November 21, 2008

Not having been trained in the Scholes’ School of Speculation has its advantages.  By now it should be painfully clear the buy-and-hold doctrine yields volatility rather than performance.  Acknowledging fallibility, as stocks go down, I get out.  Value-Priced Growth Strategy finished September with 90% cash and so avoided the market decline since then of 30%.  Though the S&P is down almost 50% since 2006, the Value-Priced Growth Strategy has given up less than 10%. 

I grew up in the Southwest where in Boy Scouts I was taught not to pitch my tent in an arroyo.  99% of the time it wouldn’t matter, but in the event of a flash flood, it would.  In the woods I learned from experience to avoid the dips even if it offered an enticing floor of moss and pine needles.  Just in case of rain, the higher ground would be the dryer alternative.

Just another day in November

Like a turkey having been fed every day, and used to the idea, life is good-until a day in November...  Just when most confident the past is prologue, often another possibility should be considered.  

In my August 18 blog (TheMarketsValue.com blog—“Going for the Gold”), I suggested it would be a mistake to buy the dips in oil and gold, in speculation prices had nowhere to go but up.  These commodities, then off highs by some 15-20%, have since August fallen dramatically, oil from $140/barrel to $53 and gold from almost $1000/oz to $745.  

Back then it also looked like the dollar would fall forever.  Then came the event that caused everyone in the world to want to own nothing but the dollar and US Treasuries.

Though not privy to their particular trades, I’m willing to speculate among their losers, bets on oil, gold and the dollar contributed to the collapse of hedge funds like Platinum, the $3.75 billion reincarnation of Myron Scholes’ Long Term Capital Fund which in 1998 nearly brought the financial world to its knees, or the $4.2 billion Citigroup CSO fund which lost 53% of its value last month.

With leverage of as much as 25 to 1 on commodity contracts already heavily leveraged, one can see where some of the recent volatility comes from.  Facing liquidation these funds must sell all holdings, stocks included.  (Really, someone should take the keys from these guys.)

Housing expectations were modeled on 30 years when prices rarely declined.  But when values collapsed in the Depression leaving the government owning most of the nations’ houses, the invention of the 30 year mortgage was the solution.  To keep people in their homes, payments were extended over a long period of time.  Similarly, portfolio managers looking only at recent history, pretended what happened in 1929-1932 could never happen again in the stock market.  But if you’re standing in a ditch, with waters rising to your ears, swim to higher ground.  It doesn’t make sense to argue since the waters haven’t been there for 100 years, it’s safe to hang in there.

The certainty de jour is “the demise of the financial world as we knew it, the imminent worst recession since the Depression”.  Just when we are getting used to the idea of earnings collapsing, maybe something else is beginning to happen.

It could be the recent pickup (or slower decline) in earnings will prove to be temporary. But with the narrowing spread between LIBOR and Fed Funds (the cost of borrowing), a dramatic pickup in housing sales, and the Treasury working overtime to put Humpty Dumpty back together again, perhaps this is the start of something new.

The market is not a ballot box or a slot machine.  It is where earnings are valued in a given interest rate environment.  With the selloff in the market and collapsed interest rates, the market is now inexpensive.  A dollar in the market represents more earnings than the 30 year Treasury pays in interest. 

In a year, earnings may not look bad compared to what is happening now.

Warren Capital investors were fortunate to have protected principal by keeping a large cash position throughout 2008 and by further raising cash in the 3rd quarter.  We are prepared to take advantage of stocks in companies with stable or accelerating sales and earnings that now sell at reasonable prices relative to interest rates.

Stuart Brown

Chief Investment Strategist - Portfolio Manager
Warren Capital Group
1701 Pennsylvania Avenue, Suite 300                       2 Wisconsin Circle, Suite 700
Washington, DC 20006                                             Chevy Chase, MD  20815
Phone: 202.244.2246  fax: 240.235.6021  
sbrown@warcap.com          also at: TheMarketsValue.com
 
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