of capitalism believe fervently that it is the most effective economic system. In theory the capitalist, free market system rewards innovation, efficiency in production and distribution, hard work, responsiveness, and the wise allocation of resources. Different countries adapt the free market, capitalist model to their preferences, incorporating social safety nets, financial regulation, trade restrictions, wage requirements, price support programs, along with other elements of government control and planning.

While the wealth generating aspect of capitalism has universal appeal, the boom/bust cycles that occur with some frequency create social and political tension, and the misallocation of capital. Government efforts to forestall the bust phase of the cycle can actually make things worse. We believe that former Fed Chairman Greenspan’s low interest rate policy during 2002-2005, which continued his pattern of rescuing financial markets, actually exaggerated the boom/ bust cycle in real estate and financial assets. In a previous strategy update, written several years ago, entitled “Greenspan’s Legacy” I forecast that his actions could lead to a financial collapse too big to contain. It seems that the day of reckoning has arrived.

At the end of the day people don’t care about economic systems, they only care about outcomes. With unemployment soaring, financial markets plunging, and the wealth gap widening, most people are not happy with the results. In the past few years our economic system enriched people who invented new financial products such as pick-a-payment mortgage loans, credit default swaps, collateralized debt obligations, etc. The biggest financial rewards went to people who produced nothing of lasting value. When an economic system rewards failure and misallocates resources the repercussions for society can be severe. The policy mistakes of the Bush-Greenspan era have damaged the system in ways that will take years to repair. The Obama administration is inheriting a 1.2 trillion dollar annual deficit from the Bush administration, and that is before the proposed stimulus package of 800 billion dollars.

President-elect Obama and his advisors understand that they need to move quickly and decisively to break the downward momentum of the economy and restore confidence in the functioning of American capitalism. In our opinion the goal of the large stimulus package is to inflate, inflate, and inflate, while creating some needed infrastructure. Government policy makers would prefer to rein in inflation a few years down the road than face deflation and depression now. Deflation is deadly for those who are in debt. Falling prices cut revenue and incomes needed to service the debt. If deflation takes hold the current debt implosion will accelerate. Inflation raises revenue and incomes which makes it easier to pay down debts. The government has no choice other than to inflate the economy at all costs.

Deficit spending and inflation have negative effects that will have to be dealt with later. If inflation takes hold as planned and the economy recovers, taxes will be raised in a couple of years to both shrink the budget deficit and provide subsidies to those who cannot keep pace with inflation. Entitlement spending will also have to be contained in an effort to close the trillion dollar budget deficits. One of the more enduring benefits of the Obama plan may be the focus on alternative energy and medical information technology which, if carried out well, could improve the quality of life and lessen the increase in energy and medical costs longer term. If the country comes out of this period with a vastly improved medical, energy, education, transportation, and communication infrastructure, some of the deficits being passed onto future generations will have been justified.

The Bernard Madoff Debacle

In mid-December, after suffering through one of the worst years in Wall Street history, investors were further shaken by the news that a man named Bernard Madoff had been arrested and charged with investment fraud on a massive scale. Madoff was the founder in 1960 of a securities trading firm that specialized in over the counter (NASDAQ) stocks, and later on he started a hedge fund which is the object of the fraud allegations. Madoff was a former chairman of the NASDAQ stock exchange in the early 1990’s. He was known and revered in certain circles, but was unknown to most people, including us, partly because he cultivated an air of exclusivity and secrecy. If the allegations against him prove to be true, his name will live in infamy as the perpetrator of one of the most devastating swindles in financial history.

The Madoff debacle is yet another black eye for the Securities and Exchange Commission. The SEC failed to blow the whistle on Enron with its hundreds of shady offshore partnerships, stood by as investment banks became insanely leveraged, and completely missed Bernie Madoff’s alleged Ponzi scheme even though there were numerous warnings and allegations about his operation dating back to the 1990’s. In a Ponzi scheme early investors are paid false “returns” with money deposited by later investors. The strongest warning came from Harry Markopolos, an accountant who first alerted the SEC about Madoff in May 1999, and followed up with a 21 page treatise in 2005, taking issue with Madoff’s secret formula and his supposed returns. Markopolos concluded that Madoff was either front running (an illegal activity to gain a market timing advantage) or was more likely running a giant Ponzi scheme. The SEC is now doing an internal investigation to determine why the agency failed to verify the allegations made by Markopolos and others. Congressional hearings are also underway to explore why the SEC has been so inept at uncovering serious cases of financial fraud.


Investors should be wary of entering into financial arrangements that take away control, transparency, and accountability. Investors who had money with Bernard Madoff’s hedge fund were in a situation where one company (Madoff’s) held their assets, had investment authority over those assets, could pool the funds, and had unlimited power to move the funds to satisfy trades, redemptions, or for any other purpose. From a structural perspective giving such power over one’s account to a single organization with no outside (third party) verification is inherently dangerous.


With major banks and insurance companies failing, regulators asleep at the switch, and con men on the loose, people are justifiably nervous. Such fears should not override a clear understanding of investment management relationships and safeguards. The client relationship with a typical money manager is very different than the arrangement people have with hedge fund managers. Registered investment advisors (money managers) rarely hold client assets directly. The assets are typically held at a large brokerage firm or bank in the name of the client. The custodian bank or brokerage firm has the primary responsibility for ensuring the integrity of the assets and the validity of any money transfers from a client’s account. Money cannot move from the account to anyone other than the client (same name, same social security number) without a signed letter from the client authorizing such a transfer. Clients receive statements from multiple sources, from the bank or brokerage firm holdings the assets and from the firm managing the account. With multiple parties viewing and reconciling a client’s account, and tight procedures covering withdrawals, the possibility of any wrongdoing is extremely small. Unfortunately, investors who put money with Bernard Madoff had no such safeguards.


Current Strategy

The stock market declined in 2008 by the third largest percentage in its history, eclipsing all other down years except for two that occurred during the 1930’s depression. While stock valuations, as measured by traditional ratios, have become far more favorable for buyers, the economic collapse will continue to exert pressure on stock prices. The corporate revenues, earnings, cash flow, balance sheets, and dividends that make up the currently favorable ratios will erode as the economy continues to falter.


Over the past few months we have increased our clients’ exposure to stocks, buying into companies that have stable revenue flow and strong balance sheets. We have also taken positions in companies that should benefit from the Obama Administration’s focus on alternative energy and health care information technology. While stock prices are enticing, our buying is tempered by the severity of the economic crisis. We are maintaining large cash and short term bond positions that can be used for further stock purchases depending on market and economic conditions. We essentially have one foot in the market and the other foot out. The equity exposure level for our typical, balanced account is substantially higher than six months ago, but still much lower than the 1990’s level.


For the fixed income part of portfolios we are buying TIPS (U.S. Treasury Inflation Protected Securities) at historically low prices. TIPS protect investors against inflation. Certain holders of TIPS are unloading the bonds at distressed prices, because fear of inflation has been replaced by fear of deflation. The shorter term (1 to 3 years) TIPS are now priced to yield between 3.5 and 6 percent over inflation. We think fears of deflation are somewhat overblown, and are eager to buy the TIPS at favorable prices.

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